metadata: authors: 0: author: Calderon,Cesar
1: author: Chuhan-Pole,Punam
2: author: Lopez-Monti,Rafael Matias
count: Africa
docna: 0: docna: Cyclicality of fiscal policy in Sub-Saharan
            Africa : magnitude and evolution
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Adjustment and Lending,Public Finance Decentralization and
            Poverty Reduction,Public Sector Economics,Global Environment,Energy and Natural Resources,Coastal and Marine Resources,International Trade and Trade Rules
teratopic: Macroeconomics and Economic Growth,Water Resources,International Economics and Trade,Energy,Public Sector Development
abstracts: cdata!: This paper studies the cyclical aspects
            of fiscal policy in Sub-Saharan Africa countries during
            1970–2014. It compares the cyclical properties of real
            government consumption in the region with those in other
            developing regions and high-income countries, and examines
            whether there has been a change in the cyclical nature of
            fiscal policy in recent years. The analysis finds that
            government consumption is procyclical in Sub-Saharan African
            countries, more so than in other regions, and that
            accounting for endogeneity increases the degree of
            cyclicality. The cyclical properties of government spending
            vary along the business cycle, with the level of cyclicality
            being larger when the level of real economic activity is
            above the trend relative to when it is below the trend.
            Mirroring the pattern in other developing regions, the
            degree of cyclicality has changed since 2002 in Sub-Saharan
            Africa, with incipient signs of a shift toward acyclical or
            more countercyclical policies. The evidence does not suggest
            that resource wealth or fragility increases the
            procyclicality of government consumption in Sub-Saharan
            Africa. Official development assistance is found to
            exacerbate the procyclical stance of fiscal policy in the
            region, but the result depends on the relative size of
            foreign aid received.
repnme: repnme: Cyclicality of fiscal policy in Sub-Saharan
            Africa : magnitude and evolution
display_title: Cyclicality of fiscal policy in
            Sub-Saharan Africa : magnitude and evolution
listing_relative_url: /research/2017/06/27668493/cyclicality-fiscal-policy-sub-saharan-africa-magnitude-evolution
topicv3: Natural Resources m1326446 1979,Government Expenditure m1326649 1112,Trade m1326924 698,Fiscal Policy m1327144 445,Environment, Natural Resources and Blue
            Economy m1327391 566
publishtoextweb_dt: 2017-06-22T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Water Resources,International Economics and Trade,Energy,Public Sector Development
no_of_pages: 34
author_keys: 0: author_key: 166739
1: author_key: 91092
2: author_key: 1461326
model_extractions: WPS8108 Policy Research Working Paper 8108 Cyclicality of Fiscal Policy in Sub-Saharan Africa Magnitude and Evolution _César Calderón Punam Chuhan-Pole Rafael M. López-Monti_ Africa Region Office of the Chief Economist June 2017
Policy Research Working Paper 8108

# **Abstract**

This paper studies the cyclical aspects of fiscal policy in Sub-Saharan Africa countries during 1970–2014. It compares the cyclical properties of real government consumption in the region with those in other developing regions and high-income countries, and examines whether there has been a change in the cyclical nature of fiscal policy in recent years. The analysis finds that government consumption is procyclical in Sub-Saharan African countries, more so than in other regions, and that accounting for endogeneity increases the degree of cyclicality. The cyclical properties of government spending vary along the business cycle, with the level of cyclicality being larger when the level of real economic activity is above the trend relative to when it is below the trend. Mirroring the pattern in other developing regions, the degree of cyclicality has changed since 2002 in Sub-Saharan Africa, with incipient signs of a shift toward acyclical or more countercyclical policies. The evidence does not suggest that resource wealth or fragility increases the procyclicality of government consumption in Sub-Saharan Africa. Official development assistance is found to exacerbate the procyclical stance of fiscal policy in the region, but the result depends on the relative size of foreign aid received.

This paper is a product of the Office of the Chief Economist, Africa Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at ccalderon@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Cyclicality of Fiscal Policy in Sub-Saharan Africa: Magnitude and Evolution**<sup>**1**</sup>

## **César Calderón**

The World Bank Office of the Chief Economist of the Africa Region

**Punam Chuhan-Pole** The World Bank Office of the Chief Economist of the Africa Region

**Rafael M. López-Monti** George Washington University Department of Economics

## **JEL classification: E62; C13**

**Key words:** Fiscal Policy; Cyclicality; Sub-Saharan Africa; Developing Countries

> 1 We are grateful to participants at the CSAE Conference 2017: Economic Development in Africa for their comments and suggestions. The views expressed in this paper are those of the authors, and do not necessarily reflect those of the World Bank or its Boards of Directors.
# **1. Introduction**

Fiscal policies in the short run are typically geared toward the stabilization of economic activity. In general, a countercyclical fiscal policy is a desirable feature to counterbalance economic cycles. For example, countercyclical government spending is needed to stimulate real economic activity, given shortfalls in aggregate demand, or to transfer resources to less favored individuals.<sup>2</sup> In other words, during “bad times” (contractions) an above-the-trend increase in the government consumption expenditure might be a useful tool to boost the economy. However, the other side of the countercyclical behavior is often forgotten, that is, during the “good times” (expansion) government consumption expenditure should increase below the trend, not only as a mechanism to avoid overheating the economy, but also to gain room by saving the extra income for future smoothing of adverse demand-side shocks.

