Abstract
This Selected Issues paper and Statistical Appendix for Azerbaijan aims to provide a guide to the management of Azerbaijan’s expected natural resource-generated windfall. The paper provides information on Azerbaijan’s endowment of oil and gas deposits and the projected revenue stream, and highlights the common characteristics of policies leading to the mismanagement of natural resource wealth in natural resource-abundant countries. It also outlines a medium- and long-term policy strategy for oil wealth management in Azerbaijan.
II. Managing Oil Wealth in Azerbaijan
A. Introduction
5. Azerbaijan has a substantial endowment of oil and gas deposits, estimated to be the third largest in the Caspian region. Oil production in Azerbaijan is projected to increase sharply starting in 2005, and to reach a peak around 2009 of 1.3 million barrels per day, or four times current production. Gas production is expected to increase in 2006 following the development of the Shah Deniz gas field and construction of the related gas pipeline, reaching an annual peak of twenty billion cubic meters in 2010. Even under conservative assumptions about international oil and gas prices, the expected revenue windfall to the government of Azerbaijan over the next 20 years is substantial. However, given the current underlying reserves and production profile, oil and gas revenue is expected to peak at the turn of the decade and decline gradually thereafter, and to be largely depleted by 2024.
6. In the near future, Azerbaijan will be facing the challenging task of managing its oil wealth in such a way as to reduce its dependence on potentially volatile and short-lived oil revenue. It is vital to the country’s economic future that the government manages this revenue in a way that allows the diversification of the economy, in order to ensure a steady increase in the living standards of the Azeri population. This is essential, as the oil sector—while a substantial source of revenue for the country—is not a source of much employment, with only 1.1 percent of the Azeri labor force employed in the sector in 2001.
7. Few countries that have been heavily dependent on the oil sector have succeeded in managing oil-wealth in a manner that allowed the simultaneous development of the non-oil sector. Norway and Indonesia are frequently cited as exceptions. Indeed, the Norwegian economy has experienced solid economic growth for the last three decades. The fact that Norway was already a developed and diversified industrial economy, with a long tradition of democracy, a market-oriented economy, and solid and mature institutions may largely explain its success. Indonesia undertook prudent macroeconomic policies, which at times required significant expenditure cuts and correction of misaligned exchange rates in order to adjust to volatility in oil revenues, as they sought to ensure that other export commodities (rubber, coffee, timber) continued to generate considerable income (Appendix II-1).
8. The list of countries that failed to avoid the problems associated with natural resource booms is long, including Nigeria, Angola, Algeria, Mexico, Venezuela, and Ecuador. For most of these countries, natural resource booms were the impetus for economic disorder and crises (some examples are discussed in Appendices II-2 and II-3). It is crucial that Azerbaijan designs and adopts prudent and coordinated macroeconomic policies and institutional reforms that take into consideration the experience of these countries in order to avoid the mismanagement of natural resource wealth and its implications.
9. This chapter aims to provide a guide to the management of Azerbaijan’s expected natural resource generated windfall. Section II-B discusses the economic theory of natural resource booms and explains the standard Dutch Disease phenomenon. Section II-C provides common characteristics of policies leading to the mismanagement of natural resource wealth in natural resource abundant countries. Section II-D explains the institutional arrangements of oil revenue management in Azerbaijan and estimates oil and gas revenue prospects for the country. Section II-E outlines a medium and long term policy strategy for oil wealth management in Azerbaijan, building on the lessons in Section II-C. Section II-F concludes.
B. Economic Theory and Natural Resource Booms
10. Studies of past experiences of countries rich in exhaustible natural resources reveals that natural resource-driven booms have often led to deterioration in macroeconomic performance and uneven development of industry. Sachs and Warner (1995) provide empirical evidence that economies with abundant natural resources have tended to grow less rapidly than economies with scarce natural resources. Large foreign exchange inflows due to the exploitation of natural resources often turn into a curse for the country if they are mismanaged. This adverse effect of natural resources has been called “the Paradox of Plenty” (Karl, 1999).
11. In economic theory, the adverse economic conditions associated with natural resource booms are commonly known as “Dutch Disease.” This phenomenon refers to the loss of competitiveness, or deindustrialization, of a nation’s economy that occurs when a natural resource-inspired boom raises the value of the domestic currency, making manufactured goods less competitive, increasing imports and decreasing exports.
12. A simple two-industry model can describe the Dutch Disease phenomenon. Suppose two industries are producing goods traded at prices determined in the international market. The industries employ labor from a common pool, combined with another factor specific to that sector and in fixed supply. Each industry uses capital specifically designed for that industry. If the world price of the output for one of these industries rises, the returns to that industry will increase, pushing up wages in that industry. The marginal productivity of labor in the booming industry will increase and attract labor away from the non-booming industry. This change in the sectoral composition of labor is called the resource movement effect of the boom (Corden, 1992). Higher wages in the booming industry will also squeeze profits of the other traded-goods industry that has not experienced a rise in price. As a result, the production of the second industry will decline.
13. The two-sector Dutch Disease model can be extended to three-sectors to more accurately reflect the real world: a traditional traded goods industry, a booming traded-goods industry and a non-traded goods industry. Higher real incomes from the booming sector lead to increased expenditures on both traded and non-traded goods. This does not cause the price of traditional traded goods to rise, as their price is determined in the international market. By contrast, the price of non-traded goods is set in the domestic market and does rise due to increased demand. This is called the spending effect of the boom (Corden, 1992). This real appreciation (defined as an increase in the real exchange rate, the price of nontradables relative to tradables) leads to a resource movement from the traditional traded to the non-traded sector, an expansion in the non-traded goods industry and a contraction in the traditional traded-goods industry or Dutch Disease.
14. This real exchange rate (RER) appreciation is almost inevitable during a boom, and is required to maintain money market equilibrium. Saving some of the income from the booming sector abroad in the form of foreign assets, or using it to pay off external debts ahead of schedule, could however curb domestic spending, thereby limiting the RER appreciation and its adverse consequences.
15. The importance of prudent management of revenues accruing from the booming sector and the avoidance of Dutch Disease is magnified in circumstances where natural resource revenues are expected to be short-lived, as is the case in Azerbaijan. If the boom leaves behind a noncompetitive and contracted traded-goods industry, export incomes will not be able to finance an expanded public sector and the country’s need for foreign exchange in the period following the natural resource boom. This will make an economically painful and politically difficult adjustment unavoidable.
