political institutions and macroeconomic outcomes in arab oil-rich economies - adeel malik

The Political Economy of Macroeconomic Policy in

Arab Resource-Rich Economies

Adeel Malik University of Oxford

[email protected]

Arab Fund for Development Kuwait

November 2015

Adeel Malik PE of Macroeconomic Policy - 1

mailto:[email protected]

Introduction

Politics is a central dimension of macroeconomic policy: policy choices are partly determined by political choices This presentation assumes knowledge of the global literature and basic MENA patterns Focus on fiscal and financial policies, and linkages between different aspects of macro policy Shock-prone, but resilience depends on deep pockets rather than sound institutions


Fiscal policy – the centrality of politics

FP can be construed as an articulation of the political and social bargain with the population – or the nature of underlying political settlement Acts as a prime means of rent distribution to citizens and elites Patronage commitments to purchase consent (downwardly sticky but evolving upward adjustment) => manifested through pro-cyclicality FP mostly about spending, not taxes; in state capacity terms, Arab RREs are not extractive states Reflection of state autonomy (esp. with a weak tax effort) – but this autonomy is variable over time


KEY DECISION NODES – with political economy implication ACCRUAL OF RESOURCE REVENUES

- How and where do resource revenues accrue? - Are they transparently published and recorded - Important for determining the extra-fiscal space

SPENDING How much to spend? What determines the composition and variability of spending? How much to save and how? TIME INCONSISTENCY Focus on structural misalignment of incentives Optimal political responses in periods of low oil prices may not be the same as those in boom periods


COMPOSITION informs us about the nature of distributive commitments

- Distribution to citizens, elites and external patrons - Resources for repression and distribution

RREs typically spend substantial sums on social services and other patronage commitments: crucial for understanding the politics of the middle class

- salaries and subsidies - Health, education, social services - Housing loans

In GCC states between 40-60% of government budgets are consumed by wages and social service provision


Historically embedded political economy of urban provisioning Pro-rich bias of subsidies + resistance to subsidy reform => rooted in a dependent middle class constituency, role of rent-seeking intermediaries, etc. INFRASTRUCTURE: Driven by the politics of development and rent distribution to elites; Debate largely centres around “white elephant projects” with low-returns; Determinants of project selection? How important is connected capital?


VARIABILITY – provides us a sense of more binding political commitments Initial fiscal bulge explained by middle class nationalism, early investments in human development, etc. In times of adjustment, some expenditure commitments are more binding than others:

- Civil-service wages and subsidies more resilient in RREs

- Health and education spending is similarly resilient

- Robust spending on “coercive apparatus” even during downturns

- Investment spending sharply curtailed during busts


Fiscal dynamics entail an important commitment problem How to commit rulers to prudent fiscal policy during boom years? In non-Arab RREs where political turnover is generally higher the issue is largely about inconsistent fiscal incentives of different political govts. Given the greater regime durability in Arab RREs long-run fiscal sustainability is more important issue Despite growing concerns about fiscal sustainability there are limited political incentives for any individual ruler to contain spending LOGIC: even if the prevailing fiscal regimes re unsustainable over the long-run they are sustainable over the lifespan of the individual ruler


The politics of fiscal adjustment Mainly relevant in labour-abundant Arab RREs (e.g., Algeria) Declining public spending => erosion of the social contract => Middle class grievance Burden of fiscal adjustment fell disproportionately on middle classes and the poor. Essential for understanding the age of protest politics The ability of Arab RREs to ride through the political crisis is based on oil resources, not good institutions Ability of withstand shocks rests almost completely on the available resource envelope


Pro-cyclicality of FP Pro-cyclicality: reflects the importance of political, rather than economic, smoothing; driven by the imperative of regime stability

- Subsidies and salaries => rise disproportionately with rising oil prices, but show downward stickiness

- FP also drives cycles in public and private investment

- Growing expenditure commitments during good times => depleting fiscal buffers => limited ability to absorb shocks


Counter-cyclical policies are partly rooted in the political objective function

- Underlying political settlement and social contract

- Few constituencies with countervailing powers

- Strength of the “Sovereign” relative to productive sectors of the economy/autonomy

