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December 26, 2018

Fiscal Rules and PFM in Resource-Rich Developing Countries

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Posted by Fazeer Sheik Rahim and Richard Allen[1]

Several low-income countries in Africa are gearing up to become significant resource exporters in coming years. These include Liberia, Mozambique, Sierra Leone, Tanzania, and Uganda. Many are taking steps to enhance their fiscal framework to better manage their resource wealth. Uganda, for example, has set up a Petroleum Fund to finance infrastructure and development, and is considering a fiscal rule based on a nonoil fiscal balance. Similarly, Tanzania envisages the creation of an Oil and Gas Fund, and setting its fiscal objectives based on a non-resource balance target.

In resource-rich developing countries (RRDC), the main goals of fiscal rules—numerical constraints on the budget balances, spending or debt—are to address the exhaustibility and volatility of resource related income, while prioritizing development spending. Yet many countries find it difficult to stick to these rules, particularly in bad times. A recent study by the Natural Resource Governance Institute shows that, of the 34 resource-rich countries with a least one fiscal rule in place in 2015-2016, only six adhered fully to their rules following the latest commodity price crash. Worse, some countries did not follow their rules in good times either.  

The implementation of fiscal rules depends critically on the quality of PFM systems. A system where budget execution is weak, for instance, will not deliver the fiscal outcomes as planned.

While it can be argued that all PFM systems matter for the implementation of fiscal rules, the most fundamental elements are strong macroeconomic and fiscal forecasting, a robust system of preparing the annual budget, reliable medium-term expenditure ceilings, timely and accurate fiscal reporting, and—since infrastructure is often the lynchpin of the strategy of RRDC governments to use of resource wealth—good public investment management.

Ideally, countries should start improving their PFM systems well before the natural resource revenues start flowing. The following areas of PFM are especially important:

  1. Strengthening budgetary management. The effective implementation of fiscal rules requires a strong Medium-Term Expenditure Framework (MTEF) that sets credible and preferably binding aggregate expenditure ceilings over the medium term. A robust MTEF requires (i) strong political ownership of the top-down fiscal objectives, (ii) the ability to prepare reliable forward estimates of the cost of existing and new policies and projects, and (iii) the ability to set budgetary ceilings based on the above. At the execution stage, a strong MTEF requires effective commitment controls, the prevention of spending arrears, and limited recourse to supplementary budgets, all of which are critical to the credibility of fiscal rules.
  2. Improving fiscal reporting. To be effective, the coverage of fiscal rules should be broader than budgetary central governments, and ideally extend to the general government sector. Comprehensiveness matters: a fiscal rule with narrow coverage increases the temptation for governments to embark on extra-budgetary operations to bypass the rule. The definition of petroleum revenues should also be clearly spelt out, particularly when a non-resource balance is targeted.
  3. Enhancing the reporting of fiscal risks. In a rules-based framework, particularly with volatile resource revenue, governments should be transparent about the risks they face, and how they are being managed. In the face of resource revenue volatility, providing the public with a clear statement of fiscal vulnerabilities to resource price downturns, and the kind of fiscal adjustments that would be required can help build support for prudent and less pro-cyclical fiscal policies.
  4. Improving fiscal transparency. International experience points to the critical role of fiscal transparency in the sustainable management of resource revenues. Transparency should cover each stage of the revenue extraction cycle—the allocation of resource rights, resource revenue mobilization and management, and reporting on resource sector activity.[2] The special characteristics of the sector—volatile and uncertain future revenues, large potential rents, upfront costs and long production periods—underscore the need for transparent practices that can foster the more efficient use of public funds, reduce the risk of unstable macroeconomic policies, and improve public confidence in the budget process.
  5. Improving public investment management (PIM). The goal in resource-rich economies with limited resource horizons is to transform their underground wealth into durable wealth. In a capital-rich economy, this could translate into the accumulation of financial wealth. In a capital-scarce economy, the emphasis could be on developing public infrastructure and spending for development. Scarcity of capital does not mean that public investment will automatically translate into a larger and more efficient public capital stock, and evidence shows that “leakages” can be greater than 50 percent in many LICs. The benefits of RRDC improving their PIM institutions (by “investing in investing”) ahead of scaling up their infrastructure spending are potentially large. Evidence shows that, for the same dollar spent, countries with the most efficient institutions can get twice as much growth in the first four years as those with the least efficient institutions.

 

[1] Fazeer Sheik Rahim and Richard Allen are respectively Senior Economist and Visiting Scholar in the IMF’s Fiscal Affairs Department.

[2] See IMF Fiscal Transparency Code Pillar IV for the principles for good practice. Available at https://www.imf.org/external/np/fad/trans/.

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.

Comments

Excellent contribution. Thanks Fazeer and Richard for sharing. It is very concerning that so few countries follow fiscal rules, even during good times. One might interpret this as isomorphic mimicry to give countries credibility when they are not really seeking to make meaningful reform.

But how is breaking expenditure targets possible, given the extensive investments in financial management information systems? Shouldn’t these ensure that budgets are executed according to plan? Checks/vouchers issued conditional on an automatic budget check? Countries that commit to expenditure rules but break them are likely to have an FMIS that cannot ensure this ‘core’ functionality. Perhaps the success of an FMIS investment should be judged based on its ability to hold countries to their expenditure targets?

But here is the catch: an FMIS can subject expenditures to the necessary controls only if the budget is actually routed through it. If not the FMIS will be effective in controlling some expenditures, but others not. In some of our work we have seen large expenditure items such as subsidies, wages and salaries, transfers, etc… to be executed manually and only posted to the general ledger after the fact, despite there being a fully functioning FMIS in place. This gives the illusion of control, when actually transactions are handled outside of the system. This may be the case purposefully to give the executive spending flexibility and break expenditure rules if they so desire without prior legislative approval. For example: in one country we reviewed the wage bill was doubled (from one day to another without any budgetary provisions). Were these routed through the existing advanced FMIS solution this would not have been possible and expenditure rules could not have been so grossly broken. I view countries’ willingness to route the budget through their FMIS as an indication to their commitment to expenditure rules. If they do so, they tie their hands. If not, it might be a revealed preference for exceeding expenditure targets at will. This however is a political economy question rather than a technical FMIS investment question. Why not make an effort to systematically collect such data? It would at least shed light on the expenditure side of the equation.

If we see minerals as a shared inheritance, and mining as a conversion of mineral wealth to other forms of wealth, 3 simple rules can be used, either as a passive benchmark, or like a index fund, a real set of fiscal rules. These are :

a) Sell minerals for Zero Loss, ie, capture the entire economic rent (sale value minus costs of extraction including a reasonable profit)
b) Save everything from mining in a Norway style fund - clear fiscal rule, easy to see when breached
c) Distribute only the real income (using a POMV rule) only as a Citizen's Dividend, a right of ownership - another clear fiscal rule, easy to see when breached.

More details here: https://medium.com/@thefutureweneed/what-is-the-future-we-need-8ae3de8d55a3

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