C. Country Experiences with Managing Natural Resource Windfalls
16. The experiences of natural resource abundant countries show that, in general, authorities have tended to act based on optimistic assumptions about the size and extent of natural resource booms. Decisions regarding the spending of natural resource revenues should be based on the likely duration of the resource boom, the expected income (subject to price assumptions), extraction costs and the time horizon during which exhaustible resources may be depleted. In light of the uncertainties associated with these estimates and the unpredictable path of the terms of trade, it would be logical to take a cautious stand and forego present consumption in favor of security against unfavorable developments in the future. However, the experience of resource boom countries shows that generally, authorities tend to act on optimistic assumptions. Below are some examples of policies that have been common in both developed and developing countries managing windfalls from natural resources boom during the 1970s and 1980s and the implications of these policies.
17. Authorities frequently did not utilize higher natural resource revenues to reduce budget deficits, and tended to spend them inefficiently. Counting on high current and future income, expenditures were brought into line with a high income level within a relatively short period of time and as a result, the budget deficit widened (Mexico, Nigeria). In some cases, countries borrowed heavily against their anticipated future oil income (Algeria, Venezuela). Authorities found it difficult to reverse non-sustainable expenditure levels once the windfall subsided. In addition, authorities often granted large wage increases to public sector employees (Trinidad and Tobago, Nigeria, Venezuela) and created new government structures with new positions. Later, financing increased wage bills contributed to higher inflation.
18. In expectation of continued revenue from the resource boom, authorities undertook ambitious public domestic as well as foreign investment projects with low economic rates of return, politically attractive payoffs, inadequate screening and undiversified risk (Algeria, Trinidad and Tobago, Nigeria, Iran, Cote d’Ivoire). Often such projects served the interests of well-connected individuals. Furthermore, the maintenance costs of these large, nonviable projects were underestimated and following the resource boom, the government faced the difficult tradeoff of sharply reducing other expenditures, postponing their implementation or stopping project maintenance completely (Nigeria, Mexico, Indonesia). The discontinuation of such projects would leave valuable financial resources wasted and former employees jobless.
19. The windfall associated with the natural resource boom weakened the authorities’ commitment to undertake necessary restructuring of underdeveloped sectors. Subsidies to these sectors, which were easy to finance during the boom, became hard to maintain after revenues from the booming industry declined. The ailing sectors would have functioned without subsidies, or at least with substantially smaller subsidies, had they undergone the necessary restructuring during the boom times. In general, authorities of countries endowed with rich natural resources tended to be overly confident and underestimated the need for the creation and development of growth conducive institutions and infrastructure (Gulfason, 2001).
20. The exploitation of natural resources often promoted rent-seeking behavior, especially under conditions of inappropriately defined property rights and lax law enforcement. Windfall revenue from an export boom also contributed to social problems such as corruption, and caused further imbalance in the income distribution. The neglect of the environmental impact of natural resource exploitation led to unrecoverable damages, requiring a high cost of restoration (Nigeria, Ecuador, Indonesia).
21. Following a natural resource boom, stop-gap policies adopted to counteract the resultant economic imbalances tended to have a further negative impact on the economy. After an adverse terms of trade movement, the traditional traded goods sector was not in a position to earn the necessary foreign exchange, and authorities employed protectionist policies such as restrictive quantitative controls, import quotas, higher tariffs and bureaucratic barriers to prevent foreign exchange outflows. Such inward-looking policies hurt the manufacturing sector and made repayment of external debt difficult (Ecuador, Nigeria, Mexico).
22. Many natural resource rich countries created savings or stabilization funds with the aim of protecting the domestic economy from a volatile path of natural resources revenues or for saving the windfall resources for future generations. The study of experience of such funds in five selected countries by Fasano (2000) showed that saving natural resource revenues in such funds and investing the funds’ resources abroad might have contributed to limiting domestic spending pressures (spending effect) and reducing real exchange rate appreciation during periods of a rising price for the natural resource (Norway, Chile). The same study concludes that the experience with stabilization funds has at times been less positive, due to frequent changes in the fund’s rules and deviations from their intended purposes (Venezuela, Oman). Success did not lie in the creation of such funds, but rather in fiscal discipline and sound macroeconomic management.
23. To avoid the consequences of a mismanaged natural resource boom, Azerbaijan will need to make important decisions about consumption, savings and investment policy, and not relax its attention to underlying structural problems. If the country does not prepare itself properly before the boom occurs, this may at the end bring economic disorder.
D. The Oil Sector in Azerbaijan
24. Azerbaijan has a rich natural resource endowment and a long history of oil and gas exploration. Oil and gas reserves in the country are estimated to be the third largest in the Caspian region.1 Oil production peaked in 1941 at 172 million barrels of oil, or almost 75 percent of the output of the Soviet Union. From there, production declined steadily, dropping off sharply in the final years of the Soviet Union. Only in the late 1990s did discoveries of new oil and gas reserves lead to a turnaround in output, driven primarily by foreign investment from international partners.
25. The management of the oil sector falls into two categories. Soviet-era oil and gas fields are operated by the state oil company (SOCAR) with weak prospects for a further expansion of production. Most new fields are developed and managed under the leadership of international partners. Income from these operations is shared with the government according to pre-determined production sharing agreements (PSAs).
26. Azerbaijan has signed a number of PSAs for the exploration and development of the country’s hydrocarbon resources. In 1994, the government signed its first foreign-partnered PSA, popularly referred to as the “Contract of the Century” with the international consortium, the Azerbaijan International Operating Company (AIOC), to develop the Azeri, Chirag and Guneshli (ACG) oil fields in the Azerbaijan sector of the Caspian Sea. In addition, 21 other PSAs have been signed and ratified since then for the exploration and development of the country’s onshore and offshore hydrocarbon reserves.
27. Despite some significant oil and gas discoveries, most PSAs have yet to find commercially viable oil or gas deposits. In 1999, potential recoverable natural gas resources in excess of 14 trillion cubic feet were confirmed in the Shah Deniz field, reportedly the largest natural gas discovery since 1978. In 2002, total oil reserves in the ACG fields were determined to be higher than anticipated at 5.4 billion barrels. Current production stands at around 130,000 barrels per day (bpd), with peak production of slightly over a million barrels of oil per day anticipated at the turn of the decade. The recently sanctioned pipeline project from Baku to Ceyhan has greatly enhanced these prospects. However, the success of the other 20 PSAs has been limited. A few PSAs have been abandoned due to the lack of commercially viable oil deposits. To date, only one other PSA (Salyan Oil Consortium), in addition to ACG, are in the production stage while a few others are under discussion for abandonment.
