Fiscal Rule of Azerbaijan: A Positive First Step?

As a broad term, fiscal policy refers to the management of taxes and expenditures by governments. It is certainly the number one tool that the governments utilize to intervene into the national economy. That intervention, on the other hand, should have definite restraints, which brings us to the topic of fiscal rules…

Fiscal Rules (FRs) are constraints (often numerical) on various indicators, such as the budget deficit, foreign debt and etc. They have been progressively adopted around the globe particularly since the 1990s. Yet one may wonder, why do we need these limitations at all?  This question can be addressed from two points of view: economic and political.

WHY FISCAL RULES ARE NECESSARY?

Economically speaking, FRs are useful because when government expenditures are left without any regulation/framework, they tend to be highly pro-cyclical[1]. This [pro-cyclicality] is a problem, because the fundamental idea (according to Keynesians) is that the governments ought to combat insufficient levels of aggregate demand during recessions by boosting government expenditures and therefore by injecting money into the economy. Although there are plenty economists who do not endorse the Keynesian perception of government’s role in the economy, many of them would still uphold a counter-cyclical fiscal policy than a pro-cyclical one.

Secondly, nonexistence of FRs is also a concern due to the so-called ratchet effect. From the graph below, you can see the timeline of U.S. government’s expenditures to GDP ratio[2]. Highlighted area represents the 2008 – 2009 recession. The red line, corresponding to 37.43%, is the above-mentioned ratio for the year of 2007.

Graph 1: U.S. Federal Government spending to GDP Ratio

Graph1.png

Source: OECD

As you can observe, the government expenditures hiked throughout the crisis (following a Keynesian approach). However, they took longer to contract even well after the recession was over in 2010. By the end of Obama’s second term – 2016, the ratio was 0.78 percentage points higher than the pre-recession times[3]. The gradual decline, as well as the ratio still being higher than pre-recession levels even as of 2016, are indicators of the ratchet effect. It means that once the governments increase its spending, particularly during economic downturns, it becomes a lot harder to reverse this trend later. Ever-increasing share of public sector in the economy is therefore the expected long-term outcome in the absence of a functioning Fiscal Rule.

In my latest post, I put a lot of emphasis on Azerbaijan’s profoundly unsustainable fiscal policy due to its inability to strategically manage the natural resource revenues. FRs are also crucial for achieving more sustainability in this regard. In resource rich countries, this is done by mathematically limiting the utilization of resource revenues. If left without a limit, volatility of the commodity prices also poses a risk to the economy (particularly to the financial sector and the industries involved in international trade) due to fluctuations of the national currency exchange rate.

The need for FRs can also be justified on political grounds. Long story short, conflict of interests and political bias prior to elections (or chance of losing control of the government) may result in politicians focusing on short-term goals that may be economically undesirable. For example, a ruling political party that faces the risk of losing authority may move to announce an enormous infrastructure plan by running a hefty budget deficit and financing it with long-term loans. Such a policy is not likely to make economic sense, but since the current ruling party is not going to bear the burden of debt repayment, it has little incentive to care. There are many reputable reads on this matter, for example Cukierman & Meltzer (1986) and Kopits & Symansky (1998).

At this point, it should be explicit to us that Fiscal Rules are imperative. Yet, not all of them are the same. In the next section, we’ll take a quick glimpse into different kinds of FRs used around the world.

TYPES OF FISCAL RULES

Fiscal Rules can be designed with various methods and targets. First and foremost are the ones aimed at balancing the budget. In some cases, the rule calls for an overall balance in the budget whilst in others, it bypasses the interest expenditures or borrowing for public investments (known as the “golden rule”). A good example here is the FR of the European Monetary Union (EMU), which implies that states cannot run budget deficits that are larger than 3% of their Gross Domestic Product (GDP)[4]. Fiscal Rules can also institute limitations on growth of budget expenditures in order to keep the public sector in check.

