Liquidity buffers can protect spending in the event of adverse resource revenue shocks. Their optimal size will depend on the degree of resource dependence, policy objectives, and risk tolerance (box 6.1). Exogenous general fiscal risks can sometimes be mitigated through the use of financial instruments. In the case of resource-exporting countries, resource price risks could be hedged by the government (to hedge resource-related budget revenue) or by the national resource companies (if r elevant). Hedging transfers risk, at a cost, to financial markets that may be better able to bear i t. For example, the budget in Mexico is vulnerable to oil price uncertainty and volatility, as taxes and levies paid by PEMEX (the national oil company) have typically contributed over one-third of the federal revenue. The ministry of finance operates a hedging program on the basis of put options that set a minimum oil strike price to be r eceived. This approach, underpinned by strong institutional arrangements, limits downward oil price risks. It has helped moderate udget. the effects of oil price volatility on the federal b The use of market instruments to reduce risk requires considerable technical capacity and strong governance; it is best not attempted if those elements are not in place. Risk management programs involving the use of derivatives
BOX 6.1
Fiscal Risk Analysis in Resource-Rich Countries Probabilistic analyses—using historical parameters of the stochastic process driving resource prices—can be used to determine the optimal size of financial assets to stabilize spending in the face of s hocks. Value-at-risk (VaR) analysis is an example of this approach. It can be used by resource-rich countries to assess the optimal size of a liquidity pool, given the stochastic process driving resource revenue. The resulting buffer would be used to absorb resource revenue volatility. How much liquidity is needed to ensure, with a given degree of confidence, that the buffer is unlikely to be depleted over a specific time horizon, given a fiscal policy as embodied in the nonresource balance (NRB)? Fan charts that show a projected baseline for the liquidity buffer and ranges for possible deviations with their estimated probabilities can be used. The VaR results would be used to help calibrate country-specific target levels for the NRB, contingency reserves, and liquidity cushions from a fiscal vulnerability perspective.
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A simulation for Nigeria, for example, suggested that the country would need to have a precautionary buffer stock of about 60 percent of annual oil revenue in order to be reasonably confident that a smooth government spending path can be maintained over three years (Baunsgaard and others 2012; see also Bartsch 2006). Simulations for Gabon made several years ago indicated that a minimum buffer equivalent to about 30 percent of annual oil revenue in 2012 would be needed to ensure, with a probability of 85 percent, that the buffer would not be fully depleted over a three-year period (IMF 2013). Model-based approaches also seek to determine the likelihood that an NRB path can be maintained given resource revenue volatility. These approaches are more complex and require more information than VaR approaches because they link fiscal policy to the macroeconomy and take macroeconomic feedbacks into account. See IMF (2012c) for operational details regarding the practical implementation of the VaR and model-based a pproaches.
Balancing Petroleum Policy