External adjustment in oil exporters: The role of fiscal policy and the exchange rate

• Date: 01 March 2018
• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/twec.12593

ORIGINAL ARTICLE

External adjustment in oil exporters: The role of

fiscal policy and the exchange rate*

Alberto Behar

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Armand Fouejieu

International Monetary Fund, Washington, DC, USA

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INTRODUCTION

Until 2014, oil exporters enjoyed many years of large current account surpluses, raising questions

at the time about whether they were too big from a normative point of view and from the perspec-

tive of global imbalances (Arezki & Hasanov, 2013; Beidas-Strom & Cashin, 2011). Assessments

of current account balances continue to be on the international agenda (IMF, 2016, 2017a). How-

ever, after almost four years of oil prices in triple digits, the sharp reduction in the price of a barrel

in the second half of 2014 left oil prices averaging barely $50 in 2015. They have stayed low

since then, and futures prices imply oil will not recover materially over the medium term.

In addition to considerable fiscal strains, oil-exporters’external balances are coming under pres-

sure. Many countries are set to register current account deficits. Ability to finance these deficits var-

ies greatly across countries as many have sizeable external wealth but some may face financing

difficulties and pressure on reserves (Versailles, 2015). From a normative perspective, exporters of a

non-renewable resource should generally be net external savers such that they can finance future

imports after the resource is exhausted.

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Therefore, policymakers in oil-exporting countries are con-

sidering ways to increase their current account balances. This paper studies how the special charac-

teristics of oil exporters influence the utility of fiscal policy and the exchange rate for achieving this.

A natural tool for external adjustment is the level of the exchange rate.

2

Much of the adjust-

ment is supposed to operate by increasing net exports. In particular, in settings where prices are

rigid, a weaker currency has the potential to make exports cheaper for foreigners. Similarly, a

weaker currency has the potential to make foreign products more expensive and reduce imports

through both income and expenditure-switching effects.

*The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF, its

Executive Board, or IMF management.

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This depends greatly on country circumstances, including the level of development, resource horizon and existing savings.

See Bems and Carvalho Filho (2009) and Araujo, Li, Poplawski-Ribeiro, and Zanna (2016).

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This paper does not contribute to the debate on the appropriate choice of exchange rate regime. In the literature, the adjust-

ment mechanism can operate regardless of whether nominal exchange rates are fixed or flexible. The benefits of flexible

nominal exchange rates in the presence of sticky prices are often attributed to Friedman (1953)—see, for example, Gervais,

Schembri, and Suchanek (2016)—although Hanke (2008) argues Friedman often favoured fixed rates.

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©2017 John Wiley & Sons Ltd.

The International Monetary Fund retains copyright and all other rights in the manuscript of this article as submitted for publication.

DOI: 10.1111/twec.12593

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However, oil exporters have special characteristics that may blunt the effectiveness of the

exchange rate as a tool for adjusting the trade balance and hence the current account balance. Fol-

lowing a depreciation, there may be some income compression, but their undiversif ied economies

limit the scope for import substitution and dearer imports would weaken the trade balance. Simi-

larly, with possibly a handful of exceptions, oil producers are price takers producing at full capac-

ity. As a result, total export volume gains could be negligible although depreciation would raise

local-currency prices for exports to a greater extent than for other countries. In some cases, net

remittance outflows could rise due to limited substitution between nationals and migrants.

In contrast, fiscal policy could play an important role in external adjustment in oil exporters.

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As is generally the case, fiscal and external balances are linked in the absence of full Ricardian

equivalence. In particular, lower government spending likely reduces imports and remittance out-

flows and could also reduce exports and net investment income inflows over time. For oil expor-

ters, the government plays a large role in an economy that is on average more import dependent

than in other countries, which suggests that government expenditure decisions could have a larger

bearing on the current account than in other economies.

We evaluate these claims by econometrically comparing the relative importance of the exchange

rate and fiscal policy in adjusting the trade balance and the current account. Specifically, we

regress the current account balance on the exchange rate and on fiscal policy variables. The results

show that the exchange rate has little or no effect on the current account balance but that fiscal

policy has a sizeable impact in highly undiversified oil exporters. In regressions where the trade

balance is the dependent variable, we find similar results, namely that the effect of fiscal policy is

strong and the effect of exchange rates is weak. The value of the currency tends to have a margin-

ally stronger effect on the trade balance than the current account balance, and government spend-

ing has a slightly stronger impact on the current account than the trade balance.

