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.
Barnett S and Ossowski R. 2002 “Operational Aspects of Fiscal Policy in Oil-Producing Countries”, prepared for the IMF Conference on Fiscal Policy Formulation and Implementation in Oil-Producing Countries, June 2002.
Fasano, Ugo, 2000, “Review of the Experience with Oil Stabilization and Savings Funds in Selected Countries,”IMF Working Paper 00/112 (Washington International Monetary Fund).
Gulfason, Thorvaldur, 2001 “Lessons from the Dutch Disease: Causes, Treatment, and Cures,” Institute of Economic Studies, Working Paper Series.
Karl, Terry Lynn, “The Perils of the Petro-State: Reflections on the Paradox of Plenty”, Journal of International Affairs, 53, No. 1:31-48, Fall 1999
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/02/37 Oil and Gas Journal, Energy Information Administration (http://www.eia.doe.gov/emeu/cabs/caspgrph.html)
Rosenberg, Christoph B and Saavalainen, O, Tapio, 1998, “How to Deal with Azerbaijan’s Oil Boom? Policy Strategies in a Resource-Rich Transition Economy,”IMF Working Paper 98/6 (Washington International Monetary Fund).
Sachs Jeffrey D. and Andrew M. Warner, 1995,“Natural Resource abundance and Economic Growth,” NBER Working Paper 5398 (Cambridge, MA: National Bureau of Economic Research).
Tseng, Wanda and Corker, Robert, 1991, “Financial Liberalization, Money Demand, and Monetary Policy in Asian Countries”, IMF Occasional Paper 84 (Washington, International Monetary Fund).
Source: Oil and Gas Journal, Energy Information Administration (as of July 2002) (http://www.eia.doe.gov/emeu/cabs/caspgrph.html)
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