Canada's Parliamentary Budget Office, Fiscal Sustainability, and the Dwindling Price Of Oil

Usman W. Chohan has served as a consultant to the World Bank Institute in the Parliamentary Strengthening Program, focusing on the role of Parliamentary Budget Offices in strengthening legislative oversight of the extractive industries. He had previously served as the Special Situations Analyst of the Global Equities Team at Natcan Investment Management, the investment arm of the National Bank Canada. He has an MBA from McGill University, and is commencing his doctoral work (PhD) in Economics on the impact of Parliamentary Budget Offices in Fiscal Policy decision-making, at the University of New South Wales (Australia) in August, 2015.

Abstract

Recent developments in the international commodity markets have adversely affected the fiscal position of countries, such as Canada, that rely heavily on extractive industries to augment budgetary inflows beyond taxation. Precipitous declines in international oil prices, for example, have created a pressing need for a fiscal re-examination to address the shortfall in revenues, by readjusting other macroeconomic levers.

Generally, a resource-rich country is impacted in a multipronged manner by oil price declines. First, there is a negative impact on an oil exporter’s terms-of-trade, as the value of its primary extractive exports fall in comparison to its imports. Within the oil-exporting country, there is a typical decline in the profitability of its oil companies, with labor, capital and wages suffering in that sector as a result. The adverse situation may affect smaller oil companies more perniciously than larger ones, which may create the conditions for sector consolidation through acquisitions. However, there is also an offsetting positive impact on consumers’ personal incomes as they spend less on fuel and transport; and a positive effect on firms that use oil as a primary input in their production, which now pay lower costs. Furthermore, assuming that the oil price decline is attributable to greater supply than to lesser global demand, the trading partners of the oil exporter will have greater income to divert towards its non-oil exports. The aggregate effects, therefore, of a supply-induced negative shock in the price of oil for an oil-exporting nation, is that its inflation rate will decline and its Real GDP will be left approximately neutral.

Although each country is subject to economic idiosyncrasies, the internationalization of global resource markets has created broad and far-reaching economic effects arising from fluctuations in the price of oil. For the suppliers (exporters) of oil, the variance between developing and developed countries is not quite so great with respect to fiscal stability, because the need for fiscal management in light of the weakening resource revenue stream provides a grave challenge for all exporters alike.

Parliaments, Budgets, and Extractive Industries

By virtue of the central role that parliamentarians play in the budget process, a sharp decline in commodity prices warrants informed parliamentary scrutiny and participation. To assist parliaments in this enterprise, independent Parliamentary Budget Offices (PBOs) serve to inform the fiscal debate through their execution of impartial and rigorous analysis on salient budgetary matters.

In resource-rich developing countries (RRDCs), the challenge of bringing transparency and accountability to the budget process has long demanded that PBOs be established. Important RRDCs with PBOs include Nigeria (NABRO), Uganda (PBO), Liberia (LBO); but it is heartening to see that the list continues to expand. Support from leading multilateral development entities such as the World Bank Institute (WBI) continues to foster a growing interest among legislators in RRDCs in the establishment and function of budget offices. Given the inordinately high position that extractive revenues enjoy within the budgets of RRDCs, the WBI has placed particular emphasis on providing legislators with the knowledge-resources, information networks, and expertise to help them develop their oversight and budget-analysis capabilities. With most of the future discoveries of extractive resources expected to occur in developing countries, it is indubitably important for legislators in RRDCs that they enhance their engagement in the extractive sectors. Independent PBOs can assist parliamentarians in this endeavour, while the budget offices of developed countries can provide a mentoring role to help these RRDC PBOs ready themselves for the analytical challenges that are inherent in the complex enterprise of scrutinizing extractive industries in the budget context.

Developed countries, although sheathed by deeper capital markets, stronger finances, and more robust governance systems, still face budget challenges when their dependence on export revenues from extractive industries is jeopardized by declining prices. One such member of the OECD is Australia, which faces a budgetary challenge in light of dwindling coal and iron ore revenues. With the ‘end of the commodities boom’ widely understood to have occurred, Australia requires its legislators to engage in the budget process in a way that reliance on commodities is reduced and diversified towards more dynamic economic processes. Australia established a PBO in 2012, which has given warnings in recent times of the sustainability of the budget, in light of the commodity cycle’s maturation and decline. The Australian PBO is helping to frame the parliamentary debate by apprising legislators about the budgetary difficulties, and the budgetary choices, that lie ahead.

The Canadian Parliamentary Budget Office fulfills an indispensable fiscal role by providing parliamentarians with the requisite analysis on the changing economic landscape, and the role of falling oil prices therein. It recently produced an informative and analytical document precisely to apprise parliamentarians of the projected impact of oil price declines on fiscal sustainability and budget balance. The PBO’s work warrants greater attention: first, because of the example it sets for other international budget offices in terms of the analytical rigor necessary for engagement with the extractive industries; and secondly, because of the informational value it possesses for Canadian parliamentarians in enhancing their legislative oversight capability in the extractive sectors.

