Is Fiscal Policy Procyclical in Developing Oil-Producing Countries?

A new IMF working paper by Nese Erbil "examines the cyclicality of fiscal behavior in 28 developing oil-producing countries (OPCs) during 1990-2009. After testing five fiscal measures - government expenditure, consumption, investment, non-oil revenue, and non-oil primary balance - and correcting for reverse causality between non-oil output and fiscal variables, the results suggest that all of the five fiscal variables are strongly procyclical in the full sample. Also, the results are not uniform across income groups: expenditure is procyclical in the low and middle-income countries, while it is countercyclical in the high-income countries. Fiscal policy tends to be affected by the external financing constraints in the middle- and high-income groups. However, the quality of institutions and political structure appear to be more significant for the low-income group."

Excerpts (notes excluded):

Both the neoclassical and Keynesian theories support the idea that effective fiscal policy should smooth the volatility of output during the business cycle. Barro’s (1973) ―tax-smoothing‖ hypothesis of optimal fiscal policy suggests that, for a given path of government expenditure, tax rates should be held constant over the business cycle, and the budget surplus should move in a procyclical fashion. According to the Keynesian approach, however, if the economy is in recession, policy should increase government expenditure and lower taxes to help the economy out of the recession. During economic booms, the government should save the surpluses that emerge from the operation of automatic stabilizers and, if necessary, go further with discretionary tax increases or spending cuts. As a result, fiscal policies are expected to follow countercyclical patterns through automatic stabilizers and discretionary channels. In other words, one would expect a positive correlation between changes in output and changes in the fiscal balance or a negative correlation between changes in output and changes in government expenditure.

However, empirical studies show that fiscal policies are procyclical in developing countries and in OPCs.5 They increase spending with an increase in oil revenue during an oil price boom. They are forced to reduce spending because of a revenue decline as a result of a drop in oil prices. Since, in general, these countries are not able to accumulate savings in years with high oil revenues, they can only finance deficits by cutting expenditure during revenue shortfalls. Fouad and others (2007), Abdih and others (2010), and Villafuerte and Lopez-Murphy (2010) find that oil-producing countries followed procyclical fiscal policies during the recent oil price cycle. Baldini (2005) and De Cima (2003) also present evidence for the procyclicality of fiscal policies in two oil-producing countries, Venezuela and Mexico. More recent studies, e.g. Ilzetzki and Vegh (2008), find, using instrumental variable regression, strong evidence of procyclical fiscal policy in developing countries.

Two broad arguments that have been proposed as an explanation for procyclical policies in developing counties also apply to OPCs: constraints on financing (or limited access to credit markets) and factors related to the structure of the economy ( the budget, political, power, and social structure, and weak institutions). In general, these factors are presented separately but they go together and are likely to reinforce each other. For example, weak institutions, the budget structure, or a corrupt government may hinder prudent fiscal policies, which may, in turn, affect fiscal sustainability and creditworthiness by amplifying the financing constraints.

Liquidity and borrowing constraints emerge when a developing country needs financing the most--during a downturn--and that is when it is least likely to be able to obtain it. Many countries do not have significant foreign assets or developed domestic financial markets to raise funds. When these countries face large terms of trade shocks (i.e., a sharp fall in oil prices in the case of OPCs), investors may lose confidence and be less likely to lend, because they fear that the lack of policy credibility and discipline may force the government to run up large budget deficits and to default.6 Governments in this situation will also experience recurring credit constraints in world capital markets (―sudden stops,‖ as explained in Calvo and Reinhart (2000)), which hamper their ability to conduct countercyclical policies.

Oil stabilization funds have been increasingly used by OPCs as an instrument to cope with oil revenue volatility. These funds are aimed at stabilizing budgetary revenues: when oil revenues are high, some portion of the revenue would be channeled to the stabilization fund; when oil revenues are low, the stabilization fund would finance the shortfall. However, the creation of such funds is found to have no impact on the relationship between oil export earnings and government expenditure in countries where no sound and transparent fiscal and macroeconomic policies were implemented.7 Moreover, some oil funds have operated outside existing budget systems and are often accountable to only a few political appointees. This makes such funds especially susceptible to abuse and political interference. Therefore, stabilization funds should not be regarded as a substitute for sound fiscal management.

The other argument proposed to explain the difficulty in implementing countercyclical policy focuses on procyclical government spending due to three aspects of the economy and the government: the budget structure, the weak political structure and institutions, and corruption in government.

