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Effect of oil price volatility on government expenditures in Iran.
Subject:
Petroleum (Prices and rates)
Petroleum (Supply and demand)
Petroleum (Forecasts and trends)
Petroleum industry (Prices and rates)
Petroleum industry (Industry forecasts)
Petroleum industry (Economic aspects)
Expenditures, Public (Analysis)
Authors:
Varjavand, Reza
Navid, Nazanin
Emami, Karim
Pub Date:
12/01/2008
Publication:
Name: International Journal of Business Research Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business, international Copyright: COPYRIGHT 2008 International Academy of Business and Economics ISSN: 1555-1296
Issue:
Date: Dec, 2008 Source Volume: 8 Source Issue: 5
Topic:
Event Code: 740 Commodity & service prices; 600 Market information - general; 010 Forecasts, trends, outlooks Computer Subject: Company pricing policy; Market trend/market analysis
Product:
Product Code: 2910000 Petroleum; 2900000 Petroleum & Energy Products; 1310000 Crude Petroleum & Natural Gas; 9000144 Expenditures-Total Govt; 9210124 Expenditures-State Govt NAICS Code: 3241 Petroleum and Coal Products Manufacturing; 324 Petroleum and Coal Products Manufacturing; 211111 Crude Petroleum and Natural Gas Extraction; 92113 Public Finance Activities SIC Code: 2900 PETROLEUM AND COAL PRODUCTS; 1311 Crude petroleum and natural gas; 2911 Petroleum refining
Geographic:
Geographic Scope: Iran Geographic Code: 7IRAN Iran

Accession Number:
190617023
Full Text:
ABSTRACT

In developed countries, income tax is the main source of financing for government spending, often supplemented by borrowing from the public. However, in a developing country like Iran, the oil revenue, not the income tax, is the key source of government revenue hence spending. As such, when there is too much instability in price of oil, the government cannot project its revenues accurately. Consequently, its investment spending cannot be well planned ahead of time. If the projected oil revenue will not materialize as envisioned, most public projects will have be either stopped or remain unfinished. Therefore, oil price volatility may have a broad-based impact on the Iranian economy in general and on public projects and the labor market in particular.

Government spending in Iran is categorized into current and development (investment) expenditures. While the main source of revenue for government is oil exports, it has no control whatsoever over the price of crude oil. Because crude oil is a publicly traded commodity, its price is determined in commodity markets via the interaction of demand and supply worldwide and it constantly fluctuates. When the government of Iran is faced with abrupt fluctuations in oil prices, its forecast of current as well as investment expenditures becomes complicated and often imprecise. Changes in the price of crude oil force government to adjust its expenditures in line with such changes. This creates a dilemma especially for development expenditures because they are entirely financed by oil revenues. Many public projects, as a result, will remain in jeopardy.

The overall goal of this research is to investigate the effects of oil price volatility on government expenditures in Iran and to explore the channels through which such effects are carried out. We have applied multiple regression techniques to extended time series data to examine the link between the changes in oil price and government expenditures in both categories. In addition to oil price we have also included in our research the effect of tax revenue especially on current government expenditures. Overall, we found that oil price volatility has an adverse effect on both current and development expenditures. A 1% additional volatility in price of crude oil, for example, will lower current expenditures by almost the same amount, 0.96%. Similarly, oil price volatility had a negative effect on investment expenditures. When oil price volatility increases by 1%, investment expenditures are forced down by more than one percent, 1.16% according to our finding.

An increase in the price of oil will obviously boost government revenue and its total expenditures. Our findings confirmed this relationship; a 1% increase in oil price will boost development expenditures by 1.20% and the current expenditures by about 0.75%. Similarly, a 1% increase in tax revenues will lead to 1.47% increase in current expenditures and a meager effect on development expenditures according to our findings.

Keywords: International Economics, Government Policy

I. INTRODUCTION

One of the concerns of the oil-exporting countries who depend heavily on oil revenue for their public projects is the volatility of price of oil and the impending uncertainty that make them unable to forecast state revenues accurately. According to Energy Information Administration, EIA, Iran heavily depends on oil revenue, nearly 80% of its exports money comes from oil and almost 45% of its government budget according to EIA statistics. Because oil revenue is such a major source of income for the government of Iran, oil price volatility imposes serious disruptive effects on government spending. As a prominent member of OPEC, this country has to honor the quota system imposed by the organization and because price of oil is established in commodity markets, Iran has no control over the price or the amount making it very difficult for its government to project the annual revenue. On the other hand, the government expenditures are financed mainly by oil revenue. This combination creates a serious challenge for Iranian government.

