Building Integrated Economies in West Africa
Chapter

Chapter 9. Fiscal Rules and Institutions

Author(s):
Alexei Kireyev
Published Date:
April 2016
Share
  • ShareShare
Show Summary Details
Author(s)
Olivier Basdevant and Aleksandra Zdzienicka 

Fiscal policy is the main policy tool available to West African Economic and Monetary Union (WAEMU) countries, and is critical to the stability of the monetary union. In the WAEMU, the fixed exchange rate regime, limited scope for active monetary policy, low labor mobility within the region, and no significant intraregional fiscal transfers make national fiscal policies the main stabilization instrument in a region where macroeconomic volatility remains high, and asymmetric shocks are frequent. Fiscal policies also need to contribute to addressing member countries’ large development needs. Fiscal rules and institutions in the WAEMU can be strengthened based on international experience. The WAEMU has a set of regional fiscal rules that try to balance stability and development needs. These rules, in practice, have proven to be of limited effectiveness, either because of noncompliance (for example, the fiscal deficit convergence criterion) or because they are not binding in the short term (for example, the debt convergence criterion).

Fiscal Rules Reconsidered

WAEMU convergence criteria include fiscal rules, but the two main ones are either not observed (deficit) or not binding (debt). The target of a positive basic fiscal balance—the “key convergence criterion”—has been missed in a large majority of cases over the past five years (Figure 9.1, panel 1). In addition, new economic conditions (for example, access to international markets) raise the issue of whether targeting the basic fiscal balance, which excludes foreign-financed expenditures, is still adequate. The target of a public debt ratio below 70 percent of GDP is now easily met by all WAEMU countries, thanks to debt relief (Figure 9.1, panel 2). This target was set at a time when all of these countries were heavily indebted, and restoring fiscal sustainability was the main objective. Beyond redesigning specific rules, another critical issue to reconsider is the enforcement mechanism, which has not proved fully effective.

Figure 9.1.WAEMU: Deficits, Growth, and Debt

Sources: Country authorities; IMF Staff computation.

Note: MDRI = Multilateral Debt Relief Initiative; std dev. = standard deviation; WAEMU = West African Economic and Monetary Union.

The existence of deficit biases, which create fiscal risks, is the main rationale for fiscal rules. As Table 9.1 shows, a number of WAEMU countries have accumulated significant public debt since relief was provided through the Multilateral Debt Relief Initiative. For some countries, this public debt is the result of a deficit bias, illustrated by repeatedly missed deficit targets. While WAEMU countries have experienced significant differences, deficit biases are on average of about 1 percent of GDP (Figure 9.1, panel 3). In particular, the predicted deficits one and two years ahead at the time the budget for year T is formulated, underestimate the outturn by significant margins. Over time, this tends to produce significantly higher-than-expected debt levels. This bias is found elsewhere in the world. In fiscal strategy plans reviewed in Mauro (2011), primary fiscal deficit turned out to be higher by ½ percent of GDP on average than was initially planned. Numerical fiscal rules can be helpful to address issues related to recurrent deficit biases. Credible rules can, in principle, lead to higher welfare than can discretion (Barro and Gordon 1983; Drazen 2000), as well as to lower risk premia (Hallerberg and Wolff 2006).

Table 9.1Key Debt Indicators Since MDRI
MDRI YearGeneral Government DebtAverage Increase

since MDRI
Risk of Debt

Distress1
MDRI YearIn 2013
(Percent of GDP)
Benin200612.527.72.2Low
Burkina Faso200622.633.31.5Moderate
Côte d’Ivoire201245.842.9−2.9Moderate
Guinea-Bissau201051.761.03.1Moderate
Mali200620.433.41.9Moderate
Niger200627.123.2−0.6Moderate
Senegal200621.845.23.3Low
Togo201047.343.3−1.4Moderate
Sources: IMF Debt Sustainability Analyses; World Economic Outlook database.Note: MDRI = Multilateral Debt Relief Initiative

The risk of debt distress is carried out by the Joint IMF-World Bank Debt Sustainability Analysis for the latest available year, which differs by country.

Sources: IMF Debt Sustainability Analyses; World Economic Outlook database.Note: MDRI = Multilateral Debt Relief Initiative

The risk of debt distress is carried out by the Joint IMF-World Bank Debt Sustainability Analysis for the latest available year, which differs by country.

