Syria faces two interrelated medium-term challenges posed by the prospective decline in its oil reserves. The recently approved five-year plan (FYP) laid down a comprehensive strategy to address these challenges. Syria’s public finances are headed for challenging times in the coming 10–15 years. Large fiscal deficits have marked the economic history of many developed and developing countries alike during the 1970s and 1980s, with damaging consequences to their economies. Although financial markets can help keep the deficit bias in check, market discipline has proved mostly inadequate.

Abstract

Syria faces two interrelated medium-term challenges posed by the prospective decline in its oil reserves. The recently approved five-year plan (FYP) laid down a comprehensive strategy to address these challenges. Syria’s public finances are headed for challenging times in the coming 10–15 years. Large fiscal deficits have marked the economic history of many developed and developing countries alike during the 1970s and 1980s, with damaging consequences to their economies. Although financial markets can help keep the deficit bias in check, market discipline has proved mostly inadequate.

I. Which Fiscal Policy Framework Would Suit Syria Best in the Coming Decade?3

A. Introduction

1. Syria’s public finances are headed for challenging times in the coming 10-15 years. Oil revenues, on which the budget relies to the tune of 25 percent of GDP,4 are expected to decline rapidly over the medium term, creating a budgetary gap of some 12 percent of GDP by 2015. Unless addressed through a forward-looking fiscal policy framework (FPF), this imbalance will seriously disrupt the macroeconomic stability Syria has enjoyed in the recent past.5

2. This chapter proposes an FPF that will help Syria weather the coming challenge and ensure a soft landing. The chapter starts with a review of the global experience during the 1970s and 1980s. High budget deficits in this period led many countries to adopt transparent FPFs, that is, frameworks where the authorities pre-commit to certain macroeconomic objectives for their fiscal policies, often embodied in a fiscal rule tailored to specific issues in their fiscal outlook (Section B). The chapter then lays the theoretical foundations for a proposed FPF (Section C).

B. Fiscal Policy Frameworks To Address Deficit Bias

3. Large fiscal deficits have marked the economic history of many developed and developing countries alike during the 1970s and 1980s, with damaging consequences to their economies. Large deficits contributed to aggregate demand pressures, fueling inflation and putting a strain on the balance of payments. They led to a build up of large public debts, which put pressure on interest rates and/or prices, in countries that chose to monetize public debt. In most cases, they proved harmful to long-term growth as they tended to crowd out private investment through reduced available resources, higher taxes, and higher interest rates, and when they led to forced adjustments, the brunt usually fell on public investment. Finally, large fiscal deficits did not leave room to accommodate unexpected fiscal pressures and constrained the ability of governments to use fiscal spending as a tool for counter-cyclical policies.

4. The experience with large budget deficits has drawn attention to what has been coined the “deficit bias,” that is, an inherent tendency for fiscal policy to generate budget deficits rather than balances (Alesina and Perotti, 1995). In most cases the bias is caused by pro-cyclical fiscal policy, which in good times leads to an expansion of discretionary public spending that then tends to become ossified and results in deficits when revenues decline. The deficit bias is usually supported by various factors, including (i) political economy factors, by which some economic agents and politicians benefit from increased government spending without internalizing their full costs; and (ii) weak fiscal management and the proliferation of quasi-fiscal activities, which limit the government‘s ability to control public spending. Although in principle, discretion is desirable as it allows the flexibility needed to respond to unforeseen shocks or to cyclical variations in output, the experience referred to above shows that discretion has been misused and has been ineffective (Talvi and Vegh, 2002).

5. Although financial markets can help keep the deficit bias in check, market discipline has proved mostly inadequate. Financial market discipline has been weak, as it relies primarily on signals—risk premiums and sovereign credit ratings—that do not always react simultaneously with fiscal developments. Rather, market signals have at times responded with a lag and through discrete jumps to weak fiscal policies and have therefore not always provided advance warning to the need to restore fiscal discipline (IMF, 2005b).

6. Against this background, a worldwide experience in the last decade has been the elaboration and the adoption of FPFs. What is novel in this policy initiative is the search for safeguards to address the specific problems created by the deficit bias. The experience showed the usefulness of two types of safeguards: (i) transparency to allow greater scrutiny by the public to increase accountability of policymakers, and (ii) rules to constrain discretion.

