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Albania: Selected Issues

Author(s):
International Monetary Fund
Published Date:
July 2010
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II. Fiscal Rules for Sustainable Public Finances in Albania20

Two fiscal rules—a debt rule and an expenditure rule with a debt brake—are discussed in the context of Albania’s current economic outlook. Although both rules would contribute towards enhancing fiscal sustainability, the expenditure rule directly allows for the full play of automatic stabilizers and keeps the size of government in check. Instead, the debt rule holds a closer link between the operational target and the sustainability objective.

A. Introduction

28. The recent rise in overall deficits and public debt contrasts with a decade long track record of public debt consolidation in Albania. Spending on the large Durres-Kukes road project consumed 3.5 percent of GDP in 2008 and 2009, pushing up government spending well above its long run trend. Moreover, the global economic downturn has put additional pressure on the 2009 budget through lower revenue collection. Looking ahead, the debt ratio is projected to remain rather high, given ambitious spending plans. This would reverse ten years of persistent public debt decline, making Albania vulnerable to adverse shocks.

General Government Budget, 1997–2009

(in percent of GDP)

29. Reducing the debt ratio is a desirable policy objective, all the more as Albania starts to access international capital markets to finance its deficits. In 2010 the authorities seek to place a debut Eurobond of €400 million, and reliance on international non-concessional finance is expected to increase in the future. The affordability of this strategy will depend on a credible reversal of the current debt trend. Not only is public debt on the rise, it is also large when compared to other countries in the region and the average in emerging market economies21. Although an optimal debt ratio is hard to determine, the indicative target of 50 percent of GDP—embraced the government’s program and more in line with other emerging markets—seems appropriate. Achieving such a target will require further strengthening of public finances, which could be operationalized by including a fiscal rule in the existing budget law.

30. Adopting a fiscal rule would help sustain a declining debt path, lock-in attained consolidation gains and therefore anchor market expectations of fiscal discipline. Under subsequent Fund-supported programs—from which Albania graduated in January 2009—standard program conditionality (ceilings on government net domestic borrowing and on nonconcessional external borrowing) have served as Albania’s fiscal anchor. After graduation, alternative anchors can be provided by a transparent and credible rule, which will nonetheless require political commitment to sound fiscal policy.22 An increasing number of advanced and emerging market economies have implemented some form of fiscal rule, to mitigate the well-known shortcomings of discretionary fiscal policy.

31. This paper discusses two possible numerical rules that could be introduced to attain fiscal sustainability: a debt rule and an expenditure rule with a debt brake. Albania’s specific circumstances motivate the choice of these two rules in particular and the overall discussion of this section. First, given the relatively high public debt ratio, any proposed rule has to ensure its sustained reduction. Second, since potential output estimates are unreliable, using fiscal rules based on cyclically adjusted fiscal indicators would be problematic. Finally, the rule should be fairly simple and transparent to allow government accountability while still providing a degree of flexibility in the face of economic shocks.

B. Debt Rule

32. Under a Debt Rule, the government sets a target/limit to the total stock of debt as a percentage of projected GDP. Starting from the current debt levels in Albania, and assuming 50 percent to be the target, the rule would simply require that, over time, the rate of increase in the nominal value of public debt is less than the rate of increase in nominal GDP:

Public debt ratio under the Debt Rule, different adjustment coefficients

(in % of GDP)

(Δ D/D) = α (Δ Y/Y), 0 < α < 1,

where D is nominal public debt measured in lek, Y nominal GDP and α is a coefficient determining the ambitiousness (speed) of debt decline. If α would be equal to 1, the debt ratio would not change. If α would be equal to zero, the stock of nominal debt would not change.

