An Oil Stabilization Fund for Nigeria

3. The first chapter analyzes the potential for using an oil stabilization fund to protect public spending from oil price volatility. It also presents the rationale for using a medium-term moving average of past oil prices to determine fiscal policy, depositing surpluses in a fund, and tapping into the fund to finance deficits. Based on the statistical properties of past oil prices (highly volatile with a very weak tendency to return to their mean after a shock), the chapter argues that fiscal policy cannot be based on a long-term average oil price, because surpluses accumulated during periods of high oil prices would probably be very large, and deficits during periods of low oil prices would probably deplete any existing fund. In both cases, the government would be forced to abandon its predetermined fiscal policy, which could entail sizable adjustment costs. While using a moving average would not completely delink fiscal spending from oil price volatility, it would prevent sudden, large adjustments.

4. The analysis shows that with fiscal policy determined by a moving average of oil prices over the past 3-5 years, the government needs liquidity reserves of US$16-18 billion to be reasonably well insured against a necessary adjustment.

Reforms for Private Sector-Led Growth

5. The government’s ambitious and broad-based mediumterm economic reform strategy—the National Economic Empowerment and Development Strategy (NEEDS)—aims to break with the misguided government-led development paradigm of the past that created a difficult environment for the private sector. The second chapter describes the deep-rooted structural and economic problems facing the economy, and argues that they need to be addressed to help Nigeria grow out of a low-savings-and-investment trap. It draws heavily on the NEEDS, and two World Bank surveys, Doing Business and Investment Climate Survey; and the World Economic Forum’s Global Competitiveness Report.

6. The chapter discusses the main areas of priority in the NEEDS: public sector governance, infrastructure, business regulations and the legal environment, and the financial sector. It concludes that the emphasis on these areas in the NEEDS shows that the authorities have identified those reforms that will improve the investment climate and correct for past policy mistakes. The chapter argues that, with the right policies, Nigeria can achieve higher per capita growth, and make significant progress in lowering poverty. The main challenge facing Nigeria’s policymakers is to persevere and implement the reform agenda consistently.

Pension Reform

7. With its approval of the new Pension Act in June 2004, Nigeria introduced a major reform of the pension system. This act seeks to establish a contributory, fully funded scheme for both the public and private sectors. It will be based on individual accounts that will be privately managed by administrators, with pension fund assets held by custodians. It replaces a range of largely unregulated and highly diverse pension arrangements, including the pay-as-you-go pension systems for federal government employees. Chapter III describes the reform and analyzes its potential benefits and drawbacks on the basis of the literature on oldage security and international experience with similar reforms.

8. The chapter points out that the pension reform, as currently designed, entails substantial short-term fiscal costs, with apparently limited savings in long-term fiscal costs, and implies a sizable reduction in benefits for future pensioners relative to current beneficiaries. In that context, the chapter argues for a reduction in both statutory benefits for current pensioners and documented liabilities to workers shifting from the old to the new system, as well as for protection for the lowest-income beneficiaries through progressive cuts in statutory benefits. The reform’s potential benefits in terms of improved management of pension funds and financial deepening will depend critically on the establishment of adequate technological, institutional, and regulatory frameworks.

Nigerian Trade Policy

9. The fourth chapter provides an overview of trade policies in Nigeria, with a particular focus on changes in these policies in the past two years. It shows that little progress has been made toward liberalizing trade and that Nigeria’s trade policy regime continues to be among the most restrictive in the world. Nigeria’s homegrown strategy, or NEEDS, adopted in 2004 recognizes the shortcomings of the current trade policy framework. Consistent with the trade policy strategy elaborated in NEEDS, the government will significantly lower import barriers. The chapter concludes with suggestions on how the trade reforms can be broadened and deepened.