There is vast evidence that advanced countries have the ability to conduct countercyclical fiscal policies (Mélitz 2000, Galí and Perotti 2003). Countercyclical fiscal policies in advanced countries are triggered by automatic increases in social security and welfare spending as the economy moves into a recession. Darby and Mélitz (2008) find that, on average, a reduction of one percentage point in the rate of growth is compensated by a 0.36 percentage point increase in social expenditures among OECD economies. Furthermore, well-targeted transfers in the US (which do not distort incentives to work) help stabilize output fluctuations (McKay and Reis 2013).

The cyclical behavior of fiscal policy among developing countries is a much more disputed issue. Earlier research suggests that fiscal policy in developing countries—and especially in Latin America—is procyclical (Gavin and Perotti 1997, Talvi and Végh 2005, Kaminsky, Reinhart and Végh 2004, Ilzetzki and Végh 2008). Historically, developing country governments have cut taxes and increased spending during booms and they have retrenched outlays and raised taxes during busts. This destabilizing behavior of fiscal policy is attributed, according to the literature, to either: (a) limited access to (external) funding (of policy actions) or (b) political economy distortions.

The procyclical bias of fiscal policy among developing countries is attributed to the failure of governments to support aggregate demand in the event of adverse shocks, as these countries are unable to tap either global or domestic financial markets (Gavin, Hausman, Perotti, and Talvi 1996). During booms, on the other hand, governments find it easier to finance rising public expenditure (Gavin and Perotti, 1997; Catao and Sutton, 2002). Overall, the procyclical access to external borrowing among developing countries drives the procyclical fiscal responses, leading to greater macroeconomic volatility (Kaminsky, Reinhart and Végh 2004).

Others have pointed out that a country’s institutional framework plays a crucial role in the design of countercyclical policy responses. Destabilizing fiscal policies are executed in countries with weak institutions; say, widespread corruption, repudiation of contracts, lack of property rights enforcement and, more generally, the predominance of political institutions that fail to constrain their officials (Acemoglu, Johnson, Robinson and Thaicharoen, 2003). In this strand of the literature, institutional theories that focus on political economy distortions such as common pool problems, fragmentation, and agency problems explain the inability of governments to run surpluses or rein in spending in good times. For instance, windfall revenues may not be saved by governments and are spent instead in favor of

> 2 Countercyclical social spending and timely stimulus packages are important to protect individuals during periods of hardship and stimulate employment.

2
powerful groups (Velasco 1998, Tornell and Lane 1999, Perotti and Kontopoulos 2002). Procyclical policy responses may also result from rent-extractive governments that appropriate revenues to serve special interests rather than the public welfare (Alesina, Campante and Tabellini, 2008; Ilzetzki, 2011).<sup>3</sup> Historically, the evidence shows that fiscal policy has been pro-cyclical for most developing countries; including countries in Sub-Saharan Africa. Frankel, Végh and Vuletin (2013) found that more than 90 percent of developing countries show procyclical government spending during the period 1960-2009 while 80 percent of industrial countries exhibit countercyclical government spending. Zooming in on SubSaharan Africa shows, on average, that: (a) government consumption is pro-cyclical, (b) the degree of procyclicality in the region is higher than that of other developing countries, and (c) the procyclical bias is greater among countries in the region that are highly dependent on foreign aid inflows (Thornton 2008, Lledó, Yackovlev and Gadenne, 2011).

The evidence on Sub-Saharan Africa also shows that structural and policy factors may have an influence on the cyclical behavior of government expenditure across countries and over time. Lledó and coauthors (2011) find that foreign aid inflows and fiscal space (as measured by the public debt burden and the achievement of decision point among HIPC countries) played a significant role in reducing the extent of procyclicality among African nations. However, they fail to find a robust effect of political institutions on the cyclical stance of fiscal policy. Calderón and Nguyen (2016), however, find that the cyclical behavior of government expenditure depends strongly on structural features of African economies (e.g. institutional quality) and policy factors (e.g. the margins of monetary and fiscal space). They find that the impact of institutions is not only attributed to deep roots about the formation of institutions but also to the improvement of institutions supporting macroeconomic policy frameworks.<sup>4</sup> Having an ample margin of maneuver for the government is crucial. In line with Lledó et al. (2011) and World Bank (2015), fiscal space (as proxied by the public debt burden) helps reduce the procyclicality of government expenditure. Financial openness, on the other hand, exacerbates the degree of procyclicality of government expenditure. The latter result is correlated to that of Thornton (2008) where fiscal policy is more procyclical in countries that rely heavily on foreign aid inflows. Overall, Calderón and Nguyen (2016) shows that fiscal policies can play a stabilizing role during times of crisis. However, much of the work has to be undertaken in good times. Withdrawing policy stimulus and replenishing fiscal buffers in good times has proven to be a challenge for most governments.

Finally, Konuki and Villafuerte (2016) investigates the extent and the drivers of fiscal policy pro-cyclicality among countries in Sub-Saharan Africa from 2000 to 2014. The paper finds not only that fiscal policy is more procyclical among oil exporters (2010-14) but also it has become more procyclical after the global financial crisis. Next, the authors find a causal relationship from deeper financial markets and greater reserve coverage to lower fiscal policy procyclicality. This finding implies that having space (by either having access to external borrowing or built-up buffers) will help reduce the procyclical bias.

> 3These papers empirically find that less corrupt governments are able to implement counter-cyclical policies. 4 Recent evidence shows that the strengthening of the institutional framework has enabled some developing countries to escape the pro-cyclicality trap (Frankel, Végh and Vuletin 2013). Some aspects of this institutional progress include: (a) sound fiscal rules that deliver countercyclical, credible and sustainable fiscal plans, (b) transparency in the formulation of medium-term expenditure frameworks, and (c) the ability of the government to carry out announced programs and being held accountable.

