Moderate Yet Growing Linkages to the Rest of the World

Greater openness has contributed to higher synchrony with global developments. In line with globalization trends and rising hydrocarbon prices, exports-to-GDP ratios have risen in oil exporters since the early 1990s. The increase in openness in oil importers has been smaller, owing to difficulties in gaining market share in highly competitive global markets (Table A2.1). However, the role of remittances flows in the oil-importing economies has increased, especially in the CCA and in some MENAP oil importers, as these countries have increasingly exported labor to faster-growing and richer nations. Foreign direct investment (FDI) as a share of GDP has increased, more in the CCA than in MENA. External bank exposures, as measured by liabilities to foreign banks, are moderate in MENAP and low in the CCA, with sources of funding concentrated in Europe. Banking exposures have risen in a number of countries, however, especially in Qatar and Saudi Arabia, where they now surpass their pre-global-crisis peaks (Figure A2.1).

^{Table A2.1.}

Openness Has Increased

(Exports, remittances, and foreign direct investment; percent of GDP)

Sources: National authorities; and IMF staff estimates. Note: n.a. = not available.

^{Table A2.1.}

Openness Has Increased

(Exports, remittances, and foreign direct investment; percent of GDP)

	Exports		Remittance Inflows		Foreign Direct Investment
	1993–2002	2003–12	1993–2002	2003–12	1993–2002	2003–12
CCA exporters	37	48	n.a.	0.5	5.4	6.8
CCA importers	34	32	1.4	12.7	3.6	7.0
MENAP exporters	37	53	0.2	0.1	0.5	2.6
MENAP importers	23	28	3.6	4.4	2.2	4.1

Sources: National authorities; and IMF staff estimates. Note: n.a. = not available.

View Table

^{Table A2.1.}

Openness Has Increased

(Exports, remittances, and foreign direct investment; percent of GDP)

	Exports		Remittance Inflows		Foreign Direct Investment
	1993–2002	2003–12	1993–2002	2003–12	1993–2002	2003–12
CCA exporters	37	48	n.a.	0.5	5.4	6.8
CCA importers	34	32	1.4	12.7	3.6	7.0
MENAP exporters	37	53	0.2	0.1	0.5	2.6
MENAP importers	23	28	3.6	4.4	2.2	4.1

Sources: National authorities; and IMF staff estimates. Note: n.a. = not available.

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Lending by Foreign Banks to Selected Emerging Market Regions

(Data as of March 2013; percent of recipient’s GDP)

Source: Bank for International Settlements.Note: LAC = Latin America and the Caribbean; SSA = Sub-Saharan Africa.¹ Excludes Australia, Japan, and New Zealand.

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Bilateral (non-oil) export and remittances links remain strong with Europe and Russia, and are rising with China. Because of the Maghreb countries’ proximity to Europe, about three-quarters of their non-oil export and remittance receipts come from the continent. Europe is a less important trading partner for the Mashreq countries because of their close linkages with the GCC through both trade and remittances flows. The share of non-oil exports to China from many MENAP and CCA countries has increased during the past decade, largely reflecting China’s rapid growth (Figure A2.2). Russia remains the dominant source of remittances to the CCA (Figure A2.3).

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Share of Non-Oil Exports by Destination

(Percent, period averages)

Source: UN, Comtrade; and IMF staff calculations.

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Shares of Remittances Inflows by Remitting Region

(Percent)

Sources: World Bank; and IMF staff calculations.

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Multicountry networks increase exposures to major advanced and emerging market economies. For example, the CCA countries’ exposures to Europe are amplified by their strong links to Russia’s economy, which, in turn, is closely linked to Europe’s. MENAP and CCA exposures to the United States are augmented by exports to China and hence the Asian supply chain, for which the United States is an important market. Correlations with Turkey may reflect shared exposures to other countries in addition to bilateral linkages.

Notwithstanding growing non-oil trade and remittances, oil prices remain an essential channel linking the region to the global economy. Because the world’s major advanced and emerging market economies account for a large portion of global oil demand, developments in these economies determine changes in global oil prices and, consequently, growth in MENAP and CCA oil exporters. Oil prices also matter for Russia’s economy, which means that strong correlations between the MENAP oil exporters and Russia largely reflect common global exposures rather than spillovers. For the oil importers, the net effect of oil price changes on the economy is ambiguous. An increase in oil prices, for example, tends to weaken their terms of trade, reduce disposable incomes, and raise business costs. At the same time, higher oil prices lead to higher external demand from the oil-exporting neighbors, including for tourism and other exports, as well as larger workers’ remittances. These offsetting effects are particularly important for oil importers in the Mashreq.

Increasing Synchrony of Output Cycles

Reflecting evolving bilateral and multicountry linkages, output comovements of MENAP and CCA with other economies are moderate but rising (Figure A2.4).¹

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Moderate but Increasing Synchrony

(Correlations of GDP, 1993–2002 and 2003–12)

Sources: National authorities; and IMF staff calculationsNote: Correlations are calculated for each country using annual GDP data for 1993–2002 and 2003–12, and a simple average is taken to represent subregions.

