## 1. Sustainable Overall Public Expenditure Envelop Scenarios

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### I. Introduction — hydrocarbon dependency and risks
- Proven reserves (as of end-2010): 47 billion barrels (crude oil) and 53 trillion cubic feet (natural gas).
- Annual extraction rates cited: 616 million barrels of crude oil and 1 trillion cubic feet of natural gas.
- Hydrocarbon sector share: over 65 percent of GDP and 95 percent of total fiscal revenue.
- Conflict-era production and fiscal shock:
  - Crude oil production fell from an average of 1.69 million barrels per day in 2010 to 0.48 million barrels per day in 2011.
  - Resulted in a 62 percent fall in real GDP and fiscal accounts moving from a surplus of 8.9 percent of GDP in 2010 to a deficit of 18.7 percent in 2011.
  - Restoration of hydrocarbon production improved the overall balance to a surplus of 24.0 percent in 2012, but the nonhydrocarbon primary deficit continued to deteriorate.
- Depletion horizon (assuming pre-conflict extraction and no new discoveries): crude oil reserves would last about 77 years and natural gas about 52 years.
- Policy implications:
  - Need to run surpluses during high hydrocarbon prices and invest savings in financial assets and productive public investment to preserve intergenerational equity.
  - Build buffers during oil price upswings to insulate against volatility and avoid Dutch disease effects concentrated through the nonhydrocarbon sectors.

### II. Measuring the fiscal stance — cyclically adjusted nonhydrocarbon balance
- Rationale:
  - The nonhydrocarbon primary budget balance (excluding interest and resource-based revenue including investment income) scaled by nonhydrocarbon potential GDP is a better indicator than the overall fiscal balance in resource-dependent economies.
- Methodology and parameters:
  - Trend/cycle decomposition of nonhydrocarbon GDP with the Hodrick-Prescott filter (λ adopted = 100).
  - Aggregate elasticities used for cyclical adjustment: nonhydrocarbon revenues elasticity = 1; primary spending elasticity = 0.
- Output gap estimates and uncertainty:
  - Nonhydrocarbon output gap swung 56 percentage points: from −16.1 percent in 2001 to +38.7 percent in 2010.
  - Average positive output gap in the 1990s: 4 percent; average negative deviation 1970–2005: 1.7 percent.
  - Estimates subject to uncertainty due to frequent shocks, expatriate labor, and public-sector project effects on measured potential.
- Fiscal stance findings (key magnitudes):
  - Fiscal balance moved from an average deficit of 2.7 percent of GDP a year in the 1990s to an average surplus of 15.7 percent in the 2000s.
  - Nonhydrocarbon primary deficit deteriorated from 22 percent of nonhydrocarbon GDP in 2000 to 155 percent by 2010.
  - Cyclically adjusted nonhydrocarbon primary deficit (share of nonhydrocarbon potential GDP) rose from 20.5 percent in 2000 to 185 percent by 2008 and to 225 percent in 2010.
  - The fiscal impulse (change in cyclically adjusted nonhydrocarbon primary balance) amounted to over 200 percentage points cumulatively over the boom period.
- Policy implication: Unchanged fiscal policies will erode national wealth despite short-term affordability of elevated current spending.

### III. Assessing fiscal sustainability — Permanent Income Hypothesis (PIH) results
- Framework and present-value components:
  - Computational PIH approach to value total hydrocarbon revenue until depletion and derive an annuity-consistent sustainable real per capita government spending path.
  - Present-value components include current financial wealth, present value of nonhydrocarbon revenue, and present value of hydrocarbon revenue until depletion.
- Key parameter assumptions:
  - Real rate of return on financial assets: 5 percent.
  - Inflation: 2 percent.
  - Population growth: 1.8 percent.
  - Crude oil price projection: average of $80 per barrel (based on the 2013–18 profile in the IMF’s World Economic Outlook) and assumed to increase at 2 percent thereafter.
- PIH quantitative findings:
  - Under the above assumptions, the nonhydrocarbon primary budget deficit is estimated to be 12.5 percentage points of GDP higher than its equilibrium value in 2013.
  - The gap increases to 20 percentage points by 2018.
  - Sensitivity: projections shown for discount rates i=4, i=5, i=6 and for different oil prices.
- Modified PIH (sustainable investing) alternative:
  - Excluding development expenditure that may yield returns equal to the discount rate, the nonhydrocarbon primary deficit is estimated to be 3.4 percentage points of GDP below equilibrium in 2013 and around 10 percentage points below equilibrium over the medium term.
- Broader implications:
  - Significant fiscal adjustment over the medium term is needed to avoid wealth erosion and ensure intergenerational equity.
  - Precautionary savings are necessary given oil price volatility; larger fiscal buffers reduce need for sharp tightening during downturns.
  - Diversification and productivity improvements in the tradable sector reduce precautionary saving needs and improve welfare.

