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Chapter 3. Macroeconomic Policy Challenges

Author(s):
Charlotte Lundgren, Alun Thomas, and Robert York
Published Date:
August 2013
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A key economic policy challenge for resource-rich economies is to create a business climate conducive to the transformation of natural resource wealth into real, financial, and other assets, supporting sustained and broad-based development. The transformed assets include the accumulation of human capital, domestic public and private capital, and foreign financial assets. If this process is well managed, it can pave the way for inclusive growth stemming from the development of a diversified economy with job creation in the non-natural-resource private sector. Regrettably, the experience in sub-Saharan Africa (SSA) has not been promising, although there are signs it may be improving (see Chapter 2 and Box 3.1). The management of natural resource wealth involves dealing with the particular challenges of resource exhaustibility and the price volatility often associated with procyclicality, the latter exposing the economy to damaging boom-bust cycles. Drawing on recent work carried out by IMF staff and others, this chapter elaborates on appropriate macroeconomic frameworks that can help resource-rich SSA countries address these challenges. The chapter focuses on saving and investment decisions, management of exhaustibility and price volatility, and coordination between fiscal and monetary policies to prevent sharp surges in the real exchange rate.

Policy Challenge: Consume More Now or Later?

Among the first issues SSA policymakers must address in managing natural resource wealth is how much of the resource wealth to consume now versus later. For a country on a typical development path, income increases over time and the population becomes better off. With significant natural resources, however, public consumption could be boosted in the present to facilitate welfare convergence across generations, especially because poverty levels remain extremely high in almost all SSA countries. Spending some of the resource revenue today will enhance welfare, as long as the expenditure is well targeted and executed.

Classical consumption and saving recommendations have usually been grounded in Friedman’s (1957) permanent income model. In this model, a social planner’s optimizing behavior suggests a fixed or constant level of consumption over time, with the level of consumption set equal to the implicit return on the natural resource asset. The model takes account of the exhaustibility of the resource and the desire to maintain the value of the asset for future generations (a key feature of the model is to ensure intergenerational equity).

The classical consumption approach has merit but is also severely restrictive and does not include a role for investment. As a consequence, the application of this approach to the management of natural resource wealth in SSA countries results in underinvestment. Indeed, precisely because many low-income, resource-rich countries are capital scarce, some of the resource windfall should be used up front to increase the capital stock and to raise the growth potential of the economy. The basic consumption-smoothing approach also fails to address the capital and credit constraints faced by many resource-rich SSA countries. Moreover, it does not reflect the reality that current generations may be poorer than future ones, which would make the marginal utility of consumption higher for the current generation. Finally, it ignores the uncertainty of wealth estimates. Natural resource prices are volatile, and uncertainty surrounds production volumes. Given that the bulk of natural resource reserves in SSA are yet to be discovered, the likely estimate of natural resource wealth in many of these countries is far higher than current estimates suggest.

Box 3.1.Procyclical Fiscal Policies and Boom-Bust Cycles in Sub–Saharan Africa

Until the first decade of the 2000s, many resource exporters in SSA experienced strong boom-bust episodes associated with fluctuations in resource prices. Whenever revenue surged it was immediately spent, resulting in large year-to-year changes in government expenditure. In addition, Arezki and Ismail (2010) find an asymmetric response of current and capital expenditure to changes in oil prices, with current expenditure increasing rapidly during booms and capital expenditure falling even more rapidly during busts.

Empirical research also shows that the deterioration of the non-oil fiscal balance in response to changes in oil revenue in SSA countries is considerably larger than in other countries (Thomas and Bayoumi, 2009). On average, a 1 percentage point of GDP increase in oil revenue would reduce the non-oil fiscal balance by 0.41 percent of GDP.

Figure 3.1.1, however, shows considerable differences across countries in the sensitivity of government expenditure to movements in oil revenue. Government expenditure and oil revenue follow each other quite closely in the Republic of Congo, but the relationship is considerably weaker in Equatorial Guinea and Gabon, although the long-term upward trends in expenditure and oil revenue are noticeable.