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• The output cycles of the MENAP and CCA economies are only moderately synchronized with those in advanced and emerging market economies. Economic growth in MENAP oil exporters is moderately correlated with growth in the United States, the euro area, and emerging markets, mainly reflecting linkages via global oil demand and prices. Similarly moderate and broad-based output correlations are observed for the CCA countries. For the MENAP oil importers, correlations with output growth in most other countries are low, suggesting that economic growth in this subregion tends to be driven by domestic factors.

• Comovement of output cycles in the MENAP and CCA economies with the rest of the world, particularly with China, has strengthened over the past decade. Increases in output correlations of MENAP and CCA countries with China have been larger than those with other advanced and emerging market economies, in some cases becoming positive where they had previously been negative. Output correlations between the CCA oil exporters and Russia weakened during the past decade, reflecting, in part, a reorientation of their trade from Russia to other trading partners, particularly China. By contrast, the CCA oil importers maintained strong links with Russia, especially through continued exports of labor to Russia and the associated remittances inflows.

To evaluate spillovers, the impacts of three global downside scenarios are studied.² The outlook for the region is subject to a number of external risks, including a sharp slowdown in major emerging market economies or the euro area, and a rise in global interest rates as the United States exits from very accommodative monetary policy. To distinguish between correlations and actual spillovers, the analysis estimates the impacts of shocks in these three cases.

Lower-than-Anticipated Growth in Emerging Markets Is an Important Risk

A sharp slowdown in major emerging market economies would have a large impact on global GDP and oil prices (Figure A2.5). Private investment in the BRICS (Brazil, Russia, India, China, South Africa) has repeatedly surprised on the downside in recent years. If investment in these countries falls 10 percent below the forecast in 2014, a decline in the BRICS’ external demand accompanied by capital outflows from emerging markets would reduce global GDP by 1¾ percent and oil prices by almost 20 percent on impact (see the April 2013 World Economic Outlook).

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GDP Impact of Emerging Market Slowdown

(First year, percent change relative to baseline)

Sources: National authorities; and IMF staff calculations.

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The oil exporters would share in the adverse consequences of a fall in hydrocarbon prices. Some countries would have to scale back oil output as they did during the global financial crisis. Most oil exporters have buffers with which to conduct countercyclical fiscal policy, which would limit the GDP impact to about 1 percent in the first year. The GDP impact would be higher in the CCA exporters than in the MENAP exporters because of the CCA’s stronger non-oil export linkages to the BRICS, particularly to Russia, resulting in non-oil exports falling 4 percent. However, fiscal balances would be more severely affected in MENAP than in CCA because of higher fiscal breakeven oil prices (see Chapters 1 and 3).

The oil importers would experience lower exports and remittances. For the CCA oil importers, these spillovers would be mostly from Russia and, to a lesser extent, China, whereas for the MENAP oil importers, the indirect impact through the induced slowdown in Europe would match the direct effects of a slowdown in emerging market economies. For example, CCA importers’ non-oil exports would fall 4½ percent, of which more than two-thirds would be directly through the BRICS. For the MENAP oil importers, a reduction in non-oil exports of 3 percent would be roughly equally attributable to Europe, the BRICS, and the rest of the world. Some countries would be able to ease monetary policy and allow automatic stabilizers to operate; however, the scope for countercyclical policy would be generally limited given large fiscal deficits, high inflation, and rigid exchange rate regimes. The overall GDP loss in the MENAP and CCA oil importers is expected to be about ½ percent. In a number of countries, a slowdown in growth would heighten concerns about fiscal and external sustainability, leading to a vicious cycle of declines in confidence and economic activity.

Slowdown in the Euro Area Would Mainly Affect the Maghreb

Waning confidence, reduced investment, and increased concerns about fiscal sustainability could lead to persistently slower growth in Europe. The decline in confidence might reflect slow progress in repairing balance sheets and implementing the needed structural reforms. It would lead to rising risk premiums and additional fiscal tightening, further weakening the macro environment and confidence, and reducing private investment. Euro area growth would fall by ½ percent per year over five years. Global GDP would be mildly but persistently affected, and oil prices would fall by about 1 percent per year (see the April 2013 World Economic Outlook).

A growth slowdown in Europe would primarily affect the Maghreb countries because of their close trade and remittances links (Figure A2.6). The impact on MENAP and CCA countries would be persistent but small in aggregate (about one-tenth of a percent in the first year). However, export and remittances losses of about 1 percent could make the GDP loss as large in the Maghreb (½ percent in the first year) as in Europe. The impact on the CCA oil importers would be smaller because they have more diversified patterns of trade, although CCA oil exporters would also feel the impact indirectly through Russia. To the extent that a slowdown in growth leads to further deleveraging by European banks, MENAP and CCA borrowers would be affected. However, the impact would generally not be expected to be large, because European banks in the MENAP and CCA regions often operate through subsidiaries that are primarily funded by local deposits.

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GDP Impact of Euro Area Slowdown

(First year, percent change relative to baseline)

Sources: National authorities; and IMF staff calculations.

