Macroeconomic issues and policies in the Middle East and North Africa 9781455282999, 1455282995

Table of contents :
Preface / Horst Köhler --
Acknowledgments --
Economic challenges in the Middle East and North Africa --
an overview / Zubair Iqbal --
pt. 1. Selected macroeconomic and financial issues. Demographic transition in the Middle East: implications for growth, employment, and housing / Pierre Dhonte, Rina Bhattacharya, and Tarik Yousef --
Determinants of inflation in the Islamic Republic of Iran --
a macroeconomic analysis / Olin Liu and Olumuyiwa S. Adedeji --
Financial liberalization in Arab countries / Karim Nashashibi, Mohamad Elhage, and Annalisa Fedelino --
Monetary operations and government debt management under Islamic banking / V. Sundararajan, David Marston, and Ghiath Shabsigh --
Addendum: Recent developments in Islamic banking / Ghiath Shabsigh --
Fiscal sustainability with nonrenewable resources / Nigel Chalk --
pt. 2. External policies. External stability under alternative nominal exchange rate anchors: an application to the Gulf Cooperation Council countries / S. Nuri Erbaș, Zubair Iqbal, and Chera L. Sayers --
Real exchange rate behavior and economic growth in the Arab Republic of Egypt, Jordan, Morocco, and Tunisia / Ilker Domac̦ and Ghiath Shabsigh --
Exchange rate unification, the equilibrium real exchange rate, and the choice of exchange rate regime: the case of the Islamic Republic of Iran / V. Sundararajan, Michel Lazare, and Sherwyn E. Williams --
Addendum: Exchange system reforms in the Islamic Republic of Iran: a note on past and current experiences / Ghiath Shabsigh --
Export performance and competitiveness in Arab countries / Karim Nashashibi, Ward Brown, and Annalisa Fedelino --
The impact of European Union Association agreements on Mediterranean countries / Henri Ghesquiere --
Addendum: Implementation of the European Union Association agreements / Daniel Hardy, Nicole Laframboise, and Edouard Martin --
Estimating trade protection in Middle Eastern and North African countries / Maria-Angels Oliva.

Citation preview

Macroeconomic Issues and Policies in the

Middle East and North Africa

©International Monetary Fund. Not for Redistribution

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©International Monetary Fund. Not for Redistribution

Macroeconomic Issues and Policies in the Middle East and North Africa Zubair Iqbal, Editor

International Monetary Fund Washington, D.C.

©International Monetary Fund. Not for Redistribution

© 2001 International Monetary Fund Production: IMF Graphics Section Cover design: Lai Oy Louie Typesetting: Jack Federici

Library of Congress Cataloging-in-Publication Data Macroeconomic issues and policies in the Middle East and North Africa

p. cm. Includes bibliographic references. ISBN 1-58906-041-5 (alk. paper) 1. Middle East—Economic conditions—1979- 2. Middle East—Economic policy. 3. Africa, North—Economic conditions. 4. Africa, North—Economic policy. I. International Monetary Fund. HC415.15 .M33 2001 339'.0956-dc21

2001024837

Price: $28.00

Address orders to: External Relations Department, Publication Services International Monetary Fund, Washington D.C. 20431 Telephone: (202) 623-7430; Telefax: (202) 623-7201 E-mail: [email protected] Internet: http://www.imf.org

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Contents

Page Preface Horst Kohler

vii

Acknowledgments 1. Economic Challenges in the Middle East and North Africa—An Overview Zubair Iqbal

ix

1

Part I. Selected Macroeconomic and Financial Issues 2. Demographic Transition in the Middle East: Implications for Growth, Employment, and Housing Pierre Dhonte, Rina Bhattacharya, and Tarik Yousef 3. Determinants of Inflation in the Islamic Republic of Iran— A Macroeconomic Analysis Olin Liu and Olumuyiwa S. Adedeji 4. Financial Liberalization in Arab Countries Karim Nashashibi, Mohamad Elhage, and Annalisa Fedelino

19

41 62

5* Monetary Operations and Government Debt Management Under Islamic Banking V . Sundararajan, David Marston, and Ghiath Shabsigh . . . . 8 9 Addendum. Recent Developments in Islamic Banking Ghiath Shabsigh 117 6. Fiscal Sustainability with Nonrenewable Resources Nigel Chalk 125 Part II. External Policies 7. External Stability Under Alternative Nominal Exchange Rate Anchors: An Application to the Gulf Cooperation Council Countries S. Nuri Erbas, Zubair Iqbal, and Chera L. Sayers V

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161

vi

CONTENTS

8. Real Exchange Rate Behavior and Economic Growth in the Arab Republic of Egypt, Jordan, Morocco, and Tunisia Ilker Domac and Ghiath Shabsigh 190 9. Exchange Rate Unification, the Equilibrium Real Exchange Rate, and the Choice of Exchange Rate Regime: The Case of the Islamic Republic of Iran V. Sundararajan, Michel Lazare, and Sherwyn E. Williams . 213

Addendum. Exchange System Reforms in the Islamic Republic of Iran: A Note on Past and Current Practices Ghiath Shabsigh

253

10. Export Performance and Competitiveness in Arab Countries Karim Nashashibi, Ward Brown, and Annalisa Fedelino . . . 263

11. The Impact of European Union Association Agreements on Mediterranean Countries Henri Ghesquiere 304 Addendum. Implementation of the European Union Association Agreements Daniel Hardy, Nicole Laframboise, and Edouard Martin . . . 330

12. Estimating Trade Protection in Middle Eastern and North African Countries Maria-Angels Oliva

335

List of Contributors

369

The following symbols have been used in this book: ...

to indicate that data are not available;

between years and months (e.g., 1995-96 or January-June) to indicate the years or months covered, including the beginning and ending years or months; and /

between years (e.g., 1996/97) to indicate a fiscal (financial) year.

"Billion" means a thousand million. Dollars are U.S. dollars. Minor discrepancies between constituent figures and totals are due to rounding.

vi

©International Monetary Fund. Not for Redistribution

Preface

T

he Middle Eastern and North African economies are presently at a crucial juncture in their reform process. During the past several years, a number of these economies have implemented bold steps to address internal and external disequilibria. Demand management has been strengthened in most countries, and progress has been made to rationalize the domestic price structure, ease restrictions on private domestic and foreign investment, and liberalize exchange and trade regimes. In the event, inflation has been contained and external imbalances reduced. However, growth has remained stubbornly weak, while population has continued to grow briskly. In many countries, this phenomenon has worsened already high levels of unemployment and poverty. The challenge ahead is to accelerate growth in a sustained fashion while avoiding the reemergence of macroeconomic imbalances. There is a strong awareness in the region for a concerted and comprehensive action plan, which can build upon the significant steps that have already been taken to address this challenge. First, it is recognized that fundamental structural reforms are needed to restore market-based prices and institutions, which could encourage private-sector investment, including foreign direct investment. Second, the governments in the region are aware of the critical importance of maintaining macroeconomic stability, so that market forces can efficiently allocate resources. Third, benefits from these steps will crucially depend upon the ability and willingness of countries in the region to become integrated into the global economy through exchange and trade liberalization. However, these steps will have to be matched by the opening of advanced-country markets to the exports of the region's countries. In this context, it is gratifying to note the progress that has been made under the European Union's Association Agreements with a number of Middle Eastern and North African countries. At the same time, regional cooperation and integration will be helpful in increasing the competitiveness of these economies. Finally, countries will have to invest in human capital so as to benefit from and participate in the global technological revolution. But benefits from these initiatives will presuppose vii

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viii

PREFACE

stronger and sounder governance, associated with transparency of policies, adherence to the rule of law, and secure private property rights. It should be recognized that liberalization and globalization will not only provide opportunities and improvement, but will also inevitably involve dislocations associated with the rise and fall of different economic activities. Effective social spending and social safety nets will therefore be necessary to cope with the process of change. The International Monetary Fund has been deeply involved with the regional country authorities to support the reform process through policy advice, the use of Fund resources, and technical assistance, and will remain engaged in the period ahead. Indeed, the Fund's staff has continued to undertake research on the evolving economic conditions of these countries, which has helped in pinpointing policy issues and solutions. This volume brings together a number of such papers prepared recently by the Fund's staff. In particular, these papers address the implications of changing demographic trends for growth and unemployment, determinants of inflation, the role of financial-sector reform and the development of Islamic banking, fiscal sustainability in oil-dependent economies, the role of appropriate exchange rate and trade policies, and impediments to foreign direct investment. This book concludes that accelerating growth and reducing poverty in a sustained fashion requires concerted effort. It can best be achieved by embracing the global economy, improving policies, and strengthening institutions. This will be a challenging task, but one that can be accomplished through closer collaboration between policymakers in the Middle East and North Africa and the international community. As always, the Fund stands ready to be of assistance in this endeavor. HORST KOHLER Managing Director International Monetary Fund

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Acknowledgments

I

am grateful to the following people at the IMF for their advice and support: Paul Chabrier, Director, Middle Eastern Department; Pierre Dhonte and David Burton, Deputy Directors, Middle Eastern Department; and Karim Nashashibi, Senior Advisor, Middle Eastern Department. Thanks are also due to Alfred F. Imhoff for providing editorial help; to Sean M. Culhane of the External Relations Department, IMF, for editorial guidance; to Behrouz Guerami of the Middle Eastern Department for research assistance; and to Anne-Barbara Hyde and Debra Loucks of the Middle Eastern Department for assistance in preparing the manuscriptZUBAIR IQBAL

ix

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1 Economic Challenges in the Middle East and North Africa—An Overview ZUBAIR IQBAL

D

uring the past decade, progress has been made in the Middle East and North Africa to strengthen macroeconomic stability and establish the preconditions for sustained rapid growth. 1 Most countries have also made cautious progress with structural reforms, including trade liberalization and privatization. Tables 1-5 summarize the evolution of the region's economies during the past decade. Several economies—including Algeria, Egypt, Jordan, Morocco, Pakistan, Sudan, and Yemen—have implemented macroeconomic adjustment programs, supported by the use of resources from the International Monetary Fund. During the second half of the 1990s, there was a general deceleration in inflation as the national authorities, by and large, tightened monetary policies and as fiscal deficits were reigned in, while world prices of most imports were subdued. At the same time, external current account deficits fell in response to generally tightened demand management and in some cases corrections in exchange rates. In keeping with the containment of external current account deficits, external debt (as a percentage of exports of goods and services) remained broadly un1

The Middle East and North Africa region, in this context, encompasses the Islamic State of Afghanistan, Algeria, Bahrain, Djibouti, the Arab Republic of Egypt, the Islamic Republic of Iran, Iraq, Jordan, Kuwait, Lebanon, the Socialist People's Libyan Arab Jamahiriya, Mauritania, Morocco, Oman, Pakistan, Qatar, Saudi Arabia, Somalia, Sudan, the Syrian Arab Republic, Tunisia, the United Arab Emirates, the Republic of Yemen, and the West Bank and Gaza.

1

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2

Table 1 . GDP in Constant Prices, Middle East and North Africa (Percentage changes)

Oil-exporting economies Gulf Cooperation Council Bahrain Kuwait Oman Qatar Saudi Arabia United Arab Emirates Non-Gulf Cooperation Council Algeria Iran Libya Other economies Djibouti Egypt Jordan Lebanon Mauritania Morocco Pakistan Sudan Syria Tunisia Yemen

1991

1992

1993

1994

1995

1996

1997

1998

1999

20001

7.3 -26.2 8.4 -14.6 10.7 17.5

1.7 -45.3 6.0 -0.8 8.4 0.2

6.7 47.4 8.5 9.7 2.8 3.8

12.9 46.0 6.1 -0.6 -0.6 2.2

-0.2 1.7 3.8 2.3 0.5 8.5

3.9 2.3 4.8 2.9 0.5 7.9

4.1 1.5 2.9 4.8 1.4 6.2

3.1 2.2 6.2 24.0 2.0 8.3

4.8 3.7 2.7 12.3 1.7 1.6

4.0 -1.7 1.0 7.6 -0.8 4.0

3.9 1.7 4.7 12.9 4.5 7.6

0.8 11.2 3.4

-1.2 10.6 4.7

1.6 6.1 -4.2

-2.1 2.1 -4.6

-0.9 0.9 -2.2

3.8 2.9 -1.6

3.8 5.9 5.2

1.1 2.7 -1.2

5.1 3.7 2.9

3.2 3.1 2.5

2.4 6.1 5.0

5.8 2.4 5.8 -13.4 -1.8 4.0 4.5 1.0 7.6 7.1 2.0

-4.3 2.1 2.3 38.2 2.6 6.9 5.5 7.0 7.1 3.9 -2.1

0.0 0.3 17.0 4.5 1.7 -4.0 4.6 -4.0 10.6 7.8 4.8

-6.7 2.5 5.8 7.0 5.5 -1.0 2.7 6.2 5.0 2.2 0.4

-0.9 3.9 7.6 8.0 4.6 10.4 4.4 2.0 7.7 3.3 -3.6

-3.5 4.7 3.9 6.5 4.5 -6.6 4.9 3.0 5.8 2.4 7.9

-4.1 5.0 1.0 4.0 5.5 12.2 2.9 10.5 4.4 7.0 2.9

-0.7 5.3 1.3 4.0 3.2 -2.2 1.8 10.2 1.8 5.4 8.1

0.1 5.7 2.9 3.5 3.7 6.8 3.1 6.1 7.6 4.8 5.3

2.2 6.0 3.1 1.0 4.1 -0.7 4.1 5.1 -1.8 6.2 3.8

0.7 5.0 4.0 -0.7 5.1 0.8 3.9 8.3 2.5 5.0 6.5

1990

Sources: IMF staff estimates; data supplied by the national authorities Estimated.

©International Monetary Fund. Not for Redistribution

AN OVERVIEW

Region and Economies

Table 2. Inflation Rate, Middle East and North Africa (Percentage changes in consumer price index) Region and Economies

1990

Oil-exporting economies Gulf Cooperation Council Bahrain Kuwait Oman Qatar Saudi Arabia United Arab Emirates Non-Gulf Cooperation Council Algeria Iran Libya

9.8

10.0 4.5 2.1 0.6

16.7 9.0 8.6

1992

1993

1994

1995

1996

1997

1998

1999

20001

0.9 9.1 4.6 2.9 4.6 6.1

-0.3 -0.5

2.6 0.4 1.1

0.4 2.5

3.1 2.7

-0.2

4.6 0.7

-0.3

-1.6

-0.4

0.1

-0.7

-1.1

-0.2

-0.5

-1.0

1.4 0.6 5.0

3.0 5.0 3.1

3.6 0.3 7.1 0.9 3.0

29.0 35.2 10.7

29.8 49.4

18.7 23.2

5.7

4.9

2.6

0.3

17.3

20.0

20.4

8.1

4.0

3.6

3.7

2.6

12.6 -3.0

4.9 9.4 2.3

2.5 6.2 3.0 7.7 4.5 1.0

-2.7

-0.4

10.0 101.3 13.2

12.4 115.5 15.3

12.3 68.4

10.4 132.8

11.4 46.7

2.2 4.2 3.1 4.5 8.0 2.7 6.2

2.4 2.8 0.7

6.5 6.1

3.5 7.1 6.5 8.9 4.7 3.0

2.0 3.8 0.6

9.3 5.2

6.5 9.0 3.6 8.0 4.1 5.1

4.1 0.7 4.1

8.9 3.8

17.1 -0.4

16.0 -2.1

3.1

40.0

1.9 3.7 4.6

2.7 8.0

3.3 1.9 4.4 8.0 1.1 3.0

25.9 20.7 11.7

1.0 3.0

-0.4

-0.9

6.5

0.8 4.4

31.7 24.4

20.5 22.9

9.4

7.5

7.8

6.8

3.4

4.4

21.2 -3.3 88.9

14.7

21.1

11.0

6.5 6.7 9.1

65.2 11.1

8.2

4.0

3.3

50.1

99.8 10.2

24.7

5.5 9.0

12.7 123.6

6.5

9.0 8.2

33.5

44.9

5.7 9.4

117.6 11.1

10.6

5.8

4.0

4.7

7.7 6.3

50.6

62 A

71.3

62.5

2.7

2.9

3.0 0.5 2.2

-0.4

-0.2

-1.3

-0.6

2.9

2.0

2.1

1.4

Sources: IMF staff estimates; data supplied by the national authorities. Estimated.

11.5

1.7 2.5

10.9

Zubair lqbal

Other economies Djibouti Egypt Jordan Lebanon Mauritania Morocco Pakistan Sudan Syria Tunisia Yemen

-0.3

1991

3

©International Monetary Fund. Not for Redistribution

4

Table 3. Central Government Budget Balance, Middle East and North Africa (Percentage of GDP)

Oil-exporting economies Gulf Cooperation Council Bahrain Kuwait Oman Qatar Saudi Arabia United Arab Emirates Non-Gulf Cooperation Council Algeria Iran Libya Other economies Djibouti Egypt - . Jordan Lebanon Mauritania Morocco Pakistan Sudan Syria Tunisia Yemen

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

-7.8 -32.0 5.1 2.8 -14.7 -9.0

-4.1 -151.4 0.0 -4.3 -18.8 -9.7

-6.5 -49.8 -6.5 -3.2 -9.0 -3.8

-0.3 -15.8 -8.6 -10.9 -10.5 -77

-2.3 -9.3 -8.0 -10.5 -9.3 -0.4

-4.8 -2.0 -4.6 -4.9 -5.7 -5.4

0.4 11.1 3.5 -9.1 -3.6 -7.0

-3.8 17.2 4.2 -8.9 -2.8 1.5

-4.0 7.6 -5.6 -6.9 -10.2 -6.3

-5.8 15.7 1.2 3.9 -6.8 -5.4

2.7 -1.1 1.3

0.9 -2.2 9.5

-1.8 -1.2 -2.1

-7.6 -7.2 -4.3

-3.6 -4.5 -3.5

-1.1 -3.7 4.3

2.9 -1.7 12.4

2.4 -2.5 -0.4

-3.9 -6.9 -4.2

-0.5 1.0 11.5

-7.3 -12.6 -6.4 -29.8 -5.4 -0.6 -77 -14.9 -1.3 -5.4 -13.6

-3.0 -20.3 -14.8 -13.1 -5.1 -1.0 -8.5 -24.3 -2.2 -6.0 -8.0

-11.4 -4.2 0.3 -11.4 -2.8 -2.2 -8.0 -22.5 -2.5 -3.9 -13.1

-13.0 -3.5 -0.5 -9.2 -7.8 -2.9 -8.2 -7.4 -5.3 -3.8 -14.8

-11.1 -2.1 -1.4 -20.5 -2.5 -3.8 -6.0 -2.8 -3.2 -2.1 -16.4

-8.5 -1.2 -3.9 -18.4 1.1 -5.5 -7.3 -3.2 -1.4 -4.2 -6.4

-3.9 -1.3 -2.8 -21.7 7.5 -2.8 -7.3 -3.4 -0.2 -4.9 -4.2

-4.3 -0.9 -2.5 -27.6 5.0 -3.3 -7.2 -0.7 0.9 -3.9 -2.5

0.9 -1.0 -5.9 -18.6 3.6 -4.6 -6.8 -0.7 -0.5 -2.5 -6.7

-2.1 -4.2 -3.5 -16.1 4.7 -1.8 -6.2 -0.9 -0.5 -2.3 -1.2

Sources: IMF staff estimates; data supplied by the national authorities.

©International Monetary Fund. Not for Redistribution

AN OVERVIEW

Region and Economies

Table 4. Current Account Balance, Middle East and North Africa (Percentage of GDP) 1992

1993

1994

1995

1996

1.5 23.2 12.6 10.2 -4.0 21.0

-13.0 -245.3 0.1 8.7 -23.3 10.6

-17.4 -2.3 -3.0 4.7 -14.4 10.1

-6.5 10.4 -8.3 -9.1 -14.6 11.7

-4.6 12.9 -4.7 -18.7 -8.7 3.1

4.1 18.9 -43 -26.3 -4.2 3.5

4.3 22.9 1.2 -23.0 0.5 13.1

3.0 -1.1 7.3

5.2 -8.4 3.2

2.7 -5.6 4.6

1.6 -5.2 -4.3

-4.3 7.5 -0.7

-5.4 3.8 5.4

-2.3 -2.8 -18.7 -38.7 -9.1 -2.8 -3.8 -9.0 14.2 -5.5 -3.1

-3.8 3.6 -15.3 -56.7 -16.2 -2.2 -2.7 -9.2 13.2 -4.4 -10.7

-17.0 8.7 -14.9 -49.8 -17.0 -2.1 -4.4 -43.7 4.1 -7.8 -13.2

-5.7 4.7 -11.6 -49.0 -24.3 -1.9 -4.8 -24.7 -1.8 -8.8 -16.1

-7.5 0.4 -6.6 -45.0 -21.1 -2.4 -3.6 -22.7 -5.6 -4.2 5.6

-3.4 0.6 -3.8 -42.0 -12.5 -3.6 -5.6 -20.6 1.7 -4.3 2.8

1990

Oil-exporting economies Gulf Cooperation Council Bahrain Kuwait Oman Qatar Saudi Arabia United Arab Emirates Non-Gulf Cooperation Council Algeria Iran Libya Other economies Djibouti Egypt Jordan Lebanon Mauritania Morocco Pakistan Sudan Syria Tunisia Yemen

1997

20001

1998

1999

-0.5 26.6 -2.6 -25.0 0.2 10.7

-12.6 8.7 -23.2 -24.0 -10.2 5.3

-5.2 17.0 -3.0 16.6 0.3 10.9

3.4 39.3 13.5 25.5 9.0 24.8

2.7 5.0 4.2

7.2 1.5 3.6

-1.9 -2.2 -5.1

0.0 4.6 2.0

16.8 14.0 12.1

-3.3 -0.3 -3.2 -37.2 -13.7 0.1 -6.5 -18.8 -0.1 -2.4 1.7

-2.3 0.2 0.4 -29.3 -9.5 -0.3 —4.2 -15.5 2.0 -3.1 0.3

-0.6 -3.0 0.3 -26.7 -12.3 -0.4 -3.2 -19.3 0.9 -3.4 -3.7

-0.5 -1.9 5.0 -21.5 -10.3 -0.5 -2.8 -15.4 0.2 -2.1 2.9

-5.1 -1.2 1.6 -19.3 -11.1 -1.7 -2.2 -12.7 0.9 -3.7 10.0

Sources: IMF staff estimates; data supplied by the national authorities. Estimated.

Zubcdr Iqbal

1991

Region and Economies

5

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6

A N OVERVIEW

Table 5. Total External Debt, Middle East and North Africa (Percentage of exports of goods and services) Economy Algeria

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

265

193

211

222

239

301

289

236

211

277

91

117

114

123

141

148

133

643

381

316

256

233

271

246

229

196

129

107

145

99

61

96

383

293

269

257

233

218

229

233

Djibouti Egypt Iran Jordan

53

34

302

329

229

Lebanon

205

348

264

286

184

280

227

283

323

367

Mauritania

400

450

439

467

518

516

448

468

564

636

292

346

321

322

Morocco

550

489

429

444

448

350

Oman

...

49

59

51

49

55

Pakistan

329

332

314

300

293

328

309

290

307

322

Sudan Syria

729

500

598

546

523

409

414

382

425

444

Tunisia

156

144

156

139

147

137

136

139

136

131

Yemen

...

920

926

949

869 1,136

677

723

155

278

Source: World Bank, World Development Indicators 2000.

changed for most of the economies in the region. However, the growth of real GDP generally remained weak, while population continued to grow briskly (although more slowly than in the past), and foreign direct investment inflows were well below those in other regions.2 Progress in implementing reforms has varied among countries. Before the 1997—98 downturn in oil prices, the major oil-exporting countries responded to episodes of falling oil prices with a combination of financing and adjustment. Substantial external reserves and the low level of public debt allowed room to finance external current account and fiscal deficits. Adjustment was largely undertaken through cuts in capital outlays, which also adversely affected private-sector growth and did not correct the underlying structural weaknesses of the economy. The adjustment strategy during these earlier episodes of declining oil prices thus did not seek a lasting solution, which would have reduced fiscal vulnerability to oil revenue fluctuation. The strategy instead was 2 Although there has been some moderation in population growth rates in most of the region's economies, they rank between a low of 1.3 percent in Tunisia and a high of 3.6 percent in Yemen. Eleven of the 20 economies have registered population growth averaging 2.5 percent during the past several years.

©International Monetary Fund. Not for Redistribution

Zubair Iqbal

7

predicated on the assumption that oil prices would recover and stabilize at a higher level. The oil price downturn of 1997—98 spurred a policy response that sought to fundamentally reform underlying structural distortions—not only to deal with the short-term adverse effects of fluctuating oil export receipts, but also to establish a firm foundation for reducing dependence on oil and facilitating sustained growth of the non-oil sector. Although fiscal consolidation through rationalization of expenditure and mobilization of non-oil revenues is deemed to be the central plank of this reform strategy, attention is also being paid to narrowing the role of the government sector—through public-sector restructuring and privatization, correcting prices of officially supplied inputs to reduce implicit subsidies, strengthening the financial sector's ability to mobilize and allocate savings more efficiently, and introducing regulatory reform to encourage the foreign direct investment that will deepen and diversify the economic base. A number of oil-producing countries have initiated steps to implement this adjustment strategy. The experience of non-oil-exporting countries has been much more diverse. Recent initiatives toward reform have included policy measures to ensure macroeconomic stability, attract foreign direct investment, increase exports, and create favorable conditions for private-sector growth based on new technologies and improved labor skills. The European Union's Association Agreements with countries of the southern and eastern Mediterranean to establish free trade in industrial products have played a catalytic role in facilitating the needed structural reform in a number of countries. The Greater Arab Free Trade Agreement was launched in 1997 to establish free trade among its 18 signatories over a ten-year period. It aims at an upfront elimination of quantitative restrictions on trade and annual reductions in tariffs by 10 percent. The effort has, however, been constrained by concerns about the potential short-term social consequences of a quick reform of the existing widespread structural distortions. The resulting gradualist policy stance has slowed the pace of trade liberalization and integration with the global economy.3 And the consequent slow pace of improvements in production efficiency may have contributed to the modest inflow of foreign direct investment and kept growth largely import substituting rather than outward oriented. 3

Reflecting the gradualist approach and a slow deceleration in inflation, during the past five years, many countries have experienced real effective appreciation of their currencies; important exceptions have been some major oil-exporting countries and countries with IMF programs (including Mauritania, Pakistan, and Sudan) where low or falling inflation and market-based exchange rate flexibility have allowed the maintenance of appropriate exchange rate policies.

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8

A N OVERVIEW

Challenges for the Future Important challenges remain. Economic growth needs to be accelerated to accommodate the rapidly expanding labor force and alleviate mounting unemployment. Although the rate of population growth has slowed, the labor force is projected to increase rapidly in the medium term. During the past several years, productivity has stagnated, resulting in little increase in per capita output, and real wages also have stagnated. The fight against poverty remains daunting. Demographic changes have also been associated with an increased concentration of unemployment in rapidly expanding urban areas. Conversely, investment has grown only modestly. There is a broad consensus in the region on the need for a structural reform strategy to improve resource allocation and create institutional conditions suitable for accelerated growth while maintaining internal and external stability. Such a strategy would include further reducing fiscal deficits, increasing exchange rate flexibility, and liberalizing trade policy—supported by decontrolling prices, privatizing state-owned enterprises, and encouraging investment, especially foreign direct investment. Strengthening rules to ensure private property rights and increasing the number of activities in the private sector have come to be accepted as essential building blocks of such a strategy. In particular, there has been a recognition of the need for early reform of the financial sector—especially stronger prudential regulation and supervision—as a precondition to reap the full benefits of reform undertaken in the other areas, significantly raise the levels of domestic savings and investment, and thus promote higher growth and employment generation (IMF, 1997). Appropriately sequenced capital account liberalization has also been recognized as desirable to promote foreign direct investment (Chabrier, 1998). However, the preferred gradualist approach to reform in the region, in combination with the more and more challenging external environment, may be adversely affecting prospects for an early acceleration of growth. This book brings together a number of papers prepared by IMF staff during the past few years on some of the region's major structural and macroeconomic issues, with which its governments are grappling. By identifying specific policy imperatives in particular countries or groups of countries with a broad relevance to the entire Middle East and North Africa region, the book aims to reinforce the importance of structural reforms—in combination with macroeconomic stability and marketbased prices—in promoting self-sustaining growth. The book is divided into two parts: one dealing with selected macroeconomic and financial issues, and one addressing external policies.

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Selected Macroeconomic and Financial Issues Part I consists of six chapters and one addendum that focus mainly on macroeconomic and financial-sector issues. In Chapter 2, "Demographic Transition in the Middle East: Implications for Growth, Employment, and Housing," Dhonte, Bhattacharya, and Yousef emphasize that the working-age population is expected to grow faster in the Middle East than in any other region of the world between 2000 and 2015, rising annually by 2.7 percent. This demographic explosion presents the region with a major challenge: to provide jobs, adequate incomes, and housing for the growing population. However, the chapter argues that the expanding labor force can also be seen as an opportunity to generate higher per capita income growth on a sustainable basis. It stresses the importance of market-friendly institutions and policies in turning this challenge into opportunity. In addition to improving the enforcement of property rights and increasing total factor productivity, the emerging situation will call for, among other things, steps to promote investment, including foreign direct investment; restore appropriate exchange rates; liberalize trade; introduce market-clearing domestic prices; and reform the financial sector, in an environment of macroeconomic stability. In Chapter 3, "Determinants of Inflation in the Islamic Republic of Iran—A Macroeconomic Analysis," Liu and Adedeji develop a macroeconomic framework for analyzing the major determinants of inflation in Iran during the period 1989/90-1999/2000. The chapter was inspired by mounting evidence that persistent macroeconomic disequilibria in many regional economies have been associated with expansionary financial policies, while correction of exchange rates has been resisted through intensified controls (including administered prices). In the event, inflationary pressures have persisted, resulting in weaker growth. An empirical model for Iran is estimated by taking into consideration disequilibria in markets for money, foreign exchange, and goods. The model estimation shows that excess money supply generates an increase in the rate of inflation, which in turn intensifies asset substitution (from money to foreign exchange), thereby weakening real demand for money and exerting pressures on the foreign exchange market. The authors call for sustained, prudent monetary policy to reduce inflation and stabilize the foreign exchange market. In Chapter 4, "Financial Liberalization in Arab Countries," Nashashibi, Elhage, and Fedelino note that the substantial progress in financial liberalization in a number of Arab countries has placed them on a more solid macroeconomic footing, which has been associated with fiscal adjustment efforts and structural reforms—often as part of an IMF-supported program. However, much of the progress has focused on

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10

AN OVERVIEW

the banking sector and the conduct of monetary policy. Conversely, capital markets have remained undeveloped, with limited integration with the international markets. This is particularly the case for most non-oil-exporting Arab countries, where controls on capital movement remain. Moreover, the authors note that—given the limited size and depth of domestic financial markets—available domestic financing in some countries has fallen short of their developmental needs. The chapter therefore stresses the need to promote domestic equity and bond markets and to encourage foreign direct investment to provide the much-needed financing for productive activities. It emphasizes the crucial role of good macroeconomic and growth performance, trade and capital liberalization, and well-functioning financial institutions as important prerequisites to attract external private inflows and to integrate domestic capital markets into global markets. During the past several years, Islamic banking has grown rapidly in the region. It has led to financial innovation, necessitating changes in central banking operations, diversification of money markets, the establishment of more rigorous accounting and disclosure standards, and strengthened supervision. In Chapter 5, "Monetary Operations and Government Debt Management Under Islamic Banking," Sundararajan, Marston, and Shabsigh outline recent progress in developing Islamic financial instruments for the management of monetary policy and public borrowing requirements. The chapter provides details on new instruments that have been under development in Iran and Sudan. The authors touch upon the institutional arrangements for interbank market operations and the design of effective central bank credit facilities that are needed under the Islamic banking to support these new instruments. They emphasize that the unique challenge of implementing market-based monetary policy operations in the Islamic banking system derives from the complexity of designing market-based instruments for monetary control and government financing that satisfy the Islamic prohibition on ex ante interest payments. This challenge can limit the development of efficient mechanisms for monetary control and general government funding, and thus perpetuate reliance on direct controls. These inefficiencies should be addressed by creating new instruments to avoid disintermediation and persistent inflationary pressures. In his addendum to Chapter 5, "Recent Developments in Islamic Banking," Shabsigh looks at progress made in the past four years, particularly in the development of financial instruments, in central banking operations, and in the regulatory and institutional areas to address the issues noted above. In Chapter 6, "Fiscal Sustainability with Nonrenewable Resources," Chalk addresses crucial issues confronting economies that depend on

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resources such as oil and gas for much of their exports and budgetary revenues. Apart from the intergenerational equity implications of the finite nature of such resources, the national authorities are confronted with the difficult task of adjusting government spending to fluctuations in resource-related revenues, while cushioning the nonresource (domestic) economy from the effects of these fluctuations. Chalk develops—in a simple dynamic framework—an alternative fiscal behavior in an economy where wealth is derived predominantly from a nonrenewable resource such as oil. The chapter highlights the structural weaknesses in the underlying budgetary position, takes into account the rate of depletion of a country's natural resource base, and examines the effects of changes in a country's terms of trade in order to develop an alternative indicator of fiscal sustainability. When the budget is strongly influenced by natural resource income subject to exogenous shocks, the situation of the budget rather than the level of the deficit has important implications for sustainability. The chapter therefore notes that, rather than the traditional deficitGDP ratio as an indicator of fiscal health, fiscal sustainability in resource-dependent economies should be measured by the "core" deficit, which is defined as the overall deficit less net transfers and resourcebased and investment income. A higher core deficit leads a country further away from long-run sustainability. The chapter stresses the importance of a country's terms of trade for the conduct of fiscal policy; under improving terms of trade, a large resource endowment can act as a substitute for fundamental fiscal reform. However, such policies could be disastrous if the terms of trade worsen over an extended period. Chalk demonstrates that to provide for future generations, governments need to have a strong commitment to replace their nonrenewable resource wealth with financial assets. More recent work in this field has encouraged the establishment of savings and stabilization funds from oil export receipts as a means to achieve the twin objectives of intergenerationally distributing oil wealth and of countering the adverse effects of falling exports and budgetary receipts on government spending, and thus on the growth of the non-oil economy (see Valdes and Engel, 2000; Fasano, 2000).

