V A Framework for Strengthening Fiscal Institutions in Oil-Producing Countries

Mauricio Villafuerte, Rolando Ossowski, Theo Thomas, and Paulo Medas
Published Date:
April 2008
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The experience with the recent oil boom highlights the importance of ensuring the quality of spending and the sustainability of fiscal policies. For countries with appropriately strong fiscal positions and budget management systems capable of ensuring the quality of higher spending, increases in the non-oil deficit consistent with the preservation of macroeconomic stability may be an appropriate response to higher oil revenues (see IMF, 2005a). At the same time, many oil-producing countries with low indices of government effectiveness have increased spending rapidly, and the long-term fiscal sustainability of a number of oil-producing countries saw limited improvement or deteriorated between 2000 and 2005.

Some specific challenges faced by oil-producing countries affect the ability of SFIs to enhance fiscal management and achieve desired fiscal outcomes. The difficulties posed by a volatile, unpredictable, and exhaustible source of fiscal revenue to fiscal management have been compounded in a number of cases by institutional weaknesses and complex political dynamics. Against this background, the evidence suggests that in many cases SFIs by themselves have not been able to overcome these constraints. SFIs have been more successful when there was broad political support for the pursued fiscal objectives.

SFIs based on partial approaches and rigid rules have sometimes hindered flexible responses to changing conditions or have been modified since first established. In particular, although in a number of cases SFIs may initially have helped achieve specific fiscal objectives, tensions have tended to surface over time between rigid SFI rules and shifting policy objectives, including in the case of oil shocks and rapidly changing economic environments. In a number of these cases, the rules were modified, bypassed, or abolished. In some cases, a focus on SFIs may also have diverted attention from a more comprehensive view of fiscal policy, including longer-term considerations.

The evidence suggests that the quality of institutions matters for fiscal policy. The findings presented earlier tend to confirm the results in the literature that broader institutions—for example, accountability and the quality of public administration—can have a positive impact on economic policy.1

Institutions, PFM Systems, and Medium-Term Frameworks

Some specific characteristics of oil-producing countries and expenditure trends underscore the significance of developing comprehensive policy frameworks and institutions. In particular, many oil-producing countries need to strengthen PFM systems, enhance the links between annual budget decisions and medium- and long-term fiscal objectives, and introduce comprehensive assessments of volatility and risk as appropriate.

  • In a number of oil-producing countries, increases in spending associated with the availability of unexpected and large financial resources make the enhancement of administrative capacity and fiscal transparency particularly urgent, especially as governance indicators tend to be below other countries at similar levels of income. Rapid growth in expenditures warrants intensified scrutiny of their quality and efficiency, including in public investment procedures. Country authorities should undertake and report periodic reviews of the quality of stepped-up spending to ensure efficiency and value for money. In recent years, IMF staff have noted in the reports for many of the countries in the sample the need to improve budget processes, fiscal transparency, and the quality of spending.
  • With liquidity constraints lifted in a number of oil-producing countries, capital markets may play less of a disciplining role than in countries that need to access markets to finance fiscal deficits.
  • The development of institutions that promote a longterm perspective is warranted given the inability of future generations to voice preferences on the use of oil, a nonrenewable resource.

The analysis also suggests the importance in oil-producing countries of appropriate longer perspectives and risk analysis in fiscal planning. In many oil-producing countries, short-term horizons in annual budgets may not give adequate weight to oil price volatility and uncertainty. This may give rise to procyclical expenditure patterns, as spending adjusts to revenue availability, and increases the risk of large and costly expenditure adjustments. Rather than providing greater flexibility to cope with oil revenue and other shocks, annual budgets that do not provide a clear link to longer-term policies and plans, including the recurrent cost of capital projects or for entitlement programs, may create multiyear spending commitments that entrench rigidities and undermine fiscal discipline.2

Priority should be given to enhancing PFM systems where appropriate. The budget systems in many oil-producing countries suffer from PFM weaknesses, including in the capacity to manage the planning, allocation, and effective control of budgetary resources. The increase in spending associated with higher oil revenues is likely to place additional pressures on PFM systems. Depending on their particular circumstances, oil-producing countries should consider undertaking reforms in PFM areas such as budget planning, accounting and classification, internal control, audit, and reporting.