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Effects of Tighter Global Financial Conditions Should Be Manageable

A faster-than-expected recovery in the United States would lead to higher global interest rates. If a recovery starting in 2014 results in the United States growing more quickly than in the IMF World Economic Outlook baseline, monetary policy would tighten earlier and by more than expected. The policy rate could rise 50 basis points above baseline expectations in 2014 and peak at 150 basis points above baseline in 2016 (IMF, 2013f). Global uncertainty surrounding U.S. monetary policy could increase international yields and risk premiums. The resulting tightening of financial conditions would reduce domestic demand across the world, offsetting the positive effects from stronger U.S. import demand, so oil prices would be likely to rise by only about 2 percent.

External and domestic demand in most MENAP and CCA countries would not be materially affected (Figure A2.7). Effects via oil prices and trading partner growth would be small. Export and remittance receipts of the CCA and Maghreb countries would decline slightly because Russia and Europe would experience a small slowdown in growth. Domestic interest rates in countries with U.S. dollar pegs would rise in tandem with U.S. rates, weighing on investment and growth, but the transmission of policy rates to private sector activity would be limited in many countries, particularly in the GCC, because of caps on lending rates and structural excess liquidity on bank balance sheets. However, some public capital expenditure plans would become more expensive to finance and would need to be scaled back, while countries with high public debt might need to tighten their fiscal positions, which would soften domestic demand.

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GDP Impact of U.S. Growth and Monetary Tightening

(First year, percent change relative to baseline)

Sources: National authorities; and IMF staff calculations.

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A rise in the cost of funding should also have a limited effect on the region, because financing needs are generally low or are met by relatively stable sources. The effect of higher global interest rates on MENAP oil exporters would be mostly felt through a decline in the book value of their sovereign wealth portfolios. Financing needs of MENAP oil exporters are generally small (Figure A2.8), given their large external and fiscal surpluses, although Dubai and Bahrain would need to roll over debts at a higher cost in the coming years (see Chapter 1). Oil importers have large external and fiscal financing needs, but they are met mostly by external official flows at concessional rates, nonresident deposits, or through sales of local bonds to domestic banks (see Chapter 2). Foreign participation in local bond markets is small (Figure A2.9); rollover risks are thus limited. Those risks may become an issue if, for example, FDI were to dry up; otherwise domestic banks would need to sharply step up their purchases of government bonds to substitute for declining external financing. For a discussion of the likely effects on the CCA, see Chapter 3.

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Gross External Financing Needs in 2013¹

(Percent of GDP)

Sources: National authorities; and IMF staff calculations.¹ Calculated as the sum of current account deficit (excluding official current transfers) and amortization scheduled, with a floor of zero.² Excludes nonresident deposits.

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MCD: International Issuance of Bonds, Equity, and Loans

(Percent of GDP)

Sources: Dealogic; national authorities; and IMF staff calculations.

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In most countries, financial sectors should be able to withstand moderate shocks. Banks are generally healthy and have limited external exposures. International bank lending to MENAP firms and banks has been rising but remains below the emerging market average, except for Morocco, Qatar, and the United Arab Emirates. Lending by global banks to the CCA is small (less than 10 percent of GDP), as Kazakhstani banks have reduced their exposure to wholesale funding since the global financial crisis. Firms in MENAP and CCA generally rely on domestic sources of funding, mostly through banks, which finance themselves largely through local deposits.

Nonetheless, pockets of financial vulnerability exist. Some banking systems have loan-to-deposit ratios exceeding 100 percent, and some banks with large external wholesale financing needs might be vulnerable (Figure A2.10). Capital buffers are typically above emerging market averages (Figure A2.11); although, in some cases, capital positions could prove vulnerable in light of relatively low provisioning (Jordan, Tunisia), while nonperforming loans are high in others. Kuwait’s investment companies could be exposed to funding and asset valuation risks (see Chapter 1).

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MENAP and CCA Banking System: Loan-to-Deposit Ratios

(2008–June 2013, or latest available month)

Sources: National authorities; and IMF staff calculations.Note: Em. Eur. = emerging Europe.

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Capital Adequacy Ratios

(Percent of risk-weighted assets, 2012 or latest available data)

Sources: National authorities; Global Financial Stability Report, April 2013; and IMF staff estimates. Note: EM = emerging market.

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Significant protracted economic and financial market volatility, especially in emerging markets, would affect MENAP and CCA. In the event of a sudden stop of capital flows to emerging markets and a severe loss of liquidity, global economic activity is likely to slow down. Economic activity in the region is likely to weaken because of lower oil prices, lower production, or both, as well as declining non-oil exports to the affected trading partner countries. Remittances inflows, which generally tend to be more resilient than exports of goods and services, may also moderate. In addition, as shown by the recent episode of increased financial market volatility and capital outflows from emerging markets in May and June 2013, bond yields for countries in the region generally rise in tandem with those in emerging markets (Figure A2.12).³ The effects on bond yields for most MENAP oil importers tend to be smaller than those in MENAP oil exporters and CCA because country-specific and regional factors are the main determinants of risk premiums in this subgroup (see Chapter 2).

