A quarterly magazine of the IMF

March 2003, Volume 40, Number 1

Why oil-producing states must husband their resources

Oil-producing countries face special challenges in managing their economies, not just because oil prices and revenues are highly volatile and hard to predict but also because they must plan for the time when the oil runs out. The uncertainty of oil revenues has a number of implications, for both short- and long-term fiscal policy, while the fact that oil is a nonrenewable form of energy raises complex issues of sustainability and intergenerational resource allocation.

Obviously, oil-producing countries are not all the same. There are considerable differences not just in the relative importance of oil to the economy but also in the size of oil reserves, maturity of the oil industry, ownership and taxation structure in the oil sector, stage of development of the non-oil economy, and the government's financial position. All these differences affect decisions about fiscal policy. Nevertheless, it is possible to suggest some general principles that are important for formulating and assessing fiscal policy in oil-producing countries.

The biggest challenge for an oil-producing country is how to use its oil wealth wisely, without squandering the proceeds. Oil is exhaustible, and it is therefore inevitable that oil earnings will, at some point, dry up. Therefore, focusing first on the long run, a key challenge for fiscal policy is deciding how to allocate government wealth (including, prominently, oil wealth) across generations. This challenge, reflecting a concern for intergenerational equity and general financial prudence, should be met by targeting a fiscal policy that preserves government wealth—appropriately defined to include oil. Analogous to standard permanent income arguments, the preservation of wealth requires that consumption in each period be limited to permanent income or, in this case, the implicit return on government wealth.

The government of an oil country, however, is confronted with significant uncertainty relating to its oil wealth. The volatility of oil revenue, because of swings in oil prices, is problematic, especially for short-run macro-fiscal management. But it is the uncertainty about oil wealth itself, which stems from uncertainties about such issues as the future path of oil prices, the size of the oil reserves, and the cost of extracting them, that is most important for long-run considerations. Just as an increase in uncertainty would typically lead a consumer to make more conservative consumption decisions, uncertainty about oil wealth would lead a government, for precautionary reasons, to adopt a more conservative fiscal policy than it would if these factors were known with certainty.

Key principles for assessing the fiscal stance from a long-run perspective include the following points.

First, it is important to focus on the primary non-oil balance and relate it to government wealth. The best way to look at the fiscal side is to separate out the oil and non-oil revenues and spending. The pertinent deficit measure is the (primary) non-oil deficit, which makes explicit that revenue excludes oil income on the grounds that it is more like financing and provides the most useful indicator for measuring the direction and sustainability of fiscal policy. From a long-run perspective, the government's objective boils down to choosing a primary non-oil deficit consistent with fiscal sustainability, taking into account the uncertainty surrounding oil wealth. And the sustainable non-oil deficit is determined by government wealth (including the present discounted value of oil revenues), rather than by the flow of oil revenue.

Second, governments should accumulate assets in order to sustain the non-oil deficit when oil has been exhausted. Specifically, there should be enough accumulated assets for the return on those assets to finance the non-oil deficit once oil revenue has dried up. A strategy of targeting a non-oil deficit that would be financed by drawing down accumulated assets once oil production ceases would not be sustainable. Such a strategy would eventually deplete all of a country's assets, forcing the government subsequently to borrow, leading to explosive debt dynamics. Likewise, strategies aimed at stabilizing the (positive) net debt-to-GDP ratio or even just eliminating all debt are generally not consistent with fiscal sustainability. Such strategies would result in the need for either substantial fiscal adjustment or explosive debt dynamics in the post-oil period.

These principles are of significant practical importance as, by and large, many oil-producing countries seem to fall short in applying them. For example, few oil-producing countries highlight the (primary) non-oil balance in their budgets. As for the accumulation of financial assets, a number of oil-producing countries have sizable sovereign net financial liabilities. In mature producers, such liabilities send a potentially troubling signal about the sustainability of fiscal policy and are a source of fiscal vulnerability, especially when oil prices fall. At the same time, while not highlighted above, oil wealth, if properly managed, does afford a country the luxury of being able to sustain a potentially sizable primary non-oil deficit.

