Beyond the Resource Curse

5. Challenges Facing Central Banks in Oil-Exporting Countries: The Case of Azerbaijan

5 Challenges Facing Central Banks in Oil-Exporting Countries: The Case of Azerbaijan Elkin Nurmammadov Central banks have evolved over time. Whereas the Swedish Riksbank and the Bank of England of the late-seventeenth century were established to finance war expenditures of their governments, modern central banks function as regulators of a nation’s money supply and as monopoly providers of legal tender. They pursue a variety of goals, such as price stability, output growth, and the stability of the financial sector. Moreover, central banks today exhibit much higher degrees of independence and transparency than even twenty years ago, when many of them practically functioned as departments of ministries of finance. The economic structures of different countries vary considerably today, and so do the practices and challenges of central banks. Many consider the practice of central banking an art, albeit one benefiting from scientific foundations . In the words of Sir Ralph Hawtrey: it is a special characteristic of the art of central banking that it deals specifically with the task of an authority directly entrusted with the promotion of human welfare. Human welfare, human motives, human behavior supply material so baffling and elusive that many people are skeptical of the possibility of building a scientific edifice on so shifting a foundation. But however complex the material, and however imperfect the data, there is always an advantage to be gained from systematic thought. 138 Elkin Nurmammadov Arguably, central banking in emerging market countries is much more of an art than elsewhere. These countries usually suffer from political instability , are “small open” economies (relying on exports of a single major agricultural or mineral commodity), and, in the case of transition economies, have taken on the difficult task of institution building from scratch. The focus of this chapter is the practice of central banking in yet another type of economy—namely, the economies of oil-exporting countries. Oil-exporting countries often suffer from important problems that stem from oil-price volatility. Oil prices are twice as volatile as prices for other commodities. Moreover, changes in oil prices have historically been poorly forecast. Oil prices collapsed with the onset of the global financial crisis and hit a price of less than $40 a barrel in January 2009. Just half a year earlier , oil prices were at an all-time high of $147 a barrel, the culmination of the unprecedented 2003–8 oil boom. Oil price booms lead to strong fiscal and external positions in oilexporting countries. Higher international oil prices are associated with higher revenues for these countries’ public sectors, and lower international oil prices are associated with lower revenues. The same logic applies to government spending in oil-exporting countries: it rises when oil prices are high and falls when they are low. Recent estimates show that the overall fiscal balance in a subsample of oil-producing countries would on average decrease by 3.5 percent of GDP in response to a $10 per barrel reduction in the price of oil. Because the public sector plays a major role in oil-exporting countries, oil price shocks pose a number of serious challenges to a central bank’s goals of macroeconomic and financial stability. Oil-price volatility makes the choice of an exchange rate regime a critical and difficult policy choice for oil exporters. As oil-exporting economies depend heavily on revenues from transactions carried out on international markets in foreign currencies, the exchange rate can have a significant impact on the health of these economies. On one hand, the exchange rate regime must account for the vagaries of international oil prices, the need to anchor inflationary expectations, and the potential risk of currency and banking crises. On the other hand, the exchange rate regime must accommodate other priorities, such as economic diversification and reduction of unemployment. In practice, it seems very problematic for oil exporters to find a single exchange rate regime that is compatible with all these considerations . Most oil-exporting countries fix their currencies to the U.S. dollar (see Table 5.1). Some countries announce the fixed exchange rate formally; Challenges Facing Central Banks in Oil-Exporting Countries 139 others pursue foreign exchange market interventions without making explicit announcements. This substantially limits the scope of independent monetary policy to address domestic problems and exposes oil exporters to the risk of speculative attacks on their currency. There are strong arguments in favor of oil-exporting countries adopting more flexible...