  • Fiscal transparency encompasses broadening the coverage of fiscal reporting to extrabudgetary activities, identifying and possibly quantifying the main fiscal risks arising, for example, from the fall in the price of the country’s main exports, thereby reducing the possibility of negative surprise, and adopting a forward-looking approach to budget formulation (multi-year budgets and a better coordination of current and capital expenditure). These elements combined create a more predictable planning environment for line ministries and help identify spending pressures ahead. The accountability of those responsible for fiscal policy is increased through the provision of these benchmarks (Hemming and Kell, 2001).

  • Fiscal rules define one or more specific macroeconomic objectives of fiscal policy, by providing a clear numerical benchmark for one or more main fiscal aggregates. They pre-commit governments to fiscal discipline, by holding them accountable for the way they use discretion. The adoption of fiscal rules is, in itself, a signal that the government is serious about tackling fiscal profligacy.

7. Numerous countries have adopted various fiscal rules depending on their fiscal outlook. Fiscal rules are usually classified as below (see e.g., Koptis and Symansky, 1998).

  • Deficit rules: these are rules that set a ceiling on the overall deficit. Their main advantage is that they relate to fiscal indicators that can convey important information about the short-term macroeconomic consequences of fiscal policy, and can therefore help address inflation and balance of payment problems. The EU’s fiscal framework, the “Stability and Growth Pact (SGP),” which was developed to sustain a cohesive monetary union within the European Union, set a limit of 3 percent of GDP on countries’ overall budget deficits, with an understanding that member countries are supposed to maintain fiscal balance over the business cycle. The Western African Economic and Monetary Union (WAEMU) set a limit of 4 percent of GDP on budget deficits excluding grants. The FPFs in Australia, New Zealand, and Switzerland call for a balanced budget over the cycle. In Sweden, the Spring Fiscal Policy Bill calls on the government to achieve a budget surplus of 2 percent of GDP over the cycle, both to reduce public debt (which was as high as 70 percent of GDP when the bill was introduced) and to prepare the public finances for population aging.

  • Debt rules: these rules put a ceiling on net or gross debt. The advantage of such rules is that they target directly the debt sustainability problem. The key issue here is to know what a country’s debt tolerance is, which requires an element of judgment. The example of the SGP, setting a debt ceiling of 60 percent, is again the most famous example of a debt rule. The United Kingdom’s “Sustainable Investment Rule,” which requires the government to keep the level of public debt at a stable and prudent level, currently defined as net public debt at 40 percent of GDP, is another example. Some countries, with a high debt burden, have adopted fiscal rules which commit the government to achieve a reduction in the debt stock to a certain level by a certain horizon. An example is Jordan, where the aim of fiscal policy over the medium term is to reduce the debt-to-GDP ratio to 60 percent by 2010, and Tunisia where the aim is to reduce it to 45 percent by 2011.

  • Borrowing rules: these rules include not allowing (or limiting) government borrowing from domestic sources or from the central bank, so as to keep in check the debt monetization problem. In practice, however, it is questionable how sustainable this rule is, as countries that accumulate unsustainable debts are bound to monetize them sooner or later (the so-called “fiscal dominance or unpleasant monetarist arithmetic”). The most famous such rule is the SGP rule by which the governments of countries having adopted the Euro as their national currency are not allowed to borrow from the European Central Bank. The WAEMU set a 10 percent of the previous year’s revenues as a limit on access to central bank financing. The United Kingdom’s Golden Rule is another type of borrowing rule. It requires the current budget to be in balance over the cycle, which in turn, requires the government to borrow only to invest.

  • Expenditure rules: these rules set a ceiling on overall spending or on some spending components. They are effective in promoting fiscal discipline since they attack the problem at its source, as politically induced deficit bias typically results from expenditure pressures. Sweden is a country that has implemented this rule, as the expansion of government spending to 65 percent of GDP has come to be seen as unsustainable.

8. In some countries FPFs have been enshrined in Fiscal Responsibility Laws (FRLs).6 These are institutional devises that aim to consolidate a government’s commitment to fiscal discipline by attaching legal force to fiscal policy objectives, and making those responsible for fiscal policy more accountable to the legislature and to the public (Hemming and Kell, 2001). This is achieved through pre-commitment to a monitorable fiscal target, and penalties in case of failure to adhere to it, which could be either reputational or in the form of automatic triggers to cut expenditure. FRLs combine procedural rules—which specify transparency and accountability requirements—and numerical rules—which specify quantitative fiscal targets—with varying degree of relative emphasis. New Zealand was the first country to introduce an FRL by adopting a Fiscal Responsibility Act in 1994. Australia and the United Kingdom followed suit shortly after by adopting a Charter for Budget Honesty (Australia) and a Code of Fiscal Stability (the United Kingdom). More recently FRLs have been implemented in several Latin American and European countries.

