Chapter 6. Economic Policy Spillovers: Saudi Arabia in the Global Economy1
- Samya Beidas-Strom, Tobias Rasmussen, and David Robinson
- Published Date:
- October 2011
Spillovers from Saudi fiscal decisions and a slowdown in emerging Asia are simulated using an augmented three-region version of the IMF’s Global Integrated Monetary and Fiscal model (GIMF). Saudi fiscal multipliers are fairly low, due to the large leakage via imports, but the composition of fiscal spending packages matters greatly—public investment and transfers to liquidity-constrained consumers having the largest impact. Cross-border spillovers are largest to Asia, via the trade channel. A slowdown in emerging Asia would have important adverse spillovers for Saudi Arabia in the short term—largely through a decline in demand for oil—but less so over the medium to long term.
Decisions taken in Saudi Arabia affect, and are affected by, the global economy. The global crisis highlighted the truly interconnected nature of the global economy and the critical role of spillovers from policy decisions in one country to others. At the height of the global crisis, Saudi Arabia implemented a large fiscal expansion to support the national economy while cognizant of the need to support global demand. Similarly, the fiscal spending packages announced in Saudi Arabia in early 2011, while intended to address domestic issues, will also impact economies within the region and globally. The oil market also provides important spillovers: Saudi Arabia is currently the second largest oil producer in the world and is the only producer with significant spare capacity that can be used to stabilize markets. But spillovers work both ways in the oil market—the level and composition of global growth have important impacts on the demand for oil, particularly growth in emerging Asia, which is becoming increasingly important in determining oil market fluctuations.
The cross-border spillovers noted above can be analyzed using GIMF. GIMF features rich layers of intraregional trade, an oil market, and aggregate demand, allowing the transmission mechanism of the fiscal stimulus and external shocks to be fully articulated. The specific model employed here includes three regions—Saudi Arabia (SA), emerging Asia and China (AS), and the Rest of the World (RW)—and a separate oil sector (a similar model was used in IMF (2011) to model the long-run behavior of the oil market).
Variants of GIMF have been employed to analyze a wide range of policy issues in various countries. These include, among others, macroeconomic implications of alternative fiscal responses to commodity price booms in Australia (Hunt, 2008) and Chile (Kumhof and Laxton, 2009); the effectiveness of fiscal stimulus measures to cushion the global downturn in Australia (Hunt, 2009) and Korea (Eskesen, 2009); macroeconomic and structural policies needed to rebalance Asian demand (N’Diaye et al., 2010); the impact of fiscal consolidation in advanced economies (IMF, 2010a); quantifying the macroeconomic policy adjustment needed to prepare for participation in the European Monetary Union (Tamirisa and others, 2007); and alternative G20 scenarios to deliver sustainable and balanced global growth (IMF, 2010b).
The domestic impact of Saudi fiscal policy is constrained by relatively low fiscal multipliers, but the composition of the spending package matters. As in other studies, Saudi fiscal multipliers are found to be fairly low due to the large leakage, reflecting a high import content of spending and a relatively high marginal propensity to save. Depending on the composition of the spending, short-term multipliers could be in the range of 0 to 1.2—when the fiscal expansion is largely comprised of capital spending, the longer implementation cycle implies that the short-run expansion in GDP and increase in inflation will be smaller and more gradual than when it is implemented through an expansion in goods and services; and targeted transfers to liquidity-constrained groups have a durable impact on output while untargeted transfers have no impact.
Medium-term dynamics of the fiscal expansion are different from those of most other countries. In most countries,2 increased government consumption implies smaller government savings, requiring higher public sector borrowing and increased interest payments, ultimately inducing increases in taxation. However, in Saudi Arabia, the absence of a debt burden, or at this juncture of a need for financing, leaves interest payments unaffected so that the net impact is a redistribution of wealth away from Saudi Arabia (in the form of lower net foreign assets (NFA)) in favor of other regions as international reserves are reduced. In the long run, NFA positions return to the steady-state calibration.
Weaker demand in Asia would have adverse effects on Saudi Arabia in the short run, but long-run effects are more mixed. A slowdown in demand from Asia, for example due to a decline in the productivity of the tradable sector, reduces the demand for oil and Saudi Arabia’s output falls, and the trade balance initially deteriorates, generating a redistribution of NFA to the rest of the world. As demand stabilizes in the long run and trade balances narrow in Saudi Arabia and Asia, output, consumption, and investment in the rest of the world pick up.
