1

ManagingExtremeVolatilityforLong-runGrowth1

Doug Addison

1.1 Introduction

Thischapter identifiesmacroeconomicpolicyoptionsfor long-rungrowthandpoverty reduction thatarecompatiblewith thechallenging realities facingNi-gerianleadersandthehighdegreeofmacroeconomicvolatilityinparticular.Assuch,itincludeslessonsdrawnfromrecentresearchongrowth,investmentandvolatility. Some of the policy proposals included here are standard, others aretailoredtoNigeriancircumstances.Inthiscontext,intheconcludingsectionofthechapter,recentpolicychangesadoptedin2003,2004and2005areevaluatedfortheirimpact.

The Nigerian economy is not merely volatile, it is one of the most volatileeconomiesintheworld.Thereisevidencethatthisvolatilityisadverselyaffect-ingtherealgrowthrateofNigeria’sgrossdomesticproduct(GDP)byinhibitinginvestment and reducing theproductivityof investment, bothpublic andpri-vate. Economic theory and empirical evidence suggest that sustained high fu-turegrowthandpovertyreductionareunlikelywithoutasignificantreductioninvolatility.OilpricefluctuationsdriveonlypartofNigeria’svolatility;policychoiceshavealsocontributedtotheproblem.Yetpolicychoicesareavailablethatcanhelpaccelerategrowthandthushelpreducethepercentageofpeoplelivinginpoverty,despitetheseverityofNigeria’sproblems.

Twocaveatsareinorder:first,althoughthischapterfocusesmainlyontheis-suesandpolicyoptionsassociatedwithvolatility,itiscertainlythecasethatotherpolicychoicesinotherrealmsmatterjustasmuch.Thequalityofgovernance,infrastructureandpublicservicesareamongthese.Putanotherway,thischapterargues that employinga strategy to reducevolatilitywillhelp reduce thedragontheNigerianeconomytoasignificantdegreebutonlyifothersustainingele-mentsarealsoinplace.Manyoftherelevantpolicychoicesarediscussedinotherchaptersofthisbook.Second,theanalysisisconfinedtothenationasawhole.Ifdataqualitycontinuetoimprove,itshouldbepossibleinthenearfuturetogodeeper,lookingatstate-levelorindustrial-levelissues.

Section1.2describesthebreadthanddepthofvolatilityintheeconomy.Sec-tion1.3describestheimpactthisvolatilityhashadoninvestmentandgrowth.

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Section1.4exploresthesourcesofvolatilityandhowitwastransmittedthroughtheeconomyupuntil2000–01.Insodoing,thejustificationforseveralchangesinmacroeconomicpolicybeginstoemerge.Section1.5tiesthesecluestogetherinto a coherent strategy and offers some thoughts about the feasibility of im-plementation. Some elements of this strategy have already been implementedin2003,2004and2005.Section1.6thereforeprovidesabriefassessmentoftheshort-runimpactofwhathasbeenachievedsofarandproposesnextsteps.

1.2 Breadthanddepthofvolatility

Table1belowshowshowNigeriacomparestoothernationsinthevolatilityofseveralkeyeconomicindicators.Volatilityisdefinedhereasthestandarddevia-tionofgrowthratesinrealvariables,pricesandmonetarygrowth.2Thenumberofcountriessampledisquitelargeandislimitedonlybydataavailability.

ExaminationofTable1leadstoastrikingconclusion.Nigeriarankedamongthe top tenmostvolatile countries for theperiod1961–2000 forall indicatorsexceptmonetarygrowthandconsumerpriceinflation.Moreover,Nigeriawasinthetopfivecountriesforthevolatilityofrealgovernmentrevenuespercapita,terms-of-trade(TOT)volatilityandrealexchangerate(RER)volatility.Whenthetimeperiodisshortenedto1991–2000,Nigeriaremainsinthetoptenmostvola-tilecountriesforallmeasuresexceptrealGDPgrowthandmonetarygrowth.Inaddition,Nigeria’sconsumerpricevolatility,whichwasrankedtwenty-firstoutof114forthelongerperiod,wasrankedninthoutof114fortheshorterperiod1991–2000.

Morerecently, thedegreeofvolatility in theTOTfor theperiod2000–2005remainsalmostthreetimeslargerthanthesamplemeanfor1991–2000andthevolatilityforrevenuesover2000–2005istwoandahalftimesasvolatileasthe1991–2000samplemean.(Seecolumnfor2001–2005inTable1.)Thissuggeststhattherehasnotbeenanyabatement inthenatureoftheprobleminrecentyears.

1.3 Impactofvolatilityongrowthandinvestment

Nigerianpolicy-makers seekingeconomicgrowthhave faced strongchallengesoverthecourseofNigerianhistory.Amongthesehavebeendeeplossesfromacivilwar(1967–70),drought,diseaseandpests,andextremelyvolatileTOTduetooilpriceshocks.Thewarappearstohavecausedthedeepest losses,bothintermsofliveslostandintermsofeconomiclosses.Yettheeconomyreboundedquickly when the war ended. By contrast, there is strong evidence that macr-oeconomicvolatilitymayhavesubstantiallypenalizedgrowthandthequalityofpublicspendingonanongoingbasis.3

Recentempiricalandtheoreticalresearchhasestablishedthatmacroeconomicvolatilitycanhaveanadverseimpactongrowththroughatleasttwochannels.

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� Addison

Volatilitycanaffectgrowthbyinducinglessinvestmentorbyreducingproductiv-ity–forexample,bymakinginstalledcapitallessefficient.

Easterlyet al.(1993)findthatcountrycharacteristicsalonearenotsufficienttoexplaincross-countrygrowthpatterns;externalshocksareanimportantpartof the story. Similarly, Bleaney and Greenaway (2001) find that real growth isnegatively affected by TOT volatility. Hnatkovska and Loayza (2003) find thatmacroeconomicvolatilityandlong-runeconomicgrowtharenegativelyrelatedwith causality flowing from volatility to reduced growth. They find this nega-tivelinkisexacerbatedincountriesthatarepoor,institutionallyunderdeveloped,undergoingintermediatestagesoffinancialdevelopment,orunabletoconductcounter-cyclicalfiscalpolicies.

Empirical researchhasestablished thatprivate sector investmentcanbede-pressedbyextremelevelsofriskanduncertainty.BleaneyandGreenaway(2001),forexample,concludethatRERuncertaintydepressesinvestment.Servén(2002)findsthattheprivateinvestmentrateisafunctionofRERuncertainty.HefindsthattheimpactofRERuncertaintyismorepotentathighlevels,possiblyimply-ingathresholdeffect,andthatthedirectionofimpactdependsuponthedegreeofopennesstotradeandthestrengthofthefinancialsystem.PrivateinvestmentisreducedbyRERuncertaintyinnationswithlowtradeopennessand/orweakfi-nancialsystems.Conversely,RERuncertaintyappearstoencourageprivateinvest-mentinnationswithahighdegreeofopennessandstrongfinancialsystems.

Oneexplanationfortheabilityofastrongfinancialsystemtoreducethenega-tiveimpactofvolatilityisprovidedbyAcemogluandZilibotti(1997).Theypro-posethatthereisavirtuouscirclewherebyriskisreducedbywealthandportfoliodiversificationwhiletheinvestmentneededfordiversificationisencouragedbyfallingriskandrisingwealth.Inarelatedpaper,Denizer et al.(2002)findempiri-calsupportforthepositiveeffectthatfinancialsystemshaveinreducingmacr-oeconomicvolatility.

Nigerianfirmmanagershavecomplainedaboutinadequateaccesstofinancemoreoftenthananyotherproblemexceptuncertaintyandpoorinfrastructure(Marchat et al.,2001).Lackofcreditforcesenterprisestorelyoninternallygener-atedfundsbothforworkingcapitalandforinvestment.Thishampersfirms’abil-itytomanagetheirworkingcapital,makingitdifficultforthemtoincreasesalesandoperateat fullcapacity.Theshortageoffinancealso limits investmentstoimprovetechnology,tolowercostsandtoexpandoutput.Thehighcostandlim-itedavailabilityofcreditisthusoneofseveralfactorsthatraisethecostofdoingbusinessandlowercompetitivenessinNigeria.Otherimportantfactorsincludehighenergyandinfrastructurecosts.

In Nigeria’s case, the available evidence suggests that growth was reducedthroughboth investmentandproductivity.Nigeria’sprivate sector investedanaverageof7percentofGDPperannumbetween1980and1994,wellbelowtheaverageof20percentinvestedbytheworld’sfastestgrowingeconomies.4Cal-culationsinWorldBank(2003)suggestthisreducedgrowthbyanaverageofof0.6percentperannum.Productivitylossesweremuchlarger,estimatedat2.8percentperannum,foratotalof3.4percentperannum.Analysisofthedataalso

Managing Extreme Volatility for Long-run Growth �

showsthatgovernmentinvestmentismoreproductivewhentherateofgovern-ment investment is stable – and that general productivity growth is adverselyaffectedbyTOTvolatility.Similarconclusionscanbedrawnfortheprojectsthatmakeupgovernmentinvestment.Inparticular,thereisempiricalevidenceatthemicroeconomic level thatvolatilityhasnegativelyaffected theperformanceofWorldBankprojectsinNigeria.5

1.4 Sourcesofeconomicvolatility

InSection1.3,itwasestablishedthatmacroeconomicvolatilityhashadahighcostforNigeria.Wenowexplorethisvolatilityindepth.Sections1.4.1to1.4.3examinethecausesandconsequencesofvolatilityintheTOT,fiscaloutcomes,inflationandtheRER.Thisanalysismakesitclearthat,whileNigeriaissubjecttoquitelargeexternalshocks,policychoiceshaveaddedtothelevelofvolatilityoftheeconomy.ThisisillustratedinSection1.4.4.Bythesamelogic,alternativepolicychoicescouldhelpreducethelevelofvolatilityandthushelpstimulategrowthandmoreproductiveinvestments.

1.4.1 Terms-of-tradeshocks

TheTOTindexisdefinedastheindexofexportpricesdividedbyanindexofim-portprices.Nigeriawasrankedfirstoutof110countriesforthestandarddeviationofTOTinlevels,1960–2000.IfonelooksatthevolatilityoftheannualchangeintheTOTindex,thenNigeriaisrankedthirdoutofasampleof90countriesfortheperiod1961–2000.ThestandarddeviationintheannualchangeinNigeria’sTOTindexoverthatperiodwas27percent,comparedtothesamplemedianofonly10percent.Nigeriaremainsrankedinthirdplaceevenwhenonelooksatashorter,morerecentperiod,suchas1991–2000.(SeeTable1above.)Otherna-tionswithastrongexportconcentration inoildisplaysimilarlyhighstandarddeviationsinTOTgrowthrates:23percentforIran,20percentforVenezuelaand20percentforTrinidadandTobago.