3
This paper revisits the issue of cyclicality of fiscal policy in large sub-set of Sub-Saharan African countries. It measures the cyclical behavior of real government consumption over a long time period (1970-2014), employing an identification strategy to correct for possible endogeneity in the cyclical components of spending and GDP. It also directly tests whether the cyclical stance of government consumption has changed over time. The paper extends the empirical literature in several important dimensions. First, unlike other papers in the literature, we estimate fully heterogeneous fiscal policy reaction functions (i.e., all coefficients and variance-covariance matrices) for SSA countries with different structural features (say, resource abundance, financial openness, extent of ODA inflows, and fragility). When applicable, the cyclical properties of government consumption expenditure in the region are compared with those in other developing regions and in high-income countries. Second, it examines asymmetries in the cyclicality of government spending during different phases of the economic cycle. Specifically, it assesses how cyclical properties vary with fluctuations in the level of real economic activity—that is, when the level of real economic activity is below the trend relative to when it is above the trend. The rest of the paper is organized as follows. Section 2 presents the model and empirical strategy for analyzing the cyclical behavior of fiscal policy. Section 3 reports the results of the quantitative analysis, and Section 4 concludes.

# **2. Methodology and Empirical Strategy**

## **2.1 Model and Empirical Strategy**

To examine the cyclical stance of fiscal policy, we focus on the expenditure side—and, more specifically, real government consumption. We should note that expenditure rather than revenue indicators measure more accurately policy rather than outcomes or targets. On the other hand, public investment (or development expenditure) is not included in this analysis of the stance of fiscal policy—as it is the case of Blanchard and Giavazzi (2004), Buiter and Grafe (2004), and Fatás (2005). Government investment is perceived as being quite different from consumption expenditures. First, investment decisions generally have a multi-year horizon (as there are often very few shovel ready projects), so the reaction to the business cycle might not be contemporaneous and might potentially affect the government budget in several periods. Second, the benefits resulting from public investment (for example, services) are spread over many years, with the possibility to increase private output and tax revenues. This paper also does not distinguish between discretionary and non-discretionary (automatic stabilizers) components of government expenditure, because what really matters for our analysis is the aggregate response of government consumption to the cycle as opposed to identifying the source.<sup>5</sup> Unlike most papers in the literature, the government consumption expenditure is not expressed as a percentage of GDP given that the ratio might be directly affected by the cyclical behavior of the GDP.<sup>6</sup> Thus, in order to capture the cyclical behavior of fiscal policy, we specify the following general policy reaction function:

> 5 In addition, there is evidence that automatic stabilizers are in general weak among developing countries —and, especially, Sub-Saharan African countries (World Bank 2014).

> 6 See the discussion in Kaminsky, Reinhart and Vegh (2004), and Ilzetzki and Vegh (2008).

4
<!-- Start of picture text --> JitCc _= CoG + GGVitCc + C26 Git-1Cc + M3GDit—1 + Eit<br>Cc<br>Git<br>Le t VitCc<br>i t<br>Dit-1<br>Aig<br>Q4G<br>Aig A<br>aig _= a;+<br>Cc _— - Cc<br>Vit dig = a; Vit<br>Jit(a= %+ + AL+,,CVi_ + A+ Git-1Cc + AZ+ Dit-1 + Eix “VitCc<br>JitCc _= %- + Oy—,,CVig + O2—- Git-1Cc + AZ- Dix-1 + Fix VitCc<br>Tit(Cn= UM + AigCc + AQDCiy.+ VigCc + CaGi¢_yCc + AsDit—1 + Eit<br>DCit+ VitCc<br><!-- End of picture text -->
Sub-Saharan Africa. Hence, we test whether the cyclical behavior in the period 2002-14 was different to �� that of the period 1970-2001. Specifically, we assume that ��� = �� ( _i=0,1,2,3_ ) for the period 1970-2001 ( _P1_ ) and that ��� = ���� ( _i=0,1,2,3_ ) for the period 2002-2014 ( _P2_ ). Analogous to equations (2) and (3), we have: Similar regression analysis is performed for Latin America and Developing Asia, but with their corresponding breaking points (years).

**_Figure 1_** _. Root mean square errors from multiple panel regressions with different breaking points (years)._

<!-- Start of picture text --> (a) Sub-Saharan Africa (b) Latin America<br>0.0420 0.0182<br>2002 2005<br>0.0419 0.0182<br>0.0418 0.0181<br>0.0418 0.0181<br>0.0417 0.0180<br>0.0416 0.0180<br>0.0415 0.0179<br>(c) Developing Asia<br>0.0234<br>1999<br>0.0234<br>0.0234<br>0.0234<br>0.0233<br>0.0233<br>0.0233<br>1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008<br>1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008<br><!-- End of picture text --> _Note: The unknown turning point (year) of fiscal cyclicality in each region is found through running multiple panel regressions with country fixed effect, testing the possible breaking points (dummies) from 1985 to 2008. To assess the performance of each regression (year), the Root-MeanSquare Error (RMSE) is stored. After running all regressions, the turning point (year) corresponds to the regression with the lowest RMSE_ _Access to external borrowing (Case 4)._ It is documented in the literature that the procyclical bias of fiscal policy —and, more specifically, government spending— among developing countries (and, notably, among SSA countries) might be attributed to their procyclical access to global capital markets. This implies that African countries might not be able to fund fiscal stimulus packages during downturns through external borrowing. At the same time, access to global capital markets might be directly related to the extent of international financial integration of the country. Hence, we define countries with low (high) degree of financial openness as those countries where the average value of the Chinn-Ito index of financial 6
� openness is below (above) the world median by decade.<sup>7</sup> Hence, we assume that ��� = �� ( _i=0,1,2,3_ ) for � countries with low financial openness, and ��� = �� ( _i=0,1,2,3_ ) for countries with high levels of financial openness.

