OREANDA-NEWS. Fitch Ratings says in a new report that the recent decline in oil prices has highlighted the vulnerability of subnationals with revenue dependence on commodity-based transfers. This has been particularly severe in recent months following the decline in oil prices to close to USD55 per barrel by end-December 2014 from just over USD100 per barrel in June 2014.

As low oil prices are projected to persist into 2015 we expect that subnationals may also see a decline in transfers received related to oil revenue proceeds. This will mean that original expenditure budgets may be scaled back unless they can find alternative sources of revenues.

These subnationals tend to have a low level of internally generated revenues due to a lack of incentives to increase local revenues or improve collection rates. This leads to significant imbalances with a large proportion of potential volatile transfers from the central government funding rigid expenditure at the local level.

In some countries, the transfer formula of oil-related revenues from central to local governments favours oil producing regions as they receive a greater share of the revenues. However, this tends to lead to increasing income inequalities between oil and non-oil producing states, particularly if the transfer amount is significant. It can also result in disagreements among the regions and also between the regions and the central government.

Commodity-based revenues are inherently volatile as they depend on external demand, production volumes, price and exchange rates. Most of these variables are beyond the control of the subnationals. Sharp devaluation of the local currency against the commodity reference currency, which is usually the USD, can also have significant negative impact on domestic proceeds from oil revenues.

Apart from the inherent volatility of revenues, low revenue flexibility has a negative impact on subnationals while undermining their ability to counteract falling revenues through fiscal adjustment. Long-term budget planning is largely determined by revenues outside their control. In addition, during favourable times there is pressure to overspend in capital projects that may be politically motivated.

One of the more effective ways to counteract the cyclically in revenues is to create reserves or stabilisation funds/sovereign wealth funds which can be used when commodity revenues decline. This has already been created by sovereigns in countries such as Azerbaijan and Kazakhstan but it is still fairly rare at the subnational level. In conjunction with this, subnationals could increase the proportion of internally generated revenues through local taxes and fees to reduce the dependence on one single source.