Republic of Kazakhstan: Selected Issues
Author: International Monetary Fund
Publication Date:
15 Nov 2004
eISBN:
9781451820935
Language:
English
Keywords:
ISCR; CR; economy; government; development institution; consumption; natural resource curse; BH rule; expenditure policy; C. Medium-Term expenditure Framework; revenue projection; expenditure path; Oil prices; Oil; gas and mining taxes; resource fund
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This Selected Issues paper analyzes the optimal policy response on the part of the Kazakhstan authorities to the prospective oil inflows. It surveys the literature on the so-called natural resource curse and offers an analysis of Kazakhstan’s petroleum potential. The paper analyzes the impact of the oil boom on the non-oil sector, based on a general equilibrium model. It provides an analysis of fiscal rules and fiscal sustainability and assesses the possible role of fiscal policies in addressing the “natural resource curse.”

Abstract

This Selected Issues paper analyzes the optimal policy response on the part of the Kazakhstan authorities to the prospective oil inflows. It surveys the literature on the so-called natural resource curse and offers an analysis of Kazakhstan’s petroleum potential. The paper analyzes the impact of the oil boom on the non-oil sector, based on a general equilibrium model. It provides an analysis of fiscal rules and fiscal sustainability and assesses the possible role of fiscal policies in addressing the “natural resource curse.”

V. Fiscal Rules and Fiscal Sustainability Analysis1

1. Fiscal policy design in oil-producing economies poses a challenge for two main reasons: the exhaustibility of the oil underground and uncertainties surrounding oil prices and revenues. Exhaustibility of oil resources raises the issue of intergenerational equity and sustainability, requiring a long term perspective in policy making to ensure that all generations benefit from the oil riches to a similar extent. The volatility of oil prices and revenues renders fiscal policy very complicated. It is critical to insulate fiscal expenditures from the volatility of oil revenues, as frequent swings in expenditures are costly. Moreover, it is important to avoid procyclical fiscal policy, and instead pursue policies to minimize fluctuations in domestic demand in the face of volatile oil revenues.2

2. Recent work on fiscal policy suggests the use of simple rules to guide policy in oil-producing countries. A fiscal rule is typically defined as a permanent constraint on fiscal policy, specified in terms of an indicator of overall fiscal performance.3 Examples of fiscal rules include a balanced budget rule, a ceiling on borrowing, or a limit on stock of government liabilities as a percentage of GDP. In the context of oil producing economies, fiscal rules are typically defined as a function of oil prices and/or the non-oil fiscal balance.

3. The concept of non-oil fiscal balance can be useful in designing fiscal policy rules. Unlike the overall fiscal balance, the non-oil budget balance is not directly affected by temporary fluctuations in oil revenues, and therefore is a good gauge of the stance of fiscal policy. It also reflects, to a large extent, the current and future economic developments in the domestic economy. Focusing on the developments in the non-oil economy can help the government to pursue the objective of diversifying the economy, and create a tax base that does not solely rely on oil revenues.

4. A range of fiscal rules has been discussed in the literature.4 At the one extreme stands the “balanced budget rule.” Under this rule, the overall budget is kept in balance, and all oil revenues are spent. Thus, the non-oil deficit is equal to oil revenues and no part of oil revenues is saved. This rule does not insulate fiscal expenditures from oil price volatility and, since there are no financial savings, it does not target intergenerational equity, unless government spending is focused on investment in education, healthcare, and infrastructure. At the other extreme is a cautionary rule called the Bird-in-Hand (BH) rule, where all oil revenues are saved in the form of income generating assets, and only the income from the available stock of assets is used for consumption.5 The ceiling on consumption expenditures based on oil wealth therefore would be equal to the projected return on the available stock of assets. The non-oil budget would be in balance, and the overall balance would be in surplus by an amount equal to the difference between oil revenues and the income from available assets.