External Policies There has been an increased recognition in Middle Eastern and North African countries of the role played by external policies, particularly exchange rate policies, in achieving and maintaining competitiveness, and thus balance of payments viability, which is critical for

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12

AN OVERVIEW

sustained growth. This has been manifested in important steps toward reform of the exchange and trade systems during the past few years, which are examined in the six chapters and two addenda of Part II. In Chapter 7, "External Stability Under Alternative Nominal Exchange Rate Anchors: An Application to the Gulf Cooperation Council Countries," Erbas, Iqbal, and Sayers suggest that the estimated import and export elasticities would imply little improvement in external stability by shifting from an effective peg to the U.S. dollar to the SDR. In some cases, the authors note, stability may actually not be improved by switching from a dollar peg to an SDR peg. Effective pegging to the dollar has been guided by the broad objective of minimizing exchange risks for the private sector and ensuring stable exchange rates among Gulf Cooperation Council (GCC) member countries. In late 2000, the GCC countries decided to formalize a common peg to the dollar as an initial step toward a possible common currency area in the future. In Chapter 8, "Real Exchange Rate Behavior and Economic Growth in the Arab Republic of Egypt, Jordan, Morocco, and Tunisia," Domac and Shabsigh examine the effects of real exchange rate misalignment on the collective economic growth of these countries. They argue that misalignment, among other things, can lead to a reduction in economic efficiency, a misallocation of resources, and capital flight. Correction of the real exchange rate, combined with appropriate demand management, is required to restore macroeconomic equilibrium. Three measures of misalignment are constructed for Egypt, Jordan, Morocco, and Tunisia to test the hypothesis. They include measures based on purchasing power parity, on a black-market exchange rate, and on a structural model. The empirical results confirm that misalignments stemming from exchange rate policies in these countries had adverse effects on their economic growth during the period 1970—90. The authors note that the liberalization and economic reform policies initiated by these countries in the late 1980s and 1990s have resulted in major realignments of their real exchange rates, which—if pursued in a sustained fashion—could enhance their growth prospects. In Chapter 9, "Exchange Rate Unification, the Equilibrium Real Exchange Rate, and the Choice of an Exchange Regime: The Case of the Islamic Republic of Iran," Sundararajan, Lazare, and Williams illustrate how economic policy variables and exogenous shocks affect the real exchange rate primarily through the fiscal balance and, consequently, the savings-investment gap. By assessing developments before the steps initiated in 1999/2000 toward exchange system reform, the authors emphasize that the appropriate level of the real effective exchange rate and its medium-term path depend upon the mix of monetary, fiscal, and structural policies that underpin the evolution of inflation, balance of

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payments, and productivity growth. They note that there has been a large variability in the real exchange rate, which reflected the corresponding variability in both domestic (fiscal deficits and inflation) and external (real price of oil and terms of trade) factors. The reduction in inflation is viewed by the authors of Chapter 9 as critical to sustaining competitiveness and growth. They contend that the pursuit of the dual objectives of reducing inflation and maintaining appropriate real exchange rate targets can best be achieved by a managed-peg regime or by managed fixing with a sufficiently wide band around the central parity. Implementing such a mechanism would require eliminating multiple exchange rates, consolidating fiscal accounts within a medium-term framework, adopting more flexible market-based instruments of monetary policy that are consistent with declining inflation, and relaxing exchange controls. The proposed exchange regime should be managed by setting up indicators and operating targets by developing progressively more market-based instruments of exchange market intervention. In the addendum to Chapter 9, "Exchange System Reforms in the Islamic Republic of Iran: A Note on Past and Current Practices," Shabsigh describes steps taken by the national authorities, effective in 1999/2000, to reform the exchange system. The number of multiple rates has been reduced, and the market-based Tehran Stock Exchange Rate (TSE rate) has been allowed to depreciate significantly in line with market conditions. Concurrently, fiscal and monetary policies have been tightened, laying the groundwork for successful exchange reform toward unification. Meanwhile, although apparently managed on a day-to-day basis by the Central Bank of Iran in the form of a crawling-band regime, the TSE rate has remained broadly market determined. In Chapter 10, "Export Performance and Competitiveness in Arab Countries," Nashashibi, Brown, and Fedelino note that the export performance of Arab countries since the 1980s has been mixed. Even though non-oil-exporting countries have improved their product diversification, their market share in world imports did not keep pace with growth in world trade during the 1990s. Analysis based on real effective exchange rates implies some loss of competitiveness. At the same time, weaker macroeconomic policies and the adoption of fixed exchange rates in a number of countries also resulted in real effective appreciations. Although financial stability was improved because of fixed exchange rates, the fixed rates contributed to higher real interest rates, reducing investment and diverting savings toward financial assets. In the period ahead, without significant productivity gains, the combination of the current policy stance would add further pressures on competitiveness, especially for non-oil-exporting countries.

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AN OVERVIEW

The authors of Chapter 10 emphasize that improvement in competitiveness will depend crucially on the pace at which the economies and trade regimes are liberalized, so that market signals improve resource allocation. Accelerating privatization and creating a friendlier environment for foreign direct investment would provide the much-needed technology and managerial skills to facilitate productive growth. These initiatives would benefit from the adoption of more flexible exchange rate regimes supported by structural reforms, so as to enhance the supply responsiveness of the economy. To expand the size of their markets and access to capital and technology, and thus promote growth, several countries of the southern and eastern Mediterranean have entered into Association Agreements with the European Union (AAEUs). In Chapter 11, "The Impact of European Union Association Agreements on Mediterranean Countries," Ghesquiere evaluates the economic benefits and costs of AAEUs for Egypt, Jordan, Lebanon, Morocco, and Tunisia. He argues that these AAEUs will provide a major impetus toward an open trade regime during the next 12 years and constitute a powerful catalyst for overall economic reform. However, benefits will be forthcoming only if major supplementary reforms are implemented consistently and front-loaded. An important challenge for the authorities would be to ensure continued macroeconomic stability while overseeing a socially acceptable transformation of the production structure of their economies. The chapter stresses that the success of the AAEUs will hinge on the countries' ability to generate a critical mass of foreign direct investment in labor-intensive, export-oriented sectors. This will require substantial further transformation, including liberal rules governing trade in services and property rights, privatization, reform of judicial and administrative practices, and a reduced role for the government. The chapter also provides preliminary estimates of static benefits for the countries under review and contends that firm macroeconomic policies with flexible exchange rates would need to be supported by well-focused EU assistance and cooperation. The addendum to Chapter 11, "Implementation of the European Union Association Agreements," by Hardy, Laframboise, and Martin, provides information on the progress of the AAEUs thus far in Jordan, Morocco, and Tunisia. Finally, in Chapter 12, "Estimating Trade Protection in Middle Eastern and North African Countries," Oliva studies the structure and evolution of trade protection in these countries during the 1990s. She argues that conflicts between pressures for liberalization to promote growth and imperatives to maintain unsustainable macroeconomic objectives (especially appreciated exchange rates) have determined the direction of trade policy. Whether the balance moved toward protec-

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tionism or liberalization depended upon the ability of the national authorities to deal with domestic imbalances and regional trading relations. It is particularly interesting that trade arrangements have so far been aimed mainly at promoting trade with industrial countries and not necessarily at encouraging intraregional trade. Oliva notes that Middle Eastern and North African countries use tariffs and nontariff barriers, and tariff dispersion and nontariff barriers, as substitute protection instruments, with tariff levels and tariff dispersion acting as complements. Excluding Tunisia, the cross-country correlation between tariff and nontariff barriers is -0.5, whereas the correlation between tariff dispersion and nontariff barriers is -0.8. The chapter also develops an overall index of trade protection and finds that tariff levels, their dispersion, and nontariff barriers account, respectively, for 30, 20, and 50 percent of overall protection.

References Chabrier, Paul, 1998, "How Has the Asian Crisis Affected Other Regions? The Middle East and North Africa," Finance & Development, Vol. 35 (September), pp. 16-17. Fasano, Ugo, 2000, "Review of the Experience with Oil Stabilization and Savings Funds in Selected Countries," IMF Working Paper WP/00/112 (Washington: International Monetary Fund). IMF (International Monetary Fund), 1997, Building on Progress: Reform and Growth in the Middle East and North Africa (Washington). Valdes, Rodrigo O., and Eduardo Engel, 2000, "Optimal Fiscal Strategy for OilExporting Countries," IMF Working Paper WP/00/118 (Washington: International Monetary Fund).

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PART I

Selected Macroeconomic and Financial Issues

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2 Demographic Transition in the Middle East: Implications for Growth, Employment, and Housing PIERRE DHONTE, RINA BHATTACHARYA, AND TARIK YOUSEF

T

he population of the Middle East has grown very rapidly in the past three decades, faster than all regions of the world, except subSaharan Africa.1 Along with this demographic explosion, the region's labor force has grown, urbanization and rural—urban migration have increased, and the gap in food self-sufficiency has widened. Yet, for much of the period, rapid population growth was of little concern to policymakers. Regional economies were undergoing rapid structural transformation, and gross domestic product (GDP) growth performance was above the average for developing countries. Moreover, national governments expanded their role as employer and consumer, and the oil boom stimulated substantial flows of labor and capital within the region. In the aftermath of the oil bust in the mid-1980s and the regional conflict in 1990, economic growth has decelerated in most countries in the region. In response, governments have pursued reform efforts aimed at liberalizing their economies and generating faster growth. NotwithThe authors thank Eduard Bos, David Burton, Paul Chabrier, Zubair Iqbal, and Karim Nashashibi for comments and suggestions, and Ilse-Marie Fayad and Binta Terrier for research assistance. 1 Throughout this chapter, unless otherwise stated, "Middle Eastern countries" refers to the countries of the Arab League (the "Arab countries") as well as Pakistan, the Islamic State of Afghanistan, and the Islamic Republic of Iran, which together constitute the area of the IMF's Middle Eastern Department.

19

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DEMOGRAPHIC TRANSITION

standing progress in trade reform and financial liberalization, structural adjustment has been slow, and the dominance of the public sector continues to be evident throughout the region; in many countries, the private sector has yet to become an engine of economic transformation. The labor markets of the region, despite an enviable record of employment creation, remain burdened by high rates of unemployment, which are partly the result of existing distortions and the legacy of the role of the state as the main employer. Moreover, during the next two decades, the dynamics of demographic transition will generate growing pressures as the population age structure matures. Indeed, the region's working-age population is forecast to grow faster than that of any other region in the world between now and 2015, at an annual rate of 2.7 percent. Employment growth rates in excess of 4 percent a year will need to be sustained to absorb this growing population, allow for rising participation rates, and reduce unemployment. Accordingly, the region's key economic challenge is to accelerate economic growth through rapid accumulation and enhanced efficiency so that it can absorb large numbers of new workers in jobs that ensure sustained increases in real wages, while it also addresses labor-market rigidities and biases in educational systems. This chapter highlights selected aspects of this challenge. The rest of the chapter is organized as follows. The second section provides an overview of recent demographic trends in the region, emphasizing the maturing age structure and rapid rise in the share of the working-age population. The third section highlights the potential positive contribution of this "demographic gift" to the process of accumulation and GDP growth. The fourth section places the demographic projections through 2015 into a growth-accounting framework and carries out simulations of labor-market conditions. The fifth section shows the wideranging implications of the new demography for the housing-construction sector. By way of conclusion, the sixth section points to the broader implications for economic policy.

The New Demography of the Middle East The populations of the two groups of countries that make up the Middle East are comparable in size, present demographic characteristics, and projected demographic trajectory (for details on the demographic sources and projections used in this chapter, see Box 1). The population of the Arab countries is about 280 million; that of Pakistan, Afghanistan, and Iran is about 240 million. In both groups of countries, the working-age population (15-64 years) accounts for more than 55 percent of the total, and the school-age population (0-14 years) is the

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Box 1. Demographic Data Sources The demographic data for this chapter are drawn from the World Bank's World Development Report database (1999; hereafter, "WDR"), supplemented by additional data from the World Bank. Data for 2000 and 2015 are projections based on a baseline scenario; the sensitivity of the scenarios to alternative assumptions for fertility and mortality rates would not affect materially the points of emphasis here. The other main source of cross-country data on demography is the United Nations Population Division. The WDR demographic data are based on the most recent official figures, which are usually individual country census results supplemented by official estimates for years immediately following the census. Only in a few countries (e.g., Saudi Arabia) where there is no recent population census, or where the census results yield implausible figures, does the WDR rely on estimates from the U.N. Population Division. For example, the 1999 WDR demographic data on Algeria are official estimates from the national statistical agency, the Office National de Statistique, which are based on preliminary results from the 1998 census; the data for Iran are based on the results of the 1996 census and official estimates from the Statistical Centre of Iran; the Moroccan and Tunisian data are based on the results of 1994 censuses, supplemented by official estimates to 1998. For Egypt, the 1996 census results have been adjusted using estimates of the number of Egyptians living abroad, supplemented by World Bank projections for subsequent years. Likewise, for Jordan, the results of the 1994 census have been combined with World Bank projections for more recent years. The World Bank projections make use of a cohort-component method, which projects age-specific fertility and mortality schedules that are based in part on recent country-specific trends in these variables and on life tables that provide projected life expectancy and infant mortality rates. There are two main sources of discrepancy between the WDR and U.N. demographic data and projections. The U.N. Population Division data in some cases do not reflect the latest available information—such as the results of the 1997 Population and Family Health Survey for Jordan—because they place more emphasis on consistency of data across countries (e.g., that the global net migration figures add up to zero). By contrast, the WDR concentrates more on the individual country data and projections, and on incorporating the latest available information for each country. The second main source of discrepancies between the WDR and U.N. data are country specific. For example, the U.N. figures for Jordan incorporate the West Bank and Gaza, whereas the WDR data do not.

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DEMOGRAPHIC TRANSITION

second largest group (40 percent) (Tables 1 and 2). People 65 years of age and older form a comparatively small fraction of the total Similar characteristics apply to individual countries within each group. During the past three decades, the population of the two country groups has been growing rapidly. It more than doubled from 223 million in 1970 to 525 million by 2000, and is projected to rise to 720 million by 2015. Such rates of increase vastly exceed those in the rest of the world or in any of its other major regions, including South Asia; only Africa comes close. As a result, the population of the Middle East will rise from 6 percent of the world total in 1970 to more than 10 percent in 2015, and the region will be home to 1 in 7 of the world's new babies over the next 15 years. However, population growth will ease in the twenty-first century. Already, fertility rates have sharply declined in a number of countries, and overall growth rates are projected to decelerate gradually during the next 25 years. Equally significant, the demography of the Middle East will be shaped by the trends in age structure: the expanding bulge in the middle and the shrinking younger tail in the age distribution of the population. The share of the working-age group in the total population rose from 52 percent in 1970 to 57 percent in 2000, a trend that is proTable 1 . Key Population Data for Selected Regions

Region and Age World (total) 0-14 years 15-64 years

____1970

Population (in millions) 2000 2015

Annual Growth Rates (in percent) 1970-2000 2000-2015

3,676 1,369 2,085

6,055 1,814 3,827

7,103 1,804 4,739

1.70 0.94 2.05

1.07 -0.04 1.43

European Union (15 countries) 0-14 years 15-64 years

340 84 215

376 63 252

371 54 245

0.34 -0.95 0.53

-0.08 -0.97 -0.19

Middle Eastern countries 0-14 years 15-64 years

223 101 115

524 205 300

721 242 449

2.88 2.39 3.25

2.15 1.11 2.72

Arab countries (total) 0-14 years 15-64 years

122 55 63

281 107 164

385 129 240

2.82 2.24 3.24

2.12 1.25 2.57

Pakistan, Afghanistan, and Iran 0-14 years 15-64 years

101 46 52

243 98 136

336 113 210

2.97 2.55 3.26

2.16 0.95 2.91

Source: World Bank, World Development Report database, 1999.

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Table 2. Age Structure of the Population in Selected Regions

Region and Age World European Union (15 countries) Middle Eastern countries (total) Arab countries Pakistan, Afghanistan, and Iran

Share of Working-Age Population (in percent) _______1970 2000 2015

Demographic Gift1 (in percent per year) 1970-2000 2000-2015

57.1

63.2

66.7

0.34

0.36

63.2

67.0

66.0

0.19

-0.12

51.6 51.6

57.2 58.4

62.3 62.3

0.36 0.41

0.56 0.44

51.5

56.0

62.5

0.28

0.73

Source: World Bank, World Development Report database, 1999. 1 Growth rate of the working-age population, minus that of the total population.

jected to accelerate in the next decade so that the ratio exceeds 62 percent by 2015 (Table 2). Such a trend is expected and conforms to observed patterns across the world. For the world as a whole, the working-age population was 63 percent of the total in 2000 and is expected to rise to 67 percent in 2015. Thus, in fact, the ratio is still relatively low in Middle Eastern countries, and will continue to expand for decades to come. In combination, the high total population growth rates and rapidly changing age structure entail extremely high rates of growth of the working-age population—a compound growth rate in excess of 3 percent for the half-century after 1970! To put this in perspective, the working-age population of the Middle East was half that of the European Union (with 15 member countries) in 1970; it will be almost twice as large in 2015. Although its growth rate will fall over time, the absolute numbers will rise strongly; new entrants to the working-age group will average 15 million a year during the next 15 years, whereas the net increase (allowing for aging and mortality) will average 10 million a year. Moreover, employment will need to grow even faster than the working-age population. Employment needs will be boosted by rising labor participation rates and by the objective of reducing current unemployment rates. Table 3 projects employment needs for seven countries for the period 2000—2015, assuming a uniform contribution (1 point) from rising participation rates and a halving of the unemployment rate by the end of the projection period (except for Pakistan, where the initial rate is low). The calculations suggest that, during the next 15 years, employment in the seven countries will need to rise on

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(Annual growth rates, in percent) Employment Growth

Unemployment Rate

Contribution of Country

Estimated, 1973-94 1

Required, 2000-2015

Algeria

3.2

Egypt Iran

1.4 2.6

Jordan

(In percent) Unemployment Reduction3

Latest Available Official Estimate

Targeted, 2000-2015

Work ing-Age Population

Participation Rate2

5.0

2.7

1.0

1.3

28.0

14.0

3.6

2.2

0.4

12.0

6.0

4.1

2.5

0.6

14.0

7.0

4.4

2.8

1.0 1.0 1.0

0.6

15.0

7.0

13.0

6.0

Morocco

3.6

3.6

2.1

1.0

0.5

Pakistan

2.5

4.1

3.1

1.0

0.0

6.0

6.0

Tunisia

2.3

3.6

3.1

1.0

0.6

15.0

7.0

Sources: Employment, 1975-2000: International Labor Organization Yearbook, various years, except Iran, national estimates; population working-age projections: World Bank, World Development Report database, 1999. 1 Or closest available. 2 Level in percentage of labor force. Contribution in points to the desired increase in employment.

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Table 3. Projected Employment Needs in Selected Middle Eastern Countries

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average by an astounding compound growth rate of more than 4 percent, with a "low" target of 3.6 percent in the Arab Republic of Egypt, Morocco, and Tunisia, and a "high" figure of 5.0 percent in Algeria.2 In all countries, the growth of the working-age population provides by far the greatest contribution to the targeted employment growth. Such employment growth requirements are much higher than those registered in the fastest job-creating regions of East Asia and the Caribbean and Latin America, where, respectively, employment grew during the period 1990—97 on average by 2.3 and 2.9 percent a year.3 Moreover, this development is a new trend for the region. In all countries, the needs for employment growth are strongly in excess of recent performance. The strongest acceleration in the rate of employment growth would be required in Algeria and Egypt, where it would be about 2 percent a year.

The Middle East's Demographic Gift What are the consequences of demographic changes for long-run per capita GDP growth? Early studies of this relationship have yielded no unambiguous correlations; results tended to hinge on the sample, the time period, and the choice of explanatory variables. The recent revival of the life-cycle model and its incorporation into empirical studies of cross-country growth has renewed interest in this link.4 Recent empirical studies have emphasized the importance of demographic transitions, the process of moving from preindustrial conditions of high fertility and high mortality to postindustrial conditions of low fertility and low mortality. They suggest that what matters for economic growth is not the rate of population growth per se, but rather the changing age distribution of populations as countries pass through demographic tran-

2

Due to data uncertainties and methodological difficulties, historical estimates of output and employment are subject to a wide margin of error and should only be regarded as indications of broad trends. More generally, a reference to individual countries in this and the following sections of the chapter is meant to convey the diversity of experiences; it is not meant to make factual or normative statements about the individual country. 3 Data on employment growth are from the International Labor Organization database. See Guasch (1999) for an exposition of trends and determinants of job creation in Latin America in the 1990s. 4 See, in particular, Kelley (1988) and Kelley and Schmidt (1995) for summaries of first-generation studies. On the recent work that incorporates the life cycle in crosscountry growth analyses, see Bloom and Williamson (1998) and Radelet, Sachs, and Lee (1997).

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DEMOGRAPHIC TRANSITION

sitions.5 When a large share of the population is young and nonworking, an economy carries a demographic burden that lowers labor input per capita, depresses the savings rate, and reduces the rate of GDP per capita growth. This was the case in Asia and Latin America in the 1950s and 1960s. Conversely, countries are endowed with a demographic gift when, with a lag following the decline in fertility, a larger share of the population is of working age, raising the labor force per capita, capital accumulation, and GDP per capita growth—as was the case in Asia during the miracle years of the 1970s and 1980s—particularly in East Asia. In turn, a growing share of the older, nonworking population may cause a reversal of the process. Altogether, whether a country carries a demographic burden or receives a demographic gift depends on the change in the share of the working-age population in the total. As is shown in Table 2, Middle Eastern countries stand to receive a large demographic gift in the coming period. A rather natural augmentation of the notion of the demographic gift is to focus, beyond the share of the working-age population, on the ratio of employment in the total population; these two ratios differ over time owing to changes in the participation rate and in unemployment. This augmented gift can be simply expressed in the form of a positive wedge between the growth of income per capita and that of output per employee, where the former is augmented by the increase in the employment ratio: ( y - n ) - ( y - l ) + (l-n)

(1)

where y, n, and l are, respectively, the growth rates of output, population, and employment. In the Middle East's circumstances, the growth of the working-age population should be significantly augmented by increasing participa5

In focusing on the impact of the changing age distribution of the population on economic growth, we are following a recent promising line of research that has disaggregated this impact into its components of fertility and mortality effects on economic growth (Barlow, 1994; Brander and Dowrick, 1994; Kelley and Schmidt, 1995). The theoretical basis of this argument relies on an examination of the impact of changes in the age distribution on the transitional dynamics of GDP per capita growth in a standard neoclassical growth model. The full explanation can be found in Bloom and Williamson (1998). For a diagrammatic exposition of the demographic transaction, see Crafts (1998). Bloom and Williamson (1997) have identified demography as the most important factor distinguishing the high-performing East and Southeast Asian economies from the slower-growing economies in South Asia. On the basis of demography alone, they attributed one-half to two-thirds of East Asia's superior growth performance in 1965-90 to its favorable demographic structure.

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tion rates and by a decline in the unemployment ratio. As shown in Table 4, employment overall has not grown much faster than the population in the past two decades. In contrast, under the previously mentioned targets for unemployment and assumptions for the participation rate, it would outpace population growth by more than 2 percent a year, and in some cases close to 3 percent, in the projection period. This is indeed a large and growing augmented demographic gift. Its significance can be brought out by noting that even a relatively unambitious real-wage growth target of 1.5 percent per employee would entail a major acceleration of income growth on a per capita basis. By combining equation (1) with an equation expressing the determinants of steady-state output per worker from a standard Ramsey model, Williamson and Yousef (1999) arrive at the following equation for the growth of output per capita:6 (y-n) = o1l + oc2n +EBiXi+

E

(2)

Equation (2) relaxes the parameter restrictions of equation (1) and allows for different coefficients for growth in population and employment that are consistent with the dynamics of the demographic transition. Under a variety of specifications, Williamson and Yousef (1999) conclude that the demographic gift as defined above is a significant argument in regressions where real per capita GDP growth is the dependent variable, a finding that applies to all regions of the world, including the Middle East. Where the working-age population grows faster than the total population, GDP per capita also grows faster. According to their estimated parameters and the projected population structure, the large demographic gift of Middle Eastern countries alone would contribute 1.1 percent annually in real GDP per capita growth during the period 2000-2015 (other things being equal). With the targeted annual laborforce growth of 4.0 percent, the augmented gift would contribute 2.7 percent a year in real per capita growth during the same period.

Employment Opportunities Although it is an opportunity, the rapid expansion of the workingage population also presents a serious challenge: How can faster and 6

In addition to traditional neoclassical variables—initial conditions, measures of physical and human capital, economic openness, and political stability—the matrix X of variables that determine steady-state growth in output per worker includes indicators that control for natural resource intensity, economic geography, government policy, and the quality of institutions.

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DEMOGRAPHIC TRANSITION

Table 4. The Augmented Demographic Gift in Selected Middle Eastern Countries (Growth rates, in percent per year)

Country

Employment (1)

Real Augmented GDP Population Gift Growth (2) (3) = (1)-(2) (4)

Real GDP per Employee (5) = (4)-(1)

Real GDP per Capita (6) = (5) + (3)

1973-94 estimates Algeria Egypt Iran Jordan Morocco Pakistan Tunisia

3.2 1.4 2.6 ... 3.6 2.5 2.3

2.7 2.2 2.9 3.9 2.1 3.0 2.2

0.5 -0.8 -0.3 ... 1.5 -0.5 0.1

2.9 5.6 0.3 6.6 4.4 5.9 4.5

-0.3 4.2 -2.3 ... 0.8 3.4 2.2

0.2 3.4 -2.6 2.7 2.3 2.9 2.3

2000-2015 projections Algeria Egypt Iran Jordan Morocco Pakistan Tunisia

5.0 3.6 4.1 4.4 3.6 4.1 3.6

2.1 1.5 1.7 2.3 1.5 2.4 1.3

2.9 2.1 2.4 2.1 2.1 1.7 2.3

6.5 5.1 5.6 5.9 5.1 5.6 5.1

1.5 1.5 1.5 1.5 1.5 1.5 1.5

4.4 3.6 3.9 3.6 3.6 3.2 3.8

Sources: Employment data are from Table 3; population and working-age population data are from World Bank, World Development Report database, 1999; historical data on real GDP growth are from Collins and Bosworth (1996). For 2000-2015: Real GDP and real GDP per capita were derived from the target of 1.5 percent annual growth in real GDP per employee.

more labor-intensive economic growth be facilitated to provide jobs to an expanding labor force while ensuring sustained increases in per capita income? The mechanics of the demographic gift highlighted in the previous section implicitly assume well-functioning labor and capital markets. In the absence of well-functioning labor markets and steady output growth, the rising working-age population in the 1990s compounded the problem of double-digit unemployment, especially among first-time entrants into the labor force.7 We use a simple growth-accounting framework to highlight this question. Rather than project long-term growth potential, our goal is simply to provide plausible quantitative scenarios linking the dynamics of demography to the policy objectives of employment creation and 7 Although the estimated high unemployment rates for the region in the 1990s were second only to those of sub-Saharan Africa, the figures were considerably higher within the age group 15—24, who are largely first-time job seekers; e.g., in Algeria, the unemployment rate for this group was more than twice that of the overall labor force (Pissarides, 1993).

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GDP growth in the immediate future. The starting point for the exercise is a Cobb-Douglas production function with increasing returns to scale in human capital: (3)

where Y is output, L is labor, H is the stock of human capital or "labor quality," K is physical capital, and A is the level of technology or total factor productivity (TFP). Expressing the variables in equation (3) in terms of growth rates, the equilibrium-wage condition yields the following expression for the required TFP growth, given targets for employment and the real wage and assumptions on human and physical capital accumulation:8 (4)

The implication is that employment of the growing labor input associated with the demographic gift would not be consistent with maintained wages unless there is faster capital accumulation or TFP growth.9 In focusing on TFP as a policy variable, we depart from the more conventional approach, in which a "warranted wage" growth is seen as the outcome of targets of accumulation. This restatement is in line with the now well-accepted thinking that regards government policies—both with respect to the macroeconomic environment and to the creation of institutions that foster economic growth—as an important determinant of the overall efficiency of economic activity.10 Against this background, Table 5 computes the gains in total factor productivity that are required to meet the employment needs shown in Table 3 and still allow real wages per employee to rise by 1.5 percent a year, assuming a moderate investment ratio. The simulation results point to considerable differences among the countries in terms of the magnitude and the nature of the challenges involved in meeting the employment targets. In large part, this is a reflection of their differing

8 We follow Collins and Bosworth (1996), who argue for the imposition of a uniform value of 0.35 for the elasticity of output with respect to growth of capital. 9 This requirement, however, is eased by the demographic transaction itself. Recent crosscountry studies indicate that national savings and investment ratios are strongly influenced by demographic transitions: High dependency rates depress both savings and investment, whereas a rise in the working-age population induces the opposite (Yousef, 1998). 10 Page and Van Gelder (1999) discuss the channels through which institutional capabilities affect the pace of accumulation and the allocation of resources; in particular, they note the negative influence of investor perceptions on the level of private investment in the region.

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Table 5. Total Factor Productivity Growth Requirements for Selected Middle Eastern Countries

Contribution of:1 Human Employment Capital

TFP Growth

Real Wage

1973-94 estimate Algeria Egypt Iran Jordan Morocco Pakistan Tunisia

-3.4 2.9 -3.4 0.0 -0.2 3.2 -0.2

-0.3 4.2 -2.3 0.0 0.8 3.4 2.2

1.1 0.5 0.9

2000-2015 projection Algeria Egypt Iran Jordan Morocco Pakistan Tunisia

0.2 0.0 -0.3 -0.4 0.0 0.3 -0.3

1.5

1.8 1.3 1.4

Country

1.5 1.5 1.5

1.5 1.5 1.5

1.3 0.9 0.8

1.5 1.3 1.4 1.3

Physical Capital

Estimated Incremental Capital Output Ratio

Investment Ratio (I/Y) Level

-0.6 -0.3 -0.7 0.9 -0.2 -0.1 -0.6

-3.6 -1.5 -1.3 -2.5 -2.0 -1.0 -2.7

12.5 3.7 56.9 4.3 5.5 2.9 6.4

36.0 21.0 19.0 28.0 24.0 17.0 29.0

-0.6 -0.3 -0.7 -0.9 -0.2 -0.1 -0.6

-2.5 -2.5 -2.5 -2.5 -2.5 -2.5 -2.5

4.3 5.5 5.0 4.8 5.5 5.0 5.5

28.0 28.0 28.0 28.0 28.0 28.0 28.0

Sources: 1975-2000: Real wage growth is real GDP per employee, from Table 4; Employment data are from Table 3; human capital and investment ratios are from Collins and Bosworth (1996). Physical capital growth, incremental capital output ratio, and TFP are calculated. Assumptions and calculations for 2000-2015 are descibed in the text. TFP growth is derived from equation (4). 1 Assumes labor share of 0.65, capital output ratio of 2.5, and depreciation ratio of 4 percent.

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DEMOGRAPHIC TRANSITION

(Annual growth rates, in percent)

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initial conditions:11 On the one hand, Algeria and Iran, with historically weak productivity performance reflected in negative TFP growth and a high incremental capital-output ratio (ICOR); on the other, Egypt, Morocco, Pakistan, and Tunisia, which have done historically better in terms of efficiency. Within each of these groupings, countries differ historically in their investment ratio; we assume for the projection period a uniform investment ratio of 28 percent of GDP, which in some cases (Egypt, Iran, Morocco, and Pakistan) requires an additional investment effort, and in other cases (Algeria) represents a slackening or (Jordan and Tunisia) a sustained effort.12 Turning first to Algeria—where unemployment is currently running at about 28 percent—the working-age population is expected to rise by more than 2.7 percent a year during the period 2000—2015 and the labor force by 3.7 percent, given the assumed rise in the participation rate. Halving the unemployment rate by the end of 2015 would call for annual employment growth of 5.0 percent and real GDP growth of 6.5 percent. Given also the above assumptions for human and physical capital formation, this would require annual TFP growth of 0.21 percent (compared with -3.4 percent a year for the period 1973-94), which would be consistent with a sharp reduction in ICOR, from 12.5 to 4.3. The strong underlying message for Algeria is that greater efficiency in the use of capital, rather than increased resource accumulation, is the key to achieving high, employment-intensive growth. A similar conclusion applies to Iran. Here we set a target of reducing the unemployment rate from about 14 percent at present to 7 percent by 2015; this in turn requires an average annual growth in employment of 4.1 percent. Even if gross investment rises from 19 to 28 percent of GDP and human capital continues to grow at the high historical rate of 1.1 percent a year, the ICOR must fall from 57 to 5.0, and TFP growth must improve from an estimated -3.4 percent for the period 1973-94 to -0.3 percent a year. The situation is rather different in Egypt, Morocco, Pakistan, and Tunisia, where halving the unemployment rate by 2015 would require annual employment growth of 3.6—4.0 percent. With human capital 11 The legacy of import-substitution policies, with their emphasis on capital accumulation, historically varies across countries, depending on the nature and intensity of state intervention. See Richards and Waterbury (1996) for a survey of country experience with state planning and industrialization before the 1990s. 12 It needs to be noted that the required TFP performance depends on the assumed investment ratio; with the parameters used here, a difference of (±2.5 points in the investment ratio makes a difference—with opposite sign—of 0.3 point to the required TFP gain.

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DEMOGRAPHIC TRANSITION

growing at its historical average, there is no pressing need for faster TFP growth or for a reduction in the ICOR—assuming, however, in Egypt and Pakistan that the investment ratio rises to 28 percent, or that they sustain their apparent strong historical record of low ICOR and high TFP growth. Although individual country situations thus differ rather markedly, the overall message is strikingly positive: Given a moderately high investment effort, and a "reasonable" level of efficiency in resource use, there is scope in all countries for absorbing into employment the growing labor force and the overhang of unemployment. Whatever the possible flaws in measurement of historical performance, what matters is that the "required" level of efficiency derived in this section—and the assumed investment ratio—are both well within the range of international and historical experience.

Housing Construction as an Engine of Growth Where will the additional employment come from? Much attention has focused on the potential impact of trade liberalization and foreign direct investment on job creation in the region. We focus here on another channel, directly linked to the very demographic conditions that raise the issue in the first place: the demand for housing. As they have elsewhere, the new demographic conditions in the region are likely to spur a massive expansion in the housing-construction sector.13 Because housing construction is predominately a labor-intensive activity, meeting the demand for housing can go a long way in addressing the employment problem, providing a two-way improvement in welfare. Recent trends in the housing market in the Middle East, especially on the supply side, are difficult to establish. On the basis of early surveys and

13

Mankiw and Weil (1989) have shown in the context of the U.S. baby boom generation that, although an individual generates little demand for housing before the age of 20, housing demand rises sharply between the ages of 20 and 30 and remains flat thereafter. Accordingly, the rise in the demand for housing and real estate prices in the 1970s were a predictable consequence of the maturing of the baby boom generation, who were born in the late 1940s and early 1950s. More recently, Lindh and Malmberg (1999) have established this link in the context of the countries that belong to the Organization for Economic Cooperation and Development. Sternleib and Hughes (1986) have attributed the parallel cycles in labor-force growth and housing expansion to the changing age structure of the U.S. population since the 1950s. Our analysis follows this line of reasoning, namely, that the rise in the working-age population and the increase in the demand for housing are closely related.

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qualitative evidence, however, there is little doubt that a substantial shortage of housing units has been building up since the late 1970s, with disproportionate effects on young adults and the poor-14 We provide a rough approximation of the need for new housing units to give an idea of the magnitudes involved, a necessary exercise given the limited attention devoted to the housing problems in policy discussions-15 The exercise concludes that, for a group of seven Middle Eastern countries (Algeria, Egypt, Iran, Jordan, Morocco, Pakistan, and Tunisia) with a total working-age population of 206 million in 2000, the annual need for new housing is in excess of 6 million units, whereas about 1 million units are actually built (Box 2; Table 6). There would exist a large potential demand, which, if it could be made effective, would provide a major boost to domestic activity. The massive gap between need as defined in Box 2 and effective demand for housing is a major opportunity for growth in the Middle East. Because housing construction typically accounts for 3 percent of GDP and 5 percent of employment in Middle Eastern countries, though with a rather wide dispersion, a large increase in housing construction would provide a major boost to employment and activity. Moreover, because housing construction is largely self-financing, this boost would be sustainable.16 The issue can be considered in terms of a "housing transition" needed to match the demographic transition. It may be postulated that financing of housing is endogenously related to its availability: Whether indirectly (in the form of rent payments) or directly (in the form of mortgage payments), households will allocate some of their income to cover their housing needs; and widespread experience with housing savings schemes shows that this is a very powerful savings incentive indeed. On this assumption, the flow of housing finance may be

14

E.g., the accumulated deficit in housing in Egypt between 1960 and 1979 was estimated at 2 million units (Mohie el-Din, 1982). In Algeria, the construction of housing units fell from 90,000 in 1986 to 30,000 in 1991, at a time when annual demand for housing was 200,000 units (World Bank, 1994). 15 We note, however, that social scientists have devoted extensive attention to the political and social implications of housing shortages in the Middle East. As Richards and Waterbury (1996) have rightly observed, the high unemployment rates and lack of affordable housing in the region in the 1990s are two intertwined problems facing young adults there; indeed, a healthy housing market is a reflection of well-functioning labor and credit markets. 16 Available estimates of output and employment in the construction sector generally do not provide a clear breakdown between residential construction, other construction, and infrastructure, and for this reason need to be treated with caution.