Figure 3.1.1.Government Expenditure and Oil Revenue

Source: IMF, World Economic Outlook database.

Once the choice between consumption and saving has been made, policymakers must decide how to invest the savings, allocating it between physical and financial assets. Because in capital-scarce countries the payoff of some investments (such as in economic infrastructure) can be quite large, a substantial share of resource revenue should be allocated for this purpose. In the same vein, certain types of current expenditure complementary to capital spending (in particular, spending on education and health, which builds human capital) can also yield high returns. In resource-intensive and fragile SSA countries, public spending on the security and justice sectors (e.g., to strengthen private property rights) may also have significant growth returns. Therefore, although most resource revenue should generally be used for capital spending, the precise balance between capital and current spending must be made on a country-specific basis. As an example, Botswana finances all of its investment spending from resource rents (Box 3.2).

Box 3.2.Managing Natural Resource Wealth: Lessons from Botswana

Botswana’s ability to avoid the resource curse by prudently managing its mineral wealth has been justly acclaimed. Five decades of virtually uninterrupted, rapid growth lifted Botswana from one of the world’s most impoverished countries into the ranks of the upper-middle-income nations (Figure 3.2.1).

Figure 3.2.1.GDP per Capita, 1980 and 2010

Sources: IMF, World Economic Outlook database.

Over the years, Botswana has earned a reputation for good governance and prudent macroeconomic policies. Botswana’s sound macroeconomic management and ability to manage revenue from its natural resources, including diamonds, has been one of the main drivers for its remarkable economic performance. The creation of “inclusive institutions” has also helped. Indeed, the government has formed stable, long-lasting partnerships with mining companies, leaving company management in the hands of private sector firms, and carefully increasing its share of equity or revenue through skillful renegotiation of contracts.

Mineral wealth management is based on a rule that allocates non-renewable-resource revenue to investment expenditure or savings: a Sustainable Budget Index (SBI) principle ensures that “non-investment” spending is financed only with nonresource revenue. Over time, Botswana has built a large stock of government savings in its Pula Fund (Figure 3.2.2), which is managed by the Bank of Botswana. The central bank’s official exchange reserves (Figure 3.2.3) and the Pula Fund have helped the government limit the adverse effects of boom-bust commodity price cycles on the economy.

Figure 3.2.2.Botswana: Resource Revenue and Gross Fixed Capital Formation

Sources: Botswana authorities; and IMF staff estimates.

Figure 3.2.3.Botswana: Terms of Trade and Foreign Exchange Reserves

Sources: Botswana authorities; and IMF staff estimates.

Supply-side bottlenecks and absorptive-capacity constraints will influence the speed of public investment expenditure. Supply-side bottlenecks may warrant a sharp increase in domestic investment to prevent the increase in domestic demand associated with higher resource prices, which could create inflationary pressures and adversely affect the competitiveness of the nonresource sector (and lead to Dutch disease). Absorptive constraints often arise from the weak capacity of country authorities to choose and implement productive projects and can lead to poor investment rates of return (Chapter 4). When choosing between physical and financial investments, that is, spending now or later, countries must take both challenges into account, as well as the expected duration of the revenue surge.

Policy Challenge: Ensuring External Sustainability

To assess and ensure external sustainability, appropriate benchmarks for a sustainable current account position for resource-rich countries must be developed. In this regard, it is useful to derive a nonresource current account balance, that is, one that excludes resource export proceeds, investment income outflows associated with resource investments, and imports related to the extraction of natural resources. A nonresource current account approximates the current account that would prevail in the absence of the natural resource, and can be viewed as a measure of the long-term nonresource saving and investment balance once the resource is exhausted. This estimate could then be compared with the annual resource flow from the net present value of resource wealth and an assessment of a sustainable net asset position. For example, in the extreme case in which all resource wealth is consumed, the nonresource current account would be compared with the annual annuity from this wealth estimate. If the medium-term nonresource current account and the annual annuity match, the real exchange rate is judged to be in equilibrium, whereas any mismatch between the two indicators would suggest that a real exchange rate adjustment can help restore equilibrium (Box 3.3). If the estimate of the nonresource current account is not representative of long-term trends because of a large temporary buildup of investment, this investment buildup can be excluded from the calculation of the sustainable level. Moreover, prudence factors can be added to the analysis to control for the uncertainty of resource price movements.