Another major type of constraint put forth by FRs is the ceiling on government borrowing. This can include either domestic or foreign borrowing, as well as a combination of both. A pre-defined limit can also be instituted for public debt of the country, often in the form of debt to GDP ratio. Following the same example of the last paragraph, EMU has identified 60% of national GDP as the maximum for accumulated public debt. On the other hand, if a member state fails to abide by the rules of EMU, then they are subject to fines varying from 0.2% to 0.5% of the national GDP[5].

One of the widely used types of Fiscal Rule concerns the national reserves. A country may have a rule to spend only a modest share of revenues from the natural or currency reserves. For example, according to FR of the Russian Federation (effective between 2013 and 2015), all of the oil revenues above a pre-determined base price must be saved in the National Welfare Fund. However, the rule was proven dysfunctional following the oil price plunge as well as the sanctions on the Russian Economy.

The legal basis of FRs can range from constitution to regular laws or international treaties. For obvious reasons, it is more desirable to have a competent authority independent of the executive branch in overseeing the compliance with the fiscal rules, although that power tend to rest with the Ministry of Finance. In order to ensure that the rule is effective, it should also take into account the budget execution, not only the approval.

Additionally, a mere limit on the budget deficit is not enough as it is likely to pave the ground for raising taxes with the aim of balancing the budget. Therefore, an adequate Fiscal Rule must also assure that tax rates be remained stable over time. In short, there are a lot of small factors that are easy to overlook but contribute to the success of a Fiscal Rule.

Let’s now have a brief look at FRs currently in use by different countries;

  1. Chile: the rule envisions a structural surplus[6] equal to 1% of the national GDP. For achieving this target, the government has set up a council consisted of independent experts. The council estimates the long-term price of copper (a major export of Chile) and the potential output (GDP). Although the council’s rules are not legally binding, its public views play an important role in shaping Chile’s fiscal policy.
  2. Denmark: since 2014, Denmark has had binding restrictions on the state budget expenditures. The ceiling levels are determined by the parliament for each 4-year period. The country also has a rule for balancing the budget, which provisions that the structural budget deficit cannot be larger than 0.5% of the national GDP unless there are “extraordinary circumstances”.
  3. Germany: starting from 2016, Germany’s Fiscal Rule provides that the state budget cannot have a structural budget deficit which is larger than 0.35% of the national GDP. As a member of the European Monetary Union (EMU), the country is naturally subject to supranational FRs mentioned above as well.
  4. Georgia: starting from 2014, Georgia utilizes FR on three targets: (a) ratio of expenditures of the consolidated budget to GDP cannot exceed 30%, (b) ratio of consolidated budget deficit to GDP cannot exceed 3% and (c) ratio of the public debt to GDP cannot exceed 60%. It comes as no surprise that although not an official member of the European Monetary Union, Georgia is following the public debt and budget deficit rules of that particular organization.
  5. Mongolia: according to Fiscal Stability Law of the country, the budget expenditures cannot exceed the growth in non-mineral sector of the economy. The law also limits the public debt at 40% and structural deficit at 2% of the national GDP. The structural deficit in this case means the difference between the expenditures and revenues of the budget with 16 year moving average of Mongolia’s main export commodity prices.
  6. Norway: non-oil deficit of the structural budget cannot exceed the expected return of the Government Pension Fund Global (Norway’s national welfare fund), which tends to be around 4%.

FISCAL RULE IN AZERBAIJAN

The Azerbaijani budget rule was amended in summer of 2018[7]. I will briefly introduce the rule first and then will give my interpretation and comments. The regulation, which came into force on January 2019, can be divided into two parts and be summarized as follows:

  1. Limiting Expenditure Growth: The budget envisions that the expenditures of the consolidated budget[8] for the current year cannot grow more than 3% year on year. Apart from that, the expenditures are also constrained by the sum of Spendable Oil Revenues (we will define this term later) and the Non-Oil Revenues (such as taxes and duties from entities of the non-oil sector, revenues from social security and unemployment taxes, as well as the revenues from financing budget deficits and etc) of the state budget.
  2. Reducing Non-Oil Primary Deficit: Each year, the ratio of the non-oil consolidated budget deficit to non-oil GDP should be lower than the same indicator of the previous year. Be noted that this provision is not a “must be” as the first one, but rather a “should be”. Therefore, it might not be legally binding. On the other hand, the rule mentions that when the above-mentioned ratio is not lessened in comparison with the previous year, then the expenditures of the following year will be amended in line with the target indicator of the ratio.