The costs of TOT volatility

TOTvolatilityhasnegativeaffectsatthemacroeconomiclevel,onproductivitygrowthandtherateofprivatesectorinvestment,andatthemicroeconomiclevelontheperformanceofinvestmentprojects.TheuncertaintycreatedbyvolatileTOTgrowthmakesitdifficultforNigerianfirmmanagersandprojectmanagerstodecidehowmuchtoproduceandwhatproductiontechniquestouse.Forexam-ple,machinesinstalledforcarpetmakingthataredependentuponimportedarti-ficialfibrescanbeveryproductivewhentheTOTfavourimportsbutveryhardtoadapttolocalinputs(andhenceunproductive)whentheTOTarelessfavourable.Moreover,onceadecisionhasbeenmadeandequipmentinstalled,productivitywillbereducedbecauseofthefluctuatingavailability,qualityandcostofinputs.

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Sources of TOT volatility

PartofthereasonforNigeria’sextremeTOTvolatility istheveryconcentratednatureofitsexportsrelativetoitswelldiversifiedimports.Roughly95percentofNigeria’sexportscomefromoilandthishasnotchangedmuchsince1974.Theotherproblemisthatoilpricesareextraordinarilyvolatilerelativetomostothercommodityprices.Asampleofworldpricesfor37keyexportcommoditiesshowsthatonlythefreemarketpriceofsugarwasmorevolatilethancrudeoilpriceswhenvolatility isdefinedasthestandarddeviationofannualpercentagepricechangesfortheperiod1960–2001.6

Policy implications

Diversificationofexportsper seisnotguaranteedtoreduceTOTvolatilityforthenation.Instead,thebestoutcomeforNigeriawouldbediversificationintoactivi-tieswithoutputandpricetrendsthatareuncorrelatedwithoilprices.Forexam-ple,expansionintonaturalgasexports isauseful formofdiversification–butonlybecauseNigeria’slong-termcontractsmandateminimalpriceadjustmentsover time.7 The alternative, linking prices to the spot market, would not helpreduceTOTvolatilitymuchbecausespotpricesforgasarepositivelycorrelatedwithoilprices.

ItisalsoimportanttodistinguishbetweentheTOTfacedbythenationandtheTOTfacedbyindividualsandfirms.Expandingtheoutputoftraditionalnon-oilexportssuchascocoawillhelpreducenationalTOTvolatilitybutitshouldbeacknowledgedthatthesecommoditiesalsofacevolatileworldprices,eveniftheyareuncorrelatedwiththepriceofoil.Thus,theindividualsmarketingcocoaandothercommoditieswillcontinuetofaceconsiderableuncertainty.Worldpricesformanufacturedgoods,however,aregenerallylessvolatile.8

1.4.2 Revenuesandexpenditures

Roughly86percentof federallycollected revenues inNigeriaarebasedonoilreceipts,upfrom77percentin2001.Thishighdependencyuponoil,combinedwithitsvolatileprice,madeNigeriathethirdmostvolatilecountrywithrespecttorealpercapitarevenueperformanceinasampleof71countriesovertheperiod1961–2000andthesecondmostvolatilefortheperiod1991–2000.ThestandarddeviationinthegrowthrateofrealrevenuespercapitainNigeriafortheperiod1961–2000was41percentcomparedtothesamplemedianof11percent.Otheroilexporterswithaheavydependenceuponoilexportsforrevenuesdisplaysimi-larlyhighstandarddeviationsinrealrevenuepercapitagrowthover1961–2000:45percentforKuwait,37percentforIran,28percentforSaudiArabia,26percentforVenezuelaand20percentforTrinidadandTobago.

ThisvolatilitycanalsobemeasuredaschangesinGDPshares.9Figure1showsthatthevolatilityoffederallycollectedrevenuesplusstateinternalrevenuesasashareofnon-oilGDPhadbeenincreasingthrough2001.

Managing Extreme Volatility for Long-run Growth �

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Standard Deviation of Changes

Figure 1 Revenuevolatility,1971–2001.aa Includesfederallycollectedrevenuesandstateinternalrevenues.Standarddeviationsarecalculatedusing10-yearperiods.

The costs of revenue volatility

Oneconcernregardingrevenuevolatility is its impactonprivatesectorspend-ing.Accordingtoclassicmultipliertheory,inordertostimulategrowth,thetaxburdenontheprivatesectorshouldbemadetofallwhenGDPgrowthslows.10InNigeria,thisislessofaconcernbecauseanaverageof75percentofallrevenuesbetween1974and2001camefromtaxesleviedontheenclaveoilindustryratherthantheprivatesector.Instead,thelargermacroeconomicissuesaretheimpactofrevenuevolatilityongovernmentexpendituresandtheRER.

Revenuevolatilityisfrequentlycitedasasourceofdifficultyinthedeliveryofhighqualitypublicservices–mainlybecauseofthehavocuncertaintyplayswithbudgetaryplanningandimplementation.11Partoftheproblemisthatmin-istriesdonotknowwhetheranupturnordownturnistemporaryorpermanent.Predictingthedirection,magnitudeanddurationofrevenueshocksisextremelydifficult.12

Boomsinprojectspendingmayleadtolesscarefulscreeningofnewprojectsandprogrammes.Manynewspendingitemswillendupbeingpoorlyconceivedorwasteful–andmore thana fewwillbebasedon theassumption thathighrevenueswillcontinueindefinitely.Whenrevenuesfall,manyprojectscannotbesustained.Manyprojectsmustbeabandonedwhilethosethatsurviveeitherarepoorlyexecutedorarewellfundedonlythroughborrowing.

The results are visible to any traveller in Nigeria: abandoned governmentprojectscanbeseeninalmosteveryregionandstate.Lessanecdotally,the1992Presidential Monitoring Task Force identified 3907 federal projects which had

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been started prior to 1992. Of these, only 808 had been completed by 1992.Project managers were able to identify future completion dates for only 1068projectsoutoftheremaining3099uncompletedprojects.Manypeoplehavealsoarguedthatthisoutcomeistheresultofinappropriateincentivesforprojectof-ficersandtheirsuperiors:rentseekingiseasierwithalargeportfolioofprojectswhileprojectcompletionispoorlyrewardedifatall.

Revenuevolatilitycomplicatesmonetaryandexchangeratepolicyaswell.Ifthegovernmentchoosestomaintainitsspendingtargets,regardlessofrevenueoutcomes,thenitmustsaveandborrow.Iftheborrowingcomesfromdomesticsources,thenthegovernmentmustaccepthigherinflation,higherinterestratesorboth–dependinguponthemixofbankandnon-bankfinancing.Ifthegov-ernmentisabletoborrowfromabroad,asitdidheavilyintheearly1980s,thenit may eventually face higher debt service obligations that will force a choicebetweenlessspendingandexchangeratedepreciation–unlesstheshockquicklyreversesitselforthereareplentyofforeignassetstodrawupon.

The impactof inflationary spendingon theprivate sector canbe especiallyperverseinaneconomylikeNigeria.Nigeria’sunderdevelopedfinancialmarketslimittheabilityofthegovernmenttoswitchintonon-bankfinancingandtheCentralBankhaslittlepowertoreiningovernmentspending.Whenfiscaldisci-plineislacking,theonlyoptionavailabletotheCentralBank(CBN)forfightinginflationistotrytoholddowninflationbysharplyreducingcredittotheprivatesector.Theeffectofsuchapolicyisclearlyrecessionary.

There are issues of political economy as well. During boom times, the bestpolicywouldbetoassumetheshockistemporaryandsosavetheexcessrevenuesandsterilizetheimpactonthemoneysupplythroughanincreaseinforeignas-sets.Yet,duringbooms,ministriesfeelpressurefromtheirconstituenciestoaccel-eratespending.Thespendingpressureoftencomesfromdemandsforhighercivilservicewagesandmoreprojects.Theformerisextremelyperniciousbecausethewageincreasesarenoteasytoreverseifrevenuessubsequentlyfall–thusforcinggovernmenttorelyonborrowing.Theironiceffectofthesespendingpressuresisthatfiscaldeficitstendtoemergeduringorjustafterrevenuebooms.13

Sources of revenue volatility

MostofNigeria’srevenuevolatilitycanbetraceddirectlytoNigeria’sdependenceuponoilexportsforthebulkofitsfiscalrevenues.Between1974and2001,oilaccountedforanaverageof75percentoffederallycollectedrevenues.14Asoilpricesclimbedinrecentyears,thissharehasrisento86percentin2005.Anex-aminationofoilpricesovertimerevealsthattherehasbeenaconsistentupwardtrend inoilpricesover time.Yet there is considerable short-termvolatility su-perimposedonthistrendevenaftertheboomandbustcyclesfromOPECinthe1970sand1980sandthewarsintheMiddleEast.Infact,inthe15yearsbetween1987and2001,thereweresevenupturnsandeightdownturnsandonlyfiveyearshadchangesoflessthan10percent.Recentyearshavebeenespeciallyvolatilewiththepricecrashingby37percentin1998to$12/barrel,thenrising46percentto$18/barrelin1999,$26/barrelin2000and$55/barrelin2005.15Themost

Managing Extreme Volatility for Long-run Growth �

recentdataatthetimethischapterwaswrittensuggestthatthedegreeofvolatil-itycontinuesunabated:afterreachingapeakof$75/barrel inAugust2006,oilpricesthenfellby$16/barrelinSeptember2006.

Thenextlargestrevenuesourceisimportdutieswhichcontributedanaverageof13percentoffederallycollectedrevenuebetween1974and2001and4percentin2005.Thisrevenuesourcesometimesmirrorsthevolatilityinoilprices.Thisisbecause,inNigeria,long-termimporttrendscloselyfollowexporttrends,subjecttofluctuationsinexternalfinancingandreservemovements.Thestatisti-calcorrelationbetweenoilrevenuesandcustomsrevenues,expressedassharesofnon-oilGDP,thusbecomesfairlytight(0.62)fortheperiod1984–2001,theyearsafterexternalloandrawingsbegantodecline.