5. A third fiscal rule is based on Friedman’s (1957) Permanent Income Hypothesis (PIH) of consumption. According to the PIH, which lies between the two extreme rules outlined above, the government has a forward looking perspective, and bases its decisions on consumption and saving on total wealth rather than current income. Total wealth is defined as the sum of current financial assets and oil wealth, where the latter is defined as the present discounted value of future oil revenues. The welfare maximizing behavior under the PIH requires that the government should not consume more than its permanent income, which is equal to the real interest on total wealth. This strategy keeps total wealth of the society constant across generations. The following sections of this chapter apply the PIH and the BH rules to Kazakhstan, using the projections of the oil sector model developed by the Fund and the World Bank. The aim is to illustrate how these two fiscal rules would address the problems of intergenerational equity and oil revenue volatility.

A. Long-Term Consumption Under the Permanent Income Hypothesis

6. This section applies the PIH rule to Kazakhstan.6 The calculations are based on revenue projections of the oil sector model developed by the Fund and the World Bank staff. The macroeconomic scenario through 2009 is based on staff projections. The long term assumptions for the analysis include: a nominal interest rate of 7 percent, a discount rate of 5 percent, a 2 percent inflation rate, and 3.5 percent real growth in the non-oil sector. Under these assumptions, the total wealth in the economy is equivalent to $101 billion, and the level of wealth per capita that would be kept constant stands at $6,805.

7. Figure 1 shows the path of the non-oil deficit-to-GDP ratio under different price assumptions. The trend of non-oil deficits implied by the PIH is downward sloping, and converges to about 2 percent of GDP towards the end of the period for the WEO baseline case. Table 1 provides a summary of the results. Under the baseline case, the results of the PIH analysis suggest a 3.3 percent non-oil deficit-to-GDP ratio for the period 2004-2049. Over the short term, non-oil fiscal deficits declining from over 10 percent of GDP in 2004 to just above 5 percent by 2010 would be consistent with a sustainable expenditure path. In U.S. dollar terms, the sustainable non-oil deficit would be about $3 billion for the rest of the decade. This figure is substantially higher than the current non-oil deficit of about $1 billion in 2003.

Figure 1:
Figure 1:

Non-Oil Deficit-to-GDP Ratio Implied by the PIH, 2004-49

Citation: IMF Staff Country Reports 2004, 362; 10.5089/9781451820935.002.A005

Source: Fund staff projections.
Table 1.

Fiscal Indicators Under the Permanent Income Hypothesis, 2004-49

article image
Source: Fund staff projections.

8. The optimum non-oil deficit implied by the PIH is sensitive to oil price assumptions. Table 1 presents three alternative scenarios: two scenarios where the paths of oil prices are 5 percent higher and lower than the WEO baseline oil price path, respectively, and a scenario with a constant oil price of $19 per barrel. The results suggest that the long term average non-oil deficit ratio can reach 4.4 percent of GDP under the price assumption of $5 over the baseline scenario. This amounts to a non-oil fiscal deficit of about $4 billion for the rest of the decade and a $6.4 billion long-term average. If oil prices were $5 below the WEO baseline, the sustainable non-oil fiscal deficit would be 2.2 percent of GDP over the period 2004-2049, or $3.2 billion in nominal terms. The short run optimum level of consumption would be around $2 billion for this decade. Assuming an oil price of $19 per barrel would imply a 1 percent non-oil deficit-to-GDP ratio in the long run. The average non-oil fiscal deficit for the 2004-2049 period would amount to about $1.5 billion, and about $1 billion for the remainder of this decade.

9. Results for the sub-samples are shown in Table 1. Irrespective of the assumption about oil prices, the non-oil deficit as a percentage of nominal GDP is lower during the period 2031-2049 than the previous periods for two reasons. First, a substantial share of revenues from oil will arise in the second half of the period under analysis, after 2030. Consumption smoothing under the PIH requires that savings will be higher during periods with relatively high revenues. Second, because of economic growth, GDP will be higher towards the end of the period, and the non-oil fiscal deficit would constitute a smaller share of GDP. In U.S. dollar terms, the average non-oil fiscal deficit during the period 2031-2049 is higher than during 2020-2030.

B. Long-Term Consumption Under the Bird-in-Hand Rule

10. A second fiscal policy rule, adopted by Norway, is the BH rule according to which all the revenues from oil are saved and only the interest income of the accumulated assets is spent. This is a cautious rule and based on a single assumption about the future: return on financial assets during the following years. Figure 2 illustrates the path of the non-oil deficit-to-GDP ratio through 2049 under the BH rule. The BH rule, in contrast with the PIH rule, dictates a very cautious expenditure path over the short term, whereas it allows for large non-oil deficits in the future. Towards the end of the period, increases in the stock of financial assets slow down because of declining oil revenues. The non-oil deficit continues to increase in U.S. dollar terms, but declines relative to GDP.

