In the “normal” case that the real exchange rate tends to appreciate following an increase of oil earnings, government policymakers can “engineer” that appreciation in two ways. In the first case, the central bank maintains a floating exchange rate. The oil proceeds lead to an appreciation of the nominal exchange rate vis-a-vis the dollar. This puts downward pressure on the local currency prices of non-oil traded goods and thereby leads to a fall in the price of traded goods relative to non-traded goods (i.e., a real appreciation). In the second case, the nominal exchange rate of the national currency is pegged to the U.S. dollar, or euro or basket.
Now the increase in domestic spending that follows the oil boom leads to a rise in the prices of nontraded goods, while traded good prices are kept constant because of the constancy of the nominal exchange rate. Once again, there is a fall in the price of traded goods relative to non-traded goods (i.e., a real appreciation). There is no decisive case as to which of these exchange rate mechanisms is to be preferred. For small countries such as Guyana which will be facing large structural transformations, instability in the demand for the local currency, and the uncertainties of oil and capital flows, there is probably a preference for maintaining an “adjustable peg” exchange rate, wherein the central bank keeps the nominal exchange rate stable, but reserves the option to make discrete devaluations or revaluations in the future. (If oil prices fall sharply, for example, the central bank might undertake a devaluation to reduce the relative price of nontraded goods). The pegged race adds predictability to the price level and makes monetary policy subordinate to the exchange rate target. Of course, a successful peg requires substantial foreign exchange reserves, the avoidance of excessive domestic credit expansion, and the avoidance of high levels of short-term external indebtedness that can lead to panicked withdrawals of foreign capital and self-fulfilling speculative attacks on the domestic currency.
As described in the preceding text, a real appreciation is not the same as a squeeze on the production of the traditional tradable sector (e.g., agriculture). It is perfectly possible that the exchange rate appreciates, and that the non-oil tradable production expands. This is the case when oil earnings are used to finance public investments that boost the productivity of the non-oil tradable sector. In poor countries with extremely efficient infrastructure, the productivity gains in the non-oil tradable sector that result from new infrastructure investments (especially in power, roads, telecoms, and port facilities) are likely to outweigh any negative effects on production caused by exchange rate appreciation due to the public investment spending. This conclusion will at least apply over a period of a few years (enough time for the infrastructure to get into place), if not immediately at the start of an oil boom. The idea, therefore, that the government should withhold investment spending in order to prevent real appreciation of the exchange rate, in order to “protect” the non-oil tradable sector, is very likely to be wrong in practice. (Of course, even if the non-oil tradable sector production is actually squeezed, whether or not that is a “disease” depends very much on whether there are special externalities or income distributional consequence associated with the traditional tradable sector).
The beneficial economic impact of oil production could be dented if a rising exchange rate were to negatively affect other tradable goods sectors (Bayoumni and Muhleisen 2006). Overall, higher production and export of crude oil should provide a boost to the Guyanese economy, both by offering high value-added employment opportunities and raising national income through additional foreign exchange earnings. However, the non-energy tradable sector could come under increased pressure if current account surpluses, as well as rising capital inflows, were to put upward pressure on the exchange rate (“Dutch Disease”). Moreover, the economy’s sensitivity to global oil market conditions would increase as the share of oil production in total Gross Domestic Production (GDP) rises.
Commodity exports affect the exchange rate through changes in their volumes and in the terms of trade. Commodities are generally exchanged at a single world price with quantities determined by production capacities. This implies that commodity trade (in foreign currency) is largely independent of exchange rate considerations.
In addition to any balance of payments benefits, the oil production impact will be amplified by the large amount of factor inputs needed to support rising production levels. Significant capital equipment, as well as energy, transport, and urban infrastructure, need to be in place before oil can be produced. Unlike in countries with more conventional energy reserves, the production process itself is also very resource-intensive, reflecting both energy and labour inputs and the need for large replacement investment.
Whether for importing or exporting-oil economy, the real price of oil is negatively and significantly related to the variability of the real exchange rate (Selmi, Bouoiyour, Ayachi 2012). While an oil boom will lead to massive increases in international reserves, they can also be associated with real exchange rate appreciation and declines in competitiveness in the traditional export sectors. In addition, policymakers will be faced with serious challenges in trying to insulate their domestic economies from the effects of the balance of payments surpluses. The problems of monetary control will become difficult when faced with pressures from volatile oil prices, and rising budget and trade deficits.
Policymakers will have to sterilise the effects of changes in reserves on the monetary base. In some countries, it has been seen that changes in domestic credit were directed toward balance of payments equilibrium. However, efforts at monetary control could be undermined by the monetisation of budget deficits and the associated real exchange rate appreciation. Still, policymakers can be able to enhance monetary control through nominal devaluations and fiscal restraint. Hence, it must be emphasised that competitive real exchange rates are vital to improving the effectiveness of monetary policy in a developing oil-exporting country such as Guyana. As such, there must be effective policies to guide the current exchange rate reforms. However, if those policies are to endure, they must be augmented by deficit reduction and additional financial liberalisation.
Managing Oil Earnings to the Public
Among free-market advocates, there is a repeated call on the state to distribute oil earnings directly to households in a lump-sum transfer. The free-market analyses base their arguments on three positions.
- First, they tend to reject the idea that investments in infrastructure (including road, power, telecoms, water, and sanitation) should be provided by the public sector in the first place. The private sector, they claim, will supply the needed investments, but only if the government is truly pursuing the rule of law.
- Second, they distrust the political leaders of the state to manage large income flows on behalf of the general population as opposed to their own behalf. By forcing the state sector to disgorge the oil earnings in dire payments to the public, the argument holds, the abuses of public spending can be avoided.
- Third, they believe that social safety net spending should be carried out through direct transfers from the state to the poor. This has been done, with some apparent success, in Brazil and Mexico where direct cash transfers to poor households are linked to a “good performance” by the households in sending the children to school and to health check-ups.
These positions are not generally persuasive, especially for the poorest countries. For example, the experience on private financing of infrastructure in low-income settings has been very disappointing. There is an increasing scepticism that private investments will finance the basic infrastructure network, especially roads and power. Both sectors are subject to important increasing returns to scale, suggesting the need for a public supplier of the infrastructure or at least a publicly regulated monopoly.
In addition, some of the most urgent investments (such as for primary health and education) are beyond the financial reach of the poorest households. Direct public financing of these services is needed to ensure the universal access to such services by those in need. Finally, Brazilian or Mexican private transfer schemes to households work in large part because the basic rural infrastructure (school, clinics transport and power) is already in place in those countries. That is not the case in rural areas of many low-income oil-exporting countries.
Note that even the Brazil and Mexico programs are far from the proposals for a general handout of a fixed share of oil earnings to each household, a proposal repeatedly made by free-market advocates in the United States and modelled on the distribution in Alaska (Humphreys, Sachs, Stiglitz 2007). The transfers in the Brazil and Mexico programs are targeted to low-income households and are conditional on certain actions of the households in support of their children’s well-being. Thus, the transfers are providing social welfare services. In Norway, the gas earnings are also distributed to the public, but as pension benefits. As such, the gas earnings are first accumulating in national pension accounts, which will then be used to service pension obligations for decades in the future. As in Brazil and Mexico, the gas earnings are thereby satisfying a core public function of social insurance, rather than serving as a mere transfer of income to households.
