U.S. Monetary Policy Spillovers to GCC Countries: Do Oil Prices Matter?
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Contributor Notes

This paper provides empirical evidence that the size of the spillovers from U.S. monetary policy to non-oil GDP growth in the GCC countries depends on the level of oil prices. The potential channels through which oil prices could affect the effectiveness of monetary policy are discussed. We find that the level of oil prices tends to dampen or amplify the growth impact of changes in U.S. monetary policy on the non-oil economies in the GCC.

Abstract

This paper provides empirical evidence that the size of the spillovers from U.S. monetary policy to non-oil GDP growth in the GCC countries depends on the level of oil prices. The potential channels through which oil prices could affect the effectiveness of monetary policy are discussed. We find that the level of oil prices tends to dampen or amplify the growth impact of changes in U.S. monetary policy on the non-oil economies in the GCC.

I. Introduction

Monetary policy in the GCC countries is sensitive to the monetary policy stance in the U.S. in view of the pegged exchange rate regimes to the U.S. dollar.2 These pegs continue to serve GCC countries well, providing a clear and credible monetary anchor. Nonetheless, with open capital accounts and pegged exchange rate regimes, GCC countries are faced with the “trilemma”—i.e., their monetary policy cannot substantially deviate from the monetary policy stance in the U.S.3 The Fed raised policy rates during 2015-18 before reducing policy rates in 2019. An important question is how these changes have affected economic growth in the GCC.

Spillovers from monetary policy in the U.S. could be significant for other countries (Dahlhaus and Vasistha 2014; Caceres et al. 2016), particularly for those with pegged exchange rate regimes. In terms of GCC specific studies, an increase of 150 basis points in the federal funds rate was found to decrease non-oil activity in the GCC by 1.5 percentage points two years after the shock (Prasad and Khamis, 2011).

This paper adds to the literature by providing empirical evidence that the size of the spillovers from U.S. monetary policy to non-oil GDP growth in GCC countries depends on the level of oil prices. Oil prices are critical to the size of monetary policy spillovers because they can amplify or dampen the growth impact.

The level of oil prices – through the effect on domestic liquidity – could potentially dampen or amplify the impact of interest rate changes on non-oil GDP growth. In this regard, monetary policy tightening that coincides with increased liquidity associated with higher oil prices would tend to have a more limited growth impact. While the opposite would be the case if monetary tightening is accompanied by lower oil prices and less liquidity.

Against this background, this paper investigates how oil prices affect U.S. monetary policy spillovers to non-oil GDP growth in the GCC countries. Specifically, GCC countries’ non-oil real GDP growth rates are modeled using panel models with the U.S. real interest rates and the real oil price as explanatory variables. The focus is on non-oil real GDP instead of the total real GDP. This allows for a cleaner identification of the monetary policy spillovers, given the oil component of the GDP is largely driven by production decisions made on the basis of developments in the global oil market (Adedeji et al. 2018).

To our knowledge, this paper is the first attempt in the literature to study the impact of the U.S. monetary policy spillovers on oil-exporting economies, taking into consideration the level of oil prices. The results suggest that at a real oil price of $35 a barrel, a 100 basis-point increase in the U.S. real policy interest rate leads to a drop in annual non-oil real GDP growth of a ⅓ percentage point. If the real oil price, however, were $30 a barrel, the same 100 basis-point increase in the U.S real policy interest rate would lead to a decrease in the annual non-oil real GDP growth rate of almost ⅔ percentage point. The spillover from U.S. monetary policy disappears when the real oil price rises above $43 a barrel.

The rest of the paper is organized as follows: Section II focuses on stylized facts with emphasis on the relationship between U.S. and GCC monetary policy. Section III discusses empirical evidence on growth spillovers associated with movements in monetary policy in the U.S. Section IV concludes and offers policy recommendations.

II. Stylized Facts: U.S. Monetary Policy and GCC Countries

The GCC monetary authorities conduct monetary policy in the context of pegged exchange rate regimes. GCC policy rates broadly follow U.S. interest rates. During the past three years, most GCC central banks have been moving domestic policy rates in line with the U.S. Federal Reserve which is consistent with previous U.S. tightening and easing cycles (Figure 1 and Table 1).