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DEMOGRAPHIC TRANSITION

Box 2. Estimating the Need for Housing This exercise derives the potential flow demand for housing units as the sum of three components: replacement of the existing stock, reduction of the existing shortfall, and accommodation of the growing population. For comparison, a similar exercise is conducted for four industrial countries. First, replacement demand is assumed to be equivalent to 2.5 percent of the existing stock in Middle Eastern countries, which would be consistent with a 30-year average life of a housing unit and a 2.5 percent annual growth rate of the housing stock. Rather than a technical constraint, the replacement ratio is an economic variable, reflecting changes in the demand for quality, location, and so on; it is likely to be rather high in emerging economies, given the poor quality of important components of the existing stock, the rise in aspirations, the trend to urbanization, and so on. The data in Table 6 suggest that these factors have a lesser incidence in industrial countries, where replacement demand (calculated in this case as a residual) may be only 1 percent of the housing stock, which would be consistent with a 50-year average lifetime of a housing unit at a 2.5 percent growth rate of the housing stock. Second, in most emerging economies, the existing stock of housing is less than the desired stock, resulting in the overcrowding of existing units. It is assumed here that the adjustment to the desired stock would span a 30year period along a geometric growth path at 5 percent a year. The estimate for the desired housing stock itself is based on the size of the working-age population, which is a proxy for the number of single-family households. The ratio of the housing stock to the population aged 15-64 years averages 60 percent in the industrial countries listed in Table 6, and this provides a convenient benchmark to estimate a desired stock for the Middle Eastern economies; by construction, this estimate makes allowance for the reduction in overcrowding and assumes a gradual shift in household composition toward the single-family pattern prevalent in industrial economies. The third component of flow demand is the accommodation of the increase in the number of households, proxied by the growth rate of the population aged 15-64. Because adjustment to the "desired" housing conditions has been allowed for above, that growth rate applies to the desired stock of housing. Three major conclusions flow from this exercise. First, the present rate of housing construction hardly meets 20 percent of the estimated need in the countries listed in Table 6, with a particularly acute percentage shortfall in Pakistan, and a better situation in Tunisia. Second, the estimated need for new housing is much greater in the seven Middle Eastern countries, where it represents 3 percent of the working-age population, than in the sample industrial countries, where the ratio is only 0.9 percent. Third, the primary reason for the higher need in the seven countries is the impact of population growth; that is to say, demographic conditions alone provide a compelling reason why the housing-construction sector should represent a much larger share of GDP in Middle Eastern countries than in industrial countries.

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Table 6. Key Housing Data for Selected Countries, 2000 (In millions of housing units)

Country

Jordan

Morocco Pakistan Tunisia Total for seven Middle Eastern countries France Italy United Kingdom United States Total for four industrial countries

Existing Stock

Desired Housing Stock2

Replacement3

Desired Flow Shortfall Population Reduction4 Growth5

Total

Average Actual Flow

4.0(1997) 12.6(1995) 11.2 (1998) 0.6(1996) 4.1 (1994) 20.0(1997) 1.5(1990)

18.2 38.7 40.2

6.2

(2.0)

3.7

62.0 28.2(1996) 19.7(1991) 23.6(1991) 102.3(1990)

205.9 38.9 39.2 38.2 181.0

1.4

3.4

6.1

1.1

0.3 0.2 0.2

1.0

0.0 0.1 0.0 0.0

0.1

(0.7)

123.4 23.3 23.5 22.9 109.0

1.3

(0.2) (-0.6)

0.0 0.8

0.4 0.2 0.2 1.8

0.4(1995-96) 0.2 (1993-94) 0.2 (1995-96) 1.4(1995-96)

173.8

297.3

(0.4)

178.4

1.7

0.1

0.8

2.7

2.2

2.8

18.0 81.8

(2.7) (2.2) (2.5) (2.5) (2.1)

10.9 23.2 24.1

0.1 0.3 0.3

0.1 0.3 0.3

0.3 0.5 0.8

0.1 0.5

0.1 0.6

0.2 1.5 0.1

1.7

10.8 49.0

-0.1

0.5 1.1 1.4 0.1 0.4 2.6 0.1

0.1 (1995-97) 0.2 (1986-92) 0.3 (1995-97) 0.1 (1995-97) 0.3(1997) 0.1 (1995-96)

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Sources: United Nations, Economic Commission for Europe, Trends in Europe and North America, 1988/99; Compendium of Human Settlement Statistics, 1995; and Housing and Building Statistics for Europe and North America, 1998/99; IMF staff estimates. Estimated working-age population in 2000 and average annual growth rate, 2000-2015. (Source: World Bank, World Development Report database.) 2 Sixty percent of estimated working-age population in year 2000. 3 One-fortieth of existing stock for Middle Eastern countries, 1 percent for industrial countries. Elimination of the gap between actual and desired stock over a 30-year period at a steady geometric rate; no correction is made for the discrepancies in dates of estimates of existing stock. 5 Growth rate of the working-age population times the desired housing stock.

Pierre Dhonte, Rina Bhattacharya, and Tarik Yousef

Algeria Egypt Iran

Working-Age Population Growth Rate1 (in millions) (in percent)

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DEMOGRAPHIC TRANSITION

taken as the rate of depreciation, rent, and some markup, times the stock of housing. Housing investment, conversely, is driven by the growth of the working-age population; the ratio of investment to the existing stock may be approximated by the sum of the growth rate of the working-age population and the rate of depreciation. On this basis, the dynamics of the housing sector are closely related to the demographic transition. As the working-age population expands, there is a strong acceleration in housing investment, while endogenous financing trails, creating a possible constraint on investment. As the process matures, however, housing investment levels off, while the housing stock continues to grow, so that housing-related savings catch up and eventually exceed the flow of investment. The hitch is in the takeoff stage, when the availability of financing is a constraint on investment; the operation of housing savings schemes and the development of mortgage markets, not the provision of public housing, are the answer. Why is this constraint so strong, and why does need fail to result in effective demand for housing? Part of the answer is historical, rooted in the preferences of policymakers in many countries of the region for investment in industrial plant, which has depressed the housing sector of the initial funds needed for takeoff. Another part lies in the poor documentation of property rights, which are inadequately identified and secured, so that they cannot be used as collateral to provide access to financing. "Modern market economies generate growth because widespread, formal property rights permit massive, low-cost exchange, thus fostering specialization and greater productivity. . . . A piece of land without [a formal] title is extremely hard to market" (de Soto, 1993). Recent work on Egypt—confirming earlier results for Haiti and Peru—illustrates this point by documenting that the acquisition of title and a construction permit to a piece of desert land would require 77 bureaucratic procedures in 31 different offices and could take 6 to 14 years to complete (de Soto, 1997). The link between constraints on titling and shortfalls in the housing sector is further suggested by the absence of mortgage financing in many Middle Eastern countries. Populous countries such as Algeria and Egypt have no mortgage market, and Morocco's and Pakistan's are minimal. Jordan stands out in this respect among regional economies in that its stock of mortgages is equivalent to 10 percent of GDP. By contrast, the European Union market is equivalent to 30 percent of GDP, and the U.S. market to more than 60 percent (Kabbaj, 1999; Renaud, 1996). It follows that improving the documentation of property rights would not only facilitate an expansion of the housing sector but would also deepen financial intermediation in the region.

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Policy Implications This chapter has highlighted two key demographic features of Middle Eastern countries: the high growth rate of the working-age population and its rising share in the total population. It has explored two immediate consequences of these conditions: a strong, accelerating demand for employment, and a large unsatisfied demand for housing. It has suggested that individually—and, even more so, jointly—these consequences should be seen as opportunities as much as challenges: The demand for employment and the demand for housing can be met, provided government policy sets the stage for moderate gains in total factor productivity—or at least averts the large losses experienced by some countries in the past—and provided in particular that a major effort is made to improve the documentation of property rights. These conclusions owe their specificity to the demographic conditions of the region; otherwise, they are quite in keeping with mainstream developments in growth theory. "In the long run, initial conditions and expansion of factor inputs still play a role; but the magnitude of such factor expansion, the efficiency with which factors are employed, and the long-term technological developments which also increase efficiency depend very much on policy. Good policy includes an effective legal support of property rights" (Havrylyshyn and others, 1999, p. 4). There are many facets to "good policy" in this context, which have been detailed for the Middle East in recent contributions (Chabrier, 1998; Nashashibi, 1999). Let it suffice here to focus on three quantifiable indicators. First, Middle Eastern countries are not, as a rule, seen as secure locations by foreign investors, and there is little reason to believe that domestic investors would see things differently. Only 6 of the 24 Middle Eastern countries, all of them members of the Gulf Cooperation Council (GCC), ranked among the top 40 ratings of Institutional Investor in September 1990; only 4 of these remained on the list in September 1998. Similarly, only four GCC countries and Morocco and Jordan ranked above the median in a composite index of economic security, developed from standard sources, in 1995 (Fabricius, 1998). These are highly significant indicators, because the need for economic security, of which the need for proper documentation of property rights is a main component, is not confined to real estate; it encompasses all aspects of economic activity, including notably, the creation of new businesses (Tanzi, 1997). Second, the average external tariff rate for Middle Eastern countries in 1998 was 18.2 percent, second only to that for African countries (20

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percent) and well above the world average (14.1 percent); 10 of the 24 countries had trade restrictiveness ratings of 7 or above, on the IMF scale, a proportion twice as large as the world average (Sharer and others, 1998). This again is significant, because trade distortions are a primary cause of slow or negative TFP growth. Third, the number of Middle Eastern countries that have adopted IMF Article VIII—thereby renouncing exchange restrictions for current account purposes—rose from 7 in 1990 to 15 in 1999. This is also highly significant, because the imposition of exchange restrictions is universally correlated with a regulatory environment that does not offer a level playing field to all market participants (and as such is insecure), provides heavy capital subsidies to public enterprises (and as such includes an antilabor bias), and supports a distorted price structure with an overvalued exchange rate (which further prevents adjustment of the labor market to full employment). There is little doubt, on balance—taking into account trends in privatization and reform of the financial sector—that the region has made significant progress in the past decade to establish a level playing field and support the development of a market economy. Yet, in many countries, overvalued exchange rates, subsidized interest rates and energy prices, and preferential tariffs on imported capital goods continue to reduce the cost of capital and energy relative to labor. Higher rates of growth in the Middle East can indeed be achieved, but they will require the removal of key economic distortions, effective government support for a market-based economy, and—perhaps above all—better-defined and enforced property rights.

References Barlow, R., 1994, "Population Growth and Economic Growth: Some More Correlations," Population and Development Review, Vol. 20, pp. 153-65. Bloom, D., and J. Williamson, 1997, "Demographic Transitions and Economic Miracles in Emerging Asia," in Emerging Asia: Changes and Challenges (Manila: Asian Development Bank). , 1998, "Demographic Transitions and Economic Miracles in Emerging Asia," World Bank Economic Review, Vol. 12, No. 3, pp. 419-55. Brander, J., and S. Dowrick, 1994, "The Role of Fertility and Population in Economic Growth: Empirical Results from Aggregate Cross-National Data," Journal of Population Economics, Vol. 7, pp. 1-25. Chabrier, Paul, 1998, "Middle Eastern and North American Countries' Need to Accelerate Process of Economic Integration," IMF Survey, July 6, pp. 205-8.

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Collins, Susan M., and B.P. Bosworth, 1996, "Economic Growth in East Asia: Accumulation versus Assimilation," Brookings Papers on Economic Activity, Vol. 2. Crafts, Nicolas, 1998, "East Asian Growth Before and After the Crisis," IMF Working Paper WP/98/137 (Washington: International Monetary Fund). de Soto, Hernandez, 1993, "The Missing Ingredient," Economist, September 11, "Special Supplement—The Future Surveyed," pp. 8-10. , 1997, Dead Capital and the Poor in Egypt (Cairo: Egyptian Center for Economic Studies). Fabricius, Michael, 1998, "The Impact of Economic Security on Bank Deposits and Investment," IMF Working Paper WP/98/98 (Washington: International Monetary Fund). Guasch, J. Luis, 1999, Labor Market Reform and Job Creation: The Unfinished Agenda in Latin America and Caribbean Countries (Washington: World Bank). Havrylyshyn, Oleh, Thomas Wolf, Julian Berengaut, Marta Castello-Branco, Ron Van Rooden, and Valerie Mercer-Blackman, 1999, Growth Experience in Transition Countries, 1990-98, IMF Occasional Paper No. 184 (Washington: International Monetary Fund). Kabbaj, S., 1999, "Housing Sector in the Middle East," Middle Eastern Department (unpublished; Washington: International Monetary Fund). Kelley, A.C., 1988, "Economic Consequences of Population Growth in the Third World," Journal of Economic Literature, Vol. 27, pp. 1685-728. Kelley, A., and R. Schmidt, 1995, "Aggregate Population and Economic Growth Correlations: The Role of the Components of Demographic Change," Demography, Vol. 32, pp. 543-55. Lindh, T., and B. Malmberg, 1999, "Age Structure Effects and Growth in the OECD, 1950-90," Journal of Population Economics, Vol. 12, No. 3, pp. 431-49. Mankiw, G., and D. Weil, 1989, "The Baby Boom, the Baby Bust, and the Housing Market," Regional Science and Urban Economics, Vol. 19, pp. 235-58. Mohie el-Din, Amr, 1982, Income Distribution and Basic Needs in Urban Egypt, Cairo Papers in Social Science 5, Monograph 3 (Cairo: American University in Cairo Press). Nashashibi, Karim, 1999, "The Social Impact of Free Trade in the Euro-Mediterranean Region," address to Wilton Park Conference on the Social Impact of Free Trade in the Euro Mediterranean Region, Malta, November 8-11. Page, J., and L. Van Gelder, 1999, "Institutions, Investment and Growth in the Middle East and North Africa," paper presented at a seminar sponsored by the Arab Fund for Social and Economic Development, Arab Maghreb Union, and International Monetary Fund, Kuwait, April. Pissarides, C., 1993, Labor Markets in the Middle East and North Africa, World Bank Discussion Paper No. 5 (Washington: World Bank). Radelet, S., J. Sachs, and J. Lee, 1997, "Economic Growth in Asia," in Emerging Asia: Changes and Challenges (Manila: Asian Development Bank).

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DEMOGRAPHIC TRANSITION

Renaud, Bertrand, 1996, "Strategies to Develop Mortgage Markets in Liberalizing Economies" in Globalization and Housing Industries, ed. by Hee-Soo Chung and Dong-Sung Lee (Seoul: Korea Housing Institute and Nanam Publishing House). Richards, A., and J. Waterbury, 1996, A Political Economy of the Middle East (Boulder, Colorado: Westview Press). Sharer, Robert, and an IMF staff team, 1998, Trade Liberalization in IMF-Supported Programs, World Economic and Financial Surveys (Washington: International Monetary Fund). Sternlieb, G., and J. Hughes, 1986, "Demographics and Housing in America," Population Bulletin, Vol. 41, pp. 1-34. Tanzi, Vito, 1997, "The Changing Role of the State in the Economy: An Historical Perspective," IMF Working Paper WP/97/114 (Washington: International Monetary Fund). Williamson, J., and T. Yousef, 1999, "Demographic Transitions and Economic Performance in the Middle East and North Africa," in Population Challenges in the Middle East and North Africa: Towards the Twentieth First Century, ed. by I. Sirageldin (Cairo: Economic Research Forum). World Bank, 1994, The Democratic and Popular Republic of Algeria: Country Economic Memorandum, the Transition to a Market Economy (Washington). Yousef, T., 1998, "Demography, Capital Dependency and Growth in MENA," ERF Working Paper 9801 (Cairo: Economic Research Forum).

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3 Determinants of Inflation in the Islamic Republic of Iran—A Macroeconomic Analysis OLIN LIU AND OLUMUYIWA S. ADEDEJI

T

his chapter establishes a framework for analyzing the major determinants of inflation in the Islamic Republic of Iran during the period 1989/90-1999/2000. Equilibrium relationships pertaining to the markets for money, foreign exchange, and goods are established, along with their dynamic specifications. The chapter assesses the transmission mechanism of monetary policy and explores the predictive power of key policy variables, including nominal money, in forecasting inflation dynamics. To further identify the leading determinants of inflation, impulse response functions and the variance decomposition technique are used to examine the responses of relevant variables to shocks emanating from money, goods, and foreign exchange markets. Most macroeconomic empirical studies on Iran have focused on a single sector of the economy. Bahmani-Oskooee (1996) developed a stable long-run demand for money under a system of multiple exchange rates using annual observations for the period 1959-90. He found that the parallel market exchange rate (in its nominal form) played an important role in the money demand function. Pesaran (1998) estimated a real money demand equation using annual data for 1960/61-1995/96,

The authors thank Pierre Dhonte and Zubair Iqbal for insightful comments on an earlier version, and Farhan Hameed for research assistance.

41

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DETERMINANTS OF INFLATION IN IRAN

a period characterized by significant political, social, and international instabilities, including the Islamic revolution in 1979 and the eightyear war with Iraq (1980-88). Pesaran (1998) found a structural break around the time of the revolution, relating to the income elasticity of real demand for money, which shifted from 1.85 during the prerevolution period to 0.53 in the postrevolution period. Both studies confirm that real income is an important determinant of real money demand in Iran. Becker (1999) used the common (stochastic) trend model to investigate the evolution of prices, market exchange rates, money, and real output in 1959-96 and concluded that monetary shocks would have a temporary effect on real output but a permanent effect on the price level. Other studies have investigated determinants of exchange rates in Iran. Bahmani-Oskooee (1996) applied a purchasing power parity framework and found that the real exchange rate depends on the productivity differential between Iran and its trading partners. Sundararajan, Lazare, and Williams (1999) explored determinants of the equilibrium exchange rate (using annual data for 1970-95). A long-run relationship was established between the real exchange rate and economic fundamentals, including the fiscal balance, terms of trade, broad money, net foreign assets, capital stock, and productivity. This chapter achieves the following objectives: • First, it establishes constant long-run equilibrium relationships for each market. Building upon them, it develops a macroeconomic framework that links these markets through a stable dynamic model of inflation, which explicitly incorporates the error-correction terms of the three markets to examine the impact of external shocks and internal disequilibria on inflation dynamics. • Second, it investigates the effect of excess money supply and monetary growth on the exchange rate dynamics under a system with a restricted exchange and trade regime and multiple exchange rates. Moreover, it analyzes the transmission mechanism of monetary policy in an environment of significant interest-rate rigidities and administratively fixed official exchange rates. • Third, it establishes a stable model for a period characterized by major economic shocks, including the attempt at liberalizing the exchange and trade systems (1993/94), unforeseen sharp declines in global oil prices (1993/94-1994/95 and 1998/99), the emergence of a balance of payments crisis (1994/95-1995/96), internal economic imbalances emanating from policy reversals, and weak demand management.

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• Fourth, it uses quarterly data rather than annual observations to conduct an in-depth analysis of lagged effects among key economic variables. The chapter is organized as follows: The second section briefly describes the Iranian economy. The third section discusses a theoretical framework for a small economy whose exports are relatively insensitive to exchange rate movements because of its dependence on oil. The fourth section presents the cointegration results of long-run equilibrium relationships of the monetary sector and balance of payments, as well as the results obtained from the use of the Hodrick-Prescott filter approach for the estimation of the real output gap. The fifth section discusses the short-term dynamic error correction models for inflation, money, exchange rates, and real output. The sixth section presents policy implications and the conclusion.

The Iranian Economy During the past two decades, the Iranian economy has been subject to a number of major adverse shocks. Some of them were external, including the eight-year war with Iraq and volatility in global oil prices, and others were policy driven, resulting from the controls on the allocation of credit and foreign exchange, intensive exchange and trade restrictions, and distortions in the pricing system (including exchange rates, interest rates, and domestic energy prices). These price distortions have induced inefficiency in the allocation of resources, rendered the economy less competitive, and weakened its capacity to respond to external shocks. These factors have led to chronic inflation in Iran in the range of 20 to 30 percent in recent years. To a large extent, the internally imposed constraints have prevented Iran from taking full advantage of productivity gains through efficient resource allocation and globalization, and constrained the government from formulating effective and consistent policy responses. The harmful consequences of the policy-induced imbalances have become more acute in the light of Iran's high population growth and pressures on employment. The government has made attempts to reform the economy within the framework of the two Five-Year Development Plans since 1989/90, which established a relatively cohesive macroeconomic framework based on the consensus reached among ministries and Parliament on key economic issues. Growth objectives under the first plan were ambitious and were anchored in expansionary financial policies, including public investment programs financed by monetary expansion and short-term external borrowing, while maintaining highly appreciated

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DETERMINANTS OF INFLATION IN IRAN

exchange rate and significantly negative real interest rates (as well as other price subsidies). large monetary expansions aggravated resource misallocation, inhibited sustained high growth and employment generation, and eventually led to high inflationary and balance of payments difficulties. Against this background, the second plan (1995/96-1999/2000) focused on rationalizing relations with external creditors, lengthening the maturity of external debt, curtailing total external debt stock, and reducing inflation. The economy, however, continued to depend heavily on crude oil revenues, which were the resources for providing large implicit subsidies for energy products and maintaining appreciated exchange rates. The effects of inefficient resource allocation combined with declines in oil export receipts, and severe import compression adopted during 1995/96-1998/99 to service the external debt, contributed substantially to lower economic growth (an average of 3.2 percent during the period 1994/95-1998/99, in comparison with 8.1 percent during 1989/90-1993/94) and a decline in the real demand for money in recent years. Against this backround, the government reinforced its reform efforts in early 1999/2000 to establish a market-clearing exchange rate in the Tehran Stock Exchange (TSE) for a significant share of current account transactions, introduce positive real interest rates, increase domestic petroleum prices, initiate steps to liberalize the trade system, and develop the framework to restructure banking and state-owned enterprises. In the process, access to foreign exchange in the TSE market was liberalized, and the Iranian rial was allowed to depreciate in the TSE in response to market prices. As a result, the parallel market premium declined substantially to below 5 percent by the end of 1999/2000. At the same time, foreign exchange restrictions were liberalized, regulation of exchange transactions was simplified, and transparency in exchange operations improved. Progress on other fronts, however, remains slow.

The Long-Run Model The long-run model describes an economy that is small relative to the rest of the world but open to terms of trade shocks and international financial flows (mainly through the parallel exchange market). The financial system is dominated by state-owned banks, operating under mostly fixed interest rates and administratively determined official exchange rates, with limited financial assets for investment. The long-run model linking the markets for money, foreign exchange, and goods is constructed,

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and is estimated to analyze the effects of market disequilibria on dynamics of inflation, monetary growth, and exchange rate movementsDemand for Money

In Iran, financial markets are at an early stage of development. Investment options are limited to three main categories: money, real assets, and foreign exchange- Asset allocation is influenced by the expected real rates of return, liquidity, and transaction costs. Interest rates on money are not only fixed in nominal terms but also significantly negative in real terms. Over time, a permanent shift away from the holding of money to real assets and foreign exchange has taken place as a result of a sustained period of large negative real rates of return, as well as sizable real exchange rate appreciation. Equation (1) specifies the long-run demand for money as a function of real income, price, and degree of asset substitution. When large negative real rates of return on money are expected, in the long run, against positive and substantial real rates of return on foreign exchange (i.e., through the depreciation of rials in the parallel market), an investor would substitute money for foreign exchange as much as possible at a given level of income. The degree of asset substitution, therefore, is affected by the parallel market exchange rate and asset prices. The long-run demand for money thus can be specified as: M = a* Y* * PAR-Y* P\

a, p, y, and r| > 0

(1)

where M is the nominal money balance; Y, real income; PAR, the parallel market exchange rate; and P, the price level (measured by the GDP deflator). Taking logarithms, the long-run real demand for money can be written as:1 m - p = a + b{* y - b 2 * par,

a, bu and b2 > 0

(2)

where m — p denotes real money balance (deflated by the G D P deflator, p);1 y is real income; and par is the parallel market exchange rate. Equation (2) can be established by imposing homogeneity between money and price (r| = 1). This restriction is tested; it cannot be rejected at the 10 percent interval. In addition, the rate of inflation measuring the opportunity cost associated with the forgone return on physical assets is found to be stationary, thus, it has no bearing on the determination of demand for money in the long run. A l l other variables are found to satisfy the AR( 1) processes. 2 In Iran, a more appropriate measure of prices for the economy is the GDP deflator. The consumer price index basket contains a large share of government-subsidized essential goods and services as well as energy-related products that are administratively priced.

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DETERMINANTS OF INFLATION IN IRAN

Balance of Payments

The structure of the Iranian economy is mostly dictated by its reliance on crude oil exports, which account for more than 80 percent of Iran's total foreign exchange earnings. Crude oil exports are subject to the quota of the Organization of the Petroleum Exporting Countries, and are vulnerable to price volatility in the global oil market. During the sample period, Iran's crude oil exports experienced cycles of significant ups and downs, which had a significant impact on Iran's foreign exchange earnings. In the model for balance of payments, specified in equation (3), export earnings, combined with the capacity of external borrowing and net changes in net international reserves, determine the real foreign exchange supply in Iran (RSfx): _, ( X + NFB-AR) RS X / = p (3) where X represents exogenous export revenue; NFB, net foreign borrowing; AR, net accumulation of international reserves; and Pt, the price of imports. The change in international reserves is a policy variable in Iran, whereas net foreign borrowing could contain both the exogenous factors (such as debt-service payments and private capital flows) and policy-driven items (such as official external borrowing). Real demand for foreign exchange can be specified as a function of the real exchange rate (RER), real domestic demand (RD), and real demand for currency substitution, which is a function of the excess money supply ( M s - M d ) : RDfx = /(RER, RD) + g(Ms -Md)

(4)

During most of the study period (1993/94-1998/99), demand for foreign exchange at official exchange rates far exceeded the supply of foreign exchange, as a result of highly misaligned exchange rates and extensive exchange and trade controls. Although imports are compressed through trade restrictions, the unmet private demand for foreign exchange (i.e., for both the current and capital account needs) are channeled to the parallel market, exerting pressure on the parallel market premium. The public sector is officially barred from using resources from the parallel market. Therefore, the parallel market exchange rate may not reflect the effect of the unmet import demand of the public sector. With this in mind, the long-run equilibrium condition of the exchange market can be derived (with excess money supply at zero, M s M d = 0) by setting the identity, RSfx =RDfx, in logarithms:

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Olin Liu and Olumuyiwa S. Adedeji

fxs = a - $ * r e r + $ * r d ,

p, and (32 > 0

47

(5)

Rewriting equation (5) in nominal terms, the nominal exchange rate (par) can be related to real supply of foreign exchange, fxs; real domestic demand, rd; domestic prices, p; and international prices, pt: par

= a- ft* fxs + p2* rd + &* p - p4* % P2, P 3 ,andp 4 >0

ft,

(6)

It is important to note that equation (6) describes an equilibrium condition for a system with foreign exchange and trade controls. Thus, parameter estimates in equation (6) are sensitive to the liberalization of the exchange and trade regimes. The unrestricted long-run equilibrium exchange rate (in the absence of controls) could be substantially more depreciated as compared with the level estimated by equation (6). Indeed, the gap between the observed market exchange rate and unrestricted equilibrium exchange rate (unobserved) measures the degree of restriction on import demand of the public sector that is excluded from using resources of the parallel market. Goods Market The model investigates the goods market to incorporate the effects of an output gap on inflation. The Hodrick-Prescott filter (HP filter) is used to decompose the actual real G D P to potential and cyclical components, which is in line with the methodology used by a number of studies, including Debelle and Lim (1998) and Roldos (1997).3 The difference between actual G D P and its trend as given by the H P filter estimates the output gap. Specifically, the H P approach uses a smoothing estimation method to separate the permanent component of G D P from the temporary one by choosing y* to minimize the following function:

i(y of dollars) Algeria Bahrain Egypt Jordan Kuwait Lebanon Morocco Oman Qatar Saudi Arabia Syria Tunisia United Arab Emirates Yemen Total

225

1,825 30 0 0 0 225 0 0 0 0 122 0 0

3,690 4,410 558 1,024 98 0

154 0

8,027 2,552 0 40 300 0

0 389 37 0

2,990 4,520 0 0

0 160

195 0

85 0

962 243 976 1,192 17 0 23 44 86 1,046 400 7 123 298 61 278 0 2,963 992 3,241 0 0 450 135

3,200 1,128

1,016

0 480

0 627

0 44

0 495

0 0

276 0

0 0

222 0

206 0

781 0

177 100

194 915 233 0

263 115 440 1,389 695 1,316 15 350 140 370

1,664 1,433 141

2,106 2,474 1,770 1,148 250 200 2,440 902 3,437 3,480 1,148 2,945 996 5,892 6,165 516

1,421 651 397

2,500 4,267

2,427 16,364 12,865 4,798 9,016 14,186 9,722 19,294 12,300 13,041

By investment 2,427 16,364 12,865 4,798 9,016 14,186 9,722 19,294 12,300 13,041 International 958 bond issuer 978 2,197 2,305 1,525 3,111 Other fixed 0 0 19 158 0 income 25 0 0 0 0 Loans 1,253 12,790 7,602 2,356 7,315 10,178 6,037 11,289 5,824 8,439 International equity 34 0 8 0 89 410 1,858 1,110 70 0 issues Loan facilities 1,079 3,574 5,263 2,434 565 2,977 579 2,784 3,840 1,402 Fixed income 0 0 0 0 0 178 900 0 facilities 0 500 (As percentage of total) GCC

economies1 Other Arab economies Bonds Equity Other

75.2

76.6

60.3

67.8

86.1

59.0

73.5

69.8

72.4

67.9

24.8

23.4

39.7

32.2

13.9

41.0

26.5

30.2

0 0

0 0

0

0 0.2

6.9 0.2

9.6 4.2

9.7 2.2

27.6 12.4

32.1 12.8

24.8

23.4

39.7

32.1

7.5 0 6.4

33.9

12.6

18.2

3.0

0.7

12.2

18.6

Source: IMF (2000). 1 Gulf Cooperation Council: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates.

What factors underlie the weak integration of the region's capital markets with international capital markets? Possible reasons include: • A lack of macroeconomic stability • Weak market regulation and supervision • Distorted tax systems

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Table 8. International Equity Issues in Arab Countries (In millions of dollars) Economies

1993

1994

1995

1996

1997

1998

1999

... ... ...

... ... ...

... ... ...

...

... ... ... ...

... ... ... 34

... 291 ... 313 ... 33 1,140 81

...

... ... ... 650

... ... ... 233 ... ... ... 117

... 102 ...

... 89 ...

145

... 8

... ...

... ...

... 60

... ...

... 80

...

... ... ...

...

... ...

... ... ...

... 742 ...

...

...

... ... ...

... ...

... ...

... ...

... ...

... ...

... 40

... ...

... 658

...

... 34

... 410

... 1,857

... 1,109

... 89

Comparator economies ... Argentina 2,655 Chile 288 Czech Rep. ... Poland Korea, Rep. of 328 Thailand 623 South Africa ... Emerging markets 12,380

... 735 799 10

... ... 224 32 70 1,310 531 336 9,952

... 217 297 104 17 1,151 151 626 17,816

... 1,799 563 ... 928 630 28 698 26,174

... ... 72 126 957 495 2,179 656 9,436

... 350

Algeria Bahrain Djibouti Egypt Iran Jordan Kuwait Lebanon Libya Mauritania Morocco Oman Pakistan Qatar Saudi Arabia Sudan Syria Tunisia United Arab Emirates Yemen Total

1,168 759 176 17,950

...

636 6,591 757 659 23,157

Source: IMF (2000). Note: Based on data available at the time of writing.

• Barriers against foreign ownership • A limited number of available financial instruments • The long history of heavily regulated, somewhat isolated capital markets • The closed, family-owned structures of enterprises • Irregular financial relations with external creditors (which affect perceived country risk and portfolio flows) • The continued public-sector role in a wide range of economic activities

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FINANCIAL LIBERALIZATION

Table 9. International Bond Issues In Arab Countries (In millions of dollars) Economies Algeria Bahrain Djibouti Egypt Iran Jordan Kuwait Lebanon Libya Mauritania Morocco Oman Pakistan Qatar Saudi Arabia Sudan Syria Tunisia United Arab Emirates Yemen Total Comparator economies Argentina Chile Czech Rep. Poland Korea, Rep. of Thailand South Africa Total bond issues in emerging markets Total bond issues in international bond market

1994

1995

1996

1997

1998

1999

... ... ... ... ... ... 400

60 ... ... ... 50 ... 350

60 ... ... ... ... ... 510

200 ... ... ... 100 ... 1,273

... ... ... ...

209 ... 100 ...

... 1,525

... 1,421

... ... ... ...

... ... ... ...

... 290 ... 150 1,200

... ... 225 450 ...

... ...

... 152

...

1,000

280 ... 278 ... ...

... 578 ... ...

... 137 ... ...

... 507 ... ...

... ... ... ...

... 229 ... ...

958

1,038

2,347

2,755

1,525

3,112

5,319 155 400 ... 6,383 3,102 1,469

6,474 500 ... 250 11,058 1,815 1,319

14,070 2,020 543 364 16,479 4,499 970

16,412 1,800 450 1,662 13,689 2,069 5,985

16,300 1,063 815 1,943 5,084 300 1,381

14,183 1,764 422 1,653 4,906 798 1,805

59,209 105,319 133,186

80,201

86,977

797,704 938,413

1,362,236

53,834

463,024 504,676 729,433

Source: IMF (2000).

Conclusions Although most Arab countries have made considerable progress during the past decade in reforming their financial sectors, they are still at early stages in the process. Their financial sectors continue to be dominated by commercial banks, and in some of them state-owned banks still play a leading role. Their securities markets are relatively small, and in most of them the supply of corporate securities remains generally low. The development of their capital markets is related to a range of eco-

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nomic, financial, institutional, and legal factors that they need to address decisively if they are to integrate themselves into the global economy. The experiences of many developing and emerging market countries show that capital markets potentially can provide substantial benefits, including a larger pool of capital to finance productive investments, as well as facilitate the process of privatization. However, with a more open capital account, the economy becomes more vulnerable to abrupt shifts in investor sentiment. This was illustrated in 1997 and 1998 in the Asian and Russian markets and in the early 1990s in Mexico. Therefore, although financial reform is both desirable and inevitable, it should follow a certain sequencing according to the characteristics of each country. For instance, free capital movement for residents as well as nonresidents should be allowed only when strong macroeconomic management is established, so as to minimize exchange rate risks as well as financial risks to the banking system. At the same time, a systematic financial-sector assessment of vulnerabilities and potential risks is needed to ensure that external shocks and pressures on the exchange rate do not translate into a banking crisis. Nonperforming loans, mostly extended to public enterprises, need to be addressed; and the moral hazard that surrounds the relationship between the government, state-owned (or -dominated) banks, and public enterprises also needs to be addressed. Finally, there is a need to foster greater openness to trade and to foreign capital inflows by liberalizing trade and harmonizing trade regulations and procedures, particularly among Arab countries. Recent measures by the GCC countries to allow greater equity participation by foreigners in local enterprises is a move in the right direction. So are the free trade association agreements attained or being negotiated with the European Union, which are complemented by the Greater Arab Free Trade Agreement. More openness, together with more transparency and disclosure of information, should contribute significantly to financial deepening and to integrating Arab countries into the global economy.

References Chalk, N., A. Jbili, V. Treichel, and J. Wilson, 1996, "Financial Structure and Reforms," in Building on Progress: Reform and Growth in the Middle East and North Africa, Middle Eastern Department (Washington: International Monetary Fund). Demirguc-Kunt, Asli, and Vojislav Masksimovic, 1998, "Law, Finance, and Firm Growth," Journal of Finance, Vol. 53, pp. 2107-37.