Figure 2:
Figure 2:

Non-oil Deficit-to-GDP Ratio Implied by the Bird-in-Hand Rule, 2004-49

Citation: IMF Staff Country Reports 2004, 362; 10.5089/9781451820935.002.A005

Source: Fund staff projections.

11. Table 2 shows that the long run average non-oil deficit-to-GDP ratio for the period 2004-2049 under the two fiscal rules is quite similar. For the baseline case, this ratio equals 3.3 percent under the PIH rule, and 3.4 percent under the Bird-in-Hand rule. However, in U.S. dollar terms, the long-term average under the BH rule is higher than the PIH rule, as the former allows for a larger non-oil deficit in the future when GDP is high.

Table 2.

Fiscal Indicators Under the Bird-in-Hand Rule, 2004-49

article image
Source: Fund staff projections.

12. Average consumption in U.S. dollar terms is lower under the PIH rule because of intertemporal smoothing. The PIH rule dictates a higher saving rate towards the end of the period in order to keep consumption per capita constant for each generation including those who live after 2049, when oil reserves are depleted. Contrary to this, under the BH rule, the interest income generated from the stock of financial assets is always spent without any concern for consumption smoothing. As a result, the stock of financial assets at the end of 2049 is higher under the PIH rule than under the BH rule, suggesting a higher income stream for future generations who will live beyond 2049.

13. The results presented in this study seem to suggest that the BH rule favors future generations over the current generation. However, these findings are based on assumptions that advocates of the BH rule would object to. The most important is that the results are based on production and revenue projections extending four decades ahead. One of the rationales for using the BH rule is that such projections are subject to a substantial amount of uncertainty and should not be relied upon. A comparison of the two rules using projections for such a long time horizon is in contradiction with the spirit of the BH rule.

Fiscal Policy Rules in Botswana and Indonesia

In Botswana, a sustainable fiscal position is defined as a fiscal outcome, in which the non-mining revenue of government equals at least the “noninvestment recurrent expenditure” of the government. For the purpose of this fiscal rule, current expenditures on education and health are excluded from the definition of “noninvestment recurrent expenditure” and can therefore be funded from mineral sources (IMF 2002). The government has devoted the revenue from mining to public investment, aimed at expanding and diversifying the economy’s productive base in an intertemporally efficient manner. Based on this rule, in the early 1980s, when the sale of diamonds was discontinued for 6 months, the government was able to maintain its expenditure programs by drawing down its reserves rather than through disruptive changes to taxation (Acemoglu et al. 2003). This rule facilitated large investments in human capital and infrastructure, which had raised life expectancy to almost 70 years prior to the AIDS pandemic, while simultaneously generating budget surpluses in every year since fiscal year 1983/84.

In Indonesia, according to Bevan et al (1999), in “response to the excesses of the guided economy period during the 1950s and early 1960s, the New Order elevated the concept of a balanced budget to become a major symbol of good government.”2 Although the budget was balanced in the technical sense of no domestic borrowing, the authorities sometimes covertly ran surpluses, particularly during periods of high oil prices. Spending restrictions were often imposed on government agencies despite funds being distributed, increasing the build-up of deposits by subsidized institutions. This reduced the volatility of actual expenditure, and in effect the non-oil primary balance, but at the cost of fiscal transparency (Eifert et al. 2003). Temple (2003) argues that while the authoritarian control over the budget exercised during the Suharto period may have enabled the government to bend its own fiscal ‘rules’ it might also have been a factor that undermined its long-term sustainability and contributed to the economic crisis in the 1990s as the credibility of economic policy was diminished.

1 This reflects the belief that education and health build human capital and should thus be treated as investment. A significant feature of resource allocation in the budget has been the relatively large share of social spending, especially on education, which averaged 24 percent of total spending in the 5-year period ending 2001/02 (IMF 2002). Malaysia spent a similar share of its public expenditure on education during the 1970s and 1980s.2 The balanced budget concept was in fact based on a non-standard definition of the fiscal accounts, which included official foreign capital flows and aid loans as revenue rather than financing. Using a more conventional GFS measure, the deficit was relatively stable at around 3 percent of GDP for most of the following decade.