Table 1.

Correlations Between U.S. and GCC Central Bank Policy Rates in Easing and Tightening Periods

article image
Note: Our sample covers 1999M1-2019M9. In this sample, US tightening cycle include: 1999M7-2000M12, 2004M7-2007M8, 2015M11-2019M7. These dates are identified using turning points in federal funds target rate/midpoint and effective federal funds rate. Policy rate refers to the one-week central bank deposit rate in Bahrain, the central bank discount rate in Kuwait, the average repo rate in Oman, the central bank lending rate in Qatar, the reverse repo rate in Saudi Arabia (the reason for not using repo rate is that repo rate has been flat during the most recent US tightening cycle), and central bank CD rate in the UAE.
Figure 1.
Figure 1.

Policy Rates

(Percent)

Citation: IMF Working Papers 2019, 304; 10.5089/9781513519357.001.A001

Source: Haver; and IMF staff calculations.Note: Since December 2008, the Fed has targeted a range of 25 basis points for the Fed Fund Rate (for example, the current range is 1.75% – 2.00%). The data in the figure takes the mid-point value of the upper- and lower-limit of the fed fund target range since December 2008. Data prior to December 2008 is the given single target for the fed fund rate.

GCC countries depend significantly on oil as their main source of export and fiscal revenues. Between 2013–17, the average contribution of the oil sector to the total GCC GDP was 35 percent.4 Oil contributed about 62 percent of GCC exports and 72 percent of GCC government revenues. Since oil forms a large component of exports and government revenue, it has a strong relationship with the current account and fiscal positions of GCC countries. Oil prices, the current account, and the fiscal balance usually move in tandem in the GCC (Figure 2).

Figure 2.
Figure 2.

GCC Current Account and Fiscal Balance, 2004–2018

Citation: IMF Working Papers 2019, 304; 10.5089/9781513519357.001.A001

Sources: National authorities; and IMF staff calculations.

“Liquidity” is defined as the subset of central bank domestic currency liabilities vis-à-vis commercial banks that is readily available for payments purposes, essentially commercial bank excess reserves at the central bank.5 The operation of monetary policy is complicated by the large oil price-driven liquidity fluctuations. Large external and fiscal surpluses during periods of high oil prices have generally beeen associated with increases in liquidity, reversed during times of low oil prices (Figure 3).

Figure 3:
Figure 3:

GCC Liquidity and Oil Prices Growth

(Jan 2008=100)

Citation: IMF Working Papers 2019, 304; 10.5089/9781513519357.001.A001

Source: Haver; national authorities; and IMF staff calculations.1/ GCC liquidity refers to the simple average of monthly excess reserve ratio, measured by the share of excess reserves in total banking assets.Note: Data is not available for all countries before 2008.

For example, there is a clear structural break in Saudi Arabia’s excess reserve ratio in 2004 (the only country for which we have a long time series of data), coinciding with a structural break in the real oil price (Figure 4). The real oil price was stable around $25/barrel from 1993 to the early 2000s. It then increased in 2003 and has stayed above $40/barrel since 2004. Following an almost identical path, excess liquidity in Saudi Arabia was low through most of 1990s and early 2000s and went up in 2004 and has stayed high since.

Figure 4:
Figure 4:

Saudi Banking System Excess Reserves

(Percent of Banking System Assets)

Citation: IMF Working Papers 2019, 304; 10.5089/9781513519357.001.A001

Source: National authorities; IMF World Economic Outlook; and IMF staff calculations. Note: Real oil price uses the average of the WTI, Brent, and Dubai prices deflated by the US energy commodities CPI.

Central banks manage liquidity to limit imbalances and ensure that short-term market interest rates are consistent with their policy rates and to avoid actions by banks that may run counter to their objectives. While banks typically want to hold a certain level of liquidity for payment and precuationary purposes, excess liquidity can find its way into the interbank market, translating into lower interest rates and higher credit growth. Tight liquidity conditions can increase the cost of funding for banks and lead to higher lending rates that curtail credit expansion with potential implications for growth.

