Revenue volatility is often a leading concern for countries dependent on extractive industries. As future revenues are uncertain, government investment planning is difficult, with the risk of over-spending on poorly planned projects in boom times and harsh spending cuts when prices or production fall. Further, the resulting volatility of exchange rates, inflation, and government spending can cause businesses to spend in a manner than exacerbates the volatility problem.

The most reliable, long-term solution is to reduce revenue dependence on resource extraction. Diversifying the economy, particularly the tax base, away from the extractive sector can ensure a supply of government revenues that is not tied to the fortunes of one industry. Diversification is a long and difficult path that requires short-term stability. To manage this interim process, governments have a range of tools including the design of the extractive industry tax regime, managing the flow of revenues in and out of the budget, and decisions about which types of expenditure are more volatile than others. A suitable strategy may involve a combination of these, along with improvement in underlying institutions to ensure that the tools are effective in controlling government spending, and shield the economy from macro disturbances.

The government’s decisions are hampered by the difficulty of knowing whether a change of commodity prices signals a temporary or enduring shift. If a price change is temporary, government application of one of these tools to manage volatility is suitable. If a price change is more permanent, the government should instead consider making an adjustment to its long-term spending plan. This is no easy task, and government decision makers should be cognizant of this uncertainty.

Consider how the extractive industry tax regime affects volatility

To some extent, the design of the tax regime can influence how price volatility affects revenue volatility. The use of fees and royalties provides somewhat more protection than corporate or excess profit taxes, for example. However, this protection is limited and may come at a cost of lower revenues on average.

Consider using hedging contracts

In some cases, governments may be able to insure against downturns in revenues in the form of financial contracts that allow governments to insure themselves against commodity price uncertainty; these are called "hedging contracts." While this may be appropriate for insuring for short periods, longer-term protection can be expensive. There is a significant outlay associated with even short-term hedging that yields a return only in the event of falling prices. This may prove economically and politically costly for lower-income, resource-rich countries. Hedging, where used, is best deployed as part of a mixed portfolio of other strategies.

Consider accumulating foreign assets, and borrowing in the short-term

A third strategy is to form a fund with surplus revenues to accumulate foreign assets in boom times, and liquidate those assets (or borrow if these are insufficient) when revenues fall. The use of funds for stabilization differs conceptually from savings funds with longer-term goals of storing wealth for future generations, which may be a lower priority for developing countries. In practice, a single fund may perform both functions.

Funds for stabilization should hold foreign assets such as foreign government treasury bills, rather than domestic assets such shares in domestic businesses, for three reasons. First, the funds should insulate the country from the harmful effects of volatile expenditure. Investing them in the domestic economy merely shifts expenditure off-budget, thus failing to reduce overall expenditure volatility in the country. Second, undertaking domestic expenditure from funds off-budget may lack the checks and scrutiny that are normally applied to the budget. Finally, holding foreign assets denominated in foreign currency helps to limit the impact on a country’s exchange rate when the country experiences significant financial inflows.

It is difficult to estimate how much savings a country might need to cope with future drops in the prices of extractive commodities: since these prices are inherently unpredictable, the government may need to build up large funds. This is a challenge early in the life of a fund, and is potentially not an appropriate use of revenue. In such cases, borrowing from international capital markets might be more preferable. However, the government should be aware of the risks of over-borrowing, and ensure that borrowing occurs only on a short-term basis. Over the long term, the government should use resource wealth to reduce, not increase, its debt.

Furthermore, the government should integrate any natural resource fund with the national budget so as to prevent the creation of an institutions that makes domestic spending decisions outside the national budgetary system that either complicates public financial management or weakens existing accountability measures.

Make changes to investment expenditure before recurrent expenditure

Finally, if volatility is so pervasive that government cannot smooth total expenditure, it is preferable to allow investment expenditure to change more abruptly than recurrent expenditure. Investment expenditure is inherently uneven, while recipients of recurrent expenditure, such as public sector workers, require regular, periodic payments. Abrupt reductions will not be popular, while large increases in payments may be politically difficult to reverse when prices fall. However, such measures should be a last resort: volatile, stop-start funding is still damaging to investment projects. Critically, the decision must also rest on understanding whether a fall in prices is temporary or permanent—if permanent, government should consider reducing both types of expenditure.

Establish checks to ensure appropriate use of instruments

There is no guarantee that future decision-makers will use these instruments for managing revenue volatility effectively. For instance, stabilization funds may be raided, or not replenished in boom times, while borrowing may quickly become unmanageable. The use of these instruments can be particularly opaque given their complexity and the ease with which financial transactions can be hidden or obscured from public scrutiny. Transparency measures in this area are particularly warranted.

Monitoring government decisions requires an explicit target. Non-discretionary rules are useful to guide government’s use of hedging, saving funds and borrowing instruments. Authorities ought to weigh these rules against the flexibility to respond to changing circumstances, particularly the difficulty of predicting the future course of prices. To provide some degree of flexibility, the government can employ a mechanism to regulate deviations or alterations to the rules, subject to public debate and formal oversight.

For more information about implementing the principles of the Natural Resource Charter precepts, click here.