33. The operational target for this rule is either the primary balance or the overall balance, for given expectations on the exchange rate and evolution of the debt service. To understand how the rule would work in practice, note that the evolution of public debt is given by:

Dt+1 = [(1 + ε)(1 + rf) DFt] + (1 + rd)DDt – PBt+1,

where ε measures expected currency depreciation and rf, rd are foreign and domestic interest rates. DFt, and DDt stand for the initial value (in lek) of, respectively, foreign and domestic debt stocks and PBt+1 represents primary balance run during the period starting in t and ending in t+1. Thus, Dt+1 is the end of period lek value of the total debt stock. Given the desired convergence pace (α*) and projected increase in nominal GDP (ΔYp/Yp), the government would target an increase in debt equal to

(Δ Dt+1)* = α* (ΔYp/Yp)* . Dt

implicitly budgeting the primary and overall balances23:

PB*t+1 = -[α* (ΔYp/Yp)* . Dt] + [ε DFt + rf . DFt + ε . rf . DFt] + [rd . DDt],

OB*t+1 = -[α* (ΔYp/Yp)* . Dt] + ε DFt.

The lower is α, the smaller would be the targeted increase in nominal debt relative to the increase in nominal GDP, the stronger would be the required primary balance, and the faster would be—other things being equal—the reduction of the debt ratio. Using staff’s medium term macro projections, the necessary balances for different α’s are computed and plotted bellow (for α=1 we show also the necessary fiscal balance if the lek depreciates by 5 percent—in the figure labeled “ER shock”):

Required overall balance under Debt Rule

(in % of GDP)

Required primary balance under Debt Rule

(in % of GDP)

34. For the rule to be effective, GDP projections need to be on the conservative side. A systematic overestimation of nominal GDP would produce a slower decline in the debt ratio, and vice versa. The concern is not a projection mistake related to cyclical fluctuations in nominal GDP, but rather a mistake related to longer-term growth potential. To avoid a perception that nominal GDP projections would be biased as a result of political consideration, an independent projection could be used to determine ΔYp.

35. The debt rule can be modified to allow more cyclical flexibility, as long as credibility is not undermined. When a negative output gap is expected, the authorities may wish to temporarily reduce the adjustment pace and run higher primary deficits (and vice versa). Modifying the debt rule to allow for this kind of discretion is theoretically beneficial for macroeconomic stabilization. However, the discretionary feature could in the end turn the rule less transparent, if only because reliable output gap projections are arguably hard to obtain and agree upon.

C. Expenditure Rule with Debt Brake

36. Another option for Albania would be an expenditure rule, with a correction mechanism to guide against slippages on the revenue side: a debt brake. The correction mechanism is considered to be an important safeguard of the expenditure rule, because on its own, such a rule may not suffice to ensure low deficits and a declining debt ratio. There are several options on how to set the targeted expenditure growth. The rule could aim to maintain a chosen ratio of expenditure to GDP or target a rate of real expenditure growth (γ) that is consistent with fiscal sustainability. The operational target is, by construction, public expenditure growth:

where G denotes nominal expenditures and πe is the expected inflation rate.

However, since the overall budget balance depends on revenue performance, the final debt dynamics is not directly controlled by the operational target. Slippages on the revenue side (or increased tax expenditures) could weaken the fiscal stance even if expenditure limits are strictly observed. One solution to this weakness, used in countries with the expenditure rule, is to reinforce it with a mechanism that would require corrective measures if revenue collection weakens for other than cyclical reasons. The proposed rule will then trigger lower expenditure growth (and, if necessary, tax increases) if debt levels stay persistently above the target. In that event, the adjustment mechanism would be similar to a debt rule.