_Resource-rich vs. nonresource-rich countries (Case 5)_ . Further analysis leads us to analyze whether the cyclical behavior of the government consumption expenditure differs between nonresource-rich and resource-rich countries among Sub-Saharan African countries. Our prior is that, in the event of commodity windfalls, resource rich countries will be more prone to conduct expansionary fiscal policies (say, increase government spending). To distinguish between resource and nonresource-rich countries, we need to define criteria to classify countries in the region. First, we define resource rich countries ( _RNR_ ) as those with rents from natural resources (excluding forests) that exceed 10 percent of their GDP (World Bank 2011).<sup>8</sup> Our econometric specification then assumes that ��� = ��� ( _i=0,1,2,3_ ) for countries where ����� � exceeds 10 percent of GDP in the decade, and ��� = �� ( _i=0,1,2,3_ ) for countries that are not abundant in natural resources. Finally, to avoid exceptional observations, we average the rents coming from the natural resources (excluding forest) as a percentage of GDP by decade (see footnote 7). A second criterion to classify SSA countries by resource abundance requires their average net commodity exports exceeding � 25 percent of total exports throughout the sample period. Again, ��� = �� ( _i=0,1,2,3_ ) for countries � surpassing the 25% value of exports threshold and ��� = �� ( _i=0,1,2,3_ ) for those countries unable to surpass that threshold. A final method to characterize (although imperfectly) resource abundance is to test whether SSA countries have established a sovereign wealth fund (which is typically commodity-based in the region). The list of countries with SWF (and their corresponding year of inception) is obtained from � the Sovereign Wealth Fund Institute. In this case, ��� = �� ( _i=0,1,2,3_ ) for countries with a sovereign � 9 wealth fund and ��� = �� ( _i=0,1,2,3_ ) for those countries without one.

_Foreign aid (Case 6)_ . Net official development assistance (net-ODA) is an important source of funds for many cash-strapped countries in Sub-Saharan Africa.<sup>10</sup> The size of ODA flows to the region have increased from a median value of 6.8 percent of the gross national income (GNI) in the 1970s to 13.3 percent in the 1990s (Figure 4.a). After 2000, the median value of net ODA has declined to 9.3 percent of GNI, reflecting the faster pace of economic growth of the region’s countries with respect to the nineties (see Figure 4.b).

To examine how the relative size of ODA inflows affect the cyclicality of fiscal behavior, we need a threshold to determine the impact of net ODA on a country’s fiscal policy. Given that the median netODA to GNI ratio among Sub-Saharan African countries is 9.5 percent over the period 1970-2014, it seems reasonable to classify countries into low (high) recipients of net ODA if it received the corresponding country receives foreign aid (net of repayments of principal) of at least 10 percent of its GNI. All SubSaharan African countries in our sample have received some type of ODA during the last forty-five years,

> 7 After 2000, we take the average and median for the 2000-2014 period.

> 8 Total natural resources rents are the sum of oil rents, natural gas rents, coal rents (hard and soft), mineral rents, and forest rents.

> 9 Note that we use to different ways to code countries with sovereign wealth fund: (a) we assume constancy over time, and (b) we code a fund only for the years since it was established.

> 10 ODA is concessional finance from bilateral and multilateral donors.  It does not include non-concessional development financing from these donors.

7
including South Africa. The question then is whether the relative magnitude of the assistance provided � changes the cyclical stance of government consumption expenditure. We assume that ��� = �� �� ( _i=0,1,2,3_ ) for countries where ����� exceeds 10 percent of GNI in the decade, and ��� = �� ( _i=0,1,2,3_ ) for countries that have received less than 10 percent of GNI or that have not received foreign aid over several years. For robustness purposes, we repeat analysis for low and high-ODA recipients but assuming a higher threshold: 13 percent of GNI, which is the 67<sup>th</sup> percentile of the SSA distribution of net-ODA to GNI ratio.

_Fragility and Conflict (Case 7)_ . Fragile and conflict states are those nations with a harmonized Country Policy and Institutional Assessment (CPIA) rating lower than or equal to 3.2, or with presence of peacekeeping or peace-building missions (World Bank 2011). The definition of fragile country has evolved over time from the classification of low income countries under stress (2006-9) to the harmonized list of fragile situations (from 2011). In this context, we will use the _polity score_ data from Polity IV data set, which characterizes the qualities of democratic and autocratic authority in governing institutions. This polity score ranges from -10 (hereditary monarchy) to +10 (consolidated democracy). It also includes exceptional cases of foreign interruption, interregnum or anarchy and transition (that takes special values of -66, -77 and -88). Using this database, we define fragile countries as those countries with failed/occupied scores (special values of -66, -77 and -88) and autocracies (values from -10 to -6 in the polity score). For robustness purposes, we expand the previous definition to include closed anocracies (values greater than or equal to -5 and smaller than 0 in the polity score).<sup>11</sup> _Estimation procedure_ . We estimate Equation 1 through the Pooled OLS and Fixed-Effect regressions. Since we are using deviations from a potential trend, the means of the cyclical components, ���� and ���� , tend to zero. Therefore, the Pooled OLS and Fixed Effect techniques will give similar coefficients, because the “within” estimation uses deviations from the country means. Second, we extend the analysis to account for possible endogeneity between the fiscal policy and GDP by using an IV/2SLS method to estimate the cyclicality coefficient ( �� ).<sup>12</sup> Following the approach used in Galí and Perotti (2003), Lane (2003), Jaimovich and Panizza (2007), and Calderón and Nguyen (2016), the cyclical component of real GDP ( ���� ) is instrumented using its own lags and the weighted average of the GDP growth of each country’s export partners. The idea is that external trade shocks do not affect government spending except through the business cycle channel. Similarly, there is no reason to think that government spending in small economies directly affects the growth rates of their trading partners. In the case of large economies, however, fiscal policy might affect the growth rates of trading partners.