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FINANCIAL LIBERALIZATION

El-Erian, Mohamed, and Manmohan Kumar, 1995, "Emerging Equity Markets in the Middle East Countries," Staff Papers, International Monetary Fund, Vol. 42, pp. 313-43. Levine, Ross, and Zervos Sara, 1998, "Stock Markets, Banks, and Economic Growth," American Economic Review, Vol. 88, pp. 537-58.

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5 Monetary Operations and Government Debt Management Under Islamic Banking V. SUNDARARAJAN, DAVID MARSTON, AND GHIATH SHABSIGH

S

ignificant progress has been achieved during the past two decades in widening the range of financial instruments that are compatible with the principles of Islamic finance. Several financial instruments suitable for Islamic commercial banking or for funding specific projects have been developed. But there has been less satisfactory progress in developing instruments for noninflationary financing of government deficits, and for market-based monetary management. Transparent, operationally feasible instruments for general government funding, and for overall liquidity management, have yet to be fully developed. The challenges of implementing market-based monetary policy in Islamic banking systems are unique and complex. For effective monetary control under any system, it is usually assumed that a central bank must have discretionary control over its balance sheet, and hence over the growth of reserve money. Invariably, this would be facilitated through the existence of independent funding markets for the budget and the availability of flexible instruments with which to offset and regulate the flow of liquidity created by autonomous items on the central bank's balThis chapter was presented at the Eighth Annual Conference on Monetary and Foreign Exchange Policies, sponsored by the Central Bank of the Islamic Republic of Iran, Tehran, May 20-21, 1998. The authors thank their colleagues in the Middle Eastern and Monetary and Exchange Affairs departments of the International Monetary Fund, with special thanks to Tito Cordelia and Abbas Mirakhor.

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ISLAMIC BANKING

ance sheet. Moreover, it is also assumed that there exist responsive money markets and payment systems, through which banks manage their own liquidity positions and through which policy intentions are transmitted. In countries with full or partial Islamic banking systems— as in many developing countries—these arrangements to facilitate effective monetary policy are at various stages of evolution. The unique challenge for Islamic banking systems derives from the complexity of designing market-based instruments for monetary control and government finance that satisfy the Islamic prohibition of ex ante interest payments, and provide for a sharing of profits and losses on underlying transactions. Under the Islamic mode of finance, debt-based instruments cannot earn a positive rate of return (through interest, fixed or variable) and cannot be discounted in a secondary market (i.e., can be traded only at par and under strict transfer limitations). Conversely, equity-based securities can be traded in the open market, with trading values reflecting market expectations of economic performance, and hence of rates of return. However, designing equity-based instruments linked to government or central bank operations poses significant difficulties because of complexities in computing appropriate profits and rates of return. These constraints have also limited the development of efficient mechanisms for money market trading and central bank credit facilities, which are necessary for the effectiveness of market-based monetary policy and for improving banks' management of highly liquid portfolios, which could arise, in part, from the portfolio structure of Islamic banks. Notwithstanding these unique challenges, there is an urgent need to resolve these issues. The absence of efficient instruments for monetary operations and general government funding has perpetuated a reliance on direct controls on credit and high, unremunerated reserve requirements (the latter contributing to high intermediation margins). The absence of money markets has also led to large excess reserves (adding to intermediation margins), and to a loss of monetary control when central banks continue to provide credit to individual banks while lacking flexible means to absorb excess reserves. The overall consequences of these inefficiencies have been progressive disintermediation and persistent inflationary pressures in many Islamic banking systems. This chapter outlines progress achieved thus far in developing money market and government funding instruments and provides details on new instruments currently being developed, drawing on the experiences of Iran and of Sudan. The chapter also touches on issues related to institutional arrangements for monetary operations, particularly interbank markets and the design of central bank credit facilities. The organization of the chapter is as follows. The second sec-

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tion discusses the existing approaches to designing government funding and monetary instruments under Islamic banking, and their institutional and operational implications. The third section reviews the most recent developments in country practices in market-based instruments and proposes new approaches. The fourth section discusses possible reforms to institutional arrangements for monetary operations and approaches to money market development that are consistent with Islamic banking. The fifth section offers concluding remarks.

Issuance of Government Securities Although a range of Islamic financial products are available for specific government projects, or for government procurement of particular goods, a funding instrument to support general government functions (or to absorb bank liquidity) has been conceptually difficult to design under Islamic finance principles. Although returns on a specific project or on purchase and resale transactions are easy to define, an appropriate rate of return for general government services or central bank operations has been difficult to formulate. Nevertheless, some progress has been made recently to overcome these problems. Specific Funding Instruments

Several countries have developed project-specific funding instruments by applying the principles of Mudharaba or Ijara.1 For projects that yield an identifiable rate of return (e.g., a factory or trading company), the government would issue a Mudharaba certificate (restricted Mudharaba) to investors and would invest the proceeds in specific projects; in return, investors would claim a share of the profits (Box 1). This instrument is equity-based and hence marketable in the secondary market, with the secondary market price determined by the performance prospect of the underlying project.2 1

"Mudharaba" is a contract where one party provides funds and the other provides work. Profits are distributed according to a negotiated percentage (the party providing the work cannot claim wage, salary, or any compensation other than a share in profits), whereas losses are borne by the fund provider. "Ijara" is a leasing-type contract. For more detailed discussions of Islamic financial contracts, see Kazarian (1993) and Iqbal and Mirakhor(1987). 2 The scope of this instrument could be widened to cover a pool of projects (i.e., an unrestricted Mudharaba) instead of specific projects, with the rate of return being determined by the average yield of all the projects. It is also possible to issue and float the two types (the restricted and the unrestricted Mudharaba) simultaneously.

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Box 1. Participation Papers in Iran (Restricted Mudharaba) Issued Since 1993 In the restricted Mudharaba framework, commercial banks act as agents to raise funds to finance a specific investment project. The borrower provides market and financial analyses of the project, which include an expected return that it is prepared to share with lenders.1 The commercial bank undertakes an initial economic review of the proposal and its terms to determine its accuracy and reasonableness. With due diligence completed, the commercial bank and the borrower forward the proposal to the credit committee within Bank Melli Iran (BMI), which conducts its own independent review of the proposal. No fee is applied. If approved, the credit committee also sets a guaranteed minimum return that will be paid to investors. It is expected that the actual rate will be higher than the minimum, and that it will be paid as it is realized during the course of the project.2 In addition, the principal is also guaranteed by the commercial bank. To ensure payment of the guarantees, the following steps are taken: • The proceeds of the Participation Papers (PPs) are placed with the agent-bank, and a monitoring process for their withdrawal as well as use is put in place. • Additional collateral, including a claim on the project's real assets, is obtained in addition to cash deposits. • The central bank appoints an auditor and trustee. The trustee protects the interests of the investors by overseeing the implementation of the project, utilization of the proceeds from PP sales, and ensuring that cor-

1 Presumably, the borrower deducts fees and other payments from projected financial flows to reward his own entrepreneurship and management acumen. 2 The rationale for the guaranteed minimum rate is that the commercial bank and BMI due diligence should have screened projects below that minimum rate.

For government projects that do not yield a readily identifiable rate of return (e.g., schools), a leasing-based instrument (Ijara) is used sometimes to raise the needed funds. Under this arrangement, investors become co-owners of the project with the government (or the sole owner if they provide full funding). Once the project is completed, the investors lease their share to the government for a certain period of time at a negotiated rate. The lease contract often includes an option to buy for the government at the end of the contract. Despite the validity of these approaches to developing government funding instruments, their usefulness for flexibly managing monetary matters and efficiently managing domestic debt is inher-

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rect payments of interest and principal are made as specified to all bondholders. PP offerings. Iranian governmental bodies, religious foundations, and private-sector enterprises issued five PPs between 1995 and 1997. PPs combine features of debt and equity in that they have specific terms ranging from 22 to 5 years and set a minimum return, but may provide an actual return higher than the minimum if warranted by the ultimate profitability of the underlying investment. Pricing and the method of distribution. Individuals and legal entities (incorporated bodies) may purchase participation bonds. Banks are not eligible purchasers at the primary distribution. PPs are sold at face value on a firstcome, first-served basis. If an issue is not well received, issuers extend the sales period. They have also raised the return to investors by nonprice means, an approach presumably meant to avoid further regulatory review. For example, the Hazrat Imam Reza PP improved the attractiveness of its bonds by offering bondholders on maturity a discount of 10 to 15 percent on the price of the homes incorporated into its project.3 Repurchases. After sale, a purchaser may resell a PP to the agent bank at face value plus accrued interest. The bank is expected to resell the bond at face value, less accrued interest, to the public on demand. No fee is charged for these secondary-market transactions. Rates of return. The minimum return so far has been set by the credit committee. 4 As determined by the trustee, a balloon payment is expected to be paid on maturity. To date, PPs have only paid the guaranteed minimum rate.

3

Similarly, the Tehran project and the car project are considering tie-in sales. It has been kept above bank deposits with similar terms to ensure marketability and to compensate for a 5 percent tax applied to the return from PPs, but which is not applied to earnings from bank deposits. 4

ently limited. Generally, an efficient system of price discovery is essential to developing markets in securities. If the process lacks transparency or is insufficiently market-friendly—in terms of frequency of issue and price setting, and availability of information to assess pricing—investors' participation will be limited. In the case of projectspecific funding instruments, primary issues may be too infrequent and not widely enough held to form the basis for market development. The specificity of a project and the maturity of funding it requires may result in niche investors. Therefore, the usefulness of the resulting price as a benchmark or reference rate for other issues is then very limited.

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Beyond the issue of price discovery, these approaches do not achieve the goal of cost minimization, a core principle of public debt management. This principle is usually applied by ensuring that market-based methods are used for primary issuance of securities. The markets for the securities are made liquid and efficient through arrangements such as discounting, repurchase agreements, and active secondary markets; and the distribution of the securities is broadly based. To achieve these attributes, instrument design, selling techniques, and arrangements to ensure instrument liquidity are important. Some recently used approaches (e.g., the restricted-Mudharaba Participation Papers, or PPs, in Iran) incorporate special nonprice features in instrument design to raise the rates of return (see Box 1). But these arrangements also make the instrument relatively illiquid, and inhibit the development of secondary markets. Further, the practice for PPs to be redeemed at face value (as opposed to a negotiated price) imposes risks on the agent bank, and may also be against the interest of the seller, insofar as his right to any accumulated additional payment above the minimum return is eliminated. Nuances such as these in instrument design result in restricted market participation, and the use of such instruments could result in the government budget paying a premium to raise funds, thereby undermining the cost-minimization objective. General Funding Instruments

As regards general-purpose funding instruments, the determination of an appropriate method for calculating an overall rate of return on these instruments—which could be used as a proxy for the profits from, or returns on, general government activities—poses difficult issues owing to the conceptual problems of measuring the costs, benefits, and risks of providing government services. Over the years, various proposals have been made to resolve these difficulties, including calculating project shadow prices and utilizing social rates of return (see Choudry and Mirakhor, 1997). At present, general-purpose government funding papers are issued only in Malaysia under the Government Investment Issues (GII) scheme. The purchase of GII by investors is considered a benevolent loan (Qard Hasan) made by the public to the government to enable it to undertake projects or provide services for the benefit of the nation. The providers of the funds do not expect any return on their loans, but do expect the principal amount to be returned at maturity. As a sign of goodwill, however, the government can decide to provide some return in the form of dividends (gifts). The rate of dividends, set by a commit-

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tee, takes into consideration variables such as inflation, the real growth of the economy, and existing yields on other financial instruments.3 The GII instrument was designed primarily to allow the Islamic Bank of Malaysia to hold liquid paper in order to comply with the liquidity requirements of the central bank in Malaysia—Bank Negara Malaysia (BNM)—as well as to invest its excess reserves. The GII, however, is not meant to be used as a monetary tool by BNM; moreover, GII is used in parallel with conventional interest-bearing government securities, which are the main instruments of domestic financing of fiscal deficits. This approach of setting the rates of return on the GII by a committee, based on ex post developments of key macroeconomic variables, may not be sufficiently transparent to foster wide participation. The limitations of these instruments for efficient management of public-sector funding requirements have meant that domestic financing of deficits has come to rely exclusively on central bank credit for countries operating under fully Islamic banking systems—thereby exacerbating inflationary pressures. Money Market Development

The difficulties of defining rates of return on general funding instruments have also limited the development of money and interbank markets and constrained the efficiency of central bank credit facilities, and hence limited the scope of monetary management. In addition, the unavailability of high-frequency accounting data, based on uniformly applied standards, has also limited the development of short-term instruments. Although not inherent to the nature of Islamic banking, the liability portfolio of Islamic banks is substantially liquid in practice, and the absence of money markets for short-term liquidity management can impose significant costs on Islamic commercial banks. Islamic banks normally operate three broad categories of deposits. First, the current account, as in conventional banking, gives no return to depositors. It is essentially a safekeeping (Wadiah) arrangement between depositors and banks that allows depositors to withdraw their money at any time, but permits banks to use depositors' money. Second, savings accounts are also operated on a Wadiah basis, but a bank may

3 The formula for determining the purchase or sales price of the GII at the discount window of Bank Negara Malaysia is as follows: Price = (1 + a*b)/365*100; where a = the number of days after the issue date for certificates of 1 year of original maturity, or the number of days after the last dividend payment date for certificates with more than 1 year of original maturity; and b = the expected dividend rate in percent.

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at its own discretion periodically pay depositors a positive return, depending on its own profitability. Third, investment accounts are based on an unrestricted Mudharaba contract, and are term deposits that cannot be withdrawn before maturity without a penalty. In practice, however, investment deposits are of relatively short maturities, and demand deposits constitute a significant proportion of total deposits. The high proportion of callable (demand) deposits predisposes the system to large holdings of very liquid assets. In the absence of money market instruments and efficient central bank credit facilities to manage these short-term positions, banks typically hold a substantial volume of unremunerated excess reserves at the central bank. This tendency to accumulate large excess reserves is then priced into profit shares through lower deposit yields and higher loan spreads, thereby inhibiting intermediation and financial deepening. The absence of interbank markets and efficient central bank lending facilities has limited the use of indirect monetary instruments and perpetuated the use of direct controls on credit and rates of returns. Table 1 reviews liquidity indicators in selected countries and illustrates the tendency of countries that apply Islamic banking principles (in this case, Iran, Pakistan, and Sudan) to have a relatively higher proportion of callable deposits and bank reserves in relation to total deposits.

Recent Developments in Monetary Instruments Against this background, several new initiatives to develop general funding instruments for budget financing and monetary management recently have been launched. As was noted, there have been two underlying difficulties. The first is how to define the range of assets created by the government, measure the costs and benefits of related government services, and determine a rate of return that compensates investors in assets created by the government. The second—in the absence of benchmarks, such as fixed, predetermined interest rates—is how to enable market participants to make a decision on the price of government paper, as is the case in a conventional financial system (see Haque and Mirakhor, 1997). This section examines three new modalities for monetary and public borrowing instruments: the National Participation Paper, the Central Bank Musharaka Certificate, and the Government Mudharaba Certificate. The viability of these approaches for evolving broadly based markets in securities—which can be flexibly used for general budget funding and sustained monetary management—is yet to be proven. Nonetheless,

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Table 1 . Cross-Country Comparison of Bank Liquidity Ratio of Demand to Total Deposits (in percent)

Ratio of Reserves to Total Deposits (in percent)

Country

1993/97

1997

1993/97

1997

1

Iran Pakistan Sudan

40 38 87

40 34 87

31 57 24

33 59 27

Bangladesh2 Egypt Jordan

18 10 19

16 10 17

11 20 14

8 17 16

Sources: National authorities; IMF, International Financial Statistics. 1 Data for Iran were reported on the basis of fiscal years ending in March. Data for 1997/98 are preliminary for five months. 2 Data for Bangladesh for 1997 refer to September.

they represent a recognition of the need for such instruments and markets, and should be viewed as positive contributions to evolving efforts to solve what has been an intractable problem of Islamic banking systems. National Participation Paper

The National Participation Paper (NPP) is a monetary instrument that is used to finance government operations, in particular infrastructure projects—but that is not tied to specific projects—and that can also be used to conduct open market operations (for more details, see Haque and Mirakhor, 1997). The design of the NPP is based on the presumption that because of the characteristics of government infrastructure and development projects, their social rate of return must be greater than or at least equal to the rate of return in the private sector; otherwise, there is no economic justification for governments to undertake these projects. On the basis of this reasoning, a non-interest-based government security can be issued and traded on equity markets. This security promises on maturity to pay a rate of return that approximates the average rate of return of the underlying government assets, and is set equal to or above an estimated rate of return in the private sector. A variety of methods has been proposed for approximating the rate of return on private-sector activities and hence the rate of return on the NPP. An index based on stock market transactions could be developed to proxy the private-sector rate of return.4 The efficient implementa-

4 Haque and Mirakhor (1997) discuss the possibility that international or regional elements could be included in the index.

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tion of this approach would require a relatively developed, efficient stock market to capture a sufficiently large segment of private-sector activities in the economy; and the use of a filtering formula to eliminate signals emanating from expectations of future earnings, speculative fervor, and seasonal variations. It might also be reasonable to construct an index of return on capital that is based on past movements of nominal GDP and its components, given that GNP growth closely proxies the expected growth of the private sector's output. Other possibilities for measuring the private-sector rate of return (particularly where markets are insufficiently developed) include constructing an index based on the ratio of market price of capital to its replacement cost (Tobin's q), or an index using information such as earnings per share and price earnings ratio, or a composite general index that uses elements from all of the above. The operational effectiveness of such indexes would depend upon the stability and transparency of the estimates. The proposal for an NPP, with its return linked to an index of stock market and other measures of the private sector's returns, is being considered at present by the Central Bank of Iran. Technical issues in constructing a sufficiently transparent index to use in determining the rate of return on the NPPs are being examined.5 Central Bank Musharaka Certificates

The Central Bank Musharaka Certificate (CMC)6 is an equity-based instrument that is issued against the government (or central bank) ownership in commercial banks. Such a security was recently introduced in Sudan to enable the central bank to regulate domestic liquidity through open market operations, and thereby facilitate exchange market unification. In principle, the central bank's profits can constitute a basis for issuing securities that can yield an identifiable rate of return to investors in these securities, and can be used in open market operations to regulate liquidity, because these securities can be traded on a secondary market.

5

A decree was issued in early 1997 by Ayatollah Gholamreza Rezwani allowing the authorities in Iran to issue NPPs representing a set value as a proportion of a portfolio of assets (composed of completed development projects) with an expected rate of return. Financial resources thus mobilized are to be used to repay government debt to the central bank and as a monetary control instrument. The central bank will calculate and guarantee a minimum rate of return. 6 "Musharaka" is a partnership contract (usually in capital) with profits distributed according to contributions or on a negotiated basis.

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The central bank's profits are derived from fees charged on account clearances, foreign exchange operations, profit transfers from commercial banks owned by the central bank, profits from credit to banks and the nonbank public, and other sources. Under a Musharaka-based security (i.e., CMC), the central bank becomes a partner with the investors in its profits. The distribution of profits between the central bank and the investor is negotiable, and the contract can be traded in the secondary market (to another bank or to the central bank). The return on CMCs could be derived from the central bank's total profits, or from the profits of a subset of identifiable assets of the central bank, or from government assets (i.e., the government-owned commercial banks) that are administered by (or transferred to) the central bank. Two factors, however, would make CMCs issued against all of the central bank's profits impractical. First, it is difficult to make the central bank's operations, and hence profits, transparent for investors to evaluate performance, while keeping the minimum secrecy needed for the central bank's operations. Second, profits are not usually a principal motive for the central bank's operations; the central bank could willingly accrue losses to serve monetary policy purposes. The problems associated with the use of the central bank's profits as a basis for CMCs could be avoided by issuing the CMCs against a special fund composed of government (or central bank) ownership in commercial banks. Such a fund would have an identifiable value and rate of return, providing ideal conditions for issuing a well-structured CMC. (Appendix A outlines some of the issues regarding the operational modalities of designing CMCs.) The design of a CMC should be based on four general principles that underlie any instrument of market-based monetary operations. First, the instrument should have the potential to be widely held so that monetary signals can be transmitted efficiently through the market. Second, the instrument should be attractive to banks as an instrument of managing excess reserves, so that monetary policy can quickly influence the marginal cost of funds to banks. Third, the instrument should carry the lowest possible price and investment risk, so that it can serve as a benchmark for other more risky securities and financial instruments. Fourth, the instrument should be "rediscountable" (i.e., be eligible for repurchase at a price) at the central bank to provide liquidity to the instrument, particularly in the initial stages when the secondary markets are in the process of being developed. In designing the operational modalities of the fund against which the CMCs will be issued, there will be technical issues involving accounting, asset valuation, and calculation of yields, especially for non-

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listed commercial banks. Some of the design issues include valuing the net worth of nonlisted banks and assessing the value of the central bank's holdings; valuing the CMC fund (given the existence of traded and nontraded stocks in the fund's portfolio); determining a transparent measure of returns and dividends for nontraded banks; and establishing transparent periodicity of fund valuation and the information disclosure needed by the market to assess the fund's performance. Beyond these technical issues, the central bank will need to develop the techniques for primary issuance of the CMCs, including pre- and postauction procedures and information, and accounting and settlement procedures for primary and secondary transactions. With respect to further development of the market, and to provide liquidity to the CMCs, the central bank will need to foster an appropriate microstructure for secondary markets. Liquidity of the instrument will be important, especially in the initial stages, when the central bank will be seeking to establish the credibility of its operations. The central bank will need to establish a mechanism through which it will be willing to repurchase CMCs owned by investors.7 The setting of the repurchase price should be market related and encourage secondary trading outside the central bank. Finally, the central bank will need to set up its liquidity-forecasting and monitoring procedures to guide placements and modify existing instruments, including its credit facilities, to ensure effective use of the CMC to influence bank liquidity and exchange market conditions. The principle underlying the CMC was approved in November 1997 by the High Shariaa Supervisory Council (HSSC) of the Bank of Sudan (BOS)—the central bank of Sudan. Subsequently, a financial company (Sudan Financial Services Company) was established to hold the shares of the government and BOS in banks, and the CMCs were issued against their value (3,940 CMCs were issued for a nominal value of LSd 10 million (about $5,000) for each CMC). A uniform-price auction was used for the first primary issue of CMCs on June 3, 1998.8 The auction was successful, and 200 CMCs were sold against market demand of 559 CMCs. The cutoff price (i.e., the auction price) cleared at a small premium of LSd 1,000 over the preannounced nominal value.9 Notwithstanding its successful introduction in Sudan, the scope for expanded operations in CMCs and its cross-country applicability may 7

See the detailed description of issues related to CMC design in Appendix A. See Appendix A for a definition of a uniform-price auction. 9 In line with a preset timetable, subsequent auctions of CMCs have taken place. Moreover, a repurchase auction has also been conducted, and the net liquidity effect of these operations (up to July 22, 1998) has been an absorption of LSd 9 billion. 8

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be constrained by the underlying institutional arrangement—of central bank ownership of equity positions—in banks. Moreover, because the fund is finite (without undermining other objectives of privatization), there is a limit on the possible volume of transactions that may or may not be compatible with the requirements for monetary stability. The fund can be augmented (as it has been in Sudan) by the transfer to the fund of the government's equity positions in banks, but this too is finite.10 This constraint can be loosened somewhat by expanding the concept of the CMC to a Government Musharaka Certificate (GMshC), whereby the equity instrument issued would be against the public sector's ownership of income-yielding assets in general. A GMshC would then be issued by the government and would constitute an independent funding source for the budget that, as markets develop, could replace the CMC as a monetary instrument. Government Mudharaba Certificates

The Government Mudharaba Certificate (GMC) is an instrument that enables the government to raise funds by issuing securities that promise investors a negotiable return linked to developments in government revenue (e.g., a share in government revenue) in return for their investment in the provision of general government services. A proposal to issue GMCs is currently under consideration by the Bank of Sudan's HSSC, and no decision has yet been made on the suitability of this instrument. This instrument attempts to accommodate the fact that government activities mostly involve producing intangible services, and hence moves beyond the literature's emphasis on designing government funding instruments solely on the basis of the government's production of tangibles. Most of these intangible services (security, foreign relations, legal arbitration, etc.) could, in principle, be produced by the private sector—which, in this case, would have collected rents or fees on them. Furthermore, the private sector would have been allowed to enter into Musharaka and Mudharaba contracts against the production of these services, with investors being remunerated from the generated revenue. It is argued, however, that these services are best provided by the government (viewed as a cooperative entity representing the public interest rather than being motivated by profits), which would, in lieu of rents or fees, collect taxes to cover the expenses of providing the ser10

In principle, central banks could acquire shares in the open market up to any limit, and build up a balanced equity portfolio, against which CMCs could be issued.

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vices. The GMC would allow the public to assist the government in creating these services by providing funds to cover some of the expenses to produce them, and to share in return the collected rents or fees. The overall benefits generated by government services facilitate economic growth by raising revenue for the government. Better government services contribute to higher economic growth, higher income for taxpayers, and hence higher revenue. Investors—whose funds enabled the government to produce the services that benefit the economy and facilitate the expansion of the revenue base—have a legitimate claim on government revenue. Such revenue can also be perceived as a measure of the value or benefits of government services. Hence, investors who fund the provision of such services are entitled to a share of the benefits of these services. It is important to keep in mind that all government funding instruments, under any financial system, Islamic or otherwise, give holders and investors a claim on future government revenue (mostly taxes, in a market economy); the key issue under Islamic banking is how to specify the claim. One might argue, however, that government revenue also depends on the tax structure, and not necessarily on the benefits of government services. However, it cannot be argued that the tax structure is an involuntary contract (Aqed Idhaan) imposed on taxpayers, because the tax structure and the budget both are subject to the approval of the representatives of the taxpayers (i.e., the parliament or other consultative bodies). Therefore, the tax structure can be viewed as a negotiated formula between the government and the public on the price (cost) of producing government services. Investors in the provision of government services would need, as when investing in any other economic activity, to evaluate the factors that affect revenue performance. These factors could include, among other things, projected economic growth, expected rate of inflation, projected government expenditures, projected revenue performance during the maturity period of the GMC, changes in the tax regime, and information on past revenue performance. In addition, the actual rate of return received by the bidder would vary according to revenue performance. On the basis of the disclosed information and investors' evaluation of them—including projected revenue and the effectiveness of government services—investors would bid an appropriate rate of return on their investment in the provision of government services, taking into account the rates of return of alternative investments in the economy.11

11 The issuance of GMCs would, therefore, require a significant disclosure of budgetary performance and revenue objectives.

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Investors would receive ex post a larger or smaller return, depending on actual revenue performance. This could be achieved operationally either by allowing bids specified as a share of tax revenue, or by ex post adjusting the actual rate of return on the basis of actual revenue in relation to revenue targets (see Appendix B). The GMC would be an equity-like instrument in the sense that it could be transformed into assets (services). Hence, the GMC could be traded on a secondary market like any Mudharaba in private assets (commodities or services), with the secondary-market value (lower, higher, or at par with the face value) reflecting changing expectations regarding future revenue performance, in a manner not much different from secondary-market trading in private Mudharaba securities. The government would not guarantee investors either the principal or the return on the investment. Investors would make a profit or incur a loss depending on whether the actual revenue performance during the holding period of the GMC was higher or lower than the initial expectations. The success of the GMC would crucially depend on applying proper fairness criteria to protect the interests of investors. The fairness criteria could include the application of general Islamic rules that protect investors in Mudharaba contracts against moral hazards; establishing a proper disclosure criterion to inform the public, among other things, about actual tax revenue performance, past and present; projections of tax revenue performance for the duration of the GMC period; and changes in the tax regime. In its essence, the GMC is a modern, more refined and sophisticated version of a system of public finance that was practiced by various Islamic states for centuries—namely, the Qabala system of raising funds for general government purposes. In the former Qabala (acceptance) system, an investor accepted (Taqabul) to pay the state a fixed sum of money and in return made a claim on the tax revenue of a certain tax locality; the investor was often allowed to collect the taxes himself, either to ensure that the state would not default or as a matter of convenience. The investor paid the state mostly up front, but sometimes in installments, or at a determined time in the future (usually around tax collection time). This Qabala method, however, was disliked by most Islamic scholars for two reasons. First, the system was often abused, particularly when investors realized that they could incur a loss due to lower than expected revenue and hence attempted to extract more revenue by overtaxing the taxpayer, utilizing in many instances abusive force, in the absence of proper government supervision. Second, scholars feared that the Qabala contract could degenerate into a Riba contract (i.e., an interest-based contract) in cases where investors or investors' funds

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were not reinvested in the tax base. Both concerns are addressed under the G M C scheme. The government will not delegate the tax collection to investors, and the funds raised from issuing the GMCs are reinvested in the tax base (i.e., the economy) through the provision of govern-

Issues in Institutional Arrangements for Monetary Operations The active use of the instruments described above for market-based monetary management can contribute to the development of money markets. To deepen such markets would, however, require the monetary authorities to foster proper institutional arrangements. A n active money market through which banks can manage their short-term portfolio positions underpins central bank operations to regulate liquidity, and facilitates the efficient transmission of monetary policy signals. The institutional arrangements for interbank and secondary markets need to be supported by efficient payment and settlement systems and an appropriate design of central bank credit facilities, and these three elements are also crucial to ensure effective monetary control. Fostering Interbank Markets Market Information

The effective operation of interbank markets requires providing the market with adequate information, as well as adopting proper disclosure standards. Instruments such as interbank lending and deposit placements, which are used to recycle liquidity among participants, are easily affected by the perceived credit risk of the borrower bank and the timeliness of information from the clearing and settlement system for payments. Even if mechanisms existed to facilitate trading, market segmentation may continue and concerns about credit risk can arise if banks do not have adequate information on counterparts. In addition, timely information on bank balances in their settlement accounts, and on net amounts due following check clearing, are crucial in facilitating interbank trading.

12

For more discussions of the historical Qabala system, see Cizakca (1989) and Morimoto (1981).

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Although market segmentation due to perceived credit risks is normal, this segmentation can be substantially reduced by promoting common accounting standards and adequate reporting and disclosure. Until accounting practices are standardized to the point where meaningful analysis and comparisons can be made, financial reporting, such as it exists, will not be reliable. Certified statements with standard methods for calculating and reporting income recognition, nonperforming loans, and interim recognition of rates of return that are subsequently adjusted at the conclusion of the contract are all crucial not only for prudential supervision but also for assessing counterparty risks. Any strategy to improve interbank activity must therefore include reporting and frequently publishing good-quality information on the state of the financial institutions.13 Deepening interbank markets under Islamic banking requires widening the range of instruments beyond interbank deposit placements. Interbank transactions in instruments such as bankers acceptances— which are based on self-liquidating third-party commercial paper, where the primary source of repayment is the payment by the issuer, and the endorsing bank (borrowing bank) is only the secondary source of repayment—would seem to have significant potential under Islamic banking. Interbank transactions in central bank and government instruments (e.g., CMCs, NPPs, and GMCs) can develop rapidly, because the purchaser (surplus bank) can assess risks, depending mainly on the issuer of the underlying security (government or central bank) and less on the seller of the security (borrowing bank). Moreover, a further possibility for developing self-liquidating third-party paper could be through securitizing Mudharaba contracts, where the underlying asset would be the performance of the project funded. Trading Arrangements Trading arrangements for interbank transactions based on Islamic finance principles have not been addressed sufficiently in the literature. The model designed by BNM in Malaysia remains, at present, the only working model. In its guidelines on the Islamic Interbank Money Market (1993) that became effective in January 1994, BNM outlined arrangements to facilitate interbank investments under the Skim Perbankan Tanpa Faedah scheme (SPTF)—interest-free banking. The guidelines

13

Significant progress has been achieved in preparing standardized accounting and reporting methodology by the Bahrain-based accounting and auditing organization for Islamic financial institutions.

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refer to the system whereby a surplus SPTF bank can invest in another SPTF bank that has a deficit in check clearing or is simply experiencing a short-term need for liquidity, on the basis of Mudharaba (profit sharing). Modalities of Arrangement

The features of the mechanism are as follows: • The period of investment can be from overnight to 12 months. • The minimum amount of investment is RM 50,000 (ringgit million). • The rate of return shall be based on the rate of gross profit before distribution for investments of one year of the receiving bank. • The profit-sharing ratio is based on the period of investment: For periods of less than or equal to 1 month, the profit-sharing ratio shall be 70 : 30 (i.e., 70 percent to the provider of funds); for periods exceeding 1 month and less than or equal to 3 months, the profit-sharing ratio shall be 80 : 20; and for periods exceeding 3 months, the profit-sharing ratio shall be 90 : 10. The formula for calculating the profit element to be paid to the provider of funds is as follows: x =

P* R* T* K 365* 100

(1)

where X is the amount of profit (in ringgit) to be paid to the provider of funds, P is the principal investment, R is the rate of gross profit (in percent a year) before distribution for investments for one year of the receiving bank, T is the number of days invested, and K is the profit-sharing ratio. Although these trading arrangements work well in Malaysia, they presume a scheme where there is uniformity in the reporting of rates of return and where banks post continuously their gross profit before distribution for investments of one year. Without some reference rate against which a lending bank can calculate its profit share, lending banks would have difficulty determining the basis of their short-term participation in the borrowing banks' profits. Design of Central Bank Credit Facilities

Central bank lending can be classified into standing and discretionary facilities. Standing facilities are accessed at the initiative of banks subject to meeting criteria established by the central bank; discretionary facilities are operated at the discretion of the central bank to achieve its objectives. The issues in designing central bank credit

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facilities generally—whether these are exclusively focused on supporting payment and settlement arrangements (lombard-type facilities), or facilities to supply longer-term liquidity needs of banks—revolve around collateral, pricing, and other access rules of these facilities. Under conventional banking, requiring collateral for central bank lending is vital to insulating the institution from potential losses. An additional benefit of collateralization is that it promotes the use of assets accepted by the central bank. As noted, this helps develop the collateralization of interbank transactions, which in turn helps enhance financial discipline in the system, particularly if there is limited reliable information about the solvency of potential interbank counterparts. To be eligible for the central bank operations, underlying assets should fulfill three criteria. First, they should be instruments issued or guaranteed by financially sound entities. Second, they should not be issued by the counterparty of the central bank. Third, they should not fall due before the maturity date of the operation they collateralize. To avoid losses due to settlement risk, the assets should be easily accessible (i.e., transferable in book-entry form or pledged to the central bank). Currently, central banks in Islamic banking systems provide medium-term refinancing to commercial banks on a Mudharaba basis, which, although partly addressing the issue of price and returns to the central bank, does not constitute collateralized lending. Unless the central bank is providing a loan, which in this case cannot earn interest (i.e., Qard Hasan), users of central bank funds cannot be asked to post collateral against these funds under existing facilities in Islamic finance (e.g., Mudharaba and Musharaka). This feature gives particular importance to defining the rules governing access to central bank funds. These rules must be uniform and transparent, and should include compliance with all mandatory prudential ratios, including foreign exchange exposure limits, compliance with reserve requirements, satisfactory repayment records for previous credits, compliance with reporting requirements, and satisfactory performance in clearing and settling payments. In addition to access rules, credit limits as a ratio (or multiple) of each bank's capital or deposits could be set.14 As regards facilities supporting the payments system, the typical arrangement in Islamic banking systems is for the central bank to provide uncollateralized overdraft access to banks. The central bank

14

For a discussion of issues pertaining to prudential regulations and supervision in Islamic banking, see Errico and Farahbaksh (1998).