Defining Fiscal Rules

Several approaches may be considered for any future revision of fiscal rules. These include:

  • Specifying the ultimate objective—Existing convergence criteria are numerous and target multiple objectives such as fiscal sustainability, the composition of spending, and revenue mobilization. The ultimate objective should be fiscal sustainability, which is critical for the stability of the monetary union and exchange rate regime.
  • Keeping a short list of criteria that are directly related to attaining the ultimate objective—Having too many criteria runs the risk that the authorities do not focus sufficiently on those that are critical for fiscal sustainability. From this perspective, only two or three criteria would be kept, while the others would become indicators that would continue to be monitored. One of the remaining criteria could be on the stock of public debt and another one related to flows contributing to debt accumulation (for example, a deficit rule).
  • Ensuring, as much as possible, the internal coherence of the set of remaining criteria—If a debt criterion and a deficit criterion are kept, the link between the two should be as clear as possible. For instance, a ceiling on the deficit should not be set at a level so high that it would likely lead in the medium term to a breach of the debt ceiling by most countries. From this perspective, relying on comprehensive debt sustainability analysis would help ensure this consistency. Another way to force this consistency would be to introduce “debt brakes,” which would adjust the deficit ceiling based on past deviations from targets or the distance to the debt ceiling.
  • Keeping rules simple and easy to implement and monitor—Sophisticated rules can help address simultaneously a number of issues. For instance, a structural deficit rule may help preserve fiscal sustainability while allowing for countercyclical policy. However, defining, calculating, and monitoring a structural deficit would likely be challenging in countries with data availability and quality problems and where the existence of an economic cycle is debatable. Simple rules might be cruder, but they would have the advantage of being easy to understand and implement.
  • Allowing for some tailoring of the rules at the national level—While general principles should be common to all countries and defined at the regional level, this does not necessarily preclude different specific rules at the national level, as long as they take into account country circumstances and are consistent with the general principles. For instance, countries with a high share of revenue coming from natural resources may wish to adopt rules specifying how this revenue should be saved for a rainy day if prices for natural resources are high, saved for future generations (because of the exhaustibility of the resources), or invested in public infrastructure. Countries with stronger budget processes, including effective medium-term frameworks, and with easy access to financing may wish to specify the scope for countercyclical policies.
  • Not construing any ceiling as an optimal level—Ceilings on public debt and the fiscal deficit are typically levels that countries should try to stay away from, not optimal levels to target. This means, in particular, that the deficit should be significantly lower than the ceiling when economic circumstances are favorable. In other words, fiscal rules with ceilings on debt and the deficit say little about how fiscal policy should be conducted and can be complemented by additional rules at the country level (as discussed earlier in this section).

Overall, fiscal rules should contribute to a strengthening of budget processes. The latter are critical to avoid deficit biases (Milesi-Ferretti 1997) and, therefore, to achieve fiscal sustainability. The WAEMU has a number of recent public financial management rules, which are spelled out in directives. However, countries are late in transposing these rules into their national laws (with only Senegal having finished this first step, which was expected to be completed by the end of 2011) and this raises doubts as to whether the deadlines for implementation will be met. Accelerating this process is therefore of critical importance. In particular, framing a fiscal strategy in a credible and binding medium-term fiscal framework would help ensure that deficit biases are avoided.

Addressing fiscal risks and planning for contingencies is also key to the success of fiscal rules. Delivering on a fiscal strategy requires not only a plan, but also measures to address fiscal vulnerabilities. For example, countries facing specific expenditure risks need to implement measures to mitigate these risks to ensure the success of their fiscal strategies (IMF 2010). A typical issue for WAEMU countries in this regard is the risks pertaining to the energy sector. The budgetary cost of supporting energy sectors has not only tended to be high, but it has often been higher than initially budgeted, thus complicating fiscal management and adherence to fiscal rules. This has also led to inefficient adjustment, with investment spending bearing the brunt of spending cuts. Contingency planning is therefore highly desirable to avoid such outcomes.

Fiscal Rules Flexibility

Fiscal rules do not preclude growth-friendly fiscal policies. A concern often expressed is that rules focusing on fiscal sustainability will hamper growth and development. However, the contribution of fiscal policy to growth is not through permanently higher deficits. As Figure 9.1, panel 4 shows, larger fiscal deficits in the WAEMU have not been associated with higher growth rates since implementation of the Multilateral Debt Relief Initiative. The empirical literature also suggests that fiscal multipliers tend to be small in developing countries (see Spilimbergo, Symansky, and Schindler 2009). These results suggest that growth should not be sought through sustained fiscal stimulus. There is likely a larger role for fiscal policy to foster growth through contributing to macroeconomic stability, the composition and quality of spending (for example, favoring investment over inefficient transfers such as generalized price subsidies), and more efficient tax systems that reduce distortions.