The key objective of this paper is to examine the impact of fluctuations in price of crude oil on government expenditures in particular and the Iranian economy in general. We also try to discover the channels through which such effects are carried out.

During the last two decades there have been considerable changes in economic policies of GCC (Gulf Cooperation Council) countries forcing these countries to smooth out the abrupt fluctuations in oil price. Following the persistent increase in price of crude oil, especially after 1970s, the policy makers in these countries decided to utilize the additional oil revenue by investing it in the infrastructure of their countries thus boosting their economic growth rate. On the contrary, during the period of declining oil price, the government has been forced to cut its investment expenditures because they are entirely financed by oil revenues and to augment the non-oil sources of revenue for its non-developmental expenses. Obviously, when oil price increases, current expenditures are more likely to increase. Fluctuations in oil price have also exerted broad-based effects on the economy in these countries. As such, the investigation into the effect of oil price volatility and government expenditures is certainly of great importance and merits profound research. Because oil revenue is mainly devoted to long term investment projects, the surge in price of oil and consequent increase in government revenue do not necessarily result in higher level of welfare for Iranian people in the short term. If price fluctuations are orderly hence governments revenues grow gradually in a predicable fashion and are utilized in an efficient way, there is no need for concern. However, if the changes are abrupt and intense, as have been during past few years, and the resulting additional revenues are injected into the market suddenly, then the overall economic equilibrium will be disturbed. Conversely sudden decrease in such revenues creates budget deficit. Robert Weiner believes that unanticipated decline in government revenues make government incapable of fulfilling its commitments and finishing its investment projects on time.

Generally speaking, unanticipated fluctuations in price of strategic commodities results in detrimental effects for the economy. Strong increase in price of oil, for example, encourages the government to engage in lavish spending on unnecessary projects thus promoting inefficiency. Government spending, of course, is not always wasteful. Government investment in infrastructures of the country, if done efficiently, can generate external benefits for private sectors hence facilitates output and stimulates economic growth. Consumptive spending, however, can be wasteful and inefficient especially large-scale expensive subsidy programs sponsored by government. Researches by some economists show that the productivity of such expenditures is often low and in some instances even negative.

Given the inherent uncertainty about government revenues, some economist, see Ho-Hehm-Joon, suggests the establishment of precautionary saving program which should be taken very seriously in oil-exporting countries. The finding of his research shows that increased uncertainty about future income will cause perverse variations in future consumption. He observed that the growth rates of consumption and household savings are both influenced by uncertainty about conditional incomes. When there is uncertainty about the future income, current consumption will go down; however, there should a plan for precautionary savings. Therefore, consumption may drop in the short term; however, it will go up in longterm if precautionary saving program is in place.

Another important point that deserves attention is that the effects of oil-price fluctuations on government current expenditures are not the same as their effects on developmental expenditures. Current expenditures such as employees' salaries and government purchases of goods and services are mostly paid for by tax revenues. If tax revenues are not adequate, then oil revenues are used as supplementary source of financing. Developmental expenses such as purchases of capital goods, building a hospital, construction of highways and bridges are financed totally by oil money.

Distinction between these two types of expenditures really matters in our research. While current spending has temporary effects on the economy, developmental expenditures are the sources of additional income necessary for economic growth. Consequently, they have, long lasting impact on the economy.

The findings of a research by Nagy Eltony indicated that abrupt fluctuations in oil price played a role on variations in government expenditures in Kuwait. However, the developmental expenditures showed a stronger reaction to oil price fluctuations. Similar results have been found by Fasano, Ugo, and Wang for many other oil-exporting countries; Bahrain, Qatar, United Arab Emirate, and Saudi Arabia. A few other researches in this area have produced similar results.

We must notice that the markets for strategic commodities especially for crude oil are very unstable and characterized by excessive volatility. Wild fluctuations in oil revenues create variety of economic problems for such countries. As such, it is imprudent for a country to depend entirely on the exports money as the source of funding for its economic expansion projects.

