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VII External Shocks, Policy Responses, and Domestic Adjustment

Author(s):
Volker Treichel, and Ahsan Mansur
Published Date:
November 1999
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Author(s)
Saade Chami Chami

External Shocks, Policy Responses, and Domestic Adjustment

Oman’s economy is extremely vulnerable to terms-of-trade shocks because of its heavy reliance on oil export proceeds, which account for more than 90 percent of exports. Over the past 20 years the price of oil has fluctuated considerably, and with it Oman’s current account balance. The price of oil surged in the mid- and late 1970s, collapsed in the mid-1980s, and recovered somewhat in the 1990s. In the past, Oman was able to respond to these shocks by incurring large budget deficits, financed primarily by drawing down previously accumulated foreign exchange reserves and by resorting to external borrowing. Given the reduced availability of official external reserves and of the country’s oil resources, however, the scope for similar policy response in the future is limited.

Oil prices will likely continue to be volatile, and therefore policy measures will be needed to respond to future negative external shocks without further depleting official assets or bringing forward the depletion horizon of oil reserves. In the meantime, favorable oil price developments, should they occur, would provide the opportunity for introducing needed adjustment and structural reform measures, since policies undertaken during an adverse terms-of-trade shock have more severe implications than policies implemented in a timely and orderly manner.

Against this background, this section examines how Oman responded to oil price shocks over the 1980–97 period; evaluates the effects of the policy measures used in response to the four distinct terms-of-trade cycles during that period; reviews the appropriateness of the policy instruments used in the adjustment process; and highlights some of the policy challenges now facing Oman and some policy responses that would enhance the country’s capacity to absorb future shocks. Results based on broad economic indicators show that although the import intensity of the economy was reduced during the negative shocks, imports were not compressed sufficiently, and this outcome reflects the expansionary and countercyclical fiscal policy of the period. At the same time, non-oil exports increased significantly, although from a very small base, in part as a result of promotion measures, a much depreciated currency (as measured by the real effective exchange rate), and a decline in real wages. Given that fiscal policy was the main instrument used to shield the economy from adverse terms-of-trade shocks, the structure of the economy remained virtually unchanged, resources were considerably reduced, and the economy’s ability to withstand future oil price shocks was further weakened.

The remainder of the section is organized as follows. We first look at adjustment policies in response to external shocks in a general context by reviewing briefly the policy options and the role of macroeconomic policies and structural reforms. The successful experience of Indonesia in adjusting to oil shocks is also discussed.1 Oman’s policy choices and constraints and its actual adjustment to external shocks during 1980–97 are then described. We then link the outcomes of these shocks to the policy measures undertaken. The section concludes with some observations and policy lessons for Oman.

External Shocks and Adjustment

Unfavorable external shocks caused by a steep decline in the price of an export commodity can have serious implications for macroeconomic performance if the policy response is inadequate. Studies have shown that a country’s economic performance depends in part on how quickly and efficiently it reacts to external shocks, and that it is not so much the external shocks themselves as the domestic responses to them that determine a country’s success or failure (Little and others, 1993).

In general, countries have at their disposal a host of policy variables with which to respond to external shocks. The most important policy instruments include fiscal and monetary policies and their appropriate mix, to steer the economy back toward a sustainable path by restoring macro economic balance; exchange rate policy, to permit a rapid adjustment in the relative prices of tradables and nontradables and maintain external competitiveness; labor market policies entailing flexible wages and the alleviation of other tabor market distortions, to preserve or enhance the country’s competitiveness in the world market; and structural reform policies aimed at enhancing the role of the private sector and reducing rigidities in the market. The relative importance of each of these policy instruments depends on the specific economic and institutional characteristics of each country.

Role of Macroeconomic Policies

Fiscal policy is critical to adjustment. Measures designed to restrain spending and mobilize saving are essential in responding to unfavorable external shocks. Policymakers frequently tend to postpone structural adjustment to an adverse shock by cutting capital expenditure. The lightening of fiscal policy through the postponement or elimination of large, capital-intensive and import-dependent projects has the added advantage of directly improving the current account balance. However, such a policy is not sustainable if the shock is of long duration, since it is detrimental to the formation of capital stock in the economy—this type of public investment tends to crowd private investment in rather than out.2 Although revenue-enhancing measures take lime to devise and implement, they have positive and lasting effects that provide good protection against future external shocks.

Exchange rate adjustment remains one of the most efficient ways to respond quickly to temporary and unexpected negative external shocks. Depreciation of the currency improves the competitiveness of exports, makes imports more expensive (thus giving rise to expenditure-reducing effects), and shifts resources from those sectors producing nontradables to those producing tradables (expenditure-switching effects). Devaluations in terms of the nominal exchange rate, however, remain unpopular and often are used as policies of last resort, because their effects are powerful and can spread rapidly across all segments of society, disturbing the implicit social contract (Woo, 1994).