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therefore assumes the risk of default and, where unpenalized, these operations convert the central bank into the preferred lender in the system, thereby undermining the development of interbank and secondary markets. When a bank borrows to facilitate clearing and set' tlement, the assumption should be that it is inviting the central bank to participate in its profits in the same way that the central bank participates in profits derived from longer-term Mudharaba lending. The profit share of the central bank should be set above that which would have applied in the interbank market or would have been offered to investors in the bank. Access to central bank credit needs to be priced carefully to ensure that arbitrage opportunities are not created by mis-pricing and also to ensure that the central bank retains its last-resort status in the system. If priced below market, the central bank could unwittingly impede the development of interbank and secondary markets. If priced too high above market, the central bank could run the risk of having its lending facility made irrelevant and its ability to influence market rates of return diminished, as banks find it too prohibitive to borrow and seek to maintain a large cushion of excess reserves.

Concluding Remarks Central bank monetary operations play a crucial, catalytic role in stimulating money and interbank markets, and measures to foster these markets are essential for the successful adoption of marketbased instruments. The weakness of central bank monetary operations in Islamic banking systems has been a major factor in the ensuing financial repression, and overcoming this weakness is therefore crucial for financial deepening. Success in developing market-based instruments to regulate liquidity and meet general government borrowing needs would greatly enhance the discretionary control of central banks over the growth of their balance sheets, and strengthen monetary control.

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Appendix A. Designing the Central Bank Musharaka Certificate Establishing the Open Market Operations Fund. Issuance of Central

Bank Musharaka Certificates (CMCs) requires the establishment of an Open Market Operations Fund (OMOF) that would hold the shares in commercial banks that the government or the central bank owns that form the base for issuing the CMCs. This appendix assumes that it is the central bank's share partnership in commercial banks that is included in the OMOF. If these shares are originally owned by the government, they will either be transferred to the central bank (probably against the central bank's outstanding claim on the government), or the ownership will remain with the government; but the management of the OMOF will be delegated to the central bank to pursue the desired monetary policy. The central bank establishes the OMOF as a separate entity (in the accounting sense) and transfers to it all of its holdings of commercial banks' shares. The value of the fund would be equal to the sum of all shares' values. If the central bank has holdings in two types of banks, listed in the stock market and not listed, the fund's value will be a composite of market values of the listed stocks and the book values of the nonlisted stocks. In Sudan, a financial company (Sudan Financial Services Company, or SFS) was established to serve the function of an OMOF. The shares of the government and the BOS in banks were transferred to SFS, and CMCs were issued against their values. The SFS is 99 percent owned by the BOS and 1 percent owned by the Ministry of Finance. Accounting issues in establishing the Open Market Operations Fund. The

transfer of the central bank's shares to the OMOF could be financed by an advance from the central bank of an equal value. As a result, the capital account (in "other items, net") of the central bank would decline by the value of the shares, while its claims on the OMOF account (under "net domestic credit") would increase by the same amount, as shown below (assume a fund value of 1,000); the central bank's flows thus would be: Assets Net domestic assets Net domestic credit Claims on OMOF Other items, net Capital

+0 +1,000 +1,000 -1,000 -1,000

Liabilities Reserve money

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And the Open Market Operations Fund's flows would be: Assets

Shares in commercial banks

Liabilities

+1,000

To central bank +1,000

Recording the Open Market Operations in CMCs. The OMOF could be divided into equal-value units (or shares) that could be sold and bought by the OMOF at the instruction of the central bank (in our example, 100 shares with a share value of 10). The shares, or the CMCs, would become a monetary instrument for the central bank because trading in CMCs would directly impact banks' liquidity positions. To contract liquidity by 200, for example, the central bank would instruct the OMOF to sell 20 CMCs to banks. Banks could finance the purchase from their reserves at the central bank, resulting in a decline in banks' reserve balance at the central bank by 200 (20 shares times 10, assuming no change in market value), and hence a decline in reserve money by 200. The assets of the OMOF would not change, although its ownership composition would change (reducing the central bank's ownership from 100 to 80 percent while increasing the banks' ownership to 20 percent). On the liability side, the OMOF would transfer the sale's proceeds to the central bank, resulting in a decline in the central bank's claims on the OMOF by 200, while banks' claims on the OMOF would increase by 200. The asset position of commercial banks would not change, only its composition; banks' claims on the central bank (i.e., banks' reserve position) would decline by 200, while their claims on the OMOF would increase by 200. The net monetary effect is a decline by 200 in the central bank's net domestic credit (NDC) and reserve money. The central bank's flows thus would be: Assets

Net domestic assets Net domestic credit Claims on OMOF Other items, net Capital

Liabilities

-200 -200 -200 +0 +0

Reserve money -200 Banks' reserves -200

And the Open Market Operations Fund stock would be: Assets

Shares in commercial banks

Liabilities

+1,000

To central bank To banks

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Commercial banks' flows would be: Assets

Deposits at the central bank (reserves) Claims on OMOF

Liabilities

—200 +200

Valuation of the CMC. The nominal value of the CMC would reflect the fair (accounting) value of the CMC at the time of its inception, and is determined as the sum total of each bank's paid-in capital, retained earnings, and foreign exchange revaluation reserve (all based on balance-sheet data) multiplied by the percentage of total shares outstanding that are held by theOMOF.Thereafter, the fair value would include the total amount of dividends accumulated in the OMOF since its inception. The calculation of the fair value of the CMC is intended for information purposes only to assist in determining market values of the CMC. In Sudan, the fair value is calculated using monthly bank balance-sheet data. The market value of the CMC would be based on the auction price for primary issues and secondary market price. The market price would be different from the calculated fair value to the extent that the market valuation of the current and future performance of the underlying assets is different from their net worth position as reflected in the balance sheet (which would primarily reflect past performance). Treatment of dividends paid to the fund. The dividend earned by the

OMOF could be distributed to holders of CMCs. However, given that the targeted investors in the CMCs are the banks, which would use the CMCs primarily as a tool for managing liquidity, it would be more efficient (in the sense of improving the liquidity of the CMC) if dividends were retained by the OMOF and were not paid to holders of CMCs (as is done in Sudan). Instead, income would be earned by CMC holders only through capital gains (increases in CMC market values, which in part reflect retained earnings) when CMCs are sold. It is also possible that the retained earnings could be used by the central bank as partial payment for purchases of CMCs made from time to time in the secondary market, allowing, therefore, for the distribution of dividends to CMC holders. Terms of CMCs. CMCs could be issued as a term paper (in the sense that the Musharaka contract, as represented by the CMC, would expire at a certain future date) or without maturity date. A CMC without maturity could improve its liquidity, in the sense that banks would not need to factor the term of the paper into their pricing decision when

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trading in the secondary market. In Sudan, the CMC is issued without a maturity date. Forms of issue for CMCs. CMCs could be issued in fully registered form or as a book entry, with fully transferable ownership. A book-entry system has the advantage of requiring less administrative work and more efficient registration when issuing the CMCs or when they are traded in secondary markets. In Sudan, the CMC is a fully registered form in the name of the owner, and is recorded in the CMC register. Primary issuance of CMCs. Primary issues of CMCs could be sold to investors (banks) through a competitive auction process. A differentiatedprice auction or a uniform-price auction could also be used. Differentiatedprice auction mechanism bids would be classified according to the highest price, and winning bids would be awarded in descending order from the lowest price to the point where the accumulated winning bids absorb the total amount offered for sale. The lowest price would be the cutoff price. All winning bids would be allocated to bidders on the basis of their offered prices, and the auction price would be the weighted average price of all bids. Under a uniform-price auction mechanism, the cutoff price would be applied to all winning bids, thus representing the auction price. A uniform-price auction might have an advantage over a differentiated-price auction, particularly in the early stages of issuing CMCs, because of the complete lack of market experience with CMCs, and the absence of any representative benchmark price (as in Sudan). A wide dispersion of prices might occur in the early auctions if a differentiatedprice auction is used, and some investors might perceive the results as inequitable, thus undermining confidence in CMCs. Secondary market trading and repurchase facility. CMC holders may

trade their certificates in the secondary market for a variety of reasons: The nonbank public (particularly nonbank financial institutions) may find the instrument attractive (albeit it was designed for banks) and purchase it from banks in the secondary market; CMCs can be used by banks to circulate excess funds, in the absence (thus far) of an Islamically acceptable short-term interbank lending facility; and banks may use CMCs as a tool to cover overdraft positions, either by selling them to the central bank or to other investors. To improve the function of the CMC as a liquidity management tool for banks, it is recommended that the central bank establish a repurchase-on-demand window. However, the repurchase price should be set lower than the secondary market price to encourage the development of secondary-market trading. The discount reflected in the repurchase price should, conversely, be set at a level lower than the penalty rate on overdraft to encourage banks to use their CMC holdings to generate the needed funds, rather than going overdraft.

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Appendix B. Determining the Rate of Return on the Government Mudharaba Certificate Investors can bid for the Government Mudharaba Certificate (GMC) in two ways: They can bid for a share in future government revenue (e.g., 20 percent of revenue) that will generate an expected income commensurate with what they consider an appropriate rate of return on their investment. Or they can bid what they consider an appropriate rate of return on their investment (e.g., 10 percent rate of return). The two methods are basically similar. The second method, however, has the advantage of giving investors a clearer way of comparing the expected rate of return on their investment in the government to other investments in the economy. In the first case, the rate of return to investors at maturity is calculated as: r = s(y)-l

(B.I)

where r is the actual rate of return to investors, s is the share in tax revenue that investors bid for, T is the actual tax revenue, and I is the amount invested in the government. In the second case, the return to investors at maturity is calculated as:

r=U+r*)[l + ( ^ ) ]

l

(B.2)

where T* is the government's projection at the time of auction t of tax revenue for the relevant period, and r* is the rate of return that the investor bids for after the government communicates T*. The following example illustrates how the two methods apply. A t the time of the auction, the government will announce the amount of funds it intends to raise, the maturity period, and the expected tax revenue T* for the period. This information will be supported by the disclosure of the relevant macroeconomic projections and other information needed for investors to assess the value of the investment (as outlined above). Assume that I = 1,000, T* = 5,000, and bidders' expectation of tax revenues is also 5,000. Suppose further that investors find it profitable to invest in GMCs if they offer an expected rate of return of at least 10 percent. In the first case, they would bid for a share in government T revenue s = 22 percent. In the second, they would directly bid for r* = 10 percent. Suppose now that tax revenues are T = 6,000. It is easy to check that in both cases the actual rate of return paid to investors is 32 percent. From equations (B.I) and (B.2), we have: r = 0.22 (6,000/1,000) - 1 = 0.32, and r = (1 + 0.1) {1 + [(6,000 5,OOO)/5,OOO]} = 0.32.

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It is also clear from the example that investors could lose some of their principal if actual revenue collection was below initial expectations (if T = 4,000, r = -12 percent). The monthly volatility of tax revenue could be a cause for concern for both the government and investors. High volatility would increase the uncertainty regarding future returns to investors, resulting in higher risk premiums. In addition, it would be difficult for the government, with high tax revenue volatility, to efficiently manage its budget, while taking into account future payments to investors. Tax revenue volatility could be reduced by introducing a smoothing factor to reduce the spread between the highs and lows of returns to investors, which would be caused by higher or lower than expected tax revenue. In this case, equations (B.I) and (B.2) above are modified as follows: [ T.

+ a(TT-)]

(B3)

r = (l + r*)*[l + oc(^*)] i

(B#4)

r =s

where a is the smoothing factor with value 0 < a < I.15 In the earlier example, T = 6,000, or T = 4,000, would have generated rates of return of 32 and -12 percent, respectively. If, however, a = 0.5, then r = 21 percent (instead of 32 percent) if T = 6,000, and r = -1 percent (instead of-12 percent) if T = 4,000. If a smoothing factor is used in determining the return to investors, it is essential that the value of a is announced at the time of the auction, because it would constitute an important piece of information for investors. To simplify the management of the GMCs, the term T — T*/T* = k in equation (B.4) may be rounded to the closest decimal. In doing so, the rate of return would be, for instance: r, if 0.05 > k > —0.05; r + 0.1, if 0.15 > k > 0.05; and r - 0.1, if-0.05 >fe> -0.15.

15 The variable a in effect determines the distribution of profits or losses arising from an over- or underperformance of revenues in relation to the initial projections of the government.

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References Choudhry N., and A. Mirakhor, 1997, "Indirect Instalments of Monetary Control in an Islamic Financial System," Islamic Economic Studies, Vol. 4, No. 2, pp. 27-66. Cizakca, M., 1989, "Tax-Farming and Resource Allocation in Past Islamic Societies," Journal of King Abdul Aziz University: Islamic Economics, Vol. 1, pp. 59-81. Errico, L., and M. Farahbaksh, 1998, "Islamic Banking: Issues in Prudential Regulations and Supervision," IMF Working Paper WP/98/30 (Washington: International Monetary Fund). Haque, N., and A. Mirakhor, 1997, "The Design of Instruments for Government Finance in an Islamic Economy," paper presented at a seminar on the Design and Regulation of Islamic Financial Instruments, Central Bank of Kuwait, Kuwait, October 25-26. Iqbal, Z., and A. Mirakhor, 1987, Islamic Banking, IMF Occasional Paper No. 49 (Washington: International Monetary Fund). Kazarian, E., 1993, Islamic Versus Traditional Banking: Financial Innovations in Egypt (Boulder, Colorado: Westview Press). Morimoto, K., 1981, The Fiscal Administration of Egypt in the Early Islamic Period, Asian Historical Monograph No. 1 (Kyoto: Dohosha Publications).

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Addendum. Recent Developments in Islamic Banking GHIATH SHABSIGH

T

he purpose of this note is to provide a brief update of the recent developments in Islamic finance. Although the Islamic finance industry continues to grow at impressive speed, this note focuses only on the progress in building the important infrastructure that is needed to support the industry. Most of this progress has been achieved during the past five years and has been concentrated in the following areas: financial innovation, central banking operations, establishing money markets, accounting and disclosure standards, regulation, and rating standards.

Financial Innovation The most important innovation in Islamic finance in the past few years has been the development and the steady spread of assets securitization. Under conventional finance, securitization represents the creation of securities that are backed by interest-bearing loan contracts. Securities under Islamic finance, however, must be backed by a pool of contracts representing transactions in real assets. The return on this type of security is derived from the assets backing it, and returns could be variable, if securities are based on profit-generating assets (e.g., Musharaka or Mudharaba contracts); or stable, if securities are based on rent or markupgenerating assets (e.g., Ijara and Murabaha contracts).1 Securities can be issued against existing assets or new assets. Securitization offers Islamic fi-

1 Securities issued against debt-based contracts (e.g., Murabaha and installment sales) cannot be sold at discount and should be included as a minority share in a fund that includes mostly non-debt-based contracts. Moreover, a security market for Islamic debt contracts has been operating in Malaysia for several years. However, this experience has not spread beyond Malaysia.

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nance many of the same benefits it engendered for conventional finance. These include increased liquidity, diverse range of terms and rates, market assessment of risk and value, and risk diversification. The Islamic Development Bank (IDB)2 pioneered the securitization development with its Unit Investment Fund (UIF), which was launched in 1990. The UIF is an open-ended fund consisting of Ijara, installment sale, and Murabaha contracts that are contracted by the IDB. The UIF is divided into equal-value units and sold in its entirety to investors (mostly to Islamic banks). The units are transacted over the counter, with the bid and offer prices posted regularly by the IDB and composed of a discount or premium on the net asset value of the unit. To improve the liquidity of the UIF, the IDB instituted an on-demand buyback window. The IDB has been using the UIF successfully to unlock capital for additional financing, while providing relatively secured investment to investors. The second major development in securitization was the launching of the Central Bank Musharaka Certificate by the Central Bank of Sudan (CBS) in June 1998. The CMC was intended to provide the CBS with a market-based indirect monetary control instrument. The CMC was designed to be used by the CBS in open market operations (OMO) to regulate banks' liquidity. The CMC is based on the Musharaka principle in a close-ended fund that consists of government and central bank share ownership in commercial banks. The fund is divided into a finite number of equal-value certificates, which were sold or bought at the discretion of the CBS through auctions (primarily to banks). The CMC imbedded features that made it highly liquid, including no maturity term, recapitalization of the dividends transferred to the fund, and an on-demand buyback window at the CBS. The CMC proved quite successful in meeting its objectives and became the first equity-based instrument to be used by a central bank in OMO. This success rekindled the interest in securitization by widening the horizon of design possibilities. Following the introduction of the CMC, a similar-concept instrument, the Government Musharaka Certificate, was launched in Sudan in May 1999 as a government-funding security, with design features suitable for its intended purpose. Another similar instrument, the Central Bank Participation Paper (CPP), is being considered by the Central Bank of Iran. In addition to these Musharaka-based instruments, stable income instruments (similar in concept to the UIF) are being considered as government financing instruments in Pakistan, Sudan, and other countries.

2

The IDB is an international financial institution established by the Organization of Islamic Countries and based in Jedda, Saudi Arabia.

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The progress in securitization has also encouraged the interest of other Islamic financial Institutions (IFIs) in such operations. It is becoming more and more common for individual Islamic banks to securitize large financing contracts (mostly Ijara contracts, at present). However, the level of securitization has not yet reached the critical volume that could support the establishment of organized local securities markets. Most transactions continue to be over the counter operations. The recent efforts to develop an international Islamic money market (see below) could accelerate the securitization development process.

Central Banking Operations In a market-based economy, central banks offer an overdraft facility to support the payment system, and a lender of last resort window to guard against systemic risks, securities window for conducting OMO to regulate short-term liquidity fluctuations. Under certain circumstances (usually in less developed financial markets), some central banks have also provided a general-purpose short-term financing facility to support the economy, mostly through credit auctions. The operations of these facilities are usually responsive to market forces and based on changing the financial system's incentives through price signals (i.e., influencing movement in market interest rates). Developing similar facilities that are in line with Islamic finance principles has been difficult. As a result, Islamic banks were put in a disadvantageous position, as they were cut off from traditionally interestbased central banking facilities. They had no choice, for example, but to maintain, at great cost, unnecessarily high internal liquidity levels to avoid overdraft penalties and to manage liquidity risk. As part of the its economic reform program, Sudan began, with IMF technical assistance, to develop fully fledged central banking operations that are in line with Islamic finance principles, to service its fully Islamized banking system and to regain control of monetary and credit aggregates. As discussed above, an OMO facility was established with the introduction of CMCs in June 1998, and has been used actively since to regulate bank liquidity. Furthermore, Mudharaba-based nonOMO facilities were also developed. A short-term standing credit facility was established as an overdraft facility and as a lender of last resort, and has been in use since mid-1998. A general-purpose financing facility was also established in Sudan with the introduction of Mudharaba auctions in central bank funds in May 2000. Banks that are qualified to participate in the auction bid a Mudharaba rate (which determines the distribution of bank profits between the bank and the central bank) for

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the central bank's funds. The outcome of the auction and the Mudharaba rate that is set for the standing credit facility have become reference rates for the banks.

Establishing Money Markets An interbank fund market for Islamic banks was developed first in Malaysia in 1994, through the creation of an interbank deposit placements mechanism based on Mudharaba principles.3 An interbank market, similar in concept to the Malaysian one, was developed in Sudan in 1998. The major difference between the Sudanese and Malaysian markets is that in the former the Mudharaba ratio, at which the profits are distributed between the placing and receiving banks, is negotiated between them, while in the latter it is determined by the central bank. Proper market information and reporting standards are essential for the success of such arrangements. Common accounting standards and reporting are needed particularly for calculating and reporting income recognition, nonperforming loans, and interim recognition of rates of return, which are subsequently adjusted at the conclusion of the contract. The lack of good-quality information on the state of the financial institutions and the infrequency of its reporting have, for example, hindered the operation and development of Sudan's nascent interbank funds market. Developing instruments for liquidity management that are compatible with Islamic finance principles is critical for the long-term growth prospects of IFIs, the development of an adequate regulatory framework, and the proper conduct of monetary policies in countries that are fully or partially implementing Islamic banking. The recent conceptual and practical advances in securitization of Islamic financial contracts have been a stepping stone to the establishment of organized Islamic financial markets. Concerted efforts are under way to establish an International Islamic Financial Market (IIFM). The initiative was spearheaded by the Bahrain Monetary Agency (BMA), the IDB, and the Malaysian Labuan Offshore Financial Supervisory Authority, which signed a memorandum of understanding in October 1999 to launch the project. Since then, central banks from several other countries have joined the

3

See Chapter 5 above for a detailed description of the Malaysian interbank funds market.

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project. A working group with representatives from a number of countries has recently been established. It is expected that IIFM will have two connected bases for trading, one in Bahrain (serving the Middle East) and the other in Labuan, Malaysia (serving Southeast Asia). The IIFM will include a liquidity management center (LMC) to be established in Bahrain and a market management center (MMC) in Labuan. The IIFM is expected to be dollar-based, and trading will most likely be carried out electronically. The IIFM is anticipated to be fully operational by the end of 2001. The IIFM will be most useful in facilitating IFIs' international transactions, including settling international payments, facilitating the mobilization of foreign capital, and providing diverse dollar-based investment opportunities. However, it is unlikely that the IIFM will replace the need to develop local money centers and central banking facilities that are necessary for an efficient liquidity management operation. Furthermore, the long-term prospect of the IIFM would depend on the ability of such local markets to generate the needed critical volume of real investment opportunities on which the financial securities (including those that will be listed at the IIFM) will be based.

Accounting and Disclosure Standards An accounting framework that is appropriate for the operations of IFIs is essential to ensure that the transparency and disclosure of their operations are sufficiently rigorous and accurately reflect their financial position. This would allow for better market evaluation and appropriate supervision by the regulatory agencies. For example, Islamic banks' deposit taking (whether from depositors or from other banks through an interbank market) is based to a large degree on Mudharaba arrangements, which would require a uniform methodology for determining profits and for income recognition. Furthermore, the banks' methodology for classifying and disclosing their liabilities and assets has significant regulatory and legal ramifications. To supplement the existing International Accounting Standards (IASs) to capture the true picture of IFIs' operations, the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has developed a set of Financial Accounting Standards (FASs). The FASs are rapidly becoming the world standards for IFIs in conjunction with IASs wherever the FASs are silent. These standards have been implemented by some countries (e.g., Bahrain, Qatar, Saudi Arabia, and Sudan) and are being considered by many other countries (e.g., Iran, Kuwait, Malaysia, and Pakistan).

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Furthermore, given the level of transparency and rigor embedded in the FASs, international rating agencies have given favorable ratings to the IFIs that adopted them. As a result, large numbers of international IFIs have adopted the standards voluntarily. In countries where FASs have not yet been approved by the concerned regulatory agency, some IFIs have prepared their balances using both the IASs (or other required national standards) and the FASs. In addition to accounting standards, the AAOIFI has prepared one standard on capital adequacy, a few standards on governance, and Sharia standards for several financial transactions. The latter could potentially become an important milestone for Islamic banking. By harmonizing the Sharia interpretations, the financial transactions of the IFIs would not only become comparable, but they would also provide sound ground for developing an appropriate, internationally acknowledged regulatory framework.

Regulating IFIs The risk profile of IFIs differs from that of conventional banks in a number of important respects, and this has important implications both for risk management and regulation. At present there is no internationally accepted risk metric, comparable to that developed for conventional banks by the Basel Committee on Banking Supervision, that can be used to assess the capital adequacy of IFIs. Although important progress has been made in this area by the AAOIFI, so far its recommendations have related only to the liabilities side of the balance sheet. A comprehensive approach to assessing the risk-adjusted assets of IFIs, and hence their required regulatory capital, is at present unavailable. It was with these considerations in mind that the Conference on the Regulation of Islamic Banking was held February 8-9, 2000, under the auspices of the Bahrain Monetary Agency, and organized by the IMF, the Islamic Development Bank, and the AAOIFI. The conference was designed to bring together senior policymakers from countries with a significant presence of institutions offering Islamic products, industry representatives, standard-setting bodies, and academic experts to discuss key issues in the regulation of Islamic finance. The conference focused on key industry and regulatory challenges, the need for harmonization of prudential and transparency standards, and possible future steps. Two main themes emerged from the conference. First, the development of liquid money market instruments that are consistent with Islamic precepts is not only critical for effective monetary control and ef-

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ficient liquidity management by IFIs, but also a major precondition for sound banking and effective banking supervision. Second, complex issues underly the development of new prudential norms or the adaptation of existing Basel Committee norms to reflect the specific risk characteristics of Islamic financial contracts. There is an urgent need to design appropriate capital charges, internal controls, and disclosure standards that reflect the characteristics of Islamic financial products and press ahead with harmonizing these standards across countries and institutions so that there can be effective supervision and a level playing field. The conference recommended that a Financial Services Board (FSB), made up primarily of concerned central banks, be formed to help support the design and adaptation of uniform prudential supervision standards for Islamic financial products. A larger follow-up meeting of interested central bank governors and representatives was held during the Annual Meetings of the IMF and World Bank in Prague in late September 2000 to examine how to organize international cooperation in designing and harmonizing prudential and regulatory standards for IFIs. The meeting strongly supported the call for establishing an FSB to serve as an international regulatory and standard-setting agency for IFIs. A working committee was established, with representatives from the central banks of Bahrain, Iran, Malaysia, and Sudan, as well as the IMF, IDB, and AAOIFI, to prepare a report outlining the FSB's terms of reference and structure. The report is expected to be submitted to the concerned central banks and international agencies during the first half of 2001.

Risk and Credit Rating The public must be offered the opportunity to evaluate banks' performance independently from the assessments of the banks (through their annual reports) or the regulatory agencies (through their enforcement of the prudential regime). This is particularly important in the case of Islamic banking, because depositors' earnings (as well as the security of deposits) on their investment deposits (which are based on Mudharaba arrangements) depend on the banks' performance in managing and investing these deposits. This is achieved in good part through credit and risk ratings that are prepared by rating agencies. The standard methodologies used by international rating agencies, however, may not be fully suitable for Islamic banking. International rating agencies have had difficulty rating Islamic banks, and the banks continue to complain about the unfairness of these ratings, because the agencies do not fully appreciate the nature of Islamic banking. An ap-

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propriate rating methodology that takes into account the nature of Islamic banking would need to be developed. To address this need, the IIFM launched in November 2000 an initiative to set up an international Islamic rating agency in 2001 to rate Islamic securities. In addition, a Pakistani agency has developed a rating methodology that is supposedly appropriate for Islamic banking. A l though the work in this area remains in its infancy, significant progress is expected in the near future.

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6 Fiscal Sustainability with Nonrenewable Resources NIGEL CHALK

T

his chapter seeks to answer the question "What constitutes sustainable fiscal policy in an economy where wealth is derived predominantly from a nonrenewable resource?" In particular, the focus is on oil-producing countries. Because the current fiscal stance imposes constraints on future fiscal policies, this issue requires an examination of fiscal policies in an explicitly dynamic framework. For example, an oil producer's fiscal position, as typically measured by the ratio of overall deficit to GDP, can look quite sustainable either fortuitously, because of a temporary rise in the oil price or, if unconstrained by OPEC quotas, because of a deliberate increase in production. However, higher production has consequences beyond the current period, because it speeds the depletion of the resource, which in turn places greater constraints on future fiscal decisions. In such an economy, conventional fiscal indicators can be deceptive in describing the sustainability of the underlying fiscal position, particularly in the face of volatile world commodity prices. The aim of this chapter is to assess "sustainability" using a simple dynamic framework that explicitly incorporates a nonrenewable resource. This approach leads to an alternative measure of the fiscal position, which we call the "core deficit." This measure is affected less by changes in resource revenue and also highlights structural weaknesses in the underlying Thanks are due to Richard Hemming, Zubair Iqbal, George Kopits, and Steven Symansky for their helpful comments on this chapter.

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budgetary position. The chapter describes the type of fiscal policies that can be carried out in the long run. In addition, it examines the implications for fiscal policies of developments in a country's terms of trade. In some cases, a country endowed with a nonrenewable resource may be able to permanently run core deficits without an explosive accumulation of public debt. The chapter identifies the principal factors that determine the sustainability of these deficits, which include, among others, the proportion of entitlements and net transfers in the budget, the net asset or liability position of the economy, the economy's endowments of natural resources, the rate of population growth, and the rate of return on assets. It should be stated at the outset that in capturing the dynamic nature of the problem, the chapter is forced to simplify and abstract to obtain a manageable framework for analysis. However, this effort is intended as a step toward assessing the fiscal situation in countries with nonrenewable resources that can be eventually extended to capture additional salient economic features that are omitted here. It should be emphasized that the chapter is concerned primarily with the long-run feasibility of a particular fiscal program and not with its optimality from a welfare perspective. A government's decision-making process is extremely complicated. One approach may be to assume that the fiscal authority aims to optimize aggregate welfare—however it may be defined—using a variety of tools. These tools include, in the case of a resource economy, the rate of extraction, whether the resource income should be absorbed or saved, whether that absorption should be through government consumption, investment, or transfers, and whether spending should be on physical capital, human capital, social capital, industrial projects to diversify the economy, or other uses. For example, a permanent income approach would lead the government to save oil revenues in a boom and spend them in the future when the market turns down. Gelb and others (1988) take such an approach and in simulations suggest that, optimally, about 70 percent of oil windfall receipts should be saved. Rather than investigate these decisions, this chapter instead looks at whether a constant fiscal policy—resulting either from an attempt to optimize welfare or perhaps from rent-seeking behavior—is sustainable in the long term or whether it will lead to an accumulation of fiscal liabilities that will force an eventual change in policy.1 Sustainability is taken as meaning "can a given policy continue indefinitely?" It should be noted that such a definition of sustainability constitutes a necessary, although not sufficient, condition for optimality.

1 Gelb and others (1988) provide some insight into the factors that are driving these decisions in several countries.

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Sustainability Indicators and Tests There is an extensive literature focusing on both conceptual and empirical issues in appropriately assessing the sustainability of a particular country's fiscal policies. For the most part, the literature has assessed fiscal sustainability by asking whether fiscal policy leads to budget balance in present-value terms or results in an explosive debt accumulation. This long-run solvency criterion is viewed as the main constraint faced by the public sector in running a sustainable program. In particular, it implies that the current public debt must be offset by the net present value of future public surpluses. Ponzi games are not possible, and the government is forced to obey a transversality condition in the limit. Algebraically, this implies that, (1) where Bt is the stock of government debt, R(t, t + j)-1 is the discount factor between periods t and t + j , and Dt is the level of the primary surplus. It then becomes an empirical question as to whether a given country can be reasonably expected, ex ante, to satisfy the present value budget constraint or whether it will violate long-run solvency, forcing monetization, repudiation, rescheduling, or a change in the underlying fiscal stance. By taking the present-value budget constraint to be synonymous with sustainability, most authors have attempted to construct indicators that highlight inconsistencies between current policies and the medium- or long-term continuance of such policies. Buiter (1985) uses the permanent adjustment necessary to maintain the ratio of publicsector net worth to output at its current level as an indicator of sustainability. The larger the necessary adjustment, the further a given set of policies is from being sustainable. Blanchard (1990) takes a similar approach by calculating the deficit or surplus necessary to maintain the current debt-output ratio (rather than the government net worth). The "primary gap," which is the difference between the deficit needed to maintain a constant debt-output ratio and the prevailing deficit, measures the degree to which current policies differ from those necessary to stabilize the debt-output ratio in the long run. Blanchard (1990) also looks at the necessary adjustment in taxes, given a projected path of expenditures, to stabilize the debt-output ratio in the medium term. The "tax gap" is calculated as the difference between the current tax ratio and that necessary to stabilize the debt stock. All three indicators, as outlined in Home (1991), attempt to measure how far current policies are from those that would satisfy the present-value budget constraint.

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An alternative approach has been to examine the constraints the no-Ponzi game criterion places on the time-series properties of fiscal variables. In particular, Hamilton and Flavin (1986) test for the stationarity of the stock of debt in the United States as an implication of policies that satisfy the present-value budget constraint. Trehan and Walsh (1991) suggest that the transversality condition imposes a long-run cointegrating relationship on the behavior of the debt and primary deficit, and they test for such a relation. Wilcox (1989) argues that the present-value budget constraint implies that the discounted value of the debt, R(t, t + j)-1Bt+j, should be stationary and have an unconditional mean of zero, and he tests these constraints for the case of the United States. Kremers (1989), by adding a further constraint on the ability to tax income, derives stationarity in the behavior of the debt-output ratio as a precondition for sustainability. These approaches, while yielding useful information on the longterm viability of a particular fiscal stance, have some shortcomings. First, the tests on the time-series properties of the debt and deficit, and the calculation of the fiscal indicators, depend critically on the assumptions on either the interest rate, the growth rate, or both. In addition, the above empirical exercises can impose large information requirements—particularly on the stock of government assets and liabilities—which can be met in only a few nonindustrial countries. Second, the indicators are usually presented as a ratio to GDP. In a country that is dependent on natural resource income, this can be quite misleading when GDP fluctuates widely from year to year. In an oilproducing country, for example, a temporary surge in world oil prices can make the country appear significantly closer to sustainability (by reducing the deficit-GDP ratio) without any change in the policy stance (or indeed even in cases where the underlying fiscal position is actually loosened). Third, there is a more fundamental question as to whether the prerequisite of intertemporal budget balance is in fact a necessary condition for sustainability in the case of a country with considerable natural resources. In particular, if the value of the resource wealth of a country is appreciating over time, it could indefinitely run a primary deficit equal to that appreciation without depleting its resources. Such a permanent primary deficit is not permitted, however, by the present-value budget constraint. This has led some to recommend that government assets and liabilities should be defined more widely to include natural resource endowments (see Liuksila, Garcia, and Basset, 1994), but this would require valuing a stock of proven reserves in the face of uncertain future prices.

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A Theoretical Framework This section outlines an overlapping-generations model of a country endowed with exhaustible resources that are being depleted over time. The model abstracts from the productive sector and assumes all national income is obtained either from returns to invested assets or from the sale of a natural resource. The government is assumed to own the resource, which it then sells; it uses a portion of the proceeds to make net transfers to the population. The government and private sectors are also endowed with a stock of financial assets (or liabilities). Consumers Consumers are assumed to live two periods and to receive an income solely from government transfers Tt when young.2 In each period there are two generations alive, the young and the old. Population is assumed to grow at a rate (1 + n), and all the variables of the model described below are expressed in per capita terms. The consumer problem is max {c (t),c (t+1)} t t

s.t.

U[ct(t)]+Bu[ct(t+1] ct(t)+zt(t) =

Tt

(2)

c t (t+l) = Rt+1zt(t)

where ct(t) represents consumption when young, ct(t + 1) is consumption when old, zt(t) represents the savings of the young, and Rt+1 is the rate of return on assets. Assuming a simple logarithmic utility function, the solution to the consumer problem is to save a constant fraction of income received when young, that is, Zt(t)

=

oTt

(3)

Resource Use and Technology The country is initially endowed with a per capita resource stock s0, and the stock is depleted by per capita production yt. The dynamic behavior of the real per capita resource stock is described by (1 + n)st+1 + st - yt s0 fixed, and st+j > 0

(4)

Let pt represent the relative price of the resource in terms of consumption goods; as such it can be viewed as proxying the terms of trade a 2 The model could be modified to allow for transfers to accrue to the old as well, but this would complicate the analysis and does not materially affect the results.

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country faces. For simplicity, let us assume that the relative price of the resource evolves according to fc+i=8fc

(5)

If 5 < 1, this implies deteriorating terms of trade whereby the resource the country possesses is worth less over time relative to the bundle of goods it consumes. Similarly, 8 > 1 represents improving terms of trade. Letting St = p,st be the value of the resource in terms of consumption goods, we can rewrite (4) as3 (l+n)St+l = 5St-8ptyt (6) The country is also able to accumulate financial assets; such assets (at in per capita terms) receive a gross return Rt. One can view this as a small-country assumption where the rate of return on assets is exogenous. Aside from the natural resource, there are no other forms of domestic production. One could introduce a productive capital stock, but it is ignored here for analytical convenience. The Government

The government owns the natural resource and derives revenue from its sale. In addition, the government receives investment income from its asset holdings (af) while paying interest (Rt) on its debt (bt). It is assumed that the government has access to the same foreign assets as private consumers and receives a return R r In addition, the government receives revenue from non-oil sources such as direct and indirect taxes. The government spends a portion of the oil and investment revenue on net transfers to consumers and runs a core deficit of gt. The core deficit is defined as total government spending less transfers to individuals and revenue from sources other than oil and investment income. For simplicity, it is assumed that (1) government spending represents consumption expenditure and (2) net transfers to the private sector are an exogenous proportion \ of the total revenue from asset income and from the natural resource. Note that Xt is exogenous but not necessarily constant. These last two assumptions require some explanation. One could imagine the government using oil revenues to spend on investment goods and, as Gelb and others (1988) point out, this was often the case

3

See Appendix A for the derivation of the model that follows.