Adopting a medium-term framework (MTF) for fiscal policy can help connect the annual budget to longer-term policies and sustainability objectives, and enhance risk analysis in oil-producing countries. MTFs can provide a framework to set fiscal policy objectives and the policies to achieve them. Establishing a sustainable long-term fiscal framework is particularly important for oil-producing countries with volatile and exhaustible resource revenues. However, such longterm planning is subject to considerable uncertainty: measures of sustainable spending may vary over time, and budgets often respond to short-term policy considerations. Therefore, a well-designed, rolling MTF should help clarify fiscal policy choices, considering both immediate and longer-term objectives and their likely consequences.3

The design and implementation of an MTF needs to be consistent with institutional capacity, particularly the PFM systems. There are generally several stages in the evolution of an MTF, requiring varying degrees of institutional capacity and effectiveness of PFM systems (Box 3). Although MTFs must often be supported by improvements in PFM systems, these frameworks can also spur such improvements.

Box 3.Using Multiyear Fiscal Policy and Planning Frameworks

In a number of countries, budget processes have been reoriented to lengthen the period covered by fiscal frameworks. Although the specific forms vary, these reforms generally do not mean extending the budget, in terms of the legal appropriations, beyond one year. Most include a clear fiscal policy statement establishing a medium- to long-term path for expenditure aggregates, medium-term macroeconomic forecasts, requirements for ministries to maintain budget estimates beyond the budget year and to explicitly cost new measures, and hard cash budget constraints for ministries. Medium-term frameworks (MTFs) also generally emphasize fiscal discipline and play a central role in guiding public financial management (PFM) reform and micro-level performance management.

MTFs have tended to evolve gradually through three basic stages of institutional development:

  • A medium-term fiscal framework (MTFF) provides a top-down statement of fi scal policy objectives and sector strategies (not necessarily disaggregated to spending agencies), and a set of integrated medium-term macro-economic and fiscal targets and projections. The MTFF is designed to augment the compliance requirements of the traditional budget to meet a government’s stabilization objectives, including the identifi cation of fiscal risks, such as the vulnerability to shocks in oil-producing countries, and the need to control fi scal aggregates and coordinate with monetary policy.
  • A medium-term budget framework (MTBF) incorporates realistic projections of spending by individual agencies (e.g., line ministries) that allocate resources in line with strategic priorities and consistent with overall fi scal objectives of the MTFF. Information on the distribution of resources within the budget seeks to bolster the stabilization objective with harder medium-term spending constraints for line ministries, along with the productivity of public expenditure, because spending agents can be held accountable for their share of resources.
  • A medium-term expenditure framework (MTEF) extends the analysis further with more detailed costing within sectors and the development of more specifi c performance measures. This stage also commonly seeks to identify and promote incentives for better public sector performance, often through the increased delegation of authority to line ministries or agencies and increased flexibility in the mode of service delivery. This stage is predicated on reasonably sound, well-established PFM systems, and a commitment to fi scal discipline and stabilization objectives.

Specific examples of MTFs in oil-producing countries at various stages of institutional development include the following:

  • Mexico’s FRL, approved in March 2006, requires the annual budget to be presented to congress with quantitative projections for the next fi ve years and explicit costing for new fi scal measures. It includes other measures designed to smooth expenditures, strengthen expenditure management, ensure greater transparency, and steps toward performance-based budgeting.
  • Russia embarked on an ambitious budget system reform program in 2004. A rolling three-year budget for the federal government and federal extrabudgetary funds was introduced in 2007, approved by parliament, with a detailed breakdown of revenue projections and expenditures. A key innovation is the introduction of the concept of the non-oil fi scal balance, which will be capped at a deficit of 4.7 percent of GDP starting in 2011. These reforms are accompanied by wide-ranging PFM reforms and performance budgeting methods (Diamond, 2006).
  • Timor-Leste adopted a fi scal framework based on the estimated permanent income from the oil wealth over the long term. Annual budget documents also roll forward three-year projections based on sector investment programs with detailed plans to guide expenditures and against which performance can be measured. Considerable technical assistance is being targeted to try to overcome the severe administrative capacity limitations and weak PFM systems that constrain budget execution.

The simplest form of MTF is a medium-term fiscal framework (MTFF). It entails a comprehensive statement of fiscal policy objectives (against which fiscal performance can be assessed), integrated medium-term macroeconomic projections, and (aggregate) fiscal targets based on macroeconomic stabilization and fiscal sustainability considerations (a top-down approach). Even a simple MTFF can help incorporate longer-term perspectives into budget planning processes and promote predictability, fiscal discipline, transparency, and ac countability. It may a lso help bolster suppor t for pr udent fiscal policies among policymakers and the public, and get the political debate to span longer horizons. Further MTF stages involve medium-term budget frameworks (MTBFs) and medium-term expenditure frameworks (MTEFs). The introduction of these frameworks entails more fundamental changes in the way budgets are put together. Different models could be considered by countries at varying stages of development.