An essential point here is the definition of the term “Spendable Oil Revenues (SOR)”. According to the budget rule, the calculation of this value changes based on the price of oil. In order to explain this, we need to introduce three indicators first: (a) Forecasted Oil Revenues (FOR), (b) Net Financial Assets (NFA) and (c) Spendable Part of the Net Financial Assets (SPNFA). The first term is rather straight-forward as FOR denotes the estimated amount of oil revenues that will be received by Azerbaijan in a given year. The second indicator, NFA is mostly consisted of assets of the State Oil Fund (SOFAZ). Lastly, SPNFA equals 30% of NFA. I mentioned that the formula of the term “Spendable Oil Revenues” differs depending on the price of oil. The rule here creates two potential scenarios: high oil price and low oil price.

When the oil prices are high, Forecasted Oil Revenues (FOR) will be greater than Spendable Part of the Net Financial Assets (SPNFA, which is 0.3*NFA). With low oil prices, vice versa will take place. Therefore, the rule defines “Spendable Oil Revenues” as the following:

SPNFA + 0.2*(FOR – SPNFA) when FOR > SPNFA (high oil price)   (1)

FOR + 0.2*(SPNFA – FR) when FOR < SPNFA (low oil price)   (2)

These equations may seem baffling at first and make it arduous to draw anything, therefore I decided to include historical data in order to better comprehend what these new rules mean for the outlook of the fiscal policy in Azerbaijan.

The first and foremost point of the Fiscal Rule is about the expenditures of the consolidated budget. On the graph below, you can see the dynamics of Consolidated Budget Expenditures (CBE) of Azerbaijan between 2013 and 2019. In several years, Azerbaijan has been operating within the boundaries of the current Fiscal Rule (although it was not in effect prior to 2019). On the other hand, 2017 and 2018 recorded a considerably extravagant growth rate than the 3% limit. It is evident that CBE of Azerbaijan are, by no means, stable. This comes as a no surprise since apart from the State Budget and the Social Protection fund, the consolidated budget also includes the State Oil Fund, which naturally is dependent on the price of oil in global markets.

Graph 2: Dynamics of Consolidated Budget Expenditures of Azerbaijan

Graph2.png

Source: Ministry of Finance of Azerbaijan

Bearnig the historic volatility of the CBE in mind, the 3% limit is most welcome and has the potential (if it is implemented) to stabilize the haphazard fluctuations. Yet, we should remember that the utmost goal of the Fiscal Rule should be exerting pressure on the state budget rather than the consolidated budget. On the paper, 3% might look like an ambitious target (as it is quite low) but in order to understand what it means, we need to look from the perspective of the state budget expenditures. In 2018, CBE of Azerbaijan was 26.3 billion manat. Considering that the non-oil revenues of the state budget[9] was only 8,747.9 million manat, 3% of CBE (790 million manat) translates into 9% of non-oil revenues for the state budget.

The 9% mentioned above is a concern in my opinion. Firstly, because the non-oil state budget revenues of Azerbaijan are not capable of surging at such a rate. Given that the state budget expenditures are allowed to rise by 9% each year whilst non-oil budget revenues are destined to lag far behind effectively means that the Fiscal Rule relatively fails to prevent higher dependence of the state budget on the oil sector[10].