Canadian Impact

With the international oil price declining precipitously from roughly $100 in April 2014 to a trough of $40 in early 2015, the PBO began a comprehensive analysis of the broader budget impact, at the request of the Honourable John McKay, MP. The PBO sought to answer two fundamental questions about the nation’s future fiscal position:  (1) what would the impact of lower oil prices be on projected federal surpluses? and (2) what would the impact of lower revenues resulting from lower oil prices be on the fiscal gap of the total government sector?

To examine a variable as inherently inestimable as the future price of oil, the PBO applied financial models to two scenarios: a bleaker one in which the oil price (West Texas Intermediate, WTI) would remain at $48 for an extended period of time; and a slightly rosier one in which oil would average $51 in 2015 and then gradually rise to $81 by 2019.

The PBO’s work produced the following results: at $48 dollars a barrel, the Canadian government would lose $5.3 billion dollars and produce a deficit of -$400 million in 2015-16. In this bleaker scenario, the government would reach its balanced budget target by 2016-17. The nominal GDP cost of the lower oil price over the five-year period 2015-20 would be $54 billion annually on average. In the second scenario, the PBO gauged that, should the average price of oil rise from $51 barrel to $81 over five years, federal revenues would still decline by $4.2 billion, but it would still be possible to have a slim surplus of $700 million in 2015-16. The nominal GDP cost of the lower oil price would be $42 billion in 2015 and $30 billion in 2016. Real GDP growth would slow to 2.0% in 2015-16 and average 1.8% for the period 2017-2020.

In sum, the PBO found that the oil price would have an “ultimately negative” effect on the Canadian economy, reducing real GDP growth by 0.4% in 2016 and 0.5% in 2017. The PBO stressed, however, that the two scenarios that it modelled did not include the second-order impacts from Canada’s lower real GDP that would very likely materialize, and therefore cautioned that the fiscal impacts of their calculations should be viewed as lower-bound estimates.

Prior to the drop in oil prices, the Conservative government had projected that the government budget would produce a surplus of $1.9 Billion. This would not be attainable in the two scenarios examined by the PBO. However, Prime Minister Stephen Harper had pledged to maintain his government’s plans for a balanced budget without additional cost cutting. The PBO found that the executive could still adhere to its promise of a balance budget by 2015-16, and enumerated the measures by which it could do so. In other words, the PBO was in agreement with the executive’s promise, as long as it enacted remedial measures in light of declining oil revenues. These measures included selling shares in companies where the government held a stake, such as the $5 billion equity in General Motors, for example; or delaying projects with high capital expenditures. The PBO also pointed to the $3 billion contingency fund that the government has set aside, which could be tapped into on a “rainy day”. In short, so long as the PM could find other means of offsetting the deficit impact, the PBO believed that the budget could be balanced as scheduled.

The aforementioned exercise in projecting the fiscal impacts of declining oil prices helps to demonstrate three vital points about Canada’s parliamentary role in the budget process. First, it shows that the PBO, despite its somewhat recent provenance (est. 2007-08), is capable of contextualizing a complex issue with highly informative analysis. It is able to provide parliamentarians and the public alike with digestible information about the possible outcomes resulting from what invariably is a global issue with tremendous repercussions well beyond the borders of Canada. Second, it presents a template for other legislative budget offices, particularly in RRDCs, to follow in addressing the very same problem, which no doubt has arisen in the minds of parliamentarians everywhere – “how will falling oil prices impact our budget?” RRDC PBOs could draw on the financial modeling roadmap laid out by Canada’s PBO in addressing their own projected national balance sheets. This is simply one more way in which the Canadian PBO serves as a guide for the legislative budget offices elsewhere. Third, parliamentarians can, given their central role in the budget process, leverage the enhanced decision-making capability that arises from the PBO’s analytical work.

Later in 2015, the PBO will provide further clarity and granularity into the impact of the oil price in its Fiscal Sustainability Report. Seen in the broader light of parliamentary engagement with extractive industries, the Canadian PBO has demonstrated the essential role that a legislative budget office can play in informing the debate on fluctuating oil prices with vigorous fiscal analysis. Other budget offices abroad can draw upon this example in proffering their own legislators with valuable financial modeling that helps to draw conclusions about budget sustainability over a longer time-horizon. Parliamentarians in Canada, meanwhile, can draw upon the PBO’s current analysis, as well as its forthcoming reports, in bolstering their necessary parliamentary contribution to the budget process. Therefore, as mercurial as the price of commodities may be, and as challenging as the task of fiscal sustainability may seem, the PBO plays a necessary fiscal role by facilitating parliament’s contribution to the extractive sectors.

Notes

1. Parliamentary Budget Office of Canada. Pre-Budget Outlook. Ottawa, 2015.
2. Parliamentary Budget Office of Canada. Expenditure Monitor: 2014-15 Q3. Ottawa, 2015.
3. Parliamentary Budget Office of Canada. Fiscal Impacts of Lower Oil Prices. Ottawa, 2015.
4. Chohan, Usman, Canada and the Global Network of Parliamentary Budget Officers. Canadian Parliamentary Review. Vol. 36, Issue 3. Ottawa, 2013.
5. Chohan, Usman, Fostering a Community of Practice Among Parliamentary Budget Offices of the Commonwealth. The Parliamentarian Journal. Commonwealth Parliamentary Association. Issue III, 2013. Page 40-43 (198-201).