Oil price volatility and fiscal policies in oil‐exporting countries

• DOI: http://doi.org/10.1111/opec.12074
• Published date: 01 June 2016
• Date: 01 June 2016
• Author: Ibrahim Alley

Oil price volatility and fiscal policies in

oil-exporting countries

Ibrahim Alley

Doctor, Department of Economics Fountain University, Osogbo Osun State, Nigeria. e-mail:

alleyi@yahoo.com

Abstract

The meteoric decline in oil price in late 2014, a manifestation of crude oil price volatility, pressured

the fiscal positions of many oil-exporting countries (OECs). This study examined the relationship

between oil price volatility and OECs’fiscal policy [proxied by primary fiscal balance (PFB)]

responses. It estimated a small open-economy aggregate demand model in which oil price is

externally determined. Using various measures of oil price volatility in a vector error correction

(VEC) model, this study established that fiscal policies in OEC were not procyclical but driven by oil

price volatility. Oil price volatility reduced PFB in the short run. In the long runhowever, PFB rose in

response to price volatility, suggesting that OECs’governments eventually consolidate their fiscal

positions to reduce short-run fiscal deficit induced by oil price volatility. Though their fiscal policies

were pressured in the short run, OECs were able to stabilise their fiscal dynamics in the long run.

1. Introduction

Oil prices, like many other commodity prices, have not only been volatile but have also

been characterised by uncertainties (Mehrara and Oskoui, 2007; Anshashy and Bradley,

2012). In fact, oil price swings have been larger than those of other mineral resources

(Eifert et al., 2002; Regnier, 2007; Frankel, 2010). These characteristics, and the

associated large receipts of export revenue, have been noted to negatively affect oil-

exporting countries (OECs) in many ways. While oil price volatility is known to be

associated with real exchange rate fluctuations (Mehrara and Oskoui, 2007) and pose

challenges for monetary policy in countries with fixed or pegged exchange rate regimes,

large receipts of oil revenue caused internal struggle for oil resource ownership (Hodler,

2006), corruption (Leite and Weidman, 1999), inequality (Gylfason and Zoega, 2002)

and poor education (Gylfason, 2001).

Oil price volatility is an outcome of exogenous shocks. It is transmitted to the

economies of OECs through fiscal policies because oil revenues accrue to governments.

The revenues affect the economy through government spending decisions. However,

JEL classification: C3, C5, E2, O4, Q4.

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optimal decisions on current government expenditures take into consideration informa-

tion about current and future revenues (as propounded in permanent income rule and

bird in hand rule; (Collier et al., 2009). Thus, primary fiscal balance (PFB), the net of

government revenue and spending, better reflects fiscal response of governments to

variation in macroeconomic phenomena than government expenditures, which many

previous studies used in capturing fiscal response.

Many studies have examined the effects of oil price volatility on macroeconomic

indicators in OEC such as output, unemployment, inflation and exchange rate (Loungani,

1986; Olomola and Adejumo, 2006; Rafiqet al., 2009; Omojolaibi and Egwaikhide,

2013). Few studies have however paid attention to the implication of oil price volatility

on fiscal policies. Few studies (Anshashy and Bradley, 2012, for example) in this

direction focus on response of government expenditure, and not PFB, to oil price

volatility. Some other studies that considered fiscal deficit response to oil price volatility

did not however make distinction between the short run effect of oil price volatility on

PFB response and the long run response of the latter to the former.

This study therefore examined the short run effects of oil price volatility on fiscal policy

in OECs and how the latter adjusts to the former over a longer time horizon. It used PFB to

capture the fiscal policy because it represents the outcome of fiscal expenditure, vis-

a-vis

revenue dynamics, and thus captures policy response better than either item of fiscal policy.

The study analysed data on 18 OECs in a vector error correction (VEC) model, and found

that oil price volatility reduced PFB in the short run. The balance however rose in the long

run in response to volatility. The results suggest that oil price volatility caused government

expenditure to rise above revenues in the short run because the volatility constrained the

ability of the government to perfectly forecast its revenues. The short run decline in primary

balance has however led to long run fiscal policy adjustments such that planned

expenditures are kept within forecast revenues. The primary balance thus rises, in the long

run, in response to oil price volatility. This is evidenced in the build-up of stabilisation

funds

1

maintained by many OECs. Details on the nexus and the influence of other

macroeconomic variables are discussed in subsequent sections.

The positive response of primary balance to oil price volatility does not necessarily

require that government expenditure falls, as Anshashy and Bradley (2012) find. The

balance would rise while government spending grows so long growth rate of spending is

less than that of revenue. While government expenditures may actually fall, it is

uncommon for many governments to cut spending because it is unpopular to do so,

except in situations of permanent negative shocks to revenues.

The rest of this paper is organised as follows. Section 2 presents the review of

relevant literature. Section 3 highlights the model while Section 4 discusses the data and

present findings from preliminary analyses. Section 5 discusses the main findings while

Section 6 presents the concluding remarks.

©2016 Organization of the Petroleum Exporting Countries OPEC Energy Review June 2016

Oil price volatility and fiscal policies 193