First, developing countries run procyclical fiscal policies because of their budget structure. These countries have a few automatic stabilizers built into their budgets. As a result, government spending in developing and emerging countries displays less of a countercyclical pattern than in industrial countries. For example, Gavin and Perotti (1997) note that Latin American countries spend much less on transfers and subsidies than do richer OECD economies (24 percent of total government spending, compared with 42 percent in the industrial countries). Furthermore, most developing countries and OPCs cannot raise revenue effectively through taxes since they usually suffer from inefficient tax collection systems, owing to the low level of compliance with tax laws, insufficient political commitment, and a lack of capacity, expertise, and resources.8 Additionally, non-oil tax bases in these countries are in general very low.9

Second, weak institutions and political structure encourage multiple powerful groups in a society to attempt to grab a greater share of national wealth by demanding higher public spending on their behalf. This behavior, called the ―voracity effect‖ by Tornell and Lane (1999), results in fiscal procyclicality arising from common pool problems, whereby a positive shock to income leads to a more than proportional increase in public spending, even if the shock is expected to be temporary. This is discussed extensively in ―resource curse‖ literature as a reason for low economic growth in resource-rich countries.10 Moreover, fiscal policies are more intense in countries with political systems having multiple fiscal veto points and higher output volatility (Stein, Talvi, and Grisanti, 1998;and Talvi and Végh, 2000). Similarly, Lane (2003) and Fatas and Mihov (2001) find that countries with power dispersion are likely to experience volatile output and procyclical fiscal behavior.

Lastly, Alesina and Tabellini (2005) argue that a more corrupt government displays more procyclical fiscal policies as voters, who do not trust the government, demand higher utility when they see aggregate output rising. This behavior would be more prevalent in democracies since a corrupt government is accountable to the voters, whereas, in a dictatorship, the government would not be accountable and, even if corruption were widespread, voters could not influence fiscal policy. Alesina and Tabellini conclude that corrupt governments in democracies, rather than credit market imperfections, are the underlying cause of procyclical fiscal policy.


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The results confirm that political and institutional factors, as well as financing constraints, play a role in the cyclicality of fiscal policies in the OPCs. Most of the variables on the quality of institutions and the political structure appear to be significant for the low- income group. Two of the variables are significant for the middle-income countries: the composite institution index and checks and balances. None of the institutional variables turns out to be significant for the high-income countries.21 Domestic financing constraints seem to matter for the low-income group. But fiscal policy is affected more by the external financing constraint in the middle- and high-income groups, as they may be more integrated into the global financial system than the low-income countries.

Despite their many differences, all the OPCs face volatile and unpredictable oil revenues, a situation that makes fiscal management challenging. For this reason, it is imperative for them to formulate effective countercyclical fiscal policies by which they can smooth government expenditure, decouple it from the volatile oil revenues, and prevent boom-and-bust cycles. Breaking away from a procyclical fiscal policy will enable them to sustain long-term growth and keep the safety net that the poor need. Sound fiscal policies and discipline require strong institutions, a higher-level bureaucracy, and more transparency. Strong institutions and transparency would also help reduce the ―voracity effect,‖ which, in turn, would facilitate the accumulation of financial assets and build up confidence among investors to raise funds when needed.

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IMF working paper: Iran — The Chronicles of the Subsidy Reform

A recent IMF Working Paper by staff of the Middle East and Central Asia Department, "Iran — The Chronicles of the Subsidy Reform," [1] analyses the December 2010 changes in subsidies of domestic energy and agricultural prices, which increased about 20 times, making it the first major oil-exporting country to reduce substantially implicit energy subsidies.

Their paper reviews the economic and technical issues involved in the planning and early implementation of the reform, including the transfers to households and the public relations campaign that were critical to the success of the reform. It also looks at the reform from a chronological standpoint, in particular in the final phases of the preparation. The paper concludes by an overview of the main challenges for the second phase of the reform.

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Excerpts:

On Saturday, December 18, 2010, at 9:00 p.m. Tehran time, speaking in a televised “conversation with the nation”, President Ahmadinejad announced the start of what he termed the most sweeping economic “surgery” in Iran’s modern history. Just after midnight on December 19, Iranian media began releasing announcements detailing the new price structure for liquid fuels. Within twenty-four hours, new natural gas, electricity, and water tariffs were published, and allowable ceilings for the increase in taxi and public transport tariffs followed. At the time, close to 80 percent of Iran’s population was granted unrestricted access to compensatory payments that had been deposited in specially-created bank accounts starting in October 2010.