II. THE SOURCES OF PRICE VOLATILITY

Even though, the importance of crude oil in western countries in general and in the US in particular has been moderating in recent years, it is still a strategic commodity that plays a vital role in global economy. Despite the relative stability during earlier decades, price of crude oil has experienced resilient volatility since 1973 following the energy crisis and many other crucial events that have occurred since then as shown by the following chart. We have been witnessing stronger volatility during the past

[FIGURE 1 OMITTED]

Many factors believed to be responsible for the growing volatility of price of crude oil. In this section, we explore some of them that are more significant than others in our opinion. We should notice a priori that the market for crude oil is quite complicated because crude oil is a globally demanded good traded in commodity markets on a continuous basis by thousands of brokers and dealers who trade crude oil for speculative motives on behalf of their clients. In addition, there is no common consensus among economists concerning the nature and the structure of crude oil market.

When it comes to the sources of volatility in oil price, the immediate focus is on OPEC as the culprit. Some economists as well as many politicians blame OPEC as the still dominant authority in oil market. We believe, however, that assertion is inaccurate and many other factors play a greater role in price fluctuations. A few of them will be examined in this section.

For OPEC to be the determining force in oil market, it has to have the power to control a substantial portion of the oil market and be able to enforce strict quota system on its members. Its share, currently, is limited to about 50% of the global market according to the information provided by EIA, Energy Information Administration. This is, indeed, small relative to the market share of other world's commodity cartels such as; the International Tin Council, International Coffee Organization, International Cocoa Agreement, international cartels on diamond, rubber, copper, etc. These cartels have also enforced stringent quota system since the day of their establishment with persistent monitoring and punishment mechanism. OPEC, on the other hand, has not enforced such an apparatus. In addition, the OPEC members do not pursue a common objective of price control. The development of non-OPEC sources has intensified competition in crude oil market further diminishing the controlling power of OPEC. When it comes to price setting, the OPEC countries are very much constrained by non-OPEC producers such as; Russia, Canada, Brazil, and Norway who set the price according to market conditions and OPEC countries have to put up with that price. In other words, OPEC members are forced into the position of "price taker".

In addition, in all OPEC member countries the oil industry is owned and operated by government, therefore, it is not subject to market-imposed discipline. Saudi Arabia, for example, used to maintain a huge excess capacity that allowed this country to regulate the abrupt fluctuations in world supply thus price if deemed desirable. In other words, Saudi Arabia played the role of "swing producer" when necessary to stabilize price. Likewise, some other OPEC members have been also accommodative. When there was a political unrest in Nigeria, turmoil in Venezuela, revolution in Iran, or war in Persian Gulf that resulted in plummeting production of oil, it was the Saudi Arabia that released a hefty amount of oil to replenish world supply and kept prices from soaring. However, the spare capacity of OPEC countries has been reduced to a very low level in recent years. Without adequate excess capacity that can serves as a balancing factor, the power of OPEC to stabilize oil price in the global market has grown weaker to a great extent, resulting in further price volatility.

In our judgment, the following other factors have also played a role in variations in oil price.

1. The change in the structure of oil market after 1970. Before 1970, the oil market was kind of collusive oligopoly controlled by huge oil companies: Standard Oil of New Jersey, Royal Dutch Shell, Anglo Persian Oil Company, the Gulf Oil, and Texaco, etc. These companies, known as seven sisters had the huge market power on production, refining, and distribution of oil. The oligopoly structure of the market precludes them from price competition and provided them with a strong economic incentive not to increase the price. They kept price stable and low because they made huge profit from the variety of products derived from crude oil. After 1970's, however, the market power swayed toward oil-exporting countries because of a wave of nationalizations in oil exporting countries led to the declining influence of seven sister companies and disintegration of oligopoly structure in the oil market.

2. Major political events such as unrest in Venezuela and especially revolution in Iran and the removal of the Shah who acted as the leading force of OPEC and the protector of the US interests by keeping oil prices stable. Iranian revolution led to further volatility because of huge cut in production of oil afterward.

3. US invasion of Iraq in 1990 and again in 2002 led to escalation of violence and continuous tension in Middle East raising the fear of disruption in supply of crude oil. The resulting uncertainty is still lingering around.