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Bond Yields

(Percent, September 1, 2012–September 10, 2013)

Source: Bloomberg, L.P.

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The Role of Fiscal Policy for MENAP and CCA Oil Exporters

Fiscal management advice in oil-exporting countries needs to take into account country-specific characteristics:

• Oil dependence. Oil exporters in the MENAP and CCA regions tend to depend heavily on oil exports for fiscal and export revenues, making them very vulnerable to changes in production and international oil price fluctuations (Figure A3.1, panel a). To the extent that these countries depend on oil, fluctuations in international oil prices may have a large impact on macroeconomic stability, suggesting the need to build up buffers.

• Size of oil reserves. Most countries in the region could sustain current production levels for more than a generation (30-plus years), in which case medium- to long-term fiscal sustainability may not be an immediate concern. Some countries with shorter horizons face more binding fiscal sustainability constraints (Figure A3.1, panel b).

• Fiscal vulnerabilities. Fiscal breakeven oil prices vary across countries and have increased since 2009, underscoring the vulnerability to lower oil prices (Figure A3.1, panel c).

• Development needs. Some countries have pressing development and reconstruction needs that may warrant front-loading investment spending while maintaining long-term fiscal sustainability (Figure A3.1, panel d). Part of oil revenues can also be prudently used to promote economic diversification.

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Country-Specific Fiscal Management Considerations

(Percent, average 2006–13)

Source: IMF World Economic Outlook database.

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Ratio of Proven Reserves to Total Oil and Natural Gas Production

(Percent, 2012)

Sources: U.S. Energy Information Administration; and British Petroleum (2013).¹ Iraq has one of the largest natural gas reserves in the world but produces very little of it; only oil is included. Including natural gas, Iraq’s ratio would be around 4,500.

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Change in the Fiscal Breakeven Oil Price, 2009–13

(U.S. dollars per barrel)

Source: IMF staff calculations.¹ Turkmenistan does not have a 2009 breakeven price, so 2011 is used for the earlier period.

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Human Development Index and per Capita Purchasing Power Parity GDP

Sources: United Nations Development Programme; and IMF World Economic Outlook database.

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Fiscal Management in Oil Exporters: Objectives and Tools

Managing public finances in oil-rich countries involves distinct objectives relating to macroeconomic stabilization, fiscal sustainability (including intergenerational equity), and development. Macroeconomic stabilization entails the use of spending and taxation decisions to smooth the impact of economic fluctuations caused by domestic and external shocks. Ensuring fiscal sustainability includes explicitly linking fiscal policy to resource exhaustibility, and helping to accumulate savings for intergenerational equity. The development objective involves making expenditure decisions with long-term economic growth in view, and includes economic diversification. The prioritization of the objectives, and the analytical tools used to formulate policies, may vary with specific country characteristics, such as the length of the resource revenue horizon, development needs, and the level of fiscal buffers that can be tapped if there were to be a sustained fall in resource prices (Baunsgaard and others, 2012) (Table A3.1).

^{Table A3.1.}

Fiscal Goals and Analytical Tools

Note: DSGE = dynamic stochastic general equilibrium; FSF = fiscal sustainability framework.

^{Table A3.1.}

Fiscal Goals and Analytical Tools

		Short- to Medium-Term Macro Stability			Medium- to Long-Term Fiscal Sustainability		Developmental Needs
Analytical Tool		Facilitates assessment of the fiscal stance impulse	Deals with oil revenue volatility	Helps target precautionary buffer	Links fiscal policy with exhaustibility	Helps set savings for intergenerational equity	Accounts for growth return on investments	Links to other macro variables
Non-oil primary balance (as a percent of non-oil GDP)		✓ (if cyclically adjusted)	✓ (excludes oil revenue)
Structural balance (with oil price-smoothing mechanism)		✓	✓	✓
PIH-based rules	Permanent income hypothesis (PIH)				Can serve as a medium-term benchmark	✓
	Modified PIH rule or FSF (allows for front-loading investment spending)				Can serve as a medium-term benchmark	✓	✓
Structural DSGE models					✓	✓	✓	✓
Precautionary saving-investment model			✓	✓	✓		✓	✓

Note: DSGE = dynamic stochastic general equilibrium; FSF = fiscal sustainability framework.

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^{Table A3.1.}

Fiscal Goals and Analytical Tools

		Short- to Medium-Term Macro Stability			Medium- to Long-Term Fiscal Sustainability		Developmental Needs
Analytical Tool		Facilitates assessment of the fiscal stance impulse	Deals with oil revenue volatility	Helps target precautionary buffer	Links fiscal policy with exhaustibility	Helps set savings for intergenerational equity	Accounts for growth return on investments	Links to other macro variables
Non-oil primary balance (as a percent of non-oil GDP)		✓ (if cyclically adjusted)	✓ (excludes oil revenue)
Structural balance (with oil price-smoothing mechanism)		✓	✓	✓
PIH-based rules	Permanent income hypothesis (PIH)				Can serve as a medium-term benchmark	✓
	Modified PIH rule or FSF (allows for front-loading investment spending)				Can serve as a medium-term benchmark	✓	✓
Structural DSGE models					✓	✓	✓	✓
Precautionary saving-investment model			✓	✓	✓		✓	✓

Note: DSGE = dynamic stochastic general equilibrium; FSF = fiscal sustainability framework.