# **_2.2 Data_**

The sample includes 37 Sub-Saharan African countries (SSA), 20 countries from Latin America (LAC), 20 from developing Asia, and 22 industrial economies. In the Appendix, Tables A.1 and A.2 contain the complete list of countries and the classification of resource-rich and nonresource-rich countries for SSA

> 11 Anocracies are government regimes with inherent qualities of political instability and ineffectiveness, as well as an incoherent mix of democratic and autocratic traits and practices (Marshall, Gurr and Jaggers 2016). 12 See the discussion about the endogeneity problems in Rigobón (2004).

8
respectively. Annual data from 1970 to 2014 are used in the analysis. The government consumption expenditure and real GDP in constant national currency are from the United Nations’ National Accounts Database. In general, most papers on fiscal cyclicality use the IMF’s databases, however, the UN statistics provide a more complete and consistent national accounts data for the time period covered. We apply the Hodrick-Prescott filter (HP) and use a value of λ equal to 6.25 in order to derive the cyclical components of the government consumption expenditure and real GDP (both in logs). General government gross debt as a percentage of GDP is from Abbas et al. (2010) and updated with the IMF’s World Economic Outlook. Natural resources rents (% of GDP) and net ODA received (% of GNI) are from the World Bank’s World Development Indicators (WDI). The instrumental variable is calculated with bilateral export values from the IMF’s Direction of Trade Statistics and UN COMTRADE, while the growth rates of trading partners are from the United Nations’ National Accounts Database updated with the WDI.

# **3. Results**

## **_3.1 Cyclical behavior of government consumption in 1970-2014_**

Before we conduct our regression analysis, we compute the degree of association between the cyclical components of real government consumption and real GDP from 1970 to 2014. The behavior of government consumption along the business cycle is defined as follows: government consumption expenditure is countercyclical (procyclical) if the correlation coefficient between the cyclical components of real government consumption expenditure and real GDP is negative (positive) and statistically significant at 5 percent. It is acyclical if that correlation is not statistically different from zero. Figure 2 shows that government consumption expenditure is procyclical for nearly 40 percent of SSA countries in our sample. Over the period 1970-2014, no country in the region exhibits countercyclical fiscal policies. The proportion of countries with a procyclical bias in fiscal policy is even larger in Latin America (60 percent). By contrast, 77 percent of industrial countries have exhibited an acyclical stance and 9 percent conducted countercyclical policies. The Appendix (Figure A.1) presents the correlation coefficients by region and country for the whole sample period.

9
**_Figure 2_** _. Cyclical properties of Government Consumption Expenditure: proportion of countries by groups._

<!-- Start of picture text --> 1970-2014<br>100%<br>9%<br>Coutercyclical<br>80% 40%<br>62% 60%<br>60%<br>77% Acyclical<br>40%<br>60%<br>20% 38% 40%<br>14% Procyclical<br>0%<br>Sub-Saharan Africa Latin America Developing Asia Industrial Countries<br><!-- End of picture text --> _Note: The government final consumption expenditure and GDP are expressed in local currency at constant prices (source: UN-Statistics database). Their cyclical components are obtained using the Hodrick-Prescott filter. Countercyclical government consumption means that the correlation coefficient is negative and statistically significant at 5% level. It is procyclical when it is positive and significant, and acyclical when the coefficient is not statistically different from zero._ Next, we estimate the fiscal policy reaction function defined in equation (1) using least squares. The relationship between the cyclical components of the government consumption expenditure and real GDP is positive and statistically significant in all developing regions. The coefficient of real GDP cycle, however, is larger in Sub-Saharan Africa (Table 1). On the other hand, least squares estimates point to a nonsignificant relationship between government consumption and the business cycle.

The results are qualitatively similar when we account for the likely endogeneity of (the cyclical component of) real output. Our instrumental variables (IV) estimation shows that government consumption is still procyclical in Sub-Saharan Africa and Latin America —with the former group having the larger coefficient estimate. For developing Asia, the coefficient estimate of real GDP is still positive but fails to be statistically significant. When we account for endogeneity, the extent of procyclicality of government consumption in Sub-Saharan Africa is greater and twice as large as that in Latin America. Note that the estimates for the SSA region are the only ones where least squares exhibits a downward bias. This suggests that government consumption expenditure among SSA countries is ineffective in boosting short-run aggregate demand.

The lagged debt-to-GDP indicator has a negative coefficient across all regions, implying that higher debt levels tend to constrain fiscal policy. However, the coefficient is only significant for Latin American and industrial countries. The coefficient on the lagged cyclical component of government consumption has a positive sign for all country groups, except Sub-Saharan Africa. But after correcting for the potential endogeneity problem, this coefficient is only significant in the group of industrial countries. In SubSaharan Africa, this coefficient on the lagged dependent variable is negative and not significant. Note that we are working with deviation of government consumption expenditure with respect to its trend, thus a negative coefficient for its lagged variable would suggest an oscillating behavior of fiscal policy. That is, when the cyclical component of government consumption is below its trend in the previous period, it is more likely to be above the trend in the current period, suggesting variability in government spending.