The Global Integrated Monetary and Fiscal Model (GIMF)
GIMF is a multi-region dynamic stochastic general equilibrium model. The model integrates domestic supply, demand, trade, and international asset markets in a single theoretical structure, allowing transmission mechanisms to be fully articulated. Its features have been found important for replicating real-world behavior, including finite planning horizons of households and firms, gradual adjustment of prices and nominal wages to unexpected changes, and macrofinancial linkages in the form of a financial accelerator. The version employed in this paper has three economic regions—Saudi Arabia, emerging Asia (including China), and the rest of the world. Following the GIMF model featured in IMF (2011), an oil sector is added.
The behavioral assumptions within GIMF can be adjusted to reflect the policy framework in Saudi Arabia and the other regions (Appendix 6A). Governments finance expenditure through a range of tax and nontax revenues, and maintain nominal anchors. They purchase final goods for public consumption and to maintain public infrastructure, and add to the capital stock by increasing public infrastructure. Governments also provide transfers to households. Households are modeled as overlapping generations, living finite lives, consuming goods, and there are wage rigidities. Monetary policy is modeled as an augmented Taylor rule, seeking to stabilize output and inflation by adjusting the nominal interest rate. In the case of Saudi Arabia, the rule is fully tilted toward a preference for no nominal exchange rate volatility to reflect the fixed exchange rate regime. The rest of the world is assumed to follow an inflation-targeting regime. Inflation in Saudi Arabia adjusts to account for the real exchange rate movement (based on the underlying savings-investment behavior) relative to the fixed nominal exchange rate. Nominal rigidities here include sticky inflation Phillips curves in each sector of the economy. NFA is fixed in the model, and all regions return to their steady state in the long run (100 years).
The baseline model is established using end-2007 data (Appendix 6B). 2007 is used for the steady state in all GIMF simulations so as not to have the results tempered by the possibly temporary distortions introduced into the data by the financial crisis and recession beginning in 2008.
Fiscal Expansion in Saudi Arabia
A benchmark scenario is developed to assess the impact of a fiscal expansion in Saudi Arabia—constituting a combination of permanent and temporary measures—on the baseline underlying GIMF. First, a 1 percent increase in spending to GDP of each type of public spending is examined separately to identify the fiscal multipliers associated with each. Second, the cumulative impact of a 10 percent increase in spending (comprised of capital and current spending in equal amounts, with capital being temporary and carrying over for five years, while current spending is 40 percent permanent and 60 percent temporary) is examined. The permanent increase in current spending could be implemented through general or targeted transfers, or just goods and services.
Saudi fiscal measures produce effects on real GDP that are similar to if not larger than those predicted in previous studies. An expansion of 1 percent raises baseline output on impact by 0 to 1.2 percent (Figure 6.1).3,4 As expected, the impact of one-off temporary measures quickly dissipates, but expenditures that carry over, including public investment, have a more permanent effect.5 In part this persistence may reflect the large steady-state stock of assets and thus Saudi Arabia’s ability to sustain a fiscal surplus (or deficit) for an extended period (i.e., unlike most countries, Saudi Arabia has no immediate need for a fiscal consolidation due to the lack of need for external financing).
Figure 6.1.Saudi Arabia: Impact of Fiscal Spending Measures on GDP
Source: IMF staff calculations.
The composition of fiscal spending matters. When fiscal expansion is implemented by increasing capital spending, the short-run expansion in GDP is smaller and more gradual (i.e., more durable) than when the spending goes to goods and services (Figure 6.1).6 Moreover, the impact of general transfers is very modest compared to that of increases in targeted transfers, since the latter will reach liquidity-constrained households with a higher marginal propensity to consume, while the former save the transfer to smooth future consumption over time.7
A cumulative increase in total government spending of 10 percent of GDP has an initial (average of first two years) 4.7 percent expansionary impact on output and 2.9 percent on private consumption (Figure 6.2). The fiscal expansion will cause a pickup in inflation—which could reach 4.5 percent above the baseline in Year 1 and 1 percent above the baseline in Year 2—and it is assumed that the Saudi Arabia Monetary Agency does not tighten monetary conditions to contain the temporary spike in inflation. Hence, the real interest rate initially falls, consistent with the maintenance of the nominal exchange rate peg. As a result, there is a “double uptick effect” on the real economy which contributes to lifting output (and investment) above its steady-state level, well into the medium or long term. The real effective exchange rate initially appreciates, however, after a few years; it depreciates and results in a gradual recovery in the trade balance, after the initial large deterioration (between 9 and 11 percent during the first four years). Oil revenues, financial wealth, and NFA fall gradually as ratios to GDP. The current account gradually widens to a deficit of just over 5 percent of GDP, narrowing to 2.5 percent in the medium term.