9. However, FRLs are not a panacea, and can, at times, be harmful by not allowing discretion, when discretion is needed. Fiscal rules can create problems including the use of creative accounting to artificially meet numerical targets (e.g., classify current expenditure as capital expenditure), or adherence to the letter of the fiscal rules rather than to the spirit of the rules, which might ultimately harm the economy, such as the fire sale of state assets to meet deficit targets. When they are fully observed, they may prevent a country facing unexpected shocks from using discretionary spending to mitigate the impact of the shock, or when they are breached to face such contingencies, this may backfire by eliciting a negative market reaction (see, for example, Milesi-Ferretti, 2000).

C. A Suitable Fiscal Policy Framework for Syria

10. Syria will benefit doubly from adopting a transparent FPF. As in other countries, political economy factors as well as weak fiscal management create risks for a deficit bias and hence an FPF would help guard against this risk and maintain fiscal discipline. In addition, Syria is expected to face a severe deterioration in its fiscal outlook over the medium term.7 The challenge of maintaining fiscal discipline is more daunting, and hence the added benefit from adopting an FPF.

11. A suitable FPF for Syria entails appropriate fiscal transparency and accountability provisions, and a fiscal rule. In the context of the ongoing review of the basic finance law, amendments should be introduced that would enshrine the fundamental principles of fiscal transparency (including a clear definition of roles of public bodies and the timely provision of fiscal data), accountability (such as independent external audit reporting to the legislature on budget execution), stability (which would call for casting budget objectives and targets in a medium-term framework), and performance (which would call for recent outcomes of budget programs to be reported in budgetary documents).

12. Choosing an appropriate fiscal rule boils down to deciding on an optimal macroeconomic objective of fiscal policy. The ultimate macroeconomic objective of fiscal policy is always, ultimately, fiscal sustainability; i.e., a situation where the fiscal stance is consistent with the government’s intertemporal budget constraint, or equivalently if the expected net present value (NPV) of government revenues is equal to the expected NPV of government spending (see Blanchard and others., 1990).

13. Endowment in a non-renewable natural resource (say oil) poses a specific challenge for fiscal sustainability as well as an issue of inter-generational equity. The main issue for fiscal sustainability arises from the fact that the stream of income from selling the natural resource is bound to stop when the resources is exhausted.8 The issue of inter-generational equity relates to the distribution across generations of the income from the resource wealth. The fundamental question, therefore, is whether oil revenues should be consumed as long as they last and fiscal policy adjusted accordingly when they dry up, or should consumption by today’s generations from the income from the resource wealth be caped such that the stock of wealth remains constant (in absolute terms or in per capita) and can be passed on to future generations? Maintaining the stock of oil wealth constant in per capita terms requires that the per capita consumption out of the income from the oil wealth is equal to the annuity (adjusted for population growth) on the NPV of the oil wealth.

14. It is too late to address intergenerational equity considerations in Syria. Managing the remaining oil wealth with the aim of keeping it constant such that it could be passed on to future generations would call for a large adjustment that is neither politically feasible nor socially desirable. Indeed, the net present discounted value of Syria’s oil wealth is estimated at about US$90 billion, i.e., 325 percent of GDP. To ensure equal benefit to all generations indefinitely, the level of consumption out of this wealth should be limited to US$70 per person per year.9 At the moment consumption out of the oil wealth is about US$370 per person. Hence to ensure inter-generational equity, today’s generation has to take a cut of over 80 percent of the benefit it is enjoying. This would call for an upfront fiscal adjustment of close to 20 percent of GDP. Forgoing the right of future generations to the remaining oil wealth seems unavoidable.