Expenditures

Intheory, there isnoreasonwhyrevenuevolatilityshouldaffectexpendituresaslongasgovernmentshaverecoursetoborrowing.Inpractice,however,mostgovernmentsindevelopingnationshaveratherlimitedaccesstoflexiblelevelsofinternationalborrowing,domesticbondmarketsareinadequateandthereisalimitedtoleranceforinflationarydomesticfinancing.Fielding(1995)showsem-piricallythattheconsequenceofthesepracticalconstraintsisthatexpendituretrendsinmanycountriestendtobestronglycorrelatedwithrevenuetrends.ThisisthecaseinNigeriaaswell.

Inmostyearsbetween1971and2001,itappearsthatNigerianexpendituresare well explained by the revenue performance of the previous year. In otherwords,despiterevenueprojections,despiteintentionstosaveoilwindfallsanddespitebudgetedexpenditureallocations,Nigerianpolicy-makersauthorizedac-tualexpendituresasifrevenuescollectedinoneyearwouldberoughlythesameasinthepreviousyear.16Thisbehaviouristheresultofweakfiscaldisciplineanddifficultiesinmakingreliableoilpriceforecasts.Asaresult,thedatadonotrejectthesimplehypothesisthatcombinedfederalandstateexpendituresareasimplefunctionoffederalandstaterevenuescollectedfromthepreviousyear–withbothmeasuredasnon-oilGDPshares.17(SeeFigure2.)Thisresultholdsupevenwhenonelooksatthedatainfirstdifferences–forexample,thechangeinexpendituresharesisafunctionofchangesinlaggedrevenueshares.(SeeTable2below.)

The data also indicate that spending rose and fell more than proportional-lywith respect to revenues –butonly through1986.This canbe seen inFig-ure2whereexpendituresacceleratedmuchmorerapidlythanrevenuesthrough1977/78andthenfellmorethanproportionallywhenrevenuesfellin1978/79.Whenrevenuespickedupagaininthefollowingyear,sotoodidspending.Before1986andonaverage,a1percentchangeinthelaggedrevenueshareofGDPwasmetbya1.3percentchangeinexpenditures.After1986,expenditurescontin-uetofollowlaggedrevenuesthoughtherelationshipismuchweaker,especiallywhenmeasuredinfirstdifferences.18

Whywouldexpendituresexpandandcontractfasterthanrevenuesover1970–86?Apartialexplanationispresentedhere,thoughmoreexplorationiswarrant-ed.PartoftheanswercomesfromthevoracityeffectpostulatedbyTornelland

10 Addison

Table 2 Elasticityofexpenditurestorevenuesa

GDPshares ChangesinGDPshares

Elasticity p-valuesb Elasticity p-valuesb

1970–2001 0.4 0.00 0.4 0.03

1970–1986 1.3 0.00 1.2 0.01

1987–2001 0.3 0.02 0.2 0.19

a Federalandstateonly.b Valuesabove10percentindicatetheestimatedelasticityisnotsignificantlydifferentfromzero.Source:Staffcalculationsbasedonregressionsofexpendituresharesonlaggedrevenueshares.

Lane(1998).Theysuggestthatspendingbecomesmorethanproportionaltorev-enuewindfallswhenthepoliticalandlegalinstitutionswithinanationareweakandcontestedbystronginterestgroups.19ThisseemstobeagooddescriptionoftheNigeriansituation.AsshowninChapter1ofWorldBank(2003),thehistori-calqualityofgovernanceinNigeriahasbeeninadequatemeasuredagainstmanystandards. It is also well known that Nigerian society is strongly factionalizedalongethniclines.Bevanet al.(1999)notethatethnicconcernshaveinformedmanyfiscaldecisions,notablywithregardtorevenuesharing,thecreationofnewstatesandthedistributionofdevelopmentprojects.TalviandVegh(2000)buildon this, suggesting that more volatile economies have a harder time resistingspendingpressuresduringboomsbecausetherevenueboomsaresomuchlarger.

Figure 2 Revenuesandexpenditures,1971–2001.aa Includesfederalandstategovernments.Revenuesarefederallycollectedplusstateinternalrevenues.Source: CBNandWorldBankstaffcalculations.

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Managing Extreme Volatility for Long-run Growth 11

Theybackthisupbydemonstratinganempiricallinkbetweenrevenuevolatilityandexpenditureelasticities.

Whyhastheelasticityofspendingtorevenuesdecreasedovertime?Partoftheexplanationforthisweakenedlinkisthattheexternalcreditorshadatendencytolendonapro-cyclicalbasis,lendingmoreduringboomyears,thusamplifyingthesensitivityofspendingtooilrevenues.ThisbehaviourendedwhenitbecameapparentthatNigeriawouldnotbeabletomeetallofitsdebtserviceobligations,particularlyaftertheoilpricecrashof1986.

Fiscal balance

Ifexpendituresarewelldescribedbylaggedrevenue,thenitmustalsobetruethatthefiscaldeficitiswelldescribedbyrevenuelesslaggedrevenue.Thissuppositionissupportedbythedata.(SeeFigure3below.)Thecorrelationbetweenthechangeinfederalandstatecollectedrevenueandthecombinedfederalandstatefiscalbalanceis0.51overtheperiod1970–2001whenthedataaremeasuredassharesofnon-oilGDP.Infact,61percentofthetrendbetween1971and2001canbeexplainedbythedataforlaggedrevenuescombinedwithdatafornetexternalflowsfromcommerciallendersandthelaggedbalance.20

Policy implications

The fiscal behaviour described above has adverse consequences for macroeco-nomicstability.Thevolatilityintheoverallfiscalbalancecouldbereducedbyasmootherexpenditurepath.Thischangeinfiscalbehaviourwouldalsodomuch

Figure � Revenueandthefiscalbalance,1971–2001.aa Revenuesincludefederallycollectedrevenueplusstates’ownrevenues.Expendituresincludefederalandstatelevels.Spendingbylocalgovernmentsandspecialfundsisexcludedforlackofdata.

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83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

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ue

(%N

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-30%

-20%

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10%

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40%

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Change in Revenue

Fiscal Balance

12 Addison

Figure � Volatilityofgrowthratefortherealexchangerateindex.aa RealexchangeratedataarefromIMFandarebasedontheexchangerateusedbyGovernment.Thisdivergedfromtheofficialrateappliedtoprivatesectortransactionsduring1995–98.Standarddeviationsarecalculatedusing10-yearperiods.

toimprovetheefficacyofpublicservicedeliveryand,thus,increasegrowth.Sec-tion1.3abovecitedevidencethatproductivitygrowthandprojectperformancearebothencouragedbystabilityingovernmentspending.

Theimpactofasmootherexpenditurepathontheoverallfiscalbalanceisil-lustratedbelow.Supposerevenuesalternatebetween20percentofnon-oilGDPinoneyearand50percentofnon-oilGDPinthenextyear.Supposethatspend-ingfollowsthepro-cyclicalbehaviourdescribedaboveinwhichspendingfollowslaggedrevenues.Inthiscase,thefiscalbalancewouldalternatebetweenpositiveandnegative30percentofGDP.Contrastthisoutcometoanalternativewhereexpendituresareheldconstantat35percentofGDP.Theresultingalternativefis-calbalancewillalternatebetweenpositiveandnegative15percentofGDP.Thelaggedrevenuespendingruleinthisexampleistwiceasvolatileastheconstantspendingrule.

Thegoalofaconstantexpendituresharedoespresumeaccesstoforeignex-changeduringrevenueshortfalls,whetherfromborrowingorfromdrawingdownforeignassets.Itisimportant,inthisregard,tobeveryrealisticaboutaccesstoforeignexchange.Ifforeignassetsaretoolowtosustainspending,orifthereislit-tleaccesstoconcessionalborrowing,thentheexpenditureshareofnon-oilGDPmustbereducedandheldtothenew,lowerleveluntilcircumstancesimprove.

1.4.3 Therealexchangerate

AsindicatedinTable1,NigeriahasoneofthemostvolatileRERsintheworld.Moreover,RERvolatilityhadbeenrisingalmostcontinuouslythrough2001.ThiscanbeseengraphicallyinFigure4below.Ingeneral,thosecountrieswithhigh

Managing Extreme Volatility for Long-run Growth 1�

TOT volatility tend to also display high RER volatility. Within a sample of 87countries,31displayedhighTOTvolatilityover theperiod1980–94.Of these,25hadhighRERvolatility.Aswillbeshownbelow,theoutcomedependsuponwhetherfiscalexpendituresarepro-cyclicalorcounter-cyclicalwithregardtorev-enues.ExpendituresmayeitherdampenoramplifyrevenuefluctuationsdrivenbyTOTvolatility.

The costs of RER volatility

RERuncertainty(proxiedbyvolatility)isimportantbecauseitinhibitsprivatesec-torinvestment.21RERuncertaintyaffectstheprofitabilityofinvestmentsthroughpricechannelsandthroughthecostofborrowing.Riskaverseinvestorsinagri-culture,manufacturingorserviceswillhesitatetoinvestuntiltheycanbeassuredofstrongprofits.Oncetheyhaveinvested,theymayalsohesitatetoabandonaprojectforsomethingbetterbecausetheycannotbecertaintheeconomicclimatehaspermanentlyturnedagainstthem.Yetthenewinvestmentsrequiredtomakean enterprise grow may not materialize because a bright future is not in clearview.Second,volatilityaffectstherankingofinvestments:iftheexchangerateislikelytodepreciate,thenalowrankedprojectincocoaexportsmightbecomemoreprofitablethanahighrankedmanufacturingenterprisethatreliesheavilyon importedmaterials. Risk averse investors thus tend todefer their decisionsuntilmoreinformationisavailable,theuncertaintyisreducedortheygainac-cesstosomeformofinsurance(riskdiversification).Accesstofinancialmarkets,bothdomesticandinternational,iscrucialforthelatter.Hence,asdocumentedinServén(2002),theadverseimpactofRERuncertaintyisstrongerforeconomieswithlessdevelopedfinancialsystems.

Determinants of RER volatility

TheRERisdefinedinthischapterastheexchangerateindollarspernaira,ad-justedbytheratioofNigeriantotradingpartnerinflation.Theeconomicdeter-minantsofRERmovementsarechanges inrealaggregatesupplyanddemand.Inparticular,fiscaloutcomes,with their impactonmoneyand inflation,havebeenthemainsourceofRERvolatilityinNigeria.22Thisistracedoutbelow:infla-tionisshowntobeafunctionmainlyofmonetarygrowthandrealGDPgrowthwhilemonetarygrowthinNigeriahasbeenmainlytheresultofdomesticcreditextendedtothegovernment.