Interest rate policy is directed primarily at private sector investment and saving, lo reestablish macro-economic equilibrium in the wake of a terms-of-trade shock. However, the effectiveness of interest rate policy in addressing macroeconomic imbalances depends on the degree of capital mobility and on the exchange rate regime. If the exchange rate is fixed and the capital account is fully open, the scope for using domestic interest rates to stabilize the economy is limited.

Structural Reforms

Structural reform measures generally take longer to put in place than do macroeconomic policies and are unlikely 10 overcome the negative impact of external shocks in the short run. Their importance derives, however, from their lasting impact on macro-economic adjustment and stability; their ability to reorient private sector behavior, enhancing economic efficiency and growth prospects; and their effects in diversifying the economic base. The role of structural reforms in realizing these objectives does not manifest itself easily in robust statistical relationships; nonetheless, there is a consensus that, combined with macroeconomic stability, structural reforms can elicit a supply response and increase growth and efficiency. More important, reducing rigidities and regulatory constraints and creating an environment conducive to private sector investment (particularly foreign investment) are critical in countries where the public sector plays a dominant role and policies have been inward looking.3

Labor Market and Wage Policy

Labor market reform is critical in bringing about a durable response to an external shock through enhanced competitiveness and improved resource allocation. Labor market rigidities and segmentations restrict labor mobility, create wage differentials beyond those warranted by differences in productivity, and thus hinder the efficient allocation of resources.

In general, for economies highly dependent on exports, the unit labor cost relative to those in partner countries is a key element in responding to shocks and sustaining growth (Mazumdar, 1993). Wage policy acquires a special importance in responding to external shocks when the nominal exchange rate is fixed. Labor market conditions that influence wage rates and factor productivity are potentially as important as the effects of nominal exchange rate adjustments in defining labor unit costs and competitiveness.4 The difference lies in the speed with which these adjustments are transmitted in the economy. Leaving this speed differential aside, wage adjustment would be a preferable policy option since it provides a positive signal for foreign investors, who sometimes are concerned about frequent nominal exchange rate adjustments and are interested in cost and efficiency considerations.5

Indonesia’s successful adjustment to external shocks and its efficient and timely use of policy instruments are illustrated in Box 7.1. Even though the Indonesian economy is structurally different from Oman’s and has a more diversified base, the two countries shared a high degree of dependence on oil revenues during the period under consideration. Indonesia’s experience is therefore relevant to the situation in Oman.

Adjustment to Terms-of-Trade Shocks in Oman

Policy Setting and Constraints

Oman is a small, open economy with perfect capital mobility and a fixed exchange rate regime. The rial Omani is pegged to the U.S. dollar, and the exchange rate has remained fixed for decades except for a small devaluation in 1986. The structure of the economy and the constraints imposed by policymakers on the use of certain policy instruments have important implications for the way Oman can adjust to external shocks.

First, the Omani authorities attach great importance to the stability of the nominal exchange rate and consider that this arrangement has served the country well. Accordingly, although the authorities have not completely ruled out exchange rate adjustment in the past—as reflected in the 10 percent devaluation in 1986—exchange rate adjustment is not currently viewed as a policy option in responding to a deterioration in the terms of trade. Policymakers in Oman are concerned that a devaluation of the currency and the perception that it has become unstable could lead to loss of confidence in the economy, with a negative impact on domestic and foreign investment.

Second, in view of the fixed exchange rate and the open capital account, monetary policy has very limited scope, particularly in the absence of financial market distortions. In a fully liberalized financial system, the difference between domestic and foreign interest rates reflects risk elements and institutional differences related, among other things, to fees and taxes. In the past, when interest rates and credit allocations were subject to ceilings and restrictions, domestic interest rates could differ markedly from foreign rates. However, many of the distortions that once characterized the Omani monetary system have been eliminated in recent years, and the leverage of monetary policy over the economy has diminished considerably (see also Sections V and VI).

Third, although Oman has long maintained a liberal employment policy with regard to expatriate labor, its labor policy is constrained by labor market segmentation, partial rigidity of the wage rate, and the presence of a large public sector with generous entitlements. The two major labor market segmentations that are visible in Oman are those between the public and the private sector and between Omani national and expatriate labor. Available data on average wage rates in the private sector over the last decade indicate that wages have been quite flexible. This flexibility, however, was limited primarily to expatriates’ wages; wages for Omani nationals, particularly in the public sector, were not as flexible. In addition, public sector jobs offer higher entry-level wage rates and much greater benefits than the private sector, creating a leverage effect on private sector wages. A liberal labor market policy and a flexible wage policy also have special roles in the “Omanization” of the labor force currently under way. In the absence of wage flexibility for all, the Omanization strategy could lead to efficiency and productivity losses, discourage private domestic and foreign investment, and hinder the development of the non-oil export base and diversification, and thus could undermine the government’s objective of making the economy less vulnerable to adverse shocks.