The implementation of the more advanced MTF modalities should be consistent with administrative capacity. Implementation may require the prior adoption of more basic PFM reforms, such as improving budget and accounting classification. Although existing PFM systems in some oil-producing countries are likely to be sufficient to support the gradual introduction of advanced MTF forms, the implementation track record in low-income countries with significant PFM weaknesses has been mixed. This suggests that countries should start cautiously with the more basic forms (World Bank, 2005). Each stage in this process should build on the preceding one and be in line with the capabilities of the budget system.

Public investment planning should be fully integrated into the MTFs. Some oil-producing countries retain separate fiscal institutions that plan or execute certain types of capital or development expenditures, not confined to extrabudgetary funds and oil funds. Separate arrangements do not necessarily undermine integrated fiscal planning, but they do raise the risk of harmful “dual budgeting” practices.4

MTFs in oil-producing countries can be specifically designed to help address the fiscal risks posed by reliance on volatile and uncertain oil revenues. They should incorporate explicit risk management strategies to help offset shocks and facilitate less disruptive adjustment processes, thereby contributing to the smoothing of spending over the medium term.

  • It is important to introduce budgetary contingencies or other self-insurance mechanisms. Traditional MTFs include technical and prudential contingencies for dealing with changes in key macroeconomic assumptions or unexpected expenditures. Oil-producing countries should give appropriate weight to the risk of oil shocks and their potential fiscal impact in determining the appropriate size of contingency reserves and non-oil deficits from a vulnerability and sustainability perspective, especially in light of the asymmetric costs of adjustment.
  • Scenario or stress tests to the MTF and long-term fiscal position in relation to potential oil and other shocks should be regularly conducted to calibrate country-specific target levels for contingency reserves and non-oil deficits.5 This approach can be conducted at various levels of complexity, and should help internalize the risks in fiscal policy formulation in oil-producing countries.6

The experience with MTFs among oil-producing countries varies widely. Many oil-producing countries are moving toward adopting at least basic forms of MTF for managing fiscal policy (see Box 3 for additional country examples).

  • Most sub-Saharan African oil-producing countries are in the early stages of developing an MTF. In many of these countries the link between policies and the annual budget remains weak, and PFM systems require substantial upgrading. Nonetheless, reforms in Cameroon, Chad, Gabon, and Nigeria include a move toward a basic MTF to help implement their poverty-reduction strategies. The initial focus tends to be on developing a top-down MTFF with more detailed sector strategies for priority ministries, along with complementary PFM reform plans to help improve budget planning and execution.
  • Some emerging oil-producing countries are adopting MTFs. Azerbaijan, Kazakhstan, and Timor-Leste have introduced rolling MTFFs ranging from three to five years. However, more comprehensive and detailed medium-term planning is often hampered by the fragmented nature of the budget and the need for complementary PFM reforms.
  • More mature oil-producing countries are also beginning to embrace MTFs. The Islamic Republic of Iran’s fourth Five-Year Development Plan, which outlined basic policy objectives and set out a wide range of mac-roeconomic targets, also recommended that fiscal policy be anchored within a medium-term framework to help reduce procyclicality of expenditure and improve policy coordination. Algeria, Libya, and the United Arab Emirates have also indicated their intention to develop MTFs in conjunction with other PFM reforms.

The Role for SFIs Within Broader Institutional Reforms

The design of SFIs and the underlying fiscal institutions are crucial if they are to be effective. SFIs are not a panacea for managing oil revenues, but under an appropriate institutional framework, well-designed SFIs may help support sound fiscal policies. In particular, more flexible SFIs, such as financing funds and procedural FRL aimed at transparency and accountability, may hold more promise for helping fiscal management. Successful SFIs require strong institutions and political commitment. SFI development should not detract from other more fundamental PFM and governance reforms; these should be given priority as appropriate. In addition, international experience suggests the following specific principles for the design and implementation of effective SFIs.