Fiscal rules are helpful to address deficit biases, but can affect to various degrees the ability to conduct countercyclical policies. Simple rules usually imply a trade-off between a focus on debt sustainability (for example, debt or deficit rules) or on avoiding procyclical policies (for example, expenditure rules). Table 9.2 summarizes the properties of commonly used fiscal rules. As discussed above, the procyclicality of certain rules, such as ceilings on the debt ratio or the overall deficit, can be greatly reduced by staying away from the ceilings in favorable economic circumstances and thereby building buffers to be used in the event of a negative shock.

Table 9.2Performances of Simple Numerical Rules against Key Objectives
Simple Rules Setting a Ceiling On:
Debt RatioOverall DeficitPrimary DeficitExpenditure
Preserve a sustainable debt ratio++++++
Maintain sound deficit level+++++
Avoid large adjustments in a single year+++++
Limit procyclicality++
Target controllable variables+++++
Achieve comprehensive coverage+++++++++
Source: IMF staff.Note: +++ = very good, ++ = good, + = fair, - = poor.
Source: IMF staff.Note: +++ = very good, ++ = good, + = fair, - = poor.

Well-defined escape clauses can play a useful role. They allow for the temporary suspension of the fiscal rule in exceptional circumstances. However, they too need to be designed carefully to avoid abuse. A typical way to address such a hurdle is to require supermajorities (for example, from parliament) to approve the temporary suspension of a rule.

Adherence to Fiscal Rules

One of the reasons for the lack of effectiveness of WAEMU fiscal rules is the insufficient incentives for compliance. The WAEMU Commission is in charge of regional surveillance, but its mission is hampered by the lack of availability and timeliness of data, and also by capacity issues (IMF 2013). Sanctions are possible but not applied. For example, under the excessive deficit procedure, a deviating country is given 30 days to develop an adjustment strategy, which can benefit from financial support from the Union. Otherwise the country would expose itself to potential sanctions.

International experience suggests that incentive mechanisms are more effective at the national level. Regional rules are desirable in a monetary union because of externalities. In the WAEMU, they are even more critical because of the need to ensure that the regional fiscal stance is consistent with the exchange rate regime. However, regional rules may not be fully owned by the national authorities. Adopting binding rules at the country level may help foster ownership and adherence. The fundamental issue is to encourage policymakers to comply with rules by increasing costs for deviations. Financial sanctions have proven ineffective; costs therefore need to be of a different nature. Typically these costs can be either legal or political (by raising public awareness of deviations and their economic implications). Thus, two avenues, which have been taken by some countries, could be explored. First, rules could be transposed into domestic laws (or even enshrined in constitutions), which would increase their binding characters for national policymakers. Second, fiscal councils could strengthen compliance by increasing public awareness of potential deviations from announced policies (as discussed in the following section).

National fiscal councils could play an important role in increasing fiscal transparency. To the extent that fiscal councils are independent, perceived as such, and credible, they can provide an effective contribution to fiscal stability and growth. They are increasingly used across countries (Figure 9.1, panel 5), and are typically in charge of an independent assessment of public finances and public information about this assessment. There are many design options, ranging from fiscal councils simply reporting to the public and parliament about compliance of budgets and their executions with rules, to more elaborate options that provide in-house fiscal projections. In resource-constrained countries like the WAEMU members, there could be fiscal councils solely dedicated to reporting and alerting the public on compliance and noncompliance. Councils tend to work better at the national level, as they can more easily contribute to and influence domestic debates on fiscal policy. They would be a complement to the regional surveillance exercised by the WAEMU Commission.

Fiscal Federalism and Stability

A centralized fiscal risk-sharing mechanism could help smooth macroeconomic volatility. Idiosyncratic shocks are still frequent (Table 9.3) and there is limited wage and price flexibility, limited labor mobility, and constraints on the scope for countercyclical fiscal policies (for example, availability of financing). Other existing risk-sharing mechanisms are much less effective in the WAEMU, in particular when they are most needed, that is, during crises (Figure 9.2, panel 1). These mechanisms include private insurance via international capital markets (for example, through the holding of diversified portfolios of international assets or explicit insurance); saving and borrowing via international credit markets; private transfers (for example, remittances); official transfers (for example, foreign aid); and fiscal risk sharing across countries via intra-union transfers. Against this background, more efficient fiscal risk-sharing mechanisms may provide a greater insurance against shocks and increase consumption smoothing. Public saving plays a significant role in consumption smoothing during normal output fluctuations, and larger fiscal buffers would help absorb the impact of shocks. When shocks become more severe, however, a centralized fiscal mechanism could significantly increase demand smoothing in the member states.