Terms-of-Trade Shocks and Policy Responses

Although major external positive shocks took place in the 1970s, with the tripling of oil prices in 1973–74 and their further substantial increase in 1979—80, in this section discussion of external shocks and the policy responses in Oman is limited to the 1981–97 period, primarily because of data limitations. This period is broken into four phases, coinciding more or less with the terms-of-trade cycles, with 1981 used as a benchmark year. The first phase, 1982–86, reflects the significant deterioration in the terms of trade, which reached its lowest point in 1986. with the collapse of oil prices (Figure 7.1). Over this period the terms of trade deteriorated by about 57 percent, with a 50 percent decline in 1986 alone, when the price of Omani oil dropped from $27 to $13.50 a barrel. The second phase, covering 1987–90, was characterized by an upward trend in oil prices, which reached its peak in 1990 following the regional crisis. The terms of trade improved by 8 percent, and the oil price rose to a peak of $21.50 a barrel in 1990, The third phase, covering 1991–95, was characterized by a general downward trend in oil prices; the terms of trade fell by 30 percent, and the export price of crude oil declined by $5 a barrel. The fourth phase, covering 1996–97, saw a sharp increase in oil prices: the terms of trade increased by 25 percent, and the crude oil price rose by more than $2 a barrel. Given the dominance of oil exports in the trade account, the movement in the terms of trade tracked closely the path of crude oil prices, especially at limes of large price movements. In those oil-exporting countries that usually have a merchandise trade surplus, export price changes tend to have a proportionately stronger impact on the trade balance than do similar changes in import prices.

Box 7.1The Indonesian Experience with External Shocks

Indonesia presents an interesting case study for analyzing the macroeconomic effects arising from oil-related shocks and the use of policy instruments in responding to these shocks. Its experience is of relevance to both other developing countries and other oil-exporting countries. Although the Asian financial crisis of the late 1990s revealed major structural deficiencies in its economy, Indonesia previously enjoyed success in addressing negative external shocks through flexible macroeconomic management and swift structural reform. These have enabled the country to maintain macroeconomic stability while improving its social indicators. When the price of oil collapsed from $28 to $10 a barrel in 1986, the government responded swiftly, devaluing the currency by 45 percent, reducing public investment in the short run, and allowing greater foreign investment in the country by adopting far-reaching structural adjustment measures, including measures aimed at increasing labor market flexibility. The principal initiatives undertaken were the following:

  • A strong fiscal package—designed to restrain spending and mobilize revenue (with emphasis on non-oil tax revenue)—was the central element of the policy package. This strong fiscal adjustment was also necessary to support the other policy measures taken in response to the external shock, to translate the nominal currency devaluation into a real effective exchange rate adjustment, and to reduce the burden on interest rates to protect private sector credit and investment.
  • The rupiah was devalued in terms of the real exchange rate by 55 percent between 1981 and 1988, essentially in two major nominal devaluations effected in 1983 and 1986. In some instances in the past (e.g., in 1978), Indonesia had resorted to devaluation even in anticipation of a decline in the oil price, on the assumption that the extent and cost of devaluation would be less if measures were taken before rather than during a balance of payments crisis.
  • Devaluation and restrained fiscal policy were not sufficient, however, to deal with the exogenous shocks that occurred, and the policy package had to be supported by other policy actions. These included measures to improve flexibility in the labor market, characterized by free mobility between urban and rural areas and downward adjustment in real wages; other structural reforms, which were instrumental in making the economy more resilient to external shocks; and measures to reduce the incidence of poverty. The structural reform measures were in the areas of financial sector reform, trade reform, and deregulation of the real sector; investment regulations applying to domestic and foreign investors were also simplified.

Deregulation of the economy rendered the economy more efficient: Total factor productivity growth increased from an average of—2.5 percent in 1982–85 to 1 percent in 1986–88. The rate of return on investment increased from 13 percent to 22 percent. And the incremental capital-to-output ratio fell from 7.8 to 5.2 between the two periods (Woo, 1994).

Figure 7.1Terms of Trade and the Real Effective Exchange Rate

(1990= 100)

Sources: Data provided by the Omani authorities; IMF, World Economic Outlook, Information Notice System, and staff estimates.

A Methodology for Evaluating Policy Responses

To examine the responses to the external shocks just discussed, this section presents some quantitative analysis based on the approach developed by (McCarthy, Neary, and Zanalda 1994).6 This approach decomposes the responses to external shocks during 1981—97 in terms of four performance measures: import intensity, economic compression, export promotion, and changes in the level of external debt as a balancing (residual) item. These performance measures might also reflect in part the effects of other factors that could be at work but are not related to specific policy changes; thus the performance measures should be interpreted as providing only broad indications of the adjustments achieved. For this purpose the effects of the shocks on the external sector are estimated in relation to GDP. and the policy responses are measured (also in percentages of GDP) essentially in terms of deviations from trend. In the case of Oman, only the terms-of-trade shocks are considered, given their predominance in the country’s external sector developments.7