Domestic inflationEconomictheoryandresearchareveryclear:monetarygrowth,relativetorealoutputgrowthisthemaincauseofinflationinallcountries.23Internationalinfla-tion,transmittedthroughimportedgoodsandexchangeratemovements,isan-othersource.24Formanycountries,however,internationalinflationisaltogethersecondarytomonetarypolicybecausetheinternationalpricesofmanufacturedgoodsarefairlystable.Finally,thereisusuallyanelementofinertiawherebya

1� Addison

highrateofinflationinaprecedingperiodtendstopushupsubsequentinflationrates.25Thisinertialelementcanaddtovolatility.

Fiscal outcomesIt is straightforwardtoestablish thatmonetarygrowth inmostyearshasbeendriven mainly by fiscal outcomes.26 Growth in monetary assets (M2) must bematchedbygrowthinmonetaryliabilitieswhicharecomposedofdomesticcreditextended by the banking system, net foreign currency holdings (reserves) andnetotherassets.InNigeria,thestockofnetdomesticcreditcontributesthelion’sshareofthestockofM2:domesticcreditaccountedforatleast80percentofthetotalin25ofthe32yearsbetween1970and2001.Itisnotsurprising,then,thatmonetarygrowthisalsodrivenmainlybychangesindomesticcredit.Inturn,netdomesticcreditisstronglyinfluencedbyfiscaloutcomes.Inmostyears,changesinnetcredittothegovernmentoutweighchangesinnetcredittotheprivatesec-tor.Thecorrelationbetweenflowsoftotalnetcreditandflowsofnetcredittothegovernmentisextremelytight(0.81whenmeasuredinmillionsofnairaand0.97whenmeasuredasshareofnon-oilGDP).

Afurtherexaminationofthehistoricalrecordshowsthatmost, thoughnotall,fiscalbalanceshavebeenfinancedbychangesindomesticcredit.Thisisthestraightforwardconsequenceoftheunderdevelopednatureofthebondmarketand Nigeria’s lack of access to international commercial credit since the mid-1980s.Thereisaverystrongcorrelation(0.75)betweenthecombinedfiscalbal-anceofthefederalandstategovernmentsandthechangeinnetdomesticcredittothegovernmentovertheperiod1970–2001whenbotharemeasuredassharesofnon-oilGDP.Thus,onecan reasonablyconclude that, formostyears,fiscaloutcomeshavebeenthemainforcebehindchangesintotalnetcreditinNigeria.Infact,thecorrelationbetweenthetwo(againmeasuredasnon-oilGDPshares)isalso0.75.

1.4.4 Anexampleofhowvolatilityiscreated

Understanding the interplay between fiscal outcomes, inflationary inertia andexchangeratepoliciesiscrucialtounderstandingvolatility.Theperiod1994–96displayedastrongincreaseinvolatilityandservestoillustrateseveralaspectsofthisinterplay.Theinitialtriggerforthreeyearsofinstabilitywasthefiscaldeficitof1993worth26percentofnon-oilGDP.(SeeTable3below.)Spendingbehav-iour inthatyearreflectedtheexpectationthatthe1992oilpriceof$20/barrelwouldbemaintainedwhen,infact,itfellto$17.50/barrel.Moreover,spendingin1993wasunderpressurefromthecostoffinancingpresidentialelectionsandfromasharpincreaseinthecivilservicewagescale.Thisledtoaninflationrateof57percent.Theinflationaryinertiacreatedin1993ensuredthattheinflationrateremainedat57percentin1994eventhoughthefiscaldeficitfellto11percentofnon-oilGDP. In1994, the full impactofdomestic inflationfellontheRERbecausetheauthoritiesheldtheexchangeratefixed,byfiat.Thus,whenfall-ingworldpriceswerecombinedwithdomesticinflation,theRERappreciatedby86percent.

Managing Extreme Volatility for Long-run Growth 1�

Table � VolatilityininflationandRER,1993–97

1993 1994 1995 1996 1997

Revenueaspercentageofnon-oilGDPa 27 21 27 30 30

Expenditureaspercentageofnon-oilGDP 53 32 28 27 30

FiscalBalanceaspercentageofnon-oilGDP –26 –11 –1 2 0

CPIinflationrate(%) 57 57 73 29 9

Parallelexchangeratepremium(%)b 157 228 –3 1 4

Exchangerategrowth(%)+devaluation 28 –1 270 0 0

Realexchangerategrowth(%) 10 86 –15 24 15

a Federalandstategovernments.b Basedonofficialrateusedbyprivatesector.Source:CBNandWorldBankstaffcalculations.

By1995,theauthoritiesrealizedthatsomethinghadtochange.Thehighinfla-tionratehadputpressureontheparallelexchangerate,boostingthepremiumto226percentin1994,upfromanalreadyhigh157percentin1993.This,inturn,undermined theofficial exchange rate,prompting theauthorities to introducetheautonomousforeignexchangemarket(AFEM)forprivatesectorusein1995.27Theprivatesectorthussawaneffectivedevaluationof268percent,farinexcessoftheacceleratinginflationrate.Thus,theRERfellby15percent.

Thefiscalauthorities,reactingtoinflationarypressures,managedtobalancethebudgetin1995.Yetinflationcontinuedtorisein1995mainlybecauseofthelargedevaluationinthatyearandtheinertiafromtheprecedingyear.Inflationdidnotfallto29percentuntil1996afterasecondyearofbalancedbudgets.ThisinflationratewaspassedondirectlytotheRERbecauseofanalmoststableex-changerateandalowinternationalinflationrate.TheinflationrateandRERsta-bilizedfurtherin1997thankstoathirdyearofbalancedbudgets.(Thisoutcomewasmademucheasierbyhigheroilpricesovertheperiod1995–97.)

Policy implications

TherootcausesofRERvolatility inNigeriaareTOTvolatilityandtheconductoffiscalpolicy.Thissuggeststheneedforatwo-prongedapproach.Inthelongrun,buildinga less volatile revenuebasewouldhelpgenerate the stablefiscaloutcomesneededtoreduceRERinstability.Thisisalong-runprocess.Yet,evenifrevenuescannotbequicklysmoothed,theanalysisaboveindicatestherearestill gains to be had from smoothing expenditures with deficits and surplusesabsorbedbychanges innet foreignassets.Duringboomtimes, thebestpolicywouldbetoassumetheshockistemporaryandsosavetheexcessrevenuesandsterilizetheimpactonthemoneysupplythroughanincreaseinforeignassetsorfasterrepaymentofexternaldebtobligations.Duringsevereoilpricedeclines,thegovernmentcouldeitherdrawdownitsownforeignassetsorcoordinatewith

1� Addison

theCBNsothatreservedrawingscouldbalanceincreaseddomesticcredittothegovernment. This approach is challenging, mainly because of current politicalandinstitutionalissuesbutalsobecausepastpoliticaldecisionshaveconstrainedNigeria’s access toexternalborrowingand reduced the stockof reservesbelowwhattheycouldhavebeen.Morerecently,however,therehasbeenasubstantialaccumulationofreserves.

1.5 Establishingaconducivemacroeconomicenvironment

Theanalysisaboveprovidesusefulguidanceincreatingastrategyforamorecon-ducivemacroeconomicenvironmentforgrowthanddiversification.Stabilizationisthenecessaryfoundation,giventhehighlossesingrowthcausedbyNigeria’sextremelevelsofmacroeconomicvolatility.Theobjectivesofthestrategyaretoincreasetheprivatesectorinvestmentrateandraisetheproductivityofbothpub-licandprivateinvestment.Theprivatesectorinvestmentratecanbeincreasedthroughacombinationofmacroeconomicstabilization,financialsectordeepen-ing, improved governance and more openness to trade. More stability in gov-ernmentspendingcouldhelptoraiseproductivityofgovernmentinvestments,especiallyifcomplementedbyeffortstoimprovethecapacityforpublicfinancialmanagement.Theuseof an expenditure smoothingfiscal rule and/or revenuesmoothingwillleadtothenecessaryfiscalstabilizationandtolessRERvolatility.Thismacroeconomicstabilitywillencouragetheprivateinvestmentneededforgrowthandeconomicdiversification.

A more diversified economy, in turn, will lead to less volatility in the TOTandabroader,lessvolatiletaxbase.LessTOTvolatilitywillincreaseproductivitygrowthwhilerevenuesmoothingwillhelpensurethesustainabilityandeffective-nessofpublicexpendituresformuchneededpublicservices.Additionalsupport-ingreformsmayalsobeneeded,especiallywithregardtoinstitutionalrolesandinstitutionalcapacity.Amongthesearean improvedcapacity forproject selec-tion,preparation,executionandmonitoring.

Thesequenceofpolicyreformsisimportanttothestrategy.ThemainsourcesofRERvolatilityinNigeriafortheforeseeablefuturewillbeoilpriceshocksandinstabilityingovernmentspending.Theseissuesareintertwinedandcanbead-dressed together in themedium term through the adoptionof an appropriateexpendituresmoothingfiscalrule.Yetthiskindofrulecannotoperatewithoutasufficientlylargestockofforeignassetsand, ideally,accesstoexternalcredit.Thus, building foreign assets and working towards credit-worthiness must be-comeshort-runimperatives.

Privateinvestmentcanstillbeencouragedduringthisfirstphase,evenwithoutstabilization,throughreformsaimedatstrengtheningthefinancialsystem,mov-ingtowardsgreatertradeopennessandbyimprovingthequalityofgovernance.

Fiscaladjustmentmayalsoberequiredintheformoflessspending,ifrevenuegrowthisnotsufficient;firsttobuildexternalassetsandthenlatertoeliminatethecrowdingoutofcredittotheprivatesectorbythegovernment.

Managing Extreme Volatility for Long-run Growth 1�

1.5.1 Preparingforstabilization

Inthissection,severalpolicyoptionstoreducevolatilityandencouragegrowtharedescribed.Thesearedescribedinsequencewithshort-termfoundationbuild-ingprecedingthestabilizationeffort–andwithinvestmentencouragedbystabil-ityprecedinglong-rundiversification.