Figure 6.2.Impact of Saudi Fiscal Expansion Package (10 percent of GDP): GIMF Simulations
Source: IMF staff calculations.
1Increase indicates depreciation.
Three alternative scenarios were carried out to identify the key sensitivities: a lower rate of public capital productivity (from 10 to 5 percent), a higher rate of depreciation of the government capital stock (from 4 to 8 percent), and a higher steady-state interest rate (from 3 to 5 percent). These experiments reduced the impact on domestic demand (output and consumption) only modestly (Table 6.1).8
|Fiscal Measures||Baseline||Lower Capital|
|Temporary government current spending hike||1.21||1.21||1.21||1.11|
|Permanent government current spending hike||0.96||0.86||0.86||0.85|
|Temporary government investment hike||0.40||0.36||0.37||0.40|
|Permanent hike in government transfers to|
|liquidity constrained households||0.08||0.08||0.08||0.08|
|Permanent hike in government transfers to all households||0.07||0.07||0.07||0.07|
Spillovers from the fiscal expansion
Spillovers from the fiscal expansion to output in other regions are modest, increasing growth in Asia on impact by 0.08 percent of real GDP and half of that in the rest of the world (Figure 6.2, columns 2 and 3). The trade balances of both regions (AS and RW) also improve a little (0.04 percent of GDP in both regions) on the back of the heavy import content of the Saudi fiscal expansion. Real consumption increases slightly in AS but deteriorates a little in the RW. Long-term dynamics are somewhat different from most other countries: in most countries, smaller government savings generated by larger government consumption tend to increase interest payments, inducing increases in taxation. However, as Saudi investment income falls, ceteris paribus, calling for a re-accumulation in NFA for intergenerational equity purposes,9 a small redistribution of wealth in the form of net foreign assets, from Saudi Arabia (0.3 percent of GDP) in favor of Asia (0.08 percent of GDP) and the rest of the world (0.3 percent of GDP) takes place.
A Slowdown in External Demand
A growth slowdown in Asia—for example due to a permanent 2.5 percent decrease in the productivity of the tradable sector—affects Saudi growth by reducing demand for oil. As Asian output falls by about 1.3 percent, demand for oil from Saudi Arabia falls and thus Saudi Arabian output contracts gradually (to a trough of 0.3 percent in the fourth year of the shock), while real consumption and investment fall by a larger amount (1.0 and 0.6 percent, respectively) (Figure 6.3). The fall in output in Saudi Arabia is induced by falling oil prices on the back of a near-vertical global oil supply curve,10 as the demand curve shifts down due to lower Asian demand. Consequently, Saudi Arabia’s terms of trade weaken, causing the real exchange rate to depreciate. The upswing is temporary, causing the trade balance to shift between an improvement followed by a deterioration, with an eventual small fall in NFA in the long run. While this demand shock slows NFA to GDP accumulation in Asia, in the sixth year it returns to positive growth. Thus NFA wealth is redistributed away from Asia to Saudi Arabia, as the oil trade balance of Asia falls into deficit (Figure 6.3).11 As demand stabilizes and trade balances narrow in Saudi Arabia and Asia over the medium term, output, consumption, and investment in the rest of the world pick up.
Figure 6.3.Impact of 2.5 percent Decrease in Asian Tradable Productivity: GIMF Simulations
Source: IMF staff calculations.
1 Increase indicates depreciation.
Directions of Future Work
The analysis presented above offers useful insights, but there are a number of possible extensions to the model that could provide richer insights into potential spillovers affecting Saudi Arabia. Two immediate priorities are: (i) to deepen the analysis of oil market behavior to enable an exploration of the implications for Saudi Arabia of its spare capacity in oil supply; and (ii) to develop a Mashreq12 bloc that would capture the impacts of the Saudi economy on the MENA region through both trade linkages and flows of workers’ remittances.
