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Fiscal deficits and Fund-supported programs: A survey of recent experience

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1983
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Margaret Kelly

One of the major causes of balance of payments difficulties is excessive government expenditure and fiscal deficits that are frequently financed in inflationary ways. That is why Fund-supported programs often provide for reductions in these deficits, although there is no a priori view regarding the amount of external adjustment that should be achieved through such reductions. Moreover, not only do they often address a major immediate cause of external disequilibrium, but the size of the fiscal deficit often can also be controlled more directly by certain government policies (such as expenditure cuts) than can the private sector surplus or deficit. The effects of government measures on the latter are almost always more difficult to predict. The importance of fiscal deficits in adjustment is borne out by experience: empirical examinations of Fund stabilization programs have found that most unsuccessful programs failed because of fiscal problems and that overall credit ceilings were more likely to hold if subceilings on credit to government were observed.

This article draws selectively from a fuller study, “Fiscal Adjustment and Fund-Supported Programs, 1971-80,” published in IMF Staff Papers, Vol. 29, No. 2 (December 1982).

The fiscal measures normally included in Fund programs supported by upper credit tranche stand-by and extended arrangements may include policies to be implemented prior to the Fund’s approval of a program, or policy commitments and targets to be achieved during the program period; the latter may include fiscal performance clauses (that is, clauses which, if not observed, interrupt a member’s right to resources under a program). The practice of including fiscal performance clauses in Fund programs increased during the 1970s and in recent years has become almost universal. Between 1978 and 1981, all but 4 of the 78 upper credit tranche and extended arrangements approved by the Executive Board included a fiscal performance clause. The most usual was a ceiling on domestic bank credit to the government or the non-financial public sector; the second most frequent clause was a ceiling on the size of the overall fiscal deficit. Other clauses covered such areas as measures to reduce government payment arrears, specific government taxation, expenditure measures, and public enterprise pricing policies.

An analysis of 77 stand-by arrangements in the upper credit tranches between 1971 and 1980 suggested that almost half the average reduction in the balance of payments current account deficits in the program countries was a result of reduced fiscal deficits. More to the point, in those countries whose current account deficit fell, a reduction in the fiscal deficit was the main reason, and in those where the current account deficit rose, the primary culprit was the increasing fiscal deficit. Although economic performance can be measured in a variety of ways, and a reduction in balance of payments deficits does not always suggest that effective adjustment is taking place, this study found that to the extent adjustment did require reduced current account or overall balance of payments deficits, smaller fiscal deficits made a significant contribution to achieving them.

Accounting relationship

From the well-known national income accounts identity, the current account position is equal to the gap between national savings and investment (or the gap between domestic income and expenditure M − X = I − S, where M = imports, X = exports, I = investment, and S = saving). When investment and savings are split between the government and private sectors, the private sector financial gap and the overall government deficit or surplus are equal to the current account position (Ip - Sp) + (Ig - Sg) = M - X. Subtracting net capital inflows to obtain the overall balance of payments position, this is equivalent to the change in net foreign assets or, where external payments arrears exist, to the change in reserves plus the change in outstanding arrears.

These definitions are useful because they focus on the need for consistency between external developments, developments in domestic savings and investment, and in aggregate income and expenditure. More particularly, they emphasize that the current account balance of payments deficit can be affected by two broad sets of policies: (1) those that change net private sector savings and (2) those that affect the overall government deficit. Likewise, policies that change the overall balance of payments must influence the private sector deficit (net of private capital inflows), the domestically financed government deficit, or both.

For fiscal policy, these definitions imply that fiscal targets and the policies to achieve them must be consistent with external objectives and targets for private sector savings and investment. For example, an economic program that aims to reduce the current account deficit without altering net private sector savings must include fiscal or other policies that will diminish the overall deficit of the government.

In this context, three points should be made. First, the accounting separation of the domestic private sector and the government sector financial balances does not imply that they are independent of each other in a policy sense. In fact, policies intended primarily to affect the government deficit (for example, changes in tax rates or government expenditure) also generally change the private sector position, and policies intended mainly to influence private savings or investment, such as interest rate or exchange rate changes, usually also change the government deficit.