Central bank liquidity management operations are important to facilitate monetary policy implementation. Depending on liqudity conditions – associated with oil prices – market interest rates may deviate from policy rates. Too abundant liquidity due to high oil prices leads banks to supply more loans to other banks through the interbank market. This puts downward pressure on interbank rates, reduces banks funding costs, and prompts them to pass it on to borrowers in the form of lower lending rates (See Figure 5).6 Therefore, oil price driven liquidity fluctuations can generate an undesired divergence with policy rates and impede monetary policy transmission.

Figure 5.
Figure 5.

Oil Prices and Monetary Policty Transmission

Citation: IMF Working Papers 2019, 304; 10.5089/9781513519357.001.A001

Source: IMF staff

In some GCC countries, liquidity swings have made it more difficult for central banks to steer short-term market interest rates, with liquidity imbalances reducing the pass through of policy rates to interbank rates (IMF, 2017). Interbank rates may increase by a larger extent than normally entailed by policy rates if oil prices and liquidity decline, with banks in turn charging higher rates for loans, slowing down the demand for credit and consequently economic growth. This same paper IMF, 2017, establishes that in GCC countries, interbank rates have indeed been influenced by liquidity conditions, with tighter system liquidity pushing rates up. It finds that higher liquidity (measured as excess reserves) is assocaited with lower interbank market interest spreads (vis-a vis policy rates which could weaken the pass through of policy rates to interbank market rates with implications for lending and deposit rates.

III. Empirical Evidence of Monetary Spillovers

A. Empirical Strategy

This section analyzes the growth impact of a change in U.S. monetary policy on the GCC countries. Specifically, we examine the impact of the U.S. real interest rate and the U.S. real GDP growth on the non-oil real GDP growth in GCC using a panel regression with fixed effects.

It is well established empirically that the spillovers from U.S. monetary policy to GCC countries can be significant (Prasad and Khamis, 2011). We contribute to this field of research by allowing the size of the U.S. monetary policy spillover to depend on real oil price. The closest work to our paper is di Giovanni and Shambaugh (2008). Examining the role of exchange rate regimes on the U.S. monetary policy spillovers, they found the spillovers to be larger in countries with fixed exchange rate regimes. To our knowledge, our paper is the first in the literature to examine the role of oil prices on the size of the U.S. monetary policy spillovers.

To investigate spillovers from a change in the U.S. monetary policy stance on GCC economies, we use a smilar approach to di Giovanni and Shambaugh (2008).7 Specifically, we consider the following fixed-effects panel regression specification:

nyi,t=αi+β1rtUS+β2oilt+β3rtUS×oilt+β4ytUS+εi,t(1)

where nyi,t denotes the non-oil real GDP growth in country i in year t. αi captures the country fixed effects. rtUS denotes the U.S. real interest rate, computed by deflating the effective federal funds rate with U.S. CPI inflation rate.8 oilt denotes the real oil price, which is computed by first taking the simple average of three spot prices (Brent, West Texas Intermediate, and the Dubai Fateh), all in U.S. dollars per barrel, and then deflated by the U.S. CPI. The real oil price is then logged for an easier interpretation of its coefficient size (its coefficient can be interpreted as an elasticity). rtUS×oilt is the interaction between the U.S. real interest rate and the real oil price to capture the potential impact of the oil price on the U.S. monetary policy spillover. ytUS denotes the U.S. real GDP growth rate. εi,tdenotes the standard error. To control for both cross-country and cross-time correlations in the error terms, Driscoll-Kraay (1998) standard errors are computed.9

We expect β1 to be negative, as has been well established in the literature, because of the trilemma (See Section I). A higher real interest rate (abstracting from the liquidity impact of oil price movement) would be expected to lead to reduced credit to the private sector and consequently, lower real non-oil GDP growth. We expect β2 to be positive, since higher oil price can boost consumption and investment confidence and aggregate demand. We expect β4, the coefficient on the U.S. real GDP growth to be positive–it captures external demand, which has positive impact on non-oil exports.

The other key variable of interest is β3—the coefficient on the interaction between the real oil price and the U.S. real interest rate—which is expected to be positive as we expect the U.S. monetary policy spillover to be weaker when oil prices are higher. 10

B. Empirical Findings

Table 2 presents panel regression results.11 The first column reports the regression results without the interaction term in equation (1); the second column shows the results with the interaction term. The data are from national authorities and Haver Analytics. When the interaction term is omitted, none of the explanatory variables are significant and the coefficient on the U.S. policy rate has the wrong sign. Once we control for the interaction term, all explanatory variables become signficant with expected signs.