GIMF, developed at the IMF by Kumhof et al (2010), is a multi-region dynamic stochastic general equilibrium model. The model integrates domestic supply, demand, trade, and international asset markets in a single theoretical structure, thereby allowing transmission mechanisms to be fully articulated. Its features have been found important for replicating real-world behavior, including finite planning horizons of households and firms, gradual adjustment of prices and nominal wages to unexpected changes, and macrofinancial linkages in the form of a financial accelerator. The model is well suited to analyzing the effects of monetary policy, fiscal policy, and structural reforms, as well as the global and regional implications of these policies and other events. The version employed in this paper has three economic regions—Saudi Arabia, emerging Asia (including China), and the rest of the world.
Following the version of GIMF featured in IMF (2011), an oil sector is added. In GIMF an economy is divided into 10 interlinked micro sectors.1 There are wide-ranging nominal and real rigidities at the sectoral level generating realistic inertial dynamics for key macroeconomic aggregates. Unions, manufacturers, and distributors face nominal rigidities in price setting, while retailers and importers are subject to real adjustment costs as it is costly to rapidly adjust their sales volume. Manufactures are also subject to real adjustment costs in capital accumulation.
Each economy is populated with two types of households, overlapping generations (OLG) households, and liquidity-constrained (LIQ) households. The main difference between these two types of households is that the latter do not have access to financial markets, and are forced to consume their after-tax income each period. Unions buy labor services from the two types of households and sell them to manufacturers who also purchase capital goods from distributors and use the three production factors—oil, labor, and capital—to produce tradable and nontradable intermediate goods. The intermediate goods are then sold to domestic distributors and import agents of foreign countries—this is the first layer of trade (intermediate goods trade). Distributors combine domestic and foreign-produced tradable goods, along with nontradable goods, with positive benefits from public infrastructure, to produce output that will be used as inputs in the production of domestic consumption and investment goods, on the one hand, and as exports of those same goods on the other—this is the second layer of trade (final goods trade). Final goods producers sell their final outputs to the government and retailers, who in turn sell their output to households.
Oil is a third factor of production and also a second factor in final consumption, in addition to output of goods and services. The price and availability of oil therefore influence production as well as consumption possibilities and choices. The price responsiveness of oil demand is an important parameter determining the impact of changes in oil market conditions, reflecting the scope for the substitution of oil by other factors. On the supply side, there is an exogenous oil endowment which is exhaustible and costly to extract, with oil supply being responsive to higher oil prices with low price elasticity. Finally, there is a difference between the market price and extraction costs—oil rents. This rent is distributed between the domestic private sector and the government.
GIMF relaxes the conventional assumption that all government spending is wasteful and does not contribute to aggregate supply. Instead, public investment spending adds to a public capital stock, which enhances the productivity of the producers of domestic goods. The government determines how the fiscal-balance-to-GDP (surplus) ratio responds to excess revenue (from oil, in the case of Saudi Arabia) using a simple fiscal policy rule. The rule can be determined so as to be procyclical, neutral, or countercyclical. In the case of Saudi Arabia, it is assumed to be a budget surplus of 4.5 percent of GDP that stabilizes NFA at its end- 2010 level, 105 percent of GDP. All excess surpluses accrue to a hypothetical sovereign wealth fund.
Monetary policy is modeled as an augmented Taylor rule which traditionally aims to stabilize output and inflation through the manipulation of the nominal interest rate. In the case of Saudi Arabia and Emerging Asia, the rule is fully tilted towards a preference for no nominal exchange rate volatility to reflect the fixed exchange rate regime in these regions. Thus AS and SA target the nominal RW exchange rate, thereby importing the short-term nominal rate from RW. Inflation in SA (or AS) adjusts to account for the real exchange rate movement (usually based on the underlying savings-investment behavior) relative to the nominal fixed rate. The rest of the world is assumed to follow an inflation targeting regime. Nominal rigidities here include sticky inflation Phillips curves in each sector of the economy.
The model is calibrated to contain three blocs: Saudi Arabia (SA), emerging Asia including China (AS) and the rest of the world (RW). Each period corresponds to one year.