Weak role of automatic fiscal stabilizers => Asymmetric adjustment of expenditures and revenues

Expenditures respond more quickly to oil price cycles than revenues


Comparing the two oil price booms: Is there any evidence of social learning? Infrastructure spending is more restrained relative to the first oil boom Evidence of higher savings in good times than before – extensive reliance on stabilization Funds (size in GCC: approx. $1.8 trillion)

- Continuing issues of transparency; operations of SWFs are usually opaque;

- Withdrawal rules are usually neither well-spelled out nor adequately implemented;

- Debate over form versus substance - Overseas investments of SWFs: part of investment/diversification

strategy or “external commitments”?


Mapping the “de facto” FP regime - I Importance of off-budget spending across the Arab RREs Have limited knowledge of the functioning of budgetary institutions Quasi public spending through public sector enterprises also relatively unexplored Large components of spending evade fiscal accounting Examples abound: land sales, tax benefits, oil and budgetary support for neighbours, military spending, military purchases, etc. Contingent liabilities in the geo-political domain


Mapping the “de facto” FP regime - II Tight segmentation between the affairs of the Ministry of oil and the Treasury; both are governed by different decision logics

- Finances of state petroleum companies not disclosed - Is there high level of resource fungibility in the former? - What is the number and strength of veto players in the system?

Additional complication: limited distinction between whether oil is a public or private wealth Fundamental Q: Where does the authority for fiscal decisions rest? Who are the veto players?


Financial Sector – Common Pathologies

Banks are largely state-owned; limited/selective liberalization

Boundaries between the public and the private are blurred (high concentration of banking sector assets)

Credit allocation and financial intermediation are often politically

controlled (whether through explicit or implicit means);

Domestic debt market remains under-developed;

High reserve requirements: volatility avoidance is the dominant concern;

Weak regulatory framework


The politics of finance

Financial sector can be construed as providing a:

SOURCE of rents

- Rents generated through FS liberalization (control of licenses);

- financing oligarchic interests masquerading as the public sector

MECHANISM for rent distribution

- Subsidized loans for consumers (esp. Housing-related)

- Targeted sectors: SME, agriculture, other preferential sectors

Financial Sector usually

- acts as the principal intermediary between the state and the rest of the economy;

- serves more a distributive rather than a productive function


Beyond crude markers of financial development

Many Arab RREs have relatively deep financial structures

- one of the highest deposits to GDP ratios

- extends reasonably high levels of credit

- high levels of financial openness (except for Iraq, Algeria and Yemen).

HOWEVER: financial depth does not translate into financial access

- Large deposit base of banks but limited credit to the private sector

- One of the most concentrated loan portfolios in the world (Ratio of the top 20 exposures to total liquidity is 182% in GCC)

- Large exposures to a handful of borrowers


WHO DO BANKS LEND?

- Mainly real estate, consumer loans, housing

- Infrastructure projects

- Public sector corporations

High exposure to real-estate lending (In Bahrain Islamic Banks are especially exposed)

Kuwait: real estate market represents about 18.5% of total investment and over 60% of total collateral

Saudi Arabia: Real estate credit has grown by 30% from a small base

UAE: real estate represents a significant portion of banks’ credit portfolio

Controlled forms of capital accumulation (land is in the hands of government or connected actors


EXCESS LIQUIDITY

Banks tend to keep more liquidity than required by law

- Liquid assets represent 50% of total assets in Qatar - High reserve requirements can be a tax on financial intermediation - One of the lowest bank credit to deposits ratio

Earnings from hydrocarbons => determines Banks’ funding base (not through the “endogenous dynamics of depositing institutions”) Exogenous resource flows > intermediation capacity of the FS

- Volatility of hydrocarbon revenues - Fewer lending opportunities in the non-oil sector - Institutional impediments: credit information, collateral registries, bank

resolution, legal rights of creditors


COMPETITION AND TRANSPARENCY Discretionary and fragmented decision-making means that either connected actors at home or influential foreign parties are given licenses for banks Limited disclosure of investment policies, portfolio and performance of PSEs and core public financial institutions In Algeria: the government is the largest bank owner, it acts as a regulator and it is the main client (through the SOEs). Weak crisis management: the standard response is government recapitalization of banks, deleveraging or complete liquidation


