This section is intended to derive some guiding principles on the appropriate medium-term fiscal stance for the Baltics on the basis of theoretical and empirical evidence. It will look at: (1) the relationship between fiscal policy and growth, including the extent to which economic performance can be enhanced by shifts in the composition of public expenditure and in the structure of taxation: (2) determinants of fiscal and external sustainability; and (3) recent experience with fiscal policy rules.
Growth
Fiscal consolidation, depending on how it is achieved, can be conducive to improved economic performance over the medium to long term. This view is rooted in economic theory and supported by empirical evidence. There is an extensive literature on the relationship between fiscal policy and economic growth from which it emerges that fiscal sustainability is in itself conducive to improved economic performance (Box 2). This conclusion is based on the general notions that fiscal policy should support efforts to achieve and sustain stable and low inflation, and that the public sector should not absorb an excessive share of national saving. The point at which the public use of national saving becomes excessive is unclear. It will depend, among other things, on the benefits of public spending and the extent of crowding-out and crowding-in effects. Sustained fiscal prudence in Estonia, for example, has been an important factor behind a favorable credit rating and low interest rates, including for private entities.7
Economic performance can be further enhanced by shifts in the structure of taxation and public expenditure. Theories of “optimal taxation” suggest that a shift toward indirect taxation can improve economic efficiency by reducing distortions to saving and investment decisions, thereby raising potential growth. Empirical evidence lends to support this view, and a number of countries in western Europe have sought to modernize their tax systems along these lines. The theory of “optimal expenditure” is less well-developed as such, although similar conclusions emerge: it is possible to identify “productive” and “nonproductive” expenditure, and a shift in the composition of expenditure toward the former can enhance growth. In addition, the success of fiscal consolidation itself, in terms of both its durability and its impact on growth, partly depends on the manner in which it is achieved. Experience in other countries suggests that consolidation tends to be more successful where it is based on expenditure cuts rather than on revenue increases.
There are, however, limits to the extent to which the structure of taxation and expenditure can be altered. Moreover, such decisions are also subject to a range of noneconomic considerations. Tanzi and Schuknecht (1996) studied historical trends in public expenditure and improvements in social and economic indicators in industrial countries. They concluded that, as a rule of thumb, total spending could be reduced to about 30 percent of GDP without sacrificing much in terms of social economic objectives. Public spending in the Baltics is above this threshold (albeit only slightly in Lithuania). However, spending on categories that are typically regarded as “nonproductive” (that is, social security and welfare) is already low by international standards (with perhaps the exception of Latvia). This suggests that the Baltics may need to identify other nonproductive or inefficient spending programs that could be cut to create the room for desirable tax cuts or EU-related expenditure, or to facilitate further modest fiscal adjustment where needed.
The potential efficiency gains from shifts toward indirect taxation would also need to be matched against equity considerations.8 Consumption taxes tend to be less progressive than income and payroll taxes. Such a shift would affect intergenerational equity, in favor of younger generations during the transition period (since pensioners would not reap the benefits of lower taxation on wage incomes). It would also shift the burden of taxation to recipients of transfer incomes (including pensioners and the unemployed). Because indirect taxes are already a significant source of tax revenue in the Baltics, the scope for a significant further shift to indirect taxation may therefore be limited.
Fiscal Policy and Economic Growth
Fiscal policy can affect economic growth through the size of the government’s budget balance (and the resulting government debt) and the scale and composition of taxation and public expenditure. Permanently large fiscal deficits and the associated rising stock of government debt will tend to lead to an increase in interest rates, crowd out private sector investment, and ultimately reduce growth relative to potential. However, there is little consensus on what constitutes an optimal level of debt, and different economic theories indicate that the optimal level of government debt is likely to be influenced by a disparate range of factors.
Endogenous growth theories suggest that investment in human and physical capital can affect an economy’s long-run growth rate, and that some elements of tax and government expenditure can play a role in the growth process.1 In empirical work on OECD countries, for example, Kneller, Bleany, and Gemmel (1999) find that “productive” expenditure (defined as public services, health and education, transport, and communication) tends to increase growth, whereas “nonproductive” spending (mainly social security and welfare expenditure) has a limited impact. By the same token, Gerson (1998) concludes that expenditure has a more powerful effect on growth rates than revenues and that balanced-budget increases in spending on health, infrastructure, and the social fabric, if well-targeted, can be growth enhancing.