Second, both private and government financial sector balances as well as the current account of the balance of payments are influenced by such exogenous factors as changes in the terms of trade and in foreign demand. Thus, an increase in the current account deficit accompanied by an increase in the overall deficit does not necessarily imply a causal link between the two.

Finally, to the extent adjustment programs aim to reduce the government deficit, the choice of policies will depend partly on whether the emphasis is on demand restraint or on structural change. In either case, it will be desirable to attempt to cut unproductive outlays rather than those that add to medium-term growth. However, the distinction between productive and nonproductive expenditure is generally not apparent from government budget classifications of recurrent and capital expenditure and developmental and non-developmental expenditure.

No simple link was found by the Fund study between the changes in government capital expenditure as defined in budget documents and changes in the rate of economic growth. Growth was measured as a three-year average beginning with the program year compared with the average for the preceding three years, so the absence of a link could mean that increases in government capital expenditure require more than three years to affect the rate of growth. But there are several other interpretations. It could mean that increases in government capital expenditure are offset by reductions in private investment (there is some evidence that this occurred, at least in some countries); that other factors (changes in capacity utilization or in capital/output ratios) affected growth more during this period than did changes in the level of government investment; or, as suggested above, that capital expenditure is not a good proxy for productive expenditure in the government sector. Whatever the reason, these results suggest that disaggregated analysis is required to evaluate the profile of government expenditure and the efficiency of government investment.

Improving the balance of payments

The current account deficits of countries with Fund programs increased substantially in preprogram years in 1975-77, again in 1979, and since 1980. Their fiscal deficits relative to GNP in preprogram years also showed a distinct tendency to increase, and accounted for an increasing proportion of their external imbalances. Among other factors, this trend reflected both expansionary fiscal policies and exogenous developments that had adverse effects on both the fiscal deficit and the current account of the balance of payments.

A recent analysis of countries with Fund programs compared their balance of payments, growth, and inflation performance with that of all non-oil developing countries and concluded that countries following Fund programs broadly achieved significant absolute and relative reductions in their external deficits (though these were not necessarily synonymous with effective external adjustment, in that in some cases reduced deficits may have resulted from factors such as import restrictions), as well as a relative reduction in average domestic inflation rates. (See Donal Donovan “Macroeconomic performance and adjustment under Fund-supported programs”, IMF Staff Papers, June 1982.) Moreover, this adjustment was generally not achieved at the cost of lower real rates of growth in gross domestic product and higher inflation; average changes in these variables for program countries were not significantly different from those experienced by all non-oil developing countries.

How far did the reductions in external deficits result from adjustments in the government’s financial position as opposed to adjustments in the rest of the economy? The data showing the size and direction of changes in the fiscal and current account deficits for the 77 programs studied indicated that on average for all programs the current account deficit declined by 1.5 percentage points of GNP, about 40 per cent of which was associated with a reduction in fiscal deficits (see table). The fiscal deficit and the current account moved in the same direction in 48 programs (62 per cent of the total): 28 registering a reduction in both and 20 an increase. In the remaining 29 programs, an almost equal number showed an increase in the current account deficit despite a decrease in the overall fiscal deficit, and a decline in the current account deficit despite an increase in the overall government deficit.

In those cases where cuts in the fiscal deficit were associated with reductions in current account deficits, the results could reflect the effect of policy-induced changes in the fiscal deficit on the balance of payments or the effects of exogenous variables on both the current account and the budget deficit. It is noteworthy, however, that the budget balance and the balance of payments current account moved in opposite directions in a large number of programs. When the current account deficit fell in spite of an increase in the budget deficit, it is not clear whether this was in line with the original program design or whether it resulted from an unintended “crowding out” of private sector investment or from a resort to trade and payments restrictions.