4. Because of immense complexity of oil market, industry analysts are not able to forecast supply and demand accurately, thus creating additional risk and difficulties in predicting the direction of the market. Lack of reliable data on demand and supply create an atmosphere that has become a breeding ground for rumor and inaccurate information. In addition, the popularity of futures and commodity-based contracts in recent years has contributed massively to price volatility. These innovative products are indeed the pivotal forces in setting up the commodity prices including crude oil. Prices in these markets are influenced by wide variety of factors including market fundamentals, traders' expectations, and barrage of information coming to market on a nonstop fashion. When it comes to price of crude oil, it seems that the political as well as psychological factors also play a determining role. Too much speculation about possible direction of supply and demand by market participants has intensified price volatility in crude oil market especially during the past few years.

III. THE METHODOLOGY

We can use different methods to measure the effects of uncertainty and price fluctuations on government spending. In this study we use regression model. The following two equations, 1- 3 & 2-4 represent government consumptive spending and its developmental expenditures in constant price.

Log(CUP) = [C.sub.1] + [[alpha].sub.1] Log(OPLFV) + [[beta].sub.1] Log(OPL) + [[gamma].sub.1] Log(TT) (1)

In which:

CUP = Government current expenditures

OPLFV = Fluctuations in oil price

OPL = Price of crude oil

TT = Government revenues from taxes, expressed in 1376 prices

Log(INP) = [C.sub.2] + [[alpha].sub.2] Log(OPLFV) + [[beta].sub.2] Log(OPL) (2)

In this equation INP represents the government developmental expenditures.

The data for our research have been obtained from the statistical publications provided by the Central Bank of the Islamic Republic of Iran. All the statistical figures are quarterly from the first quarter of 1379 to the last quarter of 1384.

IV. THE STATISTICAL RESULTS

Because the selected explanatory variables in our ANBASHTEH model are first degree, we performed the co-integration test accordingly. The result of co-integration test indicated that in both of our models developmental as well as current expenditures have a long term are correlation with the specified variables. The following two equations present the estimated coefficients for the selected variables:

As shown by these equations, one percent change in oil price fluctuations results in decline of 0.96% in current expenditures and a negative 1.16% change in developmental spending. On the contrary, a one percent increase in price of crude oil leads to 0.75% rise in current expenditures and 1.20% increase in developmental spending. As expected the effect of tax revenues on current expenditures has the largest coefficient, a one percent increase in tax collection causes about one and half percent change in current expenditures.

V. CONCLUSIONS & RECOMMENDATIONS

The overall conclusions of our research are as follows:

The unpredictable fluctuations in price of oil has negative impact on current government expenditures despite the fact that we hypothesized that such expenditures are mainly financed by tax revenues. Our statistical results show that a one percent increase in price volatility causes a similar but negative change in such expenditures. The proportional change is due to the fact that such expenditures are divisible. Therefore, they can be influenced by oil price dollar by dollar.

Because such expenditures are necessary, government has not much discretion and has to pay them any way even if the lead to budget deficit. We believe, oil price fluctuations create uncertainty for policy makers forcing them to lower such expenditures in case they are faced with oil price volatility during fiscal year and inability to attain the projected revenues. Such precaution allows them to avoid the possible budget deficit in case that projected oil revenues do not materialize. Otherwise, government has to finance its deficit spending by borrowing from the central bank that may force prices to go up reinforcing inflationary pressure or lower its developmental expenditures.

When it comes to developmental expenditures negative but stronger effect has been shown by our findings. A one percent increase in oil price fluctuations forces such expenditures to drop by 1.16% weakening the ability of government to invest in long term projects especially the countries infrastructures. The more than proportional effect can be due to the fact that such projects are not divisible and some of them may be totally abandoned as a result of low revenues. Such decisions may lead to slower economic growth and increase in unemployment rate. It may also impose additional costs on government when reopening these projects.

As can be observed from our finding, the effect of oil price volatility on developmental expenditures is more pronounced because these projects are entirely paid for by oil revenues. However, a portion of current expenditure comes from tax revenue. Developmental expenditures are not also flexible. They change in a lump-sum fashion. In additional a less painful method for government to cut its costs is to lower the developmental spending. Given the broad based subsidy programs especially for gasoline and given the fact that Iranian population is very young, the current expenditures are necessary and in most cases unavoidable.

