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The George Washington University
School of Business
Department of Finance
Fakhri Ismayilov, PhD
Fulbright Scholar
Long-term Fiscal Sustainability in Azerbaijan: Current issues
and Post-crisis Challenges
 Population: 9 million
 Territory: 86 th.sq.km.
 GDP of Azerbaijan
(PPP based) is around
2/3 of total GDP of
South Caucasus region
 GDP per capita in 2009
5400 USD
The Importance of Theme

Last periods of high economic growth rate achieved by a broad
social dynamics and capital budget in the face of rising oil
revenues.

Increasing dependence on oil revenues, the budget deficit in the
state budget, in particular the non-oil budget deficit is important
in terms of macroeconomic stability and sustainability of the
budget issue.

The difference from other resource-rich and developing economies
emanates from the fact that proven oil and gas reserves of Azerbaijan
are short-lived to be depleted by mid-2025, which exacerbates the need
to ensure longer-term fiscal sustainability.
3
The main purpose of the paper
 Assess the current situation of fiscal deficit on a macroeconomic point of view,
 The methodology for the calculation on the basis of international practice in determining
the level of non-oil budget deficit;
 To ensure the sustainability of the budget for a fixed volume of used oil revenues by the
principle of Permanent Income Hypothesis methodology and determination of the limit of
the optimal use of oil revenues;
 Medium-term fiscal strategy evaluation and implementation opportunities in Azerbaijan;
 Fiscal Policy Consolidation - “The New Procedures for the Preparation of the Sate Budget
(within MTF)“.
4
The structure of budget revenues
Budget
revenue,%strukturu, %
Dövlət büdcəsi
gəlirlərinin
100%
100
90%
Neftin
vəbudget
dövlət expenditure
büdcəsi xərclərinin
Oilqiyməti
price and
artımı
97,6$
90
32.2
80%
41.7
40.7
80
72,7$
50.8
70%
61.5
60%
60
50%
50
40
40%
67.8
30%
58.3
38.5
54,4$
38,2$
77
75
61
30
59.3
49.2
20%
65,4$
70
62.1
43
20
37.9
10
22
10%
0
2004
0%
2003
2004
2005
Oil revenue
Neft
gəlirləri
2006
2007
Non-oil revenue
Qeyri-neft
gəlirləri
2008
2005
2006
2007
2008
Budget
expend.growth,%
dövlət
xərclərinin
artım tempi, %
Oil price
neftin
qiyməti (orta illik)
In recent years, an average of 60% of the budget expenditure is
financed through oil revenues.
5
The level of non-oil budget deficit is defined…
Büdcə
kəsiri
Budget deficit,%
2004
2005
0
-0.2
2006
0.4
Twinkəsirlər
deficit,%
Əkiz
2007
0
2005
-0.03
-0.3
-0.7
2008
2006
2007
2008
-5
-10
-10
-15
-11
-20
-20
-20
-25
-22
-21
-22
-21
-24
-30
-30
-35
-32
-40
-40
-38
-32
-38
-45
-50
Budgetkəsirinin
deficit in ÜDM-ə
share of GDP,%
Büdcə
nisbəti,%
Qeyri-neft
icmaldeficit
büdcə
q/n
ÜDM-ə
nisbəti,
Non-oil budget
in kəsiri
share of
non-oil
GDP,%
%
-47
-47
-50
Non-oil
budget
deficitq/n
in share
of non-oil
Q/N
fiskal
kəsirinin
ÜDM-ə
nisbəti,GDP,%
%
Non-oil
CAB q/n
in share
of non-oil
GDP,%
Q/N
CƏB-in
ÜDM-ə
nisbəti,
%
Non-oil budget deficit = budget expenditure – non-oil budget revenue (budget revenue – oil
revenue). (IMF methodology)
6
Economic growth
Qeyri-neft sektoru üzrə məcmu tələbin
Aggregatestrukturu,
demand,% %
(non-oil sector)
2004 2005 2006 2007 2008
100%
90%
GDP, %
10.2
26.4
34.5
25.0
10.8
17.9
31.7
80%
40.1
43.8
59.9
56.2
2007
2008
70%
60%
Oil sector, %
3.0
66.3
63.1
36.8
7.0
50%
40%
Non-oil
sector, %
82.1
68.3
30%
13.6
8.3
11.8
11.4
15.7
20%
10%
0%
GDP per
capita, $
2005
2006
1060 1600 2508 3906 5404
Private
demand Dövlət
Public demand
Özəl
tələb
tələbi
Government expenditure has a significant impact on
economic growth.
