A quarterly magazine of the IMF

December 2006, Volume 43, Number 4

Point of View

Spend Now or Save?

Paul Toungui

Africa's oil producers, including Gabon, must decide how to manage windfall oil revenues

Africa's oil-producing countries are benefiting from high global market prices for oil, raising the question of how they should manage their windfall revenues. Is it better to use the resources to tackle the many challenges they face, thereby advancing their efforts to achieve the 2015 Millennium Development Goals (MDGs)—which cover a broad range of social goals, including halving poverty from its 1990 level, reducing child mortality and improving maternal health, and achieving universal primary education—or should they set aside a portion of the resources to provide for future generations?

It is very tempting to use these revenues to make up lost ground. Like other developing countries, Gabon has deficiencies in basic infrastructure, job creation, and access to basic social services (especially in health care and education). Poverty afflicts an ever-greater percentage of the population—now about one-third.

The dilemma of how oil revenues should be managed is not new for Gabon. During past oil booms, windfall revenues and favorable financing terms led it to borrow excessively to finance ambitious investment programs in basic infrastructure—resulting in public debt outstanding during the 1980s that exceeded 70 percent of GDP. Those who worry about Dutch disease note that this approach led, not surprisingly, to higher production costs and unsustainable debt.

Taking into consideration the country's weak absorptive capacity, Gabon is now opting to use its additional resources to finance social spending—focusing on sectors that can serve as a foundation for increasing the country's economic growth potential—while at the same time setting aside a portion of those revenues to cushion the impact of external shocks in the future.

Using oil to get out of debt

It is virtually impossible for African countries to achieve the eight MDGs by 2015, given their present starting point. Real growth remains weak in many countries, falling well short of the 7 percent needed to reach the MDGs, and debt service places a heavy burden on public finance, absorbing resources that could be used to alleviate poverty. As a result, social indicators stagnate or worsen.

Although African countries have, for several decades, carried out structural adjustment programs and sought debt rescheduling, they have not succeeded in freeing themselves from debt. For oil producers, the oil windfall therefore presents them with an opportunity to escape the debt cycle that has long hobbled their development. Accordingly, a number of oil-producing countries have explored innovative debt management mechanisms. Some have used current budget surpluses to undertake unilateral debt reduction initiatives to strengthen their public accounts as a way to withstand possible future shocks.

From 2002 to 2005, public debt as a proportion of GDP fell from 97 percent to 41 percent in Saudi Arabia, from 35 percent to 14 percent in Russia, and from 47 percent to 24 percent in Qatar. In 2006, Algeria concluded an agreement with France to retire the full outstanding balance on its bilateral debt, and Libya has paid down almost all of its external debt. These countries' experiences have taught us many lessons, one of which is that paying down debt early brings greater benefits than building up savings that earn a low rate of return.

Gabon's problems are particularly acute. Although oil accounts for over 40 percent of GDP, Gabon was ranked 123 out of 177 countries by the United Nations Development Program's Human Development Index in 2004. Its debt service absorbs nearly 40 percent of total revenues and severely constrains the government's capacity to invest in the social sectors. Because oil revenues are volatile and Gabon's output is already waning (having fallen from 368,000 barrels per day in 1997 to 266,000 barrels per day in 2005), the economy must be diversified over the medium term if the sustainable growth necessary for poverty reduction is to be assured.

For countries like Gabon, whose oil output is declining, the fact that oil revenues will eventually fall (rising prices cannot offset dwindling output indefinitely) means that the proceeds from the upturn in oil prices must be used to make a significant dent in the outstanding debt. This choice is all the more justified because Gabon has virtually no access to debt cancellation programs. At the same time, rescheduling is no longer an alternative because of its cost and the shrinking of the debt base that can be rescheduled. Moreover, official development assistance is difficult to obtain, and grants are relatively small. Gabon has been through eight Paris Club reviews without achieving an overall reduction in its debt. Now Gabon could exit the Paris Club by using its oil windfall to pay off a part of its debt in advance.

Spending within their means

As for spending the oil windfall, it is essential to remember the past mistakes that have been made in the execution of spending programs. Certainly, the oil price increases of the 1970s shocked the world economy. The industrial countries, victims of their own energy dependency, suffered the aftereffects of high energy costs for an extended period. Petroleum-exporting countries such as Gabon benefited for a time from an inflow of petrodollars in the form of both net revenues and massive loans before succumbing to government deficits and soaring inflation.

The same can happen again today if governments undertake investment programs and social measures that outstrip their economies' capacity to respond to strong demand. In Gabon, for example, early oil revenues were accompanied by a significant increase in investment and consumption. Wages and benefits rose without any meaningful link to increased productivity. At the same time, Gabon did not have enough workers with the necessary skills and so turned to foreign workers in large numbers; this meant a significant transfer of funds abroad at the expense of domestic savings.

No one can question the need to build up savings to be ready to cope with an abrupt downturn or to assist future generations. That is why Gabon established the Fund for Future Generations in 1998 and has contributed to it regularly since 2003. But such a strategy requires choosing between saving domestically at a modest rate of return and investing in global financial instruments that offer the potential of a high yield, albeit at a higher risk. The experiences of countries that opted to set up funds for future generations within their local banking systems are mixed. In contrast, those that opted to invest in foreign financial instruments through internationally reputable portfolio managers are now reaping high financial returns from the loans and investments they made, which are contributing to their current account surpluses.

The President of Gabon, hoping to ensure a better contribution of the national oil wealth to the development of the country, has decided to allocate a significant portion of the windfall oil revenues to a number of development infrastructure projects. For the most part, the projects are concerned with building transport infrastructure, strengthening the health and education systems, and encouraging the development of the private sector to lay the foundation for sustainable development. The spending reflects the priorities identified in Gabon's Growth and Poverty Reduction Strategy Paper.

Gabon is also trying to promote transparency and good governance in the management of its extractive industries. That is why it chose to join the Extractive Industries Transparency Initiative in 2004, a process it intends to pursue to strengthen the allocation of oil and mining revenues.

Grasping a rare opportunity

The recent higher oil prices and the resulting financial windfall have given Africa's oil-producing countries a rare opportunity to correct or reduce their structural imbalances. Given the scope of the challenges they must overcome to achieve the MDGs, the countries have little choice but to invest a significant part of their windfall in basic social and production infrastructure.

However, the pace of spending has to be commensurate with the economies' capacity to absorb large additional spending programs. If capacity is relatively weak, countries should set aside some of the funds rather than use them to respond to immediate and sometimes pressing social demands. The choice of the proper combination of spending and saving is therefore important because it will determine the return that a country can expect from its oil wealth. For the amounts that are saved, the option of allocating them to funds for future generations in the local banking system may offer relatively low financial returns. A more attractive option is to invest the savings in global financial instruments and make early repayments of expensive debt.