Table 9.3Frequency of Asymmetric Shocks in the WAEMU
19901991199219931994199519961997199819992000200120022003200420052006200720082009201020112012Country
Benin
Burkina Faso
Côte d’Ivoire
Guinea-Bissau
Mali
Niger
Senegal
Togo
Source: Nguyen and Zdzienicka (2013).Note: The idiosyncratic growth stocks are derived as part of the country-specific growth shocks that are not explained by WAEMU-wide growth shocks. Growth shocks (both for the WAEMU and individual countries) are computed as the residuals from a regression of the country’s growth rate (respective to the WAEMU) over two lags. Red indicates negative shocks (inferior to 3.5 percent); Blue positive shocks (superior to 3.5 percent).
Source: Nguyen and Zdzienicka (2013).Note: The idiosyncratic growth stocks are derived as part of the country-specific growth shocks that are not explained by WAEMU-wide growth shocks. Growth shocks (both for the WAEMU and individual countries) are computed as the residuals from a regression of the country’s growth rate (respective to the WAEMU) over two lags. Red indicates negative shocks (inferior to 3.5 percent); Blue positive shocks (superior to 3.5 percent).

Figure 9.2.Shocks in the WAEMU

A regional stabilization mechanism (IMF 2013) could provide an effective instrument to deal with asymmetric shocks within the region. The mechanism should: (1) be relatively simple; (2) automatic; (3) nonregressive (in the sense that the size of transfers and contribution do not vary with per-capita income); and (4) consist of temporary transfers that are a function of serially uncorrelated shocks and able to offset a large part of these shocks (Hammond and von Hagen 1998). Another issue to address would be the nature of shocks triggering transfers. In a region where a number of asymmetric shocks have been triggered by sociopolitical events, the mechanism would need to be set up carefully to focus on smoothing non-policy-related shocks and to reduce moral hazard issues. Such a mechanism would be financed by contributions that would be used to pay transfers to countries negatively hit by the shocks. While this exercise is highly stylized and should be interpreted cautiously, staff estimations show that a relatively small contribution of about ¾ percent of each WAEMU country’s GDP would allow achieving an amount of income smoothing comparable with that observed in existing federal states (Figure 9.2, panel 2). A contribution of about 1–1¼ percent of GDP could insure WAEMU countries against even more severe downturns. Disbursed transfers would be proportional to the size of the shocks, to the relative size of each economy compared with the rest of the Union, and to the resources accumulated in the fund each year. If no country were affected by a negative shock, no disbursement would take place and contributions would be saved in the fund.

References

    BarroR. and D.Gordon. 1983. “Rules, Discretion and Reputation in a Model of Monetary Policy.Journal of Monetary Economics12(1983): 10121.

    • Search Google Scholar
    • Export Citation

    DrazenA.2000. Political Economy in Macroeconomics. Princeton: Princeton University Press.

    HallerbergM. and G.Wolff. 2006. “Fiscal Institutions, Fiscal Policy and Sovereign Risk Premia.Deutsche Bundesbank Discussion Paper Series 1: Economic Studies # 35/2006.

    • Search Google Scholar
    • Export Citation

    HammondG. and J. vonHagen. 1998. “Regional Insurance Against Asymmetric Shocks—An Empirical Study for the EC.The Manchester School 6633153.

    • Search Google Scholar
    • Export Citation

    International Monetary Fund (IMF). 2010. From Stimulus to Consolidation—Revenue and Expenditure Policies in Advanced and Emerging Economies. Washington: International Monetary Fund. Available from: http://www.imf.org/external/np/pp/eng/2010/043010a.pdf

    • Search Google Scholar
    • Export Citation

    International Monetary Fund (IMF). 2013. “West African Monetary Union (WAEMU)IMF Country Report #13/92International Monetary FundWashington.

    • Search Google Scholar
    • Export Citation

    MauroP.2011. Chipping Away at the Public Debt—Sources of Failure and Keys to Success in Fiscal Adjustment. Hoboken, New Jersey: John Wiley and Sons.

    • Search Google Scholar
    • Export Citation

    Milesi-FerettiG.1997. “Fiscal Rules and the Budget Process.Giornale degli Economisti 110540.

    NguyenH. and A.Zdzienicka. 2013. “Risk-sharing Mechanisms in the WAEMU.” Unpublished.

    SpilimbergoA.S.Symansky and M.Schindler. 2009. “Fiscal Multipliers.IMF Staff Position Note SPN/09/11International Monetary FundWashington.

    • Search Google Scholar
    • Export Citation

    Other Resources Citing This Publication