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Fiscal adjustment in IMF-supported programs: IEO finds no cookie-cutter approach, but some potential contractionary bias

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 2003
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IMF Survey: Critics frequently argue that the IMF uses a cookie-cutter approach to its fiscal adjustment prescriptions—that regardless of country circumstances, the IMF insists on cuts. True?

Selowsky: Some of the extreme criticisms—for example, that the IMF always insists on austerity—are not supported by our study. We find significant variability in the fiscal adjustment in IMF-supported programs. In fact, in about one-third of the cases, current account deficits, primary fiscal deficits, and primary expenditures were programmed to increase as a share of GDP. However, we find that the rationale for the scale of the proposed fiscal adjustment is not made clear. It may not be a cookie cutter, but it is a bit of a black box.

IMF Survey: Another charge is that the IMF has been inflexible—that once fiscal targets have been established for programs, they are rigidly adhered to?

Selowsky: There, too, reality didn’t match perceptions. We found that fiscal targets were often adjusted in the implementation process. If expected output dropped below predictions, fiscal targets were typically relaxed. Ironically, though, the IMF called for greater fiscal tightening less often if output performed better than expected.

IMF Survey: Critics have linked the IMF’s prescriptions with sharp declines in output.

Selowsky: The dramatic output declines that occurred in some capital account crisis countries rightly captured the attention of many observers. It is not the case, however, that there has been a general tendency for output to decline during program years. The real problem is that IMF programs are very optimistic in projecting the recovery of output and private spending, particularly when a program starts in an adverse situation.

IMF Survey: Was that genuine optimism or a bit of cheerleading?

Selowsky: Both. We did not explore why it happened, but you can speculate that it is very hard for the authorities to sell a program that does not assume things are going to get better—particularly after taking difficult measures. I suspect it is hard, too, for a chief of mission to present to the Executive Board a program that does not incorporate good output performance.

IMF Survey: Is this optimism something you would want the IMF to avoid then?

Selowsky: The key question is whether that optimism influences, analytically or substantively, the design of the program. We believe it does. First, reluctance to recognize the possibility of further declines in private spending during a crisis or unrealistic expectations of recovery may understate risks and preempt the systematic discussion of the possible role of countercyclical fiscal policy.

Second, in a number of programs, countries reduced their current account deficits and boosted accumulated reserves beyond what the programs called for. This overperformance signals a situation where foreign financing wasn’t a constraint at the margin, which suggests that a more countercyclical fiscal policy could have been considered. In other words, the economy could have responded at the margin to a demand stimulus.

We recognize, of course, that the fiscal stance cannot be determined solely on the basis of its countercyclical role. Its impact on perceptions of sustainability and debt dynamics also needs to be assessed because it influences confidence and the restoration of private investment demand.

These complex interactions can be assessed only at the individual program level, and the basis for the fiscal stance ought to be clearly explained in program documentation. Our evaluation concludes that this is not done systematically. Executive Board documents generally provide insufficient analysis and justification for the proposed fiscal adjustment path and do not spell out the assumptions driving projections of private spending. This not only reduces the transparency of the program (particularly to the outside world) but also prevents identification of the critical assumptions that ought to be monitored during program implementation to facilitate mid-course corrections if necessary.

IMF Survey: On a very basic level, did IMF-supported programs meet their fiscal targets?

Selowsky: We saw quite a bit of variation, but a large share of countries didn’t meet their fiscal adjustment targets, and most of the adjustment that did take place occurred during the first year. What seemed to happen was that the IMF relied on expedient measures to generate quick adjustment, and these instruments quickly exhausted themselves.

Measures like quickly raising the value-added tax, increasing the social security tax, or cutting wages usually didn’t produce a lasting impact. Most countries typically have small tax bases, and when programs call for hiking “easy to collect” taxes, extensive tax evasion soon follows. Similarly, when programs call for caps in public sector wages, the authorities soon find themselves under a lot of pressure to re-establish those wage levels after the program ends.

What the IMF needs to do is help countries improve the flexibility and resilience of their fiscal systems so that they can more easily and efficiently generate adjustments when they have to deal with shocks. Much longer term institutional change is needed—countries have to expand their tax bases, curb tax evasion and exemptions, and reform their civil service—but this takes time.

IMF Survey: Your study suggests the problem is not just a mismatch of short-term program objectives and longer-term institutional development needs but also a question of the IMF’s tiptoeing around politically difficult issues, such as tax evasion.

Selowsky: Exactly, but we have to be careful here. Capping wages isn’t easy politically, but it’s easier than civil service reform, which is what should be done. We have to acknowledge that programs have too short a time horizon to tackle long-term institutional reforms. That’s where IMF surveillance comes in. We suggest that the surveillance process should be used to build a road map for future reforms and to encourage the authorities to implement these reforms, particularly when their countries aren’t in crisis situations. This is the best time to undertake such reforms.

IMF Survey: To what extent is the IEO prodding the IMF to be less reactive and do more forward plan-ning—to think less as a fireman and more as an organization that devises and promotes safety regulations?

Selowsky: The institution has to think a little more about the long term, but we recognize that it is still going to be called at the last minute when the house is on fire. These two roles aren’t incompatible. Once there’s a fire, it has to be put out. But let’s acknowledge that there were Article IV consultations prior to the crisis, and there will be consultations after the crisis. Surveillance should make strong efforts to learn from the past and set a clear road map of reforms for the future to improve the resilience of fiscal systems. Let’s identify these priorities, monitor their progress, and encourage a dialogue with the authorities if progress is slow. Our evaluation finds that surveillance does not forcefully flag policy inaction—often it is not candid enough.

IMF Survey: Finally, one widespread concern that we didn’t mention earlier is that the IMF’s prescriptions for fiscal adjustment are thought to take a toll on social spending in program countries, particularly middle-income countries. Did you find evidence of this?

Selowsky: We found that the presence of an IMF-supported program did not, in itself, reduce aggregate spending on education and health care. It may, in fact, have even increased such spending temporarily. But that doesn’t mean that vulnerable groups aren’t hurt in crisis situations or during periods of budgetary retrenchments. Spending categories that often are the most critical to vulnerable groups come under pressure and are likely to be preempted by other expenditures during these periods. For example, basic medical or primary school supplies may be preempted by personnel expenditures. Protecting very targeted spending is usually not costly, particularly if it is facilitated by some reallocations in the budget. This can be particularly relevant in middle-income countries.

IMF Survey: So what can the IMF do?

Selowsky: One of the most important recommendations of our evaluation is that the IMF should have a dialogue with authorities during Article IV consultations about the need to have budgetary systems in place that can fund, in real time, critical programs during crises or periods of macroeconomic adjustment.

We recommend that the IMF invite the authorities during Article IV consultations to identify the critical social programs they would like to see protected or activated in a crisis. Selection of these programs would be entirely at the discretion of the authorities, perhaps with assistance from the World Bank. Once these have been identified, the World Bank and the IMF could agree with the authorities on public expenditure management systems geared to protecting critical programs in case of crisis.

For more information about the Independent Evaluation Office (IEO) and its work, please check the IEO’s website (www.imf.org/external/np/ieo).

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