Evidence: State-ownership of Banks

Bahrain: top 5 OBUs and top 2 IBLs own 75 percent of total sub-sector assets. Libya: the government owns 5 of the 15 commercial banks, representing 60 percent of total assets Oman: “Government and quasi-government institutions own more than 26 percent of the assets of the banking system” (Bologna and Prasad 2013); Also, three largest banks accounted for 65% of total assets! Saudi Arabia: 12 Saudi incorporated banks control 95% of total bank assets, the 7 largest banks control 85% of assets, 3 largest 45%, all of which are government entities (Very similar pattern in Algeria and Qatar)


Differences in financial structure between high rent and LA RREs

STATE OWNERSHIP: more common in labour-abundant economies with a socialist legacy of state intervention

- With more extensive distributional commitments, labour-abundant RREs use the banking sector to distribute rents to favoured constituents;

- High share of non-performing loans

- Greater informalization of the financial sector

- Mild forms of financial repression (with some explicit or implicit capping of interest rates)


The politics of High Finance

Large financial sectors in UAE and Bahrain

- In Bahrain wholesale banks’ total assets equal 480% of GDP, retail bank assets equal 270% of GDP

- Financial sector serves as a politically safe avenue for diversification

- The bulk of lending is geared towards connected parties and real estate

Overlapping structures of ownership and control (shareholders): state entities are sometimes the dominant shareholders of largest banks

Kuwait: government-owned banks => significant stakes in investment companies => which, in turn, have stakes in commercial and industrial groups.


Very high ratio of connected lending: Saudi banks known for large exposure (sometimes up to 50% of bank’s own funds) Pervasive role of “related parties in bank lending”


Monetary Policy Arrangements

- Limited scope and operation of MP: most countries follow FER regimes and permit high levels of capital mobility

- MP is largely about liquidity management through greater reliance on indirect MP tools, such as Reserve Requirements and Repurchasing Agreements.

- Government deposits are an important component of overall liabilities of central bank balance sheets

- The interest rate channel of MP plays a relatively insignificant role: low sensitivity to policy interest rates.

- MP is effectively insulated from fiscal pressures (monetization of fiscal deficits is rare)

- The main concern is to restrain the impact of external shocks


CHALLENGE 1: Underdeveloped debt markets

Lack well-developed markets for government securities

Imposes constraints on liquidity management and reduces the effectiveness of open market operations

Difficulty of building a benchmark yield curve => reduces the effectiveness of MP instruments

More than 50% of sukuk issuance is based in the UAE (even here it is difficult to build a critical mass of sukuks) => undiversified investor base

Captive demand by the banking sector and PSEs => highly concentrated buy and hold portfolio

Lack of competition from institutional investors who are protected by government through regulatory, accounting and tax arbitrage


POSSIBLE PE Explanation:

Political sovereign reluctant to concede space to the private sector.

Markets are generally a controlled domain => primed to produce concentration and fragmentation

Independent market linkages could foster competition and empower the private sector (remains a difficult power proposition

Majority of trades take place between central banks and banks: inter-bank markets are either limited or inactive


CHALLENGE 2: Low levels of central bank independence

Most countries lack a comprehensive framework for MP

Central bank operations subordinated to the demands of the external sector

Political independence of central banks is limited – subject to overriding instructions from central authorities

Absence of clearly stated rules and objectives that could act as “commitment devices” (quantifiable objectives, targets, instruments, etc)

Largely a reflection of unpredictable and discretionary policy regime

Absence of an “independent” constituency that could demand and receive policy signals => key macro variables, such as output, inflation and employment, thus remain outside the purview of MP


WHAT EXPLAINS the high de facto independence of Algerian Central Bank?

