VII Fiscal Policy

Timothy Lane, Marianne Schulze-Gattas, Tsidi Tsikata, Steven Phillips, Atish Ghosh, and A. Hamann
Published Date:
June 1999
  • ShareShare
Show Summary Details
Timothy Lane and Tsidi Tsikata

The role envisaged for fiscal policy in the Asian crisis countries has shifted with the changing assessment of the economic situation. The initial programs in all three countries included some measure of fiscal adjustment to counter an initial deterioration of fiscal positions, with a view to contributing to current account adjustment and thus avoiding an excessive squeeze on the private sector, as well as building room for noninflationary financing of carrying costs of financial sector restructuring. To the extent that fiscal adjustment made credible steps toward these objectives, it was expected to contribute to restoring confidence. This fiscal adjustment was intended to be comparatively mild in Indonesia and Korea, whereas it was stronger in Thailand where the initial current account deficit was significantly larger, as was the previous deterioration of the fiscal position. These fiscal programs were, of course, formulated in a context where the slowdown in economic growth was—as it turned out, mistakenly—expected to be relatively modest (see Section IV above).1

Beginning in early 1998, as the severity of the economic downturn became apparent, and while external current accounts shifted into large surpluses owing to declining domestic demand and large currency depreciations, fiscal deficits were programmed to expand considerably in all three countries. Fiscal policy became increasingly oriented toward supporting economic activity as the programs evolved. In the initial programs and early reviews, fiscal policies had sought to limit the deterioration of the fiscal position associated with the automatic stabilizers and the effects of exchange rate depreciations. Beginning early in 1998, they shifted to accommodating part of the effect of economic conditions on fiscal balances, and, subsequently to augmenting these effects through expansionary measures. It has proved difficult, how-ever, for the authorities—especially in Indonesia and Korea—to move quickly to make full use of the scope for expansionary fiscal action allowed under the program ceilings.

This section reviews the fiscal policy content of the programs, first discussing the rationale for fiscal adjustment in the initial programs, next describing what was done in the programs, and finally assessing the appropriateness of the fiscal stance, both in the initial programs and in the wake of the successive revisions prompted by changing economic circumstances.

Initial Rationale for Fiscal Adjustment

Fiscal deficits were not viewed as a major concern in these countries for much of the period leading up to the crisis. Indeed (as discussed in Section II above), the crises were mainly “made in the private sector,” reflecting financial sector vulnerabilities rather than the more conventional situation of monetization of fiscal deficits. Conventionally measured central government balances in all three countries were in surplus or at most slightly in deficit throughout the 1990s up until 1996 (see Figure 2.5 above). The strong fiscal positions reflected, in part, fiscal consolidation efforts in the late 1980s (Indonesia and Thailand) or earlier (Korea).2 As fiscal positions improved and growth continued to be strong, the ratio of public debt to GDP had been falling in all three countries.

However, even if fiscal imbalances were not a major part of the problem, that did not necessarily mean that fiscal adjustment could not be part of an appropriate solution. Public savings could contribute to the overall current account adjustment dictated by the reversal of capital flows and, by boosting confidence, could influence the total amount of external adjustment required. A wider fiscal deficit, if financed domestically, could crowd out financing to the private sector. In addition, the costs of financial sector restructuring needed to be met.

External Adjustment

The programs were formulated against the background of the sharp reversal of international capital inflows associated with the crisis. The programs sought to reduce the need for current account adjustment associated with these capital outflows by providing official financing and restoring confidence to encourage a recovery of private sector flows. In this setting, fiscal adjustment, particularly in Thailand, was intended to play two roles: minimizing the need for external adjustment by helping restore confidence quickly; and balancing the composition of the unavoidable current account adjustment between public and private sectors.3

Fiscal adjustment can have positive effects on confidence mainly to the extent that it is expected to have effects on investors' prospects of repayment. To the extent that fiscal adjustment has positive effects on the external current account and thus reduces the need for currency depreciation, it would tend to reduce both the expectation of currency depreciation and country risk premiums. Moreover, as reducing fiscal deficits also reduces the likelihood of their monetization, this would tend to lower expectations of inflation and currency depreciation. Excessively harsh fiscal adjustment could, in principle, have the opposite effect, to the extent that market participants expected it to result in a contraction of economic activity that would worsen their prospects of repayment.