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in the oil-producing countries. Such investment could, in turn, increase future output, generate non-oil revenue, and perhaps reduce future deficits. This link between government spending and economic activity is not captured here. However, one could argue that the historical experience with such resource-financed investment has not shown a positive link from government investment to non-oil growth. Both Murphy (1982) and Auty (1986) conclude that, in general, the return on public investment projects in oil-producing countries has been generally quite poor, and that in some cases there has even been negative value added. The second assumption of an exogenous share of transfers to income (kt) certainly does not reflect the historical experience in many oilproducing countries. In fact, as will be shown below for the cases of Kuwait and Venezuela, the level of transfers in many oil-producing countries does not appear to be a constant fraction of income and is determined by a combination of political and economic factors. During oil booms, there is typically an increase in transfers as the public is allowed to "share the wealth." However, the political climate during the downturns makes it difficult for the authorities to cut social programs and subsidies. This ratchet effect—of an increase of the ratio in booms and a failure to reduce it in slumps—is well-documented in the literature. However, to provide behavioral explanations for this ratio would add significantly to the complexity of the model described here. As a result, the determination of A,t is regarded as an exogenous process. Letting Q t = af - bt be the net asset (or liability, if negative) position of the government in per capita terms, the government budget constraint can be written as U+n)Q t+1 = Qt-gt + (1 -K)(rtQt + p^)

(7)

The interpretation of this equation is straightforward. The net assets of the government increase with the government share (1 - Xt) of income from the natural resource (ptyt) and from net assets (rtQt), while the net asset position falls with a higher core deficit (gt). Equilibrium

The simple model of the economy can thus be summarized by three equations, for the capital market, the government sector, and the resource constraint. Capital Market

In equilibrium, private savings is held either in the form of government debt (bt) or privately held investment in foreign assets (a^). Letting

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FISCAL SUSTAIN ABILITY

the total amount of financial assets held by the economy as a whole be at = af dPt> the capital-market-clearing equation can be rewritten as rQt) = (1 +n) (at+1 - Q t+1 ) (8) (government Sector

Here we reiterate the evolution of the government net asset position, (l+n)Qt+1 = Q , - f c +(l-\)(ptyt + rtQt)

(9)

Resource Constraint

The evolution of the stock of resource is given by (l+n)St+1 = 8S t -8pj t (10) As yet, we have not specified the dynamic behavior of at or A,r As discussed above, for simplicity, we assume that Xt is an exogenous process, although it would be interesting to model this process or assume an exogenous dynamic process that mimics the ratchet effect of transfers in the budget. Also, to reduce the dimensionality of the problem at hand, we assume that at remains constant over time. The conceptual question asked here therefore is how large a deficit can the government have without diminishing the economy's net asset position.4 A n alternative would be to augment the model with an additional dynamic equation, which would specify the process either for the depletion of the natural resource or for the accumulation of assets, perhaps based upon a permanent income or intertemporal consumption smoothing relation. For example, Liuksila, Garcia, and Basset (1994) assume that the level of extraction grows at a constant rate over time until the resource is depleted, whereas Zee (1988) explicitly assumes an objective function for the government. In this chapter, however, the aim is to place few restrictions on the structure of the economy in order to focus on the types of fiscal programs one should consider sustainable. In examining the implications of the model, it should be remembered that the results are conditioned on the presumption that the net asset position of the economy is kept constant. 4 One could also imagine a stronger requirement related to the size of the deficit that is consistent with a stock oi financial assets that is increasing over time at a particular rate (which might be an important consideration for an economy that faces a finite resource stock and that is trying to accumulate assets for future generations).

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The Fiscal Sustainability of Budget Deficits Case I: Deteriorating Terms of Trade

By drawing on the description of the economy that has been outlined above, it is now possible to determine what constitutes sustainable fiscal policy. The first case proceeds under the assumption that the economy faces deteriorating terms of trade, whereby its resource endowment is worth less over time in terms of the consumption good. Algebraically, this implies that 8 < 1, but the analysis follows even if the terms of trade are improving but do so at a rate less than population growth (1 + n). From equations (8), (9), and (10), one can derive a graphical representation of the simple economy described above.5 In Figure 1, the lines that represent ASt = 0 and AQt = 0 have a point of intersection such that, from some initial resource stock and a given public net asset position, the economy will tend to a steady state in which the government maintains a positive net asset position and remains solvent without depleting the country's natural resource wealth. This can be described as the sustainable case. For example, in Figure 1, a country in position A is initially endowed with a large stock of resources, whereas the government has a relatively low endowment of financial assets. Over time, the economy depletes its per capita natural resource base, while at the same time the government, with its sustainable fiscal position, accumulates financial assets. In a steady state, the economy no longer relies on its natural resource wealth; instead, prudent fiscal policies allow it to consume from the income it receives from its stock of financial assets. By converting nonrenewable assets into interest-bearing financial assets, the economy can sustainably avoid the problems of exhausting its assets and debt accumulation. By contrast, in Figure 2 the system no longer exhibits stable behavior around a steady state. From any initial stock of government asset and natural resource, the economy eventually exhausts its resources. Once the resource base is exhausted (St = 0), the government's net asset position falls over time, and liabilities are incurred to cover the fiscal shortfall. This can be characterized as the unsustainable case. Take country A discussed in the previous paragraph, which (as before) begins to deplete its nonrenewable assets. In the sustainable case, the government placed greater reliance on its stock of financial assets to cover its expenditure needs in the long term, but in this unsustainable case, the government continues to rely heavily on the sale of its natural endowments. 5

See Appendix A for details.

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Figure 1. Sustainable Case with Declining Terms of Trade Qt

ASt=0

t = 0

Eventually, the high expenditure demands lead to a depletion of the natural resource base while low government savings result in an inadequate stock of financial assets to finance public expenditures. Once the resource endowment is exhausted, the high fiscal deficit must be financed by consuming the government's stock of financial assets and eventually by increasing its level of indebtedness to unsustainable levels. What distinguishes the two possibilities is that the intercept for the A St = 0 locus lies below that for the Q t = 0 locus in Figure 1, whereas the opposite is true for Figure 2. Algebraically, as explained in Appendix A , for the fiscal policy to be considered sustainable this implies that 6*

(l-\)rt-n 1 +A t ,

a,+

(ID

If the core deficit is sufficiently small as in Figure 1 (i.e., smaller than the return on assets adjusted for the size of government transfers to the private sector, the rate of population growth, and the savings behavior of the private sector), then fiscal policy can be maintained indefinitely. Note that if this condition holds, even if the resource is depleted, then the net asset position of the government will be increasing over time

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Figure 2. Unsustainable Case with Declining Terms of Trade

because the return on government assets will outweigh the size of the core deficit. Conversely, if the country is running a relatively large core deficit, as in Figure 2, the condition in equation (11) is violated, and a steadystate path no longer exists. The loose fiscal stance leads to a depletion of the natural resource with insufficient offsetting investment in financial assets. Once the natural resource is depleted in this unsustainable case, the net asset position of the government falls over time, and eventually the economy will encounter large public-sector liabilities and a rising debt burden. Inevitably, the fiscal position becomes untenable and policies must be changed to restore the economy to a sustainable fiscal program. The simple model described yields two distinct cases (summarized by Figures 1 and 2) and leads to a precise criterion that discriminates between sustainable policies—which lead to a steady-state accumulation of government assets and unsustainable policies—that eventually erode public asset holdings and lead to spiraling public indebtedness. That criterion states that a government can run deficits no larger than the return on its asset holdings after adjusting for transfers to the private consumer and for the growth in the population. Some comparative statics of the condition for sustainability (equation 11) are perhaps useful. As outlined above, one aspect of the model

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is that a worsening of the core deficit is synonymous with less sustainable policies. A n increase in this deficit might be a reflection of either an increase in spending by the government or a fall in non-oil, noninvestment income revenue. A second feature of the model is that a lower return on externally held assets reduces the size of the sustainable core deficit that a government can run.6 In a similar way, an increase in the population growth rate also reduces the permissible size of the deficit. Finally, an increase in the proportion of net transfers from the government to the private sector lessens the likelihood that a given fiscal program will satisfy the criterion for sustainability. As Xt rises, the budget becomes structurally weaker, with the state transferring to the private sector a larger portion of its claims on resources. By doing so, the state gets poorer and the private sector becomes richer. The government has less room for discretionary fiscal spending and is forced to run smaller core deficits or face accumulating liabilities. Case II: Improving Terms of Trade

The second case to consider is one in which the economy's terms of trade are improving at a rate faster than population growth. In the model, this is captured by growth in the value of the natural resource relative to that of the consumption good (i.e., that 8 > 1 + n). In this case, the slope of the St = 0 locus becomes negative. As before, there are two possibilities to consider. Figure 3 describes the case where &£

(l-X.)r,-n

flt+1

1+n

(12)

In this case, from any initial condition on the stock of resource and the size of government assets or liabilities, the economy becomes caught in a virtuous cycle, whereby the value of the natural resource grows over time at a rate faster than the growth in population. The appreciation in the value of the resource, and the small demand for government deficit financing, causes the per capita economic wealth of the society to increase over time. Such fiscal policies are clearly sustainable. The implication is that even countries with relatively small natural resource en6

In the case of the country being a net debtor (i.e., at < 0), however, a lower rate of return implies a lower interest burden on the economy and thus represents less of a constraint on policy.

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Figure 3. Sustainable Case with Improving Terms of Trade

dowments—but resources whose value is appreciating—can experience rising income levels by engaging in appropriately conservative fiscal policies. Take country A again. Initially, a high rate of depletion of the resource leads to a fall in the per capita value of the stock of natural resources. However, as the government accumulates assets and uses the return on those assets to finance its expenditure needs, the rate of depletion will fall and the value of the remaining resource wealth will grow over time. Conversely, if the government pursues a considerably looser policy stance such that equation (11) is violated, then the economy faces a quite different situation. In Figure 4, it can be seen that from some initial conditions the path of natural resource wealth takes off in much the same way as that of Figure 3. However, in other cases, given by the shaded region in Figure 4, the economy pursues a path of resource depletion, which, if continued, will eventually lead to the exhaustion of the natural resource and an accelerating rise in government liabilities in much the same way as the unsustainable case pictured in Figure 2. The larger the gap between actual deficits and the limit described by equation (11), the larger will be the shaded region in Figure 4, and the greater will be the proportion of initial conditions that are considered unsustainable. To be more concrete, take two cases pictured in Figure 4. A country may be endowed with a relatively large stock of natural resources at po-

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Figure 4. Unsustainable Case with Improving Terms of Trade

sition A. Despite a low level of government assets and a loose fiscal policy, the government is able to rely on the appreciation in the value of its resource to offset the costs of an overly large fiscal deficit. The economy is able to rely on its good fortune of being endowed with a large resource base (that is becoming more valuable over time) to cover its imprudent fiscal position. In this sense one can see how, in a country with a large stock of natural wealth, periods where the terms of trade are improving can lead to a temptation to delay or forgo fiscal retrenchment. The appreciation of the resource wealth in effect acts as a cushion and substitutes for the reforms necessary to achieve a sustainable fiscal position. A country endowed with fewer natural resources at position B, despite a higher level of government assets, is less fortunate. In such a case, the high fiscal deficit cannot be compensated for by the appreciation of a smaller resource stock. As a result, the government is forced to deplete its foreign asset reserves in order to finance its fiscal shortfall. Despite the increasing value of the resource endowment, the underlying stock of wealth is depleted and government liabilities are accumulated—forcing an eventual change in fiscal stance. It is clear, however, that any country that relies so precariously on uncertain terms of trade to escape the consequences of its loose fiscal policies can get into serious difficulty if relative prices turn against them. Gelb and others

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(1988) have suggested the costs of governments' plans predicated on overoptimistic projections of oil prices may have been the downfall of many oil-producing developing countries. It should be noted, for the cases both of declining and improving terms of trade, that the criterion for a fiscal program to be considered sustainable is the same (i.e., the condition of equation 11). Figure 4 demonstrates, however, that the criterion does not represent a necessary condition for sustainability in the case where the country has a sufficiently large stock of natural resource and improving terms of trade. Although the sustainability condition is the same in both cases, there are considerable differences in the consequences of either satisfying or violating this constraint. In the case of deteriorating terms of trade, sustainable policies lead the economy to settle at a balanced growth path of income, asset accumulation, and per capita resources. Unsustainability, however, results in resource depletion and fiscal insolvency. With improving terms of trade, sustainability is evidenced by an increasing stock of national wealth and income, whereas the outcome of violating the sustainability condition depends crucially on the size of the country's resource endowment. It should be recalled that the analysis has looked at the set of policies that are sustainable given that the stock of foreign assets (at) remains stable over time. It is likely to be the case, in particular with rising terms of trade, that in fact the economy will face a rising asset position and a fixed or even declining value of its resource stock (St) as the resource is exploited and converted into larger stocks of financial assets. The model could be modified to capture this feature by assuming an increasing path for at and looking at the consequences for sustainability. Of the two cases examined, neither fully captures reality. It is unlikely that a country will experience perpetually deteriorating or improving terms of trade. Instead, countries may experience long periods where case I is the more appropriate description of the economy and other times when case II applies. For example, as Figure 5 demonstrates, for many of the oil producers there was an overall improvement in the terms of trade from 1970 to 1981 (case I), after which the terms of trade either declined or remained stable (case II) until recently (with the exception perhaps of the period of regional conflict). However, as a conservative guide, whether in a period of rising or falling natural resource prices, adherence to the condition of a low core deficit represents both a prudent and sustainable policy prescription. A low level of transfers in the budget, a small core deficit, and a commitment by the government to replace natural resource wealth with externally invested financial assets will all contribute to sustainable development and a long-run improvement in domestic economic welfare.

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Figure 5. Terms of Trade, Kuwait and Venezuela (Index: 1990 = 100)

Source: IMF, World Economic Outlook, 1996.

An Application of the Model to Oil Producers The model described above has clear implications for fiscal policy. It highlights a specific criterion for determining whether current policies can be continued indefinitely or whether they will lead to an exhaustion of the country's resource wealth and a rising accumulation of government liabilities. In addition, the model draws attention to three features that one should consider when assessing which policies are consistent with long-run equilibrium and which must be eventually reversed. First, as noted in previous studies, the relationship between the interest rate and the population growth rate is an important determinant of sustainability. A higher rate of population growth, by diluting the stock of assets and resources among more claimants, lowers the ability of the government to run deficits. Similarly, a lower return on externally held assets, by reducing both national and government income, constrains budgetary policies.7 On a related point, in many growth models, higher economic growth can increase the likelihood that a given fiscal policy will be considered sustainable. However, in a model of a resource-based economy, higher growth could imply faster resource depletion and may actually be an indication of unsustainable policies. 7 In the case of a country being a net debtor, the effects are reversed, with higher population growth reducing the per capita level of indebtedness and lower returns reducing government interest expenditure and helping the budgetary position.

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Second, the structural nature of the budget deficit has important implications for sustainability. A deficit predicated on generous net transfers to individuals—rather than resulting from a temporary shortfall in oil and investment income revenue—is less likely to be sustainable. Similarly, a fiscal authority that generates little non-oil revenue, and thus has a high core deficit, is more likely to exhaust its natural resource wealth and increase its net liability position. The third feature of the model is that the derived indicator of sustainability is influenced less by temporary moves in resource prices than other indicators. Expressing the model in per capita terms—rather than as a fraction of GDP—means that increases in spot prices do not immediately translate into a more sustainable position, as would happen if one looked at the deficit-GDP ratio. Changes in oil prices obviously have an effect in the model. Higher revenue automatically reduces the ratio of transfers to revenue (Xt). In addition, insofar as the revenue from these higher prices is saved, the stock of assets and level of investment income rise, which both increases at and further decreases Xt. This effect—of a lower transfer ratio and a higher stock of assets—results in a more sustainable fiscal position. This section applies the measurable indicators suggested by the model to the cases of Kuwait and Venezuela and reviews the historical experience in these countries. Tables 1 and 2 compare the parameters of the model and the experiences of both these countries. Kuwait

During the past 20 years, 96 percent of total government revenue in Kuwait has been derived from oil or investment income. The government is seen as an employer of both first and last resort, and it offers generous social welfare support. Kuwait also has had in place a policy of setting aside 10 percent of oil revenues for the Reserve Fund for Future

Table 1 . Summary Parameters for Kuwait and Venezuela (In percent)

Period 1977-81 1982-89 1990-91 1992-96

X

s

14 31 36 8

7 23 5 49

Kuwait n 6 5 5 5

Deficit1

X

38.2 13.9 -62.4 -27.5

47 57 48 80

Venezuela s n 20 15 16 12

3 2 2 2

Deficit1 -1.7 -1.1 0.6 -3.5

Source: IMF staff estimates. 1 Conventionally measured deficit as a percentage of GDP.

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Table 2. Summary of the Fiscal Positions of Kuwait and Venezuela Period 1973-78

Kuwait1 • Improving terms of trade • High capital spending and little non-oil revenue results in a large core deficit • Despite the large core deficit, fiscal position is sustainable due to appreciating value of Kuwait's large oil endowment (point A in Figure 4)

Venezuela2 • Improving terms of trade • Increase in transfers following 1973 oil boom as well as large expenditure on infrastructure and industrial projects result in a large core deficit • Unsustainable (although position improves toward the end of period as assets are accumulated by Venezuela Investment Fund)

1979-81

• Oil shock of 1979 is followed by shift from capital spending to higher current spending (transfers, wages, and subsidies) • Worsening structural nature of budget makes fiscal position more unsustainable

1982-89 • Worsening terms of trade • Core deficit remains high (although gradually reduced as capital spending is reduced) • Unsustainable (point A in Figure 2)

• Worsening terms of trade • Following financial crisis in 1983, control over nontransfer spending moves fiscal position nearer to sustainability • Decline in oil prices in 1986 worsens underlying fiscal situation • Unsustainable

1990-91 • Enormous reconstruction spending erodes foreign asset holdings while transfer payments rise • Clearly unsustainable 1992-96 • Persistent high transfers, large core deficit, erosion of foreign asset holdings, and fall in investment income • Unsustainable (point A in Figure 2)

• Transfer ratio rises until 1994, after which social transfers are cut • Improvement in non-oil revenue with introduction of value-added tax, accompanied by decline in noninterest spending • Improving but still unsustainable

Sources: national authorities and IMF staff estimates. 1 Data for Kuwait were available only from 1977. 2 Data for Venezuela exclude oil company activities and public assistance to the banking sector.

Generations in an attempt to convert oil resource wealth into holdings of external assets (which, it is hoped, will provide income when the oil resources are exhausted). Kuwait has vast per capita reserves of oil, amounting to 96 billion barrels or 135 years at current production rates, although its population is growing at a rapid rate—about 5 percent a

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year—which will dilute the amount of per capita resources available in the future.8 Level of Transfers

Figure 6 shows the ratio of transfers to oil and investment income revenue (Xt in the model) in Kuwait's budget. With the large oil income of the 1970s and early 1980s, this level was relatively low (below 20 percent). The decline in oil prices during the 1980s led to ratcheting up of the ratio to about a third in the period just before the Iraqi invasion. During the period 1990-91, the collapse in oil production and large transfer payments to individuals led to a significant, albeit temporary, increase in the ratio. After Kuwait's liberation, however, the level of transfers in the budget, relative to oil and investment income, has not fallen to pre-invasion levels but instead has remained high, estimated at 60 percent in 1995. As the model demonstrates, this structural weakening of the budget has negative connotations for overall fiscal sustainability. Fiscal Position Figure 7 shows the net difference between the core deficit and the level of the sustainable core deficit, as suggested by the model, for the case of Kuwait.9 A negative position in the figure indicates that the actual core deficit is greater than that which could be considered sustainable. Despite a fiscal surplus from 1977 to the time of the Iraqi invasion, the calculation based on the core deficit indicates that the authorities' fiscal position during this period was not sustainable. The budget was almost entirely financed by natural resource income with substantial capital expenditure. In other words, despite provisioning for the future by accumulating foreign assets, Kuwait did so by depleting its natural resource wealth at such a rate that, in the long run, it would eventually have had to change its policy. From 1977 to 1981 it could be argued, however, that, because Kuwait's terms of trade were improving, as shown in Figure 5, Kuwait could be regarded as being in the sustainable position of country A in Figure 4. During that period, Kuwait's large core deficit—due to almost zero non-oil revenue and a high level of capital expenditure—was completely compensated for by the rising market value of its large endowment of oil.

8 For a summary of the current economic situation in Kuwait, see Chalk and others (1997). 9 The basis for the calculations is explained in Appendix B.

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Figure 6. Transfers as a Proportion of Oil and Investment Income, Kuwait and Venezuela (In percent)

Source: IMF, Government Finance Statistics, 1995.

During the 1980s, however, Kuwait's terms of trade began a downward trend, with the overall deficit continuing to be predicated on high capital spending and insignificant non-oil revenue. The deficit remained larger than that which could be considered sustainable, although toward the end of the decade, the gap between actual and sustainable policies did close (largely due to a containment of capital spending). However, this retrenchment effort was still insufficient to put government finances onto a sustainable track. The dual effects of a fall in the relative value of oil and the high rate of physical depletion of Kuwait's resource base resulted in a situation similar to the unsustainable situation of country A in Figure 2. These results contrast with the conclusion one might obtain from an examination of the overall deficit as a fraction of GDP (during the period 1982-89, Kuwait registered an average surplus of 14 percent of GDP) because the criterion examined here does not focus solely on the government financial situation but also considers the rate of depletion of the country's resource base. In other words, in the face of worsening terms of trade, asset accumulation in Kuwait from 1982 to 1989 did not keep pace with the rate of resource depletion. However, given its vast resource base, Kuwait would likely be able to continue pursuing such policies for quite some time, even taking into account the production constraints imposed by OPEC quotas. This highlights one of the difficulties in this analysis in distinguishing between a policy that is sustainable in the long run and one that must eventually be reversed, al-

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Figure 7. Kuwait's Fiscal Position (Thousands of dollars per capita)

Sources: IMF, Government Finance Statistics, 1995; IMF staff estimates. Note: Negative position indicates a deficit in the overall balance or an unsustainable core deficit.

beit after a considerable period of time. One could imagine Kuwait continuing these policies—identified as unsustainable—for a century before having to reverse them. Should such policies therefore be regarded as truly unsustainable? In 1990-91, the situation in Kuwait took a dramatic turn for the worse, with the fiscal position moving to a large deficit as a result of the halt in oil production during the invasion, as well as the rise in transfers in its aftermath. After liberation, there was a sizable reduction in the country's foreign asset position, with resources expended in reconstruction efforts. In addition, higher transfer payments to the private sector (both wage rises and welfare spending) worsened the structure of the budget. Indeed, the proportion of oil and investment income revenues spent on net transfers rose from 35 percent in 1989 to 75 percent in 1994 (and the conventional ratio of deficit to GDP rose to an average of 12.5 percent of GDP from 1993 to 1995). The combination of these two effects—a reduction in at and a rise in Xt—resulted in a fall in the size of the sustainable core deficit, which, combined with a rise in the actual core deficit, led to a widening gap between actual policies and those that could be considered sustainable (as shown in Figure 7). In summary, despite large overall surpluses, the analysis presented here suggests that Kuwaiti government policies, in the face of worsening terms of trade, were causing unsustainable resource depletion during the 1980s, which was not offset by a sufficiently rapid accumulation of foreign assets. Following the liberation, a rising level of transfers and

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a growing core deficit have moved Kuwait even further from sustainable policies. The ratchet effect in government spending, especially on entitlements, as indicated by the ratio of transfers to income, will be an important challenge for the fiscal authorities to reverse in moving Kuwait's fiscal position toward sustainability. Venezuela Venezuela, unlike Kuwait, has a more diversified economy, with the oil sector accounting for 20 percent of GDP and 50 percent of government revenue in 1994. Revenue from oil and from net investment income accounted for 6 percent of GDP in 1994 (with the latter being negative due to the net debtor position of the government). Although it is estimated that Venezuela's reserves will last for 59 years at current production levels, actual depletion may be much faster because Venezuela is planning investments to double current production capacity by 2005. In recent years, Venezuela has undergone a vigorous expansion of its oil production to 3 million barrels per day, well in excess of its OPEC quota of 2.3 million barrels per day. The government also has considerable outstanding liabilities, which lead to high publicsector interest obligations.10 Level of Transfers

Figure 6 indicates that transfer payments relative to oil and asset income in Venezuela, for much of the past two decades, have been considerably higher than those in Kuwait. This reflects both the net debtor position of the public sector and the structural rigidities in public expenditures in Venezuela. Following the first oil boom in 1973, which was estimated to represent a windfall of 20 percent of GDP, transfers rose from 22 percent of oil and investment income revenue to 48 percent in 1979. At the same time, there was a significant increase in public investment in both infrastructure and industrial projects. As in Kuwait, the higher revenue associated with the 1979 oil price rise resulted in further increases in transfers, although total spending was relatively stable during this period due to a decline in capital spending. The oil prices fall of the mid-1980s had a large effect on the budgetary situation. The authorities were unable to reduce expenditures in line with lower oil prices and rising net interest payments, which in

10

For a discussion of the situation in Venezuela before 1983, see Gelb and others (1988); for the later years, see IMF (1996c).

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turn caused the ratio of transfers to oil and investment income to rise to 92 percent in 1987. Remedial policy action, however, did succeed in reducing transfers by the latter part of the 1980s. After declining during the 1990-91 price boom, the transfer ratio rose again from 1991 to 1993 before leveling off at about 75 percent in 1994. These structural rigidities in the budget remained a significant fiscal problem throughout the 1990s. Fiscal Position Figure 8 shows the difference between the fiscal policies pursued in Venezuela and those that could be considered sustainable according to the model presented in this chapter. After the first oil shock, the core deficit rose dramatically as the government began a series of public investment projects funded by the oil windfall. In addition, the level of transfers in the budget rose. Despite the fiscal surplus—due to the influx of higher oil revenue—there was a worsening in the underlying fiscal position, suggesting that government policies were on an unsustainable path. Despite growing expenditures on both transfers and interest payments during the 1970s, the gap between actual and sustainable policies fell as foreign assets were accumulated through the Venezuelan Investment Fund. A rise in the core deficit, following the second oil shock, again pushed the fiscal position further from sustainability. Capital expenditures were cut during this period in favor of higher transfers, wages, and subsidies on domestic fuel products that contributed to a structural weakening of the budget. Despite an appreciation in the value of its natural resources from 1970 to 1981, Venezuela, unlike Kuwait, was insufficiently endowed for rising oil prices to offset the impact of its high core deficit. The rapid depletion of Venezuela's resources and the worsening net asset position of its government perhaps suggest a position more similar to country B in Figure 4. Following the financial crisis in 1983, control of nontransfer spending appeared to be successful in moving the fiscal situation toward longrun viability. However, in the face of a higher net external liability position, the budget surpluses of 1984-85 were not large enough for the fiscal position to be considered sustainable. The decline of oil prices in 1986 further damaged the fiscal position as transfer payments rose relative to oil and asset income and there was an increase in the external indebtedness of the government. In 1987 a decline in the core deficit was achieved by reducing the level of spending on investment and goods and services (which fell by a combined 3.2 percent of GDP in this one year), but these gains were quickly reversed the following year as expenditure growth resumed.

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Figure 8. Venezuela's Fiscal Position (Hundreds of dollars per capita)

Sources: IMF, Government Finance Statistics, 1995; IMF staff estimates. Note: Negative position indicates a deficit in the overall balance or an unsustainable core deficit.

The move into an overall surplus in 1990, following the rise in oil prices associated with the Iraqi invasion, had little effect on the sustainability indicator, with a reduction in the relative size of transfers offset by a decline in the contribution of the oil sector to the budget in the form of tax and royalty payments. From 1991 to 1994, a strengthening of the budget, through improvements in non-oil revenue performance and a decline in noninterest expenditure, resulted in a slight improvement in the sustainability position. This was enhanced by the introduction of a value-added tax in 1993, which offset a decline in customs revenues and excises and the narrowing of the income tax base. Similarly, a fall in social transfers in 1994 contributed to a narrowing of the gap between prevailing and sustainable policies. Caution is warranted here, however. The description above is based on available data on the central government. It does not include the operations of nonfinancial public enterprises or the Exchange Differential Compensation and Deposit Guarantee Fund. As IMF (1996c) points out, this will change the picture considerably in the latter years, because the oil company had significant operating deficits in the 1990s and a large liability was incurred in 1994 as a result of public assistance to the banking sector. Both factors would move Venezuela's position further from sustainability than pictured in Figure 8, particularly in 1994. Unfortunately, a consistent time series for the whole sample that encompasses these two extrabudgetary activities is not available. The data shown here, if anything, perhaps provide an optimistic view of Venezuela's state finances.

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In summary, the two oil shocks in the 1970s moved Venezuela further from a sustainable fiscal positions, despite temporarily large surpluses. It took several years to contain the fiscal spending undertaken as a result of the 1973 and 1979 oil price rises. The model shows that Venezuela's position as a net debtor has restricted its policy latitude— both by reducing its oil and investment income (which in turn raises Xt) and by a negative at, which reduces the size of the sustainable deficit. The underlying government position improved in the 1990s despite a worsening in the overall structure of transfers, due to higher non-oil revenue and some restraint in other expenditures. However, broader coverage of the fiscal balance that includes the oil company's operations and accounts for the bank bailouts, would lead to a worsening picture of Venezuela's underlying position in this period, particularly in 1994.

Summary and Conclusions This chapter has attempted to examine what constitutes appropriate and viable fiscal policy in countries that derive much of their national income from a nonrenewable natural resource. The motivation of the chapter is a belief that conventional measures of the fiscal position, such as the budget deficit-GDP ratio, give an incomplete summary of fiscal performance. In particular, volatility in world commodity prices may have a dramatic impact on the deficit-GDP ratio despite no change in the underlying fiscal stance. The empirical indicators described here should be viewed as a complement to conventional fiscal measures in capturing the overall fiscal position and determining its long-run consequences. This section summarizes the results, discusses some limitations, draws some broad policy lessons, and offers directions for future research. Summary The model proposed here takes explicit consideration of the dynamic effects of fiscal policy and its implications for the stock of government assets and liabilities, including the net stock of resources. The aim is to describe, as a benchmark for comparison, the set of policies that can be continued indefinitely and those that must eventually be reversed. The key aspects of fiscal sustainability highlighted by the chapter include: • The model highlights the core deficit—defined as the overall deficit less net transfers and oil and investment income—as an ap-

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FISCAL SUSTAINABILITY

•

•

• • • • • •

•

propriate indicator of fiscal stance. A higher core deficit—from higher discretionary spending or lower non-oil revenue—leads a country further away from long-run sustainability. The sustainable level of the core deficit is determined by the return on externally held assets adjusted for the size of government transfers, the rate of population growth, and the level of private savings. For net creditors, such as Kuwait, lower interest rates worsen the budgetary position by lowering the level of investment income; for net debtors, such as Venezuela, lower interest rates improve the fiscal position through lower debt-service payments. A higher proportion of transfers and entitlements relative to government income from asset holdings and natural resources is detrimental to sustainability. Higher population growth rates impose greater constraints on fiscal policy by dividing the available stock of assets, including physical resources, among more claimants. Countries violating the criteria for sustainability can face a depletion of their resource base and an accumulation of government liabilities that will force an eventual shift to tighter policies. The larger the resource endowment, the more distant may be the point at which a country will be forced to tighten its policy stance. Developments in a country's terms of trade are an important consideration. In the case of improving terms of trade, the model describes how a large resource stock can act as a substitute for fundamental fiscal reform, with overspending financed by revenue from the appreciating resource endowment. However, it is also shown how disastrous such policies can be if fortunes change and the relative price of the country's resource begins to decline. In the model presented here—unlike in models where growth is generated by renewable resources such as human and physical capital—a higher level of GDP growth does not necessarily make a country's fiscal position more sustainable. In fact, the opposite may be true if the higher output growth is predicated on faster resource depletion, which will be clearly detrimental to long-run sustainability.

Strengths and Weaknesses of the Approach

Applying the model to two major oil producers highlights the strengths and weaknesses of the approach. Among the strengths:

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• The transfer-revenue indicator gives a reasonable summary description of the structural weakness of the budget, highlighting the ratchet effect of spending on transfers and entitlements (with transfers rising in periods of high oil prices but failing to fall as prices decline). • The per capita core deficit is a more robust indicator in the face of short-term fluctuations in oil prices than is the conventional deficit-GDP ratio. By focusing on a narrower measure of fiscal balance, one can see that—even with overall surpluses—a country's budget may still be predicated on overly large, nonproductive expenditures that lead to an unsustainable situation. The per capita measure can also be useful in reflecting demographic developments. • By placing relatively few restrictions on the process of resource exploitation, the conclusions can be generalized and made applicable to situations where production is constrained by OPEC quotas or where it is determined by production capacity. • By drawing attention to the behavior of the resource stock as well as that of government assets and liabilities, the model offers a broader perspective of what constitutes sustainable behavior in an explicitly dynamic context. For example, if a country were successful in doubling its oil production, its budgetary position would improve significantly, despite there being no shift in the underlying fiscal position (there would simply be a more rapid depletion of the country's oil reserves). The measure suggested here can help disentangle actual shifts in fiscal stance from the fiscal effects of the changing pace of resource depletion. The analysis is, however, subject to some limitations: • Expressing the fiscal situation in per capita monetary value, while indicating on which side of the sustainability benchmark the economy resides, does not provide insight into how far the economy is from sustainability. • The model seeks to identify a set of constant policies that can be continued indefinitely, even though—in a world of fluctuating oil prices—it may be optimal to exceed sustainable deficits in periods of low prices while running large surpluses and accumulating financial assets in booms. On average, however, the economy should satisfy the long-run sustainability condition; as such, the constant policy benchmark can still provide a useful indication of where policies should be aiming. • Assuming a constant per capita stock of foreign assets presents some problems. Although this assumption helps identify the cri-

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teria for a long-run steady state, foreign assets should be expected to rise in order to replace a diminishing resource base. To examine this possibility, it would be necessary to specify the desired path of the stock of financial assets. For each path, one could solve for the corresponding deficit ceiling above which that path of asset accumulation is not tenable (i.e., which will cause a spiraling accumulation of government liabilities). A faster pace of asset accumulation, for example, would imply a lower ceiling on the level of sustainable deficit. The criterion examined here— that is, the maximum deficit that will support a constant path of foreign asset growth without contributing to an accumulation of government debt—should be interpreted as a simple, transparent benchmark of sustainability by which one can judge more complicated policy prescriptions. • Although the model describes policies that are viable in the long run, policies identified as unsustainable may still be continued for a relatively long period of time. In the case of a country as well endowed as Kuwait, for example, unsustainable policies can be continued perhaps for decades. It is argued here that, despite the impact of loose fiscal policies being far off on the horizon, the consequences of wasting natural resources, and the need to conduct policies that provide for future generations, justify applying the precautionary criterion described above as a guide to formulating sensible and prudent policies. Policy Implications

Several policy lessons can be drawn from the analysis presented in this chapter: • The conventional summary indicator of fiscal health—the deficit-GDP ratio—may not be a reliable guide to the underlying policy stance in the case where the budget is strongly influenced by natural resource income that is subject to exogenous world price volatility. • The structure of the budget, rather than merely the bottom line, has important implications for sustainability. A high level of transfers to the private sector poses considerable risks to sustainability. The momentum of public spending, particularly entitlements, built up in periods of buoyant prices is often difficult to curb when world prices weaken. Policymakers who consider increasing the level of transfers during booms should be aware of this ratchet effect and the difficulty of subsequently reducing transfers.

