95263 March 2015 · Number 1 HOW SHOULD DONORS RESPOND TO RESOURCE WINDFALLS IN POOR COUNTRIES? Anton Dobronogov, Alan Gelb and Fernando contingent on oil prices. Simulations suggest that Brant Saldanha1 the International Development Association lending products could be structured to provide Introduction: Natural resources are being a larger degree of insurance if they are calibrated discovered in more countries, both rich and poor. to hedge against large declines in resource prices. Many of the new and aspiring resource exporters These suggestions are intended to complement are low-income countries that are still receiving other mechanisms, including self-insurance substantial levels of foreign aid. Resource using Sovereign Wealth Funds (where possible) discoveries open up enormous opportunities, and the facilities of the International Monetary but also expose producing countries to huge Fund. trade and fiscal shocks from volatile commodity markets if their exports are highly concentrated. The Problem A large literature on the “resource curse” shows that these are damaging unless countries manage Oil, gas and minerals are being discovered in to cushion the effects through countercyclical more countries, both rich and poor. Tanzania, policy. It also shows that the countries least Mozambique, Kenya and Uganda, traditionally likely to do so successfully are those with weaker regarded as energy-poor, are poised for resource institutions, and these are most likely to remain booms and Ghana has already experienced the as clients of the aid system. This brief considers initial phases. Some agriculture-based countries the question of how donors should respond to like Zimbabwe are evolving into hard-mineral their clients’ potential windfalls. It discusses exporters with investments in diamond and several ways in which the focus and nature of platinum mining. Other established mineral foreign aid programs will need to change, exporters such as Zambia have begun to see a including the level of financial assistance. It also dramatic increase in mining tax revenues as presents some ideas on how a donor like the investments are fully depreciated and new International Development Association might agreements negotiated and some, like Mongolia, structure its program of financial transfers to have seen large increases in estimates of proven mitigate volatility. The brief outlines ways in reserves. Many of the new and aspiring resource which the International Development exporters are low-income countries that are still Association could use hedging instruments to receiving substantial levels of aid. In 1995 Sub- vary disbursements while still working within a Saharan Africa had only four fuels exporters; framework of country allocations that are not depending on world market scenarios, the 1 This MFM Practice Note was cleared by Albert G. Zeufack, Practice Manager (GMFDR). outlook is for as many as 19 (Ross 2012) and vulnerability to fiscal shocks. While the virtually all of the additional countries are arrangements for the latter might be more currently IDA-eligible. Some, like Tanzania, are complex, in some situations it might be a more politically stable and well managed. Others, like acceptable approach for a donor especially if South Sudan, are beset by severe political there are concerns that providing instability and civil conflict, and with a very macroeconomic or budget support will not problematic record on fiscal management. necessarily insulate “good” development programs from changes in counterpart funding. In our recent paper (Dobronogov, Gelb, and Either way, the question is how best to design a Saldanha 2014) we consider the question of how program that is able to respond to shocks from donors should respond to their clients’ potential volatile commodity markets and how to finance windfalls. One important challenge, and the such a program within the often rigid funding main focus of the paper, is the potential role of constraints faced by the donor. donors in helping the new resource exporters to deal with increased risk. Resource discoveries Ideas for the Solution open up enormous opportunities but also expose producing countries to huge trade and fiscal How a donor like IDA might structure its shocks from volatile commodity markets if their program of financial transfers to mitigate exports are highly concentrated. A large volatility? One approach is to adjust the level of literature on the “resource curse” shows that program disbursements in response to resource these are very damaging unless countries shocks – increasing them when resource prices manage to cushion the effects through fall and/or decreasing when the prices rise - so countercyclical policy. It also shows that the that countercyclical aid flows provide a degree of countries least likely to be able to do this are insurance to the development program. The those with weaker institutions, and these are question then is how a donor like IDA can vary most likely to remain as clients of the aid system. disbursements in response to resource shocks Developing countries have a wide array of even though the country envelope, which covers potential instruments to help manage risk. They all project commitments, is determined by other can implement fiscal rules to help stabilize factors. One appealing possibility is to make the spending, save and dis-save abroad using allocation formula sensitive to terms of trade Sovereign Wealth Funds (SWFs) and can also use shocks. However, this would not be a simple the IMF, in particular the Exogenous Shocks change to a formula reached through a lengthy Facility (ESF) within the PRGF. Donors, in process of political negotiation. The approach particular, the Multilateral Development Banks, would also be subject to long data lags, including can play a role in several of the more market- the time needed to scale the country program up based approaches (Perry 2009), but some or down in response to a changing allocation. mechanisms, such as developing local currency Another possibility is the Deferred Drawdown bond markets or index-linked bonds, may be Option (DDO) that provides a credit line more applicable to middle income countries, or available to be drawn down in case of need. This at least to countries emerging from aid however would be very unattractive for an IDA dependence towards market-based financing. borrower as it requires maintaining headroom in the country program in case the drawdown is The specific topic considered here is how donors needed, meaning that highly concessional might reshape their flows of concessional financial resources needed to provide the development assistance to provide some headroom will not be utilized. Given the realities insurance against resource booms and busts. In of periodic IDA replenishments and the way of some cases, insurance could be provided to the process of determining country envelopes, there country at the macroeconomic level. is no secure way for a client country to trade low Alternatively, insurance could be provided to the commitments in one year for a larger program at development program itself to reduce its some indefinite time in the future. March 2015 · Number 1 · 2 Considering these difficulties, we outline some between the time horizon Y and the portion of possible