The initial programs envisaged a relatively minor current account adjustment, and a correspondingly small contribution of public saving to this adjustment (Figure 7.1) in the context of a modest and short-lived slowdown in economic growth. In Indonesia, the current account was expected to adjust by only about ¾ of 1 percentage point of GDP from 1996/97 through the end of the program, of which about ¾ of 1 percentage point was to reflect an improved government balance. Korea's current account adjustment from 1997 through the end of the program was projected at 2¾ percentage points of GDP, of which public saving was to account for about ¼ of 1 percentage point. In Thailand, where the initial current account imbalances were largest, the current account balance was to adjust by only 1½ percentage points from 1996/97 through the end of the program, while the programmed improvement in the public sector balance was about 1¼ percentage points of GDP.

Figure 7.1.Indonesia, Korea, and Thailand: Sectoral Savings-Investment Balances1,2

(In percent of GDP)

Source: International Monetary Fund.

1 Private sector savings-investment balances are calculated residually as current account balances minus governmnet balances.

2t is the initial program year; Indonesia (1997/98), Korea (1998), Thailand (1997/98). In most cases, data for the preprogram year, (t - 1), have been revised since the original programs were formulated.

3“Most recent review” refers to the latest available full medium-term projections as follows: For Indonesia, request for Extended Fund Facility, August 1998; for Korea, fourth review of Stand-By Arrangement, November 1998; and for Thailand, fourth review of Stand-By Arrangement, August 1998.

There is a stark contrast between the adjustment originally envisaged and the way the programs actually unfolded. In contrast to the original picture of fiscal policy helping along a modest current account adjustment, the latest reviews show a large ex post fiscal easing set against massive current account adjustments imposed by market forces. Underlying this latter set of projections, of course, is the sharp drop in output and demand and greater-than-expected currency depreciations, which strengthened the current account and weakened the fiscal position in all three countries.


Corresponding to the adjustments in sectoral savings-investment balances just discussed is the distribution of financing that is the focus of the IMF's standard financial programming framework. The fiscal position determines credit to government when other sources of funding are given. This in turn—when set against paths for money and domestic credit that are estimated to be consistent with given assumptions about growth and inflation and targets for international reserves—determines the room available for credit to nongovernment.4 For this reason, fiscal adjustment is typically needed to permit the other objectives of the program to be achieved without unduly compressing credit to nongovernment. By the same token, any slippage in achieving the fiscal targets tends to require either a reduction of credit to the private sector, an unprogrammed increase in money creation, or both. This analysis of financing flows is the counterpart of the current account adjustment just discussed.

In the Asian programs under review, the composition of financing of government deficits has been changing as the programs have evolved: domestic financing of fiscal deficits has ballooned while resource transfers from abroad have dropped. The composition of financing as of the most recent review,5 presented in Table 7.1, suggests that in Korea and Thailand, the deficit is now largely domestically financed, so the fiscal deficit has a direct negative effect on the credit available to the private sector. In Indonesia, in contrast, the balanced budget law dictates that deficits should be entirely externally financed, and changes to fiscal policy have been configured with that constraint in mind.6

Table 7.1.Financing of Fiscal Deficits1(Percent of total financing)

Bank Restructuring

Another reason for fiscal adjustment in the initial programs was to make room for costs of bank Restructuring, which was to include closing nonviable banks and injecting public funds to recapitalize some viable ones.7 The budgetary impact of banking sector restructuring is conventionally represented by its carrying costs, recently estimated at 3 percent of GDP for Thailand, 1½ percent for Indonesia, and ¾ of 1 percent for Korea in the current fiscal year; these costs are expected to rise to about 2 percentage points of GDP in Indonesia and over 2 percentage points of GDP in Korea in the medium term (see Appendix 7.3).

The budgetary treatment of bank restructuring differed across the three countries. In Indonesia and Korea, it was intended to be supported by the government directly,8 while in Thailand such support was initially provided indirectly by the central bank, with only a small proportion of estimated fiscal costs having been brought explicitly into the budget. The modes of financing bank restructuring programs have included government-guaranteed bonds (Indonesia and Korea) and short-term borrowing from the money market and the central bank (Thailand).