15. A optimal management of the remaining wealth should therefore aim at smoothing the adjustment toward a sustainable long-run fiscal position. We examine this question with a simple theoretical model. The model starts by asking the question: How should “the social planner’s” problem be formulated in this case? It seems reasonable to approximate the cost of adjustment by the change year-on-year of the non-oil budget balance, as this, in turn, is a good proxy of the contractionary impact on the economy of the adjustment in any particular year. If we let nobt be the non-oil balance at time t, rt oil revenue at time t, and dt = dnobt the fiscal adjustment at time t, then if oil revenues in the future are known with certainty, the social planner problem would be to:

min0eρtdt2dtsubject0eρtrtdt=0eρtnobtdt

16. The solution to this problem can be illustrated in the simple case where oil revenues are expected to remain flat over a certain horizon and drop to zero thereafter. Heuristically, the solution is that unique slope for the non-oil budget balance, such that the area of triangle OAB is equal to the area of triangle BCD, an area which represents the amount of savings that has to be done while the stream of oil revenues is still positive and the amount of dissavings to smooth the adjustment until the economy reaches point D.

17. Under uncertainty about the future path of oil revenues the social planner’s problem becomes an optimal control problem that has to be solved anew each year. Decision on the pace of adjustment of the non-oil budget balance would have to be made each year, incorporating new information on the expected net present value (NPV) of the oil wealth. Upward revision of the NPV of the oil wealth would call for a relaxation of the pace of adjustment and vice versa. Realization of a particular outcome for quantity and price of oil each year would determine the overall balance in that year, but would not affect the decision that would have already been made on the adjustment of the non-oil balance during that year, lending greater predictability and stability to expenditure and tax policies.

18. The above analysis points to the benefits of managing Syria’s remaining oil reserves by targeting a steady improvement in the non-oil budget balance. Such rule would stem time-inconsistent and short-sighted policies.10 It would also insulate the domestic economy from the volatility of oil revenues. Given the inherent uncertainty about the price of oil, the level of proven reserves, and the path of extraction, the optimal pace of adjustment of the non-oil budget deficit would have to be reassessed on an annual basis in light of updated information on the NPV of the oil wealth. Considerations about the cyclical position of the economy and overall macroeconomic conditions have to be factored-in in determining the desired adjustment for any particular year.

Appendix I.

A Balanced Budget Rule Versus A Steady Improvement in the Non-oil Budget Balance

19. This appendix explores through numerical examples how performance under the proposed fiscal rule compares with the performance under the traditional balanced budget rule, which some politicians might think would be appropriate. The appendix shows that while both would deliver the same performance if oil revenues were to decline smoothly, the proposed fiscal rule is a superior policy rule if oil revenues were to level off before declining. Given the inherent uncertainty about the prospective path of oil revenues, the rule to target a steady improvement in the non-oil budget balance would be better in all cases.

A. The Case of a Gradual Decline in Oil Revenue

20. Assume that oil revenues, which in year 1 are equivalent to 18 percent of GDP, were to decline by 2 percentage points each year until oil is depleted 10 years later:

  • If the government pursues a budget balance rule, it would run a non-oil budget deficit equal to 18 percent of GDP in the first year. In the second, the non-oil budget deficit would have to be adjusted by 2 percentage points of GDP in order to maintain budget balance. In year 3, another adjustment of 2 percentage points of GDP of the non-oil budget balance would be needed to maintain budget balance. This goes on until the economy has run out of oil. By that time the non-oil budget deficit would have shrunk to zero and a balanced budget could be maintained for ever.

  • If instead, the government sets the objective of 2 percentage points of GDP adjustment per year in the non-oil budget deficit, such policy would also help achieve a balanced budget on a continuous basis.

Scenario Where Oil Runs Out Gradually

(In percent of GDP)

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21. Thus, in the case of gradually declining oil revenues, both fiscal rules would deliver similar outcomes. A balanced budget rule would force a steady improvement in the non-oil budget balance, and conversely, a steady adjustment in the non-oil budget balance would deliver the necessary adjustment to the declining oil revenues and ensure an overall budget balance.

uA01app01fig01

The Case of Oil Revenues Declining Gradually

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A001

B. The Case of Oil Revenues Leveling-Off Before Declining

22. We illustrate the differences between the two fiscal rules again through a numerical example. Assume that oil revenues are at 18 percent of GDP per year, for the first five years, and then drop to zero:

  • If the government pursues a balanced budget rule, then the government could keep running non-oil deficits equal to 18 percent of GDP every year for five years. In year 6, when oil revenues drop to zero, the government would have to cut the non-oil deficit from 18 percent of GDP to zero in order to maintain a budget balance. Such a sharp adjustment would of course be extremely hard to achieve and is not advisable as it would send the economy into a very deep recession in the short run and would hurt its long-term growth prospects.