The efficiency losses associated with taxation must also be taken into account when the cost and benefits of public expenditure are being assessed. Leibfritz, Thornton, and Bibbee (1997), for example, estimate that, for a sample of OECD countries, a 10 percentage point increase in the aggregate tax-to-GDP ratio is associated with a reduction in annual GDP growth rates by about half a percentage point.2 It may be possible, however, to adjust the composition of taxation to reduce distortions and thus improve economic performance. Optimal tax theory, for example, tends to favor indirect over direct taxation. Kneiler, Bleany, and Gemmel (1999) provide empirical support for the optimal lax theory, finding that direct taxes tend to reduce growth, whereas taxes on goods and services have no significant effect.
The impact of changes in the fiscal balance remains an area of some dispute.3 The standard Keynesian view is that fiscal contraction will lower output in the short run through a reduction in aggregate demand. More recent theories, however, have argued that in some circumstances fiscal contraction can increase growth, even in the short run—for example, by reducing large risk premia on interest rates associated with a public debt sustainability problem. This underlines the importance of a credible fiscal policy for achieving investment and growth, and as a precondition to allow the successful use of automatic stabilizers. If deficit or debt levels are already high, then an automatic increase in the government deficit in response to an economic downturn may have a small or adverse rather than stabilizing effect on output, as confidence effects and increases in interest rates outweigh the income multiplier effects.
1 See Barro and Sala-i-Martin (1992) and Tanzi and Zee (1997). 2 Similar results were found by Barro (1989), Plosser (1992). and King and Rebelo (1990). Nonsignificant or positive correlation was found in other studies, such as Levine and Renelt (1992). Slemrod (1995). and Hendricks (1999). 3 See, for example, IMF (1996) and (2001).The scope for future tax reforms is also affected by changes in the nature of the world economy. Globalization has led to a general switch toward less mobile tax bases as trade and capital account liberalization have increased the potential for tax competition between countries. This has brought about a decrease in statutory and average effective rates of the corporate tax in many countries, and an increase in taxes on labor and consumption in order to preserve overall revenues. Such considerations hold particularly true for the Baltics, given their status as small open economies, increasingly integrated into the European and global economies, and their reliance on foreign saving to finance a substantial proportion of domestic investment. As a practical matter, this means that there are ever more binding constraints on the degree to which the tax treatment of capital and easily transportable commodities in the Baltics can deviate from the practice in neighboring or competing economies. Some such constraints will ultimately also become binding in a legal sense, because the Baltic countries will have to harmonize their taxation with EU requirements, as discussed above.
Fiscal Sustainability
The sustainability of public and external debt, and the current account, can be key factors in determining an appropriate medium-term fiscal strategy. But, as argued below—and discussed, in more detail, in the appendix to this section—none of these factors is likely to present a binding constraint on fiscal policy in the Baltics in the near future, provided that current growth rates are sustained and, in the case of external debt sustainability, FD1 inflows continue to remain strong.
The level of public and publicly guaranteed debt in the Baltics is enviably low by international standards, reflecting the impact of a prudent fiscal policy stance throughout much of the transition period. Public debt relative to GDP is particularly low in Estonia and Latvia, at 6 percent and 15 percent, respectively, and is also relatively low by international standards in Lithuania, at 29 percent. Public debt ratios in all three countries increased following the loosening of fiscal policies (especially in Lithuania) in the wake of the Russian financial crisis in 1999. but they have since stabilized or started to fall with the return to tighter budgets in 2000 and 2001. With Estonia having run a primary surplus in 2001, and Latvia and Lithuania likely to do so within the next one or two years, public debt ratios are likely to fall further over the medium term.
Although current account deficits have at times been sizable (see Section I), they have, for the most part, been financed by non-debt-creating FDI inflows, leaving external debt low by international standards. Annual FDI inflows have averaged around 6 percent of GDP from 1997 to 2000, sufficient to cover around three-fourths of the current account deficits over the corresponding period. Net external debt ranged from 13 to 14 percent of GDP for Estonia and Latvia to 26 percent of GDP for Lithuania in 2000. Current account deficits are expected to narrow somewhat over the medium term. FDI inflows may moderate somewhat following the completion of most major privatization projects, but they are expected to remain substantial given the Baltic countries’ favorable EU accession prospects. If growth continues at something close to current trends, this would be consistent with broadly stable external debt ratios in Estonia and Latvia, and a moderate decline in the external debt ratio in Lithuania. External sustainability could, however, become a concern in the event of a significant reduction in FDI inflows, especially if this were also associated with a reduction in economic growth. In such circumstances, concerns about external sustainability. which would argue for a tighter fiscal stance, would have to be balanced against domestic cyclical considerations.