Secondly, we also need to take into account that the Consolidated Budget Expenditures of Azerbaijan include not only the expenses of the State Budget, but also the expenses of the Social Protection Fund (SPF) and SOFAZ. Therefore, using CBE in Fiscal Rule allows an artificial hike of state budget expenditures in the event that the SOFAZ or SPF cutback on their spending. For example, if Azerbaijan decides to privatize some part of its Social Protection System in the near future, then the expenditures of the SPF will certainly be reduced by a certain amount. That certain amount, on the other hand, would pave the ground for a large boost in state budget expenditures.

Apart from the 3% limit, the first point also constraints the CBE by the amount of Spendable Oil Revenues (SOR). I have presented the calculation method of SOR above. In the table below, you can see the historical data for the calculation of SOR for Azerbaijan. Please be noted that for the years 2011 – 2014, the Spendable Part of Net Financial Assets (SPNFA, which equals 30% of NFA) is lower than revenues of SOFAZ (which represents FOR, although here it is not “forecasted” in literal sense).

Table 1: Indicators of Spendable Oil Revenues

Million AZN
NFA[11]
SPNFA[12]
SOFAZ Rev.
SOR
SOR Ratio 1
SOR Ratio 2
2011 29,800.0 7,059.9 15,628.3 8,773.6 56% 37%
2012 34,129.4 8,043.6 13,673.7 9,169.6 67% 34%
2013 35,877.5 8,443.8 13,600.5 9,475.1 70% 34%
2014 37,104.1 8,731.3 12,731.0 9,531.3 75% 33%
2015 33,574.1 10,335.1 7,721.1 8,243.9 107% 24%
2016 33,147.0 15,869.8 9,410.2 10,702.1 114% 20%
2017 35,806.5 18,489.0 12,137.5 13,407.8 110% 22%
2018 38,515.2 19,642.8 17,614.1 18,019.8 102% 28%

Source: SOFAZ, Ministry of Finance and author’s own calculations

The corresponding numbers in the column named “SOR” indicates the maximum amount of Oil Revenues that can be included in expenditures in each year according to the current Fiscal Rule in place. The “SOR Ratio 1” is the ratio of SOR to the Revenues of SOFAZ on each year, meanwhile “SOR Ratio 2” represents the ratio of SOR to Net Financial Assets of Azerbaijan. If the Fiscal Rule was implemented starting from 2018, it would have allowed 18 billion manat worth of oil revenues to be spent, which is 2% more than the actual revenues of SOFAZ for that year. This fact alone shows that similar to the 3% limit which we already discussed, the spendable oil revenue part of the Fiscal Rule is also similarly incapable of safeguarding the oil revenues and prevent further dependence of the state budget on oil sector.

There is, however, one thing that the first point of the Fiscal Rule achieves: combatting pro-cyclicality of budget expenditures. I have constructed a graph showing the past dynamics of Spendable Oil Revenues (SOR), Spendable Part of Net Financial Assets (SPNFA), Revenues of SOFAZ (on the primary axis) and the price of BRENT crude oil (on the secondary vertical axis). We can see here that SOR is more stable than oil prices and revenues of SOFAZ, thanks to the involvement of Net Financial Assets in calculation.

Graph 3: Relationship between SOR and its determinants

Graph3.png

Source: SOFAZ, World Bank Database and author’s own calculations

The second part of the FR, which is concerning the non-oil budget deficit (NBD) to non-oil GDP (NGDP) ratio does not raise as many questions as the first one. It can be summarized mathematically as the following:

formula2.pngThis condition can be achieved by lower non-oil budget deficit (i.e. higher non-oil revenues or decreased consolidated budget expenditures) or higher non-oil GDP. The only potential short coming of this point is that it is not legally binding.