Safeguarding Short-Term Macroeconomic Stability

Safeguarding short-term macroeconomic stability means avoiding boom-bust cycles by aiming to smooth spending and delink it from oil price dynamics. The experience of oil exporters, however, shows that non-oil primary deficits have tended to move closely with oil prices, suggesting that countries have not been able to avoid procyclical fiscal policy. The non-oil primary balance (NOPB) as a percent of non-oil GDP is useful for capturing the impact of policy changes on aggregate demand and is the most widely used indicator. As governments channel oil revenues through spending into the domestic economy, the NOPB measures the impact of spending on domestic demand. Using this indicator for setting fiscal policy helps separate the fiscal policy stance from the volatility of oil revenues (Figure A3.2). The NOPB can remain stable even if the overall fiscal balance shifts abruptly as a result of the volatility in oil prices or production. To be able to maintain a steady NOPB or implement countercyclical fiscal policies in the face of a large oil price drop, countries should also aim to build adequate fiscal buffers.

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Oil Exporters: Average Non-Oil Primary Deficit¹

(Percent of non-oil GDP)

Source: IMF, World Economic Outlook database.¹ For each year, the non-oil primary deficit is the average for the following countries: Algeria, Azerbaijan, Bahrain, Iran, Iraq, Kazakhstan, Kuwait, Libya, Oman, Qatar, Saudi Arabia, Sudan, Turkmenistan, United Arab Emirates, Yemen.

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The 2008–09 oil price declines illustrate the usefulness of the NOPB in the first instance to assess the fiscal stance. Countries that maintained their precrisis NOPB levels throughout the crisis were able to avoid procyclical fiscal policy and steep non-oil output drops. In addition, if a shock to non-oil output were to occur, the NOPB would be a good measure for assessing the fiscal impulse for countercyclical demand management.

Calibrating Expenditure in a Medium-Term Framework

Fiscal policy requires an anchor for short- to medium-term spending to break the link between budgets and oil price volatility. For a country with a very strong fiscal position and with large oil reserves that will last for many years, a key question is what framework can best help manage the volatility of oil revenues in the short to medium term. The structural balance approach allows for smoothing oil price volatility while calibrating spending decisions. A structural balance rule can be applied in all oil resource countries regardless of the resource horizon, and it is particularly useful for countries with long resource horizons in which intergenerational constraints derived from application of the PIH are not binding in the near term.¹ In these cases, the emphasis should be on computing the fiscal impulse, and on setting a conservative medium-term path that severs expenditure from oil volatility.

A structural balance rule requires assumptions about future oil prices and production. Assumptions about the long-term oil price and, in countries such as Saudi Arabia that have spare capacity, production, are inherently difficult but must be made to decouple expenditures from resource price volatility. The experience across countries shows that there is no one way of establishing the long-term price assumption.² A five-year, backward-looking price rule, for instance, strikes a balance between low volatility and adjustment to new market trends within a reasonable timeframe. A backward-looking rule also has the advantage of not requiring forecasts of future oil prices; however, given the oil price trends of the past decade, when average oil prices were lower than are now forecast for the medium term, a longer backward-looking rule could be viewed as being too conservative for a country with well-established fiscal buffers and a need to boost infrastructure and education spending. Considering the implications of Saudi Arabia’s spare production capacity on structural output, a three-year backward-looking average is used as the structural oil output level.³

The spending benchmark derived from PIH models is generally binding for countries with relatively weaker fiscal positions and limited reserve horizons.⁴ In these countries, government spending is often too large to be maintained after the natural resources have been exhausted. In such cases, for example, Azerbaijan, the structural balance target needs to be consistent with the PIH benchmark to ensure long-term fiscal sustainability. In this instance, anchoring the NOPB to achieve a fiscal position consistent with PIH-derived levels in the medium term would maintain fiscal discipline in times of high oil prices and help ensure intergenerational fairness.

Strengthening Institutional Capacity

In the absence of strong fiscal institutions to execute numerical fiscal rules, such as the structural balance, procedural rules can be implemented as an intermediate step.⁵ International experience suggests that strong and transparent fiscal institutions are needed for the successful implementation of fiscal rules, particularly an effective public financial management system and legislation delineating the roles and responsibilities of government agencies (see below). In countries with limited technical capacity, procedures outlining steps to be followed during the budget preparation process can be an alternative to numerical fiscal rules. As institutional capacity strengthens, countries can then move toward numerical fiscal rules.

Anchoring Medium- and Long-Term Fiscal Sustainability and Promoting Sustainable Development

Fiscal policy should be consistent with medium- to long-term fiscal sustainability, while at the same time taking into account intergenerational equity and development needs. This objective should be a priority for countries that have shorter resource horizons, or that face critical social and infrastructure gaps that merit front-loading current or investment spending. Policymakers should also focus on fostering policies to generate sustainable development. In general, PIH-based models are useful for anchoring long-term fiscal sustainability;⁶ however, richer models can be used to address the limitations of simple PIH frameworks that abstract from the volatility of oil revenues and returns on oil-funded capital spending. In this respect, precautionary saving-investment models can be used to provide for volatility of oil revenues. In addition, DSGE models can be useful for evaluating policies in a more general framework, including the macroeconomic effects of fiscal policy (IMF, 2012a).

