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Institutions and Macroeconomic Policies in Resource-Rich Arab Economies$

Kamiar Mohaddes, Jeffrey B. Nugent, and Hoda Selim

Print publication date: 2019

Print ISBN-13: 9780198822226

Published to Oxford Scholarship Online: July 2019

DOI: 10.1093/oso/9780198822226.001.0001

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Objectives, Issues, and Findings

Objectives, Issues, and Findings

Chapter:
(p.1) 1 Objectives, Issues, and Findings
Source:
Institutions and Macroeconomic Policies in Resource-Rich Arab Economies
Author(s):

Kamiar Mohaddes

Jeffrey B. Nugent

Hoda Selim

Publisher:
Oxford University Press
DOI:10.1093/oso/9780198822226.003.0001

Abstract and Keywords

This volume aims to improve our understanding of the problems of macroeconomic management in oil-rich Arab economies. In doing so, it emphasizes the role of institutions and the political economy environment underlying them. Most importantly, it attempts to assess the effectiveness of these institutions in delivering macroeconomic stability and growth in the face of commodity price volatility, comparing actual practice in the Arab region with the budgeting procedures and countercyclical fiscal policies and rules shown to be successful in other parts of the world. The analysis here, however, goes considerably beyond that. It utilizes a political economy perspective to explain how budgeting and other fiscal policies are designed and implemented by political and administrative actors in ways that distinguish budget surpluses from deficits and pro-cyclicality from counter-cyclicality. Second, it includes monetary institutions and exchange rate regimes, and the interactions between both of these and both fiscal and political institutions.

Keywords:   fiscal policies, fiscal institutions, exchange rate regimes, political economy, Arab economies

1.1 Introduction

According to the resource curse paradox, an abundance of natural resources is believed to be an important contributor to economic failure in oil-rich countries, including those of the Arab World. There are different explanations for why resource-rich economies (RREs) might be subject to a curse. Dutch disease (see Corden and Neary 1982; Neary and van Wijnbergen 1986; Krugman 1987) is one of the channels through which the resource curse makes itself felt: an increase in natural resource revenue leads to an appreciation of the real exchange rate, which raises the cost (in foreign currency) of exports of products of other industries, making them less competitive, with possible negative effects on economic activity. Economic growth might also be adversely affected by the resulting reallocation of resources from the high-tech and high-skill manufacturing sector to the low-tech and low-skill natural resource sector. Another explanation for the resource curse paradox focuses on political economy considerations and argues that large windfalls from oil and other resources create incentives for rent-seeking activities that involve corruption (Mauro 1995; Leite and Weidmann 1999), voracity (Lane and Tornell 1996; Tornell and Lane 1999), and possibly civil conflicts (Collier and Hoeffler 2004).1

Empirical support for the resource curse was originally provided by Sachs and Warner (1995), who revealed the existence of a negative relationship between real GDP growth per capita and different measures of resource abundance, such as the ratio of resource exports to GDP, even when controlling for (p.2) institutional quality. However, the empirical evidence on the resource curse paradox is rather mixed and there are also a number of grounds on which the econometric evidence of the negative effects of resource abundance on growth may be questioned; see, for instance, Cavalcanti et al. (2011a, 2011b) for an extensive discussion. While focusing on the negative growth effects of commodity abundance or dependence, with a few exceptions, most studies overlook another important channel, the volatility channel. Taking this into account, recent papers argue that the so-called resource curse may be more attributable to the volatility in commodity prices than to the abundance of the resource itself (Van der Ploeg and Poelhekke 2009; Cavalcanti et al. 2015).

A number of recent empirical works have also focused on the role of institutions. Mehlum et al. (2006), using a cross-sectional approach, show that the impact of natural resources on growth and development depends primarily on institutions, while Boschini et al. (2007) illustrate that the type of natural resources possessed is also an important factor. This suggests there are levels of institutional quality above which resource abundance becomes growth enhancing.2 Moreover, Collier and Hoeffler (2009) show that the implementation of a system of checks and balances is necessary to limit abuse of political power and hence the misuse of resource rents, even in the presence of a democratic system. In other words, only RREs with strong political checks and balances (such as Norway) are able to turn natural resource endowments into a blessing.