The link between fiscal policy and external sustainability is. however, complicated and depends crucially on the response of private saving and investment to changes in fiscal policy. This relationship—and in particular, the extent to which changes in fiscal policy are offset by changes in private saving and investment—has been the focus of extensive theoretical and empirical research (Box 3). This research concludes that the offset tends to be only partial in developing and transition economies, suggesting that fiscal policy may have some influence on movements in the current account. However, the magnitude of the response of private saving and investment to changes in fiscal policy is difficult to quantify with any certainty and will depend, among other things, on the accompanying shifts in the level and structure of revenue and expenditure. This makes it difficult to use fiscal policy to hit precisely a particular external target.
Moreover, even if the magnitude of the “Ricardian offsets” is known, factors other than fiscal policy appear to have been more important determinants of recent current account developments. Relative business cycles and asset market developments, for example, appear to be among the primary drivers of current account positions in advanced countries (see IMF, 2001, page 99). Although fiscal policy has a role to play in the Baltics in determining the size of current account deficits and ensuring external sustainability, cyclical factors may be a more important determinant of private saving.
The lack of immediate concerns about public and external debt sustainability suggests that the Baltic countries have some flexibility that could—if there were no other constraints on fiscal policy—be used to reconcile medium-term expenditure pressures with the desire for lower taxes, without the need for offsetting reductions in other expenditure. The analysis in the appendix to this section suggests that a roughly balanced primary fiscal position would be sufficient to stabilize public debt ratios, in each of the Baltic countries, at their current low levels. As an extreme example, policymakers could, in principle, target mode rate-to-large primary deficits—perhaps in the order of 1 ½ percent of GDP in Lithuania, and around 3 percent of GDP in Estonia and Latvia—for several years before public debt reached the SGP reference value of 60 percent of GDP.9 The analysis also suggests that—provided that growth and FDI inflows continue at roughly their current rates, and current account deficits stabilize at less than 6–7 percent of GDP—external debt ratios will stabilize or fall further. This contrasts somewhat with the position in other accession candidates in central Europe, where similar illustrative calculations (see Daseking and Christou, 2002) indicate that in most countries some fiscal adjustment, in the range of 2 to 4 percentage points of GDP, may be required to avoid a deterioration in external indebtedness.
Private Saving and Investment
Fiscal policy affects private saving and investment decisions, and this has important repercussions for a country’s external position. From a theoretical perspective, private saving can be affected by variations in public saving, known as the Ricardian equivalence theorem. In open economies, Ricardian equivalence implies that a decrease in public saving would not affect the external current account balance, since it would be matched by an equivalent increase in private saving. Nonetheless, the existence of such full Ricardian equivalence is challenged by theoretical models with overlapping generations, incorporating a life-cycle consumption aspect and implying that lower public saving will be only partially offset by higher private saving.1 In an open economy, less-than-full Ricardian equivalence implies that a given increase in the fiscal deficit would entail a temporary (and smaller) increase in the external current account deficit and higher interest rates.
Whether the concept of Ricardian equivalence is relevant from a practical policy perspective is an empirical question. Although close-to-full Ricardian equivalence has been observed in industrial countries, 2 such effects tend to be partial in developing and transition countries.3 A recent study concluded that Ricardian effects were also only partial in the Baltic countries, and that fiscal stimuli would therefore tend to trigger offsetting improvements in the private saving-investment balance only to a limited extent. By implication, fiscal policy could have a role to play in determining the size of the current account deficit and ensuring external sustainability.
These arguments have been further refined by recent empirical research, which has found that the impact of changes in fiscal policy on private saving and investment also depends on whether these are the result of changes in revenue or expenditure. The following broad conclusions emerge:4 (1) fiscal consolidation driven by cuts in current spending should result in only a small (if any) reduction in private saving; (2) the results on the private sector response to changes in public investment are less clear-cut; (3) increases in revenue, by contrast, tend to lower private saving significantly: and (4) the literature on the response of private investment is less developed but suggests that cuts in spending tend to raise private investment, whereas revenue-driven consolidation has the opposite effect (but likely of significantly smaller magnitude). On balance, therefore, the improvement in the current account as a result of fiscal consolidation is likely to be partially offset by a fall in private saving and an increase in private investment, although the magnitude of this offset is highly uncertain.
