CESD Chairman Had Speech at Qafqaz University

CESD Chairman Had Speech at Qafqaz University

Vugar Bayramov, chairman of CESD, had speech on Management of Oil Revenues in Azerbaijan at Qafqaz University, the top university in Azerbaijan, on February 23, 2012. Vugar Bayramov mentioned that The high inflow of oil revenues to Azerbaijan in recent years has led to large and increases in government expenditures in the state budget and State Oil Fund of the Azerbaijan Republic. Given that oil revenues are exhaustible, volatile, and unpredictable, a sustainable fiscal policy must be enabled that allows for intergenerational equity, diversification in the economy, and predictable annual revenues that reduce pressures of appreciation.

Vugar Bayramov said that possessing large oil revenues gives the Government of Azerbaijan a unique opportunity to effectively use this newfound wealth by investing in development programs that can provide a lasting benefit to its citizens’ social welfare, economic growth, security, and overall quality of life. On the other hand, the oil reserves and oil that has already been turned into liquid assets carries with itself risks of inefficiency and misuse due to the lack of institutional capacity created by traditions of bottom-up control and the legacy formed by years of participation in a centralized economy. Given that the flow of oil revenues has a finite life expectancy, the Government of Azerbaijan must implement a long-term macroeconomic strategy, fiscal rule and implementation mechanisms that ensure that the oil money is saved in the most efficient way and that the benefits of the investments address high priority needs, are highly integrated, and sustainable.

CESD chairman mentioned that the main objective of the CESD energy projects is to spend oil money effectively over a long-term period, different distribution models were evaluated. This includes modifications of the permanent income hypothesis (PIH), balanced budget rule, and the Bird in Hand approach. Unfortunately, there is no single fiscal rule that is optimal for all countries. Each country must choose an approach that fits the economy’s unique situation. Here is an explanation of the different models and why the permanent income hypothesis was selected as the most prudent choice. The Bird in Hand policy heavily discourages current expenditure of oil revenues in favor of saving more for future generations. This is accomplished by strict fiscal discipline. The government places all hydrocarbon revenues in a fund and is only allowed to annually withdraw a pre-determinded percentage of the value of the previous year’s fund for the state budget. This percentage should be equal to the expected real rate of return of the fund.

Vugar Bayramov said that since 2001, Norway has used this approach by limiting transfers to the state budget to only 4% per year, with some room for increasing this number. Certainly, Norway is a good example for other countries in areas of its government’s transparency, foresight, and fiscal disipline when dealing with a large influx of oil revenues. However, Heuty and Aristi (2009) argue that, “Even more than PIH, Bird in Hand is an unrealistic proposition for developing countries.” In fact, they point out that it is more valuable for these countries to view the steps taken by Norway during its first two decades oil production after discovering oil in 1969. Norway did not create the oil fund until 1990 and before that Norway was much more expansionary in its fiscal policy, focusing on education and developing those domestic industries viewed as having the greatest comparative advantage for the longterm economy. It is only after these initial protectionary steps taken by Norway to become a highly developed country, that the oil fund mangement became much more fiscally disciplined. Domestic priorities for Norway have shifted and now the focus is on providing a pension fund for an increasingly aging population. Certainly, Azerbaijan is at a different stage of development and its fund management must match this developmental process. In addition, Harding and van der Ploeg (2009) illustrate that “the BIH rule is inefficient, since the government spends oil/gas revenues and reacts only to financial wealth in the Fund but not to hydrocarbon wealth in the ground.” By preventing borrowing of future hydrocarbon wealth, it leaves the economy susceptible to low consumption before the windfall, booms of consumption during the windfall, and finally a return to normal consumption levels after the windfall. Hence, the BIH rule violates the principles of tax and consumption smoothing (e.g., Collier, et al., 2009). On the opposite side of extreme fiscal conservatism evident in the BIH model is the balanced budget rule that calls for spending all annual oil revenues. The goal of this approach is to achieve sustainability by having “fiscal rules target a non-oil fiscal deficit that at most equals the financing provided by oil resources”(Segura 2006). However, as resources dwindle it requires massive fiscal changes to be taken by the government that can prove very difficult to implement. In addition, this approach heavily favors the current generation over future generations in terms of level of oil consumption and benefits. It also leaves the economy highly susceptible to the boom and bust cycles of world market oil prices. If oil prices fall drastically, then the overall effectiveness of oil revenues decreases. It is a

very risky method and we do not recommend Azerbaijan to use this fiscal strategy. A useful theoretical framework that we will apply to the project, with desirable intergenerational considerations is the permanent income hypothesis (PIH) formulated by Friedman (1957). This framework is between the two extreme fiscal rules mentioned before. Although PIH is a hypothesis, it is also applied as a model in oil revenue management. According to the PIH, both individuals and benevolent governments should be considered forward-looking, trying to balance consumption over time with permanent income. Where there is zero population and productivity growth in an oil producing country, the PIH implies that constant government consumption over time is equal to the annuity present value of expected oil wealth. By definition expenditures out

of oil proceeds would be stable, thus avoiding boom-bust cycles. The added predictability this rule offers should in principle help policymakers avoid bottlenecks in absorptive capacity (Segura 2006). In addition, the Azerbaijan government created a Long-term Oil Revenue Management Strategy (LTORMS) in 2004 that adopted this principle of “constant real spending”, which is equivalent to the PIH approach, but it ha not yet been implemented.

Vugar Bayramov concluded that there are many advantages to choosing the PIH approach. Constant real spending will allow government consumption to be predictable, sustainable, and provides intergenerational equity. In addition, a more stable fiscal policy will help release the pressure of appreciation in Azerbaijan’s currency that has been created by rapid increases in government expenditures. Due to Azerbaijan’s monetary policy of having a fixed exchange rate to the US dollar, appreciation has resulted in high inflation rates, making it more difficult for the local private sector to compete abroad. Reducing appreciation pressures will make it much easier for the economy to diversify. Other variations of the PIH will also be considered. By applying this model, we intend to consider constant government consumption of oil wealth, non-oil GDP and etc. We choose this model because there are ties between the indicated theoretical model and hypotheses. Comparative application of both hypotheses will give more occasions to conduct research by considering different factors. Our hypothesis, which addresses shifts in the life-cycle permanent income model, can be tested by the PIH. We accept that there are some criticisms with the use of the PIH in managing oil revenues, especially by developing countries. When the initial capital of the economy, both physical and human, is low, the productivity gains of government social and capital spending of oil revenues could exceed the financial returns from oil savings. This can happen where there is production externality from government spending, particularly from the impact of public investment on productivity and the incentives it generates for private capital accumulation (Management of Oil Wealth under the Permanent Income Hypothesis, Alonso Segura, 2006). But compared to other models, such as Benchmark model, PIH will review more clear management of oil revenues, such as consumption of wealth and it will create a base to apply hypotheses to the Azerbaijani case.

Full speech on Oil Revenue Management, made at Qafqaz University on February, 23, 2012, is available at;
http://www.youtube.com/user/qafqazuniversiteti

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