7
Non-oil budget deficit and exchange market
Kvazi-büdcə
Quasi-fiscal kəsiri
deficit
2000
1842
25
7000
Fiskal
sektorun
valyuta
təklifi,
mln.mln.$
$
Fiscal
sector
- foreign
currency
supply,
6356.3
22
1800
6000
1600
20
18.0
5000
1400
1200
4112.8
15
4000
1000
13
800
10
2827.9
3000
2243.5
600
1997.7
2000
400
5
4.0
1334
1002
200
0
1000
2
112.6
2005
0
2006
2007
2008
0
2006
Quasi deficit, mln.azn
kvazi-büdcə
kəsiri, mln. manat
In share
of budget
expenditure,
%, right
sc. şk)
icmal
büdcə
xərclərinə
nisbəti,
% (sağ
In
share
of
non-oil
GDP,
%,
right
sc.
Q/N ÜDM-ə nisbəti, % (sağ şk)
Currency
supply
Fiskal
sektorun
valyuta təklifi
2007
2008
Net demand
exc.market
Bazarın
xalis of
tələbi
Net central
bank
intervention
AMB-nin
xalis
müdaxiləsi
Quasi-fiscal deficit in the non-oil GDP increased by 2% to about
13% level.
8
Effect of the non-oil budget deficit on macroeconomic stability
neft gəlirləri
və qeyri-neft
kəsir
OilXərclənən
revenues spent
and non-oil
budget deficit
9
47%
50%
8
7.7
45%
38%
7
40%
30%
5
25
168
19.6
150
20
15.4
120
15
25%
4.1
22%
4
106
90
11.5
11.4
20%
2.7
3
15%
11%
2
60
30
0.61
5%
0
0%
2004
10
2005
5.5
10%
1.1
1
180
35%
32%
6
Pul kütləsi
və illik
inflyasiya,
%
Money
stock and
annual
inflation,%
2006
2007
2008
38
32
5
17
0
0
2004
2005
2006
2007
2008
xərclənən
neft gəlirləri,
Spent oil revenues,
bln.$mlrd. manat
Non-oil
deficit/non-oil
sc.
QN
kəsiri/QN
ÜDM, GDP,%,right
%
Money
supplyillik
growth,left.sc
pul
kütləsinin
artımı, %
illik
inflyasiya,
(sağ
Annual
inflation, %
right
sc.şk)
 A 10% increase in budgetary expenditure of the money supply increase is 0.17% points.
9
Evaluation of the optimal level of oil revenues spent in terms of
fiscal sustainability
Permanent Income Approach in IP*:
1. Total oil wealth from financial assets:
W = V + NPV (1)
W - the creation of oil wealth is expected to total financial assets
(current value);
V - the current balance in the oil assets;
NPV - the expected total net present value of oil and gas revenues.
2. The expected total net present value of oil and gas revenues:
(2)
NPV
R - estimated oil revenues for each year during the period;
i - nominal interest rates in international financial markets;
n - number of years.
3. Limit the use of oil revenues within a year:
PI = r * W (3)
r – the real annual return on assets management of the oil (r = i p);
W – the creation of oil wealth is expected to total financial assets
(current value).
* - IP – international practice (IMF/FAD)
10000
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
SOFAZ
Reserve 100 bln.$
DX
PI
Current expend.
mövcud
xərclər
Oil revenue
neft
gəlirləri
The Goals of Long-term Fiscal Sustainability is:
• A fiscal trajectory must be constructed, so that in the
coming years the current abundance of oil revenues can be
covered with a fiscal budget when oil revenues will
decline.
• If the oil revenues are well spent on the optimal level,
after 8-9 years oil reserve assets will be around $ 100 billion
(in current prices).
• To define Sustainable fiscal benchmark: Sustainable
non-oil primary deficit = r/(1+r) * government wealth = r/(1+r) *
(present value of oil revenue + financial assets–debt)
10
Fiscal Sustainability and Managing O&G Revenue in
Azerbaijan (general)
20000
70000
15000
50000
10000
30000
5000
0
2007
2009
2011
2013
2015
2017
2019
2021
2023
Crude Oil Production 000s Tons
Gas Production BCM
Oil revenue
PIH
10000
2025
Regulation of the non-oil fiscal deficit – Model for the use of oil
revenues
The remaining
profit
OIL FUND
Profit oil
AIOC
SOCAR
Transfer
Taxes
Taxes
Permanent income
Consolidate Budget
Financing of non-oil
fiscal deficit
12
The mechanism of using oil revenues on the basis of PI
How to use the oil revenues?
