Given that producers of price elastic goods may see higher revenues, should oil-exporting nations respond to deflation through fiscal stimulus or by addressing its underlying causes?
Despite implementing a Value Added Tax (VAT) and cutting fuel subsidies, OPEC members such as Saudi Arabia—the largest crude oil producer—and the United Arab Emirates faced deflation in early 2019. This was primarily driven by economic slowdown caused by declining oil prices, which reduced export earnings and constrained government spending. Additionally, an oversupply in the property market led to a drop in rental prices, further contributing to deflationary pressures.
b. Given that producers of price elastic goods may see higher revenues, should oil-exporting nations respond to deflation through fiscal stimulus or by addressing its underlying causes? [15]
Introduction
Deflation, a sustained fall in the general price level, can have significant economic consequences, particularly for oil-exporting countries experiencing weak aggregate demand and sectoral imbalances. In 2019, oil-producing nations such as Saudi Arabia and the United Arab Emirates (UAE) faced deflation due to falling oil prices, which reduced government export revenues and impacted public spending. Additionally, an oversupply of property led to declining rental prices, further exacerbating deflationary pressures. To address deflation, governments can either implement fiscal stimulus to boost aggregate demand or adopt policies that directly target the root causes of deflation, such as addressing property market imbalances and reducing dependence on oil exports. While fiscal stimulus can provide short-term relief, its sustainability is questionable given the already weakened fiscal positions of many oil-exporting countries. Long-term structural policies may be more effective in ensuring sustained economic stability and mitigating future deflationary risks.
Fiscal Stimulus as a Policy Response
Mechanism of Fiscal Stimulus in Addressing Deflation
Fiscal stimulus refers to an increase in government expenditure aimed at boosting aggregate demand (AD) and stimulating economic growth. If an economy is experiencing deflation due to weak demand, higher government spending on infrastructure, subsidies, or direct financial support can increase consumption and investment, shifting the AD curve to the right. In an economy operating near full employment, this rise in demand can raise the general price level, thereby correcting deflation and restoring economic growth.
Challenges of Fiscal Stimulus for Oil-Exporting Countries
While fiscal stimulus can be effective in increasing AD, oil-exporting countries may face significant constraints in implementing such policies due to their deteriorating budget positions. The decline in oil prices reduces government revenues from oil exports, which form a major share of national income for these economies. As a result, many oil-producing countries experience budget deficits, limiting their ability to engage in expansionary fiscal policy without borrowing or using sovereign reserves.
If governments finance fiscal stimulus through borrowing, this leads to rising public debt. Higher debt levels impose a financial burden on future generations due to interest payments, potentially reducing long-term fiscal sustainability.
Alternatively, governments could tap into their sovereign wealth funds or foreign exchange reserves to finance spending. However, this comes with opportunity costs, as these reserves generate investment returns that contribute to future government spending. A depletion of reserves could reduce fiscal flexibility in future downturns.
If fiscal stimulus is applied when the economy is already near full employment, excessive government spending could lead to inflationary pressures rather than addressing deflation. Additionally, government borrowing may crowd out private sector investment by raising interest rates.
Due to these limitations, fiscal stimulus may not be a sustainable long-term solution for oil-exporting countries, particularly if deflation is structural rather than cyclical. Instead, policies that directly address the underlying causes of deflation, such as oversupply in the property market and overreliance on oil exports, may be more effective.
Addressing the Oversupply of Property
One of the key contributors to deflation in oil-exporting countries in 2019 was the oversupply of property, which led to falling rental prices and reduced revenues for property owners and developers. Since real estate is a significant sector in many Gulf economies, prolonged price declines can exacerbate deflationary pressures and reduce overall economic confidence.
To correct the oversupply of property, governments can implement policies aimed at increasing demand for real estate. These policies include:
Expansionary Monetary Policy (Lowering Interest Rates):
Central banks can lower interest rates, making it cheaper for homebuyers to obtain mortgages. Lower borrowing costs encourage property purchases, thereby boosting demand and stabilising property prices.
However, the effectiveness of this measure depends on whether banks are willing to lend and whether consumers have sufficient confidence in the economy to invest in property.
Relaxing Foreign Investment and Immigration Rules:
Governments can ease restrictions on foreign ownership of real estate, expanding the market to international buyers.
Relaxing immigration rules or offering residency incentives to foreign investors can increase demand for housing, helping to absorb excess supply and restore stability in the property sector.
By directly addressing the oversupply of property, these measures can help stabilize rental and property prices, mitigating one of the key sources of deflation without the fiscal constraints associated with expansionary government spending.
Reducing Dependence on Oil Exports
Another key structural issue contributing to deflation is the overreliance on oil as a primary export, making these economies highly vulnerable to fluctuations in global oil prices. When oil prices fall, export revenues decline, leading to weaker government spending, lower investment, and job losses in oil-related industries.
To diversify the economy and reduce dependence on oil, governments can implement long-term structural reforms such as:
Encouraging the Growth of Non-Oil Sectors:
Governments can provide tax incentives, subsidies, or investment grants to attract businesses in manufacturing, tourism, financial services, and technology sectors.
By creating a more balanced economy, the reliance on oil revenues can be reduced over time, making the economy more resilient to oil price fluctuations.
Investing in Human Capital and Innovation:
By investing in education, skills development, and research & development (R&D), governments can equip the workforce with skills needed for high-value industries beyond oil and gas.
Countries such as the UAE have made efforts to promote fintech, logistics, and renewable energy, reducing reliance on oil exports.
By diversifying economic activity, these policies help reduce the risk of future deflationary shocks linked to oil price volatility, ensuring long-term economic stability.
Why Policies to Lower Oil Prices or Currency Depreciation Are Ineffective
Some may argue that oil-exporting countries should try to improve export competitiveness by lowering oil prices further or implementing a currency depreciation policy to make exports cheaper. However, these approaches are not viable solutions because:
Oil prices were already declining in 2019, meaning further price reductions would worsen fiscal conditions without necessarily increasing demand.
Depreciating the exchange rate may not be effective because oil is typically traded in US dollars, meaning currency depreciation would not significantly impact oil export competitiveness.
Thus, focusing on economic diversification and property market stabilisation presents a more viable long-term strategy.
Conclusion
While fiscal stimulus can increase aggregate demand and correct deflation in the short term, it is not a sustainable solution for oil-exporting countries due to their worsening budget positions, rising debt, and limited fiscal flexibility. Instead, policies that directly address the underlying causes of deflation, such as the oversupply of property and economic overreliance on oil exports, are more effective in the long run. Measures such as lowering interest rates, attracting foreign investors, and diversifying the economy can help stabilize property prices, create alternative revenue streams, and reduce vulnerability to oil price fluctuations. Given the structural nature of deflation in these economies, governments should prioritize economic transformation rather than short-term fiscal intervention to ensure long-term economic resilience and stability.
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