### IV. Building a rule-based fiscal framework — choice, design, and implementation
- Identified budget system weaknesses:
  - Single-year, cash-basis budget with limited transparency and weak linkage between policy priorities and expenditures.
  - Fragmented processes at central and line ministry levels; lack of adequate tools for fiscal adjustment given a cyclically adjusted nonhydrocarbon primary budget deficit of over 200 percent of GDP.
- Rationale for fiscal rules:
  - Numerical/procedural limits on debt, deficits, expenditures, or combinations can moderate procyclicality and help ensure long-term sustainability and intergenerational equity.
  - Enhanced structural fiscal balance rule identified as providing the strongest anchor—accommodating output and/or commodity price shocks—yet relatively complex.
- Comparative characteristics and trade-offs of rule types:
  - Balanced budget (nominal deficit ceilings): strong on sustainability monitoring, but likely procyclical and increases volatility of main fiscal aggregates.
  - Expenditure rules: operational guidance and ease of monitoring; risks include across-the-board cuts, creative accounting, and limited direct linkage to debt without revenue-side consideration.
  - Structural balance rule: allows flexibility via cyclically adjusted targets, absorbs shocks better, but requires output-gap dating and is less transparent/easy to monitor.
  - Enhanced structural balance: adjusts for output gap and commodity-price deviations from long-run trends; better stability for commodity exporters.
  - Augmented growth-based rule: replaces output gap with difference between actual and long-term growth; avoids output-gap estimation and smooths adjustments.
  - Debt/asset accumulation rules: directly address sustainability but may be weak on countercyclicality and short-term discipline.
- Implementation prerequisites and institutional arrangements:
  - Fiscal rule should be permanent and ideally anchored in a firm statutory instrument such as a constitutional provision.
  - Supporting institutions and reforms recommended: fiscal responsibility law, robust PFM, complementary Treasury Single Account (TSA) at the Central Bank of Libya (CBL), top-down multi-year policy guidelines.
- Simulation methodology:
  - Stochastic simulation calibrated to country-specific historical VAR with Monte Carlo simulations generating fan charts for balance ratios and net debt/asset accumulation.
  - Extended model includes exogenous variables (notably the log price of crude oil) to capture external price shocks.
- Caveats and limitations:
  - Historical-based shock distributions assume future shocks resemble past shocks; structural breaks or unrepresentative samples can bias risk assessments.
  - Model omits fiscal reaction function feedbacks; each rule is imposed as binding for the forecast horizon.

### V. Policy recommendations (synthesis)
- Adopt a rule-based fiscal framework to delink government spending from volatile hydrocarbon revenues and to safeguard fiscal sustainability and intergenerational equity.
- Prefer an “enhanced” structural fiscal balance rule (adjusts for output gap and commodity-price deviations) for strongest stabilization properties, while acknowledging greater complexity and monitoring needs.
- Embed the fiscal rule in a firm statutory mandate and establish institutional supports: fiscal responsibility law, robust PFM, TSA at CBL, and multi-year top-down guidelines.
- Build precautionary savings during oil-price upswings and adopt a “sustainable investing” approach that scales up development spending in line with institutional and absorptive capacity.
- Use stochastic simulation tools (VAR + Monte Carlo) to evaluate and communicate risks and to calibrate the rule to Libya’s historical shock environment.

### Box 1 — Analytical definitions and simulation calibration (highlights)
- Definitions of simulated fiscal rules:
  - Expenditure rule: fixed nominal/real expenditure growth (simulations set equal to long-run average real GDP growth).
  - Structural balance rule: b_t = b* + a y_t^G, with a>0.
  - Enhanced structural balance rule: b_t = b* + a y_t^G + c (p_t - p*), with a>0 and c>0.
  - Augmented growth-based balance rule: b_t = b* + a (g_t - g*) + τ (b_{t-1} - b*), with a>0 and 0< τ <1.
- Exact calibration parameters used in simulations:
  - Structural balance target (b*): zero percent of GDP.
  - Long-term real GDP growth: 2.5 percent.
  - Cyclical coefficient (a): 0.25.
  - Semi-elasticity c for enhanced structural balance: 1.5.
  - Adjustment coefficient (τ) for augmented growth-based rule: 0.75.
  - Semi-elasticity of revenue-to-GDP ratio w.r.t. output gap: 0.3.
  - Semi-elasticity of revenue-to-GDP ratio w.r.t. commodity price index: 1.6.
- Simulation findings (selected):
  - Cyclically adjusted balance rules are superior in dealing with output and commodity-price shocks.
  - Enhanced structural balance rule entails the narrowest band for primary spending response to shocks.
  - For Libya, net asset accumulation follows a downward trend under most shocks.
  - An augmented growth-based balance rule yields the narrowest spectrum for fiscal balance; structural balance and expenditure rules imply wider (but generally declining) distributions for net debt/asset accumulation.
  - Expenditure rule is operationally simple but not anchored in fiscal sustainability and offers no revenue-side guidance; can serve as a transitional rule if structural rules are infeasible immediately.