Oil Funds

Some basic principles for the design of effective oil funds are the following:

  • Oil funds should be well integrated with the budget to enhance the coordination of fiscal policy—including integrated asset and liability management—and the efficiency of public spending. This integration is best achieved by ensuring that the fund operates as a government account rather than a separate institution. Rigid operational rules (such as those seen in contingent and revenue-share funds) are best avoided.
  • Funds should ideally not have the authority to spend, to avoid dual budgets and preserve the integrity of the budget.
  • Financing funds should be preferred. These funds devolve the focus of fiscal policy design and implementation to the budget and highlight the importance of the non-oil balance for fiscal programming. Expenditure decisions are reflected in non-oil fiscal indicators and in the net accumulation of assets in the oil fund, which in some cases may make fiscal policy more transparent.
  • Stringent mechanisms to ensure transparency, good governance, and accountability and prevent the misuse of resources should be in place to provide assurance that government assets are properly and prudently managed.

Oil funds can play a useful role in asset management, provided they are properly integrated with other government financing operations. The resources in the oil fund should be managed to support the government’s overall asset and liability management strategy with a medium- to long-term horizon, taking account of the major risks. This requires the development of a clear, comprehensive, and transparent investment and risk management framework. Macroeconomic stabilization, competitiveness, and liquidity considerations suggest the advisability of placing oil fund resources abroad.

Fiscal Rules and FRL

The implementation of quantitative fiscal rules in oil-producing countries has proved very challenging, mainly owing to the characteristics of oil revenue and political economy factors. Country experience suggests that rigid numerical rules have been prone to design and implementation difficulties given the substantial volatility of oil revenue. Compliance with the rules in periods of abundant liquidity has also been challenging, and inflexibility has often meant that the rules are reviewed or abandoned during oil shocks. Less rigid guidelines may work better to sustain the credibility of the fiscal framework while maintaining a longer-term perspective.

The success of procedural FRL in strengthening fiscal management hinges on appropriate design, consistency with PFM capacity, and enforcement of FRL provisions. This, in turn, depends on the extent of political commitment to fiscal discipline and a willingness to adopt key structural reforms. However, improved transparency and better management of oil revenues by themselves can act as important factors in strengthening overall institutional quality and fiscal management. The experience of some oil-producing countries and subnational regions suggests that FRL, with comprehensive procedural and transparency requirements, can contribute to improving transparency and accountability. The formulation and implementation of FRL can also help identify and address specific PFM weaknesses and improve intergovernmental coordination.

Oil Reference Prices

There is a case for an element of prudence in budget oil price forecasts, but the use of artificially low reference oil prices for budgeting purposes would best be avoided. As indicated previously, an artificial oil reference price assumption risks undermining the transparency, unity, and credibility of the budget, particularly if the reference price is associated with frequent expenditure revisions during the fiscal year, extrabudgetary activity, and reduced expenditure controls that may affect the quality of spending.

Fiscal prudence should be expressed through spending plans. Oil revenue projections used for budgeting purposes may involve an element of prudence to take risk into account, but they should also be credible. Budgeting within a realistic MTF that uses the best estimates of oil revenues and accounts for fiscal risk, and setting expenditures at prudent levels, based on medium- and long-term perspectives and risk analysis, may help countries cope better with oil price volatility and unpredictability. In addition, a greater focus on the non-oil balance in budget documents as an indicator of the direction and sustainability of fiscal policy may help foster an informed debate of fiscal policy choices.

1See Manasse (2006). Also, Mehlum, Moene, and Torvik (2006) provides empirical evidence suggesting that the quality of institutions matters for the growth performance of countries rich in natural resources.
2For examples of oil-producing countries, see Askari, Nowshirvani, and Jaber (1997); Eifert, Gelb, and Tallroth (2003); and Katz and others (2004).
3Spackman (2002) provides an overview of the rationale for adopting a medium-term framework for budgeting. See also Schick (1998), World Bank (1998 and 2005), OPM (2000), and Diamond (2006).
4See World Bank (1998) and Sarraf (2005) for a description of this practice.
5Aizenman and Lee (2005) and Rodrik (2006) look at the rationale for holding large precautionary international reserves, which can be extended to oil-producing countries facing potential large shocks. See IMF (2007) on fiscal issues related to the scaling up of aid for further discussion.
6Bartsch (2006) applies a probabilistic approach to examine the optimal size of financial assets to stabilize spending in Nigeria. Celasun, Debrun, and Ostry (2006) use a probabilistic (fan-chart) approach to analyze debt sustainability. Specific oil-shock scenarios in debt sustainability analysis exercises are also examples of this approach.

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