Welfare Dilemma: How To Manage Oil Revenues And Who Needs Fiscal Rules

  |   Econs
What is the best way to use the National Welfare Fund? Why countries have trouble with running fiscal policy in the way textbooks say they should? What can be done to improve Russian fiscal rule?
Dialogue Chain. Episode 11. Gabriel Di Bella, Ex-Resident Representative in Russia, IMF, and Stephen Cecchetti, Professor of International Economics, Brandeis International Business School

Cecchetti: Hello, Gabriel.

Di Bella: Hello, Steven. How are you?

Cecchetti: I’m fine. And I’d like to ask you about fiscal policy. And why don’t we start with the way in which fiscal policy has evolved in Russia and with the fiscal policy rules? Could you explain?

Di Bella: Yeah, absolutely. You know, it is a great question. I think that in terms of how fiscal policy evolved in Russia, it’s very clear that since the early 2000s the authorities understood very well that volatility in energy markets presented a very important challenge for them. So, what the authorities began thinking was ‘alright, in the beginning, let’s try to set up a kind of buffer that would allow us to save some of the oil windfall when prices are high.’ And then successively they began to think about rules that would target a specific benchmark price that they thought it was more stable than the market world price.

Right now, there’s a big debate in Russia about what to do with the funds that are being accumulated in the National Welfare Fund that is this big buffer that the government has associated with the fiscal rule. So, I think that there’s a question of patience here. I mean the buffers in the case of Russia, the fiscal buffers in the case of Russia are still relatively small. I mean they’re going to reach around 7 % of GDP, later this year they’re going to be I mean close to two digits by mid of the next year. I think that there’s this tradeoff between waiting and actually spending the sustainable part and… or just basically using your assets. And I think this is the debate that is ongoing right now. It’s a difficult one.

Cecchetti: So, Russia is not the first to do this or the only country that does this. Could you talk a little bit about other examples? Because I think they’ve learnt from others as well.

Di Bella: Absolutely. This is a great question actually. Interestingly enough I mean when you look at fiscal rules, in particular fiscal rules in the context of strong commodity exporters, there’re many examples. But I think that in the case of Chile and in the case of Norway Russia has a very good mirror to watch itself. I think that the real best practice is what Norway is doing. What Norway is doing is that the money that is accumulated in this buffer is completely invested in assets outside the county. Why is this important? This is important because if these assets were invested inside the country, then automatically the link between oil prices and fiscal policy is restored not through expenditures in the budget but by asset allocation of the national welfare fund. The Norwegians understood this very well. At the same time, it’s not completely possible to delink both of them because, of course, if we accumulate assets and these assets are well invested sooner or later you are going to obtain return. And this return can come back to the budget in the form of revenues to finance expenditures.

The good thing about this is this return is much more sustainable. I mean by definition the natural resources that Russia is obtaining revenues from are resources that are non-renewable in a way there’s this asset below ground that is turning into revenue but really this asset is limited. And so, investing these assets outside provides two good benefits. The first benefit is that the economy is much less vulnerable to fluctuations in oil prices. And so, this delinking of oil prices from fiscal policy is preserved. But the second thing is that by obtaining a return of these assets what de facto is occurring is that these assets are there for the current generation of Russians but also for all the future generations of Russians that are not lucky enough to be in a time in which there’s still oil below the ground. So, I think this is the debate right now. And the debate is so important because, as I said, it can have multiple consequences if, in the end, Russians decide to do otherwise, not the Norwegian way.

Cecchetti: So, is this the sort of things you would counsel countries that are resource-intensive exporters to do, to design generally?

Di Bella: Absolutely yes. Absolutely yes. This is clearly best practice. Of course, it is very difficult to calibrate exactly, I mean, how much of the returns of the fund will have to go back to the budget. The Norwegians themselves are having a problem because at the beginning they thought – when they designed this fiscal rule — that if they extracted a given return that I think was 3% of the return at the beginning it would be sustainable and would be consistent with having more or less stable real exchange rate. And what they have experienced is that they have been very successful in obtaining very large return of this fund and they’re getting appreciation of their real exchange rate even from spending the return of the fund.

Cecchetti: So, as you say, having fiscal rule helps you with monetary policy.

Di Bella: Yeah.

Cecchetti: How do you feel that that helps? Why is that such a big part of a successful monetary policy framework?