Saudi Arabia is assumed to comprise 0.7 percent of world GDP and a steady-state inflation rate of 3 percent per year. Emerging Asia has a steady-state inflation rate of 3 per year, while RW has a rate of 2 percent per year. The steady-state rate of technological progress is assumed to be 2 percent per year, population is assumed to grow at 1 percent per year, and the real interest rate in emerging Asia and the RW is assumed to be 3 percent in the initial steady state. The structural parameters regarding household preferences and firm technology are set as follows: households in all blocs are assumed to have a planning horizon of 20 years, and a decline in lifecycle worker productivity of 5 percent per year. Fifty percent of Saudi Arabian and AS households are assumed to be liquidity-constrained, while this share is 30 percent in RW. These proportions are consistent with Kumhof and others (2010).
|Variable||Saudi Arabia||Asia||Rest of the|
|Size (sums to 100)||0.694||12.745||86.564|
|Shares of GDP|
|Exports of goods and services (non-oil)||6.5||28.1||3.8|
|Imports of goods and services (non-oil)||54.9||23.2||4.1|
|Net exports of oil||48.4||–5||0.3|
|Government debt (% GDP)||5.0||37.0||40.0|
|Government balance (% GDP)||–0.2||–1.6||–1.8|
|Transfers (% GDP)||9.9||9.5||8.8|
|Oil production and demand (% GDP)|
|for consumption only||1.4||1.4||1.4|
Fiscal sector. Fiscal parameters such as the ratios to GDP of government transfers, purchases of goods and services, and public investment are calibrated based on end-2007 data. The productivity of public investment is calibrated following Kumhof et al. (2010), who, drawing on a large number of OECD and emerging market studies, estimate the elasticity of aggregate output with respect to public capital at 0.14. Accordingly, the model is calibrated so that a 10 percent real increase in public investment is associated with a long-run increase in real GDP net of depreciation of about 1.4 percent. In the absence of shocks, the fiscal balance is set to equal the value that stabilizes the debt-to-GDP and NFA-to-GDP ratios at the end 2010 levels of 4.5 and 105 percent, respectively.
Oil sector: In the simulations, the long-run price elasticity of oil demand in both production and consumption is assumed to equal 0.08.1 However, in the short-run oil demand meets a virtually inelastic oil supply curve. Thus oil demand drives prices in the short run, and causes some overshooting in the clearing oil price. The contribution of oil to output parameters has been calibrated at 2 to 5 percent, depending on oil cost share in a given sector and region. Oil supply can be responsive to higher oil prices, with a low price elasticity of supply of 0.03. Initially 40 percent of oil revenue is assumed to be used to make payments for intermediate goods inputs and that thereafter the real extraction cost per barrel increases at a constant annual rate of 2 percent. While in industrial economies the government is assumed to extract only a small share of oil rent, Saudi Arabia and the oil exporters in the Emerging Asia bloc receive 90 percent of rents. These large rents are not immediately consumed; rather, they are accumulated in a U.S. dollar-based fund, with spending at a rate of 3 percent per annum.
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Prepared by Samya Beidas-Strom, who is grateful to Dirk Muir, Daniel Leigh, Heesun Kiem, and Dong Wu for technical support.
The short-run multiplier is defined as a one-year average of real GDP (deviation from baseline) for the cumulative fiscal expansion package divided by a 4.5 percent fiscal balance (as a share of GDP) adjustment (i.e., withdrawal of spending measures).
This could be because interest rate earnings provide an opportunity cost to capital spending, as the steady-state real gross interest rate is 3 percent per annum in GIMF.
The smaller impact of capital spending on output differs from results found in the empirical literature.
The increases in general and lump-sum transfers are to the same fiscal-instrument-to-GDP ratio of 1 percentage point.
Changing the share of liquidity-constrained households could also be an additional sensitivity analysis.
NFA to GDP returns to its steady-state level gradually within 100 years.
The short-run global supply curve has 3 percent price elasticity. See Appendix 6B for more details.
Other shocks (such as a fall in oil intensity in Asia, perhaps due to a preference for renewable energy; and a capital tax shock, to address overheating and demand rebalancing in Asia towards consumption) were carried out with similar effects.
The Mashreq is a net oil importer group of Middle Eastern countries comprised of Egypt, Jordan, Lebanon, and Syria.