A. Introduction and Overview

10. In oil-dependent countries, a major issue is how to stabilize fiscal spending when government revenue fluctuates along with the international price of oil. Nigeria is highly dependent on revenue from oil exports, in terms of both its balance of payments and government revenue. Most of Nigeria’s oil and gas resources, which are abundant relative to current production levels, are exploited by joint ventures between foreign oil companies and the Nigerian National Petroleum Corporation (NNPC). Domestic income from oil and gas accrues to a very large extent to the government in the form of proceeds from equity oil sales and taxes on private companies. Private income from oil and gas leaves Nigeria largely through profit remittances. Because international oil prices are volatile, the government’s revenue from oil and gas is also volatile. Fiscal spending has been equally volatile, leading to boom-bust cycles, which are partly to blame for Nigeria’s disappointing growth performance since independence.³

11. To stabilize fiscal spending, the government must first stabilize the non-oil deficit—that is, the difference between its non-oil revenue and its spending, thereby resulting in an overall surplus or deficit when oil prices are higher or lower than anticipated. Overall deficits incurred in years with low oil prices need to be financed, and surpluses in years with high oil prices need to be disposed of. Because Nigeria cannot easily borrow in international capital markets, it may not have a source of financing for budget deficits when oil prices are low. A stabilization fund would allow the government to pull through an oil price trough and absorb windfall revenue when prices are high. This paper discusses fiscal policy and the design of a stabilization fund.

12. The government has two alternatives for holding financial assets in a stabilization fund that provides fiscal liquidity reserves. The assets can either be part of government deposits in the central bank, or be held in a separate foreign currency commercial bank account.⁴ In 2004, Nigeria deposited its windfall oil revenue in a central bank account, with monetary and exchange rate policy determining the relationship between fiscal deposits in the central bank and foreign reserves held by the central bank. Obviously, government deposits would closely mirror foreign reserves taking into account the import content of government spending to avoid liquidity injection or withdrawal in line with government deposit drawdown or buildup.

13. This chapter focuses on two key issues. First, given uncertainty of future oil prices, how much of its revenues should the Nigerian government spend? Fiscal policy design would be relatively straightforward if oil prices fluctuated in a reasonably short time around a long-term average, in which case the government should spend its mean expected oil revenue while maintaining a precautionary liquidity reserve for low-price periods. But because oil prices show very weak mean reversion—that is, oil price shocks are of long duration and the long-term average oil price is of little use for policymaking as shown in the appendix—the government has more difficulty determining its fiscal policy.

14. The chapter proposes that Nigeria use moving averages of past oil prices to estimate its future revenue and that it base its spending on this expected revenue. This solution strikes a balance between using this year’s price to estimate next year’s revenue, which would lead to the smallest forecast error because of the statistical properties of oil prices — such a policy would transmit oil price volatility to the economy—and using a long-term average price, which could lead to large and persistent surpluses and deficits because of the slow mean reversion of oil prices. Given the trade-off between stability of spending and over- or under-shooting actual oil revenue, this chapter argues that Nigeria should base spending on revenue projected on the basis of moving averages of oil prices over three to five years.

15. Irrespective of which method the government uses to guide its spending, any fiscal policy would run up against the difference between budgeted oil revenue and realized oil revenue. The question that arises about the design of a stabilization fund is, therefore, how much is enough: what level of assets should the government have in a stabilization fund to give assurance that it can maintain a stable fiscal policy.

16. This chapter uses repeated simulations of a numerical fiscal policy model with randomly generated parameters (Monte Carlo simulations) to look at the probability that a given level of assets in the stabilization fund is exhausted over a certain number of years. The model presented in Section D is based on randomly generated oil prices, where the data-generation process was estimated on the basis of real oil prices over the period 1861-2004 (see appendix). The simulations provide probabilities of the government’s encountering a budget crisis when, because of a liquidity constraint, it cannot spend the amounts budgeted. The simulations show that with a fiscal policy based on moving averages over three to five years, a stabilization fund of about 75 percent of 2004 oil revenue would be adequate. Section E derives the implications of the Monte Carlo simulations for fiscal policy in Nigeria and concludes that fiscal liquidity reserves of US$16-18 billion would be adequate.

B. The Views in the Literature

17. The literature on oil-dependent countries and revenue volatility clearly points out that delinking spending from revenue is important to promote macroeconomic stability and create an enabling environment for growth.⁵ Two possibilities for delinking are discussed: self-insurance through diversification of revenue and stabilization funds and transfer of risk to international capital markets (hedging).⁶ Diversification may take a long time and may not be compatible with a country’s comparative advantage. Hedging may be constrained by the limitations of futures markets: liquidity in long-dated instruments with maturities of more than one year is still limited (compared with Nigeria’s production volumes). In addition, hedging requires a high level of skill and oversight, and its political pay-offs may be very asymmetrical: the minister of finance may gain little political capital from the stabilization of revenue when oil prices fall, but may face severe criticism when prices rise and the country does not benefit from the upswing. Doubts over Nigeria’s creditworthiness may also make it difficult for the government to participate effectively in futures markets and would prevent it from borrowing when oil prices fell.⁷