Current Institutional Arrangements for Managing Oil Revenues
28. The separate operational structures for old and new fields have led to a division in the management of related oil and gas revenue. Figure II-1 summarizes the government’s main oil revenue sources and the two respective government bodies—the state budget and the State Oil Fund–involved in the management of oil and gas revenues. The consolidated government receives profit oil and income tax from the development of new fields as spelled out in the PSAs with international partners. These flows accrue to the State Oil Fund. The old fields, operated by SOCAR, generate income tax revenue, which is paid to the state budget.
Sources of Oil and Gas Revenue in Azerbaijan
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources of Oil and Gas Revenue in Azerbaijan
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources of Oil and Gas Revenue in Azerbaijan
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
29. The State Oil Fund (SOFAZ) is the key institution for the management of oil wealth in Azerbaijan (Box II-1). It was established in 1999 as an extrabudgetary fund in order to ensure transparency in the management of oil revenue and to curtail the use of assets. Its main purpose is to save funds for future generations, but assets are also used for investment projects. As of end-December 2002, the total assets of SOFAZ amounted to US$693 million.
30. Significant additional oil revenue accrues to the state budget primarily from SOCAR tax payments. In 2002, oil and gas related revenues of the state budget were US$340 million, about US$100 million higher than receipts of SOFAZ. However, as SOCAR’s production will decline over time and new fields are developed, inflows to the oil fund will dwarf state budget revenue as early as 2006 (see discussion below). Unifying the government’s management functions for oil revenue should be an important consideration in view of the challenges arising from the expected oil boom, as discussed below.
Prospects for Government Oil and Gas Revenues
31. Substantial, but short-lived, revenues associated with the development of the oil and gas fields are expected to accrue to the country from (i) profit oil and profit gas according to the terms of the ACG and Shah Deniz PSAs (ii) profit tax payments from partners under the PSAs and (iii) SOCAR tax payments. Figure II-2 presents the accumulation of natural resource revenue from the three sources for different production scenarios. Projections for SOCAR revenue are based on a slightly declining output profile consistent with current production expectations. SOFAZ inflows of profit oil and profit tax associated with the development of the ACG and Shah Deniz oil and gas fields, and are calculated under three production profiles; the baseline scenario which reflects the stated 5.4 billion barrels of ACG oil reserves, an upside sensitivity (scenario A) consistent with an assumption of reserves higher than the baseline scenario and a downside sensitivity (scenario B) consistent with an assumption of reserves lower than the base case, over the period 2000-2024. All three scenarios utilize World Economic Outlook (WEO) oil price assumptions as of end-March 2003. Under the baseline scenario, substantial oil and gas-related revenues are expected to accrue, with revenues increasing twelve-fold during the period 2000-2010. However, this sizeable increase in revenues is short-lived, as following the peak in 2010, inflows to the SOFAZ decline fairly rapidly and end after 2024, absent a significant new hydrocarbon discovery.
Azerbaijan Oil Revenues, 2000-2024 *
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.* Based on WEO oil price assumptions and excluding asset management revenue.Azerbaijan Oil Revenues, 2000-2024 *
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.* Based on WEO oil price assumptions and excluding asset management revenue.Azerbaijan Oil Revenues, 2000-2024 *
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.* Based on WEO oil price assumptions and excluding asset management revenue.State Oil Fund of the Azerbaijan Republic
The State Oil Fund of the Republic of Azerbaijan (SOFAZ) was established in 1999 as an extra-budgetary institution. Its main objective is the professional management of oil and gas related revenues for the benefit of the country and its future generations—i.e., savings. The inflow and outflow rules of Azerbaijan’s oil fund have been designed to reflect this feature and to save a large part of government oil and gas revenue. SOFAZ receives all government revenues associated with the post-Soviet oil and gas production fields. The oil fund has no immediate stabilization objective and net flows are not related to the oil price level or a budgetary position. On the outflow side, Azerbaijan’s oil fund rules currently prohibit spending in excess of inflows in any given year. A conservative expenditure policy has ensured a steady growth of savings in the fund. Asset management regulations require that financial assets must be kept offshore at highly rated banks. The fund is not permitted to extend credits to private or state organizations and assets cannot be used as a guarantee against any obligation.
In order to reduce political pressures to spend windfall oil revenues rapidly, the government established the oil fund under direct presidential control. The members of SOFAZ’s supervisory board are appointed by the President of Azerbaijan. An independent auditor conducts an annual audit of the fund, and the audit report is made public. SOFAZ reports quarterly in the press on total inflows received, expenditures and interest earned. The creation of an oil fund in Azerbaijan has had a positive impact on fiscal discipline and contributed to better transparency and accountability of oil revenue management.
32. Even under more conservative price assumptions the expected revenue stream is large. Figure II-3 presents the same three production scenarios, but assumes a fixed US$20 per barrel oil price. Even under this more conservative price assumption, revenues are expected to increase almost nine-fold during the period 2000-2010 for the baseline scenario. As these charts indicate, even under a wide range of production profiles and oil price assumptions, a similar pattern of oil revenue receipts emerge: an accrual of substantial revenues during a relatively short period of time.
Azerbaijan Oil Revenues, 2000-2024 *
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.* Based on a fixed US$20/barrel oil price assumption and excluding asset management revenue.Azerbaijan Oil Revenues, 2000-2024 *
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.* Based on a fixed US$20/barrel oil price assumption and excluding asset management revenue.Azerbaijan Oil Revenues, 2000-2024 *
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.* Based on a fixed US$20/barrel oil price assumption and excluding asset management revenue.E. Strategy for Managing Oil Wealth
33. With this significant asset stock, the key challenge for the government will be to strike the right balance between current expenditures and conserving assets for future generations. The government’s decision about how much to spend and how much to save involves important trade-offs. For example, addressing poverty and infrastructure needs quickly may alleviate poverty in the short-run, but may pose a risk to macroeconomic stability and damage the long-term growth potential of the non-oil sector. On the other hand, using a measured approach to the use of oil revenue assets will require a strong political commitment and public engagement to fend off political pressures for increased spending, and could be hard to justify in the face of undeniable and substantial needs.
34. One way of addressing this challenge is to separate the expenditure problem into a long-term strategy focused on conserving financial assets for future generations, and a medium-term strategy within this framework aimed at meeting immediate policy challenges. Determining expenditure priorities and fine-tuning medium and long-term policies will be a recurring problem for the government. Separating this problem into a two-step process reduces its complexity and makes it more tractable. The proposed approach provides no specific expenditure plan, as that will require critical political decisions. Instead, it provides a framework for the government to use in determining its own medium-term plan consistent with long-term policy objectives. As economic conditions change, these plans will have to be regularly updated and modified.
35. The next section discusses the determination of a long-term strategy which sets a ceiling for feasible expenditure plans in the medium-term. The subsequent section discusses medium-term policy options.