Similar to the analysis of fiscal policy, traditional models for analyzing external sustainability should be complemented by analysis that reflects external borrowing constraints and absorptive-capacity limits. In many SSA countries that face external borrowing constraints, resource windfalls can loosen these constraints, leading to a larger nonresource current account deficit in the short term as the domestic capital stock is built up. To complement traditional models for analyzing external sustainability, IMF staff has developed a model that accounts for the lack of capital in low-income countries and incorporates effects on investment decisions from potential investment inefficiencies, absorptive constraints, and limits to borrowing (IMF, 2012b, 2012d). This model can help inform current account sustainability analysis for resource-rich developing countries.

Box 3.3.Benchmarking the Non-Oil Current Account

The analysis of fiscal policy for resource exporters is rich and has a commonly used and well-defined benchmark for assessing long-term fiscal sustainability—the comparison of the nonresource fiscal balance to a measure of the appropriate annual drawdown of resource wealth owned by the government (see Chapter 4 for further details). A similar concept can also be applied to the current account, to yield the nonresource current account deficit, which can also be compared with the annual drawdown of resource wealth. This concept is further elaborated upon using data for Nigeria (Figure 3.3.1).

Figure 3.3.1.Nigeria: Alternative Estimates of Current Account Norm

Source: National authorities; and IMF staff estimates.

The nonresource current account position excludes imports of resource-related products and investment flows back to foreign head offices of multinational companies, in addition to the resource export. Nigeria provides data on repatriated earnings of oil multinationals and foreign direct investment in the oil sector, which are used as a measure of oil-related imports. The resulting non-oil current account deficit is projected to decline to about 16 percent of non-oil GDP in the medium term, falling below the sustainable annual drawdown of wealth accruing to the government. The latter is defined as the net present value of wealth (based on a 4 percent real rate of return) multiplied by the government ownership share and expressed as an annuity over a 40-year period so that the wealth is exhausted at the end of this period. Basing the analysis on the current account excluding only oil exports, and therefore assuming that companies finance oil-related imports themselves through retained earnings, the corresponding current account concept also falls below the return on wealth for the whole economy in the medium term.

The analysis suggests that Nigeria can easily finance its consumption and investment expenditure based on its current level of non-oil exports and the annuity on oil wealth, implying that an exchange rate adjustment is not needed to improve Nigeria’s international competitiveness. This assessment is, however, sensitive to changes in resource prices and the level of the real rate of return. The picture would be quite different if oil prices were to fall significantly from the levels prevailing in 2013.

Policy Challenge: Coping with Price Volatility and Avoiding “Boom and Bust Cycles”

The prices of natural resources are inherently volatile and history is replete with examples of damaging “boom and bust” cycles in resource-rich economies. Volatility in revenue from natural resources can also stem from sudden changes in production volumes. The procyclicality of government spending—higher spending associated with higher revenue, as resource prices or production rise—has the potential to further fuel macroeconomic volatility. Moreover, discretionary government expenditure of this type is generally neither effective nor productive. The volatility of resource prices should make authorities cautious when choosing between investment in physical or financial assets because physical assets cannot be unwound to address sudden drops in resource revenue. Establishing institutional mechanisms or rules to reduce the adverse effects of volatile prices is therefore essential.