18. Countries whose economies depend on natural resources have had mixed experiences with stabilization funds. Apart from Norway and Alaska,⁸ funds have usually not fulfilled the expectations of their creators.⁹ In several cases, the countries adopted rigid rules for depositing assets into and withdrawing them from the fund, which meant that the assets accumulated while budget deficits required financing, either domestic or external. Often, funds could not withstand the political pressure to use assets when natural resource prices were higher than their historical averages. If depleted, stabilization funds could not fulfill their role when resource prices slumped. In several countries, funds also developed lives of their own taking over budgetary functions by financing “national priority” investment projects.

19. The literature therefore provides clear guidance on the design of such funds. Most importantly, experience has shown that effective stabilization funds are fully integrated in the budget and are not based on specific rules that determine the accumulation of assets in or their withdrawal from the fund. Instead, changes in fund assets are derived from the difference between oil revenue and the non-oil primary balance. The question therefore is how to determine the level of expenditure.

20. Assuming that holding assets in a stabilization fund is costly (the interest earned on the assets is less than the return the government could derive from an alternative use of those assets), the government maximizes utility, which it derives from spending, under uncertainty over income and facing a borrowing constraint. While the maximization problem is straightforward, its analytical solution is not.

21. Monte Carlo simulations can indicate the level of assets the government should hold in a stabilization fund. The model presented in Arrau and Claessens (1992) derives precautionary savings from utility maximization over two periods, with each period representing one month. Using plausible parameters for risk aversion and interest rates, the Monte Carlo simulations show that about 40 percent of a government’s monthly earnings would be held in a stabilization fund. Their analysis does not explicitly impose fiscal stabilization; rather fiscal stabilization is a result of spending and saving decisions in each period. The spending path in the simulations is less volatile than revenue, showing the extent to which the stabilization fund is successful.

22. This chapter is not based on an explicit maximization model, but instead imposes a simple fiscal policy rule from the outset to stabilize the non-oil primary balance and takes into account a longer time horizon. Rather than determining the optimal level of stabilization and fund assets, it focuses on making explicit the trade-offs between stabilization and costs and on providing a more intuitive approach to determine how much is enough. The results compare well with those of Arrau and Claessens: although it is proposed here that a stabilization fund should have a higher level of assets than what they derive, the path of spending is also more stable.

23. The literature on stabilization funds makes little mention of the relationship between the government’s liquidity and the central bank’s international reserves. Research on reserve adequacy has not examined stabilizing fiscal spending when government revenue depends on volatile international prices.¹⁰ Studies on reserve adequacy in the 1960s and 1970s focused mainly on the current account and yielded the rule of thumb that reserves should cover three months of imports. Following the financial crises of the late 1990s, the literature focused on the risk of a currency crisis stemming from sudden capital flow reversals. It is based on the Baumol-Tobin inventory model with fixed costs of depleting and replenishing reserves and has yielded a new rule of thumb, coined by Federal Reserve Chairman Alan Greenspan (1999), that reserves should fully cover short-term foreign liabilities.¹¹

C. Stabilizing Fiscal Spending

24. Policymakers need to determine what level of non-oil deficit can be maintained over time. As discussed in the appendix, however, a sizable body of literature looking into the behavior of oil prices concludes that they are subject to large shocks and have a very weak tendency to revert to a mean. For practical purposes, today’s price is therefore the best predictor of tomorrow’s, and no medium- or long-term mean can be determined to anchor government spending. A fiscal policy based on a long-term oil price would, at some point, lead to either large deficits, the depletion of stabilization assets, and the accumulation of debt or to the accumulation of very large financial assets, which would be hard to justify in poor countries.

25. Because year-to-year oil price volatility can be quite large, a fiscal policy based on oil prices in the previous year would transmit oil price swings to the economy with a one-year lag. The resulting “boom-bust” cycles have been observed in many oil-dependent countries in the past. To avoid such cycles, fiscal spending should instead be anchored on a slow-moving, medium-term budget oil price.¹² A trade-off exists between fiscal stabilization and the errors made in projecting oil prices: the more fiscal spending is delinked from oil revenue, the higher the likelihood of fiscal deficits and surpluses. This section illuminates the trade-off by showing forecasting errors and forecast volatility for different degrees of stabilization.