10
# **_3.2 Cyclical properties during good times and bad times_**

Does the cyclicality of fiscal policy vary during good times and bad times? In order to capture possible asymmetries during the economic cycle, we split the sample based on the values of the cyclical component of real GDP —that is, positive (above the trend) and negative (below the trend). Table 2 tests whether the behavior of the cyclical component of government consumption differs when real economic activity is above or below the trend (i.e. expansions and recessions).

The least squares estimates show that government consumption tends to be procyclical in both good times and bad times in developing countries. For industrial countries, on the other hand, government consumption is slightly procyclical only during expansions. However, Sub-Saharan Africa is the only region where the degree of pro-cyclicality during recessions is larger than the one during expansions.

Accounting for the likely endogeneity of the business cycles, fiscal policy tends to be procyclical during expansions across all developing country groups. Among these groups, Sub-Saharan Africa exhibits the largest degree of procyclicality. The coefficient is positive, significant and greater than one —which implies that government consumption expands more than proportionally in good times. During downturns, SubSaharan Africa is the only region with a positive —although not statistically significant— coefficient estimate for the business cycle. In other regions, government consumption behaves countercyclically during bad times —although the coefficient estimate is statistically significant only for industrial countries.<sup>13</sup> Asymmetries along the business cycles emerge from implementing fiscal policies in an environment that is also affected by short-sighted considerations. In the case of Sub-Saharan Africa, we find procyclicality during expansions and acyclicality during recessions. Additionally, the magnitude of the sensitivity of fiscal policy to business cycles is greater during expansions than during recessions (1.593 vs. 0.918). Fluctuations in the business cycle are accompanied by a rising government consumption to output ratio over time. The quantitative importance of this mechanisms, as pointed out by Hercowitz and Michel Strawczynski (2004), is proxied by the ratcheting coefficient 0.675 (=1.593 -0.918).

It is likely that different factors shape a procyclical fiscal policy response during good times and bad times. In an expansion, political pressures and social needs boost government expenditures, particularly in countries with low levels of development. In downturns, the government needs funding to conduct countercyclical policies —either from its own savings or from financial markets— in a context of declining revenues. Industrial countries, emerging market economies, and some developing countries have access to international financial markets, which means that these countries can borrow to partially offset the economic consequences during the contraction periods. The pattern of fiscal policy cyclicality observed in Sub-Saharan Africa might respond to the higher demands during the expansion periods and nonnegligible borrowing constraints in downturns.

# **_3.3 How has the cyclical stance of fiscal policy changed in recent years?_**

This section tests whether the cyclical behavior of fiscal policy in Sub-Saharan Africa has changed over time —notably, in recent years. We conduct a recursive test of structural break along the fiscal policy

> 13 These are preliminary results that may suffer from the weak instrument problem since _the Kleibergen-Paap-F statistic_ is relatively low in some developing regions for certain periods.

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reaction function and identify 2002 as a turning point in Sub-Saharan Africa. Similar test was conducted for Latin America and Developing Asia. For these regions, the time break is 2005 and 1999, respectively.

All developing regions, including Sub-Saharan Africa, have made some progress towards more acyclical (and countercyclical in some cases) fiscal policies after the breaking point (year). In fact, there were no countries with negative and statistically significant correlation coefficients (countercyclical fiscal policies) in the pre-break period in all regions (Figure 3). However, after the breaking year, the proportion of countries with countercyclical fiscal policies have increased to 8% in Sub-Saharan Africa and 10% in both Latin America and developing Asia. At the same time, the proportion of countries with positive and statistically significant correlation coefficient (procyclical fiscal policies) have decreased considerably.

**Figure 3** . Cyclical properties of Government Consumption Expenditure by region

<!-- Start of picture text --> 100%<br>8% 10% 10%<br>30%<br>80%<br>55%<br>68%<br>60%<br>84% 85% 75%<br>40%<br>70%<br>20% 45%<br>32%<br>15%<br>0% 8% 5%<br>1970-2001 2002-2014 1970-2004 2005-2014 1970-1998 1999-2014<br>SUB-SAHARAN AFRICA (2002) LATIN AMERICA (2005) DEVELOPING ASIA (1999)<br>Procyclical Acyclical Countercyclical<br><!-- End of picture text --> _Note: The government final consumption expenditure and GDP are expressed in local currency at constant prices (source: UN-Statistics database). Their cyclical components are obtained using the Hodrick-Prescott filter. Countercyclical government consumption means that the correlation coefficient is negative and statistically significant at 5% level. It is procyclical when it is positive and significant, and acyclical when the coefficient is not statistically different from zero._ The analysis of the correlation coefficient between the cyclical components of government consumption and GDP in Sub-Saharan African countries in the sub-periods of 1970-2001 and 2002-2014 suggests that the region still has considerable margin to improve in terms of the cyclical stance of fiscal policy. Figure 4 shows that only 9 out of 37 countries in the region have moved from a procyclical stance (positive correlation) to a more countercyclical one (negative correlation).<sup>14</sup> Only 4 countries (Guinea, Malawi, Zambia, and Zimbabwe) have registered a negative correlation between the cyclical components of government consumption and GDP in both periods. Government consumption in the majority of countries (24) continue to exhibit a procyclical behavior. As was noted before, regardless of the dynamic between periods, most of region’s countries are still classified as having acyclical fiscal policies in the recent period 2002-2014, since their correlation coefficients are not statistically different from zero.