1 Modigliani and Brumberg (1954) and Diamond (1965). Also see Blanchard and Fischer (1993), Chapter 3. 2 Haque, Pesaran, and Sharma (1999) estimated that changes in private saving offset changes in public saving by up to 90 percent. 3 Weaker effects in less advanced economies (with a 40 to 50 percent private saving offset) typically reflect less developed financial markets and low incomes, which inhibit consumption smoothing. See Masson, Bayoumi. and Samiei (1995). 3 See Masson, Bayoumi, and Samiei (1995); Haque, Pesaran. and Sharma (1999): Callen and Thimann (1997); and Daseking and Christou (2002).However, there are other constraints on fiscal policy in the Baltics that provide stronger arguments for remaining well within the limits of what constitutes a sustainable fiscal policy. These are partly institutional or political economy arguments (discussed in the next section) and partly economic:
Doing so would reduce the likelihood of crowding out more productive private sector investment and would help to maintain low interest rates, which have already done much to stimulate private sector-led economic growth in the Baltics.
Private saving is projected to level off over the medium term. This, together with an expected increase in public investment, suggests that strong government saving will be necessary to avoid an increase in external imbalances.
Maintaining fiscal prudence would continue to provide fiscal policymakers with the flexibility to borrow, at reasonable interest rates, in response to domestic and external shocks.10 Such flexibility is particularly important in the Baltic countries, given their exchange rate regimes, and can in itself help to minimize the risk of a sudden reversal in capital flows, reduce risk premia, and thereby reduce interest rates.
Moving toward a balanced budget will make the Baltics less vulnerable to possible contagion from financial crises in other emerging market economies, especially if financing needs are short-term or require a debt rollover.
The flexibility of fiscal policy needs to be preserved in view of its role as the main macro-economic policy instrument at the disposal of the national authorities, given the Baltic countries’ exchange rate regimes,11
The Baltic countries will soon be required to operate within the constraints set by the Maastricht Treaty and SGP. During the cyclical downturns of the 1990s, many EU countries reduced fiscal deficits in order to meet the Maastricht or SGP criteria. Hence, automatic stabilizers were not, or not fully, operating during these periods. In the Baltics, therefore, a continuation of prudent fiscal policies at this stage would avoid the possible need for similar future procyclical fiscal adjustments to meet these constraints.12
Finally, a prudent fiscal stance would help to ensure fiscal sustainability in the very long term, when public debt considerations are likely to become a more binding gonstraint, for several reasons. Growth rates are likely to fall as the process of real convergence with advanced economies nears completion. Privatization receipts, which have, in part, enabled fiscal deficits to be financed without adding to the stock of public debt, will decline in the near future, and demographic pressures related to aging populations are likely to increase the pressure on the public finances over the longer term.
Fiscal Policy Rules
Fiscal policy in the Baltics could be further supported by a rules-based framework, provided that it is implemented with sufficient flexibility and transparency (Box 4). The adoption of a simple and transparent fiscal rule to which governments can commit can reduce the politically driven bias toward larger fiscal deficits. A commitment to a specific ex ante target for the budget balance, for example, may limit the deterioration in the balance that emerges ex post following policy slippage or unexpected shocks. Such rules could, for the same reason, provide the discipline necessary to check pressures for an increase in public spending that would further crowd out the private sector. This is especially relevant in the Baltics, where such pressures will emerge from the EU and NATO accession process. The upshot of adopting a rules-based fiscal framework is likely to be a virtuous cycle of enhanced government credibility, a reduction in interest rates for both the public and the private sector, and improved economic performance.
The adoption of suitable fiscal rules can also support the credibility of the hard pegs in the Baltics. One such rule, already in place, precludes the governments in all three countries from taking recourse in central bank financing. Additional fiscal rules could be considered but, given the Baltic countries’ exchange rate regimes, such rules would have to be weighed against the role fiscal policy plays as the only significant policy lever available to deal with short-term macroeconomic fluctuations. Fiscal policy rules, therefore, need to be defined in terms that allow sufficient flexibility to deal with such fluctuations, as stated above.
Against this background, questions then arise about the most appropriate fiscal policy rule for the Baltic countries and how such a rule should be applied. A balanced-budget rule is perhaps the most simple rule and has the advantage of being clear and focusing on a well-understood macroeconomic aggregate that is relatively easy to define and monitor.13 However, such a rule, if applied rigidly from year to year, would override the operation of automatic fiscal stabilizers. Maintaining a balanced budget in a recession would necessitate tax increases or spending cuts to offset the operation of the automatic stabilizers, resulting in a procyclical stance that would undermine macroeconomic stability.
Those countries that follow balanced-budget rules (or other deficit targets) have therefore tended, on average, to balance the budget (or follow the deficit target) over the medium term or the economic cycle. Although such a refinement is clearly preferable from an economic perspective, it may also undermine credibility to the extent that the benchmark against which fiscal performance is judged is less immediately visible.