Two strategies may help in this regard. First, the authorities in SSA countries could try to hedge the resource price to ensure a more secure revenue base and to reduce uncertainty about the budgeted resource price. This strategy has been in place in Mexico, for example, since the early 1990s. It was successfully implemented in the recent past with the government’s purchase of an option to sell oil at $70 a barrel, which was exercised in mid-2008 when the price fell to $40 barrel. However, this strategy can also be politically costly if it fails, given the pitfalls in forecasting oil prices.

Second, stabilization or resource funds can be created (Box 3.4). When prices are high relative to an established benchmark, leading to a fiscal surplus, resource proceeds flow into the fund and are invested in foreign assets. When prices are low leading to deficit financing, the funds are withdrawn. One of the difficulties in establishing a stabilization or resource fund in SSA countries is that with expenditure needs so immediate, reaching broad consensus on building up a financial reserve at the start of the process is difficult. Because today’s price tends to be considered the best predictor of tomorrow’s price, politicians are loathe to believe that prices will suddenly fall, which appears to many to be the critical justification for accumulating financial assets in the first place. In reality, resource prices have proved to be volatile and difficult to predict, and changing expenditures from year to year (i.e., stop-and-go public investment) can be very costly.

Legitimate questions also surround the appropriate size of a stabilization fund. In this regard, policymakers should carefully consider the persistence and standard deviation of the resource price, the costs of changing expenditure during various phases of the business cycle, and lending and borrowing fees. Operationally, they should aim to stabilize expenditures and not resource revenue. Policymakers in SSA countries should be aware that experience outside the region shows that most stabilization funds have failed precisely because they were designed on the basis of contingent revenue rules (i.e., inflows and outflows were linked to a prespecified resource price or revenue target, independent of the actual fiscal balance).1 It is also important that any funds set up be transparent and be well integrated into the budget. And if countries decide to set up separate funds for various development objectives, robust financial oversight of their use must be in place to minimize problems of budgetary fragmentation (see Chapter 4).

Box 3.4.Oil Funds in Selected Developing Countries

Following the successful examples of Norway and Chile (see Box 4.2 for more detail on Chile), a number of developing countries have established oil funds since the middle of the first decade of the 2000s. This box focuses on two of these cases: Timor-Leste and Nigeria. Ghana also set up oil funds (see Box 4.4).

The Timor-Leste Petroleum Fund, established in 2005, is governed by the Petroleum Fund law. The Ministry of Finance manages the fund on behalf of the government, which delegates day-to-day operations to the central bank. All investment decisions are validated by an independent Investment Advisory Board. The Petroleum Fund acts as both a saving vehicle and a stabilization fund, but the overriding aim is to maintain its real value and to prevent expenditure volatility. Withdrawals from the fund are fully integrated into the government budget and are linked to an estimated sustainable income formula guided by the principle of maintaining the real value of government wealth (similar to the permanent income model approach outlined earlier in this chapter).

The projected sustainable income is based on an estimated real return of 3 percent, and any transfers out of the fund in excess of this amount are subject to parliamentary oversight. Since 2009, the transfers have exceeded the projected sustainable income as the result of a policy to front-load essential investment expenditure. The Petroleum Fund only invests in external assets and is audited annually by internationally accredited auditors. Timor-Leste adheres to the Santiago Principles initiated in 2008 to reflect appropriate governance, accountability, and investment guidelines (International Working Group of Sovereign Wealth Funds, 2008). The Petroleum Fund Consultative Council that reports to the parliament also maintains an oversight role to ensure good governance. As of end-December 2012, the fund value was about $11.8 billion, equivalent to nearly eight times the projected budgetary expenditure for 2012 and more than three times nominal GDP (about nine times non-oil GDP).