In a recent volume, focusing on the unique features of the Arab World, Elbadawi and Selim (2016) identify some of the most important symptoms of the resource curse in the region (including excessive pro-cyclicality, slow growth, and inefficiency in resource allocation), their determinants (including governance and other institutions), and the relationship between both the determinants and the symptoms. They conclude that weak institutions in the Arab World are the root cause of the resource curse and its macroeconomic ramifications, or, in other words, that the Arab world suffers from an “institutional curse.” Elbadawi and Soto (2016) also show, however, that RREs with a high degree of inclusiveness (a measure of democracy) and strong political checks and balances can turn the curse into a blessing. Empirical results by Selim and Zaki (2016) confirm that appropriate political institutions can reduce the negative effect of natural resources on growth, but do not entirely offset it. Weak institutions in the Arab World have predated resource discoveries and have had adverse effects on macroeconomic policies since then; oil has only consolidated this weak institutional setup (Galal and Selim 2013).

(p.3) Building on this first wave of research, a second wave has focused on the role of institutions (economic as well as political) in mitigating the associated curse effects, and on identifying the institutional design elements that would shield economies from commodity price volatility and facilitate appropriate macroeconomic policies. To this end, in 2014 the Economic Research Forum (ERF) initiated a major multifaceted project on the role of such institutions in macroeconomic policies and outcomes in resource-rich Arab economies. The research is based on the premise that macroeconomic policies depend on the political economy context within which macroeconomic institutions are developed and operate. In fact, commodity exporters with weak institutions tend to become “rentier states”—a concept put forward by Mahdavy (1970) and Beblawi and Luciani (1987). Natural resources provide their governments with the means to benefit their supporters and buy political consent with privileges. When government accountability is lacking, resource booms allow politicians to expand public sector employment or to directly boost private consumption to enhance their popularity (Robinson and Torvik 2005; Robinson et al. 2006). They can also afford to apply low tax rates and thereby reduce the pressure for accountability. Resource rents thus break the link between taxation and representation suggested by Tilly (1975), thereby contributing to both inefficiency and lack of representation of the citizenry in government.

So far, the economies of Arab oil exporters have been very much at the mercy of the ebbs and flows of oil prices as their macroeconomic institutions (both fiscal and monetary) have fallen short of delivering macroeconomic stability in the face of oil price shocks. Fiscal and monetary institutions are of prime and timely importance for the Arab World for each of the following reasons.

First, the decline in oil prices (which began in 2014 and which many believe is the new normal for the oil market) could undermine the capacity to conduct the kinds of effective macroeconomic policies required to weather this shock.3 Indeed, the lower oil prices and hence fiscal revenues are putting pressure on exchange rates and public finances in some Arab economies, with dire implications for the sustainability of even the most essential public expenditures for health and education. Growing deficits and debt are also likely to limit the fiscal space for countercyclical policies during the coming years.

Second, with pegged exchange rate regimes, fiscal policy is the main short-term tool available to achieve real stabilization and to hedge against revenue, expenditure, and growth volatility induced by commodity price shocks. (p.4) Empirical work has shown that in countries where the oil sector is large in relation to the economy, fiscal policy—through hydrocarbon revenues—tends to exacerbate output cycles and is the main channel through which commodity prices affect the economic cycle. Husain et al. (2008) show that, once fiscal policy changes are isolated, oil price shocks do not have a significant independent effect on the economic cycle.

Third, potentially at least, appropriate fiscal policy could serve as the means of achieving long-term development objectives. These include much-needed diversification (Diop et al. 2012; IMF 2016) and the optimal savings and investments needed to ensure intergenerational equity and income sustainability if and when resource prices decline for a long period of time or reserves become exhausted. These long-term objectives require that fiscal policy plays a more effective role in allocating resources through public investment to productive uses outside the natural resource sector, including in both efficient human capital and infrastructural development. Moreover, diversification needs to be accompanied by effective private sector-led industrial growth and technological upgrading in non-resource tradable goods sectors.

