73245 The World Bank notes April PREM POVERTY 2012 NUMBER 164 REDUCTION The Fiscal Management of Natural Resource Revenues in a Developing Country Setting (or How to Design a Fiscal Rule If You Are Not Norway) Sebastian Eckardt, Ilyas Sarsenov, and Mark Roland Thomas The exhaustibility and volatility of natural When thinking about commodity funds resource revenues pose well-known economic and the fiscal management of natural resource challenges, of which those facing oil producers revenues in developing countries, two principles are the most prominent. If oil revenues represent should be applied: first, articulate a clear, meth- an important share of export earnings and of odological approach encompassing and distin- government revenues, then they can be part of guishing between the stabilizing and the saving overheating during booms and costly adjustments functions of the fund. Second, take into account during downturns, making fiscal policy exacerbate the institutional setting, for example, building volatility.1 At the same time, considerations of on credibility accumulated under existing rules, intergenerational equity suggest that fiscal policy promoting transparency, and respecting govern- should also preserve part of current oil revenues ment capacity constraints. This note first out- for future generations. To address both of these lines certain good-practice principles underlying challenges, resource-rich countries commonly rules-based fiscal approaches to managing natural establish commodity funds, into which part of resource revenues. Based on these principles, this their resource-linked revenues are deposited and note proposes an approach to determining a nonoil invested in income-generating assets (usually off- deficit rule, using Kazakhstan as a case study, shore financial assets). A key question in design- and simulates the impacts within a medium- ing such funds is what share of current revenues term fiscal framework. The concluding section should be spent and what share saved. Based on provides general lessons for policy practitioners recent advisory services offered to the Ministry and advisors. of Economy and Trade in Kazakhstan, this note summarizes one possible approach, aiming to Rule-Based Approaches provide rule-based anchors for sustainable fiscal to Fiscal Policy policy in an oil-producing country. This approach Rule-based fiscal frameworks voluntarily commit applies traditional permanent-income and debt- governments to placing constraints on discretion- sustainability frameworks, but adapts the result- ary fiscal policy, typically through numerical ing recommendations to the institutional context limits on key fiscal parameters. These may include of the country. deficit rules, debt rules, expenditure rules, and FROM THE POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK revenue rules. Such rules increase predictability institutional foundations (such as legislation, and reduce the risk of profligacy in response to the use of expert panels, and clear accountability electoral or other pressures, especially during for adherence to fiscal rules) may mitigate these boom periods. While fiscal rules have been estab- tradeoffs and are important for this reason. lished in many countries, Chile and Norway are good examples of fiscal rules specifically designed Case Study: The Fiscal to stabilize fiscal policy in the context of commod- Management of Oil ity revenues. Revenues in Kazakhstan Making rules to govern the fiscal management of commodity revenues is complicated by the fact Existing arrangements that these rules not only need to pursue the goals Kazakhstan has the Caspian region’s largest re- of good economic management (for example, con- coverable crude oil reserves, with production of sistent with monetary policy, debt sustainability, roughly 1.7 million barrels per day and proven and aggregate demand management), but beyond reserves of about 40 billion barrels. The economy this must reflect the fact that commodity revenues is reliant on extractive industries, which account are conceptually to be considered as “financing� as for more than one-third of gross domestic product opposed to “current revenue.� It is imperative to (GDP) and over half of export revenues. Oil- invest part of these, and therefore to define a suit- related tax and nontax revenues in turn account able level of consumption out of these financing for about half of government revenues. In an effort flows. Reflecting these dual concerns, consistent to reduce exposure to volatility in global commod- fiscal frameworks may comprise both fiscal rules (as in nonresource settings) and commodity fund ity prices, the National Fund of the Republic of rules. Overall, good practice for any framework of Kazakhstan (NFRK) was established in 2000 to rule-based fiscal management of natural resource serve both a saving and a stabilization function. economies should respect four key principles: Fiscal management in Kazakhstan during i. Saving: setting aside sufficient resources to 2000–2010 was disciplined overall. Public spend- protect the welfare of current and future ing was stable at an average of about 22 percent generations. of GDP for most of the period leading up to ii. Stabilization: managing the volatility associ- 2008, with the nonoil deficit averaging roughly ated with natural resource flows, including, 3 percent of GDP, despite increased inflows of oil most importantly, price fluctuations. revenues over 2000–2007 (figure 1). Savings in iii. Transparency: reliably informing stakehold- the NFRK had reached US$27 billion (21 percent ers of the use of resources and enabling them of GDP) by end2008. This strong reserve posi- to evaluate whether rules are being applied. tion then allowed for a countercyclical response iv. Credibility: using rules that market partici- to the 2008 global crisis, which hit Kazakhstan pants (for example, bondholders) believe will through insolvency problems in the banking be adhered to and thus increase the level of sector.2 As a result of a decline in nonoil revenue certainty about macroeco- nomic policy. Figure 1. Oil Revenue and Nonoil Budget Deficit, 2000– There are tradeoffs between 2010 these principles; no formula- 15 based approach and/or institu- oil revenue 10 tion will be perfect. For example, percent of GDP structural deficit calculations 5 may aid stabilization, but are 0 technically more complex and -5 tax reform therefore may reduce transpar- nonoil budget de�cit crisis ency. As a further example, the -10 high saving rates needed to meet 00 01 02 03 04 05 06 07 08 09 10 20 20 20 20 20 20 20 20 20 20 20 equity objectives may be po- litically difficult to sustain and Source: Authors’ illustration. therefore lack credibility. Solid 2 PREMNOTE APRIL 2012 and a discretionary expansion of expenditure on debt, is likely to be a costly strategy, in particular an anticrisis program, the nonoil deficit widened when spreads between the government’s lending to more than 10 percent of GDP (financed largely and borrowing rates become significant. with transfers from the NFRK). A tax reform that decreased corporate income tax and unified A fiscal framework for Kazakhstan: investment credit schemes also contributed to conceptual approach the revenue decline; nonoil revenue is therefore Widening the focus of the fiscal rules’ regime expected to remain below precrisis levels even as to include government saving (or dissaving) be- the economy recovers. yond the oil fund itself is a high priority. A more The fiscal management of oil revenues in comprehensive measure to assess the underlying Kazakhstan is currently governed by a set of rules position and sustainability of fiscal policies in adopted by presidential decree in April 2010. oil-producing countries is the so-called “nonoil These rules include: deficit.�3 Anchoring fiscal policies in a target for • A fixed annual guaranteed transfer to the the nonoil deficit, however financed, ensures a budget of US$8 billion. focus on net public savings and the trajectory of • A minimum NFRK balance of 20 percent of government net worth; the main elements of this projected GDP at end of the respective fiscal approach are summarized in figure 2. The rule year. combines an annuity-based oil revenue transfer • Public debt service (interest) not to exceed 4.5 with a state deficit target and countercyclical percent of imputed fixed investment return on component linked to the oil price. An intergenera- the fund. tionally equitable approach to consuming natural • Average cost of service and repayment of resource wealth is typically constructed using a public debt over 10-year period not to exceed permanent-income method to translate the total 15 percent of total budget receipts, including value of the asset into an annuity in constant cash transfer from the NFRK. dollar terms.4 At the same time, the trajectory of • No off-budget financing, that is, no guarantees overall government net worth may be set through or lending for domestic investment. a rule for the state deficit—the nonoil deficit minus These rules restored discipline in the use of transfers to NFRK—consistent with a desired, oil revenues in the wake of the financial crisis, but sustainable level of public debt. This ensures that their fiscal properties can still be improved. The over the long term, oil-financed expenditures and existing framework is structured around the fixed asset accumulation paths converge to sustainable nominal annuity (US$8 billion) transferred on levels, for any given set of underlying assumptions. budget, with all oil-related government revenue exceeding this saved in the NFRK. The narrow Applying the permanent-income focus on transfers into the fund and the resulting approach to generate an oil annuity fund balances can be inconsistent with the fund’s Calibrating sustainable consumption expenditure savings function because it may overlook situa- thresholds from a natural resource asset implies tions in which accumulation in the fund is paid for seeking a rule that makes a justifiable tradeoff by net government borrowing—this has in fact hap- between welfare in current and future periods. pened in recent years. Accumulating assets in this One way that has been suggested to think about way in the NFRK, while simultaneously increasing this problem is to calculate the present value of Figure 2. Fiscal Rule Architecture permanent-income debt �scal approach sustainability stabilization management permanent- sustainable income oil countercycling state de�cit nonoil annuity component rule de�cit rule (constant US$) (linked to (% of GDP) oil price) Source: Authors’ illustration. APRIL 2012 PREMNOTE 3 st te de(proven) total cit—the no oil reserves oil eficit and m nus tran f spend s to NF K (consume) — onsistent w revenue profile over time. Under the base case desired o l s e t o e only ulat path annuity on the converge o value of e susta nab eve asset, this ny given the s, for leaving et o assumption for oil reserves (which uses estimates derlying real financial value of the asset constant over of the main industry participants), and using F ure 2. Fi cal u e rch tect re Sou e Authors i lustrat on time. Extraction of oil is then simply viewed as the approximate mean Brent crude price from a portfolio transaction, converting the oil asset 1970–2010 and a 3 percent long-run financial into financial ermanent-income assetstoIn approach estimating generate thresholds, an oil annuity [[B head]] two rate of return, the implied annuity value is about components bl are taken d into consideration: h ld f r the (i) US$8.431 l billion.5 An initial conclusion of the that makes a real eexpected tradeo on return ustif ble financial between welfare n assets curren already and future analysis is therefore that the US$8 billion rule ods One n t i k o t em e e t accumulated eserves and spend ( (the onsume)balance on y the a the of va ue of th and nuity NFRK) (ii) s asset, lea currently the real used by Kazakhstan to govern transfers o ta e d o nve expected the real ng t e oil asset into return on the financial assets timating th value In e present of holds two from NFRK to the budget is set at a level that is ponents o consideration (i) the expected real return on f nancial as ets already mulated future oil revenue (the discounted future revenue broadly consistent with the permanent-income stream). discounted f The stream formula following u e revenue The fo lowi is applied: g ormula s ap approach to intergenerational equity. Applying a debt-sustainability approach to the state deficit The second element of the deficit rule is a con- straint on the state deficit that would be financed e expend ure (budgetary tra s er) in pe iod t+ r deno es he e t a where T denotes the expenditure (budgetary ) Fd b l he NFRK f r dt a Rd byth additional oil public debt. Government may want transfer) in period t+1, r denotes the expected real eds i period . to borrow for a number of reasons, including to al- of return rate ds hresho equires a (interest), sumptions abou F denotes of r balance the volume the serves, the low financial markets to benefit from having avail- ce and f ov ime the d sc e n t s fr e o ur n s in the NFRK for period t , sis he as um tions n ta e 1 we e app iedand R denotes the oil able a relatively safe and liquid tenge-denominated revenue T proceeds 1 B C A inpt period f t. asset as well as to establish market confidence and Ass mp ion thresholds Estimating Ration le requires assumptions credit ratings, which will benefit the government about the volume of reserves, their price and in the long run.6 Such borrowing, while affecting extraction profile over time, the discount rate, the net worth of the government, is consistent and the (risk-free) rate of return on financial as- with long-term fiscal sustainability as long as the sets. For this analysis, the assumptions in table 1 growth of the nonoil economy exceeds the interest were applied. paid on government debt (debt sustainability). A A range of annuity values of Kazakhstan’s solution to this should logically focus on the state oil stock computed with the permanent-income- deficit as a percentage of GDP. based approach is shown in table 1, and figure A simple way of understanding the approach 3 provides a graphical interpretation of this is to think of the debt sustainability of the country approach for Kazakhstan’s actual projected oil if it did not have any natural resource endow- Table 1. Base Case Assumptions for the Analysis of Oil Revenues Variable Assumption Rationale BP Statistical Review of World Energy 2010a 40 billion Proven reserves (low case is based on historical value for proven barrels reserves in 2000) Mean oil price of last 40 years Long-term price US$40/barrel (high case is based on mean oil price plus half stan- of oil dard deviation) Effective rate of 30% Current effective tax rate taxation Real rate of Current interest rate on 30 years U.S. treasury bonds 3% return (used as risk-adjusted rate of return) Source: Authors compilation. a. www.bp.com. 4 PREMNOTE APRIL 2012 Table 2. Permanent-Income-Based Annuity Values of Oil Oil price Rate of return Rate of return Oil reserves (US$) 3.00% (US$) 4.50% (US$) 3.4 billion T 40 6,306 8,140 Low case (25.5 billion 60 8,927 11,413 barrels) 5.6 billion T 40 8,435 10,022 Base case (41.9 billion 60 12,121 14,236 barrels) Source: Authors’ compilation. Note: T = budgetary transfer. Figure 3. Permanent-Income-Based Annuity and Projected Revenue Profile for Kazakhstan 14 extraction pro�le at US$40/barrel 12 constant US$ billions (2010 prices) sustainable expenditure under 10 shaded area permanent-income hypothesis at constitutes of 3% real return on investment NFRK savings 8 6 4 2 0 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2052 2054 2056 2057 2059 2061 2063 2065 2067 2069 Source: Authors’ illustration. ments. Resource endowments are then considered during booms. An example is Chile’s fiscal rule, separately, through a lens of intergenerational which rather than setting a target for the actual equity. budget surplus, targets the structural budget bal- ance. Similarly, Norway’s parliamentary budget Constructing a simple approval process targets a structurally adjusted countercyclical component measure of budget balance. One potential disadvantage of deficit rule ap- While structural balance targets have desir- proaches is that by constraining fiscal expansion able properties in theory, one drawback is that regardless of the economic cycle, they may induce they can be complicated to implement. Their ad- pro-cyclical fiscal policy. To overcome this limita- vantages may therefore come at a cost of reduced tion, the fiscal rules adopted by some countries transparency. If they are viewed as too difficult target the structural (that is, cyclically adjusted) for government to execute properly, they may balance rather than the cash (or annual accrual) also undermine credibility with markets. Strong balance; this allows increased spending in down- institutions are needed for successful implementa- turns, financed through a tighter fiscal stance tion. For example, Chile’s approach uses outside, APRIL 2012 PREMNOTE 5 independent expert panels to set key parameters spending in the short term. This is consistent and recommend policy to government. with countercyclical fiscal policy, given that the Kazakhstan’s business cycle is empirically Kazakhstan economy is now well into a recovery closely tied to the price of oil. A simpler approach, phase, with GDP growth around 7 percent and if the government of Kazakhstan wishes to in- inflation above its target band—Consumer Price troduce greater stabilization features into fiscal Index (CPI) inflation was 8.3 percent as of May management, might therefore be to tie a cyclical 2011. Discretionary fiscal expansion at the pres- component of deficit spending to variations in the ent time is unlikely to be growth enhancing. oil price around a long-term equilibrium oil price. A state deficit rule would encourage policy Chile executes such an approach with its Copper makers to focus on the suitable combined tra- Fund, with another external panel determining jectories of the NFRK balance and gross public the long-term equilibrium price of copper to debt. Figure 4 shows these trajectories as shares of be used. Such a mechanism could make up for GDP under the 2.5 percent state deficit rule. For a variations in Kazakhstan’s nonoil revenue, which given government revenue share, setting the state (despite the “nonoil� label) is highly correlated deficit is equivalent to choosing between higher with the oil price. NFRK balances and lower gross public debt. Under the baseline parameters for the economy Simulating fiscal impact and the rule as specified, the NFRK balance The fiscal impact of adopting a reasonably cali- reaches about 30 percent of GDP by 2020, while brated state deficit rule in Kazakhstan in conjunc- public debt remains below a threshold of about tion with a transfer on budget of US$8 billion in 20 percent of GDP, consistent with international constant (2010) dollars is illustrated in figure 4. experience of prudent public debt management The rule that is simulated sets the state deficit to for a middle-income country (Reinhart, Rogoff, 2.5 percent of GDP, which is consistent with debt Savastano 