Fiscal Policy in Oil‐exporting Countries: The Roles of Oil Funds and Institutional Quality

• DOI: http://doi.org/10.1111/rode.12293
• Published date: 01 August 2017
• Author: Wee Chian Koh
• Date: 01 August 2017

Fiscal Policy in Oil-exporting Countries: The Roles

of Oil Funds and Institutional Quality

Wee Chian Koh*

Abstract

Oil-exporting countries face challenges in the conduct of fiscal policy owing to volatile oil revenues,

especially in countries with weak institutions. Many oil exporters have established oil funds to delink

government expenditure from oil revenues; however, their effectiveness remains unresolved. This paper

examines the roles of oil funds and institutional quality in reducing fiscal procyclicality and

macroeconomic volatility in 42 oil-exporting countries from 1960 to 2014 using panel vector

autoregression techniques. The results show that oil funds are effective in reducing fiscal procyclicality in

countries with high institutional quality. There is also a reduction in the procyclical bias in those with low

institutional quality but the statistical evidence is weak. Nevertheless, oil funds are associated with

reduced volatility of government consumption and the real exchange rate in countries with low

institutional quality. These findings give credence to the macroeconomic stabilization role of oil funds but

also reinforce the importance of good institutions.

1. Introduction

In spite of the potential benefits that natural resource endowments could bring to

resource-rich countries, the underperformance of economic growth and

unsatisfactory development outcomes are well documented (e.g. Sachs and Warner,

1995; Auty, 2001). This phenomenon is referred to as the “resource curse.”

1

There

are five main explanations of the resource curse: the “Dutch disease” hypothesis

(Corden and Neary, 1982); volatile international resource prices that cause

macroeconomic uncertainty (Lane, 2003); unproductive spending on “white

elephant” projects (Gelb, 1986) and underinvestment in human capital (Gylfason,

2001); procyclical fiscal policies and inappropriate monetary policy frameworks

(Frankel, 2011); and political economy arguments of resource abundance (e.g.

Easterly and Levine, 1997; Tornell and Lane, 1999; Acemoglu et al., 2001). These

problems are even more severe in oil-exporting countries owing to the fact that oil

is a “point-source” and “lootable” resource and hence conflict, corruption, and rent

seeking are more likely compared with diffuse resources (Mehlum et al., 2006;

Arezki and Br€

uckner, 2009).

2

In addition, oil exporters are subject to larger terms

of trade shocks and, to some extent, the high macroeconomic volatility in these

*Koh (Corresponding author): Centre for Applied Macroeconomic Analysis (CAMA), Crawford School

of Public Policy, College of Asia & the Pacific, The Australian National University, J. G. Crawford

Building, Lennox Crossing, Acton ACT, 2601, Australia. E-mail: wc.koh@anu.edu.au. Thanks are due to

Warwick McKibbin, Ren

ee Fry-McKibbin, Joshua Chan, Samuel Wills, Shane Johnson, Gan-Ochir

Doojav, and participants at a CAMA Macroeconomics Brown Bag seminar for feedback and suggestions.

The author is also grateful for the detailed comments from an anonymous referee as well as the

Managing Editor, Professor Andy McKay, which helped to improve the manuscript. Acknowledgement is

also due to Inessa Love and Ryan Decker for sharing their codes. This research is supported by the

Centre for Strategic and Policy Studies (CSPS), Brunei Darussalam.

Review of Development Economics, 21(3), 567–590, 2017

DOI:10.1111/rode.12293

©2016 John Wiley & Sons Ltd

countries can be attributed to procyclical fiscal policies that amplify the boom–bust

cycle.

3

Among the policy prescriptions advocated to reduce the dependence on volatile

oil revenues to alleviate fiscal procyclicality, macroeconomic volatility, and limit

Dutch disease symptoms in oil-exporting countries is to set up oil funds, which

gained popularity from the late 1990s.

4

Oil funds fall under the umbrella of

sovereign wealth funds (SWFs). Data from the Sovereign Wealth Fund Institute

(2016) shows the total asset size of SWFs to be about US$7.4 trillion as of June

2016, of which 57% are oil and gas funds. Oil funds are typically set up with the

objective of either saving for the future to address issues with regards to fiscal

sustainability and intergenerational equity, or to smooth fiscal expenditure and

stabilize the economy.

5

As the economic argument goes, governments can smooth

expenditures and prevent excessive macroeconomic volatility by channelling surplus

oil revenues to the oil funds during booms and finance budget deficits during cycle

downturns by transfers from these funds.

6

They are therefore related to a broader

literature on fiscal procyclicality.

7

The fact that fiscal policy is procyclical in

developing countries has been documented in many studies (e.g. Gavin and Perotti,

1997; Kaminsky et al., 2004; Talvi and Vegh, 2005; Ilzetzki and Vegh, 2008).

8

The

same result holds when narrowing the sample to resource-rich countries (Cespedes

and Velasco, 2014) and oil-exporting developing countries (Erbil, 2011). In the

political economy context, Arezki et al. (2011) find that procyclical government

spending in resource-rich countries is moderated by the quality of political

institutions. More generally, Frankel et al. (2013) find that a third of the developing

world have “graduated” from fiscal procyclicality over the past decade (i.e. over the

period 2000–2009), and the key determinant is institutional quality. Interestingly,

about half of this graduation cohort comprises of oil exporters, the period that

coincides with the proliferation of oil funds.

There are only a handful of papers that quantitatively investigate the importance

of oil funds (or natural resource funds) and institutions on the conduct of fiscal

policy.

9

However, the findings of existing studies are somewhat mixed. Davis et al.

(2001) find that resource funds do not have a significant impact on government

spending and are largely redundant based on 12 selected countries (11 oil exporters

and Chile) from 1965 to 1999. Crain and Devlin (2003) find that resource funds can

in fact increase fiscal spending volatility, particularly in oil-exporting countries.

Ossowski et al. (2008) use a larger panel dataset of 31 countries from 1992 to 2005

and conclude that fiscal outcomes are not due to oil funds but they find that higher

institutional quality is associated with lower correlation between government

revenue and expenditure. Likewise, Bova et al. (2016) do not find evidence that

adopting fiscal rules and resource funds have reduced the procyclical bias in non-

renewable commodity exporters; however, they find that better institutional quality

reduces procyclicality.

In contrast, Shabsigh and Ilahi (2007) use a panel dataset of 15 oil-exporting

countries from 1973 to 2003 and find that oil funds are negatively correlated with

volatility of money, prices and to a lesser extent real exchange rates. Asik (2013)

provides evidence in favor of oil funds in reducing fiscal procyclicality and volatility

of fiscal expenditures in 29 oil-exporting countries from 1980 to 2012 but she does

not find any statistically significant association between fiscal performance and

institutional quality. Coutinho et al. (2014) provide evidence of fiscal procyclicality

in resource-rich countries but the effect is lower when there is a resource fund and

also in more democratic regimes. Sugawara (2014) finds that resource funds

568 Wee Chian Koh

©2016 John Wiley & Sons Ltd