Table 2.

Determinants of the GCC Non-Oil Real GDP Growth: Panel Regressions

article image
Notes: 1.

p<0.01,

p<0.05,

* p<0.1; 2. All regressions include country fixed effects; 3. All coefficients are estimated using panel OLS regressions; 4. Driscoll-Kraay standard errors are reported in the parentheses.

We find signficant spillovers from U.S. monetary policy on non-oil real GDP when the interaction term between the oil price and the U.S. policy rate is included—when U.S. real interest rates increase, non-oil real GDP growth rates decline in the GCC countries. Moreover, we find that the size of the spillover increases when the oil price is lower. In other words, the impact of the U.S. real interest rate on the GCC non-oil real GDP growth is larger when oil prices are lower.

To see this relationship between the oil price and the spillover from U.S. monetary policy, we plot the spillover coefficient, β1 + β3oil in Figure 6. The figure shows the relationship between the oil price and the impact of a 100 basis point increase in federal funds rate on GCC’s non-oil real growth rate. When the real oil price is $30 per barrel (at constant 2019 prices), a 100 basis point increase in the federal funds rate is associated with around a ⅔ percentage point decline in non-oil real GDP growth rate on average in the GCC; the impact reduces to a ⅓ percentage point decline if the oil price is at $35 a barrel; and disappears when the oil price rises above $43 a barrel (i.e. it becomes statistically insignificant).12

Figure 6.
Figure 6.

Impact of a 100 Basis Point Increase in the Federal Funds Rates on GCC’s Non-Oil Real GDP Growth at Different Levels of Oil Prices

(Percentage points)

Citation: IMF Working Papers 2019, 304; 10.5089/9781513519357.001.A001

Source: IMF staff estimates.

Given that the annual real oil price has been above $43 since 2004, the identified nonlinearity in the U.S. monetary policy spillover could reflect the structural break in the real oil price—and more importantly the structural break in GCC excess liquidity. The higher real oil price since 2004 has led to structurally higher excess liquidity in the GCC (relative to 1990s), which consequently has weakened the monetary policy transmission mechanism to spillovers from U.S. monetary policy.

As a robustness check, to reduce potential multicollinearity between the real oil price and the U.S. real interset rate, we replace the real oil price with a dummy variable which is set to one when the real oil price is higher than the historical long-run average of $43 a barrel and zero otherwise. The results, reported in column (3), support the finding that U.S. monetary policy spillovers depend on oil prices—higher U.S. interest rates only have an adverse impact on GCC non-oil real GDP growth when oil prices are low. This result is robust to setting the high oil price threshold at different levels.

In addition, we conduct several robustness checks which confirm our findings. Results are reported in Table 3. First, since Saudi Arabia has a large oil market share, to ensure findings are not driven by potential endogeneity between the oil price and Saudi non-oil growth, we re-run the regressions excluding Saudi Arabia from the sample. The results are reported in columns (1)-(2). Second, we replace U.S. real GDP growth with world real GDP growth to account for external demand from other increasingly important trading partners such as China. The results are reported in columns (3)-(4). Third, to account for quantitative easing in the aftermath of the global financial crisis, we replace effective federal funds rate with Wu-Xia shadow Federal Funds rate when the federal funds rate hit the zero-lower bound, and the results are reported in columns (5)-(6). Fourth, we add the real growth rate of government spending to control for omitted variable bias. The results are reported in columns (7)-(8). The coefficient on government spending is positive as expected and the other findings continue to hold. Finally, we use different thresholds for defining the high oil price dummy and the results are reported in colunns (9)-(10). The robustness check results confirm the key finding that the spillover impact of U.S. monetary policy on the GCC non-oil real GDP growth rate depends on the oil price—the spillover weakens at higher oil prices.

Table 3.

Determinants of the GCC Non-Oil Real GDP Growth: Robustness Checks

article image
Notes: 1.

p<0.01,

p<0.05,

p<0.1; 2. All regressions include country fixed effects; 3. All coefficients are estimated using panel OLS regressions; 4. Driscoll-Kraay standard errors are reported in the parentheses.