Recent applications of the PIH benchmark suggest that most oil exporters need to undergo fiscal consolidation to help ensure intergenerational equity.⁷ The PIH approach is particularly useful for countries with short reserve horizons, structural export constraints, and low levels of accumulated savings. For Azerbaijan, for example, the PIH model could provide a medium-term fiscal anchor. For countries with long reserve horizons, such as Iraq, Kazakhstan, Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates, the PIH model is unlikely to provide binding near-term spending constraints, even if the true size of oil reserves is underestimated. Nonetheless, even many countries with long reserve horizons were found to have looser fiscal positions than is consistent with intergenerational equity (Figure A3.3).

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Nonhydrocarbon Primary Fiscal Deficit, 2013

(Percent of nonhydrocarbon GDP)

Sources: National authorities; and IMF staff estimates.Note: PIH = permanent income hypothesis.¹State budget.

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The application of the standard PIH model should be complemented with robustness checks. The PIH model is extremely sensitive to assumptions, and there is a large degree of parametric uncertainty in indicators—the expected rate of return on financial assets, future population growth, GDP growth, the future trajectory of the price of nonrenewable resources, and the size of hydrocarbon reserves. Therefore, the robustness of the recommendations should be tested by using sensitivity analysis. In its standard form, the PIH also does not carve out a role for public investment in diversifying the economy (it assumes zero return on investment).

Trade-Offs in Scaling Up Investment

Modified PIH (MPIH) and fiscal sustainability framework (FSF) models can be used to analyze the impact of scaling up expenditures in the medium term on long-term fiscal sustainability.⁸ In some cases, such as Iraq, short-term deviations from the PIH framework might be warranted to address critical social and infrastructure needs, because the country has a long reserve horizon, there is a high return on capital spending, and credit markets are not functioning properly. Similarly, as in Iran, a country may optimally decide to spend beyond PIH benchmarks in the short term if export volumes are to recover to their pre-sanction levels in the medium term. The MPIH model, which allows for a scaling up of spending in the medium term that is followed by a scaling down of spending to preserve long-term wealth, computes the necessary subsequent fiscal adjustment if the scaled-up spending does not result in higher growth.

However, the need to save in later years could be lessened if the additional upfront investment spending has a positive growth and tax revenue impact. In this respect, the FSF model incorporates the impact of higher public investment on growth and nonresource revenues, generating a fiscally sustainable path that is consistent with a lower level of financial wealth. In Azerbaijan, the implementation of the FSF model underscored the effect of higher investment on absorption-capacity constraints, low impact of public investment on growth, and potential overheating of the economy.

Building Fiscal Buffers to Deal with Uncertainty

In countries with shorter reserve horizons and low levels of accumulated savings, the assessment of fiscal buffers to deal with oil revenue volatility becomes important. A precautionary saving-investment model can be used to inform the optimal allocation of volatile oil income among consumption, precautionary saving, and investment.⁹ This model (Cherif and Hasanov, 2012) allows for saving part of oil income for precautionary purposes (build buffers) that can be drawn down in case of an unexpected drop in oil prices as well as investing domestically. The application to Oman suggests that projected spending is on an increasing path, above the optimal level suggested by the model (given a projected decline in oil prices in the medium term) (Figure A3.4). There is also scope for setting capital expenditure priorities so as to bring the projected investment rate in line with the lower optimal path. The projections shown suggest that spending should not continue on its increasing current path (given a projected decline in oil prices in the medium term).

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Oman: Optimal versus Actual/Projected Spending, 2012–18

(Billions of U.S. dollars)

Source: IMF staff calculations.

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Assessing the Impact on the Overall Economy

Ambitious scaling up of public investment can generate more growth, but the cost of funding this investment can be high because it draws down from buffers or it accumulates external debt. DSGE models can be useful for making fiscal decisions, such as to invest resource revenues while maintaining fiscal sustainability, in a more general framework that takes into account the macroeconomic effects of resource-financed public spending.¹⁰ These models have features that are not addressed in standard PIH models, such as modeling the link between public investment and nonresource growth; accounting for Dutch Disease; and allowing for detailed fiscal specification of spending and saving, debt sustainability, and fiscal policy. On the downside, these models can be relatively complex and therefore are not easy to communicate to the public.

