RESEARCH AND ANALYSIS
Boom-Bust Cycle, Asymmetrical Fiscal Response and the Dutch Disease
Rabah Arezki: International Monetary Fund,
Kareem Ismail: International Monetary Fund and Johns Hopkins University
Asymmetry in fiscal policy to resource-price shocks across different types of expenditure may have strong implications on competitiveness outside the resource sector.
Resource-rich countries often experience large
movements in their exports receipts as a result of sharp swings in
commodity prices. Governments in resource-rich countries are recipient
of income flow from natural resource, and thus play an important role in
how the resource related revenue is used and distributed. In turns,
those decisions may impact the competitiveness of those resource rich
countries. Our research investigates the behavior of expenditure policy
during boom-bust in commodity price cycles and its implication for real
effective exchange rate (REER) movements.
More specifically, our work documents and explains the limited downward adjustment in REER during commodity price busts. This phenomenon is most likely rooted in political pressures that governments in resource rich countries face. Those pressures are such that it may be far easier to increase public expenditure during commodity price booms than to cut public expenditure during commodity price busts. In other words, bias in the fiscal response to commodity price shocks may explain the tendency for the level of the REER to remain elevated in commodity rich countries following a decrease in commodity prices. For the most part, commodity-rich countries continued to accumulate debt as public expenditure failed to adjust sufficiently downwards following commodity price decreases.
The implication of this asymmetry on the REER stems from the higher import content of public capital expenditure, and thus the limited impact of such expenditure on exchange rate appreciation relative to current expenditure such as on wage, subsidies and services. The higher domestic content of current expenditure spending however also means it is more susceptible to interest group lobbying, and the wage bill and subsidies particularly may be difficult to adjust downward due to the adverse impact this may have on the vulnerable segment of the population. Thus, commodity rich countries going through a commodity price bust may rely more on cuts in capital expenditure than in current expenditure. This results in a lesser adjustment to the real exchange rate than would have been the case under a more symmetric pattern of adjustment in public expenditure. In turn, this may have adverse consequences on non-resource tradable production, which may negatively affect the economic performance of resource rich countries over the medium- and long-term.
Our research examines the behavior of expenditure policy during boom-bust cycle, and its implication for REER movements. To do so, we introduce a Dutch disease model with downward stickiness in government current spending, which we assume is non-tradable intensive relative to capital expenditure. In turn, this model leads to a relative decoupling between real exchange rate and commodity price movement during busts. We test our model's theoretical predictions and underlying assumptions using panel data for 32 oil producing countries over the period 1992 to 2009. Results are threefold. First, we find that within-country variation in current spending have a stronger impact on the within-country variation in REER compared to capital spending. Second, we find that current spending is downwardly rigid, but increase in boom time and conversely for capital spending. Third, we find mixed results showing that fiscal rules have helped reduce the degree of responsiveness of current spending during booms. In contrast, we find evidence that fiscal rules are associated with a significant reduction in capital expenditure during busts while responsiveness to boosts is more muted. This raises concerns about potential adverse consequences on the long-term economic performance of oil-producing countries. Moreover, the lack of downward adjustment in real effective exchange rate during commodity busts may have consequences on the economic performance of resource rich countries.
One possible recommendation for policy makers would be to limit increases in across the board spending during boom times. That limitation would render less difficult curbing spending during bust times. In fact, many resource rich countries have put in place fiscal institutions to help rein their government spending during boom times. However, policy makers should tailor those new fiscal institutions to account for the rigidity in current spending during busts. That will avoid the crowding out of capital spending that is crucially needed in many of those resource rich countries. It should be noted, however, that the effectiveness of those fiscal institutions relies crucially on the ability of governments in resource rich countries to design and put in place checks and balances to prevent rent seeking and limit creative accounting.