### Box 3 — Reforming Libya’s PFM Framework (highlights and recommendations)
- Need for coherent PFM framework:
  - Integrate the SWF system (Libyan Investment Authority and Budget Reserve Account at the CBL) into the PFM framework with transparent rules for inflows and outflows.
  - Clarify LIA objectives and resource rules.
- Institutional capacity and organizational reforms:
  - Ministry of Finance should establish a macro-fiscal policy unit to elaborate medium-term fiscal projections and link the budget to national policy objectives.
  - Reform priorities: medium-term, strategy-oriented budget formulation; effective TSA; commitment control; accounting framework; stronger reporting and internal audit.
- Fiscal stance, sustainability, and risks (key magnitudes reiterated):
  - Cyclically adjusted nonhydrocarbon primary budget deficit widened from 20.5 percent of nonhydrocarbon potential GDP in 2000 to 225 percent by 2010.
  - Current expenditures increased significantly during and after the conflict primarily due to a sustained rise in the wage bill and subsidies.
- Quantitative sustainability scenarios:
  - Assuming constant real per capita government expenditure that delivers a constant real per capita annuity after depletion and crude oil prices at an average of $80 per barrel:
    - Nonhydrocarbon primary deficit is estimated to be 12.5 percentage points of GDP higher than its equilibrium value in 2013.
    - The gap is estimated to increase to 20 percentage points by 2018.
  - Modified PIH excluding development expenditure that may yield return equal to the discount rate:
    - Nonhydrocarbon primary deficit is estimated to be 3.4 percentage points of GDP below its equilibrium value in 2013.
    - Estimated to remain 10 percentage points below the estimated equilibrium threshold by 2018.
  - Caveat: apparent fiscal space for scaling-up development spending does not account for institutional and absorptive capacity.
- Savings, buffers, and policy imperatives:
  - Higher public savings rate required to avoid sharp long-term fiscal adjustment unless diversified.
  - Volatility of oil prices and uncertainty about future hydrocarbon revenues require additional precautionary savings.
  - Larger fiscal buffers accumulated during high-price periods reduce need for sharp tightening during downturns.
- Fiscal rule options and recommendations:
  - Enhanced structural balance rule would entail the narrowest band for primary spending response and align with maintaining cyclically adjusted nonhydrocarbon balance as a share of nonhydrocarbon GDP (set by PIH).
  - If institutional capacity constraints impede immediate implementation, adopt an expenditure rule refined for front-loaded infrastructure needs as a transitional approach toward the enhanced structural balance rule.
  - Political commitment and institutional supports (including an independent fiscal council) are essential to avoid creative accounting and off-budget operations.
- Legal anchoring:
  - Main principles of the fiscal rule should be enshrined in the constitution, with operational details in a fiscal responsibility law.
  - Recommendation: incorporate basic principles of a rule-based fiscal regime in the forthcoming constitution and set institutional and operational details in a fiscal responsibility law.

*Source: IMF staff analysis in "1. Sustainable Overall Public Expenditure Envelop Scenarios" (excerpt).*

### References .............................................................................................................