Long-Term Consumption and the Sustainable Non-Oil Balance
36. Any long-term savings objective limits the amount of available assets for immediate consumption in order to spread out its use over time. The concept of a sustainable non-oil deficit ceiling translates this restriction into an upper bound for the permissible government deficit consistent with the savings objective. In other words, it defines what the government can afford to spend over the long term without exhausting its assets, and corresponds to a path of expenditures that can permanently be financed from the use of oil revenue. The non-oil balance—as a direct measure of the level of activity that is financed from oil revenue—is a crucial guide for fiscal policy in oil producing countries. Other common measures of government activity, such as the overall balance or the current balance, obscure the actual fiscal stance as they are affected by changes in oil prices (Ossowski and Barnett 2002).
37. One long-term objective would be to ensure that spending from oil wealth remains constant in real terms, thus providing a permanent income stream (Box II-2). Under this strategy, each future generation would be able to consume the same real amount out of oil and gas wealth. Alternative objectives could be constant per-capita real spending or constant spending as a percent of non-oil GDP. The per-capita concept takes population growth into account, while the GDP concept links expenditure to economic growth, and thus saves a greater share of assets for future generations. Empirical estimates show that the concepts have similar implications; namely, that they permit, in the near future, high expenditures relative to current levels. Since Azerbaijan has large social and investment needs, the more frontloaded approach of constant real expenditures appears reasonable. As non-oil GDP grows in coming years, future generations will be able to afford to be relatively less dependent on oil wealth. A further advantage of using the concept of constant real expenditures is its computational simplicity and ease of interpretation, which makes it a suitable object for policy discussions.
38. Figure II-4 and II-5 provide estimates of the sustainable non-oil deficit for the period 2003-2024 that ensure constant real expenditures from oil wealth. The calculations are based on the production patterns and resulting revenue flows discussed above.2 The implications of two oil-price scenarios are analyzed. The figures assume the long-term nominal interest rate is 7 percent, inflation is 2 percent, and the nominal non-oil sector growth rate is 5 percent. The general trend of the sustainable non-oil deficit is downward sloping from a fairly high level in 2003-2010 to below 10 percent of GDP by the end of the period. As the economy grows at a higher rate than inflation, the share of real expenditures as a percentage of GDP declines. For the baseline case, non-oil deficits approach 8 percent of GDP by 2024 for both price scenarios. A one point reduction in the real interest rate assumptions would tighten the sustainable ceiling by roughly 3 percentage points of GDP at the beginning of the period and by about one percentage point at the end of the period.
Sustainable Non-Oil Deficit Ceiling, 2002-2024
(WEO oil prices)
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimatesSustainable Non-Oil Deficit Ceiling, 2002-2024
(WEO oil prices)
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimatesSustainable Non-Oil Deficit Ceiling, 2002-2024
(WEO oil prices)
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates
Sustainable Non-Oil Deficit Ceiling, 2002-2024
($US 20 per barrel)
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.Sustainable Non-Oil Deficit Ceiling, 2002-2024
($US 20 per barrel)
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.Sustainable Non-Oil Deficit Ceiling, 2002-2024
($US 20 per barrel)
Citation: IMF Staff Country Reports 2003, 130; 10.5089/9781451802634.002.A002
Sources: Azerbaijan International Operating Company and IMF staff estimates.Sustainable Expenditure from Oil Wealth
The sustainable expenditure from oil wealth for a given fiscal year is the amount that can be consumed and still leaves sufficient oil and gas oil wealth for an equal real amount to be consumed in all later fiscal years. Oil wealth at a particular point in time is the sum of the value of current financial assets and the present value of expected future oil and gas revenues. Sustainable expenditure for any particular fiscal year can be calculated through the following steps.
Collect the following data:
The value of oil and gas assets at the end of the previous fiscal year (V)
Projections for expected oil and gas revenues for fiscal year (R1) and future fiscal years (R2,…, Rn)
Estimated average nominal rate of return (or interest rate) on investments in the future (r)
Estimated rate of inflation (p)
Calculate:
Oil Wealth
The level of sustainable expenditures is pinned down by the requirement that the value of Oil Wealth must be equal to the present value of all future expenditure C i.e.:
W=C
The present value C is given by the sum of sustainable expenditure growing at the rate p:
where E2003 denotes the level of sustainable expenditures in 2003.
Sustainable expenditure Et in any given year t can be easily obtained by solving this condition.
Intuitively, this equation states that sustainable expenditure is equal to interest earned minus inflation, which is the amount that needs to be saved in order to have assets grow at the same rate as expenditures.
39. The conservative price scenario still leaves a sizeable cushion for expenditures compared to planned 2003 spending. Under the low-price, low-production scenario (the most conservative scenario), the sustainable deficit ceiling would be 11.7 percent of GDP for 2003. This most conservative estimate would still be in excess of the currently envisaged level in the budget of 9 percent of GDP, but clearly any future spending increases would have to be monitored for consistency with the long-term expenditure ceiling.
40. Adherence to the expenditure ceiling would be crucially important to ensure that long-term savings objectives are met. The sustainable deficit ceiling would set a simple and transparent rule for the level of expenditures financed from oil revenue, consistent with long-term savings objectives. It would be easy to measure and adherence to the implied rule could be well monitored.
41. That said, the sustainable deficit ceiling is not meant to be an unalterable target. Rather, it is determined on the basis of a savings prescription that needs to be regularly reviewed in light of changing information and economic conditions. Like any good fiscal rule, the sustainable deficit ceiling needs to be both simple and flexible. As new and more accurate information on production patterns, natural resource reserves or price developments become available, the government should review the appropriateness of its long-term assessments. Revisions should be made at regularly spaced intervals (e.g., 3-5 years), or if information becomes available indicating that the given sustainable deficit ceiling may no longer be prudent (e.g., too optimistic production assumptions). Formal reviews should be made on the basis of pre-specified rules clearly identifying changes made to relevant variables and the underlying reasons for any changes.
42. Finally, special considerations may lead the government to at least temporarily pursue a savings path different from the sustainable ceiling. One example is demographic financing needs associated with pensions obligations related to population aging. Declining birth rates and increased life expectancies can pose significant financing requirements on future generations. In this case, precautionary saving in anticipation of future use of assets may be a prudent policy and require a tighter savings path than one permitted by the sustainable deficit ceiling. Once the financing needs materialize, the government can then increase spending, which could result in spending levels above the prescribed sustainable ceiling. A wide ranging debate in Norway on pension funding led to the postponement of consumption of oil assets in order to form reserves for future pension payments. In Azerbaijan, a similar situation is conceivable. A sizeable post World War II birth cohort will begin to retire starting in 2010. Projected population growth rates will only moderately increase the labor force and the expected increase in the old-age dependency ratio could therefore, put severe strains on the existing pay-as-you-go pension system. The government should carefully analyze whether any special considerations, such as this, would warrant a more ambitious savings trajectory than the one prescribed by the sustainable non-oil deficit ceiling.