Some economists have argued the merits of a rule that targets a non-oil deficit equal to the anticipated return on existing financial assets. This has been dubbed "the bird-in-hand rule," because spending decisions are predicated only on the assets already in hand. One advantage of the bird-in-hand rule is that it highlights the potential for a shock to reduce the value of remaining oil reserves to zero. Technological advances, for example, could lead to alternative fuel sources that are more efficient and cost effective. Oil would not actually have to become obsolete, but its price would have to fall to such a level that it would no longer be cost effective (at least for most producers) to extract.

This very conservative approach could be viewed as an extreme form of precautionary saving in that it is tantamount to assuming that there would be no future oil revenues. However, prior to the exhaustion or obsolescence of oil reserves, oil wealth would be greater than accumulated financial wealth, and the rule would thus lead to very restrictive primary non-oil deficits. In this regard, it would serve as a lower bound to the solution of the framework that includes precautionary motives. This suggests that the optimal size of the primary non-oil balance should be greater than that implied by the bird-in-hand rule but smaller than that of a permanent income framework that excludes precautionary saving considerations.

The long-run factors discussed in the previous section help determine broad fiscal parameters. Within these parameters, however, fiscal policy is ultimately pinned down by short-run considerations. Reliance on oil revenue, particularly when it makes up a large share of total revenue, renders short-run fiscal management, budgetary planning, and the efficient use of public resources difficult. The challenges stem largely from the volatility and unpredictability of oil prices.

There is ample evidence that oil prices exhibit volatility in the short run and large fluctuations over the medium term. Annual average oil prices surged by nearly 30 percent in 1995–96, declined by 36 percent in 1997–98, and then more than doubled in 1999–2000. Moreover, these fluctuations are often difficult, if not impossible, to predict.

The volatility of oil prices leads to corresponding volatility in fiscal cash flows. The dependence of fiscal revenue on the oil sector renders public finances vulnerable to a volatile external variable that is, for the most part, beyond the control of policymakers. For example, in Venezuela, oil revenues accruing to the public sector fell from 27 percent of GDP in 1996 to 12½ percent of GDP in 1998, before rising again to 22½ percent of GDP in 2000.

There is a strong macroeconomic case for smoothing fiscal expenditures rather than letting them rise and fall along with oil prices. Large and unpredictable changes in expenditure and the non-oil fiscal deficit destabilize aggregate demand, exacerbate uncertainty, and induce macroeconomic volatility. The macroeconomic costs of a volatile expenditure and non-oil deficit pattern include the reallocation of resources to accommodate changes in demand and relative prices, real exchange rate volatility, and increased risks for investors in the non-oil sector. Sharp fluctuations in government spending make it difficult for the private sector to make long-term investment plans and decisions, dampening private investment and the growth of the non-oil economy.

Moreover, from a purely fiscal perspective, short-term swings in government expenditure can entail substantial costs. In particular, large and abrupt fluctuations in government spending are difficult to manage and reduce its quality and efficiency.

These considerations suggest that a generally volatile expenditure pattern is likely to be costly and, therefore, argue in favor of smoothing the path of spending in the face of oil price fluctuations.

The ability to absorb unanticipated cash-flow shocks depends on the robustness of the government's financial position. A strong fiscal and financial position provides the government of an oil-producing country with room to maneuver during oil price downturns. In particular, the government can accommodate cash-flow fluctuations through a mix of adjustment and financing. By doing so, the government can afford to pursue short-run fiscal strategies that avoid fiscal instability and help insulate the domestic economy from oil revenue volatility. Moreover, when the government can smooth expenditures and the non-oil balance in the face of cash-flow volatility, the use of oil revenue can be successfully decoupled from current earnings, enhancing the stabilization role of fiscal policy.