14. Although there is considerable uncertainty about the amount of oil revenues, a substantial expansion of the oil sector in Kazakhstan is not disputed. Moreover, risks are not limited to the downside: future oil production, prices, and revenues may be much higher than currently projected. Taking a very cautious approach may result in lower benefits from oil revenues for the current generation.

15. Of the two rules analyzed in this study, the BH rule is the more cautious one, and the expenditures suggested by this rule can be considered as a safe lower bound for the non-oil fiscal deficit. While the PIH rule provides a better framework for intergenerational equity, it is based on complex assumptions about the future, and hence subject to major uncertainties. A more conservative and gradual spending path than the one suggested by the PIH rule could therefore be warranted. The projections derived from these two rules may act as lower and upper bounds on expenditures. An ideal expenditure path would likely lie between these two bounds and depend on the trade-off between policy makers’ attitude towards risk and their concerns about intergenerational equity.

C. Medium-Term Expenditure Framework and Resource Funds

16. Whether an explicit rule is in place or not, budgets should ideally be formulated within a sustainable medium-term economic framework (MTEF) (Box 2). Typically, an MTEF is intended to (i) promote predictability within a sustainable fiscal framework; (ii) improve inter- and intra-sectoral resource allocation by linking stated policy goals to spending plans; (iii) improve the effectiveness of public expenditure; and (iv) promote transparency and accountability (Houerou and Taliercio 2002).

17. Resource funds have been set up with both macro economic stabilization and savings or financing objectives. Resource funds have been established in Alaska, Azerbaijan, Chile, Kazakhstan, Kuwait, Norway, Papua New Guinea (now abolished), and Venezuela with a significant variety in design and purpose. Kazakhstan’s National Fund was established in 2001 (Chapter III, Box 1). Stabilization funds emphasize the need to insulate the domestic economy from volatile revenue swings, while savings funds focus on the need to fund future commitments (sometimes pensions or simply consumption). In Norway the petroleum fund is essentially a government account where net-oil revenue is deposited and the fund is used to finance the non-oil deficit through revenue transfers. Overall, the experience of oil funds has been mixed as they have often contributed only marginally to improved conduct of fiscal policy or higher savings.7 Such funds have also been found to entail certain risks, including the fragmentation of fiscal policy and asset management, resulting in a dual budget, and reduced transparency and accountability.

18. Resource funds may provide a mechanism for countries with pressing social and infrastructure needs to justify the build-up of financial savings (Bartsch et al. 2004). The inflow of resource-related rents can raise issues of how to utilize the revenue flow in an efficient intergenerational manner without distorting the macroeconomic balance. In many countries, structural reforms, and improvements to human capital, infrastructure, and the management of public utilities are prerequisites to enhancing the competitiveness and viability of the non-resource tradable sector. However, building the institutional capacity of a government to utilize its resources efficiently is likely to be a costly long-term process. In this context, a resource fund with clear and transparent objectives may provide a conduit for financial savings. While resource funds may not, in themselves, improve fiscal discipline, they can help governments to build support and consensus around a particular fiscal policy. In Norway, the oil fund constituted a means of saving budget surpluses that had risen to around 15 percent of GDP per year. The fund was often associated with future pension liabilities, although there was no explicit link. Skancke (2003) argues that this helped to build a political consensus in support of saving more than 100 percent of GDP in financial assets despite social needs.

19. Resource funds that are well integrated into the budget may also help to foster transparency and accountability. In Kazakhstan the NFRK has helped to facilitate the pursuit of prudent fiscal and monetary policies that have stabilized the economy and to build up a large volume of savings. However, moving to a funding rule similar to the Norwegian model, perhaps based on a non-oil deficit target rule, would be simpler and could be used to enhance the transparency of both the fund and the budget more generally. In accordance with the Code of Good Practices on Fiscal Transparency, the consolidation of the fiscal accounts, including the NFRK, would allow the government to assess the management of its assets and liabilities within a unified framework that recognizes all the risks and returns of financing (or saving) the overall fiscal balance.8