The Medium Term: Managing Macro-Stability and Non-Oil Sector Development
43. Estimates for the long-term sustainable non-oil deficit appear not to constrain expenditure plans for the use of oil and gas revenues over the medium-term in Azerbaijan. The expected oil revenue boom, while short-lived, is substantial compared to current levels of economic activity. Under existing assumptions for production plans and oil prices, the government could afford a non-oil deficit far in excess of the planned amount and still be able to afford the same constant real expenditures each year. Thus, long run considerations are an insufficient guide for near-term expenditure plans.
44. Therefore, the government’s key challenge is to determine the level and composition of oil revenue financed expenditures that are appropriate for the medium-term. The government will be faced with the difficult question of how fast it should accelerate spending within the ceiling of sustainable expenditures, and on what it should spend the resources. While there are no simple prescriptions to guide the government through these decisions, a number of critical mistakes made by other countries need to be avoided.
45. Country experience with oil revenue booms, as discussed above, have identified three crucial policy objectives for the medium to long-run, the attainment of which are closely interconnected:
Maintenance of macro-stability
Development of a productive non-oil sector
Efficient use of assets.
46. III-timed and excessive increases in the use of oil revenue can be disruptive to the economy. As discussed above, high public expenditures can lead to economic overheating, resulting in wage and price pressures and real appreciation, as witnessed by many countries faced with a revenue boom. These destabilizing effects can severely harm private sector development and tilt demand away from a competitive export industry towards a bloated domestic services sector. Thus, maintaining macro-stability is a key condition for non-oil sector growth. Finally, an efficient use of resources is complementary to meeting the first two objectives. Here, tasks range from designing an effective institutional structure for policy design and coordination to capacity building for project appraisal, selection, and ex-post evaluation. Effective resource management is also key for ensuring long-term sustainability of expenditures.
Policy Options in the Medium Term
47. Meeting these objectives will require the improvement of existing policy instruments, design of comprehensive medium-term policies, and a constant review of the adequacy of given policy choices. Traditional policy instruments will have to adapt to the new challenges of large asset flows in order to cope with the implications for economic stability. Policies for the medium-term have to be well coordinated and comprehensive to ensure consistency with non-oil sector development. Finally, chosen policies will have to be sufficiently flexible (e.g., prioritized) to allow an adequate response to changing economic conditions.
48. The main burden of maintaining economic stability will be on fiscal policy, since monetary instruments have only limited capacities to manage resource inflows. Given a modest holding of government securities and a thin market for central bank bills, sterilization of excessive spending of the oil boom may be difficult to accomplish (see Box II-3). By directly controlling the injection of oil revenue into the economy, fiscal policy is therefore the key tool for macroeconomic management.
Monetary Policy Response to Natural Resource Booms
Experience with natural resource booms suggest that some degree of real exchange rate (RER) appreciation is inevitable, and actually desirable to affect the reallocation of factors of production in the economy necessary to accommodate these booms. The response of monetary policy has important implications for the channels through which this RER appreciation takes place.
A resource boom typically raises domestic absorption, and therefore, the demand for money in real terms. If monetary policy does not accommodate, at least in part, this increase in money demand through an expansion of money supply, the result may be an excessive nominal appreciation of the exchange rate. On the other hand, if the increase in absorption is particularly strong, full accommodation may lead to an excess supply of money, and thus higher inflation, undermining the main goal of monetary policy—i.e., the maintenance of domestic price stability.
The key therefore, is to strike a balance between price stability and nominal appreciation. Prudent fiscal policies are essential for this balance to be reached, particularly in the case of countries with underdeveloped domestic financial markets, such as Azerbaijan. Experience from Asia, for example, suggests that open market operations have proved inadequate to stabilize monetary growth, and thus inflation, during periods of particularly severe disturbances (Tseng and Corker 1991). This reflected a variety of factors, but most importantly included an inadequate development of markets and instruments for open market operations.
In the case of Azerbaijan, sterilization of excessive spending of the oil boom may be difficult to sustain, in view of the Azerbaijan National Bank’s (ANB) limited holding of securities and a thin market for ANB bills. Under these conditions, the effectiveness of open market operations will be constrained for the foreseeable future. It is therefore imperative that fiscal policy remains prudent and consistent with the maintenance of macroeconomic stability, and that it does not lead to an excessive appreciation of the real exchange rate. There is also a need to strengthen coordination of macroeconomic policies between the Ministry of Finance (MOF) and the ANB.
49. Strengthening fiscal policy will require a less fragmentary approach to managing the use of oil revenue and a careful analysis of the overall implications for domestic demand. Currently, oil revenue is managed by different government agencies (the state budget and SOFAZ) and the use of resources is not systematically coordinated. While assets from the SOFAZ are primarily directed towards capital projects, revenues accruing from SOCAR’s domestic operations are perceived as a general government finance source. In addition, while the government seeks to use the oil fund as an instrument for saving oil wealth, completely separate arrangements—independent of the oil fund—are being made for stabilizing the flows of oil revenue to the state budget. This treatment clouds the true dependency of government operations on oil revenue and makes coherent demand management difficult. By treating all oil revenues as a single source of financing, the government could better manage the overall impact of its use on the economy. In conjunction, the government should develop and maintain a model for projections of oil and gas revenues for planning purposes.
50. Strategic planning and enhanced coordination of macroeconomic policies will be crucial to accomplish this goal. In particular, the annual budget should be firmly embedded within a sound medium-term expenditure strategy, which balances the needs of macroeconomic stability and non-oil sector growth with expenditure priorities from the Poverty Reduction Strategy Paper (PRSP) and the government’s investment program. The appropriateness of fiscal and monetary policy will have to be regularly re-assessed (e.g., quarterly), discussed in a broad government forum, and realigned if necessary. In addition, government institutions, such as the public investment unit, will have to be strengthened as discussed below.
51. In striving for macroeconomic stability, the government should avoid large swings in fiscal activity by smoothing changes in the non-oil deficit and only gradually accelerating oil revenue spending. High fiscal volatility harms private investment and economic growth, as demonstrated by experiences in other countries with oil windfalls. Fiscal volatility is also likely to contribute to instability of the real exchange rate, impairing growth in the non-oil sector. Therefore, the government should strive for a predictable government expenditure path with a smooth non-oil balance over the medium run, and should move gradually to this sustainable non-oil deficit.