### References

### Boxes
- 1. Analytical Definitions of Simulated Fiscal Rules ................................................................20
- 2. Examples of Fiscal Rules in commodity-Exporting Countries............................................23
- 3. Reforming the PFM Framework ..........................................................................................24

### Figures
- 1. Hydrocarbons and the Economy ............................................................................................4
- 2. Nonhydrocarbon Output Gap .................................................................................................7
- 3. Fiscal Policy Stance ...............................................................................................................8
- 4. Nonhydrocarbon Balance and Wealth Accumulation..........................................................11
- 5. Nonhydrocarbon Primary Deficit Projections under PIH ....................................................11
- 6. Tradeoff between Alternative Fiscal Rules ..........................................................................14
- 7. Stochastic Simulations of Alternative Fiscal Rules .............................................................22

### Table
- Table

*Source: _wp1379 - References .............................................................................................................*

### 1. Sustainable Overall Public Expenditure Envelop Scenarios .............................................12

### 1. Sustainable Overall Public Expenditure Envelop Scenarios

### I. Introduction — hydrocarbon dependency and risks
- Libya’s proven reserves (as of end-2010): 47 billion barrels (crude oil) and 53 trillion cubic feet (natural gas).
- Annual extraction rates cited: 616 million barrels of crude oil and 1 trillion cubic feet of natural gas.
- Hydrocarbon sector share: over 65 percent of GDP and 95 percent of total fiscal revenue.
- Conflict-era production and fiscal shock:
  - Crude oil production fell from an average of 1.69 million barrels per day in 2010 to 0.48 million barrels per day in 2011.
  - Resulted in a 62 percent fall in real GDP and fiscal accounts moving from a surplus of 8.9 percent of GDP in 2010 to a deficit of 18.7 percent in 2011.
  - Restoration of hydrocarbon production improved the overall balance to a surplus of 24.0 percent in 2012, but the nonhydrocarbon primary deficit continued to deteriorate.
- Depletion horizon (assuming pre-conflict extraction and no new discoveries): crude oil reserves would last about 77 years and natural gas about 52 years.
- Key policy implications:
  - Need to run surpluses during high hydrocarbon prices and invest savings in financial assets and productive public investment to preserve intergenerational equity.
  - Build buffers during oil price upswings to insulate against volatility and avoid Dutch disease effects concentrated through the nonhydrocarbon sectors.

### II. Measuring the fiscal stance — cyclically adjusted nonhydrocarbon balance
- Rationale:
  - Overall fiscal balance is misleading in resource-dependent economies; the nonhydrocarbon primary budget balance (excluding interest and resource-based revenue including investment income) scaled by nonhydrocarbon potential GDP is a better indicator.
- Methodology:
  - Trend/cycle decomposition of nonhydrocarbon GDP done with the Hodrick-Prescott filter (λ adopted = 100 after experimentation).
  - Cyclical adjustment of total revenue and expenditures uses aggregate elasticities: nonhydrocarbon revenues elasticity = 1; primary spending elasticity = 0.
- Output gap estimates and uncertainty:
  - Nonhydrocarbon output gap swung 56 percentage points: from −16.1 percent in 2001 to +38.7 percent in 2010.
  - Average positive output gap in the 1990s: 4 percent; average negative deviation 1970–2005: 1.7 percent.
  - Estimates subject to uncertainty due to frequent shocks, expatriate labor, and public-sector project effects on measured potential.
- Fiscal stance findings:
  - Fiscal balance moved from an average deficit of 2.7 percent of GDP a year in the 1990s to an average surplus of 15.7 percent in the 2000s (driven by hydrocarbon revenues).
  - Nonhydrocarbon primary deficit deteriorated from 22 percent of nonhydrocarbon GDP in 2000 to 155 percent by 2010.
  - Cyclically adjusted nonhydrocarbon primary deficit (as share of nonhydrocarbon potential GDP) rose from 20.5 percent in 2000 to 185 percent by 2008 and to 225 percent in 2010.
  - The fiscal impulse (change in cyclically adjusted nonhydrocarbon primary balance) amounted to over 200 percentage points cumulatively over the boom period.
- Policy implication: unchanged fiscal policies will erode national wealth despite short-term affordability of elevated current spending.

### III. Assessing fiscal sustainability — Permanent Income Hypothesis (PIH) results
- Framework:
  - Use computational PIH approach (Barnett and Ossowski, 2002) to value total hydrocarbon revenue until depletion and derive an annuity-consistent sustainable real per capita government spending path.
  - Present-value components include current financial wealth, present value of nonhydrocarbon revenue, and present value of hydrocarbon revenue until depletion.
- Key parameter assumptions (explicitly stated):
  - Real rate of return on financial assets: 5 percent.
  - Inflation: 2 percent.
  - Population growth: 1.8 percent.
  - Crude oil price projection: average of $80 per barrel (based on the 2013–18 profile in the IMF’s World Economic Outlook) and assumed to increase at 2 percent thereafter.
- PIH quantitative findings:
  - Under the above assumptions, the nonhydrocarbon primary budget deficit is estimated to be 12.5 percentage points of GDP higher than its equilibrium value in 2013.
  - The gap increases to 20 percentage points by 2018 (Figure 4 and 5 referenced for trajectory).
  - Sensitivity: Figure 5 presents nonhydrocarbon primary deficit projections under PIH for discount rates i=4, i=5, i=6 and for different oil prices.
- Modified PIH (sustainable investing) alternative:
  - Excluding development expenditure that may yield returns equal to the discount rate, the nonhydrocarbon primary deficit is estimated to be 3.4 percentage points of GDP below equilibrium in 2013 and around 10 percentage points below equilibrium over the medium term—implying room for scaled-up development spending, subject to institutional and absorptive constraints.
- Broader implications:
  - PIH points to need for significant fiscal adjustment over the medium term to avoid wealth erosion and ensure intergenerational equity.
  - Precautionary savings are necessary given oil price volatility and uncertainty; larger fiscal buffers reduce need for sharp tightening during downturns.
  - Diversification and productivity improvements in the tradable sector reduce precautionary saving needs and improve welfare.