Institutional Fiscal Reforms: Rules and Transparency
Recent fiscal consolidation in a number of countries has been secured in the context of reforms to fiscal frameworks. These institutional reforms have included, notably, the adoption of fiscal rules and enhanced fiscal transparency.1 Fiscal rules can take various forms, such as formal deficit and debt rules, or limits on expenditure. The arguments about fiscal rules are, to a large extent, an extension of traditional arguments about the role of rules versus discretion in economic policy formulation. In theory, rigid adherence to fiscal rules might impair the short-run stabilization and tax-smoothing role of fiscal policy. A judicious mix of discretionary fiscal and monetary policy, guided by targets for macroeconomic performance (such as inflation and the current account) can be viewed as conceptually superior to fiscal rules. However, the superiority of discretionary fiscal policy has not always been corroborated in practice. Fiscal rules, by limiting the influence of contingent events on fiscal outcomes, can strengthen fiscal discipline and counter the politically induced deficit bias of many governments.2
Fiscal frameworks in some countries have been further enhanced by placing an explicit emphasis on transparency to increase accountability for the design and implementation of fiscal policy. Fiscal transparency also helps to relax the trade-off between the need for discretion and rules in fiscal policy. A commitment to transparency also raises the chance that a government can retain credibility if it needs to temporarily deviate from its fiscal rules or targets. Transparency can further enhance the credibility of fiscal rules by removing any tendency to be nontransparent in order to meet a rule, and by facilitating judgments of performance against a given rule.
Participants in the EMU have adopted deficit and debt rules under the Maastricht Treaty and the subsequent SGP, but the Baltic countries would not become subject to these rules until after EU accession. The Baltics could unilaterally declare their adherence to these rules, adopt other fiscal rules in line with practice in other countries, or announce a credible commitment to pursue their own fiscal adjustment path. Within the EU and EMU, some countries have adopted additional rules. The United Kingdom, for example, has adopted a “golden rule” for borrowing together with a limit on public debt, with the latter necessary to ensure fiscal sustainability. Sweden, Finland, and the Netherlands have adopted expenditure limits.
1 See IMF (2001), which also cautions that such reforms are relatively recent and have yet to be tested in a recession. 2 See, for example, Kopits and Symansky (1998).The concept of cyclical adjustment is also particularly difficult to apply in transition economies, where estimates of potential output and revenue and expenditure elasticities are subject to substantial margins of error. The adoption of a prudent but realistic trend (or potential) growth rate assumption could, however, allow the Baltics to converge toward a reasonable approximation of structural budget balance.
Convergence toward cyclically adjusted or structural budget balance, and the eventual adoption of a structural bud get-balance rule, would also need to be implemented with a reasonable degree of flexibility in the Baltic countries, given their particular circumstances. 14 The automatic fiscal stabilizers, for example, should normally be allowed to operate fully. The Baltics may need to accommodate asymmetric shocks by resorting to discretionary action in addition to relying on automatic stabilizers, given the absence of the exchange rate as an adjustment instrument. Moreover, in the near to medium term at least, additional room may be necessary for outlays in connection with the remaining transition-related tasks of structural reform.
Expenditure limits represent a possible alternative to a cyclically adjusted balanced-budget rule. Such limits typically apply to discretionary spending and also tackle the potential deficit bias resulting from political pressures to increase spending. They allow automatic stabilizers to work and thus operate as a cyclically adjusted deficit rule. But such limits do not necessarily preclude large tax cuts or the systematic over prediction of revenues, which can lead to excessive fiscal deficits. It may still be necessary, therefore, to supplement a binding expenditure rule with a medium-term “target” for the budget balance, again based on an appropriately prudent assumption about the trend growth rate. Such a target represents a weaker form of commitment than a binding rule, but it may nonetheless ensure sufficient discipline.15
Whatever the precise choice of fiscal rule, the experience of other countries suggests that an explicit emphasis on transparency is an essential requirement for rules to be effective. Transparency helps to build policy credibility, which can in turn enable policymakers to operate more flexibly within a given fiscal framework. In a similar way, inflation targeting can best be understood as a monetary policy framework rather than a rigid rule. And the high degree of transparency associated with inflation targeting is a critical element in building the credibility necessary to allow monetary policy to be implemented flexibly.
