Policymakers in many commodity-exporting countries confront the question of how much to consume, save, and invest out of revenues from commodity exports (see van der Ploeg and Venables 2008). In the face of highly volatile commodity revenues (especially from oil), governments have to balance several objectives at the same time. These include smoothing consumption, ensuring intergenerational equity if a natural resource is exhaustible, managing volatility by building precautionary savings, and investing in capital to promote economic development.
Because of the high volatility of the oil price and thus income, oil exporters are big savers but invest relatively little. It seems intuitive that oil exporters should save a great deal because oil prices are so volatile. However, it is not obvious how large their savings should be. Most oil exporters also have low investment despite their high saving rates (see Figures 1 and 2). Should they not invest more to grow faster, promote development, and have alternative industries when oil runs out? As we argue in our recent paper (Cherif and Hasanov 2012), the returns to investment are also uncertain, and as a consequence, there is a tradeoff between saving in safe liquid assets and risky domestic investment.
Figure 1. Volatility and gross domestic saving (1970-2008 averages)
Figure 2. Gross investment and domestic saving (1970-2008 averages)
We present a stylised model of optimal precautionary saving and investment under uncertainty to study the allocation dilemma of oil exporters. The key ingredient of the model is the irreversibility of risky investment. This assumption is natural if one considers that most public assets and in particular infrastructure are illiquid. We find that precautionary saving in the safe asset of oil exporters (typically US treasuries) is sizeable at 30% of income, whereas investment is relatively low at 15% of income given the high volatility of permanent shocks to oil income and relatively low productivity of the tradeable sector. This result is in stark contrast to the perfect-foresight model, which predicts large borrowing rather than saving at the initial stage (Figure 3, dashed line).
Incorporating uncertainty in the model results in an initial buildup of precautionary savings and in lower average consumption than average income. When there is no uncertainty, it is optimal for policymakers to borrow substantially to smooth consumption. Under uncertainty, however, policymakers need to build up precautionary savings in case the economy is hit by a negative and persistent income shock. About half way through the life cycle, policymakers can start running down accumulated assets, and average consumption exceeds average income. At around the same time, in the perfect foresight model policymakers start repaying borrowed funds, and consumption falls below average income (Figure 3).
The actual income and consumption paths, however, could be drastically different from the average path shown in Figure 3. The 80% confidence bands show that consumption and income could grow substantially but at the same time, there is a positive probability that they fall close to zero, which would be disastrous in terms of utility. Thus the role of safe assets is to protect against negative persistent income shocks in a world where both risky illiquid investment and a safe liquid asset exist1.
Figure 3. Simulated time paths of average consumption and income
Since investment is risky, the more a country invests, the faster it grows but at the cost of smaller precautionary savings and higher income volatility. There is a tradeoff between higher growth/higher volatility and lower growth/lower volatility regimes. Faced with highly volatile income, the government would optimally accumulate substantial precautionary savings in the safe asset and invest relatively little if investment productivity in the tradable sector was low, a policy associated with lower growth/lower volatility regime. In contrast, with higher productivity in the tradable sector, investment and growth rates would be much higher, facilitating a faster recovery in case of negative income shocks and reducing the need for large precautionary savings.
The model helps explain the recent pattern in the saving-investment behaviour of oil exporters and in particular in the Gulf countries. As oil prices skyrocketed in the 2000s, the investment ratio for a group of oil exporters hovered around 25% of GDP, while the saving ratio shot up from 20% in late 1990s to about 50% of GDP in 2008 (Figure 4). Accumulated savings before the global financial crisis of 2008 proved to be a boon and allowed for more consumption smoothing when income collapsed subsequently in 2009. The model also provides a way to assess the optimal current account balance. Our findings suggest that the large current-account surpluses witnessed in the 2000s stem from high volatility of permanent shocks to income and low productivity in the tradeable sector. Lastly, predictions of the perfect foresight model such as large borrowing and additional consumption exceeding received income (i.e. the marginal propensity of consumption greater than one) are in stark contrast to what we observed in the recent decade.
Figure 4. Investment, saving, and real oil price for a group of oil exporters2
To sum up, we would draw the following conclusions from our analysis of optimal policies of oil exporters:
- If productivity in the tradable sector is low, as suggested by the total-factor-productivity data, a build-up of sizeable precautionary savings of safe and liquid assets is necessary to mitigate negative persistent income shocks that might occur in the future; moreover, a growth-risk tradeoff calls for relatively lower optimal investment.
- If productivity is high, however, lower precautionary savings and higher investment would be optimal.
- Spending policy should be conservative as the optimal marginal propensity to consume out of permanent shocks is below one and is much lower out of temporary shocks, suggesting that an increase in income by one dollar raises optimal spending by less than a dollar.
- Policy should focus on improving productivity in the tradable sector and reducing volatility through developing and diversifying this sector. This is key for sustained growth and would lower precautionary saving needs, increase investment, raise consumption, and improve welfare.
Note: The views expressed herein are those of the authors and should not be attributed to the IMF , its Executive Board, or its management.
Cherif, R. and F. Hasanov, 2012, “Oil Exporters’ Dilemma: How Much to Save and How Much to Invest,” IMF Working Paper 12/4.
Van der Ploeg, Rick and Anthony Venables, 2008, “Harnessing windfall revenues in developing economies”, VoxEU.org, 2 October.
1 For instance, investing in a highway does not necessarily protect against negative persistent oil price shocks.
2 Based on an average for Algeria, Angola, Azerbaijan, Bahrain, Ecuador, Equatorial Guinea, Gabon, Iraq, Kazakhstan, Kuwait, Libya, Nigeria, Norway, Oman, Qatar, Saudi Arabia, Turkmenistan, UAE, and Venezuela. Real oil price is the average of three spot prices, Dated Brent, West Texas Intermediate, and the Dubai Fateh, deflated by the US CPI (obtained from the IMF’s World Economic Outlook database).