### IV. Building a rule-based fiscal framework — choice, design, and implementation
- Current budget system weaknesses:
  - Single-year, cash-basis budget prepared with limited transparency and weak linkage between policy priorities and expenditures.
  - Fragmented processes at central and line ministry levels; lack of adequate tools for fiscal adjustment given a cyclically adjusted nonhydrocarbon primary budget deficit of over 200 percent of GDP.
- Rationale for fiscal rules:
  - Fiscal rules (numerical/procedural limits on debt, deficits, expenditures, or combinations) can moderate procyclicality and help ensure long-term sustainability and intergenerational equity.
  - Enhanced structural fiscal balance rule identified as providing the strongest anchor—accommodating output and/or commodity price shocks—yet relatively complex.
- Comparative characteristics of alternative rules (trade-offs summarized):
  - Balanced budget (nominal deficit ceilings): strong on sustainability monitoring, but likely procyclical and increases volatility of main fiscal aggregates.
  - Expenditure rules: operational guidance and ease of monitoring; risks include across-the-board cuts, creative accounting, and limited direct linkage to debt without revenue-side consideration; can promote countercyclicality and reduce spending volatility if enforced.
  - Structural balance rule: allows flexibility via cyclically adjusted targets, absorbs shocks better, but requires output-gap dating and is less transparent/easy to monitor.
  - Augmented structural balance (“enhanced”): adjusts for output gap and commodity-price deviations from long-run trends; better stability for commodity exporters.
  - Augmented growth-based rule: mimics structural rule but replaces output gap with difference between actual and long-term growth to avoid output-gap estimation; allows guided countercyclicality with smoother year-to-year adjustments.
  - Debt/asset accumulation rules: directly address sustainability but may be weak on countercyclicality and short-term discipline.
- Implementation prerequisites and institutional arrangements:
  - Fiscal rule should be permanent (binding on successive governments), ideally anchored in a firm statutory instrument such as a constitutional provision.
  - Supporting institutions and reforms recommended:
    - Fiscal responsibility law.
    - Robust system of public financial management (PFM).
    - Complementary Treasury Single Account (TSA) at the Central Bank of Libya (CBL).
    - Top-down multi-year policy guidelines (medium-term framework).
- Simulation methodology to assess rule performance:
  - Use stochastic simulation calibrated to country-specific historical VAR (unrestricted) to capture joint distribution of shocks to the output gap, interest rates, and real exchange rate.
  - Monte Carlo simulations generate fan charts (frequency distributions) for balance ratios and net debt/asset accumulation under each fiscal rule.
  - Extended model includes exogenous variables (notably the log price of crude oil) to capture external price shocks and their effects on endogenous variables.
- Caveats and limitations of simulations:
  - Historical-based shock distributions assume future shocks resemble past shocks; representativeness of estimation period matters.
  - Structural breaks or unrepresentative short/stable samples can bias risk assessments.
  - Model omits feedback loops between budgetary aggregates and macro variables (fiscal reaction function is not incorporated); each rule is imposed as binding for the forecast horizon.

### V. Policy recommendations (synthesis)
- Adopt a rule-based fiscal framework to delink government spending from volatile hydrocarbon revenues and to safeguard fiscal sustainability and intergenerational equity.
- Prefer an “enhanced” structural fiscal balance rule (adjusts for output gap and commodity-price deviations) for strongest stabilization properties, while acknowledging greater complexity and monitoring needs.
- Embed the fiscal rule in a firm statutory mandate and establish institutional supports: fiscal responsibility law, robust PFM, TSA at CBL, and multi-year top-down guidelines.
- Build precautionary savings during oil-price upswings and adopt a “sustainable investing” approach that scales up development spending in line with institutional and absorptive capacity.
- Use stochastic simulation tools (VAR + Monte Carlo) to evaluate and communicate risks and to calibrate the rule to Libya’s historical shock environment.

