Investing Volatile Resource Revenues in Capital‐Scarce Economies

• Author: Christine Richmond,Shu‐Chun S. Yang,Irene Yackovlev
• Published date: 01 February 2015
• DOI: http://doi.org/10.1111/1468-0106.12099
• Date: 01 February 2015

INVESTING VOLATILE RESOURCE REVENUES IN

CAPITAL-SCARCE ECONOMIES

CHRISTINE RICHMOND University of Illinois; International Monetary Fund

IRENE YACKOVLEV International Monetary Fund

SHU-CHUN S. YANG*Institute of Economics, National Sun Yat-Sen

University; International Monetary Fund

Abstract. Natural resource revenues are an important financing source for public investment in

many developing economies. Investing volatile resource revenues, however, may subject an economy

to macroeconomic instability. This paper studies fiscal approaches to investing resource revenues,

using Angola as an example. With spend-as-you-go, resource revenues are spent as received, result-

ing in little external saving; public investment can be interrupted, driving up the capital depreciation

rate and undermining stability. Gradual scaling-up, instead, allows countries to build up external

saving to shield investment from revenue volatility. The framework adopted here can be used as a

planning tool to define a medium-term fiscal strategy.

1. INTRODUCTION

Natural resource revenues are an increasingly important financing source for

public investment in many capital-scarce economies. Turning resource wealth

into development gains, however, poses great challenges to policy-makers. In

particular, the volatility of resource revenues can be damaging when govern-

ment spending is pro-cyclical, moving up or down with revenue flows and GDP.

The rise and fall of resource commodity prices during the first decade of the

2000s led to boom–bust cycles in several resource-rich countries, including

Angola and Mongolia. In addition, Pieschacon (2011) finds systematic evidence

that resource revenue volatility can undermine economic stability through the

fiscal policy channel.

In light of historical volatility in resource prices, conventional wisdom advises

countries to emulate the success of the Norwegian approach to natural resource

revenue management: saving resource revenues mainly in a sovereign wealth

fund invested in financial assets abroad (e.g. Davis et al., 2001; Barnett and

Ossowski, 2003; Bems and de Carvalho Filho, 2011). Keeping spending constant

and low can shield resource-rich economies from instability, as well as Dutch

*Address for correspondence: Shu-Chun S. Yang, Institute of Economics, National Sun Yat-Sen

University 70 Lien-Hai Road Kaohsiung, Taiwan 80424, R.O.C. E-mail: syang@mail.nsysu.edu.tw.

This paper is part of a research project on macroeconomic policy in low-income countries supported

by the UK’s Department for International Development (DFID). The paper was presented at the

Conference on ‘Macroeconomic Challenges Facing Low-Income Countries: New Perspectives’

(Washington, DC, 30–31 January 2014). The views expressed herein are those of the authors and

should not be attributed to the IMF, its Executive Board or its management, or to DFID. The

authors thank Juliana Araujo, Andrew Berg, Dhaneshwar Ghura, Galina Hale, Mauro Mecagni,

Camelia Minoiu, Santiago Acosta Ormaechea, Catherine Pattillo, Mauricio Villafuerte and two

anonymous referees for helpful comments.

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Pacific Economic Review, 20: 1 (2015) pp. 193–221

doi: 10.1111/1468-0106.12099

© 2015 Wiley Publishing Asia Pty Ltd

The International Monetary Fund retains copyright and all other rights in the manuscript of this

article as submitted for publication.

disease and the natural resource curse.1For countries with non-renewable

natural resources, this advice is in line with the permanent income hypothesis

(PIH) that current spending (consumption) out of a temporary income

increase should be minimal (Friedman, 1957). It also purportedly achieves

intergenerational equity by preserving resource wealth for future generations.

The narrow interpretation of the PIH, in which spending most revenue from a

resource windfall is inadvisable regardless of whether the spending is on con-

sumption or capital, ignores the development needs of capital-scarce economies.

As many developing countries are constrained from accessing international

capital markets and have low revenue collection capacity (International

Monetary Fund, 2011), resource wealth can finance and, therefore, facilitate an

infrastructure buildup important for economic development. In addition,

because future generations are likely to enjoy a higher standard of living, the

spending share of resource wealth should be higher for the current poorer

generation than for future wealthier generations, as argued in Collier et al. (2010).

The limitations of the conventional PIH advice has been discussed extensively

in the literature (e.g. Sachs, 2007; Collier et al., 2010; Baunsgaard et al., 2012;

International Monetary Fund, 2012). Several papers also find theoretical

support for the view that public investment can dominate external saving as an

optimal strategy to manage resource revenue in credit-constrained, capital-

scarce economies (e.g. Takizawa et al., 2004; van der Ploeg, 2010a; Venables,

2010; van der Ploeg and Venables, 2011; Araujo et al., 2013). Because public

investment can potentially earn high returns in capital-scarce economies and

lead to higher medium-term growth, it implies that adopting a fiscal framework

predicated on postponing priority spending to opt for savings in a sovereign

wealth fund can forego growth benefits from more productive capital.

For highly resource-dependent economies with long production horizons,

such as Angola, the main challenge is to manage revenue volatility. The sustain-

able investing approach proposed in Berg et al. (2013) underscores the impor-

tance of building a fiscal buffer to smooth investment spending, as advised in

Collier et al. (2010), van der Ploeg (2010b), Cherif and Hasanov (2012), and Van

den Bremer and van der Ploeg (2012). It also highlights the need to cover

recurrent capital and operational costs to ensure the growth benefits of invest-

ment, as emphasized in Heller (1974) and Adam and Bevan (2014).

Another challenge developing countries face in scaling-up public investment is

the very low efficiency of investment spending. Efficiency is defined as the dollar

increase in public capital that results from one-dollar investment spending.

Empirical evidence finds that this efficiency is generally below 0.5 for developing

countries (Pritchett, 2000; Hurlin and Arestoff, 2010). Furthermore, limited

absorptive capacity in developing countries can become an impediment to

investment, as has long been recognized in the literature (e.g. Adler, 1965; Berg,

1983). When investment increases beyond the management capacity of the

1The natural resource curse, widely studied in the literature (e.g. Gelb, 1988; Sachs and Warner,

2001; Stevens, 2003; van der Ploeg, 2011) refers to the empirical findings that most resource-

abundant countries tend to grow more slowly than their counterparts.

C. RICHMOND ET AL.

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© 2015 Wiley Publishing Asia Pty Ltd

The International Monetary Fund retains copyright and all other rights in the manuscript of this

article as submitted for publication.