The economic impact of bank recapitalization depends on several factors. If the losses incurred by the banks had been completely unexpected and had occurred in the current fiscal year, or if a government bailout had not previously been expected, the operation would entail a one-time capital outlay and a perpetual stream of carrying costs on such bonds. Alternatively, if all the banks' losses had been preexisting and if it had been common knowledge that they would be covered by a government guarantee, these capital and carrying costs should have entered into an assessment of the fiscal position in economic terms as soon as the loan losses were incurred (that is, before as well as after the operation), not when the operation was carried out. In this case, since carrying out the operation itself only converts an implicit claim on the government into an explicit one, its immediate monetary and fiscal impact would, as a first approximation, be zero.9

In the Asian crisis countries, the situation was obviously somewhere between these two extremes: implicit government guarantees were pervasive but their precise coverage was uncertain; and, while it was common knowledge that financial institutions had some poor quality loans, the crisis both revealed the magnitude of these loans and led many more loans to turn nonperforming. The assessment of the overall impact of fiscal policy below will follow common practice in using, as the central case, the assumption that the fiscal impact of restructuring is approximated by its carrying costs—while noting the possibility that carrying out restructuring could have either a smaller or a larger expansionary effect.

What Was Done?

Original Programs

Based on the considerations discussed, the original IMF-supported programs in the Asian crisis countries incorporated some element of fiscal adjustment. The most meaningful way of characterizing the adjustment in economic terms is with regard to the change in the fiscal balance compared with the previous year. This year-on-year change can be broken down into a part attributable to discretionary fiscal policy and another part that is a passive response to changing economic conditions—economic activity, the exchange rate, and other factors (including oil prices, in the case of Indonesia). In contrast the “headline” amounts of fiscal adjustment, reported when the programs were announced, are defined in relation to a baseline implied by the authorities' unchanged plans. The decomposition based on the actual change in the fiscal balance from one year to the next gives a clearer picture of the economic impact of fiscal policies than the headline numbers, which focus on revisions to plans that, in the end, were never implemented.

The magnitude of fiscal adjustment based on the “headline” measure is shown on line 2 in Table 7.2. The intended fiscal adjustment was largest for Thailand—2.1 percent of GDP in the first full fiscal year of the program, including carrying costs of bank restructuring, or 3.2 percentage points excluding those carrying costs. The reason for larger fiscal adjustment in Thailand was that initial fiscal and external imbalances were larger there than in the other two countries. The programmed adjustment was smaller in Indonesia (1.1 percentage points of GDP including, or 1.6 percentage points excluding, bank restructuring) and Korea (0.8 percentage points including, or 1.6 percentage points excluding, bank restructuring). In light of the assumption of a relatively moderate slowdown of economic growth, these planned adjustments were modest.

Table 7.2.Fiscal Policy in Original Programs(In percent of GDP)
1. Overall balance (level)
2. Change compared with no-measures baseline40.
Financial restructuring0.
3. Change compared with previous year-
Due to economic environment-1.30.3-0.4-0.9
Due to policy changes0.30.2-0.11.9
Of which:
Financial restructuring-0.50.0-0.8-1.1
4. Memorandum item:
GDP growth (percent a year)

A decomposition of the year-on-year change in the fiscal balance—the more economically meaningful measure—gives a somewhat different picture, as shown in Table 7.3.10 The original programs envis-aged some year-to-year improvement in the fiscal balance in Korea and Thailand, while in Indonesia, policies aimed from the outset at containing an expected deterioration. In Indonesia, the fiscal position was projected to deteriorate by 0.9 percentage point of GDP in 1997/98 and improve by 0.2 percentage point in 1998/99. In Korea, the programmed improvement in the fiscal balance was small (0.2 percent of GDP in fiscal 1998). In Thailand, the fiscal balance was projected to improve by 1 percentage point of GDP during fiscal 1997/98, thus recovering about one-third of the sharp deterioration then expected for fiscal 1996/97. Even in Thailand, the programmed tightening was not particularly large in relation to other IMF-supported programs,11 and of a similar order of magnitude to adjustments of some major industrial countries at various times in the 1990s. In Indonesia and Korea, the overall planned adjustment was even smaller.