  • If instead, the government decides to achieve a steady improvement of 2 percent of GDP in the non-oil budget deficit, then in the second year, the government would run a budget surplus of 2 percentage points of GDP, and accumulate assets equivalent to 2 percent of GDP that are saved. The following year, the government generates a budget surplus of 4 percentage points of GDP, and net assets increase to 6 percentage points of GDP. By the end of the 5 years when oil runs out, the government would have accumulated assets amounting to 20 percentage points of GDP. In year 6, the government continues to adjust the non-oil budget deficit by the same 2 percentage points of GDP. Given that the oil revenue is now zero, this would generate a budget deficit of 8 percent of GDP, which can be financed by running down the net assets accumulated over the previous five years. Targeting a steady improvement in the non-oil budget balance will ensure that part of the oil revenue, while it lasts, is saved and used as a buffer to smooth the adjustment. The adjustment continues until year 10, when the non-oil budget balance will be in equilibrium, and the cumulative savings will have been used.

Balanced Budget Rule for a Scenario Where Oil Revenue Remains Constant, and Falls Abruptly

(In percent of GDP)

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Gradual Improvement in Non-Oil Balance for a Scenario Where Oil Revenue Remains Constant and Falls Abruptly

(In percent of GDP)

article image
uA01app01fig02

The Case of Oil Revenues Leveling-off Before Declining

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A001

23. Thus, in the case where oil revenues level-off for a while before declining abruptly, a fiscal rule that aims at a steady improvement in the non-oil budget balance delivers a superior fiscal outcome. Given the inherent uncertainty about the expected profile of extraction and international oil prices, a steady improvement in the non-oil budget balance as the objective of the fiscal framework would stem time-inconsistent and short-sighted policies. It will reduce the risk of painful abrupt adjustment, whose brunt will likely fall on much needed public investment in infrastructure, social spending on education and health, or would call for raising revenues through highly distortionary taxes, given the weak capacity in tax administration. The measures that can support good pro-growth fiscal adjustment—such as public enterprise restructuring, pension reform, civil service reform, introducing a VAT—as all measures that take time to implement and to yield fiscal savings. This is why a gradual fiscal adjustment to be promoted by a fiscal rule that would call for a steady improvement in the non-oil budget balance would be much more desirable.

References

  • Alesina, Alberto, and Roberto Perotti, 1995 “The Political Economy of Budget Deficits” IMF Staff Papers, No. 42, pp. 1–31.

  • Barnett, S., and R. Ossowski, 2003, “Operational Aspects of Fiscal Policy in Oil-Producing Countries,” in Fiscal Policy Formulation and Implementation in Oil-Producing Countries, ed. by J.M Davis, R. Ossowski, and A. Fedelino (Washington: International Monetary Fund).

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  • Blanchard, Olivier, Chouraqui Jean Calude, Hagermann Robert P. and sartor Nicolas, 1990 “The Sustainability of Fiscal Policy: New Answers to an Old Question,” OECD Economic Studies No.15, Autumn 1990.

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  • Giavazzi, Francesco, Jappelli, Tullio and Marco Pagano, 2000 “Searching for Non-Linear Effects of Fiscal Policy: Evidence from Industrial and Developing Countries,” European Economic Review, Vol. 44, pp. 125989.

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  • International Monetary Fund, 2005a, “Syrian Arab Republic: 2005 Article IV Consultation - Staff Report.” Available via the Internet: http://www.imf.org/external/pubs/cat/longres.cfm?sk=18601.0

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  • International Monetary Fund, 2005b, “Fiscal Responsibility Laws,” IMF mimeo.

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1

This would result from the projected natural growth rate of working age population (3 percent annual average) and a modest education-driven increase in labor force participation rates.

2

The rate of job creation has declined from 4.8 percent in the 1990s to about 2.9 percent a year since 2000, while unemployment is estimated to have risen from 9½ percent in 2000 to 14 percent in 2004.

3

Prepared by Jemma Dridi and Patrick Imam.

4

Oil revenues valued at international prices.

5

For a quantification of the magnitude of the problem see chapter II.

6

Named after the legal framework introduced in New Zealand in 1994.

7

See Chapter II for a quantification of the expected loss in oil-related revenues to the government.

8

We assume the case where the country does not have market power.

9

Assuming a real rate of return of 4 percent and the on-going population growth rate of 2.5 percent.

10

The annex compares the performance under the proposed fiscal rule to that of the traditional balanced budget rule, which some politicians might think would be appropriate.