37. How would the fiscal balance and debt evolve under the proposed expenditure rule? Debt dynamics will not only depend on unforeseeable cycles but also on the average tax elasticity. Up until 2008, the later exceeded 1 with a significant margin, reflecting, inter alia, the positive impact of improvements in revenue administration on tax collection. In 2009, however, it suddenly dropped to ½. Looking into the coming years, we consider three possible scenarios: (i) tax elasticity gradually converges to 1; (ii) tax elasticity recoups above 1, albeit to lower than historical levels; and (iii) tax elasticity remains below to 1, even if recovering somewhat. The following figures illustrate the resulting revenue paths under each case and the implications for projected deficits and debt. Real expenditure growth rates of two and zero percent are considered, after netting out the Durres-Kukes road cost. These are for illustrative purposes and are significantly lower than the expenditure growth rates projected in Table 2 of the Staff Report, which in turn are based on the most recent medium-term fiscal update.24

If the elasticity of tax revenue remains above 1 in the medium run, 2 percent real expenditure growth is consistent with a relatively quick convergence to the 50 percent debt target. However, in case the tax elasticity were to remain below one, such a path would protract high levels of public debt. Note that 2 percent is lower than real GDP growth and therefore the expenditure share is anyway declining.

Revenue projection for different elasticity assumptions, 2010–2015

(in % of GDP)

Overall budget balance under expenditure rule, alternative revenue elasticity assumptions

(in % of GDP)

Public debt under different revenue elasticities (in % of GDP) Real expenditure growth: 2 percent

Public debt under different revenue elasticities (in % of GDP) Constant real expenditure

38. The expenditure rule provides a significant degree of fiscal policy flexibility in response to cyclical output fluctuations, while keeping the size of the government in check. It allows the full operation of automatic stabilizers on the revenue side, meaning that at the outturn debt would fluctuate around the simulated paths. Given Albania’s still limited social safety net, revenue automatic stabilizers are more important than expenditure automatic stabilizers. In addition, the rule would allow expenditure growth to remain unaffected by cyclical output fluctuations. Because automatic stabilizers on the expenditure side are rather small, this should not produce significant further cyclical swings of fiscal balance, beyond that resulting from cyclical fluctuations of revenue. Finally, it is bound to prevent excessive public spending, which would eventually force up distortionary tax rates.

39. However, in Albania’s circumstances, there is a good case for trading off some of this flexibility for heightened credibility. Until a significant reduction in the high level of public debt is achieved, it would be beneficial to introduce a debt-brake mechanism into an expenditure-based fiscal rule. This would help anchor expectations on continued fiscal consolidation, while still permitting substantial play of automatic stabilizers.

D. Conclusion

40. As Albania starts acessing international capital markets to finance part of government borrowing needs, it is ever more important to implment a robust fiscal policy framework that would strengthen fiscal discipline and fiscal credibility. A numerical fiscal rule could play a helpful role in achieving these objectives.

41. One option would be to introduce a debt rule, where the rate of public debt growth would be set as a fraction of nominal GDP growth. Such a rule entails a strong link between the policy objective and operational target. Under some circunstances, it also allows for the stabilization of economic cycles. Alternatively, an expenditure rule could be considered, that would impose a limit on the nominal or real growth of total expenditure. Given the weak link between the operational target and fiscal sustainability in this rule, it is necessary to complement it with a correction mechanism that would trigger lower spending growth or tax increases in case the targeted reduction of the debt ratio fails to materialize due to protracted weakness in revenue collection or shocks that would permanently worsen the debt ratio.

42. The choice for one or the other rule depends ultimately on the government’s preference for a higher or lower size of the public sector, growth prospects, long run elasticity of tax revenue and the forecasting capacity. Regardless, a necessary condition for the success of either option is a strong political commitment to restore the sustainability of public finances as first priority.

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Prepared by Joana Pereira, based on Jonas (2010).

See IMF (2003) and Jonas (2010) for deeper discussions on, respectively, the appropriate debt limits in emerging markets and Albania.

See IMF (2009) for the recent overview of experience with fiscal rules. Although evidence suggests that fiscal rules improve fiscal outcomes, they cannot substitute for a lack of commitment to fiscal discipline.

Instead of defining a debt rule with a constant α, one may instead define a deficit (or primary deficit) rule that yields roughly the same pace of convergence (if ε and the interest rates are not too volatile). α would in that case vary year to year, if only slightly.

Revenue projections in Table 2 correspond to scenario (i).

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