Oil Revenues and Fiscal Policy

Philip Daniel Fiscal Affairs Department International Monetary Fund

The PRMPS/COCPO Training Workshop The World Bank May 2007

The views in this presentation are those of the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its management.

Oil Revenues and Fiscal Policy Overview

Challenges posed by oil revenue Fiscal policy and macroeconomic stability The non-oil primary balance Fiscal policy and intergenerational issues Oil funds Expenditure management Some guidelines

Oil-Producing Countries Differ

Importance of oil in the economy and fiscal accounts

Development of the non-oil economy

Maturity of the oil industry / oil production horizon Ownership of oil industry Fiscal regime for the oil sector Macroeconomic situation Financial position of the government and the public sector (gross and net debt, liquidity) Quality of institutions

Petroleum Revenues and Stabilization

Uncertainty and Instability

Stabilization

Uncertainty about value of resource and timing of revenues Instability caused by volatility of oil prices Taxes must respond robustly to realised outcomes

Stabilize by total expenditure and revenue management, not by reliance on stable taxes General economic stability

Reduces investors risk premia Avoids disruption of projects Strengthens negotiating & trading position Vital to poverty reduction

Crude Oil Spot Prices, 1970-2006 1/ A Rollercoaster Ride

110

Real oil prices

100

90

80

70

U.S. dollars per barrel

60

50

40

30

20

Nominal oil prices

10

0 1970

1975

1980

1985

1990

1995

2000

2005

Sources: IMF, World Economic Outlook (Washington, various issues); and IMF staff estimates. 1/ Average of U.K. Brent, Dubai, and West Texas Intermediate. Real oil prices deflated by the US CPI (December 2005 = 100.)

Guidelines for Stability

Keep public sector demand in line with sustainable rate of capacity growth Save excess petroleum revenues abroad Use conservative price forecasts Save foreign assets in boom periods, use in downturns No need to fine tune the economy Rely on automatic stabilizers Oil funds are no substitute for sound fiscal management.

The Non-oil Primary Balance

Key fiscal indicator in petroleum exporters.

Derived from the overall fiscal balance, excluding oil-related revenues & expenditures and net interest.
Ideally, should include explicit or imputed expenditure on petroleum product subsidies if applicable. Analytical importance of the non-oil primary balance:

Reasonable indicator of domestic government demand Measure of injection of oil revenue into the economy Measure of fiscal effort and underlying fiscal policy stance Key input into fiscal sustainability and intertemporal analysis

Size of the Non-oil Primary Deficit

Some factors to take into account:

macroeconomic objectives short-run vulnerability government wealth, including oil in the ground and net accumulated financial assetssustainability

In some petroleum exporters, large non-oil primary deficits are sustainable and do not pose vulnerability concerns. In others there may be a need to reduce the non-oil primary deficit due to vulnerability and sustainability considerations. In all cases, the non-oil primary deficit should be consistent with macroeconomic stability objectives.

Smoothing Fiscal Policy: Fiscal Considerations (1)

Costly and inefficient to adjust spending rapidly and abruptly.

The level of spending should be determined in light of its likely quality and the capacity to execute it efficiently. The sudden creation or enlargement of spending programs is risky.

Increases in spending may exceed the governments planning, implementation, and management capacity waste. Spending should not rise faster than transparent and careful procurement practices will allow.

Smoothing Fiscal Policy: Fiscal Considerations (2)

Spending typically proves difficult to contain or streamline following expansions. Expenditure becomes entrenched and takes a life of its own.
Drastic spending cuts may lead to social instability, discouraging investment and reducing future growth.

The Non-oil Primary Balance and Transparency

Focus on the non-oil primary balance helps develop constituencies in support of prudent policies, thereby contributing to a less procyclical and more long term-oriented fiscal policy. This balance should be highlighted in budget documents used in parliamentary and public discussion. A clear presentation of the non-oil primary balance helps:

Make the use of oil revenue more transparent Delineate policy choices more clearly

Example: Norways budget.

Long-Run Oil and Fiscal Dynamics: Trajectory of Net Government Wealth

Total net wealth per capita (In 1997 U.S. dollars)
16000 14000 12000 10000 8000 6000 4000 2000 0 1998

2003

2008 Oil wealth

2013

2018

2023

2028

2033

2038

Residual oil in the ground

Financial assets

A Path for Use of Oil Revenues: Permanent Income

The Concept Current consumption limited to maintain wealth for future generations Sustainable use resources converted to other incomeproducing financial assets A guideline with uncertainties Advantage of making intergenerational equity an explicit goal
The Calculation Petroleum reserve data & production profiles Production cost or state take Output price forecasts Real interest rate Population growth rate Subtract discounted present value (adjusted for population growth) from total real revenues

Oil Funds
Purposes Stabilization shield economy from revenue instability Savings wealth for future generations Precautionary if projects are uncertain or absorptive capacity is in doubt Links with Fiscal Policy

Oil funds are no substitute for good fiscal management; important producers operate without oil funds (UK, Saudi Arabia, Indonesia, Australia, Russia) Important features
1. 2. 3.