Table 7.3Sources of Changes in the Fiscal Balance(In percent of GDP; a negative number indicates of fiscal deterioration)
Fiscal balance (level)50.30.5-0.9-
Change in fiscal balance-0.90.2-2.2-9.20.2-0.3-5.0-3.31.0-4.0-3.5
Change due to economic environment-1.30.3-4.2-11. 1-0.4-1.9-1.1-0.9-0.3-3.1
Exchange rate61.40.2-3.5-6.4-0.3-0.9-0.2-0.9-0.2-2.0
GDP growth0.30.1-0.5-4.0-0.1-1.0-1.00.0-0.1-0.9
Oil price-0.20.0-0.2-
Policy changes0.
Social safety net70.00.00.0-1.0-0.2-2.1-0.60.0-0.6
Bank restructuring-
Statutory revenue change0.6-,20.0-0.7
Residual (unexplained)0.2-
Memorandum ftems:
Nominal GDP growth rate13.213.119.843.
Real GDP growth rate5.03.04.6-

The envisaged and actual changes in fiscal positions reflect a combination of economic environment and policy changes. Economic conditions—the projected slowdown of growth and exchange rate depreciation—were expected to weaken fiscal positions in all three countries. Policy changes in Indonesia's initial program were intended to improve the 1997/98 fiscal position by 0.3 percentage point of GDP—and a further 0.2 percentage point in 1998/99—with about two-thirds of the impact on the spending side. (Part of the projected improvement in revenue was associated with unspecified revenue measures that, in the event, were never implemented.)12 In Korea, the net effect of policy changes in 1998 was expected to be slightly expansionary, weakening the fiscal position by 0.1 percent of GDP. Spending cuts and revenue increases were expected to less than offset the carrying costs of bank restructuring. The projected overall improvement in the fiscal position in Korea is due to the large positive “residual” (0.7 percentage point of GDP), which in this case appears mainly to reflect optimistic revenue projections (overly optimistic, as it now appears) for given macroeconomic assumptions and tax structure. In Thailand, it was recognized that policies had likely added to the fiscal weakening in 1996/97. For 1997/98 (the first full program year) policy measures were intended to improve the fiscal balance by 1.9 percent of GDP, with spending reductions and revenue increases partly offset by the costs of bank restructuring.

Thus, the policy measures included in the original programs, had they been implemented in the macro-economic environment expected at the time, would have implied a deterioration in the fiscal balance in Indonesia, a very small improvement in Korea, and a more significant, yet far from drastic, improvement in Thailand relative to the expected outcome for the previous fiscal year. These figures suggest that the “headline” figures presented earlier (as well as in staff assessments and public announcements) gave an exaggerated picture of the fiscal adjustment effort. The key difference is that the headline figures record intended changes from the authorities' previous plans, while the figures in Table 7.3 record intended changes in policy from year to year.

Revisions and Current Prospects

The thrust of fiscal policy in the Asian crisis countries turned out to be substantially different from that originally expected. This was chiefly because of radical revisions to the original assumptions for economic growth, capital flows, and exchange rates.13 Both economic activity and exchange rates had major direct effects on fiscal balances, to which policies had to respond when the programs were reviewed.

Fiscal targets in IMF-supported programs (which may or may not be embodied in formal performance criteria) are typically projections based on current policies and assumptions together with measures adopted under the programs; in the Asian crisis countries, these assumptions were proved drastically wrong. The overall result depends on the extent to which either targets were allowed to give way to altered circumstances or policies were strengthened to maintain the targets in the face of more difficult economic conditions. In the Asian crisis countries, program revisions accommodated a substantial part of the expansionary effect of changing economic conditions on the fiscal position from the start of 1998. Later in the programs, revisions went beyond accommodation to incorporate some additional stimulus.

The recession had a substantial effect on fiscal balances, primarily through its negative effect on revenues. Initially, in the absence of formal arrangements for the government to pay unemployment or similar benefits,14 there was relatively little effect on nominal expenditure levels. Based on program projections at the end of October 1998, the impact of the slowdown in economic activity is expected to be largest in Indonesia, amounting to a cumulative increase in the fiscal deficit of41/2percentage points of GDP (in 1997/98 and 1998/99). In Korea (1998) and Thailand (1997/98), this contribution to the deficit is expected to amount to 1 percentage point of GDP.

Exchange rate changes also had an important impact on the fiscal balance in these economies. In all three countries, exchange rate depreciation had a substantial negative impact on corporate income tax receipts, as the domestic currency cost of servicing foreign-currency-denominated debt was revalued, lowering corporate taxable income. Foreign exchange gain and loss provisions allowed firms to treat both the interest payments and the increase in domestic currency value of principal repayments on foreign currency debt as an expense. Of lesser importance is the effect on the expenditure side of the increased cost of servicing foreign-currency-denominated public debt.