The present volume, therefore, provides an understanding of macroeconomic institutions (including their underlying rules, procedures, and institutional arrangements) in oil-rich Arab economies, and of the political economy environments in which they operate, which has largely been overlooked in previous research. More particularly, the objective of the research is to identify and assess the effectiveness of these various institutions in delivering macroeconomic stability and growth against commodity price volatility.

Since one branch of the literature has identified fiscal institutions, and, in particular, appropriate budgeting procedures and countercyclical fiscal policies and fiscal rules, as being of crucial importance in allowing countries like Chile and Norway to successfully cope with commodity price volatility and reduce corruption (Frankel 2011; Schmidt-Hebbel 2016), clearly budgetary procedures and rules and, more generally, fiscal institutions need to be carefully analyzed in the current volume (Alesina et al. 1996; Dabla-Norris et al. 2010). But the analysis has to be much broader than this so as to appreciate how political arrangements (electoral rules and rules governing the separation of power structures among others) can be important in distinguishing budget surpluses from budget deficits and pro-cyclicality from counter-cyclicality (Persson et al., 2000; Van der Ploeg 2011). Moreover, it also has to be extended to include monetary institutions (optimal monetary policy and degree of central bank independence), exchange rate regimes, the interactions between all of these, and, as indicated, political institutions. A political economy perspective is also included to explain how budgeting is accomplished and to link political and administrative actors to the policies adopted and their shortcomings.

(p.5) 1.2 Contributions

This volume contributes to the literature along the following two dimensions. First, the regional focus on the Arab World fills an enormous research gap as this area has been largely understudied. The dearth of attention to the Arab region is puzzling given how natural resources, especially oil and gas, have affected its economic, export, and fiscal structures (from, for some, as early as the 1930s to the present). It is also strange given that the oil and gas reserves of this region account for more than half of the global totals. Moreover, since the cost of extraction is among the lowest in the world, many Arab countries have not yet begun to search for reserves in deeper, offshore locations, or other areas where production is likely to be costlier. An important contributor to why this region is understudied is the insufficiency of informational disclosure by governments in general and especially fiscal institutions. Hence, an important contribution of this volume is to reveal more detailed information concerning the problems and policies in oil-exporting countries of the region.

Second, this volume offers a novel political economy analysis that features the way in which resource endowments affect political regimes and the choice of macroeconomic institutions and policies in Arab oil-rich economies. It is not enough to identify the optimal set of institutions, given the important political economy constraints hindering macroeconomic reform in Arab oil exporters. For this reason, an entire chapter is dedicated to the political economy context and most chapters (including all case studies) provide a political economy understanding of fiscal outcomes, so that the political economy analysis is woven throughout the volume. Such a perspective is, of course, fitting for any study attempting to add to our understanding of the Arab World.

The four main questions to be addressed in this volume are: (i) Do institutions (both political and economic) impact macroeconomic policies in Arab oil exporters, and if so how? (ii) What are the main features of the macroeconomic institutions (fiscal, monetary, and exchange rate regimes) that are most effective in mitigating commodity price volatility, growth volatility, inefficiency in expenditure allocations, and corruption? (iii) How well are existing fiscal institutions performing in terms of fiscal policies and outcomes? (iv) When fiscal institutions are not performing well, what should be done about this?

Attempts at answering these questions will be presented in all chapters of this volume. To the extent possible, the analysis tries to distinguish between two groups of countries: the six Gulf Cooperation Council (GCC) economies (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE)), which enjoy high rent per capita, and populous countries, like Algeria, Sudan, and Yemen, which have significantly lower rent per capita. While the (p.6) GCC economies are significantly richer in terms of resource wealth as compared to the populous economies, there are some important country variations within the group. Three GCC countries—Saudi Arabia, Kuwait, and UAE—alone hold approximately a third of world proven oil reserves, with all GCC countries but Bahrain being among the top 30 global oil producers. Moreover, Qatar, Saudi Arabia, and UAE are among the top ten countries with proven natural gas resources. This wealth translates into significant resource rents (Figure 1.1). As for the second “low rent per capita” group, it holds less than 2 percent of oil reserves and controls less than 3 percent of production. Algeria has the tenth largest natural gas reserves in the world but its fields are maturing. Sudan and Yemen are considered relatively small and mature oil producers, where fields are in natural decline and resource horizons are short.4

Objectives, Issues, and Findings

Figure 1.1 Natural resource rents (% of GDP), averages over 1980–2016

Note: Syria’s figures are until 2007 only, and Yemen’s data starts in 1990.