The variables in this analysis are defined as follows:

  • The terms-of-trade effects are the sum of the import effects resulting from changes in the import price, which are quite small, and the more substantial export effects arising from changes in the oil price.8 This approach avoids the problem of using fixed weights by updating the weights of imports and exports each year.9
  • Import intensity is measured in terms of deviations of actual imports from a hypothetical path derived from an import function with a constant income elasticity.10 Thus the intensity of imports measures the change in imports resulting from a change in import elasticity.
  • Economic compression measures the effects on imports due to a slowdown in economic growth, under the assumption that the elasticity of imports with respect to GDP remains constant. It is calculated by multiplying the initial share of imports in GDP by the estimated change in the real output gap, as measured by the difference between actual output and an estimate of trend output. The trend output is frequently derived by estimating (using regression analysis) a trend function over some period lying outside the bounds of the period under investigation and characterized by the absence of any major shock.11 However, in the 1970s Oman experienced very high growth rates during a period when two major positive shocks took place; these growth rates were not sustainable over the medium or the long term and hence could not be considered trend growth rates. Therefore, a trend growth rate of 6 percent is assumed, which is plausible given that the rate of annual population growth ranged between 3.5 and 5 percent and that the rate of annual increase in investment averaged about 8 percent over the period. The qualitative results of the analysis would not be affected, however, even if the trend average growth rate differed by a few percentage points from the assumed rate.
  • Export promotion is ideally a measure of the change in exports given a constant income elasticity of demand in the country’s trading partners. In some studies the growth in a country’s exports by volume is compared with world export growth, with the difference between the two taken as measuring the efforts undertaken by the country to promote its exports, 12 Given that Oman’s exports consist almost entirely of oil and that Oman is a price taker in the international market, demand conditions in the rest of the world as well as world exports are not relevant factors in measuring Oman’s export promotion. Accordingly, non-oil export promotion has been measured by multiplying the difference between the growth rates of non-oil exports and non-oil GDP by the level of non-oil exports in the preceding period—higher rates for non-oil export growth than for non-oil GDP growth reflect the effect of underlying export promotion efforts.

Quantitative Evaluation of Responses to Shocks

Over 1982–86 the cumulative impact of negative terms-of-trade shocks on the trade balance was estimated at 45 percent of GDP (Table 7.1), with 1986 alone accounting for about 35 percentage points of that impact, owing to the sharp decline in oil prices that year (Table 7.2). The responses to this severe adverse shock were a significant (albeit not sufficient) reduction in import intensity by 10 percent of GDP and a relatively modest increase in non-oil export promotion accounting for less than 1 percent of GDP. Although the response of non-oil exports was negligible given the size of the shock, it remains nevertheless significant in view of the narrow non-oil base of the economy. Non-oil exports increased from 0.3 percent of total exports in 1980 to about 2.6 percent in 1986 (and subsequently to 8.4 percent in 1997), reflecting some improvement in the diversification of Oman’s export base. The positive effects of import intensity were partially offset, however, by an opposite movement in economic compression—as measured in terms of import reduction—because of higher than normal non-oil GDP growth rates sustained largely by an expansionary fiscal policy, which pushed up imports by about 5 percent of GDP.

Table 7.1Terms-of-Trade Shocks, Performance Measures, and Policy Instruments, 1981–97(In percent of GDP unless otherwise indicated)
Performance MeasuresQuantitative Policy Instruments
PeriodTerms-of-trade shock 1Change in import intensity 2Change in economic compression 3Change in non-oil export promotionResidual 4Overall fiscal deficitUnit labor cost (percent change) 5Real effective exchange rate (percent change)
Cumulative
1981−7.1−2.62.0−2.43.46.7
1982–8645.110.2−4.90.839.0−56.0−24.9
1987–90−10.45.62.40.7−19.2−24.4−9.06−15.1
1991–9512.00.40.22.19.3−48.1−19.4−15.1
1996–97−8.2−8.70.90.1−0.5−4.82.3
Averages
1981−7.1−2.6−2.0−2.43.46.7
1982–869.02.0−1.00.27.8−11.2−5.0
1987–90−2.61.40.60.2−4.8−6.1−3.0−3.8
1991–95240.10.41.9−9.6−3.9−3.0
1996–97−4.1−4.40.5−0.2−2.42.7
Sources: Data provided by the Omani authorities; IMF staff estimates.

Positive values imply adverse shocks.

Negative values indicate that imports are higher than expected.

Positive values indicate that imports would have been higher, if real GDP had grown at its estimated potential growth rate.

Represents external borrowing or drawing down of official reserves.

Measured in rials Omani for a representative sample of three manufacturing industries and two service sectors. A negative value implies that real wages adjusted for productivity factors are declining.

Because consistent data are lacking for the period before 1988, this refers to 1988–90 only.

Sources: Data provided by the Omani authorities; IMF staff estimates.

Positive values imply adverse shocks.

Negative values indicate that imports are higher than expected.

Positive values indicate that imports would have been higher, if real GDP had grown at its estimated potential growth rate.

Represents external borrowing or drawing down of official reserves.

Measured in rials Omani for a representative sample of three manufacturing industries and two service sectors. A negative value implies that real wages adjusted for productivity factors are declining.

Because consistent data are lacking for the period before 1988, this refers to 1988–90 only.

Table 7.2Terms-of-Trade Shocks and Macroeconomic Responses(In percent of GDP unless otherwise indicated)
Item198019811982198319841985198619871988196919901991199219931994199519961997
Terms of trade−20.3−7.11.76.70.51.834.5−6.511.7−6.5−9.28.6−0.25.50.7−2.5−7.4−0.8
Import intersity−2.6−5.34.81.2−1.713.786−1.50.2−1.60.7−0.6−0.63.7−2.9−1.1−7.8
Export promotion0.070,060.160.100.050.470.670.050.02−0.010.210.400.380.610.51−0.300.40
Economic compression−2.0−1.2−1.6−1.6−1.71.12.10.10.5−0.3−0.40.40.20.50.4
Residual−2.48.13.43.25.119.2−17.813.0−7.2−7.27.70.45.7−0.42.4−2.7
Memoranda:
Terms of trade (1990 = 100)188.6191.8183.5174.3173.1166.782.992.372.786.6100.086.382.577.771.870.084.857.4
Oil price (dollars a barrel)32.036.934.429.228.427.013.417.313.516.321.417.518.015.515.216.3.9418.6
Overall public sector deficit 1−0.13.43.0−8.3−10.7−8.2−20.0−5.0−10.7−8.0−0.7−5.5−12.210.7−9.8−8.8−4.4−0.1
Current account balance14.916.26.15.83.2−0.1−12.79.13.73.3950.1−2.5−7.3−42−3.90.3−7.0
Capital expenditure11.312.014.212.914.414.916.99.98.37.25.98.59.29.53.98.36.66.4
Current expenditure31.032.S34.937.938.237.641.836.839.838.135.434.237.136.636.235.531.530.5
GDP growth (in percent)17.411.612.913.914.52.1−4.05.23.08.46.08.56.13.84.611.02.2
Non-oil export growth (in percent)50.215.034.861.332.04.547860.35.59.87.922.426.718.925.4−4.917.3
Oil production (percent change from previous year)−3.715.52.315.77.419.312.44.36.63.26.93.44.75.13.85.43.81.1
Oil exports (percent change from previous year)−5.117.6−1.08.25.022.113.75.27.42.16.22.47.55.91.25.14.62.0
Sources: Data provided by the Omani authorities; IMF staff estimates.

Excludes SGRF operations.

Sources: Data provided by the Omani authorities; IMF staff estimates.

Excludes SGRF operations.

In the second phase, 1987–90, favorable terms-of-trade shocks with an impact amounting to about 10 percent of GDP were due essentially to the rise in 011 prices on international markets, particularly in 1990, when the terms-of-trade effect accounted for 9 percent of GDP (Table 7.2). With economic compression estimated at more than 2 percent of GDP, owing to lower growth rates brought about by the lagged adjustment in fiscal policy, import intensity was reduced further (by about 6 percent of GDP), and export promotion continued to improve.

Following the regional crisis of the 1990s, oil prices began to decline, and by 1995 the effects of this unfavorable terms-of-trade shock were estimated at 12 percent of GDP. The intensity and the compression of imports were marginal (both at about ½ percent of GDP). However, non-oil export promotion improved significantly, accounting for more than 2 percent of GDP, as exports grew at more than a 20 percent annual rate over most of this period, exceeding by far the rate of growth of non-oil GDP.

The fourth phase, that of 1996–97, was characterized by positive terms-of-trade shocks, whose effects represented about 8 percent of GDP. These shocks were due essentially to increases in oil export prices. Import intensity rose, partly as a result of the favorable terms-of-trade shock, but also on account of the impact of the LNG project, whose effects far exceeded the contractionary impact on imports of the economic compression, which mainly emanated from contractionary fiscal impulses. Export promotion was insignificant.

Policy Instruments and Economic Responses

The policy response measures just described were the outcome of policy actions (or inactions) that affected these measures either directly or indirectly, through other intermediate targets.

Fiscal Policy

The policy performance measures discussed above were insufficient to counter the deterioration in the terms of trade during 1982–86. Other factors, with impacts amounting to 39 percent of GDP, were needed to redress the unfavorable developments in the current account. The deterioration in the terms of trade that began in 1982 resulted in a severe worsening of the current account, which moved from a surplus of 16 percent of GDP in 1981 to a deficit of 13 percent in 1986, despite an average increase in the volume of production and exports of about 10 percent a year, offsetting in part the effect of the fall in oil prices (Table 7.2). This external sector development mirrored developments in the overall fiscal balance, which moved from a surplus of 3 percent of GDP to a deficit of 21 percent in 1986, resulting in a cumulative overall budget deficit for the period of 56 percent of GDP. A sustained increase in oil production and a countercyclical fiscal policy helped keep real total and non-oil GDP growth rates between 12 percent and 17 percent during 1982–85; these were very high rates by any standard. These high growth rates were only interrupted in 1986. when non-oil GDP growth became negative (-3 percent) and the growth rate of GDP dropped by more than 12 percentage points, to 2 percent. The countercyclical fiscal stance was reflected visibly in the high level of capital expenditure (which ranged between 13 percent and 17 percent of GDP) and the increased level of current spending (which increased from 30 percent of GDP in 1982 to 42 percent in 1986). The resulting fiscal impulses sustained non-oil growth rates at very high levels and prevented a compression of imports.

The fiscal adjustment in response to the severe 1986 shock began to take place only in 1987, given the inherent lags in adjusting expenditure, including capital outlays, in part because of contractual agreements. Most of the adjustment fell on capital spending, which declined from 17 percent of GDP in 1986 to 10 percent in 1987 and remained in the 7 to 9 percent range throughout the period. Meanwhile the decline in current outlays was relatively modest (4 percent) and short lived.

This lower level of public investment during the favorable external shock of 1987–90 also reflected the fact that some major investment projects had been completed, the fruit of 15 years of expansionary development programs. This led to a further reduction in import intensity, since this type of spending generally tends to have a high import content. As a result of lower government expenditure during this period, non-oil growth rates were lower, and consequently economic compression was increased. In 1991–95 the small adjustment in import intensity and in economic compression were apparently caused by a modest pickup in both capital and current expenditure in relation to the previous cycle. The contraction of current and capital expenditure in 1996 and 1997 led to some economic compression, even though overall imports were higher than expected, mainly on account of the LNG project.

Monetary and Exchange Rate Policy

Exchange rate policy was not used during the 1980—97 period except, as mentioned above, for a 10 percent devaluation in terms of the nominal exchange rate in 1986, when oil prices collapsed. Since then, a fixed and constant nominal value of the rial Omani with respect to the dollar has been maintained to enhance the confidence of the domestic private sector and of foreign investors. Relative to the size of the external shock, the devaluation was rather modest, and it is not surprising that it failed to have a significant positive impact on the adjustment process, particularly on the import side. However, in terms of the real effective exchange rate, the currency depreciated over the 1982–86 period by more than 25 percent, mainly as a result of depreciation of the dollar (Figure 7.1). It continued to depreciate in real effective terms thereafter; by 15 percent during the favorable terms-of-trade phase of 1987–90, and by a further 15 percent during 1991–95. In 1996–97 the currency appreciated in real effective terms by over 2 percent, mainly because of appreciation of the dollar. At the same lime, monetary policy was cautious, money growth rates were kept under control, and inflation was low.13 The resulting price stability also contributed to maintaining the depreciation, and this helped to some degree in reducing import intensity and increasing the share of non-oil exports.

Wage Policy

The impact of wage policy on the performance measures during the three phases in which terms-of-trade shocks occurred is very difficult to pin down given the lack of good labor market data in Oman.14 Nevertheless, within the limitations imposed by the data, an assessment of wage flexibility was undertaken to shed some light on the behavior of the wage rate during the period under investigation.

One measure of wage rate flexibility is the unit labor cost expressed in foreign currency, decomposed into three elements: the wage productivity gap, the shift in the ratio of consumer to producer prices, and the change in the nominal exchange rate.15 The unit labor cost measures whether real wages have remained in line with the level warranted by productivity changes—adjusted for changes in output prices relative to consumption prices—and the change in the nominal exchange rate. Given that in Oman the nominal exchange rate did not change during the period (except, as noted, in 1986), and that there was no significant productivity improvement (see Section II), the rate of change in the unit labor cost was basically the rate of change in actual real wages adjusted by the consumer-producer price differential. A positive (negative) rate of change in the unit labor cost implies that wages are becoming less (more) competitive.

The data in Table 7.3 indicate that real wages in a representative sample of the Omani economy—consisting of three manufacturing industries and two service industries—declined significantly over the entire period (Figure 7.2). Even under the assumption of zero productivity growth, the unit labor cost for expatriate workers declined by more than 33 percent on a cumulative basis during 1980–95. The real effective exchange rate based on the nominal unit labor cost (Figure 7.1) weakened sharply in 1994. making wages in Oman very competitive. This points clearly to the flexibility of expatriate wages, but unfortunately similar analysis could not be undertaken for Omani nationals for lack of data.

Table 7.3Changes in Average Unit Labor Cost and Its Components1(In percent per year unless otherwise noted)
PeriodWage

Productivity

Gap2
Consumer-

Producer Price

Differential
Unit

Labor

Cost
1988–90−421.2−3.0
1988−2.5−2.5−5.0
19893.33.26.5
1990−13.32.8−10.5
1991–95−6.01.1−4.9
1991−8.08.20.2
19924.6−5.3−0.7
1993−6.33.1−3.2
1994−19.1−0.7−19.8
1995−1.0−1.0
Cumulative

change, 1988–95
−42.38.8−33.5
Sources: Data provided by the Omani authorities; IMF staff estimates.

Unweighted average unit labor cost of a representative sample of three industries and two service sectors.

Represents the rate of change in actual real wages (nominal wages adjusted by the consumer price index), since no productivity gains are assumed to have taken place during this period.

Sources: Data provided by the Omani authorities; IMF staff estimates.

Unweighted average unit labor cost of a representative sample of three industries and two service sectors.

Represents the rate of change in actual real wages (nominal wages adjusted by the consumer price index), since no productivity gains are assumed to have taken place during this period.

Figure 7.2Unit Labor Costs in Selected Industries

(1988= 100)

Sources: Data provided by the Omani authorities; IMF staff estimates.

These movements in unit labor costs did not seem consistent with the terms-of-trade movements on an annual basis. However, looking more specifically at the individual cycles of terms-of-trade shocks shows that, on average, unit labor costs decreased by 3 percent a year during the 1988–90 period of positive shocks, and by 5 percent on average over 1991—95—a period characterized by a steady decline in oil prices and a deterioration of the terms of trade. 16 Although these results remain at best indicative, given the quality of the data and the short time series considered, the noticeable downward trend of the terms of trade over the whole period seems to have reinforced the real effective depreciation and consequently the reduction in import intensity and the increase in non-oil exports.

Other Structural Reforms

On the structural front, Oman recently introduced some measures that should encourage foreign investment and enhance the role of the private sector. Recent amendments to the laws governing corporate and security market taxation—reducing to some extent the differentiation between foreign and domestic residents—were designed to encourage foreign participation in all economic activities and hence broaden the non-oil production and export base. These measures have not been in place long enough to have any effect on the performance measures or the adjustment to foreign shocks.

Concluding Observations

Despite the negative terms-of-trade shocks of the 1980s and 1990s, Oman’s economy performed well, with buoyant growth rates, price stability, and a high standard of living for the population. Countercyclical fiscal policies—the increase in the fiscal deficit was greater than the terms-of-trade loss—shielded the economy from these adverse exogenous shocks but prevented or postponed adjustment in the domestic and external sector imbalances. Accordingly, the economic response to the shocks—measured in terms of import intensity, economic compression, and non-oil export growth—was modest. The ability to carry out an expansionary fiscal policy despite the terms-of-trade shocks was facilitated by the previous accumulation of SGRF reserves and the government’s capacity to borrow externally. The depreciation of the dollar in the world exchange market and the flexibility of expatriate wages have also contributed in responding to the terms-of-trade shocks. Significant depreciation of the currency in real effective terms—despite the limited use of exchange rate policy—contributed to a substantial increase in non-oil exports. However, because of Oman’s very small non-oil export base, the quantitative response in relation to GDP was rather modest. The expansionary fiscal stance, through its stimulatory effect on domestic demand, prevented the expected adjustment in the demand for imports.

This lack of adjustment has left Oman’s economic structure broadly unchanged and made it more vulnerable to future external shocks. Given the significant loss of SGRF assets and their investment income, and because of the accumulation of external debt in recent years, the government’s ability to withstand pressures has become limited, and Oman’s vulnerability to external shocks has been accentuated. Unless the remaining structural imbalances are addressed by appropriate policies, future shocks could have more adverse implications for the economy. The following are some lessons for dealing with the challenges ahead.

First, maintaining a fixed exchange rate regime and using the exchange rate as a nominal anchor in an open trade and capital account system imply a huge responsibility for fiscal, monetary, and wage policies. Although the role of monetary policy is constrained, a prudent approach to monetary growth would be needed to ensure price and wage rate stability and hence keep the pressure off the real effective exchange rate. An appropriate level of the latter remains very important for diversification and the promotion of non-oil exports.

Second, fiscal policy is critical to the adjustment to external shocks. Contractionary fiscal policy not only would reduce import intensity and increase economic compression, but would also enhance the role of the private sector and increase investment. The structural weakness of the budget would need to be addressed by streamlining current expenditure. Although investing in “white elephant” projects should be avoided, public sector development expenditure, particularly that related to infrastructure, should not be jeopardized given its positive impact on private sector investment. On the revenue side, the non-oil revenue base should be broadened to reduce the economy’s vulnerability to terms-of-trade shocks.

Third, improving the functioning of the labor market by reducing its segmentation and enhancing wage flexibility across sectors and nationalities is a prerequisite for stimulating private sector (particularly foreign) investment, increasing efficiency, and maintaining competitiveness. This would require removal of the remaining labor market distortions and a rationalization of the public sector benefit structures that currently bias job seekers in favor of the public sector.