Nigeria established an oil stabilization fund, the Excess Crude Account (ECA), in 2004, and, although not well grounded in domestic law, it was initially successful. During 2004–08, significant budgetary savings were achieved by having expenditure decisions guided by the oil reference price and the saving of surplus revenue. By end-2008, the ECA had reached $20 billion and these resources were used effectively to counter the financial crisis of 2008–09 when oil prices plummeted; use of the ECA allowed the consolidated government balance to swing from a surplus of 6 percent of GDP in 2008 to a deficit of 9 percent of GDP in 2009. The ECA and the budget price rule are, however, imperfect mechanisms for ensuring fiscal buffers because the ECA is subject to ad hoc withdrawals and a weak legal framework. Spending pressures resurged because of rebounding oil prices, political uncertainty, and the election cycle. The government initiated a procyclical fiscal expansion financed by withdrawals from the ECA so that by end 2011 it was almost depleted. This motivated the creation of a sovereign wealth fund (SWF), which has been operational since July 2012. During 2012, revenue replenished the fund such that its value was $9.2 billion at end-2012. The government’s revamped SWF has three components: a stabilization fund, an infrastructure fund, and an intergenerational saving fund. With stricter rules than under the previous ECA, the sharp drawdowns that occurred during 2010–11 are less likely to be repeated. However, the precise modalities for determining how much oil revenue is to be allocated to the ECA are still to be determined.

Policy Challenge: Achieving the Appropriate Fiscal and Monetary Policy Mix and Avoiding Real Exchange Rate Appreciation

Fiscal and monetary policy coordination is important in resource-rich economies because the effects of sharp resource price changes on the domestic economy can be magnified through poor policies. SSA policymakers have numerous possibilities to consider, for example,

  • If the government saves all of the windfall gain from an increase in resource prices and the central bank keeps the foreign currency, the real exchange rate remains stable. In this case, there are no adverse implications for the real economy but nor are there benefits from higher public investment.
  • If reserves accumulated by the central bank are equal to the resource windfall from higher resource prices, the effects on domestic inflation and on the real exchange rate depend on whether the government spends its increased revenues and on whether the central bank sterilizes the increased demand for local currency by the government through open market operations. If the amount of sterilization matches the increased spending by government, the inflationary effects are muted.
  • If, at the other extreme, the government spends the increased revenue generated by higher resource prices and the central bank fails to accumulate reserves, the real exchange rate appreciation is magnified, with possible adverse consequences for the real economy.

Although the government may be successful in coordinating the public sector response to a resource windfall, the behavior of the private sector can offset these effects. Strong public policies such as mitigating the effects of revenue surges on the domestic economy can be counteracted by opposite behavior from the private sector. For example, private spending may be boosted following a hike in resource prices to take advantage of the resource boom and may offset the prudent public sector stance. This behavior is evident in movements in the external current account and corresponds to the concept of Ricardian equivalence.

Since 2000, SSA countries have experienced mixed success in insulating the real exchange rate from resource price pressures, with oil and copper exporters encountering the greatest difficulty in keeping the real exchange rate stable. An examination of the evolution of the real exchange rate across SSA’s natural resource exporters since 2000 reveals that gold exporters and “other” exporters have managed to avoid a real exchange rate appreciation in the face of rapidly increasing resource prices (Figure 3.1). In contrast, the real exchange rate has followed real export prices for oil exporters and copper and cobalt exporters (Zambia).2 The key explanatory factors for the different real exchange rate trajectories appear to be the share of resource income accruing to nationals (high for “oil exporters,” lower for “others”) and the importance of resource exports relative to total exports.

Figure 3.1.Sub-Saharan Africa: Resource Price Index and Real Effective Exchange Rate, 2000–11

Sources: IMF, African Department database, and Information Notice System; and World Bank, Commodity Price Markets.

1Excluding Democratic Republic of the Congo.

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1This issue is addressed in more detail in Ossowski and others (2008)
2The resource price is deflated by the consumer price index of countries making up the special drawing rights basket (the euro area, Japan, the United Kingdom, and the United States). The resource prices and real exchange rates are weighted by the sum of exports and imports to create group aggregates.

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