In summary, the fiscal positions in all three Baltic-countries are in essence already relatively sound. Public debt is low by international standards, and net external debt is only moderate. These two factors combined suggest scope for flexibility in setting fiscal policy without running up against concerns about debt or external sustainability—provided that FDI inflows continue to largely finance the persistent current account deficits. However, there are stronger arguments in favor of adopting a more constrained approach, as discussed above. The experience of other countries suggests that fiscal rules can be useful in this regard, provided that they are appropriately defined. In the Baltics, the adoption of a medium-term or cyclically adjusted balanced-budget rule—or some form of expenditure limit supplemented by a medium-term balanced-budget “target”—could further enhance the credibility of the authorities’ macroeconomic policy frameworks, provided that it would be implemented flexibly and supported by sufficient transparency, and be consistent with their prospective obligations in terms of policy coordination after EU accession.
Appendix: Determining the Medium-Term Fiscal Position—The Role of Public and External Debt Sustainability
This appendix assesses the extent to which the sustainability of public and external debt, and the current account, may play a role in setting medium-term fiscal targets in the Baltics. Analysis of the sustainable fiscal stance typically focuses on whether it can be financed at an acceptable inflation rate without a trend rise in public debt ratios. The current account, and especially the need for debt-creating financing, can also be a factor constraining the macroeconomic stance because investors are averse to what may be seen as unsustainable trends in external debt. The analysis is undertaken within a simple quantitative framework.16
The Public Debt Anchor
Fiscal sustainability is often assessed on the basis of the sustainability of public debt. One simple approach is to determine the primary fiscal balance (p) that is required to achieve a stable debt-to-GDP ratio(d).17 It is given by the following relationship:
whre r denotes the real interest rate: g the real GDP growth rate, and a non-debt-creating financing (e.g., privatization receipts). As long as the real interest rate on public debt exceeds the real growth rate of the economy, public debt would tend to grow faster than GDP unless a country runs a primary surplus. The larger is the wedge between the real interest rate and the real growth rate, the larger will be the primary surplus needed to stabilize the debt-to-GDP ratio.
Table 1 shows the primary balances consistent with stable public debt ratios. Assuming a real interest rate of 4½ percent, stable public debt ratios would be consistent with a broadly balanced primary position in each country. Real interest rates on public debt have actually been significantly lower than 4½percent in recent years, but real long-term bond yields in the euro area have averaged 4½ percent over the past ten years. Estonia is likely to run a primary surplus this year, and Latvia and Lithuania are expected to do so within the next one or two years, indicating that, if the positions are maintained, debt ratios will fall from their current levels. Under less favorable assumptions—of lower growth and a higher real interest rate—public debt stability would still be consistent with a balanced primary position in Estonia and Latvia, and with a primary surplus of ½ of 1 percent of GDP in Lithuania.
Public Debt Sustainability Under Alternative Assumptions
(Percent of GDP, unless otherwise indicated)
The primary balance is defined as total revenue minus noninterest expenditure.
Includes publicly guaranteed debt.
Illustrative assumptions. The average implied real interest rate on government debt during 1998–2000 (calculated as a ratio of interest payment to government debt, deflated by GDP inflation) has been close to zero in Estonia, and around I percent and 3 percent in Latvia and Lithuania, respectively.
Public Debt Sustainability Under Alternative Assumptions
(Percent of GDP, unless otherwise indicated)
| Estonia | Latvia | Lithuania | |||||
|---|---|---|---|---|---|---|---|
| Baseline | Pessimistic | Baseline | Pessimistic | Baseline | Pessimistic | ||
| Primary fiscal balance consistent with1 | |||||||
| Stable public debt ratio | -0.1 | 0.0 | -0.2 | 0.0 | 0.1 | 0.6 | |
| Public debt ratio of 60 percent in 20202 | -3.0 | -2.5 | -2.8 | -2.3 | -1.3 | -0.7 | |
| Assumptions | |||||||
| Real GDP growth (percent) | 5.5 | 4.5 | 6.0 | 5.0 | 4.0 | 3.0 | |
| Real interest rate (percent)3 | 4.5 | 5.0 | 4.5 | 5.0 | 4.5 | 5.0 | |
| Non-debt-creating financing | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | |
| Memorandum items | |||||||
| Public debt ratio (2000)2 | 6.2 | 15.0 | 29.0 | ||||
| Primary fiscal balance (2000) | 0.0 | -2.2 | -1.1 | ||||
The primary balance is defined as total revenue minus noninterest expenditure.
Includes publicly guaranteed debt.
Illustrative assumptions. The average implied real interest rate on government debt during 1998–2000 (calculated as a ratio of interest payment to government debt, deflated by GDP inflation) has been close to zero in Estonia, and around I percent and 3 percent in Latvia and Lithuania, respectively.