Another important effect of exchange rate depreciation was that it led to rising outlays on price subsidies on imported goods and increases in the domestic currency cost of government imports. This effect was particularly important in Indonesia, where subsidies on basic food items (notably rice) were increased to keep the rupiah depreciation from resulting in wide-spread starvation. On the other hand, depreciation boosted domestic currency revenues from taxes imposed on international trade 15—offset by any contraction in import volumes that occurred.

Taking all these effects together, the depreciations weakened all three countries' fiscal positions substantially. In Korea and Thailand, both revenues and expenditures were adversely affected; whereas in Indonesia, about half of the increase in expenditures associated with depreciation (mainly on subsidies) was offset by the increase in tax revenues (mainly associated with taxes on oil and gas and on consumption).

As the countries' fiscal positions were weakened substantially by the exchange rate and output movements associated with the crisis, the appropriate response depended on an assessment of the initial situation and the nature of the shocks to economic activity and the exchange rate. To the extent that these shocks were transitory, there would be a case for accommodating them, accepting temporary fiscal imbalances that would be unwound over the medium term. To the extent that they were permanent, some adjustment toward an appropriate medium-term position would be desirable. Although, of course, not all of this adjustment would need to be undertaken in the year the shocks occurred—particularly if this was already a time of grave economic weakness—a credible start with such adjustment would be needed to convince markets and the public that a sound fiscal position would indeed be achieved in the medium term.

The programs assumed that a significant portion of the shocks to real activity were transitory, with a return to growth projected over the medium term.16 Under these conditions, the appropriate response—both on grounds of stabilizing output fluctuations and of optimal tax smoothing—would be to permit some temporary fiscal easing provided that this easing could be financed.17 The appropriate degree of easing depends on various conditions. In particular, there is nothing necessarily optimal about “letting automatic stabilizers work”—since the sensitivity of the revenues and expenditures to the cycle depends on various features of the tax and expenditure system—for example, the rates and progressivity of personal income tax and the responsiveness of social spending to income (features that vary considerably across countries, and may or may not be set appropriately in a particular case). Thus, policy measures may be needed to augment or partially offset the impact of the cycle on the fiscal position. In particular, in these countries the low sensitivities of expenditures to the cycle and delays in tax collection limit the effectiveness of the automatic stabilizers, suggesting a need for countercyclical policy measures.

The exchange rate depreciations may be assumed to have both a permanent and a transitory component, owing to the assumed need for some real exchange rate adjustment along with a substantial degree of overshooting. It would thus be consistent to assume that some but not all of the changes in revenues and expenditures associated with the depreciations were permanent. The fact that some of the increase in the fiscal deficit resulting from the depreciation was reflected not in increased disposable incomes for domestic residents but in increased debt-service payments abroad, and thus did not contribute to domestic demand, would argue, other things being equal, for a greater degree of accommodation.

Policy changes in successive program revisions in all three countries accommodated a large portion of the automatic easing associated with changing economic conditions. In general, the early reviews entailed partial accommodation, with the exception of the first (November 1997) review of Thailand's program, which (it is now realized, mistakenly) tried to maintain the existing fiscal target by offsetting the full impact of the deteriorating economic situation.18 In later reviews during the course of 1998, as the severity of the downturn became increasingly evident, fiscal targets in all three countries were revised beyond the automatic effects of economic conditions, to provide a greater stimulus. In some cases, by mid-1998 IMF staff missions also found themselves pressing the authorities to use the room available under existing fiscal targets.19

This change in course leads up to the situation in recent months. According to projections based on policies in place at the end of October 1998, fiscal policy measures are projected to have had a net expansionary effect in both Korea (23/4 percentage points of GDP in 1998) and Thailand (0.6 percentage point in 1997/98), over and above the substantial automatic easing resulting from changing economic conditions. In Indonesia, in contrast, where the fiscal balance is programmed to deteriorate much more than in the other countries as a result of the economic situation—notably as a result of increasing fuel and food subsidies in response to exchange rate depreciation—other fiscal policy measures are expected to offset about one-third of this automatic easing.20