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• It has been demonstrated that even a country with a small natural resource endowment can experience stable and rising income levels if it pursues appropriately conservative fiscal policies (particularly in the case of improving terms of trade). • Prolonged periods of deficits may be feasible for a country that is well endowed with a valuable resource, but such policies contain a significant danger. If the threshold level of the core deficit is exceeded, perhaps because of an adverse exogenous shock from a downturn in world prices, the country can quickly enter a spiral of accumulating government liabilities and diminishing resources. • The model demonstrates how governments that exploit their natural resources need to have a strong commitment to replace their nonrenewable resource wealth with financial assets in order to provide for future generations. Extending the Analysis The investigation above can be extended in several directions, First, by introducing a stock of physical or human capital, one can examine the effect of channeling fiscal spending into productive investment (e.g., infrastructure, education, research and development) to enhance non-resource-based growth and overall domestic economic development. The likely outcome is that looser, but growth-enhancing, fiscal policy will be sustainable while tighter, unproductive policies will not. Second, a behavioral reaction function of the government could be introduced to look at what constitutes both sustainable and optimal policies in the face of volatile world commodity prices. By assuming an intergenerational welfare function, one can derive the optimal path of asset accumulation and resource exploitation to maximize the welfare function, subject to a path of resource prices. This approach has been employed in the context of an economy with debt and physical capital in Zee (1988), whereby the government is assumed to use fiscal policy to optimize steady state utility.11 Taking the optimal paths for at and St as given, one can then establish the maximum deficit possible that does not lead to an unsustainable path of debt accumulation. Although such an approach allows one to examine intergenerational equity issues by assigning weights to the utility of current and future generations, it does involve a degree of arbitrariness in specifying the functional form of the government's objective function, which in turn can make the analysis less transparent.

11

Alternatively, one could assume a path of resource exploitation similar to that of Hotelling's (1931) model.

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Third, it might be interesting to expand the model to explicitly consider an external sector in order to examine the implications of policies for a country's current account and the size of its external (public and private) debt.

Appendix A* Derivation of the Model The savings behavior of individuals is summarized as zt(t) = 4K

(A.I)

The dynamic behavior of the resource stock is described by (l+n)st+1 = s-yt

s0 fixed, and st+j > 0

(A.2)

Writing the resource constraint in terms of the consumption good where pt is the relative price between the resource and consumption good (l+n)lL.pt+lst+l Pt+i

=psst-ptyt

(A3)

Letting St+1 = pssv we can rewrite equation ( A 3 ) as (l+n)St+1 = 8S t -5p t ? t

(A.4)

The government flow budget constraint in per capita terms is given by (l+n)(b t+1 - a ? +1) = Rt(bt- af)-Xtrt(bt-

af)+gt- (l-Xt)

ptyt (A.5)

where a? is the stock of government storage assets, bt is the outstanding stock of government debt, and Xt[rt(b-a?)+ptyt] represents net transfers to consumers. Letting Q£ = af-bv equation (A.5) becomes

(l+n)Qt+1 = Q t -fc+(l-Xt)(r,Q t + fcfc) (A.6) Noting that Tt = A,t(rtQt+f>jt), capital market equilibrium is given in per capita terms as zM)=$K (ptyt+rtQt) = (l+n)(bt+l+aP+l) Letting at = af+af, equation (A.7) can be rewritten as H(Mt+rtQt) = d + n) (a t + 1 -Q t + 1 )

(A.7) (A.8)

We can substitute out for ^t from equation (A.4), and from equations (A.8) and (A.6) we can obtain the following equations in S and Q that describe the dynamics of the economy:

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8 ^ 8 [ R , - M H > ) r , ] a 5[&+(l+n)flt+1]

St+,=

1+n

Q t+1 =

( l + n X l - J l + GA,)

St+1 or ASt < 0: Q t < (l-A t +^X t )(l+n-8) c ^g t +(l+n)a t+1 [R,-A,(l-(|))rt]8 Rt-Xt(l-Q>)rt

(A.12)

Similarly, rearranging equation (A. 10): Qt>Qt+i^Qt>

6 A. «bX.g t -(l-A.Xl+n)a t+ i (A.13) Q«(l-At+QI+1 or AQt< 0 is

Q«^

-AA.,g t +(l-A,Xl+n)a e+ , (l-^+^^Kl+n)-^)^

(A.14)

There are two cases to consider: where the intercept for the AQ t = 0 equation lies above that of the ASt = 0 equation (the sustainable case) or where it lies below (the unsustainable case). The condition for the sustainable case is given by

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-ty\gt+(l-\)(l+n)at+, (l-\+^\)(l+n)-if\

ft+l(l+n)at+1

' Rt-A,(l-(j))rt

(A.15)

Rearranging this equation yields &*

(l-X)r t -n

a

t+l

(A.16)

1+n

Appendix B, Calculation of Model Parameters This appendix explains the calculations of the parameters of the model The aim is to try and get as close a correspondence between the model and commonly available data. A l l data are derived from that produced in the IMF's Government Finance Statistics (IMF, 1996a) or International Financial Statistics (IMF, 1996b). The government is defined as the consolidated central government and includes socialsecurity schemes but excludes public enterprises as well as deposit-insurance funds. Net transfers are defined as wages plus transfers and subsidies less taxes on individuals. O i l and investment income are figures that are net of interest payments. The return on externally held assets (rt) is proxied by the return on an efficiently diversified portfolio invested in the U.S. stock and bond markets. A proxy for the stock of foreign assets (at+l) is derived by dividing net investment income by this rate of return. Variable PtJt + rtQt

T£

^

t

gt

Measurement Entrepreneurial and property income + tax on net income and profit from oil companies — interest payments Wages and salaries + subsidies and transfers to households - individual income tax - taxes on payroll - domestic taxes on goods and services - import taxes

t t / (f)Jt + rQt) Total expenditure and net lending — (wages and salaries + subsidies and transfers to households + interest payments) — total revenue (entrepreneurial and property income + tax

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o n n e t income a n d profit from oil companies + taxes o n payroll + domestic taxes o n goods and services + import taxes) rtat

N e t income from balance of payments statistics

rt

Return on an efficient portfolio for the United States (53 percent common stocks, 6 percent intermediate bonds, and 41 percent treasury bills), as described in Ibbotson and others (1995)

n

Population growth rate

p

Total private savings / (total private savings + private consumption) from World Economic Outlook (IMF, 1996d).

References Auty, Richard M., 1986, "Entry Problems and Investment Returns in RBI: A CrossCountry Comparison," Report on Research Project 672-49, Development Research Department (Washington: World Bank). Blanchard, Olivier Jean, 1990, "Suggestions for a New Set of Fiscal Indicators," OECD Working Paper No. 79 (Paris: Organization for Economic Cooperation and Development). Buiter, Willem H., 1985, "Guide to Public Sector Debt and Deficits," Economic Policy , Vol. 1 (November), pp. 13-79. Chalk, Nigel Andrew, Mohamed A. El-Erian, Susan J. Fennell, Alexei P. Kireyev, and John F. Wilson, 1997, Kuwait: From Reconstruction to Accumulation for Future Generations, IMF Occasional Paper No. 150 (Washington: International Monetary Fund). Gelb, Alan H., and Associates, 1988, Oil Windfalls: Blessing or Curse? (New York: Oxford University Press). Hamilton, James D., and Marjorie A. Flavin, 1986, "On the Limitations of Government Borrowing: A Framework for Empirical Testing," American Economic Review, Vol. 76, pp. 809-19. Horne, Jocelyn, 1991, "Indicators of Fiscal Sustainability," IMF Working Paper 91/5 (Washington: International Monetary Fund). Hotelling, Harold, 1931, "The Economics of Exhaustible Resources," Journal of Political Economy, Vol. 39, No. 2 (April), pp. 137-75. Ibbotson, Roger G., and Associates, 1995, Stocks, Bonds, Bills and Inflation: Historical Returns (Chicago: Research Foundation of the Institute of Chartered Financial Analysts).

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IMF (International Monetary Fund), 1996a, Government Finance Statistics Yearbook (Washington). , 1996b, International Financial Statistics Yearbook (Washington). , 1996c, Venezuela: Recent Economic Developments, IMF Staff Country Report No. 96/87 (Washington). , 1996d, World Economic Outlook, May 1996: A Survey by the Staff of the International Monetary Fund, World Economic and Financial Surveys (Washington). Kremers, Jeroen J.M., 1989, "U.S. Federal Indebtedness and the Conduct of Fiscal Policy," Journal of Monetary Economics, Vol. 23, pp. 219-38. Liuksila, Claire, Alejandro Garcia, and Sheila Basset, 1994, "Fiscal Sustainability in Oil-Producing Countries," IMF Working Paper WP/94/137 (Washington: International Monetary Fund). Murphy, Kathleen J., 1982, "Third World Macroprojects in the 1970s: Human Realities—Managerial Responses," Technology in Society (U.S.), Vol. 4, No. 2, pp. 131-44. Trehan, Bharat, and Carl E. Walsh, 1991, "Testing Inter-temporal Budget Constraints: Theory and Applications to U.S. Federal Budget and Current Account Deficits," Journal of Money, Credit, and Banking, Vol. 23, pp. 206-23. Wilcox, David W., 1989, "Sustainability of Government Deficits: Implications of the Present-Value Borrowing Constraint," Journal of Money, Credit and Banking, Vol. 21, pp. 291-306. Zee, Howell H., 1988, "Sustainability and Optimality of Government Debt," Staff Papers, International Monetary Fund, Vol. 35, pp. 658-85.

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PART II

External Policies

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7 External Stability Under Alternative Nominal Exchange Rate Anchors: An Application to the Gulf Cooperation Council Countries S. NURI ERBAS, ZUBAIR IQBAL, AND CHERA L. SAYERS

T

he currencies of the Gulf Cooperation Council (GCC) countries are effectively pegged to the U.S. dollar (see Appendix A). 1 At the end of 2000, the GCC countries formally agreed to peg their currencies to the U.S. dollar as a first step in moving toward a monetary union. These policies have been guided by the broad objectives of minimizing exchange risks for the private sector and ensuring stable exchange rates among the GCC member countries. This chapter examines whether the GCC countries can improve their import and export stability by pegging their currencies to the SDR (or to another currnecy basket) in-

The authors thank Nigel Chalk, Gerald P. Dwyer, Mikis Hadjimichael, Ted Jadits, Abdeali Jbili, Frank Lakwijk, Adnan Mazarei, Saleh Nsouli, V. Sundrarajan, and Peter Wickham for their helpful input and comments, and Mohamed El-Erian for instigating the debate. Ilse-Marie Fayad, Behrouz Guerami, and Peter Kunzel provided excellent research assistance. The authors are solely responsible for the views expressed and any remaining errors. An earlier version of this chapter was presented at the Eleventh Annual Congress of the European Economic Association, Istanbul, August 21-24, 1996. 1 The Cooperation Council for the Arab States of the Gulf includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. In the GCC countries, the intervention currency is the U.S. dollar, and foreign reserves for currency cover and balance of payments purposes are largely held in dollars.

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stead of the U.S. dollar, without significantly compromising other policy objectives. For convenience, we shall refer to the bloc of five countries (including the United States) whose currencies make up the SDR as the SDR zone; the sub-bloc of four countries (excluding the United States) shall be referred to as the other SDR zone. The exchange rate of the dollar with the other four major currencies that make up the SDR (French franc, German mark, Japanese yen, and U.K. pound) has been less stable than the exchange rate of the SDR with those currencies (Figure 1). The fluctuations in the value of the dollar produce a significant degree of instability in the GCC countries' cross exchange rates with the other SDR currencies. The share of the other SDR zone countries in the GCC countries' total imports and exports is large (see Appendix B); this has frequently evoked arguments in favor of changing the effective peg of the GCC currencies from the dollar to the more stable SDR. These arguments have also been motivated by the international arrangements concerning the denomination of oil export prices. The oil exports of the GCC countries are largely dollar denominated, and such exports make up, on average, about 80 percent of the GCC countries' exports. However, the shares of the other SDR zone and the rest of the world in the GCC countries' total imports are large. The share of the dollar-denominated imports in total imports is smaller than the share of dollar-denominated exports in total exports. Consequently, fluctuations in the value of the dollar may create significant disparities between export earnings and the import bill. This, in turn, may result in disparities between budgetary revenues and expenditures; this is because, on average, about 75 percent of revenues are derived from oil exports, and expenditures have a large import component in the GCC countries. Fluctuations in the value of the dollar thus may result in budgetary instability that reflects external instability. Therefore, a case could be made to change the effective peg of the GCC currencies from the dollar to the SDR or to some other basket of currencies. The main issue that this chapter addresses is whether changing the effective nominal currency peg from the dollar to the SDR or to another basket might indeed improve overall external stability in the GCC countries.2 Since the breakdown of the Bretton Woods system, the literature on exchange rate management has focused on rate stabilization through al-

2 By external stability or instability, we mean the degree of variability in the external accounts (imports, exports, current account balance).

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Figure 1 . Volatility of the U.S. Dollar and the SDR in Relation to the Other SDR Basket Currencies (Annual percentage changes)

Source: IMF, International Financial Statistics.

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ternative pegging arrangements. Simple nominal pegging of the exchange rate—to a single currency, to the SDR, or to alternative currency baskets—as well as arrangements targeting real effective exchange rates have been examined extensively.3 The focus on nominal pegging has been motivated by the practical simplicity of pegging the nominal exchange rate to an internationally established measure of value such as the dollar or SDR. Of course, as argued by many authors, pegging the exchange rate to a custom-made basket of currencies other than the SDR may be superior to pegging it to a single currency or to the SDR, with the objective of improving import and export stability. More broadly, it appears theoretically feasible to design exchange rate pegging schemes to improve the stability of some targeted macroeconomic variables. The main drawback of such schemes is their inherent complexity, which leads to heavy data requirements. This complexity increases with the types of shocks to be accommodated and the number of macroeconomic variables targeted to be stabilized; this could limit the schemes' actual usefulness. In addition, at least in developing countries, managing more complex exchange pegging arrangements is hampered by data constraints, as well as by the lack of advanced financial markets and institutions.4 In a general equilibrium context, exchange rate stability alone cannot guarantee overall external and domestic stability. However, ex-

3 E.g., Crockett and Nsouli (1977) compared the stability of the exchange rate under pegging to import-weighted currency baskets and to the SDR in a sample of developing countries. Lipschitz and Sundararajan (1980) examined the choice of optimal trade weights to minimize real exchange rate variance. Williamson (1981) examined nominal exchange rate stability under pegging to a simple currency and to the SDR for a sample of Arab countries; he concluded that, in general, pegging to the SDR could result in greater exchange rate stability. A comprehensive review of the literature through the early 1980s is provided by Williamson (1982). Branson and Katseli-Papaefstratiou (1980, 1981) examined the design of optimal currency baskets to increase the stability of nominal and real effective exchange rates under alternative policy targets. Brodsky and Sampson (1984) examined trade-weighted exchange pegging arrangements and, for a sample of developing countries, found that the SDR peg was relatively more stable than the dollar peg. For the Communaute francophone d'Afrique zone countries, however, they concluded that the French franc peg was relatively more stable than the SDR peg. A comprehensive review of the related literature through 1990 is by Aghevli, Khan, and Montiel (1991). Wickham (1987, 1993) emphasized the importance of accounting for the heterogeneity of imports and import elasticities in designing import-weighted optimal currency baskets. He further examined (1986) the implications of arithmetic (linear) versus geometric pegging arrangements for exchange rate stability. 4 E.g., in targeting the real effective exchange rate, a main drawback is the considerable lag in the availability of price data; see the discussion of the related issues in Aghevli, Khan, and Montiel (1991). Furthermore, in some circumstances, targeting the real exchange rate can undermine price stability.

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change rate stability affects broad macroeconomic stability— that is, the stability of the fundamental macroeconomic variables.5 Therefore, the objective of exchange rate stabilization needs to be put in proper perspective by incorporating the effect of exchange rate stability on aggregate demand and supply—in particular, demand for imports and exports.6 Along those lines, this chapter examines the effects of exchange rate stability on import and export stability. The focus is on shocks on the exchange rate of the dollar with the other SDR currencies under the alternatives of pegging the home currency to the dollar or to the SDR. Under these two pegs, the stability of the real exchange rate between the home country's currency and the other SDR currencies is examined. It is shown that—although by switching from the dollar to SDR peg the stability of the exchange rate between the home country's currency and the other SDR currencies is increased—the stability of the exchange rate between the home country's currency and the dollar is decreased. The combined effects of the switch from the dollar to the SDR do not necessarily translate into an improvement in overall import and export stability. Such a switch in the peg improves import and export stability, if the import and export elasticities with respect to the exchange rate between the dollar and the other SDR currencies under the SDR peg are smaller than they are under the dollar peg. The model also is used to examine the optimal basket weights that would eliminate the variation in imports and exports in response to disturbances in the exchange rate between the dollar and the other SDR currencies.

5 In this regard, it appears that a broad consensus has not emerged either as to the relative superiority of one type of pegging arrangement over the other, or as to the relative superiority of pegging as opposed to more flexible arrangements or free floating. The divergent points of view and empirical results have evidently been associated with the divergent policy objectives adopted by various authors. Additionally, as noted by Williamson (1993), the difficulty of determining an equilibrium exchange rate to serve as a target to satisfy a certain policy objective through exchange rate stabilization appears to be an important factor in the divergent results in the literature, at least at the empirical level. 6 This is the approach taken by Flanders and Helpman (1979) and Flanders and Tishler (1981), among others. In a general equilibrium context, two formal expositions of the effects of exchange rate stability on macroeconomic stability are by Turnovsky (1976) and Dornbusch (1982). Dornbusch shows that policies that aim at maintaining a constant real effective exchange rate are stabilizing with respect to demand shocks but destabilizing with respect to supply shocks. A more recent analysis of policies targeting real exchange rates and their consequences for inflation is by Calvo, Reinhart, and Vegh (1994).

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Using estimable specifications for imports and exports, we examine if the above stability condition is satisfied in the case of the merchandise imports and exports of the GCC countries. The estimates for the import and export elasticities suggest that, in most cases, import and export stability may not necessarily be improved by switching from the dollar to the SDR peg. The regression results for the elasticities of the trade balances of selected GCC countries support this result. The regression results also suggest that, in some cases, pegging to an elasticity weighted basket of SDR currencies may prove to be more stable than pegging to the dollar or the SDR. However, optimal pegging arrangements remain to be further explored for the GCC countries. In addition, factors other than stabilization of some selected variables may be important in choosing an exchange rate regime; for example, the credibility of the exchange policy stance, the effects of exchange rate volatility on market structure, stability in foreign exchange markets, and transaction costs arising from exchange rate volatility. If no substantial gain is to be achieved by switching from the dollar peg to the SDR or some other peg, such considerations may well favor continuing with the dollar peg. An evaluation of the effects of the prevailing exchange rate regimes in the GCC countries on such factors is beyond the scope of this chapter. The rest of the chapter is organized as follows. In the second section, we present a simple estimable model of import and export stability under the dollar, SDR, and optimal pegs. In the third section, the model is estimated for the GCC countries' merchandise imports and exports, and, where feasible, for trade balances; the regression results are summarized and interpreted. The fourth section concludes. Appendix A provides a brief description of the prevailing exchange arrangements in the GCC countries. A description of the database, the derivation of the exchange rate indexes used in estimation, and relevant data are presented in Appendix B.

The Model The home country has two trading partners, country 1 and country 2. Units of currency of the home country, country 1, and country 2 are denoted by R, US$, and DM, respectively. The nominal exchange rate between the home country's currency and US$ is denoted by E, so that R = E.US$. The nominal exchange rate between US$ and DM is de-

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noted by Z, so that US$ = Z-DM. The nominal exchange rate between R and D M is V, so that R = V D M and V = E-Z.7 The price levels of the home country, country 1, and country 2 are denoted by P, P1, and P2, respectively. Thus, the real exchange rates can be defined as 2 2 1 2 e= P * _ P . „ _ P = P P = e 7 m

EP ; * zF ; v

VP

EFZPI

e

*

u;

where e is the real exchange rate between R and US$> z is the real exchange rate between US$ and D M , and v is the real exchange rate between R and D M . Imports Let y and M respectively denote the real income level (GDP) and the level of total real imports of the home country. A n estimable specification for imports is In M = c0 + q In e +c2 \nv + c3\ny (2) 8 where cs are constants. Differentiation of equation (2) with respect to Z yields $ = qe + c2v + c3y; (3)

where the caps over the terms denote proportional changes. Notice that q is the elasticity of imports with respect to e, c2 is the elasticity of imports with respect to v, and c3 is the elasticity of imports with respect to y.

7

E.g., 1 Saudi riyal is equal to 0.2670 dollars (E = 0.2670), or 1 dollar is equal to 3.745 Saudi riyals (1/E = 3.7450). Similarly (at the end of 1998), 1 dollar is equal to 1.6730 German marks (Z = 1.6730). Therefore, 1 Saudi riyal is equal to 0.4136 German marks (V = E-Z = 0.4467), or 1 German mark is equal to 2.2385 Saudi riyals (1/V = 2.2385). 8

Let M 1 and M 2 be the home country's imports from country 1 and country 2, respectively, in terms of the home country's currency, such that M 1 = e-/1(e, v, y) and M 2 = v-fi{e, v, y). - + + + -+ The assumptions for the signs of the partial derivatives of M 1 and M 2 are standard. Thus, total imports can be expressed as M = M 1 + M 2 . By differentiating M with respect to Z, it is possible to argue for total imports that, in equation (2), the signs of q and c2 are ambiguous and c3 is unambiguously positive. For easier presentation, cs are also used for elasticity coefficients generically for the export and trade balance regressions.

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Taking the logarithms of e and v in equation (1) and differentiating with respect to Z, we can show that ^ = 7 r i _ 7 l _ E ; v = K2-n-E0-Z;

g=f;Z = f-;K = f - ; ^ $ ^ = |*

(4)

where the caps over E and Z denote proportional changes in E and Z, and 7C, 7C1, and n2 are the inflation rates in the home country, country 1, and country 2, respectively. First consider the case of the dollar peg, or, the case in which the home currency, R, is pegged to US$ at a given constant rate, E = E o . Because E o is constant, E = 0, and it follows from equation (4) that the proportional changes in e and v under the dollar peg are e = nl-n; v = K2-n-Z (5) Substituting equation (5) into (3) and rearranging terms, we can show that the proportional change in total imports in response to a disturbance in Z under the dollar peg is M u s * = [ cx(nl -%) + c2 (TI2 - n) + c3 y] (6) us$ where M denotes the proportional change in M under the dollar pegNotice that c2 is the elasticity of imports with respect to Z under the dollar peg. Next consider the case where the home country's currency is pegged to the SDR (or, more generally, to another linear basket of currencies) at a constant rate o so that R = o(SDR). The assumption concerning a is that, once it is fixed, it remains unchanged when Z is disturbed, at least in the period when such a disturbance occurs. To be consistent with the IMF definition of the SDR, we define the variable SDR as a weighted average of the two currencies, US$ and D M , that make up SDR as below: SDR = ocl/S$ + (1- a) DM; 0 < a < 1 (7) where a is a predetermined constant. Thus, D M stands for the composite of the other four major currencies (excluding the dollar) that make up the SDR.9 Therefore, recalling that US$ = Z*DM and using equation (7), the exchange rate between SDR and US$ and between SDR and D M can be calculated as, respectively, 9

The average for the SDR value of a during the estimation period (1976-99) is approximately 0.40, which is calculated on the basis of the weights fixed at the inception of a period for which such weights are determined; effective average value for oc is 0.50 (see Appendix B).

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SDR = oZ + d - g ) . SDR = a Z + (l _ a ) US$ Z 'DM

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(8)

Because R = oc(SDR) = E*17S$ = V-DM, using equation (8), we can express the nominal exchange rate between the home currency and US$ and the nominal exchange rate between the home currency and D M as, respectively, ] ; V = o [ a Z + (l-cc)]

(9)

By substituting for E and V from equation (9) into (1), the corresponding real exchange rates can be derived as a LaZ + ( l - a ) A P / '

a L a Z + ( l - a ) J V p ) (10)

At the initial point in time when the home country's currency peg is switched from the dollar to the SDR, let the initial values of Z and the price levels be Z o , Po> PJ, and PQ, respectively. For small disturbances in Z, it is convenient to index Z o at unity, that is, Z o = I.10 It is possible to choose the value of G, or the rate at which the home country's currency is pegged to SDR, such that C = G0 =

E0Z0

aZo + (l-a)

-EO;ZO-1

(u)

Substitution of equation (11) into (10) shows that, if G = Go =E O , then e = e0, and v = v0 - eozo> where eo» vo> a n d Zo are the initial levels of e, v, and z- n By substituting Go = Eo (a constant) in E as expressed in equation (9) and through logarithmic differentiation of the resulting term for E, we can show that, with Z o = 1, £ =_(l_a)2 (12)

10

Choosing Z o = 1 is only an approximation for the convenience of simplifying the notation for the comparison of the variation in E resulting from disturbances in Z under the SDR and US$ pegs. 11 With e = e0 and v = VQ, the real exchange rates are not altered as a result of the switch from the US$ peg to the SDR peg; hence, the initial level of imports is not affected by the switch from the US$ peg to the SDR peg.

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Substitution of equation (12) into (4) shows that the proportional changes in e and v under the SDR peg are i = nl-n + (l-a)Z;v

= n2-n-al

(13)

By substituting equation (13) into (3) and rearranging terms, the proportional change in total imports in response to disturbances in Z under the SDR peg is M S D R = [ Cl(nl-n) + c2 (n2-n) + c3 $] - [ oc 2 - (1 - a)cj t

(14)

SDR

where M denotes the proportional change in M under the SDR peg. The term [ac2 - (1 — oOcJ is the elasticity of imports with respect to Z under the SDR peg. Comparison of the (absolute values of) the import elasticities in equations (6) and (14) shows that imports are more stable under the SDR peg than under the US$ peg, if | o c 2 - ( l - a ) C l | < |c 2 l

(15)

In summary, if the import elasticity with respect to Z under the SDR peg is less than the import elasticity under the US$ peg, then import stability is improved by switching from the US$ peg to the SDR peg. In addition, when the stability condition in expression (15) holds, then the stability of imports is improved by switching to the SDR peg without affecting the initial level of imports.12 The intuition behind the result in expression (15) can be explained as follows. As indicated by equation (5), under the US$ peg, disturbances in the nominal exchange rate between US$ and D M , or Z, affect only the exchange rate between the home country's currency and the currency of country 2, or v. But under the SDR peg, as indicated by equation (13), disturbances in Z affect both v and e; that is, the exchange rate between the home country's currency and the currency of country 1 is also affected. Notice that equations (5) and (13) indicate that v is more stable but e is less stable under the SDR peg than under the US$ peg. If the stability condition in expression (15) does not hold, then the instability introduced through e dominates the stability introduced through v under the SDR peg and, overall, imports become less stable under the SDR peg than under the US$ peg. If the choice of a currency basket, defined as in equation (7), is interpreted to be an independent currency basket under the control of the policymaker, the policymaker can choose the value of a (the basket

12 However, notice that the parameters of the elasticity terms are either behavioral (q, c2) or exogenous (a). Therefore, the values of the elasticities are not under the control of the home country, and the stability condition in expression (15) may hold only by a fluke.

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weights of US$ and DM), such that the variation in imports with respect to disturbances in Z is zero; let this value of a be denoted by a*. The left-hand side of the inequality in expression (15) is zero; that is, the variation in imports with respect to disturbances in Z is zero, if «*=^;0^1

(16)

Notice that the restriction on the feasible range of values for a* now applies as a weak inequality, because the policymaker has the leeway to choose a* = 1 (US$ peg) or a* = 0 (DM peg). Given the estimates for q and c2 in a country, it is possible that 0C*< 0 or a* > 1; that is, a* may not be in the feasible range of values. In such a case, one of the extreme values of a*, a* = 1 or a* = 0, can be chosen. By comparing the SDR peg (0 < a < 1), the US$ peg (a = 1), and the D M peg (a = 0), and the possible optimal peg (a = a*), it is possible to see which of the possible pegs in our model results in the smallest variation in imports due to disturbances in Z. The following observations are illuminating for the interpretation of the empirical results. Notice from expression (15) that, if elasticity with respect to D M , or c2, is zero (or statistically insignificant)—that is, if imports are not sensitive to variations in the home currency's exchange rate with respect to DM—the focus of import stabilization is the elasticity with respect to US$, or Cj. In this case, a should be chosen such that imports are rendered insensitive to variations in the home currency's exchange rate with respect to US$. That is, with c2 = 0, expression (15) implies that the optimal value of a is a* = 1, or the US$ peg is optimal. The opposite is true if imports are not sensitive to changes in the home currency's exchange rate with respect to US$; that is, if C\ = 0, then a* = 1, or, the D M peg is optimal. The optimal value of a is the elasticity-weighted value of a that would eliminate the variation in imports with respect to disturbances in Z only. Because prices (P, P 1 , P2) are variable (i.e., prices are correlated with disturbances in Z), the variation in imports is non-zero even when a = a*. The above argument is based on minimizing variations in the nominal effective exchange rate (NEER) of the home currency, R, and a basket of two currencies (US$ and DM). The stability of the corresponding real effective exchange rate (REER) would depend on the correlation between relative prices and the bilateral exchange rates. Therefore, the weights that would minimize the variance of REER could be different from the weights used in calculating the REER. 13 13

See Lipschitz and Sundararajan (1980).

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Exports and Trade Balance

Continuing to use the c coefficients generically, an estimable export function can be defined as ln X = c0 + c1 ln e + c2 ln v + c3 ln yF

(17)

where yF is foreign GDP; yF is chosen to be either the total SDR zone GDP or the total world GDP, including the total GCC countries' GDP.14 The regression equation in expression (17) can also be applied to the trade balances. Therefore, the same analysis in expression (15) also applies to exports and trade balances in evaluating relative stability under the US$ peg versus the SDR peg. To the extent that the GCC countries' non-oil exports are not dollar denominated, the US$ peg might be destabilizing for non-oil exports. To check whether this argument is valid, the regression equation (17) was also applied to non-oil exports, where data were available. Extension to Current Account, Domestic GDP, and Price Level It can be easily shown that stability conditions similar to those above can be generalized to current account stability, and to domestic income and price (inflation) stability. Therefore, as a first-order approximation, examining the stability of imports and exports is sufficient to draw similar conclusions about the effects on broad macroeconomic stability of a switch from the US$ peg to the SDR peg. Thus, as in the case of imports, exports, and trade balances, it is not possible to argue a priori that switching from the US$ peg to the SDR peg improves macroeconomic stability.15

An Application to the GCC Countries Regression Specifications

We now apply the model to the GCC countries. The database is drawn from the IMF's International Financial Statistics (IFS), World Economic Outlook (WEO), and Direction of Trade Statistics (DOT). The

14 The 1976-99 average for the total GCC share in world GDP is 1.1 percent. Including GCC countries' GDP in world GDP for regression purposes captures the effect of intra-GCC trade. 15 The empirical part of this chapter is confined to merchandise exports, imports, and the trade balance.

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DOT data are available only for merchandise imports and exports. The general estimation period is 1976—99; a shorter period is used for Kuwait, as dictated by the break in the time-series data during 1990—91 (see Appendix B). Ordinary least squares estimation is applied to annual data. Because our focus is aggregate import and export stability, for each GCC country, we define two trade zones: the SDR zone, made up of France, Germany, Japan, the United Kingdom, and the United States; and the world, including the SDR zone.16 Unit root tests were carried out for all dependent variables. In all cases, we were unable to reject the null hypothesis of a unit root.17 Therefore, we believe that the elasticity estimates obtained by running first-difference log-linear regressions are more reliable. Those regressions are specified as ln (dependent variable)t —ln(dependent variable)t-1 = c0 + c1(ln et - ln et-1) + c2(ln vt - ln vt-1) + c3(ln yt - ln yt-1)

(18)

Consequently, the estimates for the coefficients continue to correspond to the relevant elasticity estimates. In some GCC countries, the trade balances are positive throughout the indicated estimation periods. This enables a log-linear specification of trade balances similar to the specifications for imports and exports, and regression equation (18) may be applied to trade balances. Trade balance is regressed both on the home GDP and on the world GDP, including the GCC countries' total GDP. The first regression is suitable for capturing the variations in imports that depend on home GDP, as well as the variations in exports, which the home GDP closely tracks in the GCC countries. Conversely, regressing the trade balance on the world GDP including the home GDP has explanatory value in tracking the variations in non-oil exports and intra-GCC trade. Thus, the two regressions provide a good cross-check on each other.

16 A significant portion of trade with the rest of the world might be denominated in dollars and, to a lesser extent, in other SDR currencies. Although this conjecture is most conspicuously relevant for oil trade, it also appears to be quite relevant for the GCC economies' imports. Thus there is merit in estimating the regressions for trade including the rest of the world; i.e., for trade with the world (the SDR zone plus the rest of the world). 17 The augmented Dickey-Fuller test was used. We did not incorporate lags into our regressions because the time period for which data are available is a calendar year, which permits an adequate length of time for sticky prices to adjust. The results from the loglevel regressions in expressions (3) and (17) (not presented) are broadly compatible with the results from the log-difference regressions.

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Regression Results For each GCC country, the results for the elasticity estimates from equation (18) for imports, exports, and trade balances are summarized in Tables 1-6. When in the feasible range (0 < a* < 1), the values for a for which the variation in those dependent variables would be zero are also presented in those tables. The comparison is based on the following three arguments. First, when c1 is statistically significant but c2 is not, then the source of statistically significant variability due to shocks on Z isc1,or the elasticity with respect to the home country's exchange rate with the dollar; then, the left-hand side of expression (15) is zero if a = 1, that is, the US$ peg should be chosen; the opposite is true when c2 is statistically significant and c1 is not; then, the source of statistically significant variability is the elasticity with respect to the home currency's exchange rate with DM, and the left-hand side of expression (15) is zero if a = 0, that is, the DM peg should be chosen. Second, when both elasticity estimates are statistically significant but a* is not in the feasible range (a*< 0 or a* > 1), then, if | c1 | > | c2| , the variable is more stable if a = 1, that is, the US$ peg should be chosen; if | c1 | < | c2| , the variable is more stable if a = 0, that is, the DM peg should be chosen. Third, when a* is found to be in the feasible range and both c1 and c2 are significant, the optimal peg dominates both the US$ and DM pegs.18 In the case of Saudi Arabia, the statistically significant results indicate that imports are more stable under the US$ peg but exports are more stable under the SDR peg (Table 1). For exports to the world, the optimal US$ weight is very close to 0.40, the period initial average official US$ weight of the SDR. For exports to the SDR zone, the estimated optimal US$ weight is 0.34, lower than the SDK's average official US$ weight. For non-oil exports, however, the US$ peg dominates, with an optimal US$ weight of about 0.90. In view of the results for imports and exports that appear to countervail each other, the results for the trade balance are mixed. When non-oil exports are regressed on the home GDP, the US$ peg dominates, but when regressed on the world GDP, the SDR peg dominates. However, the results for the trade balance are inconclusive because the exchange rate elasticity estimates are not statistically significant.

18

Two values for a are used. The first value is on the basis of the 1976-99 average for the officially fixed US$ weight of SDR (a = 0.40), announced for a period (typically, five years) at the beginning of that period. The second value is on the basis of the 1981-99 average effective US$ weight of SDR (a = 0.50); the effective US$ weight of SDR varies according to the variations in the cross exchange rates between the US$ and the other SDR currencies (see Appendix B).