Forecasting errors

26. A moving average of past oil prices provides a possible medium-term anchor for fiscal policy. Table 1 compares different time spans over which the moving average can be determined. It shows the errors that would have been made in projecting oil prices using moving averages over one to nine years.¹³ For example, projections based on a moving average over the preceding four years would have diverged from actual prices by an average of US$10.2 per barrel for the period 1861-2003.

Table 1.

Root Mean Squared Errors for Price Projections Based on Moving Averages, 1861-2003

Sources: BP Statistical Review of World Energy, author’s calculations.

Table 1.

Root Mean Squared Errors for Price Projections Based on Moving Averages, 1861-2003

		Averaging period, number of years
		1	2	3	4	5	6	7	8	9
Errors (in U.S. dollars)
	Full sample	9.1	10.9	11.5	10.2	9.7	9.9	10.3	10.9	11.7
	1970-2003	10.6	12.1	13.5	14.9	14.9	15.9	17.3	18.5	19.8

Sources: BP Statistical Review of World Energy, author’s calculations.

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Table 1.

Root Mean Squared Errors for Price Projections Based on Moving Averages, 1861-2003

		Averaging period, number of years
		1	2	3	4	5	6	7	8	9
Errors (in U.S. dollars)
	Full sample	9.1	10.9	11.5	10.2	9.7	9.9	10.3	10.9	11.7
	1970-2003	10.6	12.1	13.5	14.9	14.9	15.9	17.3	18.5	19.8

Sources: BP Statistical Review of World Energy, author’s calculations.

27. The same projections over the period 1970-2003 would have missed actual prices by an average of $14.9 per barrel.¹⁴ The errors are smallest in the first column, that is, when the previous year is used to project prices. The longer the averaging period, the greater the error, at least in the volatile world following the nationalizations and ascent of the Organization of Petroleum Exporting Countries (OPEC) in the 1970s. This finding is consistent with the near-random-walk properties of oil prices: last year’s price is the best predictor of today’s, as shown in the first column of Table 1.

Forecast volatility

28. If, however, the random walk price rule—this year’s price is used to project next year’s revenue—were followed, the volatility of fiscal spending would be high. Table 2 shows average year-to-year changes in oil prices, projected by using moving averages.

Table 2:

Changes in Projected Prices, 1861-2003

Source: BP Statistical Review of World Energy, own calculations.

Table 2:

Changes in Projected Prices, 1861-2003

			Moving average over number of years
			1	2	3	4	5	6	7	8	9
Change from previous year (in percent of previous year’s price)
	Full sample	Mean	20.3	14.6	10.9	8.1	6.5	6.0	5.8	5.5	5.2
		Standard deviation	27.9	20.1	14.4	9.6	7.8	7.0	6.4	6.1	5.8
	1970-2003	Mean	24.8	17.8	14.8	12.9	11.2	10.7	10.3	9.7	9.1
		Standard deviation	40.1	24.5	17.5	15.0	12.7	11.3	10.3	9.5	8.9

Source: BP Statistical Review of World Energy, own calculations.

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Table 2:

Changes in Projected Prices, 1861-2003

			Moving average over number of years
			1	2	3	4	5	6	7	8	9
Change from previous year (in percent of previous year’s price)
	Full sample	Mean	20.3	14.6	10.9	8.1	6.5	6.0	5.8	5.5	5.2
		Standard deviation	27.9	20.1	14.4	9.6	7.8	7.0	6.4	6.1	5.8
	1970-2003	Mean	24.8	17.8	14.8	12.9	11.2	10.7	10.3	9.7	9.1
		Standard deviation	40.1	24.5	17.5	15.0	12.7	11.3	10.3	9.5	8.9

Source: BP Statistical Review of World Energy, own calculations.

29. It shows that the prices projected using, say, a four-year moving average change by 8.1 percent of the previous year’s price, on average, with a standard deviation of 9.6 percent. Obviously, the longer the averaging period the lower the volatility of projected prices, but averaging beyond about five years does not seem to lead to substantial reductions in volatility.¹⁵ The higher oil price volatility since the 1970s is reflected in Table 2 in the higher mean and standard deviation of changes compared to the full sample period 1861-2003.