Public Debt Sustainability Under Alternative Assumptions
(Percent of GDP, unless otherwise indicated)
| Estonia | Latvia | Lithuania | |||||
|---|---|---|---|---|---|---|---|
| Baseline | Pessimistic | Baseline | Pessimistic | Baseline | Pessimistic | ||
| Primary fiscal balance consistent with1 | |||||||
| Stable public debt ratio | -0.1 | 0.0 | -0.2 | 0.0 | 0.1 | 0.6 | |
| Public debt ratio of 60 percent in 20202 | -3.0 | -2.5 | -2.8 | -2.3 | -1.3 | -0.7 | |
| Assumptions | |||||||
| Real GDP growth (percent) | 5.5 | 4.5 | 6.0 | 5.0 | 4.0 | 3.0 | |
| Real interest rate (percent)3 | 4.5 | 5.0 | 4.5 | 5.0 | 4.5 | 5.0 | |
| Non-debt-creating financing | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | |
| Memorandum items | |||||||
| Public debt ratio (2000)2 | 6.2 | 15.0 | 29.0 | ||||
| Primary fiscal balance (2000) | 0.0 | -2.2 | -1.1 | ||||
The primary balance is defined as total revenue minus noninterest expenditure.
Includes publicly guaranteed debt.
Illustrative assumptions. The average implied real interest rate on government debt during 1998–2000 (calculated as a ratio of interest payment to government debt, deflated by GDP inflation) has been close to zero in Estonia, and around I percent and 3 percent in Latvia and Lithuania, respectively.
However, the optimal level at which public debt should be stabilized is unclear. It will depend, in the first instance, on how debt affects the economy—an issue on which there is little consensus.18 Public debt is low in terms of GDP in Estonia and Latvia at 6 percent and 15 percent, respectively, following the prudent fiscal stance maintained throughout most of the transition period, and it is relatively low in Lithuania at 29 percent. The Baltics could thus allow debt ratios to rise for some time, before their debt levels were considered too costly in terms of their impact on credit ratings and risk premia. As an extreme example, Table 1 shows the primary balances that would be consistent with a rise in debt ratios to 60 percent of GDP by 2020, one of the two SGP criteria for assessing fiscal discipline. Estonia and Latvia could, in theory, run annual primary fiscal deficits of around 2½-3 percent of GDP until 2020, and Lithuania around ¾-1¼ percent of GDP, before their debt ratios reached 60 percent of GDP. But the implicit overall fiscal deficit associated with such primary deficits would quickly exceed 3 percent of GDP—the other reference criterion used, under the SGP, for assessing fiscal discipline. The extent to which the Baltics should take advantage of this flexibility depends on a range of other factors, as discussed earlier in Section III.
The External Debt and Current Account Anchor
External considerations can also play a crucial role in assessing the sustainability of a country’s macroeconomic position and prospects. Vulnerability to balance of payments crises tends to grow with increasing external imbalance and indebtedness.19 Such an approach usually focuses on the sustainability of the current account (including its financing through non-debt-creating flows) and of its external debt and on determining the fiscal position that is consistent with external sustainability, subject to assumptions about private saving and investment. The behavior of private investment and saving, however, is volatile, and the response to changes in fiscal policy is uncertain. The following analysis, therefore, focuses on defining external sustainability.
The current account deficit that stabilizes the ratio of net foreign debt to GDP (NFD) is given by the following:
Where ca denotes the current account deficit, g* the growth of nominal GDP in foreign currency terms, and nd non-debt-creating financing of the balance of payments, which is assumed, in this case, to equal net FDI.20 FDI inflows are subject to some uncertainty, but a prudent assumption for the medium term would be in the order of 5 percent of GDP a year—this is below the Baltic countries' average inflows during 1997–2000 (a period comprising the Russian financial crisis in 1998). The Baltics' favorable prospects for EU accession are likely to ensure that inflows of foreign capital remain substantial despite the completion of most major privatization projects. Table 2 shows the current account balances consistent with stable external debt ratios. Current account deficits are slightly above this level in Estonia and Latvia, suggesting that net external debt may rise a little above its current very low level. Current account deficits are already below this level in Lithuania and are projected to fall further over the medium term, implying a gradual reduction in net external debt.
External Debt Sustain ability Under Alternative Assumptions
(Percent of GDP, unless otherwise indicated)
Calculations based on stabilizing net external debt at current levels.
Baseline and conservative assumptions based on average and minimum annual foreign direct investment (FDI) flows in the Baltic countries during 1997—2000.
The fixed exchange rate regimes in the Baltic countries imply that nominal GDP growth is the same in both domestic and foreign currency terms.