Development purpose
(stability and development)
Economy:
Social:
Saving:
- economic growth
- distribution of revenues
- economy diversification
- social service and
infrastructure
- storage revenues for future
generations
- infrastructure
Spend
- the payment of public debt
Saving
The principle of non-oil budget deficit (MTEF)
Permanent Income Principle:
Consumption expenditures:
Positive point:
- Short-term poverty reduction
Negative aspects:
- Import dependency
- Inflation
- Loss of competitiveness
- Dutch disease
INVESTMENT EXPENSES:
Positive point:
- Economic development and
diversification
Ending the oil wealth into
financial wealth of unending
Negative aspects:
- Poor technical capacity
- Fruitlessly projects
- Inflation
13
Adoption of a Medium-Term Fiscal Framework (MTFF)
Medium-term fiscal framework is a mechanism for setting multi-year
objectives for one or more fiscal aggregates and ensuring that they are respected
in budget formulation, approval and execution.
 Linking annual budget to long-term policies and sustainability objectives –
performance budgeting
 Integrated medium-term macroeconomic projections
 Aggregate fiscal targets, target for the non-oil fiscal deficit based on
stabilization and sustainability goals
 Administrative capacity building – Public Financial Management Systems to
ensure the quality of spending
What do MTFFs try to achieve?
Systemic problems in fiscal policy
a. Time-inconsistency
b. Short-sightedness
Policymakers’ ex ante intentions
differ from their ex post incentives
Policymakers discount long-term
consequences of current policies
c. Collective action
Policymakers favor sectional
over collective interests
d. Principal - agent
Policymakers and budget agents
have different incentives
e. Asymmetric info
Policymakers hide consequences
of their policies from the public
f. Exogenous shocks
Sound policies are blown off
course by unexpected events
What are their constituent parts?
Key MTFF components
a. Time-inconsistency
b. Short-sightedness
a. Fiscal Objective/Target/Rule
b. Medium-term
Budget Framework
c. Collective action
c. Top-Down Budgeting
d. Principal - agent
d. Budget Execution Controls
e. Asymmetric info
e. Transparency
f. Exogenous shocks
f. Fiscal Risk Management
What are the key design issues?
Characteristic
Rationale
Good Practice
Bad Practice
• Separate fiscal policy and
budget decisions
• Flexibility to deal with
volatility or shocks
• Over the cycle (UK)
• Over the Parliament
(NL)
• Annual deficit ceiling
• Debt reduction path
• Limit scope for burden
shifting
• General govt (SGP)
• Public sector (UK, NZ)
• Budget
• Central Govt
Binding on
outturn
• Reduce optimism bias in
forecasts
• Ensure deviations are
made up in future
• “Debt brake” rule
(Swiss)
• Maintain debt below
40% of GDP (UK)
• Aim for balance over
the forecast horizon
• Real expenditure
growth targets
Stable over time
• Build public support
• Raise reputational cost of
breaking the rule
• Procedural FRLs (Aus,
NZ)
• Frequent revision to
numerical rules
• Provide clear guide for
policy-making
• Facilitate evaluation of
compliance
• 1% surplus over the
cycle (Sweden)
• Increase net worth
over time
Medium-term
horizon
Comprehensive
in scope
Precise &
transparent
Fiscal, Budgetary and Expenditure MTF
The three major objectives sought by medium-term frameworks are macro-fiscal discipline and stability, strategic
allocation of resources (allocation efficiency), and technical efficiency (reduce the waste of resources).
Level
Projections
GDP projections
Inflation projections
MTFF
MTBF
MTEF
Aggregated Expenditure
Projections
Aggregated Income
Projections
Expend. Projections by
Administrative Unit
Expend. Projections by
Function
Disaggregated Income
Projections
Expend. Projections by
Program
Results Projections
Macro-Fiscal Framework on a basis of MTF
Medium term
strategic
priorities
Macroeconomic
framework
Anchor:
Non-oil
fiscal
deficit
Flexible IT
regime
Expen
diture
projec
tion
Revenue
projection
MTF
Sector limits
Organization
limits
19
Thank you for your attention!