Thegovernmentwillneedtoputtwokeycornerstonesintoplaceinordertoachievesuccessfulstabilizationinthemediumterm.Thefirstistograduallybuildasufficiently largestockof foreignassets todrawuponinthe faceofoilpricedownturns.Thesecondistoputinplaceanumberoffinancialsectorreformsthatwilllaterfacilitatetheintermediationofalargervolumeofdomesticcredittotheprivatesectorbythebankingsystem.

Building foreign assets2�

SupposethatNigeriachosetobuildthestockofforeignassetstothepointwherealmostanynegativeoilshockcouldbefullyabsorbedandstill leaveabalanceworth fourmonthsof imports.Between1970and2005,according toGovern-ment of Nigeria (GoN) data, the average annual level of imports was $8.3bil-lion.Fourmonthsofimportsisthereforeworth$2.8billion.Between1970and2005,forallyearswithpricedeclines,theaverageannualchangeinthepriceofNigerianoil (BonnyLight)was$3.40perbarrelwith95percentofallhistori-caldeclines fallingbetweenzeroand$10.88perbarrel.29SupposeNigeriaweretoeventually reachanexportvolumeof2.75millionbarrelsperday,up from2.52millionbarrelsperdayin2005.Atthisvolume,anaveragepricedeclineof$3.40/barrelwouldbeworth$3.4billionannuallywhileacatastrophicdeclineof$10.88wouldbeworth$10.9billionannually.Thus,thetotalstockofforeignassetsrequiredtocompensatefortwoyearsoffallingprices,includingthemini-mumbalanceof$2.8billion,is$9.6billionforaveragedeclinesand$24.6billionforhistoricalcatastrophicdeclines.Usingamoresophisticatedapproach,Bartsch(2006)showsthatastabilizationfundofabout$16–18billionwouldbeadequateifaccompaniedbyafiscalpolicybasedonmovingaverageoilpricesoverthreetofiveyears.Usingamovingaverageisnecessarybecauseoilpricesdonotreverttoastablemean.

Operational issuesRealinvestmentisequaltothesumofprivatesavings,governmentsavingsandforeignsavings.Foreignsavingswillfalltemporarilyasforeignassetsarebuiltup.Thus,ifinvestmentistoincreaseintheshortrun,thenecessaryfinancingmustcomefromhighersavingsbythegovernmentandbytheprivatesector.Govern-ment savings can be increased only through higher revenues or less recurrentspending.Higher revenues are certainlypossible, especially in the long run asthe economygrows anddiversifies, but the immediate adjustmentmust comefromreducedrecurrent spending. Inotherwords,until foreignassets reachanadequatelevel,alloilrevenuewindfallsmustbesavedwhileshortfallsmustbemetbyexpenditurereductions.

1� Addison

More generally, it is important to acknowledge that building foreign assetswilltemporarilydivertresourcesthatcouldotherwisebeusedforconsumptionandinvestment.Growthcouldthereforetemporarilyslowifassetsarebuilttooquickly.Deeperworkwithmacroeconomicmodelswillberequiredtoassesstheneededchangesinspendingandcredittargetsmoreprecisely.

Finally,theneedforsuchahighstockofforeignassetscouldbemoderatelyreducedifNigeriahadgoodaccesstotheinternationalfinancialmarkets–someshort-termoilpricefluctuationscouldbecoveredbyexternalborrowing,althoughthiscouldprovetobeexpensive.

Financial sector reforms

Section1.3aboveexplainedthatstrongfinancialsystemscanreducethenegativeimpactofmacroeconomicvolatility.Thesystemhasnotbeenworkingasneeded.Onemeasureofthestrengthofanation’sfinancialsectoristhevolumeofdomes-ticcredittotheprivatesector.Theaverageflowofcredittotheprivatesectorinthefastgrowingnationsforthe15-yearperiod1980–94was6.6percentofGDPversusonly4percentofnon-oilGDPinNigeriaforthe15yearsbetween1989and2003.Intermsofstocks,ratherthanflows,theNigerianaverageis19percentofnon-oilGDPversus44percentofGDPforthefastest-growingnations.

Howcanthissituationbeimproved?Partoftheansweristhatthegovernmenthashistoricallyconsumedsomuchcreditthatlittleroomisleftfortheprivatesectorwithoutriskinghighinflationrates.Infact,thegovernmentabsorbedthemajorityofallnetdomesticcreditflowsin11ofthe15yearsbetween1989and2003.Theobvioussolutionisforgovernmenttomaketheoverallfiscalbalancemorepositive.Ifthisisachievedbyreducingnon-essentialrecurrentspending,then Nigeria could continue to make needed productive investments in infra-structure.Moreover,suchanadjustmentisalreadynecessaryforthebuild-upofexternalassets.Thus,thesequencingofthispartofthereformcouldfollowthesuccessfulattainmentoftheforeignassettarget.

Intheshortrun,whileassetsarebeingbuiltup,thegovernmentmustbesat-isfiedthatthefinancialsystemiswellregulatedandfreefromdistortions.Largeparallelexchangeratepremiums,suchasthosefoundinthemid-1990s,canin-ducebankstofocusonexchangeratearbitrageratherthandomesticportfolios.Financialrepressionintheformofinterestrateceilings,ifany,excessivelyhighliquidityratiosanddirectedcreditprogrammescanconstraintheflowofcredittotheprivatesector.Therearealsostrongcorrelationsbetweenpoorfinancialdevel-opment,weakaccountingstandards,weakcontractenforcementbythejudicialsystemandcorruption,accordingtocross-countryempiricalworkbyDemirguc-KuntandLevine(1995).Propertyrightsare importanttoo.HoldenandProko-penko(2001)citethecaseofPeruwherethevalueofslumdwellingsdoubledafterthegovernmentprovidedsecure,registeredtitles.This, inturn,allowedpeoplegreateraccesstocreditfromthebanks.

Managing Extreme Volatility for Long-run Growth 1�

1.5.2 Fiscalrules

Theuseoffiscalrulesremainslimitedacrossdevelopingcountriesandfewfocusonthemacroeconomicvolatilitycreatedbyheavydependenceuponavolatileexport commodity. Instead,mostfiscal rulesaremeant to supportbroadgoalsrelatedtodebtreductionand/orlowinflation.Examplesincludetargetsforpri-maryexpenditures,theprimarybudgetbalance(theso-called‘goldenrule’),theoverallbudgetbalanceorthestockofdebt.Additionalrulesmayconstraincer-taincategoriesof spendingsuchas thewageandpensionbillormayearmarksometypesofrevenueforspecificcategoriesofspending.Theserulesareusuallyenshrinedintheconstitution,orinnationallegislation,andareoftenbackedbylegalsanctions.

Theserulesareoftenflexibleenoughtobemodifiedtoallowfortheimpactofunforeseenshocks.Insomecountries,forexample,ifGDPfallssufficientlybelowanexpectedtrend,thengovernmentsmaybeallowedtoborrow(uptoprescribedlimits)whilethesamerulemandatesfiscalsavingsifactualGDPexceedsthepro-jectedtrendbyasufficientamount.VariationsonthisthemeincludetheuseofcontingencyfundslinkedtoGDPtrendsandstabilizationfundslinkedtorevenueperformance.

ThemainselectioncriteriafortheruleslistedabovemustincludetheabilitytostabilizeexpendituresandtheRER.ThesecriteriaaremotivatedbytheanalysispresentedinSection1.3thatsuggeststhattherearehighcoststogrowthfromvolatilityinthesevariables.TheanalysisinSection1.4reinforcestheconclusionthatexpendituresshouldbestabilized:itwasnotedthatpro-cyclicalexpenditurebehaviourtendstoamplifythedegreeofmacroeconomicvolatilityintheNige-rianeconomy.

Inappropriate rules

Inthislight,anyrulethatsetsatargetfortheprimarybalanceortheoverallbal-anceisnotappropriateforNigeria.Underthegoldenrule,forexample,revenuefluctuationswouldhavetobemetbyequivalentadjustmentsinrecurrentspend-ing–somethingthatmostgovernmentsfinddifficulttoachieve–whileallcapitalspendingisfinancedbyborrowing.Thisrulefailstoinsulaterecurrentexpendi-tures.Iftheoverallbudgetistobebalancedinstead,thenrevenuefluctuationsaremetbychangesintotalspending.Thisrulealsofailstoinsulateexpenditureseventhoughitcansometimeshelpthemonetaryauthoritiesmaintaintargetsfordomesticcreditandthemoneysupplybyeliminatingtheneedforgovernmentborrowing.Debttargetrulesarealsoinappropriate:revenuecontractionswouldstillrequireexpenditurecutsinordertoavoidnewborrowing.

Expenditure smoothing rules

Ifstabilityinexpendituresisdesired,thenitisbesttosetsuchatargetdirectlyandtodosowithreferencetoafairlystablebasesuchasnon-oilGDP.Non-oil

20 Addison

GDPcouldbethoughtof,inthiscontext,asasortofcyclicallyadjustedmeasureofGDPinwhichthedirectimpactofoilpriceandvolumefluctuationshavebeenfilteredout.

Bywayofexample,a stable target forprimaryexpenditurescouldbe set intermsofnon-oilGDPshares.Sucharulewill requireadeparture fromcurrentfiscalbehaviour,inwhichspendingtendstofollowlaggedtotalrevenue.Alter-natively,onecouldsetatargetforthenon-oilprimaryfiscalbalance(meaningthatoil revenuesareexcluded)asashareofnon-oilGDP.Thetwoapproachesarealmostequivalent:expendituresunderthesecondoptionwillbestabletotheextentthatnon-oilrevenuesarestable.

Table4providesanillustrationofhowrecentfiscalperformancewouldlookifeitheroftheexpendituresmoothingrulesabovehadbeenused.Thetableshowstheconsolidatedperformanceofall levelsofgovernment for theperiod1993–2001.Non-oilrevenuesvariedaroundanaverageof12percentofnon-oilGDP.Primaryexpendituresfluctuatedaroundanaverageof41percentofnon-oilGDPwithastandarddeviationof15percentofnon-oilGDP.Thisleftanaveragedefi-citof29percentofnon-oilGDPwithastandarddeviationof13percentofnon-oilGDP.Thisdeficitwasfinancedbyaprimaryoilbalanceworth27percentofGDP.Whendebtserviceissubtracted,theoverallfiscalbalancedisplaysadeficitequalto7percentofnon-oilGDP.Theoveralldeficithadastandarddeviationof9percentofnon-oilGDP.

