Policy mix in small open economies: worthy or not? Mexico experience

In recent decades, commodity prices have been affected by various negative shocks, such as the 2008 global financial crisis or the COVID-19 pandemic crisis. They affected the global economy, especially emerging market countries that export commodities. Considering emerging market economies' closer integration with global financial markets, global cyclical conditions and interest rates in advanced economies play a key role in shaping domestic fiscal or monetary policy. The military conflict between Russia and Ukraine has triggered greater volatility in commodity prices, which in turn has put upward pressure on inflation, exacerbating the policy trade-offs faced by central banks around the world due to the presence of multiple supply shocks and uncertainty.

The authors' research focuses on the example of Mexico, but they are also useful for Kazakhstan in some ways. Mexico and Kazakhstan are typical small open emerging market economies and have a strong fiscal component linked to oil prices.

In 2021, Mexico's exports accounted for 41% of GDP, and the industrial sector, which includes oil and gas production, accounted for 31% of GDP. In terms of fiscal accounts, oil revenues from PEMEX (Mexico's largest oil production and development company) between 1990 and 2019 accounted for almost 6% of GDP and 28% of total government revenues. Kazakhstan's exports accounted for 42% of GDP in 2022 , with oil and petroleum products accounting for 57% of total exports.

Following the global financial crisis and the COVID-19 crisis, government revenues and oil-related debt were negatively impacted due to a significant drop in global oil prices and a downgrade of PEMEX's debt rating, which in turn negatively impacted the sovereign risk premium. The impact of oil price shocks on inflation has weakened over time, mainly due to monetary tightening in most developed and emerging market countries. However, financial markets are more sensitive to increases in oil prices when those markets are newly established or when they are less liquid. Therefore, the Mexican financial market remains sensitive to external shocks and needs additional tools to increase its liquidity and efficiency. This dynamic is also observed in Kazakhstan.

Thus, the presented studies are relevant not only for Mexico, but also for Kazakhstan, since commodity prices affect the CPI and contribute to government revenues, and therefore affect both monetary policy and fiscal policy. This interaction opens up the question of the most effective combination of policies.

Theoretically, the implementation of monetary policy and fiscal policy should occur independently of each other, and when making decisions, the government and the central bank should take into account only their ultimate goals. However, in practice, decisions made without taking the other party into account can lead to a situation where one policy conflicts with another. In the modern world, these types of policies often interact with each other to achieve greater efficiency and reduce the costs of stabilizing the economy. For example, on February 23, 2021, the Government of the Republic of Kazakhstan, the National Bank of the Republic of Kazakhstan (NB RK) and the Agency for Regulation and Development of the Financial Market (ARFRDF) entered into an agreement on the coordination of macroeconomic policy measures for 2021–2023. This agreement is aimed at implementing joint measures that will help ensure macroeconomic stability, support the economy, and limit risks from the external environment. On February 24, 2022, NB RK together with the Government made a statement about the launch of a program to protect tenge deposits against the backdrop of increased geopolitical risks and volatility in financial markets. Thus, it is important to understand the extent and nature of the relationship between the monetary and fiscal channels. For example, doesn’t the more rigid structure of fiscal policy impede the maneuvering of monetary policy to stabilize the economy? How exactly does one policy complement another?

These are the questions asked by the authors of the work (Aguilar et.al, 2022) when analyzing the responses of Mexico's monetary policy and fiscal policy to various shocks and assessing their effects. The authors proposed a model that includes monetary, fiscal and external blocks. The monetary block includes the most widely used models in small open economies (relevant for both Mexico and Kazakhstan): the Phillips curve, uncovered interest rate parity, and the Taylor rule. The fiscal block is based on the restrictions of the state budget: state revenues, expenses, deficits and debt are determined, also a budget rule operates in the economy. The external block describes the change in international variables.

The main difference between this model and previous studies is that the authors examine the channel of the sovereign risk premium, which refers to the additional yield that investors demand when purchasing government bonds or other high-risk country debt instruments. It represents the difference between the yield on government bonds of that country and the yield on bonds of comparable quality but more reliable countries. Thus, the authors model the sovereign risk premium channel as a function of domestic government debt.

It is common knowledge that monetary policy and fiscal policy decisions influence each other through channels such as economic activity, inflation and the exchange rate. However, the authors show that there is another channel that is important to consider when making a decision - the channel of the sovereign risk premium. It is a key channel influenced by global financial conditions. Using this channel, the authors were able to explain why fiscal policy can be procyclical even in the presence of a fiscal rule. Following the fiscal expansion, there will be a very sustained increase in the sovereign risk premium, which will also have an impact on output and the exchange rate (which will weaken). If the economy is in recession and there is fiscal support, this can help the economy countercyclically. However, if there are doubts about financial sustainability, the sovereign risk premium will increase, weakening the exchange rate and reversing the effect of fiscal expansion. By the way, such an effect can be suspected in Kazakhstan in 2022: fiscal expansion led to an increase in sovereign risks, which resulted in S&P Global Ratings downgrading the forecast for Kazakhstan’s sovereign rating from “Stable” to “Negative” on September 2, 2022.