This section has examined how and why the fiscal position changed, both in the initial programs and in the light of subsequent reviews. The original programs contained fiscal measures intended to prevent the fiscal deficit from widening excessively, but were based on the assumption of a relatively moderate economic slowdown and modest currency depreciation. The policy measures in these initial programs would have been far from sufficient to prevent a substantial expansion of fiscal deficits in light of the macroeconomic conditions that actually emerged. In the wake of the program reviews, policy was eased further. As a result, the net effect of policy measures was expansionary in Korea and Thailand. In Indonesia, where the automatic deterioration in the fiscal position was particularly large, policy measures went in the opposite direction, partly offsetting the massive increase in the deficit resulting from the changing economic situation.

These facts contrast sharply with the widespread perception that the IMF applied a standard prescription—harsh fiscal austerity—to a nonstandard situation in all these countries. In part, this is the difference between an analysis based on revisions to fiscal plans and one based on changes in fiscal actions: in assessing the economic impact, it is obviously more relevant to examine what is actually being done than to examine revisions to plans that were never realized. The impression that the programs kept a tight rein on government budgets also partly reflects the unrealistically optimistic macro-economic assumptions underlying the initial programs. Such perceptions may also reflect a lack of public understanding of the nature of targets in IMF programs: such targets are not set in stone, but in practice are frequently revised in light of changing economic conditions, in the context of program reviews—and it is the stance taken toward such revisions, as much as the initial program itself, that determines the overall result. It should also be acknowledged that, in the Asian crisis countries, the IMF may be partly responsible for overselling the fiscal adjustment measures in the initial programs with a view to bolstering market confidence.

This leaves the question of whether fiscal policies should have been more supportive of economic activity right from the start. At one level, the answer is clearly “yes”: as the severity of the downturn was not adequately taken into account in formulating the initial programs, these programs erred in underestimating the need for fiscal policy to support activity.

However, there are limits to the ability of fiscal policy to support activity in the midst of a currency and banking crisis, associated with a sharp withdrawal of external financing. The crisis implied a tightened external financing constraint that forced massive current account adjustments. These adjustments had to be brought about through some combination of adjustment of the interest rate and exchange rate, and fiscal adjustment. The limited effectiveness of currency depreciation as an expenditure switching policy (given concurrent depreciations in several countries), together with the adverse balance-sheet effects of the exchange rate depreciations themselves, implied that most of the current account adjustment came from a reduction in domestic absorption. In this setting, and given that the effects of an easier fiscal policy on the financing constraint were at best ambiguous, an expansionary fiscal policy at that stage could easily have placed an even larger adjustment burden on the private sector.

From this perspective, fiscal policy begins to have a significant stimulative effect only as external financing constraints are relaxed or as additional external financing becomes available to finance wider fiscal deficits. It was thus appropriate that fiscal policies were eased significantly in early 1998, as market pressures on Korea and Thailand began to ease, while Indonesia obtained foreign official financing for larger deficits. By the same token, if more external financing had been available at the outset, there would have been less need for current account adjustment and more room for fiscal easing to support economic activity.

Appendix 7.1. Coverage of Reported Fiscal Accounts

The coverage of the reported fiscal accounts in Indonesia is the narrowest of the three countries; it relates mainly to the operations of the central government. The accounts reflect transfers to lower levels of government and the balances of the two largest extrabudgetary funds. Although local governments are excluded, their deficits beyond those financed by transfers from the central government are estimated to be small. Also excluded are any deficits of the approximately 170 public enterprises.

Two main fiscal balances are reported for Korea —the central government balance, and the “consolidated central government” balance. The latter, on which the formal quantitative fiscal targets of the IMF-supported program have been established, consists of the central government and four public enterprises' special accounts. The central government finances are operated through a general account, 18 special accounts (including some for transfers to local governments), and 34 budgetary funds (including the National Pension Fund). The consolidated central government provides only a partial picture of the operations of the public sector, since it only covers a small portion of the operations of local governments and public enterprises (with combined size estimated to be nearly equal to the size of the central government).

Thailand has the broadest coverage of fiscal accounts of the three countries. The reported “consolidated public sector balance” takes account of the operations of the central government, local governments, and nonfinancial public enterprises. However, because of long reporting lags for local government and public enterprise accounts, the formal quantitative fiscal targets in the IMF-supported program relate to the central government balance.