30. In conclusion, forecasting errors and forecast volatility suggest that fiscal spending guided by an oil price rule based on a moving average of three to five years provides an adequate level of stabilization, while forecasting errors would be relatively small.¹⁶

D. Model Description

31. Randomly generated oil prices are fed into a fiscal policy model to produce changes in stabilization fund assets over time. The probability that stabilization fund assets are exhausted in any year during the simulation horizon is then computed over a large number of model runs.

The assumptions in detail are as follows:

32. Based on regression results, oil prices are modeled using an AR(1) process in logarithms. The current oil price depends on last year’s price and a random variable,

where α= 0.802, and β= 0.703, as shown in the appendix. Time series of 5, 10, or 15 years’ duration are produced 5,000 times starting with actual 2004 prices of oil. Government spending E_t is set equal to projected non-oil revenue, ${\hat{R}}_t^{non-oil}$, plus oil revenue, ${\hat{R}}_t^{oil}$, at the projected oil price:¹⁷

33. Projected oil revenue is modeled as the taxes paid on production value, which is calculated as quantity, Q_t, times projected price, ${\hat{P}}_t$ (where quantity is assumed to be constant):¹⁸

The projected oil price, or budget reference price, for each year is set equal to the preceding year’s price (MA 1), or moving averages over the preceding three, five, or seven years (MA 3-7). In each year, the randomly generated oil price leads to oil revenue that is higher or lower than projected, and, therefore, an overall surplus or deficit. Assets in the stabilization fund at the end of each year, A_t, rise or fall with the budget balance:

34. The analysis is performed for time periods of 5, 10, and 15 years. The model has been normalized using t_o = 2004 oil revenue, and initial stabilization fund assets, deposits, and withdrawals are expressed in percent of t_o revenue.¹⁹ The model calculates the probability that stabilization fund assets are exhausted in any year during the simulation horizons.

35. The simulation results show that the probability of asset exhaustion rises with lower initial assets in the stabilization fund, a longer simulation horizon, and more stable fiscal spending or a longer moving average (Figures 1-3). The fewer the assets in the fund initially, the greater the probability that they will be exhausted during a period of low oil prices. Because of the cumulative effect of deficits, the probability of asset exhaustion rises with the length of the simulation period. And because a longer moving average increases the divergence between the budgeted and the realized price, a more stable fiscal policy requires a higher level of assets. These results are in line with the discussion in the subsection on forecasting errors and the appendix.

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Probability of Crisis, 5-year Horizon

Citation: IMF Staff Country Reports 2005, 303; 10.5089/9781451828979.002.A001

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Probability of Crisis, 10-year Horizon

Citation: IMF Staff Country Reports 2005, 303; 10.5089/9781451828979.002.A001

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Probability of Crisis, 15-year Horizon

Citation: IMF Staff Country Reports 2005, 303; 10.5089/9781451828979.002.A001

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36. If initial asset levels are low or zero, however, fiscal smoothing through the use of moving averages reduces the risk of a crisis, the opposite of what we observe when initial assets are moderate to high. The result is due to the slow change in fiscal policy that results from using moving averages, which allows some assets to build up in “good” years when there had been no assets before. As a result, “bad” years later on in the simulation period can be smoothed over. In contrast, “bad” years early on lead to a crisis no matter which smoothing strategy is used. When using last year’s oil prices (moving average of one period), fiscal policy instead allows little room to build up assets, and short “bad” spells lead to a crisis irrespective of when they occur. On balance, therefore, using a moving average over longer periods reduces fiscal vulnerability to “bad” spells, when the fund has few initial assets. Alternatively, a government can base its fiscal policy on deliberately low oil prices to attempt to build assets rapidly until it accumulates enough to move to fiscal policy based on a three-to-five-year moving average.

37. In conclusion, the analysis shows that governments should best pursue a prudent and stable fiscal policy aimed at building up financial assets in a stabilization fund if initial assets are very low. Only then should they try to base their spending on a more realistic projection of oil revenue while keeping in mind the need for stabilization, for example, by basing spending on a three-year moving average of oil prices. Stabilization fund asset levels of about 75 percent of 2004 oil revenue provide adequate insurance against oil revenue shortfalls, allowing governments to adhere to their envisaged fiscal strategy.

