The Role of Sovereign Funds in Decoupling Spending from Oil Revenue and Creating a Permanent Source of Income
Khalid A. Alsweilem
The uncertain outlook for global oil prices has underlined the challenges Saudi Arabia faces in maintaining long-term fiscal stability and ensuring its ability to meet future obligations. This paper proposes the implementation of policies and institutions that ensure a stable and efficient fiscal framework. Specifically, we propose the establishment of sovereign wealth funds and the implementation of a rule-based fiscal framework that decouples spending from oil revenue and creates a permanent source of income.
James Tobin (1974) famously described endowment trustees as “the guardians of the future against the claims of the present”, whose task it was to “preserve equity among generations.” Sovereign wealth funds have become increasingly popular vehicles through which to achieve similar aims at the national (and sometimes sub-national) level. One of the most important functions of these funds is to facilitate a degree of intergenerational equity in the allocation of the benefits from national assets, preserving the claims of future generations to these assets from those of the present. This task is particularly difficult in the context of resource-rich countries. First, the finite and uncertain nature of resource wealth creates unique challenges in which part of the sovereign wealth fund’s task is to transform finite assets and income from depleting natural resources into permanent wealth in the form of a portfolio of financial assets and its investment income.1 Second, when resource abundance is accompanied by resource dependence, the volatility of the underlying asset and its income creates an additional challenge not encountered by other endowments. The volatility of income from commodities, coupled with its inherently finite and uncertain nature, has therefore led an increasing number of countries to adopt not only institutions (such as sovereign wealth funds), but also accompanying rule-based policies (fiscal rules), that “decouple” public spending from resource revenues.
The Kingdom has been the world’s leading oil producer for several decades and is set to continue receiving significant revenues from oil for decades to come. However, despite this wealth, the country faces fiscal challenges over the short-, medium- and long term. In the short-run, the dramatic drop in global oil prices in the second half of 2014 raises the likelihood of significant fiscal deficits and a decline in foreign exchange reserves; reversing the trend of the past decade of rising revenues, fiscal surpluses and growing reserves. Over the medium term, the much-debated prospect that the fall in oil prices may not be short-lived, but rather herald a new low oil-price corridor for a number of years, will put the Kingdom’s savings from earlier oil revenue booms at risk of depletion.
In the long run, Saudi Arabia’s growing spending needs, coupled with uncertainty around the size and level of future oil revenues, raises the risk of growing fiscal shortfalls, absent meaningful policy and institutional reforms. The steady rise in the fiscal break-even price for oil in recent years indicates that these pressures have already started to manifest. These pressures are likely to rise in the coming years and decades, as it is not prudent for Saudi Arabia to rely on ever-increasing oil revenues. Future oil prices are very difficult – if not impossible – to predict over all horizons.2 However, a number of structural developments suggest that the sharp decline in oil prices in the second half of 2014 could herald a sustained period of lower prices. These structural developments include reduced growth in the demand for oil due to “secular stagnation” in the advanced economies, a less energy-intensive phase of Chinese and East Asian growth, and the increasingly commercial viability of renewable energy; as well as growing supply from both OPEC, driven by recoveries in production levels in Iran, Iraq and Libya, and non-OPEC energy producers, particularly US shale gas and tight oil (for detailed discussions, see Maugeri, 2012; Yergin, 2013; and Jaffe and Morse, 2013). In short, maintaining existing policies and institutions for the management of Saudi Arabia’s oil revenues requires the dubious assumption that these revenues will continue to grow at a similar (or even faster) long-run trend than that observed since the turn of the century.
This paper proposes reforms that provide a more sustainable fiscal framework for Saudi Arabia in light of this uncertain oil-price environment. These reforms will result in a departure from the more ad hoc approach to spending and savings currently in place, which worked reasonably well during a period of strong revenue growth, but is problematic in a less support oil-price environment. Specifically, we propose the establishment of clearly separated sovereign stabilization and savings funds, funded by Saudi Arabia’s existing foreign exchange reserves and future oil revenues. The establishment of such funds is, however, only part of the solution, as they are rendered meaningless in the absence of an accompanying rule-based fiscal framework for allocating public assets and revenues between these funds and the general budget.
An important property of the rule-based framework we propose is that it greatly reduces the link between spending and the annual fluctuations in oil revenue. Following Hausmann et. al. (2014), this rule decouples government spending from oil revenues, as the former responds in an indirect and gradual way to changes in the latter, through a Stabilization Fund. A second property of the rule is that it establishes a source of permanent income to the government in form of investment proceeds. Therefore, the level of future spending can be raised by an annual allocation of a percentage of oil revenues to a Savings Fund, which in turn contributes a fixed percentage (equal to the long-run real return of the fund, as per the famous example of Norway) to the budget annually. We also consider the requirements of the institutional framework for the sovereign wealth funds and the governance of the fiscal rule.
The paper is organized as follows: Section 1 explores the fiscal challenges facing Saudi Arabia. The reform proposals in this paper address the need to ensure medium- and long-term fiscal sustainability. In the absence of significant spending cuts and/or fiscal reforms, a 2-3 year period of lower oil revenue (compared to 2011-13) is likely to lead to a sharp fall in previously accumulated reserves held by the Saudi Arabian Monetary Agency (SAMA) and a reduction in growth-enhancing capital spending. While drawing on existing reserves will enable Saudi Arabia to avoid painful spending cuts and will likely avert any near-term economic crisis, it risks placing the Kingdom on a perilous long-term fiscal path, as a sharp fall in previously accumulated assets will reduce the flexibility policymakers have to respond to future oil-price and revenue shocks. Moreover, the Saudi riyal is fixed to the US dollar, which requires holding sufficient foreign assets at all times to maintain the fixed exchange rate. A substantial depletion of reserves could endanger the stability of the Saudi riyal, which would have significant adverse macroeconomic ramifications.
Section 2 provides a brief overview of the proposed fiscal rule, as well as the data sources and assumptions used in modeling the rule to simulate the impact of various policy settings empirically. The discussion of these simulations in Section 3 brings a number of findings into sharper focus. First, we consider a counterfactual scenario in which the framework was adopted in 2005, which shows how the accumulation of reserve assets through SAMA over the past decade, impressive as it may seem, was in fact less than what would have occurred under a prudent fiscal rule. We then investigate the implementation of our proposed reforms in the near term, and what this implies for future spending and savings dynamics. Section 4 outlines a number of concrete proposals for implementing various institutional arrangements based on international best practices amongst leading sovereign wealth funds and other public investment institutions. Section 5 summarizes our conclusions and policy implications.
1 Economists have theorized these issues for centuries, with seminal contributions from Jevons (1865), Hotelling (1931), Solow (1974) and Hartwick (1977).
2 In his extensive analysis of the statistical properties of the historical movement of the real oil price, Hamilton (2009) concluded that it was best approximated by a random walk (particularly in the post-1973 sample period, characterized by OPEC dominance over supply). While some authors, such as Alquist et al. (2013), have found that simple auto-regressive models can provide marginally more information on price movements in the short run, the random-walk hypothesis is maintained over the medium- and long-run.