Appendix 7.2. Fiscal Adjustment and Current Account Adjustment

This appendix briefly reviews the simple analytics of fiscal and current account adjustment in a Keynesian fixed-price framework. This simplified framework differs from the standard case of the Mundell-Fleming model in that capital inflows are assumed to be limited, and exchange rate movements are assumed to affect private consumption via wealth effects.

The available policy instruments are assumed to be government spending and the domestic interest rate (for algebraic simplicity, the money market is not modeled explicitly). Output is demand determined, with aggregate demand given by:

where 0 < Cy < 1 (marginal propensity to consume is less than unity); Ce < 0 (an exchange rate depreciation raises the consumer price index via the price of imported goods and lowers real wealth); Ir < 0 (investment is decreasing in the interest rate); CAy < 0 (higher income results in higher imports and a deterioration of the current account); and CAe > 0 (the Marshall-Lerner condition is satisfied).

The country faces capital outflows, which must be financed by a current account surplus:

Totally differentiating, and substituting yields an expression for output, as a function of changes in monetary (r) or fiscal (G) policy, as well as the exogenous outflow (F):

Correspondingly, the exchange rate is given by

From the model, several results drop out:

1. There is a trade-off between interest rates and exchange rates consistent with a given financing constraint:

A larger volume of capital outflows {dF > 0) must be met with a higher interest rate, a more depreciated exchange rate, or both:

Fiscal consolidation {dG < 0) permits a lower interest rate and/or a less depreciated exchange rate, consistent with a given volume of capital outflows:

As in any Keynesian model, fiscal consolidation lowers aggregate demand and private consumption. With the financing constraint, however, part of the impact of fiscal consolidation is mitigated by the smaller exchange rate depreciation (for given capital outflow):

where Cy > 0, but -CeCAy < 0.

This result will tend to hold a fortiori if fiscal consolidation (dG < 0) results in a smaller capital outflow because of confidence effects (dF/dG > 0):

Appendix 7.3. Financial Sector Restructuring Costs in the Fiscal Accounts

Indonesia. The costs to the government of restructuring the financial system include compensation to the central bank for past support of failed banks, recapitalization of banks, payments to small depositors, and the operational costs of the bank restructuring agency (IBRA). Direct budgetary transfers and government-guaranteed bonds are the main instruments for delivering government support.

The total stock of bonds to be issued in 1998/99 is estimated at Rp 235 trillion (25 percent of GDP). The budgetary costs of servicing the bonds and the operational costs of IBRA for 1998/99 were estimated at ½ of 1 percent of GDP in the original program. They have since been revised to about 1½ percent of GDP, reflecting higher estimates of the required support (on account of the effects of the deterioration in the economy and the depreciation of the exchange rate). However, because of delays in issuing the bonds, the cost estimate reflects interest payments for less than a full year. The full-year costs are estimated to be about 2 percent of GDP.

Korea. Public funds have been made available to purchase bad loans from commercial and merchant banks and to honor commitments under the deposit insurance scheme. Assistance has been financed mostly through issues of government-guaranteed bonds. There have also been swaps of government assets for the bank restructuring agency's claims on banks.

The total public cost of bank restructuring is currently estimated at W 75 trillion (18 percent of GDP), including W 65 trillion in government-guaranteed bonds. The interest costs to the budget in 1998 is estimated at 0.8 percent of GDP, reflecting the late start to the issuance of bonds. However, because the pace of bond issues is expected to increase, it is projected that the interest cost to the budget will rise by about 1½ to 2 percentage points of GDP over the medium term. Estimated costs are also likely to increase with the imposition of tightened prudential regulations.

Thailand. The Financial Institutions Development Fund (FIDF) provides liquidity support to finance companies and commercial banks. Plans have recently been announced to replace FIDF short-term borrowing (from the interbank market and the central bank) with longer-term government bonds. Under a note exchange program, FIDF has also made payments on promissory notes held by depositors and creditors of suspended finance companies. Apart from the operations of the FIDF, other forms of public support include central government capital contributions.

The stock of obligations incurred by the state on account of financial sector restructuring is projected to rise from B 1.4 trillion (28 percent of GDP) at end-1997/98 to B 2.1 trillion (38 percent of GDP) at end-1999/2000. On the basis of a much lower estimate of public sector support, the interest costs of the original program estimated the fiscal costs of financial sector restructuring at about 1 percent of GDP for 1997/98. During the fourth program review (August 1998), it was estimated that the interest cost of servicing the total stock of debt from all forms of financial assistance will rise from 3 percent of GDP in 1997/98 to about 4 percent in 1998/99 and 1999/2000.

