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United Arab Emirates: Selected Issues and Statistical Appendix

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International Monetary Fund
Published Date:
March 2003
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III. Fiscal Sustainability with Oil Resources31

A. Introduction

59. The sustainability of a fiscal stance is traditionally assessed in terms of a country’s explicit public debt burden (both its size and debt service) and its likely dynamics over the medium and long term. However, in countries where wealth is derived from a nonrenewable resource, such as oil (and natural resource wealth represents a significant source of government revenue), this assessment must also take into account the depletion of this wealth to ensure intergenerational economic equity. The reason for this is that a fiscal stance that could lead to a stable or declining government debt to GDP ratio may rely on higher oil production and revenue (for countries that are price-takers), and thus also lead to a rapid depletion of the country’s oil wealth. By ensuring intergenerational equity, the government avoids the use of the country’s oil wealth to finance the welfare of the present generation at the expense of the welfare of future generations. 32 This position also imposes fiscal discipline on the government by requiring that the government’s total net wealth be the basis for its fiscal policy rather than current resources available.

60. Policymakers in oil-dependent economies must, therefore, decide how much oil income to spend on the present generation and how much to save for future generations. 33 One way to determine a sustainable level of public consumption out of oil resources is to derive a notional income stream from the stock of government net wealth, determined by the present value of expected future government oil revenue and the existing amount of net financial assets owned by the government net of debt. This notional income represents the “permanent income” that can be consumed indefinitely while preserving the stock of wealth for future generations.

61. This chapter provides a practical framework to estimate the United Arab Emirates’ permanent income available from its oil wealth resources to assess the sustainability of the current fiscal stance.

B. The Framework

The criteria

62. Several criteria may be applied to determine an oil-rich country’s permanent income. Two reasonable ones are to maintain the same oil wealth in (a) per capita terms, or (b) real terms. 34 The first alternative implies that the government provides a time invariant level of public goods to all citizens over time, which means that the level of government consumption must be restricted today to provide the same benefits across generations in the future. Thus, the country’s total wealth (oil plus net financial assets) will have to increase over time to keep up with the population growth, restraining the amount that can be consumed every year.

63. The second criterion is less restrictive, since it implies that the government could consume relatively more today based on the (real) return of its wealth, favoring the current generation at the expense of future generations. This puts the onus on future generations to maintain their per capita income through investments in human capital, and on the government to enhance growth prospects by developing infrastructure and human capital. The choice of criteria would therefore depend on the government’s preferences between present and future generations. The stronger the preference toward the present generation, the higher would be the desire to consume more today than in the future, thus choosing the second criterion.

64. The government’s consumption out of oil resources can be proxied by the non-oil fiscal balance. 35 This balance could be defined as (current) expenditure (including the depreciation of the government’s capital stock) minus non-oil revenue (including investment income). 36 This definition is, however, debatable because some categories of current spending, such as health and education, can be considered as investment in human capital, while some capital spending items can be considered as a form of consumption. In this context, a sustainable fiscal policy over the long run would be one in which the (consolidated) government’s non-oil (current) fiscal deficit would be less than or equal to the country’s permanent income out of the oil wealth. Nevertheless, given the uncertainty in oil prices, there may be a need for precautionary savings over and above the level implied by the permanent income.

C. The Case of the United Arab Emirates 37

65. Estimates of the permanent income are based on several factors—one of the most significant being long-term oil prices. The higher the expected future oil prices, the higher is the share of oil income which can be spent today without reducing the welfare of future generations relative to the current generation. Other important factors are the discount rate, population growth, proven oil reserves, and the extraction rate. Given the uncertainty in estimating these factors, in particular the oil reserves, which may vary over time as a result of technological changes, estimates of the permanent income can be subject to variations and must be revisited in light of new information. As a result, revisions in wealth should also lead to revisions to fiscal stance.

66. Indicative values of the United Arab Emirates’ permanent income over the medium term were estimated below. The estimates were based on several parameters and assumptions summarized in Table 10. Given the oil-proven reserves and current annual extraction rate, it would take about 120 years for the oil reserves to be exhausted. Under a conservative crude oil price assumption of $18 per barrel, the present value of the United Arab Emirates’ crude oil reserves was estimated at $245 billion, equivalent to about 345 percent of GDP. 38

Table 10.Summary of Main Assumptions and Parameters
Proven oil reserves (in billions of barrels)97.80
Daily crude oil extraction (in millions of barrels)2.21
Expected rate of growth of oil production (in percent)0.0
Long-term annual (real) discount rate (annual rate in percent)5.0
Long-term world crude oil price (in U.S. dollars per barrel)18.0
Average long-term production cost (in U.S. dollars per barrel)3.5
Expected average annual rate of population growth (in percent)2.5
Expected average annual rate of non-hydrocarbon real GDP growth (in percent)5.0
Government debt (in percent of GDP)4.5
Inflation (in percent)0.0
Source: Fund staff.
Source: Fund staff.

67. Under criterion (a), maintaining the same oil wealth in per capita terms, the annual usable amount of oil reserves for fiscal purposes was estimated at about Dh 25.3 billion ($6.8 billion) on average over the medium term through 2007. Under criterion (b), maintaining the same oil wealth in absolute terms, the permanent income was estimated at Dh 42.5 billion ($11.5 billion). Rules of thumb could also be used to estimate the permanent income. For criterion (a), every year the government can consume the projected return on the wealth (5 percent) minus the expected population growth (2.5 percent), that is, 2.5 percent out of $245 billion, or $6.1 billion. For criterion (b), the government can consume the full return on the wealth, that is, 5 percent, or about $12.2 billion a year.

68. Although the average non-oil fiscal deficit during much of the 1990s has been within the long-run sustainable path indicated by permanent income estimates, the United Arab Emirates’ current fiscal policy stance is unsustainable under a conservative crude oil price assumption of $18 per barrel for the long term. 39 This is so because the estimated permanent income under either the first or second criterion is significantly lower than the estimated non-hydrocarbon fiscal deficit in 2002 (Dh 68.5 billion). 40 Thus, under this scenario the U.A.E. authorities would need to increase non-hydrocarbon revenue and/or cut expenditures over the medium term to make government consumption compatible with intergenerational equity objectives in line with the country’s estimated permanent income.

31This chapter was written by Ugo Fasano (MED).
32See Barnett, S. and R. Ossowski, 2002, “Operational Aspects of Fiscal Policy in Oil-Producing Countries,” paper presented at the IMF Conference on Fiscal Policy Formulation and Implementation in Oil-Producing Countries, June 5-6, 2002 (Washington: International Monetary Fund); and E. Engel and R. Valdes, 2000, “Optimal Fiscal Strategy for Oil Exporting Countries,” IMF Working Paper 00/118, (Washington, D.C.: International Monetary Fund).
33Policymakers are also confronted with the issue of how to cushion the domestic non-oil economy from the sharp and unpredictable variations in oil prices and revenue, as well as avoid the Dutch disease phenomenon of real exchange rate appreciation and loss of competitiveness in the non-oil tradable sector.
34Alternative criteria are to maintain the same net wealth in percent of (non-oil) GDP or in nominal terms.
35The non-oil fiscal balance is also a better indicator of underlying fiscal trends in oil-dependent economies than the traditional overall fiscal balance, because it abstracts from the volatility in oil prices and revenue.
36See Barnett and Ossowski (2002) for a detailed analysis of operational aspects of fiscal policy in oil-producing countries.
37The framework was adopted from work done by FAD staff on Venezuela.
38The budgeted crude oil price usually ranges between 15-20 percent below the projected global price. The assumption of $ 18 per barrel is about 18 percent below the Fund’s World Economic Outlook (WEO) medium-term oil price projections.
39The non-oil fiscal deficit averaged Dh 37.5 billion a year in the period 1991-2000, which is compatible with an estimated permanent income based on a long-run oil price of $16.3 per barrel and 2.21 million barrels a day of crude oil output. During the same period, actual oil prices averaged $18.04 per barrel, oil output, 2.29 million barrels a day, and the overall consolidated fiscal balance (including estimated investment income), about -1 percent of GDP.
40The long-run oil price should be assumed at close to $27 per barrel (higher end of OPEC range price target of $22-28 per barrel) for the permanent income to be estimated at about Dh 68.5 billion.

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