Finally, although Oman has begun to deregulate and streamline the procedures for foreign investment, many impediments remain. These are related to the degree of foreign ownership, employment policies and quotas, and licensing formalities that are not conducive to foreign investment. Removal of the remaining barriers would enhance diversification and increase the resiliency of the economy to external shocks. A pro-business attitude with an open border policy combined with overall macroeconomic stability will prove key in mobilizing private sector domestic and foreign investment.

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1Clearly, Indonesia’s experience is not directly applicable to that of Oman given the fundamentally different structure a the two economics. There is, however, a certain degree of similarity given the high dependence on oil that prevailed in Indonesia during the period under consideration.
2It is reasonable to assume that crowding-in will result if public and private investments arc complementary, as is often the case with infrastructure, and crowding-out will result when they are substitutes, such as investment in manufacturing and service-related enterprises.
3In reviewing the experiences of some countries that underwent adjustment programs, (Goldsbrough and others 1996) showed that countries that have made significant progress in structural reform (such as Chile and Ghana) or began with relatively fewer structural distortions (such as Thailand) have achieved rapid productivity gains and become less prone to external shocks. Those, on the other hand, that have made little progress on the structural front (such as Senegal) lend to experience slow productivity growth and increased vulnerability to external developments.
4Thailand’s economic performance and its ability to weather adverse external shocks over the past 20 years were influenced to a great extent by its flexible wage policy and the absence of labor market segmentation that maintained its competitiveness, as measured by relative unit labor costs i Kochhar and others, 1996).
5Given the high level of globalization and integration of markets, it is becoming increasingly important for countries to use labor market reform tools lo attract foreign direct investment, and for business locations lo depend on encouraging market conditions and a friendly business environment.
6This approach was also used by a recent IMF occasional paper (Kochhar and others, 1996).
7McCarthy. Neary. and Zanalda (1994) looked al external shocks in the Philippines as they affected the terms of trade, global demand, interest rates, and additional debt service. The same set of variables, except debt service, was also used in Kochhar and others (1996). Interest rate and global demand shocks are not relevant in Oman given the relatively low level of external debt and the very small non-oil export base.
8Import and export effects are based on variations in the price and quantity of imports and exports each year. Thai is, the change in the value of oil exports (X) is measured as the volume of exports in year; times the change in the unit oil price (Pi) from the previous period. A similar method is used to derive the change in the value of imports.
9This also presumes that oil production decisions are independent of oil price fluctuations.
10Import elasticity is derived by regressing the logarithm of imports on the logarithm of GDP over the 1980-95 period. The estimated elasticity was about 0.7, which is lower than expected in an open and import-dependent economy such as Oman. One possible explanation of this low elasticity of imports is that the relatively large expatriate population contributes significantly to production but has a low rate of consumption, thus biasing the import elasticity downward. It was estimated in the context of the balance of payments compilation that expatriate laborers transfer a substantial part of their income (about 80 percent for low-skilled workers in the private sector) to their home countries.
11Another method used by Kochhar and others (1996) was based on minimising the variation of actual output (GDP) around a trend, subject lo certain assumptions regarding the variance of the cyclical component relative to that of the trend component.
12See McCarthy, Neary, and Zanalda (1994) for details.
13The only exception was 1997, when the money supply grew by 24,5 percent, mainly as a result of a credit expansion of 37,1 percent. Preliminary data for 1998 suggest that the growth of the money supply has since been brought back under control.
14Lack of data precludes the extension of the analysis to 1997.
15The unit labor cost (Uc) in dollar terms is defined asUc($)=W/V*1/e,where W denotes the wage rate per worker. V is value added per worker, and e is the exchange rate (in rials Omani per dollar). The following equation can then be derived:U˙c=(w˙v˙)+(P˙cPp˙)e˙,where the dots represent proportionate rates of change, w is the real wage, i’ is an index of productivity of labor, Pc is an index of the cost of living, and Pp is an index of prices of goods for which the unit labor cost is measured (Mazunidar, 1993). In the case of Oman, and given the lack of data. Pp measures the non-oil output deflator, v is assumed to be equal to zero (see Section II). and e has been zero except in 198n, when the rial Omani was devalued by 10 percent. Thus, the equation can be simplified toU˙c=w˙+(P˙cPp˙).
16The fact that wage movements were not consistent with the changes in the terms of trade taken one year at a time could be attributed to other factors not captured by the flexibility measure used above. Two possible factors could be cited in this regard. First, wages in Oman could be influenced to a large extent by supply considerations determined by external factors related to the economic conditions in labor-exporting countries, thus affecting the reservation wage rate for expatriates. In this connection, and since most of the labor-exporting countries are oil importers, their economic conditions may correlate negatively with those in Oman. This offers a possible explanation of the seemingly perverse behavior of wages in some years. Second, expatriate workers are normally hired and labor cards issued for a period of two to three years, creating a lagged adjustment in the wage rate with respect to terms-of-trade movements.

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