Counter-cyclical fiscal policy is the first line of defense against commodity price volatility. Ensuring macroeconomic stability in resource-rich countries depends primarily on how well public finances policy is delinked from fluctuations of resource revenue. Failure to do so can aggravate the boom-bust cycles. A mechanism should be designed to rein in the expansion of government spending by filtering large inflows of resource revenue that could be excessive or volatile. Unspent resource revenue can be saved in a fund (a stabilization fund) dedicated to liquidity management or investment in offshore assets, which can be drawn down to implement a fiscal stimulus during periods of low commodity prices or in the event of sudden reversals of foreign inflows. The operational rules anchoring fiscal policy should be simple but transparent for effective implementation and for greater accountability. While counter-cyclical fiscal policy tends to focus on the expenditure side, tax instruments can also be deployed, for example, to control rapid increases in private consumption or real estate booms. Consideration could also be given to retire external debt, especially expensive debt, early to induce an outflow of foreign funds.

To combat large capital inflows and their sudden stops, a combination of monetary policy and macroprudential regulations is most effective, along with fiscal tightening, to mitigate inflationary pressures, absorb domestic liquidity, and limit excessive risk taking by the financial sector.<sup>41</sup> Unlike resource revenues, capital inflows are not channeled through the national budget, and thus fiscal policy can dilute demand pressures only indirectly. Monetary policy alone is likely to be ineffective, as monetary tightening to slow credit growth would further encourage capital inflows. Recent experience suggests that the use of prudential instruments—such as the liquidity ratio, leverage ratio, loan-to-value ratio, reserve requirements on bank deposits, limits on exposure concentration, etc.—has been effective in safeguarding the financial sector, when the instruments are selected to target specific types of flows and used to complement macroeconomic policy measures.

Moving towards a more flexible exchange rate regime is also found to be effective in moderating the impact of volatile capital inflows.<sup>42</sup> Experience suggests that a sterilized intervention is ineffective and incurs quasi-fiscal cost, which can be substantial. Imposing some form of capital controls, as part of a comprehensive policy package, could be considered to target speculative inflows that lead to the greatest vulnerabilities, but this may not be sufficient to stabilize financial flows if there are strong incentives for investors to circumvent them. Caution is warranted as capital controls are more distortionary than traditional fiscal and monetary policy responses, and tend to lose effectiveness over time.<sup>43</sup> It is important to monitor the economic conditions for signs of overheating, and continuously adjust the policy stance. For instance, the level of government spending prescribed by the fiscal rule may need to be tightened further to contain inflationary pressures and moderate exchange rate volatility. Additional prudential measures may need to be introduced if property markets exhibit signs of real estate speculation.

# **_Removing obstacles to business activity and boosting overall competitiveness_**

The economy’s transition to a new equilibrium involves inevitable transition costs, such as short-term unemployment, bankruptcies, administrative costs of establishing and closing business. Physical capital (e.g., land, factories) is often sunk and cannot be redeployed without cost, and acquiring new capital may

> 41 See Pradhan, et al. (2011), IMF (2013b) for further discussions on policy responses to capital flows. 42 IMF (2013b).

> 43 See Kojo (1999) and Ostry, et al. (2011).

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