> 14 These countries are: Angola, Cabo Verde, Chad, Kenya, Liberia, Mauritius, Nigeria, Rwanda, and South Africa. However, only Angola, Kenya, and Mauritius have exhibited negative and statistically significant correlation coefficients in 2002-2014.

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We conduct a regression analysis to estimate the cyclical behavior of government consumption expenditure before and after 2002 (our estimated time break). Our coefficient estimates suggest a shift in the stance of fiscal policy along the business cycle across developing regions. The instrumental variable (IV) regression estimates in Table 3 show that, on average, fiscal policy has become counter-cyclical in Latin American (after 2005) and Asia (1999) —although the negative coefficient is statistically not different from zero in the latter group. In Sub-Saharan Africa, the magnitude of the fiscal policy procyclicality bias has decreased over time. After 2002, the coefficient estimates of (the cyclical component of real output) is still positive but it is smaller (in magnitude) and no longer statistically significant. The reduction in the degree of procyclicality across developing regions in recent years has been the result of better fiscal management, particularly during the strong global growth experienced in 2000-08, which better prepared many developing countries (including those in in Sub-Saharan Africa) to face the 2008-09 global financial crisis. In sum, there has been an overall change to more acyclical behavior of the government consumption expenditure in developing regions in recent years, a phenomenon that does not exclude African countries.

**Figure 4.** Sub-Saharan Africa: change in the correlation coefficients between the cyclical components of Government Consumption Expenditure and GDP by country, 1970-2001 vs. 2002-2014

<!-- Start of picture text --> Change to more Still in Procyclical<br>Procyclical region<br>BDI SLE<br>GMB<br>MLI UGA CIV<br>BFA COD GHA<br>GNB<br>TGO SEN BEN MDG<br>TZA NER<br>COM CMR COG CAF GAB<br>MOZ<br>MRT<br>BWA<br>RWA<br>NGA<br>ZWE ZMB MWI LBR<br>GIN<br>ZAF CPV<br>TCD<br>AGO<br>KEN MUS<br>Still in Countercyclical Change to more<br>region Countercyclical<br><!-- End of picture text --> <!-- Start of picture text --> Classification for the 2002-2014 period: Procyclical Acyclical Countercyclical<br><!-- End of picture text --> _Note: The government final consumption expenditure and GDP are expressed in local currency at constant prices (source: UN-Statistics database). Their cyclical components are obtained using the Hodrick-Prescott filter. Countercyclical government consumption means that the correlation coefficient is negative and statistically significant at 5% level. It is procyclical when it is positive and significant, and acyclical when the coefficient is not statistically different from zero._

# **_3.4 The effect of financial openness on the fiscal cyclical stance_**

Table 4 examines whether the degree of cyclicality of fiscal policy is different between countries with low and high levels of financial openness. Our IV estimates show that government consumption expenditure is procyclical among countries with low financial openness and acyclical among countries with high 13
financial openness. This finding suggests that the likely access to foreign borrowing during downturns may lower the degree of procyclicality of fiscal policy. The same finding holds for Latin America. For developing Asia and industrial countries, on the other hand, government consumption expenditure is acyclical in countries with both low and high financial openness.

# **_3.5 The effect of natural resources rents on the fiscal cyclical stance_**

Table 5 tests whether the fiscal policy reaction function is different between natural resource abundant countries from those that are not. We use two different criteria to classify natural resource abundance: (i) having an average ratio of natural resource rents (excluding forests) to GDP that exceeds 10 percent, and (ii) having an average ratio of net commodity exports to total exports that is greater than 25 percent.<sup>15</sup> Our discussion will focus on the estimations from column [5] through [12] in Table 5.

Regardless of the criterion used to define resource abundant countries, our IV estimates show that the coefficient of fiscal cyclicality is statistically not significant for resource rich countries in Sub-Saharan Africa. On the other hand, the coefficient is positive and significant for non-resource rich countries in the region. In other terms, our regression results suggest that government consumption expenditure tends to be procyclical in non-resource rich countries and acyclical among resource rich ones.

Overall, the results need to be interpreted with caution because of the small sample of resource-rich countries in the analysis. At the same time, the results for Sub-Saharan Africa could indicate that resourcerich countries are using stabilization funds to smooth consumption. In recent years, several of the region’s resource-rich countries have established stabilization funds with windfalls from the commodity price boom that began in the early 2000s. If well implemented, these stabilization funds can provide access to extra-budgetary funds in bad times, making them a useful tool to reduce the procyclical bias of government consumption spending. Further analysis will be useful here.

Table 6 adds to our analysis the quality of institutions. Some have argued that the quality of institutions from resource to non-resource rich countries may affect differently the cyclical component of government consumption expenditure. When using the natural resource rents criteria, the coefficient of cyclical output is positive for both resource and non-resource rich countries. It is larger for the latter group but they fail to be statistically significant. On the other hand, when using the net commodity export criterion, government consumption expenditure is procyclical for non-resource rich countries while it is acyclical for resource rich ones. Note that institutional quality has a negligible impact on the cycle of government consumption.

