Oil-rich low-income countries have sometimes been advised to accumulate their oil income into a national financial pool or fund (perhaps held in foreign stocks and bonds), and to spend only the “income” or “earnings” on the financial assets in that fund.
The idea is to create a financial endowment that can be used to fund public outlays into the indefinite future, for example, pension benefits over the course of generations. This kind of advice rightly recognises that with a depleting asset like oil, there is a powerful case for smoothing consumption over a much longer time horizon than the depleting income flow from the oil itself.
Still, the idea of spending only the income from the accumulated financial assets makes little sense as a general rule on the timing of the oil-backed outlays. To the extent that the oil income is used for public investments, the oil is turned into long-lived physical assets and human capital rather than financial capital, but the intertemporal benefits of the oil income are similarly spread across time.
In essence, policymakers face a choice among four kinds of long-lasting assets: oil in the ground, financial assets (e.g., foreign exchange reserves), physical assets (e.g., roads), and human capital (e.g., a better-educated labour force). For an oil-rich country like Norway, with extensive physical and human capital already in place, the best choice might well be to accumulate financial assets to cover the long-term costs of the public pension system.
This is indeed the expected policy objective of any resource fund. For poor countries, such as Guyana however, it is likely to make much more sense to turn oil earnings quickly into physical assets and human capital. It may even make sense to borrow against future oil earnings for the sake of increasing investment outlays on high-return public investment. Still, this latter option requires great prudence because of the volatility of capital markets and world oil prices. Attempts to mortgage future earnings for the sake of increased public outlays have repeatedly led to eventual budget and debt crises.
Good Governance
Upright management of oil income is required from the initial exploration to auctions and contracting, to long-term fiscal transparency. Here it will suffice to stress some of the elements of good governance as they relate specifically to the linkage of oil earnings and national development strategies.
- First, there is an urgent need for each government to prepare specific assessments of national income and fiscal revenues that can be expected from the oil and gas sector. These assessments should take account of costs of production, world prices, a depletion, with all of the uncertainties attached to each of these items. The expected income flows should be public information, and subject to regular revisions given the enormous uncertainties involved.
- Second, the specific fiscal flows associated with these earnings should be explained and made public. Fiscal implications of oil earnings typically come in many forms: production sharing, royalties, corporate taxation, and other ways. These should be detailed clearly and consistently, again with the stress put on the uncertainties as well as the main forecasts.
As previously noted, transparent means should be used to manage the high risks of volatile international prices and uncertain national production. The budget should be based on a cautious assessment of the future oil path of world prices. Great caution should be used in pledging future oil revenues to secure current borrowing. Aggressive borrowing, often pushed by international banks, has repeatedly proven to be the bane of commodity exporters. Ways to hedge oil price risks should be repeatedly sought.
The government should be explicit about converting the limited and depleting oil resources into long-term and sustainable benefits for society. Rather than transferring the oil earnings as current income to the current generation, the bulk of the earnings should be invested, not only to provide the foundations for long-term growth, but also to ensure that the benefits are spread across generations. That can be accomplished financially (e.g., by investing the oil earnings in international assets to be used for future pension payments), or physically, by building the infrastructure (road, power networks) and human capital that will last for decades.
The International Monetary Fund (IMF) summarized five prudent ways for a low-income country to manage increased foreign aid flows. The same basic principles apply to managing increased oil flows as well. Indeed, aid and oil have similar economic implications. Both are revenues that accrue to the state. Both are volatile. Both are tradable. And both are “depleting” resources, since aid flows, like oil flows, are likely to be temporary. Here are the five IMF recommendations with regard to aid, with brief comments on each regarding how they apply to oil.
- Minimize the risks of Dutch Disease. This can be done by ensuring that the oil earnings are invested in ways that enhance productivity, and thereby raise rather than lower production in the non-oil traded good sector.
- Seek to enhance growth in the short to medium term. The oil earnings can be invested in some high-return “quick win” areas, such as improved food production, strengthened infrastructure (especially roads, power, and ports), and increased educational outlays.
- Promote good governance and reduce corruption. The key here is transparency and reliable public information on the sources and uses of earnings, and the expected flow of oil earnings in the future.
- Prepare an exit strategy. Just as increased foreign aid flows are temporary (by design), so that a recipient government must plan to substitute its own revenue base in the future as aid flows decline, so too an oil-exporting country must prepare for the depletion of oil income flows.
- Regularly reassess the appropriate policy mix. Oil earnings are highly volatile and the specific mix of appropriate fiscal, monetary and exchange rate policies will change over time along with fluctuations in international prices, oil flows, and changes in productivity in the non-oil sectors. Evidence of serious overvaluation of the real exchange rate (e.g., an intense squeeze of profits in non-oil export sectors) should prompt policies to depreciate the nominal exchange rate, either through an outright movement of a pegged exchange rate, or a change in the monetary-fiscal mix consistent with exchange rate depreciation.
Moreover, there should be a quantitative assessment of oil revenues and national development. All that has been said here is, of course, general. To move beyond the generalisations requires quantitative modelling of a country’s specific circumstances. A typical formal analytical approach would be to maximise intergenerational well-being subject to the production possibilities of the economy, the time path of oil earnings, the uncertainties about world prices of oil, and the investment opportunities at hand, considering both physical investments, productive capacity and financial investments in overseas assets. The formal analysis can show how a temporary and depleting path of oil earnings can best be extended into a long-term benefit for succeeding generations. The rate at which the policy planner “discounts” the future will determine much about the time path of using oil revenues.
As has been noted, oil revenues need not be a curse. When properly managed, they can play a special and important role in overall economic development in low-income countries, especially by providing the public financing for critical investments in key public goods. As long as this is done, the fears about the Dutch Disease are likely to be exaggerated. The specific nature of the goods will vary by country and region, notably according to the stage of economic development. For the poorest of the poor, priorities will lie in meeting basic needs and basic infrastructure. For middle-income countries, priorities will lie in expanding access to higher education, science, and advanced technologies. For high-income countries, priorities will most likely lie in meeting the commitments of social welfare spending, especially on pensions and health care. In all of these cases, there will be a likely advantage in using the oil earnings to cover priority public spending, rather than viewing the oil earnings as an income flow to be transferred back to households. (Of course, such a conclusion begs the question of the transparency and honesty of the public sector.) Given the volatility of world oil prices and the depletion of oil over time, considerable care must be given to managing the large macroeconomic risks of oil income flows, as well as to spread the benefits of the oil earnings across generations. This is best accomplished by converting oil flows into long-lasting financial, physical, and human capital.
However, it must be cautioned that large earnings from oil and other natural resources can have adverse effects on other sectors of economies, particularly those that can be motors for sustained economic growth. The problem arises when oil earnings are used for consumption rather than for public investment. The solution lies in a long-run growth-focused investment strategy. With the correct investment strategy, non-resource export sectors can benefit from increased natural resource earnings, and indeed it is possible to reverse the infamous “Dutch Disease” by generating growth in sectors that are central for poverty alleviation but that are in practice non-tradable (including food production) alongside real exchange rate depreciation.