2003). sustainability as well as with sufficiently liquid domestic debt markets—for example, bearing in Summarizing the mind objectives of capital market development Kazakhstan Case and effective monetary policy, which are not One important attribute of the proposed frame- discussed in detail here. The adoption of such work for Kazakhstan is that it could build upon a rule would still not allow any expansion of the country’s existing set of rules. The main exist- Figure 4. State Deficit Rule (2.5 percent of GDP) 30 30 35 30 25 25 percent of GDP 25 percent of GDP 20 20 20 15 15 15 10 10 10 5 5 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 total GOK debt (stock) NFRK oil revenue budget nonoil total NFRK assets (stock) (saved) revenue budget oil total budget revenue (spent) spending current expenses Source: Authors’ illustration. 6 PREMNOTE APRIL 2012 ing feature of the oil fund management, the US$8 stance. Given that mineral revenue is only billion limit on transfers to the budget (combined one element of overall government resources, with no off-budget spending transfers), could be and the fact that financial resources are fun- maintained. This rule is simple and transparent. gible, a fund that is not anchored in a sound And not only is its level well calibrated according overall fiscal framework might simply result to a permanent-income-based approach, but keep- in “form without substance.� In the absence ing the present framework in place will allow the of liquidity constraints, the government can government to build a track record of rule-based borrow (from domestic and external sources) management and thus enhance credibility. or draw down other accumulated assets to A rule governing budget transfers from the increase spending, even if oil windfalls are fund does not, however, govern changes in the partially accumulated in a fund. Therefore, financial net worth of the government, which also the government should approach the use of depends on (net) public debt issuance. A useful natural resource revenues, and by extension addition to the oil transfer rule (based on an annu- the operation of the fund, within a fiscal ity and therefore fixed in constant dollars) would framework that takes into account as compre- be a rule governing the state deficit. In scenarios, hensively as possible all liabilities and assets, a state deficit rule in the range of 2 to 3 percent including the stock of public and quasi-public of GDP had reasonable properties: more detailed debt, commodity values in the ground, and analysis would be needed to underpin a firmer future tax revenues. recommendation. • Second, the Kazakhstan case study gives Going further, oil-based economies such as an example of how rules should and can be Kazakhstan tend to exhibit volatile growth as adapted to institutional capacity. Countries well as unpredictable government revenue. This with successful rule-based fiscal frameworks capriciousness shows that simple approaches to governing natural resource flows, such as Chile rendering fiscal management more stabilizing and Norway, have paid careful attention to (countercyclical) should also be considered. For the institutional design underpinning them. Kazakhstan, one possibility is to include a deficit In addition to legislative components and component in a fiscal rule, linked to variations quantitative rules, the use of independent in the oil price from an assumed long-term equi- expert panels to set or review key parameters librium. This has desirable stabilizing properties is one such institutional feature. Another because in Kazakhstan, nonoil revenue is highly is that any fiscal rule will be most effective correlated with the oil price. Finally, Kazakhstan’s in an institutional environment that fosters current practice of keeping all transfers from the transparency, for example through inclusion NFRK to public spending on budget should be of reporting on rule compliance in budgetary fully supported. and financial statements. A corollary is that where institutional capacity is given, and Conclusions complex arrangements not be feasible or at Rule-based fiscal frameworks offer strong ben- least credible (for example, calculating and efits to countries that are generating significant publishing a structural deficit in real time), government revenue from extractive industries. simpler rules will perform better (for example, As commitment devices, these frameworks can the suggestion to tie a countercyclical spending reinforce fiscally responsible economic manage- component to the oil price). Reflecting these ment, contain volatility, and preserve fiscal sav- issues, the approach proposed for Kazakhstan ings for future generations. To design credible did not include strong assumptions about the and practical fiscal rules, the following issues extent of institutional