Supposeinsteadthatprimaryexpenditureswerenotallowedtodeviatefromatargetof41percentofnon-oilGDP.30Definethisasfiscalrulenumber1.Inthiscase,thestandarddeviationinspendingdropstozerofrom15percentofnon-oilGDPwhilethestandarddeviationintheoverallbalanceisincreasedto15percentofGDP.Alternatively,supposethatfiscalrulenumber2mandatesaprimarynon-oildeficitof29percentofnon-oilGDP.Inthiscase,thestandarddeviationinprimaryexpendituresdropsto4percentofnon-oilGDPratherthan15percent.The standarddeviation in theoverallbalance increases to12per centofnon-oilGDP.Theoutcomeforbothrulesisareductioninspendingvolatilityandanincreaseinthevolatilityoftheoverallbalance.

The increased volatility in the overall balance can be put to good use. ThefactthatoilrevenuesarebaseduponforeignexchangereceiptsallowsNigerianpolicy-makersanimportantopportunitytostabilizetheRER–providedthatthefluctuationsintheoverallbalancearematchedbychangesinnetforeignassets–througheitherchangesinnetexternalborrowingorchangesinforeignassets.

Ifoilrevenuessuddenlyrise,forexample,spendingcanbekeptontargetbyusingthewindfalltopaydownexternaldebts.31Byusingthewindfallfullyinthismanner,theauthoritieswillavoidaRERshock(appreciation).Alternatively,thewindfalldenominatedinforeignexchangecouldbedepositedinagovernmentaccountdenominatedinforeignexchange.ItcouldalsodepositthewindfallwiththeCBNinanairadenominatedaccount,thusreducingdomesticcredit.TheCBNwouldthenpreserve itsannual targets for themoneysupplyandfordomesticcredittotheprivatesectorbybuildingupexternalreserves.Eachoftheseoptionshastheeffectofincreasingthestockofnetforeignassets,allowingtheauthorities

Tabl

e �

Fisc

alo

utc

omes

,199

3–20

01

As

per

cen

tage

of

no

n-o

ilG

DP

Ave

rage

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9319

9419

9519

9619

9719

9819

9920

0020

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912

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1550

2933

2831

2742

6464

eq

ual

sp

rim

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13–4

1–2

1–2

0–1

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9–1

8–3

0–5

0–4

5

les

sp

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oilb

alan

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2712

2717

2424

2114

2451

42

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ce5

311

74

33

36

45

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ual

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pen

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res

410

4141

4141

4141

4141

41

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mar

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94

–33

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–23

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219

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mar

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pen

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414

3837

4238

4138

4143

48

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mar

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90

–29

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–29

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–712

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22 Addison

toavoidanappreciationoftheRER.Ifoilrevenuesfallundertheserules,exces-siveexpenditurereductionscanbeavoidedbydrawingdownthestockofprevi-ouslysavedoilsurpluses.Inthisregard,itisfundamentallyimportantthattheresultingdeficitsbelimitedbythesurplusessavedfrompreviousbooms.

Athirdfiscalrule,witheffectssimilartofiscalrule2above,reliesonareferencepriceforoilforeaseofadministration.32Underthistypeofrule,thebudgetwouldbebalancedatthereferenceprice.Oilrevenuesreceivedatpricesinexcessofthereferencepricewouldbe savedand investedeither inexternaldebt reductionsorinexternalassets.Suchachoicewouldbejustifiedifonecouldbeconfidentthatoilexportvolumeswillbestableinthefuture.Thiswouldrequireapeacefulresolutionoftheconflictsintheoilproducingareasandacommitmentnottoincreaseordecreaseexportstoosharply.

Operational issues

Intheshort run, inorder tograduallybuildupexternalassets,anasymmetricapproachisrequiredinwhichalloilwindfallswillneedtobesavedwhiletempo-rarypricetroughswillneedtobemetbyreductionsinconsolidatedgovernmentprimaryexpenditures.33Later,ifthestockofassetsreachesanadequatelevel,thefiscalrulecanbemadefullysymmetric:expenditurereductionscanbeavoidedentirelybydrawingdownthestockofpreviouslysavedoilsurpluses.

Therewillbeaneedtoperiodicallyreassesstheappropriatelevelofspendinginlightofoilandnon-oilrevenuetrends.Oilpricesarenotoriouslydifficulttopredictandeventhebestprojectionsofexternalassetrequirementswillnotguar-anteeaprudentopeningstock(Baunsgaard,forthcoming).Expenditureswillneedtobereducedifoilpricedownturnsaresteeperorlongerlastingthanexpected.

Onthepoliticaleconomyside,thereisaneedtoacknowledgethatafiscalruleismeaninglesswithoutpolitical consensus and legal backing.Any rule canbeevadedgiventhewilltodoso.IssuesofNigerianfederalismmustalsobeacknowl-edged.The2002SupremeCourtrulingthatallfederationaccountrevenuesmustbedistributedcreatesneededtransparencybutitalsoimpliesthateachstateandlocalgovernmenthasthepotentialtoeitherconfoundorcontributetostabiliza-tion.TheseissuesaretakenupinapreliminarywayinChapter4ofWorldBank(2003)butmuchmoreworkwillneedtobedone.34

1.5.3 Revenuesmoothing

Itwouldbebeneficialifrevenuevolatilitycouldbereducedwhetherornotanexpenditure smoothing fiscal rule is put into place. If a fiscal rule is in place,smootherrevenueswillreducetheneedforalargestockofforeignassetsand/orreducetheneedforheavyborrowingduringoilpricebusts.Ifafiscalruleisnotinplace,smootherrevenueswillmakeiteasiertoplanfor,andmaintain,astablepathforexpenditures.

NigeriaalreadytookanimportantfirststeptowardslessrevenuevolatilitybyimplementingtheVATin1994.Thiscreatedanewrevenuesourcewitharelativelystablebase.Asecondstepmightincludetheuseofvariousfinancialinstruments

Managing Extreme Volatility for Long-run Growth 2�

tosoftenoilrevenuevolatility.Third,stategovernmentscouldalsoincreasetheircapacitytoadministerincometaxes,aspertheirconstitutionalrights,onawiderbasis.Between1995and2000,Nigeriacollectednomorethan2percentofGDPfromincometaxeswhereasotherlowincomecountriescollectanaverageof6percentofGDP.Thisisnotacalltoincreasetaxratesbutrathertofindwaystoap-plyexistinglawsmoreequitablyacrossalargernumberofcitizens.Fourth,inthelongrun,therevenuebaseitselfwillbecomemorediversifiedandstablethroughfuturenon-oilgrowthanddiversification.Thesetopicsareexploredmorebelow.

Oil revenues

TheWorldBank (1994,1996)proposed thatoil andgasprice shocks couldbeavoidedbytransferringriskabroadthroughtheuseofhedginginstrumentssuchasfuturescontracts,optionscontracts,forwardcontractsandswaps.Mexicopro-videsawell-knownexampleofwhat canbedone. In1990–91Mexicoboughtputoptions, soldoil futures andusedoil swaps tohedgeprice risk, aswell asestablishingaspecialcontingencyfundagainstoilpricedeclines.Theobjectiveofthestrategywastoensurethatitreceivedatleast$17perbarrel,thebasisforits1991budget.Mexico’sexperienceshowsthatsuchstrategiescanbesuccessful,but they are rarelyusedby exportinggovernments.One reason is asymmetricpoliticalrisk:governmentleaderswillbeblamedforlossesofpotentialrevenueifoilpricesrisebutwillreceivelittlecreditforhedgingifpricesfall.Thissuggeststhatanyhedgingstrategyshouldbeintegrallybuiltintothebudgetandclearlypresentedwiththebudget,moreasaforwardpurchaseofrevenuesthanasafor-wardsaleofoil.ThefeasibilityofthisrisktransferstrategyforNigeriawouldneedcarefulstudy,however,becauseofitsOPECstatus:thepoliticalconsequencesforanyOPECmemberbettingagainstpositionstakenbyOPECasawholecouldbeproblematic.

AnotherwaytoavoidoilpriceshocksistograduallyexchangesomeorallofNigeria’soilreservesforfinancialassets.Themoneyearnedfromthesaleofoiland gas reserves could be invested in a diversified financial portfolio that willgenerateincomeovertime.35Thiswouldgeneratearevenuestreamforthegov-ernmentthatisconsiderablylessvolatilethanoilrevenues.Suchanideaisnotasradicalasitmayseem.In1989,thegovernmentsoldapartialshareofitsequityinoneof itsoil jointventurecompanies for$2billion. In1993, theGoNsoldanotherportionof itsequity for$500million(WorldBank,1996).There isnoreasonwhymorecouldnotbesold,ifthereisenoughpoliticalpowersupportingsuchamove.

Income taxation

Stategovernmentshavetheconstitutionalauthoritytocollectstateincometaxes.Makingagreatertaxeffortwouldhavealargepay-offbecausethestategovern-mentshavesuchanimportantconstitutionalroleinpublicservicedeliveryforhealthandeducation.Itisimportanttobeclearthattheproposalisnotaboutraising the income tax rates. Instead, the idea is simplyawiderapplicationof

2� Addison

existing(orlower)ratestoabroadersegmentofsociety.(Themaximumrateforpersonalincometaxis25percent,andforcorporateincometax30percent.)Infact,ifthetaxratehadtobechanged,thenitshouldbereviseddownwardwhilemaintaining its currentprogressive structure: a slight reduction in ratesmighthelpencouragetaxpayercompliance.

Inordertoincreasetheirabilitytocollectthesetaxes,stategovernmentswillneedtospendsometimeidentifyingtheirtaxbases.Itisanadvantage,inthiscontext,thattaxpayeridentificationnumbersarebeingintroducedandthattaxadministrationsnowexistinmoststates.Thisisafarmorefeasibletasknowthanitwouldhavebeen15yearsagowhenthenationwasmorerural.Nigeria’sheavyurbanconcentrationsareidealforagreaterincometaxeffort.TherewillbeaneedforclosecollaborationbetweenthestategovernmentsandthenationalassemblyinthiseffortbecausetheconstitutiongrantsthepowertosetincometaxratestotheAssembly.Tightercoordinationbetweenstateandfederaltaxadministrationswouldalsobehelpful.

