Dynamic Portfolio Management Approach to Optimal Fiscal Policy in Resource-Rich Countries

Abstract

This paper studies a novel approach for managing macroeconomic volatility in developing countries based upon dynamic portfolio optimisation. As part of this study, we develop a sovereign risk management model in the context of an Asset-Liability Management (ALM) framework. First, we solve the optimal level of investment in commodities required to achieve Pareto efficient allocation. Second, we provide numerical results for the optimal level of wealth to allocate for fiscal spending in a country where sovereign income is subject to higher commodity market volatility. Third, we provide a mathematically tractable model for ascertaining the most efficient level of debt-to-GDP ratios to be maintained by governments in order to achieve fiscal stability. Finally, we document significant welfare gains with sovereign consumption-wealth ratios increasing monotonically in wealth irrespective of commodity price levels.