It seems logical to assume that increase in price of oil enables government to boost its total expenditures. This in confirmed by our findings which reveal a statistically positive and significant correlation between price of oil and government spending. A one percent change in price to the up side causes a 0.75% increase in current expenditures and a strong surge in developmental expenditures, 1.2%.

Because current expenditures are primarily financed by tax revenues, a one percent change in tax revenues cause a whopping 1.47% change in current expenditures.

Given our findings, we believe that attention to the following issues is necessary:

1. more research should be done about the public investment projects before they are implemented, better planning of these projects, and utilization of the techniques that allows us to shorten the completion time for these projects

2. benefiting from the experiences of other oil-exporting countries, such as Norway, who have been successful in utilizing oil price fluctuations to their advantage.

3. using the oil revenues in infrastructure of the country and investing in investment projects whose profitability is established a priori

4. examining the possibility of investing oil revenues in foreign countries with well-established financial system as well as stable economy

5. ending the conversion of oil revenues into domestic currency, Real

6. utilizing hedging and diversification techniques to minimize the risk of oil price volatility as well exchange rate fluctuations

7. expanding the relationship with World Bank and other international agencies who have successful experience in developmental projects and international contracts

8. government should pursue more aggressively the privatization policy and refine its braod-based subsidy programs. By doing so, government can free a huge amount of funds that can be allocated to more efficient projects with long lasting benefits for the economy

REFERENCES:

Abdelbasset Chemingui, Mohamed & Lofgren, Hans. (2004). "Tax Policy Reform in Saudi Arabia: a General Equilibrium Analysis". September 2004.

A. F. Alhajji, and David Huettner, (2000) "OPEC and Other Commodity Cartels: A Comparison" Energy Policy 28, 2000

A. F. Alhajji, and David Hettner (2000) "OPEC and World Crude Oil Markets from 1973 to 1994: Cartel, Oligopoly, or Competitive? The Energy Journal, Vol 21, No 3, 2000

Eltony, M.Nagy. "Oil Price Fluctuations & their Impact on the Macroeconomic Variables of Kuwait, a Case Study Using VAR Model for Kuwait".

Fasano, Ugo and Wang, Qing. (2002). "Testing the Relationship between Government Spending & Revenue, Evidence from GCC Countries". Internaional Monetary Fund.

Ferderer.J.P.(1996). "Oil Price Volatility & the Macroeconomy". Journal of Macroeconomics. 18(1). 1-26. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Danielle.(1999). "Earnings Uncertainty & Precautionary Saving". Bank of Itali Mimeo.

Ho-Hahm-Joon. (1999). "Consumption Growth, Income Growth & Earnings Uncertainty". International Economic Journal. volume 13, number 2.

Hoyos, Carola (2007), "The New Seven Sisters: Oil and Gas Against Dwarf Western Rivals" Financial Times, March 11, 2007.

Talvi, E & Vegh, C. (2000). "Tax Base Variability & Procyclical Fiscal Policy". NBER working paper. 7499.

Varjavand, Reza (2005), War with Iraq, Oil, OPEC, And the US Economy, Manuscript, presented at the annual meeting of the Southwestern Economic Association, 2005

Weiner J. Robert. (2000). " Managing Petroleum Fiscal Dependence". The Center for Latin America Issues .December 2000.

Williams, James L. (2007) "Oil Price History and Analysis" WTRG Economics, An online Website, 200.

Wolf, Holger. (2004). "Volatility, Definitions & Consequences". Peer Review Esward Prasad. IMF.

REFERENCES IN FARSI:

[TEXT NOT REPRODUCIBLE IN ASCII]

Reza Varjavand, Saint Xavier University, Chicago, USA

Nazanin Navid, Free University of Iran

Karim Emami, Free University of Iran
Log(CUP) = -4.025 - 0.960 Log(OPLFV) + 0.752 Log(OPL) + 1.473 Log(TT)
 (3-3)
                     (0.229)            (0.333)           (0.368)
                     [4.190]           [-2.255]          [-3.997]

Log(INP) = 5.982 - 1.164 Log(OPLFV) + 1.200 Log(OPL)) (4-3)
                                                    (0.342)
                         [4.238]                [-3.509]
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