This strategymightbemademorepalatable througha reduction in importtariffrates.Lowertariffrateswouldhelpoffsetthewelfarereductioncreatedbyhigherincometaxcollection.Lessexpensiveimportswouldhelpfacilitatenon-oilsectorjobandincomegrowth,especiallyfornon-oilexporters.Inaddition,becauseoilrevenuesandimportdutiesarecorrelated,areductionintariffrateswouldalsohelpreducethevolatilityofthetaxbasetotheextentthattheshareoftradetaxesintotalrevenuesisreduced.

Diversification

Inthelongrun,revenuevolatilitycouldbesubstantiallyreducedthroughhighnon-oilgrowthanddiversification.Bywayofexample,supposethatNigeriadoesachievearealpercapitagrowthrateof4percentperannuminthenon-oilsec-torswhileoiloutputincreasesby2percentperannum.Anoilpricedropworth$5perbarrelin2015wouldcauserevenuestofallby13percentofnon-oilGDP.Bycontrast,thatsameshockin2002wouldhavecausedrevenuestofallby20percentofnon-oilGDP.36

1.5.4 Exportdiversificationandterms-of-tradevolatility

ExportdiversificationwillhelpstabilizetheTOT.ThiswillbebeneficialbecauseproductivitygrowthmaybeacceleratedbylowerTOTvolatilityevenwhenpublicinvestment ratesare stabilized.Nigeria, likemostcountries, isusuallynot inapositiontocontrolthepricesofitsexportsandimports.Itcan,however,reduceaggregateTOTvolatilitybychanging thecompositionofeither importsorex-portsorboth.

InNigerian’scase,importsarealreadywelldiversifiedacrossawiderangeofmanufacturedgoodsandalessernumberofprimarycommodities.Thus,thevola-tilityofNigeria’sindexofimportpricesisfairlylow,withastandarddeviationingrowthratesoflessthan8percent.Thisputsthefocusonexports.Nigeriawillrequirediversificationofexportsintoactivitieswithoutputandpricetrendsthat

Managing Extreme Volatility for Long-run Growth 2�

areuncorrelatedwithoilprices. Inthiscontext,itisnoteworthytoobservethatexportconcentration,byitself,explains68percentofthecross-countryvariationinTOTvolatilityfortheperiod1970–86.

Israpiddiversificationafeasiblegoal?Onewaytojudgeistolookatwhatoth-ercountrieshaveachieved.Manycountrieshavesuccessfullydiversifiedoutputandexports,someofthemquiterapidly.IndonesiaprovidesanexamplerelevanttoNigeriabecauseofitsstatusasamajoroilexporter.ItwasabletoreduceitsoilshareofexportsandcutTOTvolatilitybyhalfwithinasingledecade.37

EffectivediversificationleadingtolessTOTvolatilityislikelytobedifficultinNigeriabecausetheGoNdoesnot intendtoholdoilexportsconstant.Onthecontrary, theGoN ishoping to increaseoilproductionandexports.Nigeria isalsosetforarapidexpansionofnaturalgasexports.Thiscouldalsobeaproblemifsignificantvolumesofgasaresoldonthespotmarket,becausegaspricesarepartiallycorrelatedwithoilprices.Thusfar,however,NigerianLNGpriceshavebeengovernedbylong-termcontracts.

Supportivepolicyisrequiredifanyeffortatexportdiversificationistosucceed,particularlyinthefaceofcontinuedgrowthinthevolumesofoilandgasexports.Nigeria’slargeinternalmarketofover130millionconfersanadvantagetothosewhomightinvestinmanufacturesthatdependuponeconomyofscaleforprofit-ability.Tradetheoryandempiricalobservationshowsthatsuchsituationsallowaneasierpenetrationofexports38–and,betterstill,mostmanufactureshavefairlystableworldprices.Thisnaturaladvantage,however,cannotbeexploitedwithoutaconduciveenvironment.Inparticular,itwillbeimportantnottoallowtheRERtoappreciatetothepointwhereNigerianexportsarenotcompetitiveonworldmarkets.39

1.6 Recentdevelopments

The Government of Nigeria has implemented several elements of the strategyoutlinedabove.Wethereforereviewtheprogressmadeanditsshort-termimpact.Nextstepsareproposed.

1.6.1 Fiscalrule

Until2003, thegovernmenthadnoteffectively implementedafiscal rule thatensuredsavedexcessrevenueswereusedonlywhentheactualpriceofoilfellbe-lowthereferencepricefromthebudget.40In2003,theactualpricewas$29/barrelversusareferencepriceof$22/barrel.Thatyear,2.4percentofnon-oilGDPwaseffectivelysaved.(SeeTable5below.)Thisrule,however,didnothavelegalback-ingnordidithaveapoliticalmandate.

In2004,GoNprovidedthemandateaspartofitspovertyreductionstrategyentitled the National Economic Empowerment and Development Strategy orNEEDS.Amongotherthings,NEEDScommittedGoNtotheadoptionof‘anoilprice-basedfiscalruleandafundforexcessrevenuesfromcrudeoilsales’.Thatyear,thegovernmentdepositedintheCentralBanktheoilrevenueitreceived

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1994

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2� Addison

frompricesaboveUS$25perbarrel.In2005,thefederalgovernmentfollowedthesamepolicywithabenchmarkpriceof$30perbarrel.Thefederalauthoritiesob-tainedinformalcooperationfromstateandlocalgovernments,whichthenalsodepositedtheirshareofwindfallrevenue.Thesavingsintheseyears,expressedassharesofnon-oilGDP,were11.3percentand21.9percentrespectively.Thefactthatsomeofthewindfallsavingswereusedforthe2005ParisClubdebtbuy-backdoesnotnegatetheimpactofthefiscalrule:indeedtheconsolidatednetforeignassetsofgovernmentandtheCentralBankwereincreasedratherthandepletedbythisdeal.41

The authorities announced their intention to continue this policy at leastthrough2008,subjecttotheconcurrenceoftheNationalAssembly.42

Thefederalgovernmentisnowproposinglegalbackingaswell.IthasdraftedaFiscalResponsibilityBill(HB203)thatwouldmakeafiscalrulelegallybindingonallthreetiersofgovernmentandwouldcreatetheequivalentofastabilizationfund.Asofmid-2006,thisBillwasatcommitteestageafterpassingsecondread-inginbothhousesoftheNationalAssembly.

Thefiscal rule inHB203states that federalexpendituresshouldnotexceedbudgetedrevenuesplusadeficitequivalentto3percentofGDP.Whenamovingaverageof theoilpricerisesabovethepredetermined level, theneachgovern-mentinthefederationmustsaveitsshareoftheresultingexcessproceedsinitsownsavingsaccount.ItisproposedthattheseaccountsaretobeheldattheCBN.Nogovernmentwouldhaveaccesstothesavingsunlessthereferencecommoditypricefallsbelowapredeterminedlevelforaperiodofthreeconsecutivemonths.

Theadoptionofa legalmechanismsimilar to theoneproposed inHB203,whetherwholesaleorindividuallybyeachgovernment,wouldappeartoresolvethetensionbetweenthe2002SupremeCourtrulingandtheneedforeachlevelofgovernmenttoupholdthefiscalrule.All revenueswouldbedistributedbutwindfallswould alsobe saved. If this commendable approach is toworkwell,sometechnicalandlegaladjustmentstotheHB203willberequired.Inparticular,anyActshouldrequirethatsavingsbeinvestedinforeignassetsandtheremustbestrictcontrolsinplacetoensurethatthebalancescanbedrawndownonlywhenrevenuesfallsignificantlybelowtarget.Inthiscontext,theideathatsomepriorsavingsmightbewithdrawneachyearforcapitalprojectsmayneedtoberevisited.Bailoutsandseizuresmustbeexpresslyprohibited.

Building foreign assets

Thegovernmentisontherighttrack.Itwassuggestedthatfiscalsavingsshouldbeused tobuild foreignassets inorder toavoiddistorting themonetarymar-ketsandhelpstabilize theexchangerate.Thiscanbedoneeitherby reducingliabilitiesorbybuilding assets.Nigeriadidboth. In addition, the governmentsuccessfullynegotiatedadebtreductiondealwiththeParisClubinOctober2005,resultinginawrite-offof60percentofitsexternaldebtof$30.5billion.Thebal-anceof$12.4billionwaspaidoffwiththesavingsfromtheexcesscrudeoilrev-enue.Evenafterthistransaction,Nigeriawasabletoincreasethestockofofficialreservesto$28.3billionattheendof2005,upfrom$7.5millionin2003.This

Managing Extreme Volatility for Long-run Growth 2�

stockisconsistentwiththeestimatedrequirementsofastabilizationfundand,ifmaintained,shouldhelpsmoothexpenditureswhenoilpricesfalltoofar.

Revenue smoothing

Governmenthasembarkedonanumberofnon-oiltaxreforms.Thereformsaimatimprovingrevenuecollectionandtaxservicesdelivery,broadeningthetaxbaseandaddressingdistortions.Someoftheseareconsistentwithrevenuesmoothingaslaidoutabove.Amongotherthings,draftlegislationcouldhelpbroadentheincome taxbaseby simplifying thepersonal income tax schedule, simplifyingthetaxationsystemforsmallbusinessesandintroducingtaxpayeridentificationnumbers.Detectingtheimpactofthesechangesmayrequiretime,however,astheyaresorecent.

Financial sector reforms

Agoodstartwasmadein2004and2005towardsincreasingnetdomesticcreditfortheprivatesector. In2004and2005,netdomesticcredittogovernmentcon-tractedwhilenet credit to theprivate sector continued to expand.Moreworkneedstobedone:theflowofnetcredittotheprivatesectorincreasedonlyto5percentofnon-oilGDPin2005,lessthanhalftheflowfoundinnationswithsustainedhighgrowthrates.Inparticular,theconsolidatedfiscaldeficitcouldbemademorepositiveforanextendedperiodoftime.Additionalreformswillalsobeneededto increasetheabilityandwillingnessofthebanksto lendmoretotheprivatesector.Inthiscontext,thebankconsolidationprogrammecompletedin2006isagoodstep.Sustainedcommitmenttothisandotherreforms,suchasthoseassociatedwithpropertyrightsandcollateral,willbeneeded.

Impact

InSection3above,itwasnotedthatvolatilityinhibitedgrowththroughavarietyofchannelsincludingthepredictabilityofgovernmentspendingandtheRER.Wenowexaminehowthesevariableswereaffectedbythepolicychanges.

