Stabilization Fund Instruments : Experience and Prospects
English translation © 2004 M.E. Sharpe, Inc., from the Russian text © 2003 “Voprosy ekonomiki.” “Instrumentarii stabilizatsionnogo fonda: opyt i perspektvy,” Voprosy ekonomiki, 2004, no. 3, pp. 65–75. A publication of the NP “Editorial Board of Voprosy ekonomiki” and the Institute of Economics, Russian Academy of Sciences. The author is a Doctor of Economic Sciences, professor, and chairman of the Public Finance Department of the State University—Higher School of Economics. The financial tools at the disposal of policy makers in a market economy are quite diverse and are adapted to reflect economic conditions and the chosen strategy of financial policy. International experience indicates that if world market prices for a country’s primary export products significantly affect budget revenues, it is advisable to create a stabilization fund.
Oil price instability, hedging, and an oil stabilization fund : the case of Venezuela
The Venezuelan government and PDVSA (Venezuela's state oil companies) are both exposed to oil price instability. Given the existing tax structure, PDVSA has a higher exposure than the government, especially when prices drop below $18-20 a barrel. The authors show that the volatility of prices for crude oil is higher (but not significant) than the volatility of prices for refined oil products. And both prices are highly correlated. So, there is not much strength to the argument that Venezuela, being now mainly an exporter of refined products, faces less volatility than when it was exporting mainly crude oil. The basis risk for hedging Venezuelan crude oil was founded to be higher than for other crudes of comparable quality in the region. One explanation could be the pricing policies Venezuela follows, which leads Venezuelan crude oil prices to deviate for long periods from international prices. The basis risk in Venezuelan refined products is much lower and at acceptable levels for risk management. The issue of liquidity is concentrated in contracts for periods of less than a year. For products, the liquidity is concentrated in the nearest 4-5 months. So, for short-term hedges (6-9 months ahead), there is sufficient liquidity for Venezuela to hedge a substantial part of its exports. For longer-term hedges, the over-the-counter market is the more appropriate vehicle. In either case, it will not usually be the case that all production or exports should be hedged. The authors also examined the issue of an oil stabilization fund. For an oil stabilization fund to be effective several preconditions must be met. Most notably: oil prices should not follow a random walk; financial markets are incomplete; and there are large adjustment costs. These conditions do likely apply in Venezuela. Venezuela's best strategy would be to remove as much short-term oil price risk as possible by using short-dated hedging instruments (such as futures, options, or short-dated swaps) and to also do some longer term hedging (using mainly over-the-counter options and long-dated swaps). They also find that an oil stabilization fund should be complemented by using market-based risk management tools. The oil stabilization fund could then be used to manage any remaining interperiod oil price risk to the extent considered necessary.
Hedging commodity price risks in Papua New Guinea
This paper shows that market-based financial instruments are better suited to manage external price risk for a country that is a price taker in world commodity markets. This is especially the case for mineral and energy price risks where financial instruments (such as commodity swaps) exist for hedging export earnings over long periods. For agricultural export earnings, short-term hedging tools, such as options and futures, could be used effectively. The authors design specific financial strategies that Papua New Guinea could use, and demonstrate the gains to be made from active risk management. The authors concludes that the lessons learned are not unique. Many developing countries are heavily dependent on primary commodities for foreign exchange, and their economic development has suffered from the resulting risks and instabilities. With increasing awareness of these risks and with technical assistance - strategic advice and assistance in institution building and skills training - developing countries can learn to use financial instruments to improve their economic management.