52. Equally important for managing the macro economy and non-oil sector growth is carefully planning the content and composition of overall expenditures. As government spending affects domestic demand and influences private sector activities, the specific use of oil revenue greatly influences economic stability and non-oil sector growth prospects.3 Therefore, when designing its medium-term strategy, the government should thoroughly analyze the composition of its overall spending plans:
Current versus capital spending? Since oil revenue is an exhaustible source of financing, it is generally preferable to direct spending toward capital projects. Financing needs for investments are by nature limited and not permanent as is the case for current expenditures. In addition, current spending (e.g., public wages) often directly fuels domestic consumption, as consumers demand domestically produced goods and services. On the other hand, investment projects with high import content may have only a moderate direct effect on domestic demand.
What type of capital investments should be undertaken? A key role of the government is to generate conditions in support of private sector development, including a well-designed and reliable physical infrastructure. Thus, capital investments should target basic infrastructure needs, such as the reliable provision of energy and water, and an efficient transport and communications network, particularly in regions outside the capital city. Such capital expenditures will have a direct positive impact on the competitiveness of the non-oil sector, stimulate regional development and help offset the negative effects of an appreciated real exchange rate.
What are the implicit commitments contained in capital expenditures? Large investment projects not only require expenditures over several years, but also often bring with them substantial future maintenance costs. These costs are often underestimated and have led to a significant waste of resources when maintenance costs could no longer be afforded. In this context, the design of a notional maintenance fund could be considered (Box II-4). Similarly, expansions in pension and social programs can have significant long-term implications which could erode the government’s ability to manage the use of its oil revenue assets.
Establishing a Notional Investment Maintenance Fund
A responsible investment strategy should not only incorporate immediate project costs, but also proactively save for long-term maintenance costs. These recurring costs are often vastly underestimated and have led to the significant waste of assets in many countries with resource booms. One possible way to avoid this problem would be to identify already committed assets for future capital maintenance purposes. This could be done by creating a notional investment maintenance account. Whenever a new investment project is undertaken, this account would be credited with the present value of future maintenance costs of the project. At the same time, the stock of available assets in the oil fund for financing new projects would be reduced by the same amount. During budget preparation, the government would first have to meet maintenance costs for existing capital projects from the maintenance fund, and only afterward could it commit new assets from the remaining asset pool for new investment projects. In conjunction with a limit on the non-oil deficit, this arrangement would ensure that no resources are committed in excess of the sustainable expenditure ceiling. The maintenance fund would also demonstrate to the public how much oil and gas assets have already been committed, and how much are truly available for use.
53. One way increased non-oil deficits can strengthen the private sector is through reductions in tax rates. Instead of using oil revenue exclusively for additional expenditures, the government could alternatively reduce the tax burden within the country by lowering taxes on the non-oil sector. This policy has the advantage that it can potentially reach a large share of the population and thus broadly distribute the benefits from oil wealth. In addition, a lower tax burden can ease competitiveness pressures from a higher real exchange rate and offset some of the potentially damaging effects from increased oil-revenue spending.
54. However, the government should carefully weigh the benefits and costs before undertaking any far reaching tax policy changes. First, tax policy should be evenly applied by removing widespread exemptions. Significant uncertainty about the government’s oil wealth warrants caution. Reductions in tax rates are likely to be permanent, since tax cuts are usually hard to reverse. An erosion of the domestic tax base could therefore backfire if the value of oil assets has been overestimated or assets are depleted faster than anticipated.
55. Finally, addressing medium-term challenges for fiscal policy design requires significant capacity building. In particular, the government needs to increase its ability in fiscal policy analysis and project appraisal in order to effectively implement a viable medium-term fiscal policy. Improved fiscal policy analysis will strengthen the government’s ability to assess current developments, identify the appropriate fiscal stance, and react when necessary to changes in the short-term macroeconomic environment. In parallel, the government needs to devote additional human resources to strengthening macroeconomic policy formulation and building a viable public investment unit for expenditure planning and project evaluation. This will allow the government to prepare prioritized expenditure plans, review the productivity of individual projects, and assess consistency with the overall policy objectives of macro-stability and non-oil sector growth. In the absence of adequate institutional capacity, the government may run the risk of undertaking projects with low social returns leading to a waste of resources, as has been documented above.
F. Conclusion
56. In the near future, Azerbaijan is expected to benefit from a substantial, but short-lived, oil and gas-related revenue windfall. Even under conservative assumptions, revenues accruing to the country are expected to average around US$800 million during the period 2003-2007 and over US$2 billion per year during the period 2008-2024, compared to 2002 GDP of just over US$6 billion. As few countries have been successful in managing natural resource wealth of this relative magnitude, the government faces a key and immediate challenge: managing this short-lived natural resource wealth in such a manner as to avoid the pitfalls of Dutch Disease and ensure the simultaneous development of the non-oil sector.
57. This chapter aims to provide a broad policy agenda for the government for managing this natural resource wealth. The key policies and recommendations in the chapter are as follows.
Institutional Arrangements and Capacity
Consolidate oil revenue management and treat all oil revenue as one source of financing.
Develop and maintain a model for long-term projections of oil and gas revenues.
Develop institutional capacities for project selection, monitoring, and evaluation, including the establishment and development of a project appraisal department as well as capacity building in fiscal policy analysis.
Level of Expenditures
Set expenditures of oil and gas revenues consistent with a long-term savings objective of conserving assets for the future, particularly given the short-lived nature of the windfall. The goal should be to ensure constant real expenditures out of oil wealth.
Use the concept of a sustainable non-oil deficit to provide an expenditure ceiling for the use of oil assets that is consistent with this long-term savings objective. Under the baseline scenario for oil and gas reserves and conservative assumptions for the price of oil, substantial non-oil deficits are affordable until 2010, with subsequent steadily declining non-oil deficits which approach 8 percent of GDP by 2024.
Avoid large fluctuations in the non-oil deficit.
Revise the estimate of the sustainable non-oil deficit in light of new information. The appropriateness of the sustainable non-oil deficit should be reviewed at regular and sufficiently spaced intervals, based on updated information on oil and gas reserves, production patterns, and price developments.
However, as the sustainable non-oil deficit provides only an expenditure envelope for the medium term, do not increase expenditures to this ceiling in the near future. This would not be advisable given the macroeconomic implications of excessive growth in spending. In particular, a rapid increase in expenditures consistent with this ceiling could exert substantial upward pressure on the exchange rate with all its negative consequences for the non-oil sector. It could also strain the government’s institutional capacity for planning, executing and monitoring expenditures, resulting in substantial waste.
