MONETARY AND FISCAL INSTITUTIONS IN RESOURCE-RICH ARAB ECONOMIES

NOVEMBER 4-5, 2015, AFESD, KUWAIT

Fiscal-Monetary Interdependence and Exchange Rate Regimes in Oil-Dependent Arab Economies

Ibrahim Ahmed Elbadawi , Dubai Economic Council and ERFMohamed Goaied, University of Sousse and ERFMoez Ben Tahar, University of Sousse and ERF

Outline

Motivation: why study the Fiscal-Monetary Interdependence in resource-rich Arab economies

The Case studies Fiscal foundations of exchange rate/monetary

regimes Resource rents, exchange rate regimes and counter-

cyclical fiscal policy Recapitulation

Motivation

Motivation

“…the question of monetary regime is more fundamental even than the question of a monetary rule or action.” (Cochrane, 2003) The concept of ‘regime’ here entails fundamental

questions, such as should the country: Adopt a currency peg; if so, A soft or a hard peg; or, instead, float; If float, managed or free float If free float: monetary, interest rate or inflation

targeting regime?

Motivation: Why fiscal-monetary interdependence important for RR Economies?

Fiscal Monetary: in fiscally dominated economies (FD), exchange rate regimes are determined by fiscal, not monetary considerations

Monetary Fiscal: in turn the capacity to undertake counter-cyclical fiscal policy is influenced by the extent of flexibility of exchange rate regimes

The high volatility of oil economies would requires: Viable fiscal ‘shock absorber’ under less flexible exchange rate

regimes (e.g. GCC) Under flex regimes (e.g. IT), high revenue volatility require strong

stabilizing fiscal institutions (e.g. Chile)

Motivation: Why fiscal-monetary interdependence important for RR Economies (cond.)?

Research suggests that there is a strong symbiotic relationship between IT and fiscal rules (the case of the copper-dependent economy of Chile: Elbadawi, Schmidt-Hebbel and Soto, 2011)

Allows gleaning important policy lessons by contrasting the experiences of three groups of RR economies: The Populous Oil Arab economies (Algeria, Sudan, Yemen) The GCC (Oman, Saudi Arabia, UAE) Comparators (Chile, Norway)

The Case Studies

The Case studies: Population, Level of Development and Economic Structure: Arab Oil Economies and Comparators

The eight countries reflect an interesting and diverse blend of experiences:

- Size of economy and population

- level of development

- Size of the resource rents pc

PopulationNominal GDP, billions current USD

Per Capita GDP-PPP, constant (2011) International dollar

Natural resources rents per capita (current US$)

Non-resource GDP (% of GDP - constant 2005 US$)

2012 2012 2012 2012Populous Oil Arab GroupAlgeria 38,481,705 204 12,779 1,245 82.7Sudan 37,195,349 63 3,545 140 84.7Yemen 23,852,409 35 3,765 244 72.6GCC EconomiesOman 3,314,001 78 44,491 12,352 61.3KSA 28,287,855 734 51,122 17,125 64.4UAE 9,205,651 384 57,045 52,297 85.1Comparator Economies

Chile 17,464,814 266 21,049 2,677 90.4

Norway 5,018,573 500 62,858 11,909 90.7

The Case studies: Tax and Seigniorage Revenues and Domestic Credit to the Private Sector

- Norway and Chile stands out in terms of their capacity to raise taxes and to extend credit to the private sector

- GCC group much better than the populous group in terms of credit to the private sector

- Seignioragerevenue only marginally higher in the populous group

Domestic Credit to the private sector (% of GDP)

Average Seigniorage Revenue (% of GDP)

Average Tax Revenue (% of GDP)

1990-99 2000-09 2010-12 1990-99 2000-09 2010-12 1990-99 2000-09 2010-12

Populous Group

Algeria 14.711.6 14.7 3.5 4.9 4.7 11.2 9.3 11.3

Sudan 2.98.5 11.6 3.4 2.3 3.1 6.3 6.5 6.4

Yemen 4.66.4 5.6 4.4 1.8 1.7 9.8 7.2 6.3

GCC

Oman 29.236.6 41.1 0.3 1.5 1.6 7.4 2.2 2.4

KSA 21.133.1 36.6 1.2 3.0 5.4 .. 0.5 1.0

UAE 29.947.4 66.0 0.8 2.7 1.9 .. .. 0.3

Comparator Group

Chile 53.980.2 98.4 1.4 1.6 2.2 17.8 17.2 18.5

Norway 60.2 76.0 .. 3.2 3.6 .. .. 27.8 27.4

Table 3: Government Debts and Assets

- UAE, KSA, Norway and Algeria GCC have incurred relatively small stocks of Debts, while amassing large assets in the form of SWFs and foreign reserves