Financial performance under 77 Fund programs, 1971–801
Average deficit in preprogram year2Average change in program year3Average change in program as proportion of preprogram year4
(As per cent of GNP)
All programs5
Current account balance−8.81.50.17
Fiscal balance−6.90.60.09
Balance of the rest of the economy−1.90.90.47
Programs in which both current account and

fiscal balance improved in program year5
Current account balance−10.45.80.56
Fiscal balance9.53.70.39
Balance of the rest of the economy−0.92.12.33
Programs in which both current account and

fiscal balance deteriorated in program year5
Current account balance−7.0−2.6−0.37
Fiscal balance−5.8−1.8−0.31
Balance of the rest of the economy−1.2−0.8−0.69
Programs in which current account deteriorated

and fiscal balance improved5
Current account balance−6.5−2.8−0.43
Fiscal balance−5.71.30.23
Balance of the rest of the economy−0.8−4.1−5.13
Programs in which current account improved and

fiscal balance deteriorated in year prior to program5
Current account balance−10.54.7045
Fiscal balance−4.3−1.6−0.37
Balance of the rest of the economy−6.26.31.02
Sources: IMF, International Financial Statistics and Government Finance Statistics Yearbook 1980. and national sources. The programs are upper credit tranche stand-by arrangements.

In general, where the current account deficit was reduced in the program year, the sector that accounted for the largest share of the imbalance in the preprogram year also accounted for the largest share of the adjustment in the program year. However, data on proportionate changes (the change in the deficit in the program year as a proportion of that in the preprogram year) indicate that reductions in the deficit of the rest of the economy exceeded those in the government sector. On the other hand, when deficits in either sector increased during the program period, they tended to be proportionately larger in the rest of the economy than in the government sector. This result may have reflected program design to be consistent with effective external adjustment. Equally, it may have reflected inappropriate policies or a greater uncertainty in specifying the impact of policy instruments on the rest of the economy than on the government sector.

The study also showed a high correlation between changes in the domestically financed fiscal deficit and changes in the overall balance of payments position in the countries with Fund programs. Data for 73 programs, comparing changes during the program in the overall balance of payments and the domestically financed fiscal balance, show that these indicators moved in the same direction in 68 per cent of programs, with both indicators improving in 47 per cent of the programs. In 32 per cent of the programs, the indicators moved in opposite directions. These results suggest that at least part of the improvement in the overall balance of payments reflected policies improving the government budget position.

As already indicated, economic performance can be measured in a variety of ways and the results of such measurement are open to a variety of interpretations. But to the extent reductions in the external current account and overall deficits are required to achieve a sustainable medium-term balance of payments position, this study has shown that reductions in fiscal deficits are likely to be required to ensure that this adjustment is achieved.

The Robert S. McNamara Fellowships—an update

The McNamara Fellowships Program was announced in our September 1982 issue. In March 1983, the World Bank made the first ten awards under that program. They went to 12 persons (including two group awards to teams of two persons each) and amounted to US$187,500. These persons will undertake full-time postgraduate work or research in fields related to economic development during the academic year 1983.

The Fellowships were set up in honor of the former Bank President. They are supported by the Bank and by governments that wish to contribute to an endowment fund. The Executive Directors of the Bank authorized a $1 million contribution by the Bank. Other contributions or pledges have been received from Bangladesh, China, India, Kuwait, Nigeria, Pakistan, Peru, and Yugoslavia. The Economic Development Institute of the Bank administers the Program.

About 1,500 applications were received by the Institute in response to the first announcement of the Fellowships. A Selection Panel, composed of two Executive Directors, three prominent outsiders, and the Vice President, External Relations, of the Bank, chose four applicants from developed countries and eight from developing countries. The Fellows include three each from Africa and Latin America, and two each from Asia, Europe, and North America. The Bank reserves the right to publish the product of the Fellows’ research and study.

A limited number of Fellowships will be awarded for the 1984 academic year. Small groups of up to five individuals working at the same institution may apply for a joint award. The program is not intended to support work leading to an advanced degree. Candidates normally must be not more than 35 years of age, hold a master’s degree or equivalent, and must carry out their work in a country other that their own. Applications must reach the Fellowships Office by December 1, 1983.

For further information write to J. Price Gittinger, Coordinator, McNamara Fellowships Program, Economic Development Institute, Room G-1067, The World Bank, 1818 H Street, N.W., Washington, DC 20433 USA.

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