IV. Conclusion

This paper has assessed monetary policy spillovers from the U.S. to GCC economies with emphasis on the role of oil prices. GCC policy rates broadly follow the Fed funds rate. There is evidence, however, that the level of oil prices matters for how changes in U.S. interest rates affect non-oil GDP growth in the GCC. Oil price-driven liquidity fluctuations impact the effects of monetary policy on non-oil growth. At current oil price levels, the impact of changes in U.S. interest rates on non-oil growth in the GCC appear likely to be minimal.

References

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1

We are grateful to Tim Callen, Bikas Joshi, Stephane Roudet, and participants at the IMF MCD Discussion Forum for insightful comments. Alexandra Panagiotakopoulou and Esther George provided excellent editorial support.

2

In the case of Kuwait, the exchange rate is pegged to a basket of currencies.

3

The open economy “trilemma” and its empirical examinations indicate that countries with pegged exchange rate regimes tend to give up their domestic monetary autonomy (see Obstfeld et al. 2004; 2005; 2010). The trilemma is the proposition that at any one time a country can pursue only two of the three following options: a fixed exchange rate, open capital markets, and monetary autonomy. Theoretically, a fixed exchange rate regime and an open capital account imply interest rate parity.

4

The oil sector in the GCC also influences the non-oil sector through the governments’ expenditure function. Since oil revenue is the main source of fiscal revenue, the effect on the non-oil economy is seen through the government spending these revenues on compensation to public sector employees, subsidies and transfers, and investment in infrastructure, real estate, education, and health (Fouejieu et al. 2018). GCC countries are focusing on decoupling public spending from volatile oil prices, including through the use of medium-term fiscal frameworks.

5

See Gray (2008) for a more-detailed discussion.

6

The opposite effects are in play depending on the level of oil prices.

7

As a robustness check, a linear time effect is included as an additional control variable as in IMF, 2013. We find its coefficient to be insignificant, and other results continue to hold.

8

In one of the robustness checks, Wu-Xia shadow Federal Funds rate is used instead of effective Federal Funds Rate during the quantitative easing period to account for the zero-lower bound.

9

The error structure is assumed to be heteroskedastic, autocorrelated, and possibly correlated between panels. Driscoll-Kraay standard errors are robust to very general forms of cross-sectional and temporal dependence, especially when the time dimension becomes large.

10

The impact of low oil prices on the U.S. monetary policy shock can be asymmetric as an interest rate hike could have larger adverse impact than the potential positive impact of an interest rate cut at low oil prices. We empirically tested this asymmetry using dummy and interaction variables to allow the impact of oil price on the U.S. monetary policy spillover to differ depending on the direction of the U.S. interest rate change. However, we find no empirical evidence of any asymmetry.

11

Oman changed its statistical method of non-oil GDP in 1998, leading to a structural break in the data.

12

The real annual oil price is below $30 a barrel (2019 price) for one-fifth of the time between 1990–2018. Note that by construction, the spillover would change direction (U.S. interest rate hike improves non-oil growth) once the oil price is high enough. The “break-point” oil price is given by exp(β2β4), which equals $43 a barrel in the baseline result. This result should be interpreted as that there is a level of oil price above which the spillover from U.S. monetary policy becomes insignificant on the domestic economy.

U.S. Monetary Policy Spillovers to GCC Countries: Do Oil Prices Matter?
Author: Mr. Olumuyiwa S Adedeji, Mr. Erik Roos, Mr. Sohaib Shahid, and Ling Zhu
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    Policy Rates

    (Percent)

  • View in gallery

    GCC Current Account and Fiscal Balance, 2004–2018

  • View in gallery

    GCC Liquidity and Oil Prices Growth

    (Jan 2008=100)

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    Saudi Banking System Excess Reserves

    (Percent of Banking System Assets)

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    Oil Prices and Monetary Policty Transmission

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    Impact of a 100 Basis Point Increase in the Federal Funds Rates on GCC’s Non-Oil Real GDP Growth at Different Levels of Oil Prices

    (Percentage points)