CONCLUSION AND SUGGESTIONS

As I mentioned in the beginning of this post, Fiscal Rules have more than one goal/target. In my opinion, we can summarize them in 4 general points. I will also evaluate Azerbaijan’s current Fiscal Rule on each of these points:

  1. Limiting public sector growth and the Ratchet effect: The 103% growth rule of consolidated budget is a reasonably satisfactory target. It could have been better if the rule applied to the state budget expenditures rather than the consolidated budget. On the other hand, considering that a substantial portion of consolidated budget expenditures is consisted of state budget expenditures, this cannot be regarded as a preeminent deficiency, at least for the current time-being. Although various risks (such as cuts in Social Protection Fund spending) remain unaddressed by the Fiscal Rule, I conclude that the FR somewhat manages to achieve the first target.
  2. Combatting pro-cyclicality of budget expenditures: Azerbaijani economy has long suffered from pro-cyclical budget expenditures, particularly in the form of abrupt exchange rate fluctuations of the national currency. As we saw from the graph 3, Spendable Oil Revenues (SOR), calculated with the formulas presented by the FR, have had less volatile trend than oil prices. This is largely the case thanks to using two scenarios for the calculation of SOR: low oil price and high oil price. I therefore regard this target attained by the FR as well.
  3. Constraining the utilization of natural resources: Now comes the elephant in the room. Calculations of Spendable Oil Revenues using the data from the past years yielded alarming results. For the years 2016 – 2018, the Fiscal Rule allows more than 100% of SOFAZ’s revenues to be exploited. Not only that, the rule also envisions that 37% of Azerbaijan’s Net Financial Assets can be included in budget expenditures in a single year. I don’t believe that we can talk about limiting the utilization of oil revenues when the rule allows the oil fund to spend more money than it receives. Surely, the new Fiscal Rule fails to fulfil this task.
  4. Preventing heavy indebtedness: There is (almost) no mention of public debt in the rule because it is regulated by a different piece of legislature, which is not the subject of my post today. Therefore, I cannot say anything about the relationship between the FR and the last target.

By now we more or less know the strength and weaknesses of Azerbaijan’s Fiscal Rule. In the following paragraphs, I will write about how it can potentially be improved in order to better address the needs of the Azerbaijani economy.

First of all, as I mentioned above, it would be appropriate to apply all of the compatible points to the state budget directly, rather than the consolidated budget. We have also observed from the experience of other countries that FRs are usually concerned with state budgets. It is true that for the time being there is no significant difference between the consolidated and state budgets of Azerbaijan, however using the former brings redundant complexity. If the authorities decide to move forward and use the state budget in FR, then a legitimate need to re-assess the 103% rule will arise, because a developing country such as Azerbaijan would need more flexibility (at least more than 3%) in its fiscal policy.

In this regard, we can either adopt another fixed target (5 – 7% would be applicable in my opinion) or use the experience of Mongolia and limit the growth in state budget expenditures to growth in non-oil GDP + 2%. The 2% would only be used when the price of oil is below the expected medium-term price (45 – 50 USD/barrel as of 2019).  I support giving the 2% “buffer” and leave some space for expansionary fiscal policy in case the economy goes into stagnation. By allowing the 2%, we would also ensure that the fiscal policy can operate counter-cyclically.

Secondly, the calculation formula of Spendable Oil Revenues must be revised and amended. At the moment, it tolerates a massive portion of the oil revenues to be spent. The problem is particularly binding during low oil price scenario, where the SOR is defined by the sum of Oil Revenues and a certain amount (see: equation 2). It is therefore mathematically impossible for Spendable Oil Revenues to be less than the revenues of SOFAZ in low oil price scenarios. Since the oil prices would not seemingly going to rise in the foreseeable future, the rule provisions more oil expenditures than oil revenues for every fiscal year.

Considering the above-mentioned shortcoming, an amendment is required to the formulas of SOR. However, while making this modification, we must also preserve the current counter-cyclical elements of the formula. Therefore, simply multiplying the first parts of the equations (1) and (2) (SPNFA and FOR, respectively) by 80% would suffice. The result of such adjustments can be observed from the Graph 4 below.