Our analysis builds on existing empirical work on current account determinants in oil exporters

(Arezki & Hasanov, 2013; Beidas-Strom & Cashin, 2011; Morsy, 2009) and broader groups of

countries,

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which help assess the appropriate size of a current account. We emphasise government

spending, not just the fiscal balance, to isolate this policy tool from mechanical revenue/export

links driven by oil receipts. Existing studies include exchange rates as control variables in some

cases but do not discuss them at length, possibly because the coefficients were not robustly nega-

tive. We directly discuss the small or insignificant effects found here and why they make sense for

oil exporters. Moreover, we distinguish between a relatively broad group of oil exporters and a

narrower subset of more oil-dependent economies.

To our knowledge, this is the first paper to produce reduced-form trade balance regressions for oil

exporters. Even for wider sets of countries, regressions of the trade balance are scarce. Ollivaud and

Schwellnus (2013) employ single-equation estimation for only a handful of countries. Our paper thus

fills a sizeable gap between reduced-form current account balance regressions and a related literature

on structural trade equation estimates. For a broad group of countries, Leigh, Lian, Poplawski-Ribeiro,

and Tsyrennikov (2015)

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estimate the responses of relative prices to exchange rate changes and in turn

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Fiscal and exchange rate policy are of course not mutually exclusive. Both instruments could be used simultaneously.

Moreover, the two have the potential to interact: in principle, fiscal restraint can aid real exchange rate depreciation by con-

taining domestic prices. A weaker currency can potentially improve the fiscal balance by increasing local-currency oil rev-

enues and by reducing the share of government spending in nominal GDP. Nonetheless, the arguments above suggest a

larger role for fiscal policy.

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Examples include Abbas, Fatas, Mauro, and Velloso (2011), Calderon, Chong, and Loayza (2002), Gosse and Serranito

(2014), Phillips et al. (2013), and Ollivaud and Schwellnus (2013).

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Also see Leigh, Lian, Poplawski-Ribeiro, Szymanski, Tsyrennikov, & Yang (2017).

BEHAR AND FOUEJIEU

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the responses of import or export volumes to relative prices; they argue that exchange rate changes

could have a big impact on real net exports. Studies that disaggregate across products or trading part-

ners find higher exchange rate effects (Auer & Saur

e, 2012; Imbs & Mejean, 2015). For oil exporters,

Hakura and Billmeier (2008) conduct a similar aggregate analysis to Leigh et al. (2015), finding in

contrast that import and export volume responses to exchange rate changes are negligible.

One important advantage of the reduced-form approach to estimating the trade balance or cur-

rent account is that it implicitly incorporates potential income effects from exchange rate changes

as well as channels that may not have been explicitly identified in addition to the expenditure-

switching effects emphasised in the theoretical literature. A second advantage is a more straightfor-

ward comparison of sensitivity to exchange rate and fiscal variables.

Our paper proceeds as follows. Section 2 elaborates on the potential channels through which

exchange rates and fiscal policy could affect the trade balance and other items in the current

account. Although the existing empirical evidence supports a role for both in general , we describe

the special characteristics of oil exporters that undermine the role of the exchange rate (using

adapted Marshall Lerner conditions) and amplify the role of fiscal policy (with an adapted text-

book Keynesian cross model).

Section 3 discusses the empirical results. We base our econometric work on an annual panel

data set from 1986 to 2014. Our broad sample of oil exporters has 24 countries, but we also have

a restricted sample of 15 more oil-dependent countries. Regressions on the broad sample suggest a

1% depreciation raises the current account by about 0.05 percentage points of GDP, although many

specifications are statistically non-significant or positive. This is lower than found in the literature

for other countries. For the restricted sample, the response could be even smaller. The regressions

also suggest that depreciations have a marginally larger impact on the trade balance than the cur-

rent account balance. For example, a 1% depreciation would raise the trade balance by 0.06 per-

centage points of GDP in the broad sample. The regressions show a strong association between

external adjustment and fiscal policy in highly oil-dependent countries. In particular, the estimated

elasticity of the current account balance to government spending is around 1.2 for the restricted

sample and the trade balance elasticity is around 0.7. For the broader sample, the elasticity of the

trade or current account balance with respect to government spending is up to 0.2, which is close r

to that found for other countries.

Section 4 concludes and suggests potential future research including the extension of the empir-

ical work to other commodity exporters.

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THEORETICAL CHANNELS AND EXISTING RELEVANT

LITERATURE

This section will argue that special characteristics of oil exporters reduce the impact of the exchange

rate on the trade balance and more generally the current account, while suggesting that the link

between fiscal policy and external balances could be stronger in at least some oil exporters.

2.1

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The role of the exchange rate

2.1.1

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The exchange rate and trade volumes

In many diversified economies, the exchange rate has the potential to affect net export volumes. In

open economy macroeconomic models, the main channel through which the exchange rate affects

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