Di Bella: I think, I would say it is not a part of the monetary policy framework but rather is part of… a composite of macroeconomic policies. And so, the fact that the fiscal rule very nicely delinks oil prices from changes in expenditures, fiscal expenditures, means that fluctuations in demand, and so fluctuations in economic activity, fluctuations in prices are much smoother, are less extreme than if there was no fiscal rule. Of course, this means that the economic cycle is smoother. It means that inflation changes are smoother. It means that… more importantly that fluctuations in the real exchange rate are less acute or less severe. And this of course in a country like Russia, where around 40% of the consumer price index is food and where around two-thirds of the consumer price index is dominated by tradable goods, having less fluctuations in the real exchange rate because of the fiscal rule makes the task of the central bank much easier. Of course, the central bank has other problems I mean because not only fluctuations in the oil prices or fluctuations in the current account of the balance of payments influence the real exchange rate. There’s the financial account and the balance of payments, this is another issue. But at least, the fact that they have a well-functioning fiscal rule, I mean, simplifies enormously the task of the central bank.

Cecchetti: So, to shift a little bit in sort of textbook economics when you first learn about fiscal policy, regardless of whether it’s an open or closed economy, a small economy or a big economy, an open economy or a closed economy, the first thing somebody tells you is that a fiscal policy should be balanced over sort of cycles. So, it should stabilize but you run deficits during recessions, you run surpluses during booms and you pay them off. Do you think that that sounds a lot like what you are talking about? Can we transfer some of these lessons to advanced economies that are more diversified, that seem to have trouble running their fiscal policy in the way that the textbook says they should?

Di Bella: This is an excellent question. I think that yes. I mean, of course, there’s an element that makes them more important in commodity-rich countries because there’s an element of the revenues in the federal government that depend on the resource, on revenues that are inherently unstable. So, if you go to a more advanced economy or a country that is not resource-rich, so, I think that the basic lesson is kept. As you said, what the advice should be, right... There’s automatic stabilization that is provided usually on the revenue side because taxes on profit, taxes on income fluctuate with the cycle, and, at the same time, on the expenditure side you have things like unemployment benefits that also fluctuate with the cycle. So, the idea would be to let those automatic stabilizers work. And so, basically, the fiscal policy would run against the wind in opportunities when the economy is in recession increase the deficits and when the economy is expanding increase surpluses. And in addition to that, this would build some space for you to do some structural policy. I mean create fiscal space to some structural policy, additional structural policy in terms of maybe increasing your structural deficit during bad times. I think this is a lesson that as you said this is a very basic lesson when you study economics. And it can be very useful for countries at all levels of income. So, as a matter of fact, this is the type of discussion that we have with our more advanced economy members. So, yes, I mean, the answer is yes.

Cecchetti: There’s a little bit of discussion about trying to improve automatic stabilizers. One of the things about the fiscal rule for Russia and for Chile and for Norway is that it’s automatic.

Di Bella: You know, actually, let me tell you first something about the fiscal rule in Russia because, as a matter of fact there’s still a difference and there’s something that can be if you want, improved gradually in Russia. In the case of Russia, the fiscal rule only targets the oil revenue. Actually, this’s not a fiscal rule that takes into consideration the non-[oil] revenue part. Why? Because it’s very difficult to calculate the output gap in an economy where the oil sector is around 20% of GDP. It requires calculating the output gap for the non-oil sector and calculating structural non-oil revenues. And this is something that requires some time, it requires having an institution that is going to be the official, that is going to be in charge of calculating the output gaps in the non-oil sector. And so, it has some challenges involved. So, what we are seeing in Russia is that so far, since a very large part of fluctuations are associated with oil prices, just targeting this part has been enough.

Cecchetti: Is there a way to improve the automatic part of the stabilizers that you’ve thought of for the advanced economies, for more of the high-income economies?

Di Bella: I think that the stabilization is important from the revenue side when you have a balance of taxes that are more linked with those aggregates, that are more cyclical if you want. So, what’s clearly cyclical? Revenues are, I mean, incomes are cyclical, profits are cyclical, consumption has a cyclicality but it’s more resilient. So, if you want to improve the functioning of the automatic stabilizers, create, if you want, a stronger response that is automatically wheeled, you need to resort to those taxes that are more cyclical: the profit tax, corporate profit tax, income tax.

Cecchetti: And on the revenue and the expenditure side that’s a focus of the revenues…

Di Bella: You know I think on the expenditure side building a good system of transfers, of unemployment transfers is essential. It’s very difficult because it can be costly. It can create in some cases incentives that prevent people from reinserting themselves in the labor market. So, it has to be very well-thought because you want people to actually wait but not wait too much. So, I think that good unemployment benefits that balance these issues also can significantly improve fiscal policies through the cycle.

Cecchetti: Oh well. That’s great. I think that’s a fine ending point. And Gabriel who would you like to speak to next?

Di Bella: I think that all these issues that we are talking about – interaction between fiscal and monetary policy – there’s a person that I would really discuss these issues with and he’s the Director of Monetary Policy of the Central Bank of Russia, Alexei Zabotkin.