The coverage of the fiscal accounts used for the programs differs across the three countries as described in Appendix 7.1.

For discussions of fiscal sustainability and fiscal adjustment, see Bascand and Razin (1997) and Molho (1994) on Indonesia and Kochhar and others (1996) on Thailand.

Appendix 7.2 illustrates this point in the context of a variant of the Mundell-Fleming model.

Of course, in a broader context, fiscal policy would itself affect growth and inflation, partially offsetting the effects discussed in this section.

For Indonesia, the second review; for Korea, the third quarterly review; and for Thailand, the fourth review.

This does not, of course, rule out the possibility that financing of the public sectors would partly crowd out financing to the private sector.

The financial sector restructuring is discussed in greater detail in Section VIII below.

In practice, as discussed elsewhere (Sections VI and VIII) the banks in Indonesia were also provided with large amounts of central bank liquidity support. This is not included in the bank Restructuring costs reported here.

Bank restructuring can also have an economic impact through several other channels: it may eliminate moral hazard problems associated with allowing insolvent institutions to continue in business; it may transfer wealth to banks' depositors, other creditors, and/or owners; depending on how it is financed, it may affect the money supply; and, under some circumstances, it may lead to a narrowing of bank interest rate spreads. See Daniel and Saal (1997) and Lane (1996). In principle, it would be preferable to record the capital costs of the restructuring using an augmented balance approach; see Daniel, Davis, and Wolfe (1997).

The underlying analysis of fiscal positions, undertaken by the staff of the IMF's Fiscal Affairs Department, is also summarized in International Monetary Fund (1998), Box 6.2.

By way of comparison, in the IMF's Stand-By and Extended Arrangements during 1988–92 the average change in the actual fiscal balance over the life of the program was estimated at about 3 percentage points of GDP. See Bennett and others (1995).

The methodology used defines a neutral fiscal position in terms of an unchanged tax structure and an unchanged ratio of expenditures to GDP (for a given exchange rate).

Under the programs, social safety nets were expanded, heightening the sensitivity of government spending to the cycle.

Between 1991 and 1996, the share of international trade taxes in total tax revenues fell from 45 percent to 30 percent in Indonesia (oil and gas revenues dominate these ratios), from 21 percent to 14 percent in Thailand, and from 10 percent to 7 percent in Korea. However, consumption taxes (e.g., excises and VAT), which make up a substantial share of total revenues—30 percent, 38 percent, and 43 percent in Indonesia, Korea, and Thailand, respectively—are quite sensitive to import levels, and so are affected indirectly by exchange rate changes.

See Sections IV and V above.

It is also possible that the crisis heralded balance sheet adjustments and major structural changes in these economies that would require several years of low or negative growth to work their way through. Such an assessment, if correct, would call for greater fiscal adjustment.

Tax smoothing, of course, assumes that the government can borrow and lend freely, whereas these economies were constrained in their borrowing during the crisis.

The rationale for this decision at the time was that the new government needed to establish its credibility by standing behind the targets that had previously been agreed with the IMF.

It may therefore turn out that actual fiscal policies have been more contractionary than targeted under the programs. In that case, the economic impact of fiscal policy would need to be reassessed in light of the actual outturns.

These calculations are obviously very sensitive to where one draws the line between economic conditions and policy measures. In particular, if increasing subsidies in response to exchange rate depreciations were defined as measures rather than as a neutral policy of accommodating the efforts of changing economic conditions, Indonesia's fiscal policy would appear 5—6 percentage points of GDP more expansionary than on the basis of the figures presented here.


    Bascand, Geoffrey, and AssafRazin,1997, “Indonesia's Fiscal Position: Sustainability Issues,” in Macroeconomic Issues Facing ASEAN Countries,ed. byJohnHicklin, DavidRobinson, and AnoopSingh (Washington: International Monetary Fund).

    Bennett, Adam, MariaCarkovic, and LouisDicks-Mireaux,1995, “Record of Fiscal Adjustment,” in IMF Conditionality: Experience Under Stand-By and Extended Arrangements, