The financial sector and business cycle linkages in the emerging Guyanese oil economy

The recent oil price fluctuation has created concerns for many oil-exporting countries and particularly for the Organization of the Petroleum Exporting Countries (OPEC) members. For Gulf countries, hydrocarbon exports represent more than half of total exports. Oil revenues account for 80 percent of total fiscal revenues, on average and about 20 percent of Gross Domestic Product (GDP). In addition, the projection prices for oil fall below fiscal breakeven prices, in the medium-term for most countries. In many of oil-exporting countries, the financial sector has grown fairly large, and macro-financial linkages can exacerbate oil price shocks. The high volatility of oil prices could build systemic financial sector vulnerabilities, which in turn could adversely affect the real economy.

Oil price fluctuations have a major impact on the public finances of developing, oil-exporting countries. The budget structure, the inability to smooth spending due to a lack of pertinent financial instruments, and limited access to credit markets combined with political and institutional constraints force governments to conduct procyclical fiscal policies, when facing an oil shock. Moreover, in most oil-dependent countries government investment expenditure and current spending drive non-oil GDP growth. As a result, oil price fluctuation determines the business cycle in the absence of a well-diversified economy.

Although for an economy such as Guyana, there will be an oil revenue windfall, the economy should be modelled as an autarky (economic independence or self-sufficiency) and it abstracts from exchange rate regimes. In addition to other traditional sectors in the real economy, the new economic model for Guyana must include a national oil fund collecting a share of oil revenue and a fiscal regime that depends on this fund in addition to oil revenues. This setting will allow for the determination of the role of fiscal policy in transmission of the oil price volatility to the economy. The fiscal policy ought to be guided by the public policy objective to increase capital expenditure, household incomes by transfers, and subsidies to firms (traditional and new sectors for economic growth) as a means of sharing the oil revenue. This will result in a highly procyclical fiscal regime.

Further, the new national development fund for Guyana (Natural Resources Fund) should be set to act as a saving fund, but also as a stabilization fund to hedge against the liquidity risk in the banking system. To capture government involvement in state-owned enterprises (SOEs), the government will have to provide productive capital to intermediate goods producers. Although the government fiscal regime remains a major player in the transmission of shocks, banks in transition economies like Guyana are key agents in spreading shocks across sectors of the economy. Banks give commercial loans to firms that produce goods, purchase government bonds, and finance their operation partly by borrowing through the interbank market from deposit collector banks and partly by the national development fund, which acts as a stabilizer. The endogenous interbank rate depends on the supply of deposits, which in turn is reliant upon government transfer to households. Also, banks are key in determining government bond rates and interest rates on loans to good-producing firms, thereby linking the real business cycle to the financial cycle.

Oil price shocks can affect the financial sector through multiple channels. First, with lower revenues, the government must adjust its capital expenditure. The government usually holds a large stake in SOEs and entities in a variety of sectors, and many of these SOEs remain dependent on the government’s financial support through subsidies and transfers. Therefore, lower oil revenues and government spending reflects in the economic activities of SOEs, which in turn contract out big projects to private sector companies. As government investment falls, many of these subcontracts to private firms will halt, and many investment projects will fail. Therefore, banks’ nonperforming loans (NPLs) can increase not only as a result of direct exposure to SOEs, but also because of the private sector’s failing projects. Higher NPLs diminish the credit availability in an economy, particularly to the private sector where access to finance is often a challenge in oil-exporting countries.

Second, governments remain the main employer in developing, oil-exporting countries. As oil revenues drop, efforts to contain the public wage bill increase, resulting in declines in household disposable income, consumption, and, importantly, bank deposits. Higher households’ financial fragility and the possibility of falling into arrears raises nonperforming loans, making credit less available to borrowers who are dependent on bank financing. This development also affects banks’ ability to make new loans. Moreover, deposit volatility makes liquidity management difficult and costlier for banks, requiring them to borrow from the central bank (in absence of a developed interbank market) at a premium rate. Accordingly, because of the liquidity risk, the cost of supplying longer-term lending heightens.

Third, with a lower non-oil GDP growth rate due to an oil shock, the financial markets and other real sector markets would stagnate. This is because banks are highly exposed to these markets, higher credit risks emerge, which eventually feeds back into the real economy and leads to a lower credit to the overall economy. Other channels, such as lower international reserves accumulation and capital outflow, remain important in the long run.

For the sake of simplicity, several results prevail for an economy like Guyana. First, the government’s role in the propagation of shocks remains will be crucial. A positive oil shock will boost fiscal revenues and enlarges the fiscal space, which lets the government expand the social transfer to households and increase public capital expenditure. Wealthier households consume more, but their behaviour on labour allocation also changes. Additionally, higher public investment raises non-oil output, which should result in a higher fiscal multiplier.

Second, due to development of new complementarities between the oil and non-oil sectors in our emerging energy economy, the labour market will become an important driver of shocks’ diffusion. Because of fixed labour supply in the economy, this channel becomes important essentially for the oil-sector technology shock and the oil price shock. However, this effect dampens the shock impacts on consumption and GDP and prevents the wage and prices from acting as automatic stabilizers to avoid large swings of production factors between sectors.

Finally, while banks do not have important roles in spreading the shocks, they have a critical role in amplifying them. This is because the oil sector is not directly exposed to the banking sector, the non-oil companies are not credit constrained. However, the diverse banking system, including deposit and lending banks, differentiate various market interest rates between households, government, non-oil firms, the national development fund and the central bank.

Therefore, if the economy has slack capacity of labour, the results can be somewhat different, and a positive technology shock or oil price shock would have larger impact on GDP and consumption. As such, policies aimed at stabilizing wages and prices prevents these variables to play their role of automatic stabilizers to avoid large swings of production factors between sectors. The detrimental effect on the non-oil sector also results in a pro-cyclical behaviour of the monetary policy to support price stability and stimulate the non-oil sector. Nevertheless, this setup can compensate for the lack of an exchange rate in the economy to capture a similar Dutch disease kind of phenomena in oil economies.

Further, when the oil revenues increase due to higher oil prices or a positive technological shock, the government magnifies the transfer to households and increases public capital expenditure. Higher transfer indeed improves consumption, but it also affects the households’ decision of labour allocation. On the other hand, since public capital is used in the non-oil output, total output should increase proportionally, which would result in a higher fiscal multiplier.

Additionally, although banks do not play a key role in the propagation of oil shocks in an economy such as Guyana, they have a critical role in amplifying them. Since the oil sector is not directly exposed to the banking sector, and non-oil firms are neither credit constrained nor is a default allowed in the economy, banks are not essentially driving the responses to the oil sector shocks. Instead banks in such economies can differentiate between market rates.

In reality, the oil sector is capital intensive. Additionally, the labour force is very specialized and the degree of substitutability remains low. Furthermore, the current economy abstracts from the exchange rate and trade. Indeed, for a new oil economy the major export will be oil and the revenues will be accrued to the government and a sovereign wealth fund or a development fund. The negative spill over effect from the oil to the non-oil sector can be exacerbated by the current nature of our small open economy and introducing a real exchange rate. Moreover, by choosing credit-constrained firms and introducing collaterals, the banking system becomes part of the propagation mechanism and the financial accelerator must function. Finally, the central bank of the new Guyanese oil-exporting economy must have the implicit mandate of exchange rate stabilization. The economy must be dynamic and can be improved by choosing exchange rate stabilization as one of the objectives of the central bank.