Source: Authors’ calculations based on World Development Indicators, 2018.

This volume is designed to complement recent academic books and articles on the subject. For example, the book by Humphreys et al. (2007) emphasized institutional and contractual issues related to oil extraction and management. However, these works have not addressed Arab region-specific issues, even though their analysis is inherently relevant to that region. Arezki et al. (2012) look at the challenges of commodity price volatility for low-income countries and explore some macroeconomic policy options for responding to commodity price shocks. A World Bank Report by Diop et al. (2012) on diversification and structural transformation in MENA countries focuses on the role of macroeconomic factors and policies, including the real exchange rate and fiscal policy in promoting (or not) diversification away from oil. Other relevant (p.7) works include those of Ehteshami and Wright (2008), Pelzman (2012), Ben Ali (2015), and Cammett et al. (2015), but these range from being largely political science-oriented to general economic surveys which do not deal with oil and macroeconomic policy in much detail.

In particular, the volume builds on Elbadawi and Selim (2016), which is also almost exclusively focused on the Arab World and which concludes that this area is more cursed by institutions than by natural resources, and that political and institutional reform are important in order to escape the curse. While Elbadawi and Selim (2016) broadly investigated the interactions between the quality of political institutions and natural resource wealth in explaining macroeconomic outcomes, they did not address the role of specific macroeconomic institutions in shaping economic policies and outcomes. The present volume intends to fill this gap.

1.3 Main Findings

This volume argues that it is weak institutions (including political ones) that explain, better than the commodity price volatility itself that is so endemic to oil exporters, why macroeconomic policies in oil-exporting countries are often ineffective and hence why outcomes (such as inflation, growth, economic volatility, allocative efficiency, sustainability, and diversification) are often extremely disappointing.

Part I argues that the quality of institutions governing macroeconomic policy (including political, fiscal, and monetary institutions) matter more than the abundance of oil and gas revenues for macroeconomic policies and outcomes, including long-run growth and stability, in oil exporters.

Part I begins with Chapter 2, which examines the political economy considerations that underpin both monetary and fiscal policy choices in oil-exporting countries. It argues that fiscal policies can serve as a better means than monetary policy for rewarding the elites whose support is needed for governing bodies to remain in power. Regime stability is such a priority that the oil price and external political shocks that such regimes face can induce them to display extremely procyclical spending in the face of positive shocks but to refuse to adjust their public spending downward when prices fall. This political economy perspective also explains why fiscal spending is so volatile and consumption oriented since public sector jobs at high wage rates and birth-to-death subsidies are what matter to those whom governments want to please.

Chapter 3 argues that volatility in oil revenues, combined with poor governmental responses to this, drives the resource curse paradox, not the abundance of oil revenues as such. More importantly, it establishes that there (p.8) is a role for institutions and the government (fiscal policy) in offsetting some of the negative growth effects due to the volatility curse.

Chapter 4 examines the links between institutional quality, resource wealth, and macroeconomic policy choices and outcomes in Arab commodity exporters. It argues that resource wealth, together with the quality of institutions, explain macroeconomic policy choices, including fiscal counter-cyclicality. The chapter provides evidence of a conditional effect of rents per capita on the latter. The positive effect of natural resources on the ability to implement countercyclical fiscal policy is enhanced as the quality of institutions improves. In other words, there is a threshold level of institutional quality above which resource rents promote fiscal counter-cyclicality and vice versa. This might explain why countries with low oil rents per capita like Sudan and Yemen have had to abandon their pegged regimes as a result of their unsuccessful exchange rate-based stabilization programs, whereas the GCC countries and Algeria, with much larger rents per capita, have managed to sustain more credible managed exchange rate regimes.