reform in the country, are important: but was rather designed to be implementable • First, the management of natural resource in Kazakhstan’s existing institutional setup. funds should be integrated into a compre- • Finally, an important ingredient for credibility hensive fiscal framework and asset/liability of rule-based frameworks is a track record of management system. The extent to which a compliance. For this reason, when existing fund is successful in achieving its objectives, frameworks are performing adequately, even however, depends on the overall fiscal policy if they do not precisely follow notions of inter- APRIL 2012 PREMNOTE 7 national best practice, it may be best to look in nominal dollars (based on a three-year fixed for ways of building on these frameworks by tenge-dollar exchange rate). adding complementary measures, rather than 5. The framework was applied assuming certainty altering them fundamentally. about future government oil revenues, that is, us- ing a discount rate equal to the assumed “risk-free� Acknowledgment rate of return. The risk-free rate is taken to be 3 The authors would like to thank Silvana Tordo percent, consistent with long-term low-risk yields, (SEGOM), Luca Bandiera (PRMED), and Sebnem such as the (real) return on U.S. treasury bonds Akkaya (ECCKZ) for their comments and sugges- (the nominal yield on 30-year treasury bonds tions on this note. was 4.27 percent on June 8, 2011). Allowing for uncertainty about oil revenues suggests a discount About the Authors rate higher than the risk-free rate of return, which Mark Thomas is Lead Economist in the Africa results in a rising trajectory for consumption from Region of the World Bank; Sebastian Eckardt is an oil revenues, but is analytically far more complex Economist in the Europe and Central Asia Region; and correspondingly less transparent as a public and Ilyas Sarsenov is an Economist in the Kazakh- policy. stan Country Office, Astana. 6. The current short supply of government securi- ties is a significant problem for financial markets. Notes The concern is most acute for pension funds, 1. Cuddington (1989) and Sinnott (2009) both which would optimally hold a large share of their find that government revenues in commodity- assets in Kazakh government securities, and are dependent countries respond significantly to com- currently too exposed to various risks in their modity prices, in turn inducing spending booms. absence. Commercial banks are also in need of 2. Note that although the oil fund was not set up relatively safe liquid tenge-denominated assets; the with an explicit precautionary saving function, government’s borrowing program takes this need the exceptional nature of events in 2008 essen- into account. This is one of the primary reasons tially lent it this function, as is the case whenever why the size of the transfer from the NFRK will the rules of a fiscal framework are allowed to be allow significant government borrowing over the relaxed in crises. medium term. 3. The following reflects Kazakhstan’s usage (2010 values): the “nonoil deficit� (US$11.2 bil- References lion) is total nonoil government revenues minus Cuddington, John. 1989. “Commodity Export public expenditures; the “state deficit� (US$3.2 Booms in Developing Countries.� World Bank billion) is the nonoil deficit minus all oil revenues Research Observer 4: 143–65. transferred on budget. Thus, in Kazakhstan, the Reinhart, C. M., K. S. Rogoff, and M. A. Savastano. state deficit is that part of the nonoil deficit that 2003. “Debt Intolerance.� National Bureau must be financed by net public borrowing, while of Economic Research, Working Paper 9908. the nonoil deficit drives changes in government Sinnott, Emily. 2009. “Commodity Prices and net worth. Fiscal Policy in Latin America and the Carib- 4. The annuity value may be updated over time bean.� Presented at the Myths and Realities of as new information is revealed, for example, Commodity Dependence: Policy Challenges about expected prices or reserves. Note also that and Opportunities for Latin America and the a constant dollar transfer differs from the current Caribbean Workshop, held at the World Bank, rule used by Kazakhstan, which sets the transfer Washington, DC, Sept. 17–18. This note series is intended to summarize good practices and key policy findings on PREM-related topics. The views expressed in the notes are those of the authors and do not necessarily reflect those of the World Bank. PREMnotes are widely distributed to Bank staff and are also available on the PREM Web site (http://www. worldbank.org/prem). If you are interested in writing a PREMnote, email your idea to Madjiguene Seck at mseck@worldbank.org. For additional copies of this PREMnote please contact the PREM Advisory Service at x87736. Prepared for World Bank staff 8 PREMNOTE APRIL 2012