E. Application to Nigeria

38. Nigeria’s federal government followed a fiscal rule for the first time in 2004. It deposited in the central bank the oil revenue it received from prices above US$25 per barrel. The federal authorities obtained informal cooperation from state and local governments, which then also deposited their share of windfall revenue. The federal authorities are now proposing a fiscal responsibility bill that entails formally adopting a fiscal rule that would be binding on all three tiers of government and creating a stabilization fund.

39. Nigeria’s federal government budget for 2005 is based on a budget reference price of US$30 per barrel. Although the process that led parliament to choose this price is not clear, it is consistent with a moving average of oil prices over the past three years. In 2004, the budget reference price was $25 per barrel, consistent with a moving average over four years (Figure 4).²⁰ These prices are well below price projections at the time of budget formulation, and, at least in the case of 2004, actual prices. The rationale is that the government aims to stabilize the non-oil primary balance and build financial assets.

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Moving Averages of Recent Oil Prices, Nigeria’s Budget Reference Price, 2004-05

Citation: IMF Staff Country Reports 2005, 303; 10.5089/9781451828979.002.A001

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40. The Monte Carlo simulation framework can be used to calculate the probability that the Nigerian government will exhaust its financial assets in the medium term (five years).²¹ We calculate three different fiscal policy rule scenarios: in the first, we assume that the authorities use a three-year moving average to determine the budget reference oil price and fiscal spending and that initial stabilization fund assets are equal to the saved windfall oil revenue earnings of 2004 (of US$6 billion); the authorities aim at a balanced budget.²² In the second scenario, the authorities plan for a federal government deficit of 3 percent at the same reference price in line with recent practice. In the third scenario, they follow their medium-term fiscal strategy, as expressed in the NEEDS, and project a 3 percent deficit with the price of oil at $27 per barrel starting in 2006.

41. The Nigerian government has a 40 percent chance of depleting its assets within the next five years if it pursues a balanced budget policy at the reference oil price determined on the basis of a three-year moving average (“balanced budget” in Figure 5). The simulations that were performed in percent of 2004 oil earnings are here converted back into U.S. dollar amounts. Nigeria’s 2004 oil revenue is about US$21 billion, and the $6 billion fiscal savings in 2004 from the previous analysis, translate into an initial asset level of about 29 percent.²³

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Probability of Forced Adjustment in Nigeria, 2005-10

Citation: IMF Staff Country Reports 2005, 303; 10.5089/9781451828979.002.A001

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42. If the authorities continue to target a federal government deficit of 3 percent of GDP at the reference price, the probability that they will be forced to adjust their fiscal policy stance within the next five years rises to about 50 percent (Figure 5, “3 percent deficit”). Finally, the announced medium-term fiscal stance based on a fixed reference price of $27 per barrel and a federal deficit of 3 percent of GDP brings down the risk of forced adjustment to 20 percent. This result follows from a relatively low medium-term reference price compared with the 2004 oil price of $35 per barrel (Figure 5, ‘$27 medium-term’).²⁴

43. In conclusion, the results show that the authorities’ medium-term strategy, which is based on a reference oil price of $27 per barrel, is consistent with ensuring fiscal stability over the medium term and with increasing financial assets that provide further insurance against forced adjustment later on. They also show that the oil revenue savings currently in the dedicated central bank accounts are too low to suggest that the government should target spending on the basis of realistically projected oil prices or a moving average of past prices. The government would run a high risk of being forced to abandon its intended fiscal stance. Assets of $16-18 billion would reduce the probability of crisis within the next five years to below 20 percent, depending on the fiscal policy rule.

44. The authorities’ medium-term fiscal goals (US$27 per barrel and 3 percent deficit) aim at increasing financial assets to more than the current $6 billion. The spending targeted in the 2005 budget exceeds what would be targeted in this medium-term fiscal strategy because envisaged spending is more in line with a price of $33 per barrel. However, the reference price is still below the projected oil price for 2005: the World Economic Outlook projects a price of US$49.5 per barrel based on March 2005 oil futures, while the 2004 oil price, seen as the best predictor of the 2005 price under the random walk hypothesis, was US$38 per barrel. The budget is consistent with accumulating assets that can be used to stabilize fiscal spending in the future.