Part II identifies the features of effective macroeconomic institutions which can contribute to reducing the volatility that stems from large commodity trade shocks.

Chapter 5 argues that the low level of central bank independence in Arab oil exporters reflects institutional arrangements that allow the executive branch to influence, interfere with, and, in some cases, dominate central bank operations. Interestingly, the chapter argues that, in a context of weak institutions, central bank independence (CBI) has not always mattered for macroeconomic policy outcomes in such countries. In fact, GCC central banks, which are considered slightly less independent in de jure terms, delivered better macroeconomic performances than those of the populous group. On the one hand, CBI mattered less for the GCC because the credible peg discouraged policy discretion and was a good substitute for it. On the other, soft peg arrangements in the populous economies in a context of weak institutions and in the absence of a de facto independent central bank led to discretionary policymaking and therefore disappointing monetary policy outcomes.

Chapter 6 suggests a novel policy proposition for achieving countercyclical policy—by tying the fixed exchange rates of GCC countries to a broader basket of the dollar, the euro, and the oil price, called a “currency-plus-commodity basket” or CCB. It performs a counterfactual analysis which shows that these countries would have been considerably more stable under the proposed CCB than under the fixed exchange rate regimes that were actually practiced. The practical application of the proposed CCB reform is then facilitated by a careful discussion of how it could be efficiently implemented.

Chapter 7 complements Chapter 6 by presenting empirical findings confirming the relationship between resource rents, alternative monetary regimes, and (p.9) economic performance. It shows that resource abundance leads to higher growth, while oil dependence, captured by a high level of export concentration and/or being an oil exporter, reduces growth relative to diversified and/or non-oil exporters. Resource rents, including oil and gas, lead to higher inflation, while oil dependence has a dampening effect on inflation. The results confirm that exchange regimes matter for the long-term performance of an RRE. Countries with floating exchange regimes tend to have lower growth and higher inflation than those with intermediate exchange rate systems, but being an oil exporter helps mute the inflationary effect of floating exchange rate regimes. On the other hand, while fixed exchange rates do not have a significant direct effect on growth, they help dampen the negative effect of inflation on growth and lead to lower inflation.

Chapter 8 confirms some of the earlier findings concerning the oil curse, with respect to the tendency of natural resource-rich countries to overspend or spend inefficiently. It argues that this is because oil revenues go directly to the government without passing through the hands of the citizens. Without citizen knowledge or scrutiny over oil revenues, governments have greater leeway in spending, often resulting in waste and fraud. It shows how oil rents are negatively, and taxation is positively, associated with accountability, and that accountability is associated with better public expenditure outcomes. To overcome the lack of accountability and also enhance public spending efficiency, the chapter suggests transferring oil revenues directly to citizens and then taxing them.

Chapter 9 pulls together a number of different problems apparent in Arab oil-exporting countries. It begins by tracing the evolution of fiscal and other institutions over time since the countries’ pre-oil days, through the discovery of oil to their build-up of oil exports. The chapter then identifies the unfortunate outcomes (such as excessive subsidies and the generation of government jobs with high salaries and fringe benefits) from oil revenues and their management in less than optimal institutional conditions. Finally, it identifies policy reforms, which, if implemented successfully, could go a long way toward helping the resource-rich countries of the Arab region and elsewhere to avoid the resource curse. In some cases, however, these policy proposals may give rise to important tradeoffs that will have to be evaluated carefully in individual cases.

Part III assesses the performance of current institutional arrangements in three quite different Arab oil exporters, two from the GCC (Bahrain and the UAE) and one from the larger and more populous group of Arab countries (Sudan). The case studies delve deeper into specific countries and serve the twin objectives of explaining both their budgetary institutions and their outcomes in terms of economic volatility and growth, as well as the quantity and quality of public goods. It does so by integrating into the analysis the (p.10) economic and political factors that have affected the quality of institutions. They also include country-specific strategies for turning a resource curse into a blessing for development. All three case studies provide political economy analyses of budgetary outcomes.