A final look at the influence of natural resource abundance involves testing whether having a sovereign wealth (SWF) or stabilization fund has an impact on the cyclicality of fiscal policy. The IV results are reported in Table 7. We find that countries with a SWF have an acyclical stance (i.e. the coefficient of business cycle is positive but not significant). On the other hand, countries without SWF exhibit the typical procyclical fiscal bias —that is, the coefficient of business cycle is positive and statistically significant. This finding is similar to that in Table 5.

> 15 The first criterion has also two different groups that are differentiated by the inclusion of other natural resource abundant nations; namely, Botswana (diamonds) and Niger (uranium).

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# **_3.6 How has ODA affected the cyclical nature of fiscal policy in Sub-Saharan Africa?_**

Figures 4a shows that the median size of official development assistance (ODA) flows to GNI remains large in Sub-Saharan Africa, although it is below the peaks levels in 1990-99. Importantly, in many poor developing countries, ODA supports over half of public spending. Net official development assistance (net-ODA) is an important source of funds for many cash-strapped countries in Sub-Saharan Africa.

**Figure 4** . Sub-Saharan Africa: Net Official Development Assistance

<!-- Start of picture text --> (a) Net ODA received as % of GNI, (b) Growth rate of net ODA and GNI w.r.t. the previous decade,<br>(Median by period) (Based on median by period of net-ODA and GNI indexes, 1970-1979=100)<br>14 13.3 200%<br>Net ODA GNI<br>12<br>10.1 160%<br>10 9.3 9.5<br>8 6.8 120%<br>6<br>80%<br>4<br>40%<br>2<br>0 0%<br>1970-1979 1980-1989 1990-1999 2000-2014 1970-2014 1980s 1990s 2000-2014<br>Source: Authors’ calculations based on the WDI database<br><!-- End of picture text --> Table 8 tests whether the cyclical stance of fiscal policy changes between countries that receive a greater amount of foreign aid from those that do not. In this context, we use two different criteria to classify SSA countries: first, countries receiving net ODA equivalent to 10 percent or more of their gross national income (GNI), which is the median of the SSA country-year distribution for this variable. Second, we also consider countries receiving net ODA equivalent to 13 percent or more of their GNI —about the top tercile of the SSA foreign aid distribution. The results are reported in Table 8.

Our results show that government consumption of high-ODA countries (when using the threshold of 10 percent of GNI) is procyclical while low-ODA countries is acyclical. When we increase the threshold to 13 percent, the result is the opposite: government consumption of high-ODA countries is acyclical while that of low-ODA countries is procyclical.<sup>16</sup> Note that the coefficient of business cycle is not significant when we control for the quality of institutions. Other studies (Thornton 2008, Lledó, Yackovlev and Gadenne, 2011) also find that the procyclical bias is greater among countries in the region that are highly dependent on foreign aid inflows. In our analysis, this finding is obtained when we use the lower threshold of ODA and we do not account for the quality of institutions of SSA countries. It is important to caveat here that although most of ODA is given to promote a country’s development and welfare, we are not capturing the effect on government investments (developing expenditure). Our finding might suggest that when a 16 Note that lifting the threshold from 10 to 13 percent reduces the sample of SSA countries from 27 to 22 (see Appendix-Table A.3). The countries excluded are: Benin, Rep. of Congo, Guinea, Senegal, and Togo. Note that the average ratio of foreign aid to GDP for high-ODA countries is 16.5%.

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country is receiving above-average assistance, the government consumption expenditure overreacts to the cycle. That is, in good times ODA flows might reinforce the current expenditure cycle, resulting in stronger adjustments during bad times. In any case, a further analysis is needed to properly assess the real impact of ODA flows on the cyclicality of fiscal policy.

## **_3.7 Fragility and the cyclical stance of government consumption expenditure_**

Table 9 examines whether the behavior of government consumption expenditure along the business cycle is different for fragile and non-fragile countries. We have two different criteria: (a) country-years where there is a failed/occupied government or an autocracy, and (b) includes closed anocracies to (a). The first criterion shows that government consumption expenditure is procyclical for both fragile and non-fragile countries —although the extent of procyclicality is larger among non-fragile countries. For non-fragile countries, the response of government consumption to output fluctuations in more than proportional.

When our definition of fragility includes anocracies, the results are qualitatively similar: the coefficient estimate of real output fluctuations is positive and significant in most cases. The magnitude of the coefficient is larger among non-fragile countries. If we do not account for the lagged ratio of public debt to GDP, government consumption expenditure reacts more than proportionally to oscillations in real economic activity.

# **4. Conclusions**

This paper shows that, historically, government consumption has been more procyclical in Sub-Saharan Arica vis-à-vis other developing regions over the period 1970-2014. When we account for the likely endogeneity of fluctuations in real economic activity, the degree of procyclicality in the region is higher. Our findings also show that the procyclical bias of fiscal policy in Sub-Saharan Africa has decreased in recent years. Government consumption has shifted from a procyclical stance (in 1970-2001) to an acyclical one (2002-2014).

We also find the behavior of government consumption expenditure in SSA is asymmetric along the business cycle: it is procyclical during upturns and acyclical in downturns. Given that the magnitude of the coefficient estimate of business cycle is positive and larger during expansions. Hence, the ratio of government spending to GDP is rising during expansions.

Finally, we also test whether the fiscal policy reaction function is different across SSA countries depending upon: the abundance of natural resources, extent of financial openness, reliance on foreign aid, and condition of fragility. Our results show that government consumption expenditure tends to behave: (a) acyclically among resource rich countries, (b) procyclically among low financial openness countries, and (c) more procyclically among non-fragile countries. Finally, the evidence is mixed on the role of foreign aid in explaining fiscal policy cyclicality.

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