20. Distributing resource revenues directly to the population has also been suggested to improve fiscal management and governance. In the absence of strong institutions that are able to manage efficiently public sector resources, some authors have proposed that resource revenues be distributed directly to all or parts of the population who may be better able to allocate their country’s resources (Box 3). For example, in Alaska a share of royalties from oil production (25 percent) is deposited in the Permanent Fund (a savings fund) that pays an annual dividend to the general population.9 The assets of the fund can only be used following a vote to change the Alaskan constitution. Nonetheless, Alaska has not been immune to fiscal problems. In the early 1990s voters created a $7.9 billion Consolidated Budget Reserve (CBR) with a one-off transfer of certain oil-related payments. The CBR was designed to provide a stabilization mechanism for government expenditure but it was largely run down to fund the general government’s fiscal deficit through the 1990s. In 2003 new proposals were made to the legislature to bridge the fiscal gap using a combination of fiscal tightening and resources from the Permanent Fund. In view of the mixed result for the overall fiscal stance, this approach requires a sufficiently robust disbursement mechanism, which may not be easily achieved in many developing countries with weak institutional capacity.

Using a Medium-Term Expenditure Framework

Several countries, including resource-rich countries, have employed multi-year planning. Experience has shown that successful multi-year plans tend to be comprehensive, properly costed, and fully integrated into the annual budget (Houerou and Taliercio 2002). Since its independence in 1966, Botswana has used a series of multi-year National Development Plans (NDPs) to outline its policy priorities and intended expenditure patterns for the following 6-8 years; the macroeconomic framework is updated annually in the budget, and the programs are costed in order to form a genuine guide for fiscal policy (IMF 2002). Indonesia and Malaysia have both utilized multi-year development plans to help establish programs for diversifying their economies. Australia successfully introduced a Medium-Term Expenditure Framework (MTEF) in the early 1980s to improve its fiscal adjustment process, and South Africa followed suit in 1998 (World Bank 1998).

Giving Resources Directly to the People?

Recent recommendations for improving fiscal management have included the proposal that governments distribute some oil revenue direct to citizens, for example by providing bursaries for school children and other transfers, or by reducing taxes10 A direct distribution approach could be used to underpin the principle that oil revenues belong to the population or to fulfill particular policy aims, and could enhance transparency and accountability. Sala-i-Martin and Subramanian (2003) argue that the private sector may be better suited than the government to manage resource volatility by identifying shocks and hence smoothing intertemporal consumption, and spending the windfall more efficiently than the public sector.

As mentioned in Chapter II, an additional argument for this approach is that redistributing revenue to the population and subsequently raising funds through general taxation would improve governance, as a tax-paying population may generally demand higher standards of accountability and representation from its government. This may contrast with the less transparent management of the resource windfall if it accrues directly to the state. The link between taxation and governance also suggests that giving tax cuts to offset windfall gains may not always be the best option (see below, and Rakner and Moore 2002).

D. Strategies to Strengthen Fiscal Institutions to Ensure Proper Design and Control of Spending

21. Kazakhstan would benefit from continued efforts to improve its aggregate fiscal discipline and the credibility of public financial management. According to the World Bank (2003), three key measures can underpin effective public spending: (i) aggregate fiscal discipline; (ii) allocative efficiency and equity; and (iii) regular monitoring of operational impact. These measures define the budget and public expenditure management as critical components of the accountability that the general public expects from policy makers. In particular, fiscal discipline requires a structured mechanism for resolving competing claims on the budget from politicians, administrators, subnational levels of government, and other interest groups, while remaining within an appropriate overall expenditure envelope to prevent uncontrolled spending. While Kazakhstan has a good record with regard to overall public expenditure management, the government could improve allocative efficiency and equity by:

  • Reforming expenditure policies and budget institutions. The objectives of Kazakhstan’s ambitious 10-15 year development plan were summarized in the Indicative Plan of Social and Economic Development for 2004-2006. They include (i) increasing the competitiveness of the country’s non-oil sector; (ii) creating employment opportunities; and (iii) improving living conditions for the majority of the population. However, as Table 3 suggests, the exploitation of oil has not resulted in an increasing share of resources being directed towards education or health spending.11 Accordingly, there is a need for a strategic re-assessment of government spending on human capital and infrastructure to meet both current pressing social needs and to provide for a skilled, flexible labor force in the future. However, as the productivity of public spending varies enormously, simply increasing government spending is not sufficient to improve public sector performance (Easterly 2001).