The Sudan case study (Chapter 10) provides an insightful political economy perspective on the effects of political institutions on fiscal policy outcomes and their mechanisms of perpetuation. The chapter traces the evolution of fiscal and political institutions over much of Sudan’s history from colonial times through independence to the present. The chapter describes the economic and political strategies that Sudan’s leaders have employed at different times to develop specific sectors, first cotton (with irrigation), and then oil and gold. In both cases, these sectoral development strategies were designed in such a way as to generate the public revenues with which to finance the costly infrastructural investments needed to develop these sectors without having to impose income or other taxes on the people, thereby helping to keep all groups in the country together. The institutional frictions induced by these strategies have led to important social, political, and even military conflicts.

Chapter 11 focuses on the Kingdom of Bahrain, a small GCC country, which was one of the first to discover oil and make use of the revenue to finance diversification away from oil. The chapter argues that political economy factors, rather than oil wealth per se, shape the budgetary process and outcomes in Bahrain. The fiscal volatility and excessive current spending (in the form of wages, social welfare, and subsidies) that have led to unsustainable non-oil deficits cannot be blamed entirely on oil price volatility. Instead, weak institutions, including those underlying the budgetary process, have contributed to fiscal laxity. They have allowed rulers to use current spending as a channel for the redistribution of oil rents and to secure political stability and allegiance to the regime in a turbulent sociopolitical environment. The budgetary process has been undermined by the structure of the bicameral parliament and the absence of restrictions on parliament’s ability to amend the budget and weaken the position of the executive. Given the general context of limited transparency and accountability, while the government may be exercising its discretionary powers over the budget execution, this cannot be known for sure.

Finally, Chapter 12 on the UAE provides a novel political economy explanation of its fiscal institutions, in which, rather uniquely, the oil wealth belongs exclusively to the individual emirates within which it is located, rather than to the federation of emirates which constitute the UAE. The chapter claims that the perceived limitations of the current situation are actually the result of a delicate equilibrium among the emirates to share oil wealth in a politically amicable way and raise political support for government policies. The chapter develops a political economy model, which is a variant of the authoritarian (p.11) bargain model. The model identifies a lack of transparency and weak budgetary institutions as key strategic outcomes that prevent the UAE’s various citizens from being able to understand exactly what share of the oil revenues they are receiving, thereby allowing the bargain to be maintained without challenge. The political economy analysis explains why fiscal adjustments tend to fall largely on infrastructure and capital expenditures, rather than the small local population, which is shielded from economic downturns.

The findings of this volume suggest that for resource-rich Arab countries to move forward, they must introduce effective political reforms accompanied by a strong system of political checks and balances. Stronger and more appropriate political institutions should trigger reforms in fiscal institutions that would improve information availability, accountability in revenue management, the management of natural resources, achieve more savings, and implement more effective public spending programs. It is recognized, however, that, as is often the case with policy reforms, “no one size is likely to fit all” and that in many cases there are important tradeoffs in objectives which have to be evaluated. As oil exporters adapt to a new normal of low oil prices, the sustainability of fixed exchange regimes are unlikely to be guaranteed without sound macroeconomic institutions. Stronger institutions and effective accountability mechanisms are needed to insulate central banks from political pressures.

Acknowledgments

This chapter was written before Hoda Selim was employed by the International Monetary Fund (IMF). The views expressed here are those of the authors and do not necessarily represent those of the IMF or IMF policy.

References

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Notes:

(1) See Sachs and Warner (1995) and Rosser (2006) for an extensive examination of these prominent accounts of the natural resource curse paradox.

(2) See also Persson and Tabellini (2003), Leong and Mohaddes (2011), Jarrett et al. (2018), and Mohaddes and Raissi (2017).

(3) Mohaddes and Raissi (2018) illustrate the macroeconomic consequences of the low oil price environment for the global economy in general and the Middle East and North Africa (MENA) region in particular, in terms of its effects on real output, oil prices, and financial markets. See also Esfahani et al. (2014).

(4) The secession of South Sudan in 2011 resulted in a permanent shock to Sudan because the bulk of its oil wealth was located in South Sudan. As a result, Sudan lost 75 percent of its oil production, nearly 55 percent of its fiscal revenues, and about two-thirds of its foreign exchange earnings (IMF 2013b).