Working Paper: CEPR ID: DP6954
Authors: Frederick van der Ploeg; Anthony J. Venables
Abstract: A windfall of foreign aid or natural resource revenue faces government with choices of how to manage public borrowing, public asset accumulation, and the distribution of funds to households (across time and household types), particularly when the windfall is both anticipated and temporary. These choices are acute if some households do not have access to credit markets and are unable to smooth consumption, and if the country as a whole is not a price-taker in international capital markets - both reasonable descriptions of many developing countries experiencing resource (or aid) booms. We analyse the optimal policy actions for countries in this position and show that the usual permanent income hypothesis prescription of engineering a permanent increase in consumption financed by borrowing ahead of the windfall and then accumulating a Sovereign Wealth Fund (SWF) is not optimal. Heavily indebted countries with a small windfall should both increase current consumption and accumulate capital to accelerate their development. Only if the windfall is large relative to initial debt is it optimal to build a SWF. We study the intricate dynamic trade-offs faced when using the windfall to pay off debt and possibly accumulate a SWF, build public infrastructure and hand out citizen dividends. Finally, we show that a more sophisticated range of instruments (e.g., an asset holding subsidy) makes the trade-offs easier.
Keywords: Asset holding subsidy; Credit constraints; Debt management; Developing economies; Optimal fiscal policy; Private investment; Public infrastructure; Risk premium on foreign debt; Sovereign wealth fund; Windfall public revenues
JEL Codes: E60; F34; F35; F43; H21; H63; O11; Q33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| size of the windfall (H27) | decision to build SWF (G31) |
| level of indebtedness (F34) | decision to reduce debt (H63) |
| decision to reduce debt (H63) | economic growth (O49) |
| decision to reduce debt (H63) | consumption trajectory (D15) |
| market imperfections (D43) | policy responses (D78) |