Graph 4: Historical Comparison of Current and Alternative Ratio of SOR to FOR

Graph4.png

Source: Author’s own calculations

The Current Ratio here is the SOR Ratio 1 from the Table 1 above, which is found by dividing Spendable Oil Revenues (calculated by the original formula presented in the FR) by the revenues of SOFAZ. Alternative Ratio is the same indicator but uses a slightly different formula (using 80% of SPNFA or FOR) to calculate SOR. As a result, even in the worst performing year (2016), the rule does not allow more oil revenues to be spent than saved.

Lastly, few small additions are needed for making the rule fully functional. It should include a pre-cautionary clause that forbids steep rises in overall tax rates of the economy. Without this clause, politicians can get around the constraints of the Fiscal Rule (particularly the point about non-oil budget deficit) by boosting tax revenues of the state budget. Similar clauses can be seen in Fiscal Rules of Australia (Charter of Budget Honesty Act, which requires the taxation to GDP ratio to be remained below 2007-2008 levels), of Belgium (coalition agreement on linking growth of budget revenues to GDP growth, effective between 1992 – 1999), of Denmark (taxes cannot be raised except for environmental reasons or fulfilling EU obligations, effective between 2001 – 2011) and at the most extreme, of U.S. State of Colorado (Taxpayer Bill of Rights, which allows tax revenues to be in line with inflation and population and requires a referendum for tax rate hikes).

We must also not forget that Azerbaijan’s state budget has experienced compelling amendments in the past years and for that reason, the FR should also take into account the budget execution.

At the end, I would like to conclude that the Fiscal Rule of Azerbaijan is a positive first step towards a more responsible fiscal policy. On the other hand, the rule can further be enhanced with the above-mentioned adjustments in the future.

REFERENCES

Budina, Nina. et al. (2012) Fiscal rules at a glance country details from a new dataset. Washington, D.C: International Monetary Fund.

Cukierman, Alex & Meltzer, Allan H. (1987) A POSITIVE THEORY OF DISCRETIONARY POLICY, THE COST OF DEMOCRATIC GOVERNMENT AND THE BENEFITS OF A CONSTITUTION*. Economic Inquiry. [Online] 25 (2), 363–365.

Girshin, Petr (2019) Azerbaijan Fiscal Rule. VTB Capital

Kopits, George. & Symansky, Steven A. (1998) Fiscal policy rules. Washington, DC: International Monetary Fund.

FOOTNOTES

[1] Pro-cyclicality refers to the positive relations between the economic output and budget expenditures. Put simply, the budget gets more revenues when the economy is booming (due to higher income from taxation), which in turn allows for the government to spend more. On the other hand, when the economy is going under a recession, vice-versa happens as the expenditures by the state also decreases, which further exacerbates the situation.

[2] I did not use Azerbaijan as an example here because its ratio has a general upward trend, which makes it hard to observe the ratchet effect

[3] The difference might seem minuscule but be reminded that we are talking about the share of GDP, therefore even a small number translates into a significant amount.

[4] “The EU framework for fiscal policies”, Fact Sheets on the European Union, European Parliament
http://www.europarl.europa.eu/factsheets/en/sheet/89/the-eu-framework-for-fiscal-policies

[5] ibid

[6] Structural Surplus/Deficit refers to the difference between the budget expenditures and the long-term budget revenues.  It only involves the sustainable part of the fiscal revenues by excluding the cyclical or short-term receipts.

[7] https://president.az/articles/29729

[8] Consolidated Budget of Azerbaijan also includes revenues/expenditures of State Oil Fund, Nakhichevan Autonomous Republic and Social Protection Fund.

[9] Revenues of the state budget minus transfers from SOFAZ and taxation of entities in oil sector.

[10] Readers may object to comparing non-oil revenues of the state budget and consolidated budget expenditures since one is income and the other is expense, but the underlying idea is that since 1 manat of non-oil revenue will be translated into 1 manat of state (and consolidated) budget expenditures, I believe that comparing these two values would be appropriate in our case.

[11] NFA is measured in million USD

[12] SPNFA is calculated by multiplying 0.3NFA and Exchange Rate of USD/AZN for the corresponding year.

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