Fiscal Institutions and Macroeconomic Management in the United Arab Emirates

The UAE has seemingly escaped “the natural resource curse”: it is one of the richest countries in the world and ranks comparatively highly on business environment, infrastructure, and institutional development. Symptoms of the curse can nevertheless be found in the very low growth in labor productivity, massive public sector overemployment, and the inability to counteract instability induced by oil price cycles. This chapter shows that fiscal policy is highly ineffective as a countercyclical tool due to the absence of income and ad-valorem taxes. Stabilizing instruments—such as open-budgeting procedures or fiscal rules—are notoriously absent. Why would a country design its fiscal, monetary, and exchange rate policies so that they allow for high levels of pro-cyclicality, thereby hampering efficiency and long-run growth? A political economy explanation is developed whereby weak fiscal institutions are an agreed-upon mechanism to secure political stability and transfer oil wealth among emiratis and to future generations.

Fiscal Outcomes in Bahrain

This chapter argues that political economy factors, rather than oil wealth, shape the budgetary process and outcomes in Bahrain. Fiscal volatility and excessive current spending (in the form of wages, social welfare, and subsidies) leading to unsustainable non-oil deficits are not fully derived from oil price volatility. Weak institutions, including those underlying the budgetary process, have contributed to some fiscal laxity. These have allowed rulers to use current spending as a channel for the redistribution of oil rents and to secure political stability and allegiance to the regime in a turbulent sociopolitical environment. The budgetary process has been undermined by the structure of the bicameral parliament, while the absence of restrictions on parliament to amend the budget weakens the position of the executive. In the general context of limited transparency and accountability, the government may also be exercising its discretionary powers over the budget execution but this cannot be known.

Does Central Bank Independence in Arab Oil Exporters Matter?

This chapter shows that central banks in Arab oil exporters are not independent. Low independence reflects institutional arrangements that allow the executive branch to influence, interfere, even dominate central bank operations. In a context of weak institutions, central bank independence (CBI) has not always mattered for macroeconomic policy outcomes. Gulf Cooperation Council (GCC) central banks delivered a better macroeconomic policy performance than those of the populous group because the credible peg discouraged discretion. Soft peg arrangements in the populous economies, in a context of weak institutions and discretionary policymaking and no de facto independent central bank, led to disappointing monetary policy outcomes. As oil exporters adapt to a new normal of low oil prices, the sustainability of fixed exchange rate regimes may not be guaranteed without sound macroeconomic institutions. Stronger institutions and effective accountability mechanisms are needed to insulate central banks from political pressures. In the short term, a rules-based framework could help.

The Political Economy of Macroeconomic Policy in Resource-Rich Arab Economies

Revisiting the macroeconomic policies and outcomes of Arab resource-rich economies (RREs), this chapter synthesizes the political economy considerations that underpin policy choices. It argues that, in the context of Arab RREs, fiscal policies play a particularly important role in absorbing natural resource rents. Even where monetary policy has greater room to operate, existing policy frameworks are not geared toward domestic targets, such as inflation and unemployment. I argue that the political objective function is essential for understanding these macroeconomic arrangements. With weak productive constituencies and few institutional constraints, macroeconomic policy involves limited feedback from the private sector and upholds the interest of the sovereign. In this milieu, institutional constraints on fiscal policy are more important than central bank independence (CBI). The chapter also discusses the stability implications of current macroeconomic arrangements, arguing that such stability is almost entirely predicated on the uninterrupted flow of oil rents rather than resilient institutional structures.

Objectives, Issues, and Findings

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

The Political Economy of Fiscal Institutions and Macroeconomic Management in Sudan

This chapter draws on the literature on historical institutionalism and distributive politics, combining qualitative and quantitative information from Sudan’s territorial economic structures, to highlight the evolution of the fiscal and political institutions and indicate their impact on fiscal policy and macroeconomic outcomes. The results show that the inherited colonial fiscal institutions, underpinned by cotton production partnership, significantly determined Sudan’s economic development path after independence and facilitated the incorporation of rural areas and communities into the national economy. However, the greater centralization of power to boost the elites’ legitimacy, including the prioritization of public expenditures on entrenched and inefficient political patronage networks, have not only undermined the macroeconomic management role of the fiscal policy, but also triggered a process of territorial fragmentation that escalated into open civil wars and eventually led to the breakup of the state. The policy implications of these findings are outlined.

Exchange Rate Regimes and Economic Performance in Resource-Dependent Economies

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

Oil, Volatility, and Institutions

This chapter examines the long-run effects of oil revenue and its volatility on economic growth, as well as the role of institutions in this relationship. We collect annual and monthly data on 17 major oil producers between 1961 and 2013, and use the panel autoregressive distributed lag (ARDL) approach as well as its cross-sectionally augmented version (CS-ARDL) for estimation. Therefore, in contrast to earlier literature on the resource curse, we take into account all three key features of the panel: dynamics, heterogeneity, and cross-sectional dependence. The results suggest that: (i) oil revenue volatility has a significant negative effect on output growth; (ii) a higher growth rate of oil revenue significantly raises economic growth; and (iii) better fiscal policy can offset some of the negative effects of oil revenue volatility. We therefore argue that volatility in oil revenues combined with poor governmental responses to this volatility drives the resource curse paradox.

Reforming Fiscal Institutions in Resource-Rich Arab Economies

This chapter traces the evolution of the fiscal institutions of resource-rich Arab economies (RRAEs) since pre-oil days. It then identifies challenges faced by RRAEs and variations in their severity over time. Finally, it articulates specific policy reforms aimed at dealing with these challenges. These include making budgets and budgetary processes more transparent and inclusive, minimizing expenditures which could be vulnerable to corruption or lead to relative price distortions and environmental damage, integrating short-term with medium- and long-term time horizons, and making use of appropriately designed budgetary rules and sovereign wealth funds. It also points to the need for institutional reforms going well beyond budgets and other fiscal institutions to labor laws, efficient judicial systems, greater checks and balances between government branches, and more competitive conditions for private enterprise. In some cases, however, these policy proposals may give rise to tradeoffs that will have to be evaluated on a case-by-case basis.

How to Use Oil Revenues Efficiently

Oil-rich countries systematically misallocate public expenditures relative to non-oil countries—by favoring consumption over capital, and within consumption, inefficient subsidies and public sector wages over targeted transfers. Furthermore, for given levels of expenditure, value for money is considerably less in oil-rich countries. This chapter argues that the reason for this inefficiency is that oil revenues go directly to the government without passing through the hands of the citizens, as is the case with tax revenues. As a result, governments in oil countries are less accountable for public expenditure, which leads to inefficient spending. To improve public spending efficiency, we propose that all oil revenues be distributed directly to citizens, and the resources that government needs be raised through taxation. We show that such a scheme improves the efficiency of public spending. We consider possible obstacles to such a reform and show that they have been overcome by technology, politics, and global events.