In some oil-producing countries, a history of prudent fiscal policies and the existence of large official financial assets or low levels of public debt have facilitated an orderly mix of adjustment and financing during temporary oil price downturns. For example, the solid financial position of Norway's government reflects, to a large extent, the more fundamental long-run policy objectives of spreading the benefits of oil over time—notably through high government saving rates and the buildup of foreign assets—resisting potential damage to the non-oil tradable sector from Dutch disease (see page 50) and being able to withstand negative oil market developments. These strategic choices seem to have helped Norway maintain macroeconomic stability and reasonable growth rates even in an unfavorable oil market environment.

In contrast, in a number of oil-producing countries, procyclical fiscal policies and persistent fiscal deficits have led to less favorable financial positions and recurrent fiscal sustainability concerns related to the volatile and excessive use of oil revenues. A regular feature of fiscal policy in many oil-producing countries has been the inability to rein in public expenditure when oil prices rise, with the result that expenditures have been difficult to reduce during oil price downturns. On some occasions, governments may also believe that the oil price decline will be short-lived, prompting the temptation to ride out the downturn.

The resulting fiscal deficits have been financed with external and domestic borrowing. However, the former has made many borrowers vulnerable to increases in the interest rate on foreign loans, as well as to the drying up of new loans as sustainability concerns set in, while the latter has often been inflationary or has crowded out private sector access to credit. Eventually, mounting external and fiscal imbalances, a lack of external financing, and, in some cases, monetary disequilibria and inflation associated with the domestic financing of deficits force the adoption of belated, costly, and disorderly expenditure cuts (often involving the suspension or abandonment of investment projects), sometimes accompanied by currency depreciations.

Therefore, in countries that are unable to accommodate oil revenue fluctuations because of financing constraints related to sustainability and other policy concerns, a key policy objective should be to pursue fiscal strategies aimed at breaking the procyclical response of expenditure to volatile oil prices, including the use of hedging instruments to help reduce oil revenue uncertainty and volatility. This would imply eliminating expansionary fiscal policy biases during oil booms and, critically, targeting prudent non-oil fiscal balances and reducing the non-oil fiscal deficit over time. Such a strategy would create fiscal room that could be available if needed when a transitory boom ends and restore or enhance a country's creditworthiness to improve its access to credit markets.

Given the heterogeneity of oil-producing countries and the broad scope of this article, it is not practical to draw quantitative conclusions as to the desirable non-oil deficit. Such determinations ultimately depend on country-specific factors. Nonetheless, the following general principles are important for formulating and assessing fiscal policy in oil-producing countries.

• The non-oil fiscal balance should feature prominently in the formulation of fiscal policy. Decomposing the overall balance into an oil and a non-oil balance is critical for understanding fiscal policy developments, evaluating sustainability, and determining the macroeconomic impact of fiscal policy.
• The non-oil balance, especially expenditure, should generally be adjusted gradually.
• The government should strive to accumulate substantial financial assets during the period of oil production to sustain fiscal policy in the post-oil period.
• Many oil-producing countries can, indeed, afford to run potentially sizable non-oil deficits. Decisions on how big the non-oil deficit is should be based on assessments of government wealth (including oil wealth), rather than on current oil income. There are strong precautionary motives, however, that would justify fiscal prudence, including enormous uncertainty regarding oil wealth.
• As in any economy, fiscal policy in oil-producing countries needs to support broader macroeconomic objectives. These include macroeconomic stability, growth, and an efficient allocation of resources.
• As a result of procyclical fiscal policies and recurrent fiscal deficits, a number of oil-producing countries must pay interest rate premiums on sovereign debt and face liquidity constraints related to sustainability and other policy concerns, making it more difficult for them to accommodate oil revenue fluctuations. These countries should pursue fiscal strategies aimed at breaking procyclical fiscal responses to volatile oil prices, targeting prudent non-oil fiscal balances, and reducing the non-oil fiscal deficits over time.