Consolidated budget framework Liquidity constraint on the budget Limits on domestic investment by the oil fund

Types of Oil Funds, by Objective

Stabilization Funds
Receive all revenues & inject regular amounts to budget [Papua New Guinea wound up 2000] Petroleum revenues in excess of forecast budget amount [Oman] Finance deficit or receive surplus [Norway] Receive deposits above a reference price; can withdraw when below floor price [Chile, Venezuela until 2001]

Savings Funds
Fixed percentage of petroleum revenues [Alberta, Alaska] Percentage of total government revenue [Kuwait] Net government revenues (budget surplus) [Norway]

Precautionary Funds
Assign all or part of revenues to fund in early stages of petroleum development Goal to ensure financial viability if revenues are lower than expected Guards against poor absorptive capacity Recent examples in Azerbaijan and Timor-Leste [now a Norway-type fund]

Types of Oil Fund, by Operational Rules

Contingent funds

Mainly stabilization objectives Deposit and withdrawal depend on rigid exogenous triggers, usually oil prices or fiscal oil revenues. Triggers: multiyear (fixed/moving average) or intra-annual (relative to budget oil price) Examples: Venezuela Macroeconomic Stabilization Fund (1998 rules), Iran Mainly savings objectives A fixed share of revenues or oil revenues is deposited in the oil fund. Various rules (or discretion) for withdrawals Example: Kuwait Reserve Fund for Future Generations Both stabilization and savings objectives Net oil revenue is deposited in the fund. The fund automatically finances the budgets non-oil deficit through a reverse transfer. Example: Norway Government Pension Fund

Revenue-share funds

Financing funds

Fund Management
Potential for poor management with or without oil fund: Key

elements for efficiency of oil fund

Regular public disclosure Accountability to elected representatives Independent audit of activities Clear investment strategy majority foreign assets Benchmarking of desired investment returns Competition in appointment of investment managers

Oil Funds, PFM, and Transparency

Oil funds should not have the authority to spend

avoid dual budgets: all spending should be transparently on budget.

Oil revenues should not be earmarked for specific expenditures

there should be genuine competition for fiscal resources.

Avoid separate oil fund institutional frameworks Stringent mechanisms to ensure good governance, transparency, and accountability are critical

clarity of rules, disclosure, audit, and performance evaluation

The Need to Distinguish Oil Funds from Fiscal Rules

Oil funds are sometimes confused with fiscal rules. Oil funds do not constrain fiscal policyunless the government is liquidity-constrained.

Fiscal Rules in Oil-Producing Countries

Attempt to insulate fiscal policy from political pressures. By placing restrictions or limits on fiscal variables (such as deficits, expenditure, debt), rules seek to constrain fiscal policy. Design of fiscal rules in oil producers must take into account their specific fiscal characteristics (oil volatility; expanded concept of sustainability). Rules should aim at decoupling expenditure and the non-oil deficit from the short-term volatility of oil revenues. But many oil producers are liquidity-constrainedcan these countries afford to decouple spending in the downswing? A sound fiscal management framework is a necessary (not sufficient) condition for the success of a fiscal rule.

Fiscal rules are no stronger than the will of the political class to abide by them.

Medium-Term Expenditure Frameworks

MTEFs can help limit the extent of short-run spending responses to rapidly-changing oil revenues. They can allow a better appreciation of future spending implications of current policy decisionsincluding future recurrent costs of capital spending.

Expenditure
Public Expenditure Management

Extra-budgetary funds

No special rules for expenditure from petroleum revenues Consistent base data Budget preparation procedures Budget execution system Cash planning and management

Better mobilization of public support? Simulate market conditions? Disadvantages

Loss of central control and budget integrity Resource allocation distortion Entrenching old priorities Barrier to reallocation at the margin Potential transparency concerns

Attempts in special circumstances proved difficult (Chad example)

Final Remarks
Target smooth responses of expenditure to oil revenues and prudent nonoil primary balances.
Fiscal consolidation may be needed to reduce vulnerability and strengthen fiscal sustainability.

Pay attention to the non-oil primary balance and scaling factors.

Establish sound budgetary systems. Have a long-term horizon.

Enhance fiscal transparency, so that everybody can see how oil revenue is usedor misused.