Table 3.

Selected Expenditure Items by General Government

article image
Source: Kazakhstani authorities.

  • Following the strategic re-assessment of spending priorities, it will take time for Kazakhstan to develop its policies and shift resource allocations and handle the administration of substantially larger expenditure volumes. As argued by Gelb and Associates (1988) in their study of oil windfalls, the non-oil fiscal balance should be adjusted gradually in the face of changes to oil revenues. In view of the projected doubling and even tripling of oil production, this would imply targeting a gradual widening of the non-oil deficit. In addition to a strong policy framework, sound institutions will be required to ensure that the additional revenue is spent efficiently. This includes institutions responsible for the delivery of public services (e.g., central and local governments, and the civil service), and those institutions that contribute to the overall efficiency of public spending (e.g., procurement and financial control). Institution building will require time and, over the short-term, this may imply that Kazakhstan will continue to build up its financial reserves in the NFRK.

  • Improving policy formulation and strengthening institutions through arrangements that foster responsiveness, accountability, and the rule of law (World Bank 1997). The institutional arrangements most likely to influence public sector performance are budgets, decentralization, and public administration. To emphasize the variety of approaches, the World Bank (2003) suggests an ‘eight sizes fit all’-strategy to describe the characteristics of effective service delivery arrangements. The proposed measures range from central and/or local government provision of services to contracting out or private sector provision of services.

  • Defining adequate incentives for improving the management of public finances. Without appropriate incentives, correct policies for growth and development are unlikely to be adopted, and well-functioning systems are unlikely to be established (Easterly 2001). In democratic societies, where institutions exist that protect minority interest groups, private property rights, and individual economic freedoms, governments may define the right set of incentives to promote growth in the private sector. In this regard, Kazakhstan may be well placed to take advantage of its burgeoning oil resources.

  • Developing mechanisms for regular monitoring and evaluation of the impact of government operations. As well as establishing policy priorities, the Kazakhstani government should measure and report on progress towards meeting the stated targets. As the World Bank concluded in its World Development Report 2004, “unless public expenditures are results-oriented, they will be ineffective.” During the 1990s, new initiatives in favor of performance budgeting—a method for linking policies and results—emerged, initially in developed countries and later in developing and transition economies. Performance budgeting has been closely linked to other reforms in public sector budgeting and financial management, which have aimed not only at improving public sector performance, but also at ensuring fiscal sustainability (Robinson 2004).

References

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1

Prepared by Theo Thomas and Turgut Kisinbay.

2

The experience of oil-producing countries show a high correlation between fiscal expenditures and oil prices (Katz et al. 2004).

4

See Wakeman-Linn et al. for a discussion of fiscal policy rules for Azerbaijan.

5

This is the approach pursued by Norway.

6

The mechanics of the model are outlined in Davoodi (2002).

7

See Davis et al. (2001) for a review of experiences and fiscal policy implications of resource funds.

8

See IMF (2001).

9

Part of the aim of this transfer is the support of traditional lifestyles.

10

See Sala-i-Martin and Subramanian (2003) for a detailed discussion of this proposal in the context of Nigeria and Collier and Gunning (1996) for a broader discussion.

11

Investment in human capital, in particular education has played a major role in the rapid development of Singapore and other Asian economies over the past decades. Kazakhstan’s investment in education, in particular primary and secondary education, is below the average for countries at a comparable income level.

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Cover IMF Staff Country Reports
Republic of Kazakhstan: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2004: Issue 362
Publisher:
International Monetary Fund
ISBN:
9781451820935
ISSN:
1934-7685
Pages:
76
DOI:
https://doi.org/10.5089/9781451820935.002
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    Non-Oil Deficit-to-GDP Ratio Implied by the PIH, 2004-49

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    Non-oil Deficit-to-GDP Ratio Implied by the Bird-in-Hand Rule, 2004-49

Non-Oil Deficit-to-GDP Ratio Implied by the PIH, 2004-49

Non-oil Deficit-to-GDP Ratio Implied by the Bird-in-Hand Rule, 2004-49