*Source: IMF staff analysis in "1. Sustainable Overall Public Expenditure Envelop Scenarios" (excerpt). *

### Box 1. Analytical Definitions of Simulated Fiscal Rules

### Box 1. Analytical Definitions of Simulated Fiscal Rules

### Definitions of simulated fiscal rules
- Expenditure rule
  - Dictates the rate of growth in budgetary expenditure, normally in real terms.
  - In the simulations, it is fixed at a predetermined level, equal to the long-run average rate of real GDP growth.
  - Operationally simple; imposes a ceiling on nominal or real expenditure growth.
  - Requires a reliable medium-term framework to avoid build-up of large deficits and deterioration in the net asset position due to persistently lower revenue generation.

- Structural balance rule
  - Links the budget balance in any given year to the medium-term balance target adjusted for changes in the output gap.
  - Formal expression: b_t = b* + a y_t^G, with a>0, where:
    - b_t is the overall balance in the current year,
    - b* is the medium-term balance target,
    - a is the semi-elasticity of the budget balance with respect to the output gap,
    - y_t^G is the output gap in the current year.
  - No discretionary countercyclical policy if a is set to reflect automatic stabilizers only; higher a allows discretionary countercyclical policy.
  - The cyclically adjusted nonhydrocarbon fiscal deficit rule budgets spending ex-ante in line with structural revenues (economy at full potential).
  - Operationally challenging in a hydrocarbon-based economy because it requires reliable estimates of the output gap.

- Enhanced structural balance rule
  - Links the budget balance to the medium-term balance target adjusted for the output gap and commodity price deviations from their long-term trend.
  - Formal expression: b_t = b* + a y_t^G + c (p_t - p*), with a>0 and c>0, where:
    - p_t is the actual commodity price,
    - p* is the long-term price of the commodity.
  - Parameter c plays the same role as a but for commodity price shocks.
  - Practically akin to keeping the cyclically-adjusted non-oil balance constant at b*.
  - Target b* can be set to ensure long-term fiscal sustainability and intergenerational equity (for instance, using the PIH model).

- Augmented growth-based balance rule
  - Mimics a structural balance rule but replaces the output gap with the difference between actual and long-term growth to avoid reliance on output gap estimates.
  - Includes a smoothing term to avoid large single-year adjustments by delaying the correction toward the medium-term target.
  - Formal expression: b_t = b* + a (g_t - g*) + τ (b_{t-1} - b*), with a>0 and 0< τ <1, where:
    - g_t is actual growth, g* is long-term growth,
    - τ is the pace of adjustment when the previous year's overall balance b_{t-1} is away from b*.
  - A smaller τ implies a faster correction.

### Simulation calibration and exact parameter values
- Structural balance target (b*) assumed: zero percent of GDP.
- Long-term real GDP growth assumed: 2.5 percent.
- Cyclical coefficient (a) for structural balance and augmented-growth-based rules: 0.25.
- Semi-elasticity of the balance-to-GDP ratio (c) for enhanced structural balance: 1.5.
- Adjustment coefficient (τ) for augmented growth-based rule: 0.75.
- Semi-elasticity of revenue-to-GDP ratio with respect to the output gap: 0.3.
- Semi-elasticity of revenue-to-GDP ratio with respect to the commodity price index: 1.6.

### Simulation findings and comparative performance
- General findings
  - Fiscal rules based on the cyclically adjusted balance are superior in dealing with output and/or commodity price shocks.
  - The enhanced structural balance rule entails the narrowest band for primary spending in response to such shocks, implying relatively low policy variability while allowing automatic deviations to accommodate shocks.
  - The enhanced structural balance rule is akin to maintaining the cyclically adjusted nonhydrocarbon balance as a share of nonhydrocarbon GDP constant over time.
  - Cyclical adjustment requires careful policymaking and analytical capabilities to estimate the output gap and, for the enhanced rule, the equilibrium price of crude oil, adding complexity to implementation.