External Debt Sustain ability Under Alternative Assumptions
(Percent of GDP, unless otherwise indicated)
| Estonia | Latvia | Lithuania | |||||
|---|---|---|---|---|---|---|---|
| Baseline | Pessimistic | Baseline | Pessimistic | Baseline | Pessimistic | ||
| Current account balance consistent with stable external debt ratio1 | -6.0 | -3.9 | -6.2 | -4.0 | -6.8 | -6.0 | |
| Assumptions | |||||||
| Net non-debt-creating flows (FDI)2 | 5.0 | 3.0 | 5.0 | 3.0 | 5.0 | 3.0 | |
| Nominal GDP growth (in foreign currency terms)3 | 8.5 | 7.5 | 9.0 | 8.0 | 7.0 | 6.0 | |
| Real GDP growth | 5.5 | 4.5 | 6.0 | 5.0 | 4.0 | 3.0 | |
| Memorandum items | |||||||
| Current account balance (2000) | -6.4 | -6.9 | -6.0 | ||||
| Net external debt (2000) | 13 | 14 | 26 | ||||
Calculations based on stabilizing net external debt at current levels.
Baseline and conservative assumptions based on average and minimum annual foreign direct investment (FDI) flows in the Baltic countries during 1997—2000.
The fixed exchange rate regimes in the Baltic countries imply that nominal GDP growth is the same in both domestic and foreign currency terms.
External Debt Sustain ability Under Alternative Assumptions
(Percent of GDP, unless otherwise indicated)
| Estonia | Latvia | Lithuania | |||||
|---|---|---|---|---|---|---|---|
| Baseline | Pessimistic | Baseline | Pessimistic | Baseline | Pessimistic | ||
| Current account balance consistent with stable external debt ratio1 | -6.0 | -3.9 | -6.2 | -4.0 | -6.8 | -6.0 | |
| Assumptions | |||||||
| Net non-debt-creating flows (FDI)2 | 5.0 | 3.0 | 5.0 | 3.0 | 5.0 | 3.0 | |
| Nominal GDP growth (in foreign currency terms)3 | 8.5 | 7.5 | 9.0 | 8.0 | 7.0 | 6.0 | |
| Real GDP growth | 5.5 | 4.5 | 6.0 | 5.0 | 4.0 | 3.0 | |
| Memorandum items | |||||||
| Current account balance (2000) | -6.4 | -6.9 | -6.0 | ||||
| Net external debt (2000) | 13 | 14 | 26 | ||||
Calculations based on stabilizing net external debt at current levels.
Baseline and conservative assumptions based on average and minimum annual foreign direct investment (FDI) flows in the Baltic countries during 1997—2000.
The fixed exchange rate regimes in the Baltic countries imply that nominal GDP growth is the same in both domestic and foreign currency terms.
Any dependence on international capital markets can leave a country vulnerable to a reversal in market sentiment. The above conclusion could change if FDI inflows were to fade noticeably, because lower current account deficits would be needed to achieve a given debt target. If annual FDI inflows fell to 3 percent of GDP, and GDP growth was 1 percentage point lower, current account deficits would need to fall to 4 percent of GDP in Estonia and Latvia, and remain at 6 percent of GDP in Lithuania, to stabilize external debt at current levels. The current account would respond endogenously to FDI changes, especially if reduced FDI flows were concentrated among manufacturers that use the Baltics as outsourcing centers. The net impact is unclear, since export and import growth would tend to fall in such circumstances.
External debt is low in Estonia and Latvia. A moderate increase in external debt ratios over the medium term may thus not necessarily precipitate a sudden and damaging reversal of capital flows. This would be the case especially where foreign borrowing was used to finance productive investment that enhanced the countries’ long-term growth prospects. There are limits at which this process would start to be perceived as unsustainable, raising the possibility of a sudden withdrawal of capital. However, these limits can differ substantially across countries and times,21 depending on both country-specific and external factors (both real and perceived). As with public debt, there is no clear benchmark at which the magnitude of external imbalances would become a binding constraint on fiscal policy. However, a degree of prudence is warranted in determining the fiscal stance.
In summary, these factors, in the absence of any other constraints, suggest scope for some flexibility in setting fiscal policy without running up against concerns about debt or external sustainability. Such a conclusion is based on the assumptions that the Baltic countries will continue to grow strongly and that FDI inflows will remain substantial—both of which seem likely, given the favorable prospects for EU accession. External sustainability could, however, become a concern in the event of a significant reduction in FDI inflows, in particular if this were also associated with a reduction in economic growth. In such circumstances, a tighter fiscal policy would be appropriate. Moreover, other factors (discussed in depth earlier in Section III) also suggest that the Baltics should adopt a more constrained approach to setting fiscal policy.