- Sudan and Yemen have contracted large external debts, while maintaining little or no foreign assets

Government Domestic Debt (% of GDP)

External Debt (% GDP) Net Foreign Asset (billion current US$)

2012 2011-12 2006-2012

Populous Oil Arab Group

Algeria 8.2 1.9 191

Sudan 13.4 82.2 (0.1)

Yemen 28.4 64.4* 6.9

GCC Economies

Oman 2.0 4.0 16

KSA 3.7 15.7 685

UAE 17.1 38.2 773

Comparator Economies

Chile 34.2 43.9 29

Norway 29.4 - 465

The Case studies: Government Effectiveness and Regulator Quality

Chile and Norway stand out, but GCC is better than populous

Chile and Norway stand out, but GCC is better than populous

Fiscal Foundation of Monetary/Exchange Rate Regimes

Fiscal Foundations of ER Regimes

Three equations: FD/MD regimes Money supply=money demand:

(1)

The Phillips curve relation:(2)

The gov inter-temporal budget constraint:(3)

tttt YPrVM =,..)(

)( 11

−−

−= ttt

t YYPP β

∑∞

=+

−−− =

++

0,

111

jjtjtt

t

ttft sE

PBMB δ

Populous Oil are FD economies

Key features:

Persistent and high deficitsLimited capacity to raise tax revenuesLimited capacity to rein on public expenditureLikely to try to maximize the inflation tax

Implications of FD for Populous Economies

Policies for securing domestic monetary base for inf tax: monetary targeting with a managed and/or adjustable Intermediate exchange rate regimes: No hard peg or free floating

High inflationary tax- high tolerance for inflation Legal restrictions to boost the demand for base money

through: currency controls banking, financial and interest rate controls stock and bond market regulations

Stem inflationary pressures through exchange rate-based stabilization: likely to fail due to high inflationary inertia

Populous: some to no success for exchange rate stabilization

Sudan: collapse in 2011Devaluation, high inflation, RER appreciation

Algeria: de facto crawling band around the $ since 2005:Stability but without RER depreciation

GCC are MD economies

Open economies: trade, labor and capital markets de facto institutional hard peg and currency

convertibility Monetary policy free from FD, but credibility

hinges on resource rents and SWFs/reserves: High capacity to generate fiscal surpluses during oil

booms Can draw from Sovereign Funds and/or borrow during

oil busts Accommodating Fiscal policy of the sovereign choice of

the exchange rate regime

Implications of MD for the GCC

Oman: credible peg, low inflation, RER adjusting to fundamentals

KSA: credible peg, low inflation, RER adjusting to fundamentals

Benchmark (Chile, Norway) are MD economies

Strong fiscal institutions Fiscal rules Structural fiscal policy (e.g. Chile)

Strong capacity to undertake counter-cyclical fiscal policy

Diversified economies/strong non-resource lobbies requiring competitive exchange rates: Flex exchange rate regimes Strong fundamentals: IT without risking high

appreciation (e.g. Chile)

Implications of MD for the Norway and Chile

Chile: IT and low inflation; yet stable and competitive RER due to strong fundamentals

Norway: de facto band around the Euro, low inflation, stable RER

The GCC and the Comparators

GCC: the limits to the currency peg during episodes of divergent fundamentals from those of the anchor currency

Comparators: self-regulating equilibria

Counter-cyclical Fiscal Policy

Counter-cyclical fiscal policy and ER Regimes

Elusive goal for most developing countries, especially oil and other commodity exporters Decoupling episode- up to mid 2008: mismatch of the GCC with

the fundamentals in the US economy Key channel was excessive credit growth and low cost of

lending

Main results from the received literature (e.g. Frankel et al, 2011; Cespedes and Velasco, 2011) Weak institutions promotes fiscal pro-cyclicality Flex ER regimes promotes counter-cyclicality (why: Tornell and

Velasco, 2000) Reserves accumulation promotes counter-cyclicality

The empirical strategy : step 1

First a country-specific measure of cyclicality (Gavin and Perotti, 1997; Alesina et al, 2008):

(4) Dependent variable: three indicators

government expenditure/GDP primary fiscal balance/GDP fiscal revenue/GDP

Country-specific estimate of beta: boom and bust episodes1970-2011

itititiitiiit YYCdF εφβα +−++= − )( 1

The empirical strategy : step 2

Second, estimate a cross-sectional/panel determinants of Beta:

(5) The vector Z contains:

Exchange rate regimes (Dum_Peg, Dum_Inter, Dum_Float) An index of institutional quality (IQ) A dummy variable for SFI (DumSFI, such as SWFs) Oil and mineral rents per capita (Rentpc) International reserves (Resv/Imports)

W is a vector of bilateral interaction: SFIs x ER Regimes; SFIs x IQ; Rents pc x ER Regime; Stock of reserves x ER regimes

iiii WZ ηδδγβ +++= 21

ˆ

Counter-Cyclical Fiscal Policy: Main results

First, we corroborate the received literature: Reserves accumulation promote counter-cyclical fiscal policy with

regard to both fiscal expenditure and fiscal balance However, SWFs has no effect (effect confounded with reserves)

Second, exchange rate regimes, we find that: Intermediate regime does not seem to be more effective than the

fixed regime in terms of promoting countercyclical fiscal policy Floating regime appears to be more effective in promoting fiscal

balance counter-cyclicality than do the fixed regime However, they were less effective for the case of fiscal expenditure Nonetheless, floating regime appears to be more effective overall:

The response of revenues to flex regime was higher than the corresponding expenditure response

Counter-Cyclical Fiscal Policy: Main results (cond.)

Third, the baseline model suggests that higher oil rent per capita promotes counter-cyclicality for both fiscal balance as well as expenditure

Fourth, however, controlling for threshold effects suggests that: Highly resource endowed countries (GCC and Algeria) have better

capacity to mount countercyclical fiscal policy (Figure) Instead, On view of the relatively low levels of rents per capita in

Sudan and Yemen, their capacity to mount counter-cyclical fiscal policy is rather limited (Figure)

Resource Rents pc and threshold effects

VIETCHYEMCOLNIGSUDARGMALMEXALGECUDENIRNRUSCON

IRQTRIKAZAZEANGVEN

GABBAH

LIBOMA

SAUUAE

NOREQU

QAT

KUW

0.0

5.1

.15

fisca

l bal

ance

cou

nter

-cyc

lical

ity

0 10000 20000 30000 40000Oil Rent per capita

elastFB Fitted values

VIETCHYEMCOLNIGSUDARGMALMEX

ALGECUDENIRNRUSCON

IRQTRIKAZAZEANGVEN

GABBAH

LYBOMA

SAUUAENOR

EQUQAT

KUW

-.1

5-.

1-.

05

0E

xpe

nditu

re c

oun

ter-

cycl

ica

llity

0 10000 20000 30000 40000Oil rent per capita

elastexp Fitted values

GCC vs Populous GCC vs Populous

Counter-Cyclical Fiscal Policy: Main results (cond.)

Fifth, once we control for the interactive effect, counter-cyclicality of the resource rents is conditional on high level of institutional quality, as measured by the ICRG index: This finding constitutes an important qualification to the above

results, in that counter-cyclicality of resource rents could no longer be obtained as an unconditional effect (Figure)

In this context, we find that, unlike the populous oil group, the prevailing institutions in the GCC are good enough to allow them manage their resource rents in a way that: promote counter-cyclicality of fiscal balance However, fall short for the case of the case of fiscal expenditure (Figure)

Resource Rents pc and threshold effects

GCC, Comparators and Populous

GCC, Comparators and Populous

ALG

BAH

IRN

IRQ

KUW

LYB

OMA

QAT

SAU

SUD

UAE

YEM

-.0

20

.02

.04

.06

.08

Fis

cal B

ala

nce

co

un

ter

cycl

icalit

y

.3 .4 .5 .6 .7ICRG Index

elastFB_ICRG Fitted values

ALG

ANGAZE

ARG BAHCOL

CON

DEN

ECU

GAB

IRN

IRQKAZ

KUW

LYB

MALMEXNIG

NOR

OMA

QATRUS SAU

SUD TRIUAE

VEN

VIEYEM

-.1

5-.

1-.

05

0.0

5.1

Exp

end

iture

Cou

nte

r C

yclic

alit

y

.2 .4 .6 .8 1ICRG Index

partEX Fitted values

Recapitulation

The populous oil Arab economies need to work on the basics: Better and more stable and predictable institutions Break free from fiscal dominance (political economy

considerations)

So far, the de facto hard currency peg has served the GCC so well: However, they need to rethink the optimality of the regime as

their economies becomes more complex and more diversified Eventually, they also need to establish explicit fiscal rules and

high technical capabilities for conducting monetary policy (Chile, Norway)

Thank You