- Libya-specific simulation outcomes
  - Under the vast majority of possible shocks, net asset accumulation follows a downward trend over time.
  - An augmented growth-based balance rule yields the narrowest spectrum for fiscal balance (or net accumulation of financial assets).
  - Structural balance and expenditure rules imply a wider—albeit, in most cases, still declining—distribution for net debt/asset accumulation.
  - The selected deficit target in illustrations (zero percent of GDP; that is, a balanced budget over the economic cycle) is consistent with an upward path for asset accumulation in the absence of shocks.
  - Primary expenditure paths suggest the fiscal effort required is similar across balance-rule variants, but slightly higher for the expenditure rule.
  - The expenditure rule, despite simplicity and transparency, is not anchored within a fiscal sustainability framework and provides no guidance for the revenue side, leaving room for discretionary policies that can deteriorate the fiscal position.
  - For a hydrocarbon-dependent economy like Libya, if the structural balance rule proves too complex to implement in the near term, an expenditure rule that includes capital spending could provide a transitional framework until a structural balance rule is introduced.

### Institutional design, credibility, and implementation guidance
- Requirements for effective fiscal rule implementation
  - A fiscal rule must be consistent, credible, and flexible enough to respond to various shocks.
  - Effective implementation requires an explicit mandate to prevent circumvention and distortions.
  - A well-designed, transparent, and credible fiscal rule strengthens fiscal governance, ensures fiscal sustainability, and promotes intergenerational equity.
  - The rule should be intended for permanent application by successive governments and therefore should be based on a firm statutory instrument—such as a constitutional provision—and supported by institutional arrangements, including:
    - a fiscal responsibility law,
    - a robust PFM system,
    - a complementary TSA at the CBL,
    - a top-down policy guideline over a multi-year horizon.
- Escape clauses and credibility trade-offs
  - A well-anchored fiscal rule could incorporate an explicit escape clause to accommodate temporary deviations in response to severe shocks.
  - Because there is a trade-off between flexibility and credibility, an escape clause must embody a time-bound, transparent transition path back to compliance with the fiscal policy rule.
- Political economy risks to fiscal rules
  - Electoral cycles can cause myopia, induce election largesse, and reduce interest in addressing structural deficits.
  - The “common-pool” problem may aggravate spending bias as competing demands are accommodated without fully internalizing fiscal impact.
  - Formal sanctions can help maintain compliance and transparency.

### Key policy implications
- Prefer cyclically-adjusted balance rules (structural or enhanced structural) for superior shock absorption and lower policy variability.
- If capacity constraints impede immediate adoption of structural rules in hydrocarbon-based economies, consider a transitional expenditure rule that includes capital spending.
- Anchor rules in statute and institutional arrangements to enhance credibility; design escape clauses that are time-bound and transparent.
- Regular review of the fiscal policy target is possible (suggested every four to five years) but should not be so frequent as to undermine credibility.

*Source: Authors' calculations and Box 1, provided content.*

### Box 3. Reforming Libya’s PFM Framework

### Box 3. Reforming Libya’s PFM Framework

### Need for a coherent PFM framework
- Libya needs to establish an efficient and transparent PFM system based on a medium-term fiscal framework with a consistent fiscal rule that reflects the country’s economic objectives and the volatile nature of resource-based revenues.
- The existing budgetary approach is fragmented in all its phases, from formulation to execution, and overlooks medium- to long-term considerations, reducing the effectiveness of fiscal policy in macroeconomic management and preventing a strategic approach.
- The SWF system—operating through the Libyan Investment Authority (LIA) and the Budget Reserve Account at the CBL—should be fully integrated into the PFM framework with well-defined and transparent rules determining inflows and outflows to and from the LIA and the Budget Reserve Account at the CBL.
- Currently, the LIA lacks a clear definition of its objectives and the rules governing the accumulation and use of its resources.

### Institutional capacity and organizational reforms
- The Ministry of Finance needs a macro-fiscal policy unit responsible for:
  - Elaborating medium-term fiscal projections.
  - Helping make the budget a strategic policy tool linking national policy objectives to macroeconomic performance.
  - Preparing the government’s short-term and medium-term fiscal stances.
  - Preparing the appropriate fiscal response to imbalances and contingent liabilities, including those associated with the volatility of hydrocarbon prices.
- Reform priorities include:
  - Development of a medium-term, strategy-oriented budget formulation process.
  - A more efficient and effective budget execution process based on adopting an effective treasury single account system.
  - Strengthened financial compliance through a proper commitment control system and an accounting framework.
  - More stringent reporting requirements and better-defined internal audit functions.

