INSTITUTIONAL QUALITY AND CYCLICALITY OF MONETARY AND FISCAL POLICIES IN SAARC COUNTRIES.

• Author: Nawaz, Muhammad

1. Introduction

   According to classical economists, the price mechanism is self-correcting; it takes care of external and behavioral shocks to economic equilibrium in an economy. The role of the government, in their view, is therefore confined to maintaining law and order in the country. However, the onset and longevity of the Great Depression contradicted this viewpoint as classical economists could not satisfactorily explain the prolonged recession. Keynes (1936) took up the challenge and endorsed the classical view that the market mechanism works well but drew attention on its rather slow working; after a shock, the restoration of equilibrium may take a long time during which people suffer economic hardships. Therefore, to accelerate adjustment processes Keynes (1936) suggested that the best mechanism would be the counter-cyclical government intervention in the private economy (Morgan, 1978).

   Keynes' recommendations were adopted by many countries and were found to be working satisfactorily. However, over time, the stance of policy intervention changed from counter-cyclical to pro-cyclical in many countries due to political and economic reasons. Politically, a government or a central bank which initiates or sticks to expansionary policies gets applause from its public as more jobs are created, whereas a contractionary policy is opposed as it causes unemployment. Therefore, policy makers usually follow the policy of benign neglect in favor of expansionary policy; they keep on postponing contractionary policies unless they are badly needed (Branson, 1997; Gordon, 2006).

   On economic grounds, commercial banks and other financial intermediaries, which work as conduit of monetary policy, cannot help their profit-maximization motive if they restrict their lending over an expansionary phase and expand it over a recessionary phase. Therefore, they try to accommodate increasing credit demand in an expanding economy by issuing negotiable certificates of deposits, by raising funds from inter-bank and euro markets even if the central bank follows a contractionary policy. Similarly, they do not lend aggressively when the economy is slowing down because that means an increase in expected loan defaults; they rather keep their funds as excess reserves or park them in their overseas branches or in euro banks even if the central bank follows an expansionary policy. In other words, to maximize their interest earnings, commercial banks try to undo, within regulatory limits, the counter-cyclical stance of central banks (Roamer and Roamer, 2002; Meulendyke, 1998; Moore, 1988; Friedman, 1982).

   With regard to fiscal policy, sitting governments generally use government expenditures to 'bribe' their favorites which are said to be rent-seeking (Alesina, Campante and Tabellini, 2008; Ilzeteki and Vegh, 2008) and they hesitate to adopt a contractionary policy even if it is commendable on economic grounds. During recession they want to adopt expansionary fiscal policy but due to having huge domestic and foreign debts and due to having an underdeveloped financial system, they have difficulties to finance public expenditures at the desired levels. Furthermore, they also encounter difficulties in 'monetizing' their deficits because they are usually rampant in recessionary times. This difficulty as well as the uncertainty in financing the public expenditure, have dual stance in the literature for the cyclicality of macroeconomic policies.

   Therefore, a number of researches have tried to determine the cyclical stance of macroeconomic policies. For example, Alesina et al., (1986), Gavin and Perotti (1997), Kaminsky, Reinhart and Vegh (2004), Talvi and Vegh (2005), and Ilzeteki and Vegh (2008) concluded that monetary and fiscal policies in developing countries had been predominantly pro-cyclical. On the other hand, Melite (2000), Gali and Perotti (2003), Sack and Wieland (2000), and Lubik and Schorfheide (2007) concluded, on the basis of their estimation of monetary policy rules, that central banks of advanced countries have been generally able to conduct counter-cyclical monetary policy. IMF (2009) and OECD (2009) documented that OECD countries successfully followed expansionary monetary policies after the global recession of 2009. Yehoue (2009) concluded that unlike other developing countries, the so-called emerging economies were also able to conduct effective counter-cyclical polices, particularly after the recent global recession.

   In search of more specific reasoning, some recent studies including Calderon, Duncan and Schmidt-Hebbel (2004), Calderon and Schmidt-Hebbel (2008), Calderon, Duncan and Schmidt-Hebbel (2016) have used a comprehensive index of institutional quality for each country to understand the cyclical nature of macroeconomic policies. Their results show that both monetary and fiscal policies have been conducted counter-cyclically in countries which have the institutional quality index above the threshold level and pro-cyclically in countries which have the institutional quality index below the threshold level. The index value is in general higher for developed countries and lower for developing countries but there can be reverse exceptions for many countries such as Argentina, Brazil, Bulgaria, Chile, China and Kuwait (Calderon, Duncan and Schmidt-Hebbel, 2016). Therefore, institutional quality index seems more helpful to understand the cyclical nature of macroeconomic policies of different countries.

   However, the problem with Calderon, Duncan and Schmidt-Hebbel's (2004) study is that it uses a short span of data set (1996-2002) for 10 emerging economies (Argentina, Brazil, Chile, Colombia, Ecuador, Malaysia, Peru, the Philippines, Thailand and Venezuela) which belong to two different continents and do not share the same socio-cultural background. Therefore, it is quite possible that some of the impact attributed to the institutional-quality index may actually be due to variation in socio-cultural environment. The two later studies, Calderon and Schmidt-Hebbel (2008), and Calderon, Duncan and Schmidt-Hebbel (2016) got rid of some data limitations by using longer spans (1975-2005 and 1984-2008, respectively) and included a bigger number of countries (136 and 115, respectively) from different continents in their analyses; these aspects might have further obscured the true impact of institutional quality. Moreover, these studies have been scant in selecting the set of econometric techniques; Calderon, Duncan and Schmidt-Hebbel (2004) used Ordinary Least Square (OLS) and Generated Method of Moments (GMM) techniques; Calderon and Schmidt-Hebbel (2008) used OLS Instrumental Variables (OLS-IV) technique, while Calderon, Duncan and Schmidt-Hebbel (2016) adopted Pooled OLS and GMM-Fixed Effect (GMM-FE) and GMM-IV.

   As such, the objective of the current research is to extend the previous empirical work on four fronts. First, previous studies used data for a large number of countries for their analysis and this might hide the impact of institutional quality due to other differences in socio-economic backgrounds; this study focuses on a small group of SAARC countries that have more or less the same political and cultural background and have achieved more or less the same level of economic development. Secondly, the institutional quality index that is made up by aggregating 12 different components has been used as such in previous studies and might have led to some degree of econometric bias, whereas in this study, Principal Component Analysis (PCA) has been applied upon the given values of the index before using it in the model. Thirdly, Caldron, Duncan and Schmidt-Hebbel (2012) used the exchange rate as an explanatory variable for some countries and skipped it for others whereas this research includes the exchange rate as an explanatory variable for all countries in the sample because all of them had been following more or less the same managed floating exchange rate policy for the last three decades. Fourthly, in this...