Emerged as a political concession in the wake of potent economic pressures and violence in the 1980s

Algeria was obliged to seek external donor support and sign up on the IMF’s Structural Adjustment Programme

LESSON:

Where instability and unemployment are higher and foreign exchange reserves are more precarious => more likely to have relatively independent central bank independence and flexible ER arrangements


The political economy of exchange rate choice

Old adage: the choice between fixed and flexible ER regimes is the choice between good and bad macroeconomic policy

The structural economic and political factors traditionally emphasized by the literature do not predict the de facto ER regimes in MENA

SUSTAINABILITY: countries with high reserves to import ratios are more likely to adopt Fixed ER regimes

Hydrocarbon wealth tends to shield Arab RREs from underlying economic compulsions that determine common choices around MP and ER regimes

CREDIBILITY: Question of credibility (politically cheap instrument – harder to build credibility through good policies, which require a predictable and non-discretionary arrangement)


STABILITY: Over-riding concern? Small surprises can have large political costs.

ECONOMIC STRUCTURE:

- Dominance of the Public sector

- Relative insignificance of the export sector => absence of an independent economic constituency that might wish to see its interests articulated through Monetary and ER policies.

- High degree of import dependence => the fate of merchant classes is closely tied with import agencies and licensed distribution of products

PRICE STABILITY:

High dependence on food and consumer imports

(Although inflationary pressures from food imports are typically controlled through subsidies).


CAPITAL MOBILITY:

Most Arab RREs are net exporters of capital

Liberalized capital accounts => drain liquidity from the system and prevent Dutch Disease effects; limited domestic absorptive capacity

BUT there is a COMPLIMENTARY political logic of capital mobility:

- External recycling of rents to buy geo-strategic leverage (not always governed by purely economic rates of return);

- Trillions of dollars invested in buying companies, US Treasury bills, charity contributions, infrastructure projects, etc.;

- Arms purchases, fiscal support for neighbouring governments, financing for external interventions

Such external flows can act as BINDING POLITICAL COMMITMENTS for regime stability.


Importance of linkages – General Equilibrium Effects

Hydrocarbon Dominance => implications for fiscal, financial and exchange rate policies State-ownership of banks => under-developed debt markets => fewer instruments available to manage liquidity and shocks

- Limited development or non-existence of secondary markets for government securities => hinders the broad use of open market operations by central banks

Excess liquidity => inflation is controlled largely through high deposit ratios and reserve requirements => lower private sector credit Algeria: Exchange rate controls => implications for FS and MP


Concluding Remarks Macroeconomic policies reflect the imperative of political, not economic, stabilization Political objective function is the key to understanding macro outcomes With a FER regime and the primacy of the external sector, fiscal and financial policies are more important from a political economy standpoint With limited scope of MP, the commitment problem is more pressing in the fiscal domain: institutionalized constraints on the fiscal regime are more important than central bank independence Quasi-public sector activities and de factor FP regime are largely unmapped


Absence of a clearly defined and coherent macroeconomic framework: governments pursue macroeconomic objectives through discretionary and fragmented policies. Absence of an independent economic constituency that could demand and receive policy signals No institutionalized framework for macroeconomic policy that is shaped by lobbying, bargaining and feedback from the private sector


Inherent tension between STABILITY and RESILIENCE

Impact of shocks is contained through

- Building up of reserves

- Managing the degree of exposure to global markets

- Reliance on centralized control rather than market-based instruments

In other words: stability is achieved largely by adjusting the distributional equilibrium rather than building institutional resilience


ADDITIONAL SLIDES

High levels of de facto integration with the global economy, but low integration with the non-oil economy

Two equilibriums: high exposure to external shocks in one set of countries (UAE, Bahrain), limited in another (RREs)

In both cases, financial stability does not rest on strong institutions (stability rests largely on degree of market integration)

Effects of external shocks are usually contained through limited exposure to international financial system)

Domestic debt markets under-developed through-out the region

Policy environment is both economically and politically conservative


- Discourages risk taking=> lower competitive and creative destruction=> impedes the development of an autonomous economic constituency


political institutions and macroeconomic outcomes in arab oil-rich economies - adeel malik

Government & Nonprofit