ways in which IDA could use hedging the country’s oil revenues it helps to hedge. The instruments to vary disbursements while still longer is the former the smaller will be the latter. working within a framework of country Figure 1 provides a graphical representation, allocations that are not contingent on oil prices. distinguishing disbursements received by Put differently, we consider approaches towards Uganda from total disbursements; the difference hedging the IDA program to enable is the cost of the put options. disbursements to vary in response to oil prices in the face of fixed commitment levels, offering Figure 1. Disbursement relative to Program for some ideas on how an IDA program could help Put Option Only to cushion funding volatility while still keeping its own risk within manageable bounds2. The arrangements could be set up to provide a graduated response to oil price changes or be tailored towards more “catastrophic” coverage in the event that oil prices collapse, as indeed they did during the global crisis in 2008 and again in 2014-15. We start from a discussion of two aid instruments which introduce some elements of insurance into policy-based lending, and then extrapolate the same idea to other types of IDA lending instruments. In the second instrument, at the beginning of a In the first aid instrument we propose, a country fiscal year, a country program is agreed, with borrows a given amount X which is not disbursements at the end of the fiscal year immediately disbursed. Conditional on the conditional on the implementation of agreed implementation of certain prior actions and policies and actions by the government IDA refraining from their reversal during the project agrees to disburse the program amount if the period, IDA commits to disburse for the next Y average benchmark price of oil remains in a pre- years amounts equal to 0 if the average price of agreed range, a larger amount if the price falls oil exports during a year does not fall below a below it and less if it exceeds the range (Figure certain level, and some positive amounts if it 2). Some minimum level of disbursement might does, with these amounts being larger the lower also be necessary to maintain continuous is the average price of oil. To achieve its objective engagement, even if oil prices are very high. The to help maintain macroeconomic stability, the counterpart financing for this approach would program needs to cover a sufficiently long time involve a hedging instrument called risk reversal period and a sufficiently large portion of oil (consisting of a put option and two call options). revenues. This product could be financed It might be designed in a way ensuring zero through a string of hedging instruments called upfront costs of hedging. puts. The most important trade-off is that 2 IDA cannot of course insure against all risks. It longer-run price cycles. Nevertheless, simulations cannot cover output risk, since the level of suggest that it would be possible to hedge against production can be affected by country policy. sharp declines in oil prices over a horizon of a few Neither can it cover basis risk, the changing margin years at little or no net cost if the government between the price received for Uganda’s (low- agrees to forego part of IDA’s disbursements when quality) crude and a benchmark price such as that oil prices are high. For this to work in an of Brent Light for which futures markets exist. automatic and countercyclical way, it would be Basis risk can be considerable for oil of different important not to subject the program to additional quality trading on widely separated markets but conditionality, but to see the upward and still leaves a larger component of market price risk downward revisions in disbursements as simply that can be cushioned. There are also practical scaling the agreed program. limits on the ability to hedge against medium- March 2015 · Number 1 · 3 Simulations using typical distributions of futures program, raising the hope that combining prices provide some indication of the range of domestic and external funds can improve the use hedging possibilities open to IDA. If the country of at least part of the resource revenues. In is willing to give up a substantial part of especially difficult cases donors might seek to disbursements when oil prices are very high and channel much of their funding through non- “insurance is provided only against very large government channels. price declines IDA disbursements can be more than doubled. This is not an unrealistic price The IDA program therefore could combine scenario; indeed, price declines larger than those policy-based lending, project support and simulated have actually taken place since the results-based loans, the latter two with variable middle of 2014. co-financing. If the oil prices rise, government contributes more; if the prices fall, IDA Figure 2. Disbursement relative to Program for contributes more. This approach could enable a Risk-Reversal Hedges more tailored approach than that possible through policy-based lending alone. It could help to insulate specific development programs from shifts in spending priorities that could accompany large swings in the availability of financial resources. REFERENCES Dobronogov, A., A. Gelb, and F.B. Saldanha (2014). "How should donors respond to resource windfalls in poor countries? From Aid to Insurance. Policy Research Working Paper 6952, The World Bank. With the stress on “country ownership”, many have advocated the use of budget support as an Perry, G. (2009). Beyond Lending: How Multilateral essential component of assistance if the Development Banks Can Held Developing Countries legitimacy and capacity of the government is not Manage Volatility. Center for Global Development. to be undermined by fragmented project aid. However, as resource taxes cause fiscal revenues Ross. M. (2012). The Oil Curse: How Petroleum to balloon, donors can respond by changing the Wealth Shapes the Development of Nations. Princeton University Press. mix of financing instruments, and programs for resource-rich countries might shift away from About the authors: budget support towards investment projects, especially if they provide technical assistance or Anton Dobronogov, Senior Economist, create incentives to help the country improve the World Bank’s Macroeconomics & Fiscal Management Global Practice (GMFDR) management of its own funds. Another email: adobronogov@worldbank.org; promising approach is the development of results-based assistance, such as the Program- Alan Gelb, Senior Fellow, Center for Global Development; for-Results (PforR) approach recently approved by the World Bank. Most of the PforR operations Fernando Brant Saldanha, SDA Gestao de Recursos have been quite highly leveraged, with the World Bank providing less than half the total _______________________________________________________________________________________________ This note series is intended to summarize good practices and key policy findings on MFM-related topics. The view expressed in the notes are those of the authors and do not necessarily reflect those of the World Bank, its board or its member countries. Copies of this notes series are available on the MFM Web site (http://worldbank.org/macroeconomics) March 2015 · Number 1 · 4