Take macroeconomic stability considerations into account when deciding how much oil revenue to spend in the medium term. Strengthened coordination between the Ministry of Finance and the Azerbaijan National Bank will be imperative.
Composition of Expenditures
Revenues should be utilized primarily for investment rather than consumption. Expenditures on physical and human capital will provide a solid foundation for the future growth of the country, while excessive current consumption could have a potentially destabilizing impact in the short-term. Capital expenditures have the added advantage of a substantial import content, providing an automatic means of sterilizing part of the substantial foreign exchange inflows associated with the oil windfall.
Capital investment should target the building and maintenance of a well-designed physical infrastructure necessary for improving the competitiveness of the non-oil sector, including the reliable provision of energy and water and an efficient transport and communications network, particularly in the regions outside the capital city.
A notional investment maintenance fund should be established for meeting recurrent costs associated with physical infrastructure projects. This would increase transparency of already committed resources and ensure proactive savings for long-term maintenance costs.
Reductions in tax rates could be an alternative to increased expenditures, with the direct positive impact on competitiveness offsetting, at least in part, the negative effects of real appreciation.
58. Political pressures for excessive and speedy expenditures of oil wealth are inevitable. For the government to withstand such pressures will be necessary for the economy’s long run development. But this will not be easy. The government will need to demonstrate to the population not only that oil wealth is being saved for future generations, but that it is also being used to effectively benefit the current population of Azerbaijan. The policies recommended above—focusing on infrastructure development and protecting non-oil competitiveness-—should help generate new employment opportunities and meaningful economic growth. If the government can succeed in doing this, and also succeed in explaining to the population the dangers—not just to future generations but to the current population of Azerbaijan as well—of excessively rapid expenditures out of oil wealth, Azerbaijan may succeed where so many other oil producing countries have failed: It may manage to use its oil wealth to help develop the non-oil sectors of its economy.
APPENDIX II-1: Oil and Economic Development in Indonesia
Indonesia’s oil industry is one of the world’s oldest. Indonesia ranks 15th among world oil producers, with about 2.4 percent of world oil production. The country has a mixed economy in which the government, in addition to the regulation and supervision of the economy, is engaged directly in economic activities through state-owned enterprises operating in various sectors.
Between 1960 and 1966, the country suffered from hyperinflation, and GDP grew at an average rate of only 1.8 percent per annum. In 1966, the government started the implementation of an economic policy program (“New Order”) designed by a team of presidential economic advisors. Stabilization was achieved soon thereafter in 1971 with 4 percent inflation and 6 percent GDP growth. In 1973, oil exports accounted for only around a third of total exports because of the country’s richness in natural resources (rubber, coffee, timber). International reserves grew rapidly after the first oil boom in 1972-78 and the windfall oil revenues of 1973-78 allowed the authorities to increase spending on development. Around half of mining value-added was used to finance public investment, one third was utilized to reduce the trade and non-factor services deficit and the rest was spent on consumption. The rapid growth of international reserves together with high domestic spending contributed to a sharp real exchange rate appreciation, and many non-oil sectors, such as rubber and manufacturing, started to experience difficulties. The government regarded increasing dependence on oil revenues as risky in light of uncertain prospects for oil prices and realized that future growth had to come from labor intensive exported goods. In 1978, the government decided that the devaluation of the domestic currency would help to restructure the economy to make it less reliant on oil and to move towards manufactures and non-oil exports. The devaluation of the currency by 50 percent was followed by inflation of 22 percent in 1979. The devaluation was generally regarded as successful since manufactured exports doubled during 1978-79 and the non-oil trade balance improved. The reason for devaluation was not balance of payments troubles—reserves coverage was at four months’ of imports. The aim was to help the relatively labor-intensive non-oil traded sectors.
The second oil boom raised Indonesia’s mining sector revenues again. The government increased spending once more, but the absorption of windfall oil revenues was much below the level of expected oil income and foreign aid and part of revenues were saved. This differed from the approach during the first oil boom. Oil prices started to fall in 1981 and due to a rapidly growing trade imbalance, the current account turned into a large deficit. Capital inflows were insufficient to finance the high trade deficit and foreign exchange reserves started to fall. The authorities decided to devalue the currency again to stop private capital outflows in the short term and to improve the non-oil trade balance. In 1983, the domestic currency was devalued by around 50 percent, and for the second time in five years, relative prices of traded goods and non-traded goods changed sharply. Fiscal policy was tightened and was supportive of the devaluation. In mid-1983 more than $10 billion in capital intensive public projects, amounting to almost 12 percent of GDP, were cancelled or postponed. This sharp reduction in government spending allowed the government to implement an expenditure-switching policy from industry to infrastructure and social sectors. In 1984, the authorities introduced a simplified tax code with a rudimentary form of VAT, which is easier to administer and monitor for the non-oil sector. Immediately following the devaluation, the authorities liberalized the financial system to create incentives for lending, increase competition and greater mobilization of domestic savings. This devaluation proved successful too—during 1983-85 non-oil and manufactured exports increased, non-oil imports fell, foreign exchange reserves strengthened and the overall government budget returned to balance.
Indonesia’s experience with oil windfall management stands out as relatively successful compared to other oil exporting countries. Three key factors contributed to this success: oil was not the only source of export earnings and exports of other commodities were generating considerable income; the authorities did not rely on oil sector revenues alone and tried to diversify the economy—the country was a strong non-oil exporter during the periods of the oil booms; the Indonesian government adapted macroeconomic policies to changing external environment.
Sources: Rudiger Dombusch, F. Leslie C. H. Helmers, “The Open Economy, Tools for Policymakers in Developing Countries,” 1987; Alan Gelb and Associates, “Oil Windfalls-Blessing or Curse?” 1988.
APPENDIX II-2: Oil and Economic Development in Nigeria
Nigeria has an abundance of hydrocarbon resources. It is the 13th largest oil producer in the world, the third largest oil producer in Africa and the most prolific oil producer in Sub-Saharan Africa. Prior to I960, agriculture was the dominant sector in the Nigerian economy and the country was a major producer of cocoa and palm products. Oil production in Nigeria started in 1958 and increased over time to reach the export of 2 million barrels of oil per day by 1972.
With the first oil boom of 1972-78, Nigeria’s terms of trade increased three times and international reserves almost tenfold between 1973 and 1974. Oil revenues accounted for almost 85 percent of the country’s total exports and around 60 percent of federal government revenues in 1973. At this stage, the government faced the question of how to use such vast unplanned revenues. The fiscal authorities ignored the risk of future reversal of the current favorable conditions and chose to spend these revenues by undertaking massive domestic investment projects. Public capital spending accelerated rapidly, absorbing more than the total increase in 1970–76 oil revenues, resulting in a large budget deficit, which was financed with the use of reserves accumulated in 1973–74 and monetary expansion. These policies resulted in inflation—prices increased by 22 percent and, with a mainly fixed exchange rate, the real exchange rate appreciated strongly.
