Mauricio Villafuerte, Cemile Sancak, Jan Gottschalk, S. M. Ali Abbas, Olivier Basdevant, Ricardo Velloso, Fuad Hasanov, Greetje Everaert, Stephanie Eble, and Junhyung Park
INTERNATIONAL MONETARY FUND
In response to the global financial crisis, governments provided substantial support to the financial and other key sectors. Although this cushioned the adverse effects of the crisis, it is necessary now to articulate a strategy to ensure the sustainability of public finances. This paper discusses the scale and composition of fiscal adjustment that will need to occur once the recovery is securely under way. Although specific country-level circumstances will influence the composition of the adjustment and its political feasibility, in many cases restoring fiscal sustainability will require reforms to reduce spending and increase tax revenue.
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1The impact of the global crisis on developing economies and their policy reactions and challenges are discussed in IMF (2009d).
2More technically, fiscal solvency requires that the value of outstanding government liabilities equals the expected present value of primary fiscal surpluses inclusive of seigniorage revenue.
3For a technical presentation of the intertemporal budget constraint, see Appendix IVb in IMF (2009b).
4The IMF staff recently estimated that a 1 percentage point of GDP increase in government debt leads government bond yields to rise by 5 basis points (bps). Thus, all else equal, a 35 percentage point of GDP increase in government debt would translate into about a 2 percentage point rise in interest rates (IMF, 2009e).
5Raising inflation by 5 percentage points would increase seigniorage by about ½ percentage point of GDP on average in the G7 countries, assuming that demand for base money would not decline as inflation rose.
6This simple approach, however, underestimates the total effect of growth on fiscal consolidation, because it does not take into account that it is easier for governments to run stronger primary balances when growth is higher. Ongoing research by the IMF staff envisages disentangling more clearly the interaction between growth and fiscal consolidation.
7Prudence also is required because studies of growth in the aftermath of financial crises show that only a small share of the deepest output loss is regained at the end of the decade following a crisis (Cerra and Saxena, 2008).
8Given Japan’s high level of government assets, the simulation example uses an estimate of net government debt for Japan. Moreover, in light of its weaker initial primary balance position, the example’s objective for Japan is to reduce its net government debt to 80 percent of GDP by 2030.
9The European Commission (EC), for example, recommends that fiscal consolidation start in the EU countries in 2011 at the latest, provided the recovery is strengthening and becomes self-sustaining. In addition, the EC points out that to lower debt ratios to below the 60 percent target in the Maastricht Treaty, a more ambitious adjustment path will be required in most EU countries than the Stability and Growth Pact benchmark of ½ percent of GDP a year, with required adjustments in excess of 1 percent of GDP for several years in France, Ireland, Portugal, Spain, and the United Kingdom (European Commission, 2009b).
10If the debt ratio is already lower than 40 percent, the primary balance path for that country is derived with a view to stabilizing the debt ratio at that lower level.
11Another piece of evidence that large fiscal consolidations are feasible stems from the estimation of a fiscal policy reaction function, which finds that advanced economies respond more strongly to high debt: when debt ratios are above 80 percent, the estimated adjustment in the primary balance is almost three times what is observed at lower debt levels (Callen and others, 2003).
12According to IMF staff estimates. For EU countries, health care costs are based on the Ageing Report (EC, 2009a), but using its less optimistic scenario for the growth of health care costs. (The EC’s baseline projection is regarded as too optimistic, because it does not take into account the likely continuation of the trend increase in the price of medical services observed in recent decades.) For other countries, official government projections are used when available. For pensions, baseline projections from the EU are used, and official government projections are used for other countries when available.
13Moreover, some measures could, at least in principle, have a positive effect on output. Extending the working life of the population can have a positive supply-side effect on output through an increase in the labor force; this effect is accompanied, on the demand side, by higher consumption due to higher incomes and, with a shorter retirement period, a reduced need to save.
14In the United States, the Budget Enforcement Act of 1990 actually imposed a nominal freeze on discretionary spending and a pay-as-you-go rule for any changes in mandatory spending entitlements or tax rules. This was one of the key reasons the fiscal deficit disappeared during the 1990s. The nominal freeze was successful because a rapid decline in military spending created room for higher discretionary spending elsewhere.
15For example, given the requirements imposed by the fight against global warming, appropriate carbon pricing (through either carbon taxation or the sale of emission rights) could represent an important new source of revenue, averaging some ½ percent of GDP a year in some advanced economies over the next decade and perhaps more later. Net benefits might be lower if their introduction is accompanied by increasing related transfers to developing economies.
16This said, fiscal responsibility laws and fiscal rules have played a significant role during past large fiscal adjustments. Sizable debt reductions were often accompanied by the introduction of fiscal rules—although in many cases implementation of the rule was delayed until after completion of the initial phase of the fiscal consolidation—to lock in fiscal gains and guard against reform fatigue (IMF, 2009b).
18Proper management and disposal of financial assets acquired during the crisis can make a small but not insignificant contribution to the reduction of government debt (perhaps on the order of 2 to 3 percentage points of GDP for advanced economies, against an initial investment of 4 percentage points of GDP).
19In spite of earlier sizable privatization during the 1990s, the value of state-owned enterprises in selected OECD countries still averages 17½ percentage points of GDP (based on a sample of 17 countries covered in OECD (2005); in most cases the data refer to enterprises owned by the central government).
1This exercise was also conducted for (1) end-2007, using Bank for International Settlements data (which cover a narrower list of countries) and (2) 2004, using a sample including low-income countries from Abbas and Christensen (2010). The results are robust.
2These ratings, which are published semiannually, are based on information provided by sovereign risk analysts and economists working at financial institutions that invest globally.
3This approach mimics that employed by Reinhart and others (2003), who also use institutional investors’ sovereign ratings as the preferred measure of perceived creditworthiness, with regressors including government debt-to-GDP, external debt-to-GNP, inflation, and record of past debt defaults.
4The results suggest that for countries with very high shares of domestic debt (DDINT = 2), increases in the debt-to-GDP ratio can lead to rating upgrades. A plausible explanation for this could be that higher local bond issuance in very-low-–debt countries could raise domestic debt market liquidity, thus boosting its attractiveness to investors.
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