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Table 1 . Summary Elasticity and a * Estimates for Saudi Arabia

Trade Category and Zone

(a c0

DM US$ peg peg = 0) (a = 1) c1 c2

c3

Period Effective Initial Average SDR SDR peg peg (a = 0.4) (a = 0.5) ac 2 -(1 a)c1

Implied Choice of Peg

a*

(In first-difference [dependent variable] = c0 + c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [home GDP]) Imports SDR zone t-value World t-value

0.10 2.1 0.08 2.2

-2.33 -2.7 -1.80 -2.6

0.13 0.4 0.10 0.3

0.45 1.6 0.43 1.9

1.45

1.23

US$

n.a.

1.12

0.95

US$

n.a.

(In first-difference [dependent variable] = c0 + c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [SDR zone or world GDP]) Exports SDR zone t-value World t-value

0.00 0.0 -0.03 -0.4

0.89 0.7 1.09 0.8

1.71 -1.76 3.4 1.7 1.77 -1.59 2.9 -1.3

0.15

0.41

SDR 0.34

0.05

0.34

SDR 0.38

(In first-difference [dependent variable] = c0 + c1. In first-difference e + c2. In firstdifference v + c3. In first-difference [world GDP]) Non-oil exports World t-value

-0.18 -1.4

6.29 2.8

0.78 -1.28 0.8 -0.6

-3.46

-2.75

US$ 0.89

(In first-difference [dependent variable] = c0 + c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [home GDP]) Trade balance World t-value

-0.19 -1.2

1.05 -0.24 3.98 0.4 -0.2 4.4

-0.72

-0.64

US$

n.a.

(In first-difference [dependent variable] = c0 + c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [world GDP]) Trade balance World t-value

-0.11 -0.5

2.91 0.7

3.34 -3.14 1.8 -0.8

-0.41

0.22

SDR 0.46

Source: IMF staff estimates. Note: a* = c1/(c1+c2); "n.a." means not applicable (a* is either negative or greater than unity).

In the case of Qatar, the US$ peg dominates in all cases, except for exports to the world, for which the SDR peg dominates (Table 2). Nevertheless, for exports to the world, the estimated a* value is about 0.70, significantly larger than the average effective US$ weight of the SDR. However, although statistically inconclusive, the US$ peg dominates for the trade balance.

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EXTERNAL STABILITY

Table 2. Summary Elasticity and a* Estimates for Qatar

Trade Category and Zone

c0

DM US$ peg peg (a = 0) (a = 1) c1 c2 c3

Period Effective Initial Average SDR SDR peg peg (a = 0,4) (a = 0.5) ac2-(1-a)c1

Implied Choice of Peg

a*

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [home GDP]) Imports SDR zone t-value World t-value

-0.06 -0.1 0.00 0.1

-2.81 -1.7 -1.93 -1.6

0.50 0.9 0.45 1.1

-0.19 -0.5 -0.05 -0.2

1.89

1.65

US$

n.a.

1.34

1.19

US$

n.a.

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [SDR zone or world GDP]) Exports SDR zone t-value World t-value

0.05 1.0 0.30 0.7

3.89 1.6 3.85 1.6

0.82 2.0 1.56 3.2

-2.52 -3.0 -3.08 -3.1

-2.01

-1.53

US$

0.83

-1.69

-1.15

SDR

0.71

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c1. In first-difference [home GDP]) Trade balance World t-value

-0.05 -0.6

1.93 0.4

-1.29 -1.5

2.80 4.5

-1.67

-1.61

US$

n.a.

(In first-difference [dependent variable] = c0 + c1. In first-difference e + c2 • In first-difference v + c3. In first-difference [world GDP]) Trade balance World t-value

-0.01 -0.1

11.72 1.8

1.94 -3.90 1.5 -1.5

-6.26

-4.89

US$

0.86

Source: IMF staff estimates. Note: a* = c1/(c1+c2); "n.a." means not applicable (a* is either negative or greater than unity).

For Bahrain, the US$ peg dominates in all cases, except for exports to the world, for which the DM peg dominates (Table 3). The two statistically significant results—imports from the world and exports to the world—appear to countervail each other, leaving open to question whether the country's trade balance is more or less stable under the SDR or the US$ peg. In the case of the United Arab Emirates, the US$ peg dominates in all cases, except for the exports to the world, for which the SDR peg dominates (Table 4). The estimated a* for that item is about 0.60, indicating a larger optimal US$ weight than the SDR's average effective

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Table 3. Summary Elasticity and a * Estimates for Bahrain

Trade Category and Zone

(a c0

DM US$ peg peg = 0) (a = 1) c1 c2

c3

Period Effective Initial Average SDR SDR peg peg (a = 0.4) (a = 0,5) ac 2 -(1 a)c1

Implied Choice of Peg

a*

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [home GDP]) Imports SDR zone t-value World t-value

-0.01 -0.2 -0.07 -2.5

0.90 -0.30 0.36 0.9 -0.9 0.7 1.26 -0.01 1.20 2.0 0.0 3.7

-0.66

-0.60

US$

n.a.

-0.76

-0.64

US$

n.a.

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [SDR zone or world GDP]) Exports SDR zone t-value World t-value

57.06 2.0 0.07 0.9

9.19 1.6 -0.30 -0.1

0.82 -4.90 1.3 -1.9 1.24 -1.36 2.0 -1.0

-5.19

-4.19

0.68

0.77

US$ 0.92 DM

n.a.

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [world GDP]) Non-oil exports World t-value

0.12 1.1

-2.67 -0.6

1.42 -1.07 1.6 -0.6

2.17

2.04

US$

n.a.

Source: IMF staff estimates. Note: a* = c1/(c1+c2); "n.a." means not applicable (a* is either negative or greater than unity).

US$ weight. The results for the trade balance are statistically inconclusive. However, when the trade balance is regressed on the home GDP, the difference between the US$ and SDR pegs is minimal, and the estimated a* is 0.75. When the trade balance is regressed on world GDP, the SDR peg appears to dominate, with an estimated a* = 0.71. In either case, the estimated a* values significantly exceed the SDR's average effective US$ weight of 0.50. For Oman, in contrast to most cases above, the SDR peg dominates in the case of imports but the US$ peg dominates in the case of exports (Table 5). These results are statistically inconclusive. However, in the case of imports, the estimated a* values indicate a lower optimal share for the US$; in particular, for imports from the world, a* is nearly 0.50, the SDR's average effective US$ weight. Because the results for imports and exports appear to countervail each other, the results for the trade balance are mixed. However, for the trade balance regressed on world

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EXTERNAL STABILITY

Table 4. Summary Elasticity and a * Estimates for the United Arab Emirates

Trade Category and Zone

Period Effective Initial Average SDR SDR peg peg (a = 0.4) (a = 0,5)

DM US$ peg peg = 0) (a = 1)

(a c0

c1

c2

c3

ac2-(1-a)c1

Implied Choice of Peg

a*

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 • In first-difference v + c3. In first-difference [home GDP]) Imports SDR zone t-value World t-value

0.00 0.2 0.03 1.2

-1.12 -1.7 -0.79 -1.3

0.30 0.29 1.3 1.5 0.30 0.37 1.4 2.1

0.80

0.71

US$

n.a.

0.60

0.55

US$

n.a.

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 • In first-difference v + c3. In first-difference [SDR zone or world GDP]) Exports SDR zone t-value World t-value

-0.05 -1.2 0.02 0.6

4.25 2.2 1.65 1.9

0.61 0.78 1.5 0.9 0.98 -0.63 2.8 -0.9

-2.31

-1.82

US$

0.88

-0.60

-0.33

SDR 0.63

(In first-difference [dependent variable] = c0 + c1• In first-difference e + c2 In first-difference v + c3. In first-difference [world GDP]) Non-oil exports World t-value

0.04 0.6

-0.93 -0.26 1.57 -0.3 -0.4 1.2

0.45

0.33

US$

0.78

(In first-difference [dependent variable] = c0 + c1. In first-difference e + c2 • In first-difference v + c3. In first-difference [home GDP]) Trade balance World t-value

-0.11 -0.7

2.87 0.7

0.97 0.6

2.11 1.6

-1.33

-0.95

US$/SDR

0.75

(In first-difference [dependent variable] = c0 + c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [world GDP]) Trade balance World t-value

-0.11 -0.6

2.34 0.5

0.94 2.09 0.5 0.5

-1.03

-0.70

SDR 0.71

Source: IMF staff estimates. Note: a* = c1/(c1+c2); "n.a." means not applicable (a* is either negative or greater than unity).

GDP, the estimated a* value is about 0.60, indicating a bias toward the US$ peg in an optimal currency basketforpegging the Omani currency. Finally, in the case of Kuwait, the results are statistically inconclusive (Table 6). Only in two cases, the US$ peg is dominated. First, for non-oil exports, the DM peg dominates, which may reflect the large share of exports to the other SDR zone in exports to the SDR zone, as

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Table 5. Summary Elasticity and a* Estimates for Oman

Trade Category and Zone

c0

DM US$ peg peg (a = 0) (a = 1) c1 c2

c3

Period Effective Initial Average SDR SDR peg peg (a = 0.4) (a = 0.5) ac2-(1-a)c1

Implied Choice of Peg

a*

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [home GDP]) Imports SDR zone t-value World t-value

0.05 0.9 0.05 1.2

-0.66 -0.5 -0.27 -0.3

-0.47 -1.3 -0.28 -1.0

0.60 2.0 0.57 2.4

0.21

0.10

SDR

0.58

0.05

-0.01

SDR

0.49

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [SDR zone or world GDP]) Exports SDR zone t-value World t-value

0.29 2.0 0.07 1.1

-5.35 -1.63 -1.26 -1.3 -1.4 -0.6 1.24 0.27 -1.37 0.7 0.5 -1.4

2.56

1.86

US$

0.77

-0.64

-0.49

US$

0.82

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [home GDP]) Trade balance World t-value

-0.07 -0.4

-2.22 -0.6

0.36 0.3

2.23 2.5

1.48

1.29

US$

n.a.

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [world GDP]) Trade balance World t-value

0.05 0.3

4.05 0.8

2.34 -4.44 1.4 -1.5

-1.50

-0.86

SDR

0.63

Source: IMF staff estimates. Note: a* =c1/(c1-c2);"n.a." means not applicable (a* is either negative or greater than unity).

in the case of Qatar. Second, the SDR dominates for the trade balance regressed on world GDP; the optimal weight of the US$ for that item is the same as the average effective US$ weight of the SDR, or 0.50.

Concluding Remarks We have shown that the stability of imports and exports under the dollar peg and the SDR peg depends critically on the elasticities with respect to the exchange rates. Although the home country's real ex-

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EXTERNAL STABILITY

Table 6. Summary Elasticity and a* Estimates for Kuwait

Trade Category and Zone

(a c0

DM US$ peg peg = 0) (a = 1) c1 c2

c3

Period Effective Initial Average SDR SDR peg peg (a = 0.4) (a = 0.5) ac2 - (1 a)c1

Implied Choice of Peg

a*

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [home GDP]) Imports SDR zone t-value World t-value

-0.05 -0.9 -0.02 -0.4

1.79 1.1 1.12 0.8

0.26 0.5 0.41 0.9

-0.19 -0.6 -0.16 -0.5

-0.97

-0.77

US$

0.88

-0.51

-0.36

US$

0.73

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [SDR zone or world GDP]) Exports SDR zone t-value World t-value

-0.21 -1.0 -0.12 -1.0

3.43 0.9 2.95 1.3

0.85 0.7 0.94 1.0

2.02 0.7 0.60 0.3

-1.72

-1.29

US$

0.80

-1.39

-1.00

US$

0.76

(In first-difference [dependent variable] = c0+ c1 In first-difference e + c2 . In first-difference v + c3. In first-difference [world GDP]) Non-oil exports World t-value

0.13 0.7

-1.15 -0.3

2.26 -4.96 1.4 -1.4

1.59

1.70

DM

n.a.

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [home GDP]) Trade balance World t-value

0.05 0.4

-5.60 -1.3

-2.13 -1.6

4.54 4.9

2.51

1.73

US$

0.72

(In first-difference [dependent variable] = c0+ c1. In first-difference e + c2 . In first-difference v + c3. In first-difference [world GDP]) Trade balance World t-value

0.24 0.7

3.48 0.4

3.51 -7.09 1.2 -1.5

-0.69

0.01

SDR

0.50

Source: IMF staff estimates. Note: a* = c1/(c1+c2); "n.a." means not applicable (a* is either negative or greater than unity).

change rate with respect to the other SDR currencies (v) is stabilized as a result of the switch from the dollar peg to the SDR peg, the real exchange rate with respect to the dollar (e) is destabilized. Given the import and export elasticities with respect to the exchange rates, it is conceivable that the instability introduced through e dominates the

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181

stability introduced through v, resulting in greater overall import and export instability under the SDR peg than under the dollar peg. In most GCC countries, the empirical results suggest that a switch from the prevailing dollar peg to the SDR peg is not likely to result in an improvement in external stability. In addition, other important factors besides the stabilization of selected target variables should be considered in evaluating the appropriateness of such a switch; for example, the credibility of the exchange policy stance, the effects of exchange rate volatility on market structure, the stability of foreign exchange markets, and transaction costs arising from exchange rate volatility. These factors could become critical, particularly if no substantial gain in external stability would be achieved by abandoning the dollar peg in favor of the SDR peg or an optimal peg in the GCC countries. Should the GCC countries peg their currencies to a more general currency basket instead of the dollar? Although switching to the SDR basket may not improve external stability, the benefits of switching to some other nominal exchange rate rule remain to be explored. In view of the recent initiative to officially peg all GCC currencies to the dollar, a GCC-wide evaluation of the virtues of a "bimetallic" peg (to the dollar and the euro) might be particularly illuminating.

Appendix A. The GCC Countries: A Brief Description of the Exchange Rate Regimes Saudi Arabia. The Saudi riyal is officially pegged to the SDR at SRls 4.2826 = SDR 1. The Saudi riyal has been effective pegged to the dollar at the fixed rate of SRls 3.745 = $1 since June 1, 1986. Qatar. The Qatar riyal is officially pegged to the SDR at QR 4.7619 = SDR 1. The Qatar riyal has been effectively pegged to the dollar at the fixed rate of QR 3.6415 = $1 since 1979. Bahrain. The Bahrain dinar is officially pegged to the SDR at BD 0.46190 = SDR 1. The Bahrain dinar has been effectively pegged to the dollar at the fixed rate of BD 1 = $2.6596 since December 1980. United Arab Emirates. The U.A.E. dirham is officially pegged to the SDR at Dh 4.7619 = SDR 1. The U.A.E. dirham has been effectively pegged to the dollar since November 1980 at the fixed rate of Dh 3.6710 = $1. Oman. The rial Omani has officially been pegged to the dollar at the fixed exchange rate of RO 1 = $2.6008 since 1986. Kuwait. The exchange value of the Kuwaiti dinar is determined on the basis of a fixed but adjustable relationship between the Kuwaiti dinar and a weighted basket of currencies, with the weights reflecting the relative importance of these currencies in Kuwait's trade and finan-

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EXTERNAL STABILITY

cial relations. The Central Bank of Kuwait sets the rate for the dollar on the basis of the latest available market quotations for that currency in relation to the other currencies included in the basket- The dollar appears to have a very large weight in the currency basket.

Appendix B. Description of Data and Derivation of the Exchange Rate Indexes Data

The data on nominal GDP, imports and exports, and CPI come from IFS, DOT, and WEO. Recall that E t , or the nominal exchange rate between a G C C country's currency and the U.S. dollar, is the inverse of the exchange rate between that country's currency and the dollar reported in IFS for each G C C country (e.g., in the case of Saudi Arabia, Et = 0.2670 and 1/Et = 3.745). Indexes Z t and zt Zt is the index of the nominal exchange rate between the U.S. dollar and the composite of the currencies of the other SDR zone countries (France, Germany, Japan, and the United Kingdom). The Z£ index is calculated according to the following formula:

Zt=iwitZit; wit =

it

it

s ;4 =

s

i(XF + M,V )

r VS$ \ DM, >i

(B.I)

where i = France, Germany, Japan, or the United Kingdom; DMt = the French franc, German mark, Japanese yen, or U.K. pound; 10

Sources: Sharer and others (1998); IMF staff estimates.

The Index of Aggregate Trade Restrictiveness developed by Sharer and others (1998) at the IMF provides a measure of protection that combines the unweighted-average tariff rate and a ranking of nontariff barriers. As a first step, countries are classified in five categories (ranging from open to restrictive) according to the level of tariffs. For instance, a country with tariff rates ranging between 0 and 10 percent is considered open, but a country with tariff rates exceeding 25 percent is rated as restrictive. In a second step, countries are classified in three categories (open, moderate, and restrictive) according to the use of nontariff barriers. This is a judgmental classification based on data on the share of imports and production in total demand, the number of tariff lines subject to nontariff barriers, and the share of trade subject to nontariff measures (depending on the availability of data). In the third and last step, the ratings given to a country for the use of tariff and nontariff barriers are mapped into a classification scheme providing a unique measure for overall trade restrictiveness. Tables 10 and 11 reproduce the 10-point-scale matrix of trade restrictiveness developed by Sharer and others (1998). Consider a given level of protection as measured by the use of nontariff barriers. Moving Table 1 1 . Weighting Scheme for Overall Trade Restrictiveness Nontariff Barriers Tariff Restrictiveness Open Relatively open Moderate Relatively restrictive Restrictive

Open 0+ 1+ 2+ 3+ 4+

1= 1= 1= 1= 1=

1 2 3 4 5

Moderate

Restrictive

1+ 2+ 3+ 4+ 5+

4+ 5+ 6+ 7+ 8+

3= 3= 3= 3= 3=

4 5 6 7 8

3=7 3=8 3=9 3 = 10 2 = 10

Source: Sharer and others (1998).

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ESTIMATING TRADE PROTECTION

from "open" to "relatively open," as measured by the level of tariff rates, means increasing the trade restrictiveness rating of the country by 1 unit. Similarly, consider a given level of protection as measured by tariff barriers. Moving from "open" to "moderate" on the nontariff barriers axis implies increasing the rating value assigned to a country by 3 units (except that when increasing the rating from moderate to restrictive and from relatively restrictive to restrictive, the weight increases by 2). The author of this chapter has developed an overall ranking that differs from the ranking of Sharer and others (1998) in that the frequency ratio is used to classify countries in three categories according to the percentage of tariff lines subject to nontariff barriers. For instance, a country is rated open when the frequency ratio ranges between 0 and 5 percent, but restrictive when the frequency ratio exceeds 10 percent. This classification of protection schemes is based on an objective, standard nontariff measure.17 The author adopts the weighting schemes developed by Sharer and others to combine tariffs and nontariff measures. According to the author's ranking, the levels of protection in Algeria and Morocco were similar in the late 1990s, and Pakistan was more open (Table 12). According to the overall ranking by Sharer and others (1998), Algeria and Pakistan had similar levels of protection, and Morocco was more protectionist. Overall Weighted Trade Restrictiveness Index

The overall trade index of Sharer and others (1998) and the overall index formulated by the author are based on a classification scheme that does not explicitly consider tariff dispersion as an additional source of distortion. Alternatively, tariff levels, tariff dispersion, and nontariff barriers can be viewed as indicators that serve to characterize a latent variable, "protectionism," which is unobservable. The construction of an overall trade policy index should account for these three variables. Such an indicator, developed below, has two virtues. First, it takes the dispersion of tariff rates into account. Second, the relative importance assigned to different types of trade barriers does not depend on judgment, in the sense that different analysts will obtain the same ranking when using the same database. 17

The use of frequency ratios to measure the presence of nontariff barriers does not capture the intensity of the nontariff measures set by the country. The coverage ratio measure is a standard alternative measure for nontariff barriers. However, because the coverage ratio accounts for the value of imports subject to nontariff barriers, product lines subject to prohibitive nontariff barriers (i.e., imports are zero) are not controlled by this measure.

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Table 12. Overall Rankings of Trade Orientation and Openness Penn-World Tables Ranking1 1990

Sharer's Overall Ranking,1999

Mauritania Tunisia Egypt Syria (1991) Morocco Algeria Pakistan Iran Sudan

Djibouti, Qatar, United Arab Emirates Bahrain Mauritania Oman, Kuwait Saudi Arabia, Yemen Yemen Lebanon Pakistan, Jordan, Algeria Morocco, Sudan, Egypt Iran, Syria

Author's Overall Ranking,1999 Djibouti, Oman, Qatar, United Arab Emirates Bahrain Mauritania Kuwait, Sudan Saudi Arabia, Pakistan, Egypt, Yemen Lebanon, Jordan Algeria Morocco Tunisia, Iran, Syria

Sources: Summers and Heston (1994); Sharer and others (1998); UNCTAD (1998-99); IMF staff estimates. ] Data from years other than 1990 and 1992 are noted in parentheses.

Oman Saudi Arabia Algeria Morocco Pakistan Egypt Tunisia

Maria-Angels Oliva

Bahrain (1988) Jordan Djibouti (1987) Mauritania United Arab Emirates (1989) Kuwait (1989) Tunisia Qatar (1989) Saudi Arabia (1989) Oman (1989) Yemen Egypt Syria Morocco Iraq Algeria Pakistan Iran Sudan

1992

Author's Weighted Ranking,1999

361

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ESTIMATING TRADE PROTECTION

Let us denote the latent variable "protectionism" by the symbol P. Protectionism is defined as a linear combination of tariffs (T), dispersion (D), and nontariff barriers (NT):

P = ocT + pD + ( l - a - P ) N T

(1)

The methodology for deriving the weights endogenously consists of obtaining the weights that maximize the average correlation between the three measures and protection (P). Formally, M iVlax

a,p

p(T, P) + p(D,P) + p(NT, P) r

= i_p[T, ocT + pD + (1 - a - p)NT] + — p [D, aT+pD+(l - a - p)NT] + — p [NT, aT+ pD + (1 - a - p)NT]

(2)

Notice that the endogenous weights and related ranking are invariant to changes of scale and origin in the measurement of the variables (because correlations are invariant to scale and origin).18 The correlations between the trade restriction variables and the latent variable, protection, are positive by construction (otherwise, the correlation would carry a zero weight). In principle, the correlations should be weighted according to the distortions they generate. However, the required elasticities and data on relative distortions are not generally available. Furthermore, introducing additional parameters into the system and using a judgmental criterion to weigh the relative importance of each correlation on measuring protection would weaken the analytical robustness of the indicator. The measure of protection (P) used for the OWTR classification for country i is: P = aV + fiU + (1 - a - p)NT = 0.3T + 0.2D1 + 0.5 NT (3) The weights are obtained by solving the maximization problem formulated above. Because of limited data availability, this measure of protection was computed only for Algeria, Egypt, Morocco, Oman, Pakistan, Saudi Arabia, and Tunisia.19 18

See Appendix A for an approach to weighted-average ranking. Excluding Tunisia, tariffs explain 40 percent of protection; dispersion, 20 percent; and nontariff barriers, 40 percent (i.e., a = 0.4, P = 0.2, and 1 - a - (3 = 0.4). The country ranking is the same as in Table 12. 19

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363

The correlation matrix is given by p(T, 0.3T+ 0.2D + 0.5NT) = 0.72

(4)

p(D, 0.3T+ 0.2D + 0.5NT) = 0.62

(5)

p(NT, 0.3T+ 0.2D + 0.5NT) = 0.59

(6)

There is a high correlation between tariffs and protection, and a relatively high correlation between dispersion and protection and between nontariff barriers and protection (P) for Middle Eastern and North African countries. The OWTR index provides a tool to measure protection with minimum data requirements (the level of tariff rates, standard deviation of tariff barriers, and the number of tariff lines subject to nontariff measures). An alternative mechanism to account for protection is to use a loss function accounting for the trade-off between tariffs, dispersion, and nontariff barriers, but it is difficult to assign weights. Comparison of Indexes

Table 12 summarizes the overall trade policy restrictiveness index developed by Sharer and others (1998) and the author's overall indexes. The table compares the indexes with the standard openness ratios (the ratio of imports plus exports to GDP) for 1990 and 1992 presented in the Penn-World Tables 5.6 database (Summers and Heston, 1994).20 The indexes presented in Table 12 are not based on welfare comparisons but are computable, given available data, and provide a more comprehensive protection measure than the common method of only looking at tariff levels.21 Once the rankings account for missing countries, the methodologies give roughly similar rankings. But there are some important differences. For instance, Egypt appears more restrictive than Morocco when dispersion is taken into account (author's weighted ranking), but appears equally restrictive when only tariff and nontariff barriers are considered (Sharer and others, 1998; 1999 update). The reason is that Egypt has four times the standard deviation of tariff levels of Morocco (see Table 4). According to Summers and Heston (1994), Iran and Sudan were 20

Dollar (1992) presents an outward-orientation index based on estimates obtained by regressing the index of a country's relative price level on per capita GDP and other variables for 95 countries from 1976 to 1985. Pakistan and Jordan were the most open countries, and Algeria, Egypt, and Iraq were the most protectionist. 21 For an analysis of a welfare-theoretic measure of trade restriction, see Anderson and Neary (1994).

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ESTIMATING TRADE PROTECTION

the most protectionist in the mid-1990s. According to Sharer and others (1998) and the author's ranking (1999), Iran and Syria were the most protectionist countries in the late 1990s.

Conclusions The tension between international pressures for liberalization, on the one hand, and macroeconomic pressures pushing for protectionism, on the other, are at the core of recent developments in the Middle East and North Africa. Whether the balance moves toward protectionist or liberalization depends on how governments are able to deal with domestic imbalances and regional conflicts. Up to now, regional agreements have served as a channel to increase trade relations with industrial countries, but not between the countries in the region (El-Erian and Fischer, 1996; Fischer, 1992). In contrast to the ASEAN economies, the chapter finds that nonGCC countries' tariff rates are not converging toward ASEAN rates. In the mid-1990s, the incidence of nontariff measures in the non-GCC Middle Eastern and North African countries was ten times higher than in ASEAN countries. Moreover, the chapter finds that Middle Eastern and North African countries use tariffs as a complementary protection measure for tariff dispersion, but use tariff dispersion schemes and nontariff barriers as substitute measures of protection. Tariffs and nontariff barriers are also substitutes. Specifically, excluding Tunisia, the crosscountry correlation between tariffs and nontariff barriers is —0.5, and the cross-country correlation between tariff dispersion and the level of nontariff barriers is —0.8. This chapter takes a step toward studying the evolution and current state of trade policies in the Middle Eastern and North African countries. The lack of data on tariffs and nontariff barriers remains a major impediment to objective analysis of protection policies. Further work could entail exploring alternative measures of trade protection, examining the substitutability and complementarity of different trade policies, and searching for mechanisms and domestic policies to encourage greater intraregional trade.

Appendix A. Weighted-Average Ranking The weighted-average ranking is an overall protectionist ranking based on the weighted average of the level of tariffs (T), tariff dispersion (D), and nontariff barriers (NT). Formally, weights a and B are ob-

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Maria-Angels Oliva

365

tained by maximizing the average correlation with overall protectionism (XT +PD + (1 - a -P)NT, which is equivalent to: Max a)P p(T, P) + p(D,P) + p(NT, P) = p [T, aT + pD + (1 - a - p)NT] + p[D,aT + pD + ( l - a - p ) N T | + p [NT, aT+ PD + (1 - a - p)NT] ao 2 + p cov(T,D)+(l - a - p) cov(T,NT)

oTV5P! o 2 r +P 2 a£ ) +(l-a--P) 2 oW + 2a Pcov(T,D) + 2a(l -a-P)cov(T,JV7)- h2p(l-a-P)cov(D,NT) Pa&+ a cov(D.T) + (l-a-P)cov(D,NT) OoVa o^ + p ^ + d - a - P ) 2 < ^ T + 2a Pcov(T,D) + 2a(l -a-p)cov(T,iV7) + 2p(l-a - p)cov(D,NT) 2

(1 - a - PJPaJta- + a cov(NT.T) + pcov(NT,D) l o\+ P2ak+ (1 - a- P ) 2 ^ T - i- 2a Pcov(T,D)

+ 2a(l - a - p)cov(T,JV7) + 2p(l - a - p)cov(D,NT)

(A.I)

We obtain the weights (a, P) from the first-order conditions d(p[T,P] + p[D,P] + p[NT,P])

x:

A

= and

°

d(p[T,P] + p[D,P] + ppSfT.P1)

JR

=

n

°

da dp (A2) The two-equation system was solved using Mathematical The standard deviation for tariffs is Gj = 15.1, the standard deviation of tariff dispersion is OD = 43.9, and the standard deviation of nontariff barriers is = = &NT 17-4. Covariances are given by G J C = 242.4, CFD,NT —158.4, and CT NT = 69.4, including Tunisia. If Tunisia is excluded, the standard deviation for tariffs is OT = 15.4, the standard deviation of tariff dispersion is OD = 47.6, and the standard deviation of nontariff barriers is a NT = 2.5. Covariances are given by a T D = 317.7, CDtNT = -77.7, and OTJVT = -15.8. References Anderson, James E., and J. Peter Neary, 1994, "Measuring the Restrictiveness of Trade Policy," World Bank Economic Review, Vol. 8, No. 2, pp. 151-69.

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ESTIMATING TRADE PROTECTION

Balassa, Bela, 1971, The Structure of Protection in Developing Countries (Baltimore: Johns Hopkins University Press). Bhagwati, Jagdish, 1978, Foreign Trade Regimes and Economic Development: The Anatomy and Consequences of Exchange Control (Cambridge, Massachusetts: National Bureau of Economic Research and Ballinger). Chenery, Hollis B., and Moshe Syrquin, 1989, "Three Decades of Industrialization," World Bank Economic Review, Vol. 3, No. 2, pp. 145-81. Deardorff, Alan V., and Robert M. Stern, 1998, Measurement of Nontariff Barriers (Ann Arbor: University of Michigan Press). Dollar, David, 1992, "Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976-1985," Economic Development and Cultural Change, Vol. 40, pp. 523-44. Edwards, Sebastian, 1998, "Openness, Productivity and Growth: What Do We Really Know?" Economic Journal, Vol. 108, pp. 383-98. El-Erian, Mohamed, and Stanley Fischer, 1996, "Is MENA a Region?: The Scope for Regional Integration," IMF Working Paper 96/30 (Washington: International Monetary Fund). El-Naggar, Said, 1992, Foreign and lntratrade Policies of the Arab Countries (Washington: International Monetary Fund). Foroutan, Faezeh, 1998, "Does Membership in a Regional Preferential Arrangement Make a Country More or Less Protectionist?" (unpublished; Washington: World Bank). Fischer, Stanley, 1992, "Prospects for Regional Integration in the Middle East," in New Dimensions in Integration, ed. by Jaime De Melo and Arvind Panagariya (Cambridge: Cambridge University Press). Harberger, Arnold C., 1964, "The Measurement of Waste," American Economic Review, Vol. 54, pp. 58-76. Harrison, Ann, 1991, Openness and Growth: A Time Series Cross Section Analysis for Developing Countries, World Bank Policy Research Working Paper 809 (Washington: World Bank). IMF (International Monetary Fund), 1998, "Exchange Arrangements and Exchange Restrictions," in Annual Report of the Executive Board for the Financial Year Ended April 30, 1998 (Washington). Iqbal, Zubair, 1999, "Lecture Summary: Trade Policies" (unpublished; Washington: International Monetary Fund). Krueger, A.O., 1978, Foreign Trade Regimes and Economic Development: Liberalization Attempts and Consequences (Cambridge, Massachusetts: Ballinger). , 1984, "Trade Policies in Developing Countries," in Handbook of International Economics, ed. by Ronald W. Jones and Peter B. Kenen (Amsterdam: Elsevier Science Publishers). Laird, Sam, and Alexander J. Yeats, 1990, Quantitative Methods for Trade Barrier Analysis (Washington: World Bank).

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Learner, Edward, 1988, "Measures of Openness," in Trade Policy Issues and Empirical Analysis, ed. by Robert Baldwin (Chicago: University of Chicago Press). Ng, Francis, and Alexander Yeats, 1996, Open Economies Work Better! Did Africa's Protectionist Policies Cause Its Marginalization in World Trade? Policy Research Working Paper 1636 (Washington: World Bank). OECD (Organization for Economic Cooperation and Development), 1997a, Indicators of Tariffs and Nontariff Trade Barriers (Paris). , 1997b, "Market Access for the Least Developed Countries: Where Are the Obstacles?" Report OECD/GD(97)174 (Paris). Panagariya, Arvind, 1994, "Why and Why Not of Uniform Tariffs," Economic Studies Quarterly: The Journal of the Japan Association of Economics and Econometrics., Vol. 45, No. 3, pp. 303-32. , and Dani Rodrik, 1993, "Political-Economy Arguments for a Uniform Tariff," International Economic Review, Vol. 34, No. 3 (August), pp. 685-704; issued earlier as NBER Working Paper W3661 (Cambridge, Massachusetts: National Bureau of Economic Research, March 1991). Rodriguez, Francisco, and Dani Rodrik, 1999, "Trade Policy and Economic Growth: A Skeptic's Guide to the Cross-National Evidence," NBER Working Paper W7081 (Cambridge, Massachusetts: National Bureau of Economic Research). Sharer, Robert, and an IMF staff team, 1998, Trade Liberalization in IMF-Supported Programs, World Economic and Financial Surveys (Washington: International Monetary Fund). Summers, R., and A. Heston, 1994, "Penn-World Tables, Version 5.6" (available from www.nber.org). UNCTAD (United Nations Conference on Trade and Development), 1987, Handbook of Trade Control Measures of Developing Countries (New York: United Nations). , 1994, Directory of Import Regimes; Part I: Monitoring Import Regimes (New York: United Nations). , 1998-99, Trade Analysis and Information System—TRAINS United Nations).

(New York:

Yeats, Alexander J., 1978, Trade Barriers Facing Developing Countries (Stockholm: Institute for International Economic Studies).

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List of Contributors

Olumuyiwa S. Adedeji Economist, Western Hemisphere Department, International Monetary Fund Rina Bhattacharya Economist, Middle Eastern Department, International Monetary Fund Ward Brown Economist, Policy Development and Review Department, International Monetary Fund Nigel Chalk Economist, Fiscal Affairs Department, International Monetary Fund Pierre Dhonte Deputy Director, Middle Eastern Department, International Monetary Fund Ilker Domac Senior Economist, Europe and Central Asia Region, World Bank Mohamad Elhage Senior Economist, Middle Eastern Department, International Monetary Fund S. Nuri Erbas Senior Economist, Middle Eastern Department, International Monetary Fund Annalisa Fedelino Economist, Fiscal Affairs Department, International Monetary Fund Henri Ghesquiere Senior Resident Representative, Middle Eastern Department, International Monetary Fund Daniel Hardy Senior Economist, Monetary and Exchange Affairs Department, International Monetary Fund Zubair Iqbal Assistant Director, Middle Eastern Department, International Monetary Fund Nicole Laframboise Economist, Middle Eastern Department, International Monetary Fund Michel Lazare Division Chief, Middle Eastern Department, International Monetary Fund Olin Liu Economist, Asia and Pacific Department, International Monetary Fund

369

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370

LIST OF CONTRIBUTORS

David Marston Division Chief, Monetary and Exchange Affairs Department, International Monetary Fund Edouard Martin Economist, Middle Eastern Department, International Monetary Fund Karim Nashashibi Senior Advisor, Middle Eastern Department, International Monetary Fund Maria-Angels Oliva Visiting Assistant Professor, European School of Management, ESCP-EAP (Paris Graduate School of Management and Ecole d'Affaires de Paris) Chera L. Sayers Economic consultant Ghiath Shabsigh Senior Economist, Middle Eastern Department, International Monetary Fund V. Sundararajan Deputy Director, Monetary and Exchange Affairs Department, International Monetary Fund Sherwyn E. Williams Senior Economist, Middle Eastern Department, International Monetary Fund Tarik Yousef Assistant Professor of Economics, Georgetown University

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