Institutional Reforms Needed to Strengthen Fiscal Management

Well-designed fiscal frameworks are particularly important for resource-rich countries because of their significant reliance on oil and gas resources.¹¹ The use of overly conservative oil prices in national budgets, while helping to contain spending pressures, may allow for significant deviations between actual outcomes and initial budget targets, particularly if oil prices are higher than budgeted.¹² There is scope to further enhance the role of the budget as the government’s main tool for setting and achieving economic and social goals. In particular, moving toward medium-term budget frameworks can help ensure that spending is stable—despite temporary fluctuations in revenue—and consistent with longer-term policy objectives. Many oil exporters need to build adequate capacity to carry out macro-fiscal analysis and develop strong fiscal frameworks that allow for implementation of countercyclical policies. Several countries have recently been taking steps toward introducing medium-term budget frameworks (Qatar), by starting to move beyond one-year budgets, and by establishing macro-fiscal units (Kuwait, Qatar).¹³

A credible commitment to macro-fiscal stability and effective use of oil wealth should be supported by a public financial management (PFM) system consistent with international best practices. A sound PFM system helps to ensure, as part of the budget process, (1) a transparent and comprehensive presentation of oil revenue and the underlying non-oil fiscal position; (2) a sustainable long-term fiscal strategy based on prudent revenue projections, realistic medium-term fiscal frameworks, and a good budget classification; and (3) transparent mechanisms for appraisal, selection, and prioritization of investment projects, to ensure that resource revenue is used to support long-term economic development.

The ongoing revision to the existing IMF Code of Good Practices on Fiscal Transparency (IMF, 2007) advocates good practices for fiscal reporting, and provides relevant guidance on how to enhance transparency. In particular, fiscal reports should (1) cover a wider range of public sector institutions, (2) capture a broader range of direct and contingent assets and liabilities, and (3) take a more rigorous approach to fiscal forecasting and risk analysis. The World Bank’s EITI++ initiative—building on the transparency and good governance concepts of the existing multistakeholder Extractive Industries Transparency Initiative (EITI)—is also relevant for resource-rich countries because it has widened the transparency requirements for the reporting of natural resource wealth management, including revenue and spending (see also Box 2.5).

Mobilizing Tax Revenues

Low tax revenues and weak progressivity pose a challenge (Figure A4.3). Revenues in most MCD economies are lower than in other emerging and developing economies. This gap largely reflects low income tax and corporate tax rates and weak collection, which stems from high tax exemptions and compliance issues.³ Tax progressivity is also low across the region largely because the main source of revenues for oil importers is taxes on goods and services, and for oil exporters it is oil revenues along with some income and trade taxes. In the medium term, these revenue challenges are expected to persist in oil importers. In oil exporters, projected declines in oil prices underline the importance of developing non-oil sectors and raising taxation in those sectors from their currently very low levels.

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MCD: Tax Rates and Revenue, 2012¹

Sources: National authorities; KPMG; Deloitte; and IMF staff calculations.Note: Blue bars represent CCA countries, and orange bars represent MENAP oil importers (except last chart). EMDC = emerging market and developing countries.¹ Or latest available data.² Calculated as VAT revenue, divided by the product of VAT rates and private consumption.

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Revenue measures should focus on strengthening tax structures while keeping the impact on growth to a minimum and improving equity. Measures that can be taken as first steps include the following:

• Broaden the tax base. Conventional wisdom stresses base broadening in preference to an across-the-board rate increase because the latter can be regressive⁴ and its implementation politically challenging. New evidence confirms that base broadening is also better for growth—especially for value-added taxes (VAT) (Acosta-Ormachea, Keen, and Yoo, 2013)—and for improving the business environment. Consequently, tax exemptions and deductions (except those targeted to the poor) should be heavily reduced for all taxes and, whenever possible, multiple VAT rates consolidated into a single rate. A solid communication strategy—for example, the publication of an annual tax expenditure review highlighting costs and benefits—would be critical to facilitating public buy-in for these efforts.

• Increase the progressivity of income taxes. More progressive income taxes would improve equity while having little effect on growth, and could include raising the current relatively low marginal rates on the highest income earners, and, where appropriate, on capital income.⁵ To start, cuts in top rates for personal and corporate income tax rates during the past five years could be undone (for example, in Jordan, the Kyrgyz Republic, and Uzbekistan).

• Raise excise and property taxes. Raising the currently low levels of excise taxes (Figure A4.4),⁶ especially on luxury goods, and property taxes (while protecting low-income property owners), would achieve gains in revenue, efficiency, and fairness, with benign effects on growth given that they mostly affect the wealthy. However, implementation of property taxes would require substantial upfront investment in administrative infrastructure, which would include establishing a comprehensive cadastre and valuation mechanisms, and carrying out effective enforcement.

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Property and Excise Tax Revenue, Latest Available

(Percent of GDP)

Sources: National authorities; and IMF staff calculations.Note: Blue bars represent CCA countries, and orange bars represent MENAP oil importers. EMDC = emerging market and developing countries.

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Gradual tax and customs administration reforms would further stimulate revenue mobilization and support prospective growth. A focus on strengthened administrative capacity, enhanced compliance, and efficiency will raise tax revenues and level the playing field for companies while promoting foreign investment and competitiveness. Stable and simplified tax codes and tax regimes for small and medium-sized enterprises would advance efficiency. In countries in which VAT revenue is large, a risk-based compliance system (including an automated VAT refunds system) would increase tax yield, facilitate business operations, and reduce unequal tax treatment across companies. International experience also suggests that a large taxpayers’ department, operating through a small number of offices, can lower tax evasion and improve administrative efficiency. Yields on import VAT, excise, and international trade taxes would rise substantially with customs administration reforms.