The country was not successful in diversifying the economy out of oil, particularly as specific policies further negatively affected the once strong agriculture sector. Production of major agricultural export crops shrunk by half from 1964 to 1978, partly because the government created commodity boards to stabilize crop prices and taxed farmers by paying them substantially less than world prices. Nigeria became a net importer of agricultural products in 1975.
The government responded to the difficult economic situation by expenditure cuts in 1978 but did not address the issue of the overvalued real exchange rate. The second oil boom saved the government from undertaking further painfull adjustments. Nigeria’s terms of trade increased by 25 percent and 40 percent in 1979 and 1980 respectively, and the international reserves position strengthened significantly. However, the Nigerian government did not take into account the lessons of the past. In light of the increasing oil revenues, fiscal constraints were relaxed and expenditures rose by 65 percent in 1980, to resume the suspended construction projects and to undertake new ones. However, the second oil boom did not last long, oil export receipts halved between 1980 and 1982, and this expansionary fiscal policy resulted once again in large fiscal deficits by 1982. Foreign exchange reserves fell sharply and the real effective exchange rate appreciated by 125 percent compared to its 1976 level. Inflation reached 60 percent during 1980–1983. The government introduced restrictive quantitative controls and import quotas on goods and services which hurt the manufacturing sector. In addition, payments arrears on foreign debt were accumulated, adversely affecting Nigeria’s credibility in international capital markets. At this point, the government approached creditors to prolong existing loans and to get new financing. By the end of 1983, the Nigerian economy was in trouble again and in December 1983, a military coup took control of the government.
Nigeria failed to use its oil wealth for the benefit of its people during the boom years. Experience in Nigeria shows that the high level of expenditures during oil boom periods were difficult to reverse after price falls, thus resulting in widened fiscal deficits. Fiscal volatility adversely affected the economy through appreciating real exchange rates. The authorities spent the oil income mainly for domestic investment and consumption. Any savings of oil revenues was short-lived; revenues were saved only immediately following the surge in windfall income and were then subsequently spent quickly. The large public investment projects did not succeed because of constraints in the implementation process. Investments in the industry sector failed to generate the much needed non-oil exports and the country failed to diversify its economy during the windfall decade. The decision to adjust to shrinking oil revenues through trade restrictions rather than through devaluation had a ruinous impact on macroeconomic indicators. In addition, heavy and long dependence on oil revenues resulted in a narrowing of the non-oil tax base and inefficient tax administration, which played its negative role in the country’s macroeconomic performance throughout the 1980s and 1990s, as oil prices fluctuated.
Sources: Rudiger Dornbusch, “Policymaking in the Open Economy, Concepts and Case Studies in Economic Performance,” 1993; Alan Gelb and Associates, “Oil Windfalls-Blessing or Curse?” 1988; Mered, Michael, Chapter on Nigeria in “Fiscal Federalism in Theory and Practice”, edited by Teresa Ter-Minassian, IMF, Washington, 1997; “Nigeria—Selected Issues and Statistical Appendix,” IMF, SM/02/371.
APPENDIX II-3: Oil and Economic Development in Mexico
Mexico is the world’s fifth-largest oil producer and its 10th-Largest oil exporter. Mexico began to export oil in 1911, and its oil output expanded at an average annual rate of 6 percent between 1938 and 1971. Extensive oil discoveries in the 1970s increased Mexico’s domestic output and export revenues.
Although the Mexican economy maintained a rapid growth rate during most of the 1970s, it was progressively undermined by the combination of fiscal mismanagement and an overvalued real exchange rate, resulting in the sharp deterioration of the investment climate. In the mid-1970s, the government planned large public sector investment programs in industry, agriculture and transportation. This expansionary fiscal policy together with expansionary monetary policy, the postponement of crucial tax reforms and a fixed exchange rate contributed to large balance of payments disequilibrium and intensified capital outflows. In 1976, the government devalued the peso by 45 percent. In the same year, Mexico agreed with the IMF on a stabilization program aimed at lowering inflation, building up reserves and achieving macroeconomic stability. Oil discoveries in the south of Mexico in 1978 and a sharp increase in the world price of oil in 1979 greatly affected the country’s economic outlook. Private capital started to flow into the country, financing from the IMF was no longer needed and the reform program was abandoned.
The improved terms of trade in 1979–80 brought windfall oil revenues and allowed the government to continue implementing an expansionary fiscal policy. Moreover, the government borrowed abroad against future oil earnings to further boost expenditures. Public investment increased and reached 30 percent of GDP in 1981. This growth was associated with a substantial increase in imported capital and intermediate goods. However, oil revenues were not sufficient to finance the large increase in imports and external imbalances were financed by foreign borrowing. The budget deficit rose, the current account deficit widened and the real exchange rate was allowed to appreciate. Oil became the economy’s most dynamic growth sector and the country’s dependence on income from the export of oil increased. The share of oil in total exports rose from 15 percent in 1976 to 78 percent in 1983. Government tax revenues were now heavily dependent on international oil price movements. When oil prices fell in 1981, the government decided not to cut prices for Mexican oil for several months and the volume of oil exports fell sharply. In 1982, the budget deficit reached 15 percent of GDP. In the same year, commercial banks refused to roll over government loans. In August 1982, Mexico suspended its international debt payments after falling oil prices made it impossible for the government to repay foreign loans. Around $30 billion of capital fled the country. The debt crisis led to currency devaluations and hyperinflation.
Mexico’s experience with oil revenue management is a good example of how the existence of abundant natural resources can create a false sense of security. Oil wealth is not a solution to all economic problems. Even windfall resources from oil during the skyrocketing oil price period could not sustain overly expansive public spending, and the country faced the painful need of adjustment later on. In fact, the discovery and exploitation of oil resources gave a false sense of security to the authorities and made them postpone the needed correction of the real exchange rate, balancing of the budget and implementation of various structural reforms.
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Revenue from interest earnings is not included, as returns depend on adherence to a particular expenditure strategy, while this expenditure ceiling only serves as an upper spending limit. Inclusion of interest earned, assuming the non-oil deficit was always at the ceiling, would increase the non-oil defiict ceiling by about 4 percent of GDP in 2002.
Azerbaijan has little non-concessional government debt, and therefore use of oil revenues for early repayment of non-concessional debts is not a viable option