Table5showsthattheroughcorrelationbetweenconsolidatedexpendituresandrevenueshasbeeneliminatedovertheperiod2003–05whenthefiscalrulehasbeeneffective.Spendinghasbeenheldsteadyat37percentofnon-oilGDP.Thestandarddeviationinspendingfor2003–05iszerocomparedto8percentfor1993–2002.Thisanalysiswillneedfurtherwork,however,becausetheexpendi-ture includesonly recorded federal, stateand local spending: specialaccounts,whichaccountforupto40percentof federallycontrolledexpenditures,havebeenomitted.

Theaveragerateofconsumerpriceinflationin2003–05was16percentcom-pared to 28per cent for 1993–2002. More strikingly, the volatility of inflationdecreasedto2percentfor2003–05from25percentfor1993–2002.Whilethisimprovementislaudable,somecautioniswarranted:inflationhasbeengraduallyincreasingoverthelastseveralyears,fromaperiodaverageof13percentin2002toaperiodaverageof18percentin2005.

�0 Addison

Table5showsthatRERvolatilityfellto10percentfor2002–05comparedto34percentduring1993–2002,thanksinparttothereductioninconsumerpricevolatility.Thisisveryencouraging.Moreworkmaybeneeded,however,astherateofrealappreciationacceleratedto15percentin2005.Section1.5abovesug-geststhatexchangerateappreciationcanreducethealreadydifficultprospectsforexportdiversification.Moreover,RERappreciationisnotapro-pooroutcomeinasmuchasmostofthepooraremainlyruralproducersoftradablegoodswhomustcompetewithcheapfoodimportsandwhocannotcompeteoverseaswhentheexchangerateismovingagainstthem.Itmaybethecase,therefore,thatthecom-mendablesavingsofexcessrevenuesinrecentyearsshouldhavebeengreaterstill,allowingadeeperbuild-upofforeignreservesandreducedRERappreciation.

Finally,realnon-oilGDPgrowthhasbeenveryhighfor2003–05,atanaverageof7percentperannumversus4percentperannumovertheperiod1993–2002.It isnotpossible,however, toattributeallof thisgrowthto reducedvolatility.SomeofthegrowthmustbeattributedtoimportsmademoreaffordablebytherisingTOT.Non-oilGDPgrowth,particularlyinthenon-tradablesectors,couldhavebeenpushedupthroughDutchdiseaseeffects.Inthiscontext,itisinterest-ing tonote therapidgrowth in theconstructionandservices sectors.Govern-ment services inparticularwouldhavebeen fuelledbyhighoil revenues.TheeliminationofalargeportionofNigeria’sexternaldebt,combinedwithafavour-ableBB-ratingbyFitchRatingsmayalsohavehelpedtotheextentthatinvestorsperceivedadebtoverhanginpreviousyears.Moreempiricalwork,andmoretime,willberequiredbeforedefiniteconclusionscanbedrawn.Amongotherissues,itwillbeimportanttoexploreRERpolicyforitsimpactonthetrade-offbetweenlessexpensiveimportsofcapitalgoodsandsparepartsforgrowth(throughappre-ciation)andcompetitivenessthroughrealdepreciationandincreasedefficiency.

Notes

1 TheviewsoftheauthordonotnecessarilyrepresentthoseoftheWorldBank.Theau-thorisgratefulfortheusefulcommentsreceivedfromLevFreinkman,HihnDinh,LuisServénandCadmanMills.Allerrorsaretheauthor’salone.

2 Thisimperfectlycapturestheconceptofuncertaintywherepredictabletrendsinlevelsarefilteredout.

3 Liveswouldhavebeenaffectedaswell,totheextentthathealthrelatedservicessuf-feredfromunpredictablefundingcompoundedbyissuesrelatedtoinstitutionalqualityandpoorinfrastructure.

4 TheFederalOfficeofStatisticsdoesnotdivideinvestmentintogovernmentandprivatecontributions.TheanalysisprovidedaboveisthereforebasedonestimatesfoundintheWorld Bank database where private investment equals total investment less govern-mentinvestment.

5 Formoredetailsontheempiricalimpactofvolatility,pleaseseeChapter1(PartD)andAppendicesAandBofWorldBank(2003).

6 SugarmayalsobesoldthroughprogrammessponsoredbytheUSAandtheEU.Thesepricesarelessvolatilethanthefreemarketprice.

7 LNGcontractstypicallymandateapriceconsistingofthreeparts:aconstantbasepricedeterminedbyproductioncosts,shippingcostsandamargintiedtothecostofalterna-tivefuels.Themarginistypicallyupdatedonaquarterlybasiswhilethebasepriceand

Managing Extreme Volatility for Long-run Growth �1

theformulagoverningthemarginareupdatedeverythreeorfouryears.Theoveralleffectisafairlystableprice.

8 Thereareexceptions.Somemanufacturedgoods,suchascomputermemorychips,havebecomecommoditieswithfairlyvolatileprices.

9 GDPshares incountries likeNigeriacanbemisleadingbecausesomanykey indica-torsaredriveneitherdirectlyorindirectlybyoilpricefluctuations.Non-oilGDPisthepreferredpointofreferencewhencalculatingGDPsharesandwillbeusedasapointofreferencethroughoutmostoftheremainingportionsofthischapter.

10 Onewaytomakethishappenautomaticallyistoimplementaprogressiveincometax.11 See,forexample,Nwagwu(1992).12 SeeforexampletheanalysisbyDeatonandMiller(1995)andbyCashinandPattillo

(2000).13 GavinandPerotti(1997)andTalviandVegh(2000)observethatthisoutcomeiscom-

montomanyLDCswithunstablerevenuesandproposeseveralexplanations.14 Stateandlocalgovernmentsdocollecttheirownrevenuesbutthesetypicallyaccount

forlessthan10percentoftotalrevenues.15 NigerianBonnyLightcrudepricesarefromtheOPECBulletin,variousissues.16 Nigeria’sexperienceinsavingfiscaloilwindfallsisdiscussedinChapter4,SectionBof

WorldBank(2003).17 PublisheddataonLocalGovernmentArea revenues andexpendituresprior to1992

werenotavailableatthetimeofthiswriting.18 Theseresultsarebasedonfederallycollectedrevenuesplusstateinternalrevenues.Sim-

ilarresultsareobtainedwhenretainedrevenuesareused.19 Eifertet al.(2002)provideasimilarframework.20 Thefiscalbalanceinthiscaseisdefinedasfederallyandstatecollectedrevenueslessfed-

eralandstateexpenditures.LGAexpendituresareomitted.Allvariablesaresignificantat the 1per cent confidence level with White’s heteroskedastic-consistent estimator.TheDurbin–Watsonstatisticis1.95.

21 BleaneyandGreenaway(2001)andServén(2002)usecrosscountrypaneldataandfindinvestmentisreducedbyrealexchangerateinstability.SeealsoWorldBank(2003).

22 Capitalflowshavebeenanothersourceofvolatilityinsomecountries.23 ForthespecificcaseofNigeria,seeMoseret al.(1997).24 Rainfall does not immediately affect aggregate inflation in Nigeria though there is

someevidencethatitcanaffectinflationwhenlaggedbytwoperiods.SeeMoseret al.(1997).

25 Thenewermodelsalsoincludeanerrorcorrectiontermthattendstopulltheinflationratetowardsanaveragelong-termrate.

26 This isnottrueforallyears.Reservemovementshavebeenvery important insomeyears.Forexample,in1974,duringthefirstoilboom,changesinexternalreserveswereworth31percentofnon-oilGDPwhilenetcreditfellby18percentofGDP(becauseofheavygovernmentdeposits)andnetotherassetsshrankby6percentofnon-oilGDP.

27 ThegovernmentandtheNigerianNationalPetroleumCorporationcontinuedtopur-chaseforeignexchangeattherateof22nairaperdollarthrough1998.

28 ThiscalculationhasbeensubstantiallyrevisedfromWorldBank(2003)onthebasisofrecentpricetrends.TheGovernmentofNigeria(GoN)isencouragedtoconductperi-odicrevisionsaswell.

29 Themagnitudeofrecentoilpriceincreasescouldimplyequallylargenegativeshocksinthefuture,farlargerthanthehistoricalaverages.

30 Thetargetsusedhereareillustrativeonlyandarenotmeantasendorsementsofspecifictargets.

31 This strategywouldhave theadditionalbenefitof reducing futuredebt serviceobli-gations,makingmoreroomforessentialexpenditures.Inthislight, it isnoteworthythat theGoNboughtbackone thirdof its commercialdebt inDecember2002. SeeEconomistIntelligenceUnit(2003).Morerecently,theGoNsuccessfullynegotiatedadebtreductiondealwiththeParisClubinOctober2005,resultinginadebtwrite-offof60percentofitsexternaldebtof$30.5billion.

�2 Addison

32 This is theapproachassumedbyBartsch (2006).Baunsgaard (forthcoming) analysesthenon-oilprimarydeficitruleandtherelatedpermanentpriceruleintheNigeriancontextandprovidesusefulsimulations.

33 DeatonandMiller(1995)arguethattheuseofexternalassetstoself-insurecanonlybesustainableifpricesfluctuatearoundamean.Infact,theydonot:oilpricesarebetterapproximatedbyarandomwalk.

34 Chapter4ofWorldBank(2003)alsodocumentspreviousfailedattemptsatstabiliza-tionasearlyas1989whichlackedlegalbackingandpoliticalconsensus.

35 Toavoidexchangeraterisksaswellasrisksonreturns,investmentswouldneedtobediversifiedacrossabasketofcurrencies,keyedtoimportsharesfrommajortradepart-ners,aswellasacrossavarietyoffinancialinstruments.

36 Basedonsimulationswithasimple123CGEmodel.37 SeeBox3.3inWorldBank(2003).38 SeeHummelsandKlenow(2002).39 OtherconsiderationsarediscussedinElbadawiandSoludo(1999)andSectionB4of

Chapter3ofWorldBank(2003).40 Excessrevenuesweresavedinprioryearsbuttheywerealsodrawndowneventhough

theactualpriceofoilexceededthereferenceprice.41 Theremayhavebeenafurtherwithdrawalofsavings in2005:accordingtoareport

fromtheOfficeoftheAccountant-General,approximately51billionnairawasdistrib-utedtothethreelevelsofthegovernmentin2005.ThisisnotreflectedintheCBNdatausedinthischapter.

42 PolicyStatementbytheGovernmentofNigeria,March2006.

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