### Fiscal stance, sustainability, and risks (findings)
- Procyclical fiscal policies threaten macroeconomic stability, fiscal sustainability, and intergenerational equity.
- Fiscal policy is the main stabilization instrument given hydrocarbon dependency and the central bank’s commitment to the pegged exchange rate regime.
- The fiscal stance had been expansionary prior to the revolution, with the cyclically adjusted nonhydrocarbon primary budget deficit widening from 20.5 percent of nonhydrocarbon potential GDP in 2000 to 225 percent by 2010.
- Current expenditures increased significantly during and after the conflict primarily because of a sustained rise in the wage bill and subsidies.
- Assessed according to the present value of future resource extraction and accumulated financial assets, long-term public finance sustainability is questionable, with the nonhydrocarbon primary budget deficit running well above the equilibrium level, even with high oil prices.

### Quantitative sustainability scenarios and key statistics
- Libya is estimated to have a nonhydrocarbon primary budget deficit greater than the equilibrium level.
- Assuming constant real per capita government expenditure that delivers a constant real per capita annuity after depletion of hydrocarbon resources and crude oil prices at an average of $80 per barrel:
  - The nonhydrocarbon primary deficit is estimated to be 12.5 percentage points of GDP higher than its equilibrium value in 2013.
  - The gap is estimated to increase to 20 percentage points by 2018.
- With a modified PIH approach excluding development expenditure that may yield a return on investment equal to the discount rate used in the annuity calculations:
  - The nonhydrocarbon primary deficit is estimated to be 3.4 percentage points of GDP below its equilibrium value in 2013.
  - It is estimated to remain 10 percentage points below the estimated equilibrium threshold by 2018.
- Caveats:
  - The apparent fiscal space for scaling-up development expenditure does not account for institutional and absorptive capacity.
  - Scaling-up should be tempered to ensure investment efficiency and to avoid inflationary pressures, real exchange rate appreciation, lower nonhydrocarbon output, and the need to accumulate precautionary savings against hydrocarbon revenue volatility.

### Savings, buffers, and policy imperatives
- Libya needs a higher rate of public savings to avoid sharp long-term fiscal adjustment unless the economy is diversified.
- Volatility of oil prices and uncertainty about future hydrocarbon revenues require additional precautionary savings.
- Larger fiscal buffers—accumulated during periods of higher oil prices—would reduce the need for sharp fiscal tightening during downturns.
- Fiscal policy should aim to preserve intergenerational equity and macro-financial stability, recognizing that the pegged exchange rate constrains countercyclical monetary policy and places stabilization responsibilities on fiscal policy.

### Fiscal rule options and recommendations
- A credible fiscal rule would decouple the fiscal stance from oil price volatility and ensure long-term fiscal sustainability.
- Recommended medium-term strategy:
  - Develop a rule-based medium-term fiscal framework and strengthen fiscal institutions, including a sound PFM system.
  - Determine use of resource revenues according to a legally binding fiscal policy rule that accounts for absorptive capacity and the need for precautionary savings.
  - Stabilization fund to smooth expenditure over the cycle; proceeds in excess of the reference oil price to be transferred to the SWF system to be invested abroad as a long-term saving instrument.
- Evaluated rules:
  - The “enhanced” structural balance rule (taking into account commodity price volatility) would entail the narrowest band for primary spending in response to macroeconomic shocks and is similar to maintaining the cyclically adjusted nonhydrocarbon balance as a share of nonhydrocarbon GDP constant over time (set according to the PIH-derived level).
  - However, institutional capacity constraints may prevent near-term implementation of the “enhanced” structural balance rule.
- Practical interim approach:
  - An expenditure rule refined to account for front-loaded infrastructure needs in the immediate post-revolution period is recommended, with a view to transition toward the “enhanced” structural balance rule over time.
  - An appropriately designed expenditure rule can limit the rate of increase in government spending and introduce countercyclical properties into fiscal formulation, supporting fiscal sustainability and intergenerational equity.
  - Political commitment is essential; without it, fiscal rules risk creative accounting and off-budget operations that reduce transparency and fail to improve fiscal quality.
- Institutional support:
  - Establishing an independent fiscal council to provide independent advice on the structural level of revenues, determine the expenditure envelope, and improve fiscal transparency by reporting on budgetary policy without political influence is recommended.

### Legal anchoring
- Main principles of the fiscal rule should be enshrined in the constitution, with details set out in a fiscal responsibility law to ensure continuity.
- Best practice: be clear about objectives, institutions, and reporting arrangements for managing natural resource wealth while avoiding over-prescription that could conflict with wider macro-fiscal objectives and undermine law credibility.
- Recommendation: incorporate basic principles of a rule-based fiscal regime in the forthcoming constitution, and set institutional and operational details in a fiscal responsibility law.

*Source: Box 3. Reforming Libya’s PFM Framework (excerpt).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp1379.pdf_