At the extreme, fiscal policy measures may have a net negative effect on activity, becoming procyclical. This will pose a dilemma for monetary authorities as they face lower output and higher inflation caused by pass-through of exchange rate depreciation.

The study results also show that the stricter the fiscal rule is, the easier it is for the central bank to stabilize the economy after a shock. That is, with strict implementation of the budget rule, the central bank does not need to increase the interest rate to the extremely high level (20%). The authors also found that monetary policy, by changing the trajectory of inflation, has a relatively stable effect on the real value of government debt. It also affects government debt when the real exchange rate changes, but this effect is temporary.

It is worth emphasizing again that the sovereign risk premium channel is relevant not only for Mexico, but also for Kazakhstan, since the fiscal sustainability of the countries is quite vulnerable due to the high level of dependence on oil as the main source of budget revenues. In addition to the heavy dependence of their economies on oil prices, countries are also characterized by a high degree of rigidity in most government spending.

Although there are significant differences. For example, one is that Mexico's situation is more difficult because Mexico has some of the lowest tax revenues as a percentage of GDP among OECD and other developing countries and has had decades of low growth rates, which indicates low potential growth.

The relationship between monetary policy and fiscal policy in Mexico is also presented in the article (Marine C. André et.al, 2023), which complements the studies of previous authors. Through the lens of a small open emerging market economy that exports goods and raw materials, the authors propose a new framework for the monetary and fiscal policy mix to properly analyze how policymakers will respond to various domestic and global shocks in order to maintain a balanced budget and low inflation rates. The study is based on the objectives of policies and the impact of these policies on the main macroeconomic variables of Mexico from 2001 to 2019.

The article presents a model based on the Aguilar et.al model and consisting of two blocks - monetary and fiscal. The central bank maintains the principle of independence, takes fiscal decisions as a given, and fiscal policy is passive. In most studies (including those Aguilar et.al) treats the oil price shock as a simple supply shock, but in the authors' analysis the oil price shock is studied as a demand shock, which more closely resembles the economic structure of Mexico. An oil price shock is similar to a government spending shock, which is a demand shock specific to oil. In addition, this article is special in that the model used by the authors allows us to estimate the impact of both negative and positive oil price shocks, while most similar studies analyze only positive shocks, suggesting that negative oil price shocks lead to asymmetrical consequences.

The authors propose an adapted model that allows us to identify additional mechanisms that play an important role in the relationship between the interest rate, aggregate government debt and the sovereign risk premium. Based on this, several important conclusions were drawn. First, an exogenous increase in the sovereign risk premium (for example, due to higher levels of uncertainty) leads to a reduction in government spending and an increase in the budget deficit by reducing tax revenues. In particular, an increase in the sovereign risk premium complicates the implementation of monetary policy, since this leads to a depreciation of the exchange rate and, as a result, an increase in inflation. It also leads to a fall in economic activity as uncertainty discourages private investment and therefore reduces tax revenues. The latter implies an increase in public debt servicing and a deterioration in the country's budget balance. Second, shocks that positively affect government spending lead to higher interest rates due to inflationary pressures. Third, the setting of the interest rate after a certain shock may affect the change in the state of government finances, leading to a budget deficit.

The authors also describe the most optimal type of policy that, in the event of supply and demand shocks affecting both the fiscal and monetary blocks, causes the economy to approach a steady state more quickly. The authors assume that fiscal policy always remains passive, meaning that it aims to balance government finances even in the event of shocks. According to this hypothesis, after a positive shock to the sovereign risk premium or a depreciation of the national currency, the central bank should increase the interest rate to stabilize inflation pressures. In addition, after a positive shock to primary government spending, a shock from a deteriorating financial position, or an increase in oil prices, the central bank should also increase the interest rate to counter inflationary pressures.

In the context of the global crisis of 2022, Kazakhstan, like many other countries, is trying to establish joint work between two macroeconomic policies to achieve maximum results in stabilizing the economy. Working together, both types of policies can offset tightening global economic conditions. The government tries to cut spending to reduce the need for borrowing, and the central bank raises interest rates to reduce price increases, offsetting a weaker exchange rate and higher external debt. If both structures act decisively, they can cope with increased global uncertainty.