IMF Paper: Drawing Lessons from the Dubai Debt Crisis About Policy Coordination in Fiscal Federalism

June 28th, 2011 • 70 comments

Procyclical fiscal policies and the build-up of contingent liabilities during the boom years exacerbated the severity of the crisis. The crisis in the global financial system was a complex event with far-reaching consequences, especially in countries that had had expansionary fiscal policies and a build-up of contingent liabilities prior to the crisis. While the world economy is now in the recovery stage, the debate on the preponderant causes of the financial meltdown is still far from over. Given the unprecedented severity and complexity of the crisis, it would be misleading to put the entire onus on financial excesses and regulatory weaknesses and ignore the role of fundamental imbalances. The United Arab Emirates (U.A.E.) — a major hydrocarbon-exporting country with diversified sub-national economic structures—experienced its own unraveling of macro-financial imbalances and thus presents an interesting case to analyze the underlying fragilities.

Fiscal policies, in the absence of coordination among the emirates, complicated macroeconomic management at the federal level.1 Since the U.A.E. has a pegged exchange rate regime and consequently a limited scope to use monetary policy, the burden of macroeconomic stabilization falls on fiscal policy. On the contrary, procyclical fiscal policies prior to the crisis reinforced the “financial accelerator” effect, exacerbated the economic cycle, and thereby contributed to the build-up of economic and financial vulnerabilities in the U.A.E. With the global financial crisis, the bursting of the real estate bubble and the ensuing recession in Dubai also raised concerns over the sustainability of public finances, especially in light of the risks stemming from government-related enterprises (GREs). In addition to the contingent liabilities that contaminated the sovereign balance sheet, the crisis also revealed the predicament of implicit government guarantees —a manifestation of moral hazard in a federal system with an asymmetric distribution of resources— and the lack of policy coordination among various layers of government. While the empirical findings of this paper are directly relevant to macroeconomic policymaking in the U.A.E., they also provide pertinent insights about the importance of policy coordination in other federal fiscal systems—and monetary unions, as brought to light by the recent developments in Europe.

This paper analyses fiscal policy in the run-up and after the crisis and suggests a set of measures to strengthen fiscal policy management in the U.A.E. Because the crisis is partly a manifestation of heterogeneous and diverging sub-national fiscal capabilities, Section II describes the main institutional features of fiscal federalism in the U.A.E. Section III explains the methodology for decomposing non-hydrocarbon GDP into trend and cycle components at the aggregate and emirate level and estimating the cyclically adjusted nonhydrocarbon primary budget balance before and after the crisis. This disaggregated approach provides a better understanding of the economic structure and vulnerabilities at the emirate level, considering the asymmetric distribution of resource wealth. Section IV analyzes fiscal sustainability in the U.A.E. as a whole and at sub-national level in the emirates of Abu Dhabi and Dubai. Finally, Section V sets out policy lessons to develop a rule-based framework that would help enhance policy coordination between various governments and ensure long-term fiscal sustainability and a more equitable intergenerational distribution of wealth.

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