Reorienting Spending

Consolidation is complicated by large and poorly targeted current spending (Figure A4.5). Since the onset of the Great Recession, spending has often outpaced output growth. Across the region, to mitigate the adverse social effects of lower growth and higher unemployment, many governments increased outlays on energy subsidies and wage bills (through hiring and wage increases). This new spending was partially offset by reducing already low capital spending and, sometimes, maintenance, education, and health spending. In the aftermath of the Arab Spring, these spending efforts were intensified in the ACTs and their neighbors (including the GCC and Lebanon). Inequities rose because broad-based subsidies primarily benefit the wealthiest. Hikes in public wage bills also tend to raise inequality,⁷ reflecting government employees’ above-average position in the income distribution. In a few countries, the spending power of poorer households was eroded by high inflation caused by monetization of large public deficits and high food and energy prices.

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MCD: Expenditure Components and Inequality

(Percent of GDP)

Sources: National authorities; World Bank World Development Indicators; and IMF staff calculations.¹ Blue bars represent CCA countries, and orange bars represent MENAP oil importers.² Subsidy and transfer expenditure data not available for Qatar, Turkmenistan, or Uzbekistan.³ Benefit incidence is the share of social spending allocated to the poorest 40 percent of the population.⁴ Orange bars represent MCD countries; gray bars represent others. ARG = Argentina; BGD = Bangladesh; BDR = Bulgaria; BRA = Brazil; LVA = Latvia; MEX = Mexico; RWA = Rwanda; THA = Thailand; TUR = Turkey; UKR = Ukraine.

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Carefully chosen fiscal spending tools will contain the negative impact on growth, improve targeting, and reduce expenditure rigidities. To that end, many countries with large, broad-based energy subsidies, including some ACTs, have begun to gradually phase them out, to varying degrees and taking into account sociopolitical conditions (see Box 2.4). Channeling part of the resulting savings toward better-targeted social safety nets or broader cash compensation schemes will mitigate the adverse effects on the poorest of higher energy tariffs and other reforms.

Real growth of public wage bills also needs to be contained—particularly in the ACTs, where their growth exceeds that in the rest of the region (Figure A4.6). Using the public sector as employer of first and last resort is no longer an option in those countries whose fiscal buffers are running low. It should also be discouraged in countries where inflated public sector salaries reduce the appeal of private sector jobs for the best workers. Near-term consolidation efforts can be complemented by medium-term plans for comprehensive civil service reforms that review the size and structure of the civil service while creating a skilled and efficient government workforce.

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Real Wage Growth

(Percent)

Sources: National authorities; and IMF staff calculations.

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At the same time, spending on growth-enhancing areas needs to be protected and, where possible, increased. Channeling part of the net savings from the consolidation efforts above into social outlays on health care, education, and training—especially for low- and middle-income households—and into efficient capital spending, should create jobs and reduce inequities⁸ in the near term, while strengthening long-term growth prospects. To ensure its effectiveness, the quality and efficiency of all growth-enhancing spending will need to be monitored and implementation capacity increased. Raising the efficiency of capital spending at any stage of the public investment management process⁹ could benefit all countries in the region. Sizable growth dividends can result from even a small increase in capital spending. Public-private partnerships (PPPs) can lessen the burden on capital spending budgets, but only if the political environment supports them and if strong PPP legal frameworks and mechanisms can be established to mitigate the risk of large contingent liabilities. On average, the implementation phase for capital projects is the most challenging for MCD countries, relative to comparator regions (Figure A4.7).

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Public Investment Management Index

(Index components, 0 = lowest, 4 = highest)

Source: Dabla-Norris and others (2011).Note: EM = emerging market; LAC = Latin America and the Caribbean.

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Strengthened reporting, monitoring, and procurement systems are essential for improving the efficiency of capital spending. Appropriate vetting and prioritization systems (i.e., choosing projects that relieve infrastructure bottlenecks, complement private investment, and enhance productivity), timely allocations of recurrent expenditures (in line with the budget), and routine evaluations upon project completion and internal audits would underpin improvements in the appraisal, selection, and project evaluation stages.

Supporting Measures and Policies

Appropriate monetary, exchange rate, and structural policies are necessary to support successful fiscal consolidation. In some cases, low interest rates for an extended period, resulting from accommodative monetary policy, would both reduce the cost of public debt and stimulate private sector activity. Inflationary pressures are likely to be offset by the effects of fiscal consolidation, so adverse inflationary effects on inequality or competitiveness would be avoided. In other cases, where tight monetary policy is needed in the near term to protect the current account and the exchange rate, and to contain inflationary risks, its pace and intensity can be coordinated with fiscal policy. In the medium term, a flexible exchange rate and structural reforms that attract foreign direct investment and promote competitiveness, private sector growth, and international trade would boost potential growth (Box 1.1; Box 2.6 of the November 2012 Regional Economic Outlook: Middle East and Central Asia) and lower the debt burden.