The reform, officially referred to as Targeted Subsidies Reform, made Iran the first major energy producing and exporting country to cut drastically massive indirect subsidies to energy products and replace them with across the board energy dividend transfers to the population. It is estimated that the price increases removed close to US$50–US$60 billion dollars in annual product subsidies. By December 2011, in the first 12 months following the price increase, Iranian households will have received at least US$30 billion in freely usable cash, and another $10–$15 billion will have been advanced to enterprises to finance investment in restructuring aimed at reducing energy intensity.

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Although oil and gas production has accounted for an increasingly smaller share of real GDP, oil and gas revenues remain the main source of foreign exchange earnings and fiscal revenues. The share of oil in real GDP fell from an average of 40 percent of real GDP in the 1960s to about 10½ percent in the last decade, reflecting average annual non-oil GDP growth rate of 5.7 percent compared to only 4.4 percent for oil and gas GDP. Oil and gas receipts accounted for about 72 percent of export revenues in the last decade, despite rapid non-oil export growth.  Oil and gas revenues also account for 65 percent of fiscal revenues, and are likely to remain the main source of financing for development projects in the foreseeable future notwithstanding recent efforts to diversify fiscal revenues.

Iran’s high dependence on oil export revenues has had a profound impact on its business cycle. In the most recent business cycle during 2002-2008, fiscal spending and credit growth increased at the same time as export revenues and oil prices, resulting in an overheating of the economy and a surge in inflation. The subsequent tighter monetary and fiscal policies coincided with the sharp fall in oil exports caused by the international recession of 2008-2009. As a result, inflation and output declined sharply.

Domestic energy prices have historically been set administratively in Iran, as in the majority of oil exporting countries. They were set at a level high enough to cover production costs and have been changed only occasionally. This worked well when international oil prices were relatively stable and low, and close to production costs. However, when international prices began to rise after 2002, low domestic energy prices became increasingly out of line with the market value of oil. In addition, high domestic rates of inflation and subsequent exchange rate depreciations contributed to further erode domestic energy prices vis-à-vis their international benchmarks. The March 2002 unification of exchange rates and the resulting rial depreciation also accentuated a growing disparity between domestic and international energy prices.

Increasingly cheaper energy stimulated demand, making Iran the country with the highest level of energy subsidy. Not surprisingly, domestic energy use and energy intensity in Iran, as in many other energy producing countries, increased rapidly. Cheap domestic energy prices led to a rapid increase in domestic energy consumption. As a result, Iran became one of the most energy-intensive economies in the world. The high domestic absorption of crude oil distillates, natural gas, and electricity reduced the availability of these energy products for the export market. Iranian oil energy companies were also increasingly starved of funds needed for investment since domestic energy prices were set at barely cost recovery levels. Environmental pollution and its impact on human health, as well as the time lost due to traffic congestion on Iranian roads provided additional urgency for the reform. Not surprisingly, by 2007 some analysts started questioning not only Iran’s plans to increase its oil production capacity, but also its ability to stop a decline in oil production and exports.


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The Iranian authorities were clear from the outset that the main reform objective was to reduce waste and rationalize consumption. By compensating households for the energy price increases, most consumers would be better off because the higher energy price would discourage some marginal gasoline consumption, while the cash compensation would allow consumers to buy more other goods and services.

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The reform would also improve social equity in the distribution of Iran’s hydrocarbon wealth. For the poor who benefited little for cheap domestic energy price, the compensation would represent a large share of their income, lifting virtually every Iranian out of poverty.  This gave the government a powerful public relations and moral argument in support of the reform.

The likely large substitution effect triggered by large price increases could provide a significant stimulus to Iran’s domestic production and further diversification efforts, particularly given the slow growth in recent years, and relatively high, double-digit unemployment. The distribution of about $30 billion in annual compensatory payments directly to the population would support domestic demand and nonenergy sector growth.  The reform was not expected to contribute to fiscal consolidation. The reform legislation, and the political debate that preceded it, ruled out using the reduction of energy subsidies to improve the country’s fiscal balance. To the contrary, Iranian reforms, including the privatization program launched in 2006, aimed at reducing the size and the role of the public sector in the economy. However, potential large savings in domestic energy use could make significant quantities of crude oil and refined products available for exports (Box 2). The revenue from such exports could support a virtuous cycle of investment in the energy sector that would add production and refining capacity and further increase exports.


References

[1]  Dominique Guillaume, Roman Zytek, and Mohammad Reza Farzin: Iran — The Chronicles of the Subsidy Reform. July 2011.