It Takes Two Functioning Cylinders to Operate the Macroeconomic Locomotive - Economic Research Forum (ERF)

It Takes Two Functioning Cylinders to Operate the Macroeconomic Locomotive

The Fiscal-Monetary Interdependence in Oil-Dependent Arab Economies

This blog is written by Ibrahim Elbadawi, director of the Macroeconomics Research and Forecasting Department at the Dubai Economic Council and Research Fellow at ERF

As part of the ERF research theme on “natural resource management and economic diversification”, the research project on “Monetary and Fiscal Institutions in Resource-Rich Arab Economies” addresses, among other issues, the interdependence between fiscal and monetary institutions. In this context, the research considered the two central policy questions of the fiscal foundation of the choice of exchange rate and monetary regimes and the capacity of fiscal and monetary institutions to conduct counter-cyclical fiscal policy during oil busts and booms. These two issues are of profound policy relevance to the oil-dependent Arab economies. Also, they have been the subject of high profile academic research in the context of the paradigm shift of monetary economics research toward focusing on the fiscal-monetary policy interdependence and on institutions and regimes rather than just policies.

What is fiscal dominance?

In fiscally dominated economies (FD), exchange rate regimes are determined by fiscal, not monetary considerations. This is because such countries are likely to be characterized by persistent and high deficits; limited capacity to raise tax revenues; limited capacity to rein on public expenditure; and hence likely to try to maximize the inflation tax. To stem the tendency of the economy to experience persistent inflationary pressures, they resort to exchange rate stabilization by adopting fixed or heavily managed exchange rate regimes. However, due to the high inflationary inertia (i.e., inflation today fueling expectations of higher inflation in the future), exchange rate stabilizations in FD economies often times fail, leading to devaluation crises and further inflationary pressures. Therefore, credible monetary and exchange rate regimes require that economies be free from fiscal dominance.

What is counter-cyclical macroeconomic policy?

Fiscal and monetary policy should be deployed to counter temporary external economic shocks. For example, in oil-dependent economies, fiscal expansion (contraction) and/or lower (higher) interest rates and depreciated (appreciated) currencies would be required during oil busts (booms) in order to insulate the non-oil sectors of the economy from oil and other external shocks and stabilize aggregate demand and inflation.

How inter-dependent are fiscal and monetary policies in resource-dependent economies?

The high volatility of oil economies requires viable fiscal ‘shock absorber’ under less flexible exchange rate regimes (e.g. GCC); and, under flex regimes, high revenue volatility require strong stabilizing fiscal institutions. On the other hand, fiscal adjustment alone can be relatively ineffective or very costly (in terms of the fiscal resources used) when the rate of interest or exchange rates are not available as policy instruments, as in the case of institutional peg to a global currency, as in the case of the GCC. This can be particularly problematic during episodes of divergent fundamentals between the anchor and pegging economies, as happened during the de-coupling phase (prior to mid-2008) of the recent global economic crisis when the Fed’s low interest rates policy provided much needed stimulus to the US economy, but caused inflationary pressures in the GCC, which, instead, needed higher, not lower, interest rates to counter the consequences of the oil boom.

So, how are these issues addressed?

We analyze the fiscal dominance issue for a sample of six Arab oil economies and two comparators: Oman, Saudi Arabia and the UAE from the highly resource endowed GCC; the relatively populous Algeria, Sudan and Yemen, with far less rent per capita than the former group; and, the two non-Arab resource-dependent countries of Chile and Norway. These two comparators provides a useful contrast to the Arab group in terms of their vastly superior fiscal institutions and sophisticated capabilities for conducting monetary and exchange rate policy, which allow macro stabilization under flexible exchange rate and open capital account regimes. For the counter-cyclical fiscal policy a two-step standard empirical model was estimated and used for assessing the nature and extent of cyclicality (or lack thereof) and its potential determinants, using a global panel data base of oil and non-oil countries over 1995-2012. The findings of the global regressions were subsequently articulated for the case of the eight country case studies.

And, what are main results and the key policy recommendations?

We find that flex exchange rate regimes promotes counter-cyclicality of fiscal policy. We also find that there exists a threshold effect for oil rents per capita, below which countries tend to be subject to fiscal dominance and pro-cyclical fiscal policy. However, the non-monotonic rent effect is conditional on the existence of robust and strong economic governance institutions. Therefore, due to their low rents per capita and relatively weaker economic governance, the fiscally dominated countries of Sudan and Yemen were outperformed by the GCC as well as Algeria.   The latter managed to sustain credible de facto pegged exchange rate regimes and convertible currencies (for the GCC) or graduate to flexible regime (for Algeria). Instead, the former had to abandon their pegged regimes as a result of their unsuccessful exchange rate-based stabilization programs. However, the contrast with resource-dependent Chile and Norway suggests that for the Arab oil economies to accommodate future oil busts, as well as cope with the emerging low long-term ‘equilibrium’ price of oil, they need to establish explicit fiscal rules and high technical capabilities for conducting monetary policy.   In particular, the populous oil Arab economies would need to focus on the basics: develop predicable and stable fiscal and monetary institutions to eventually break free from fiscal dominance. On the other hand, the GCC would need to think seriously about more flex exchange rate regimes in the future, in view of the lingering risks associated with the institutional peg to the dollar- including the problems of divergent fundamentals and the burden of relying only on fiscal adjustment as a counter-cyclical policy institution.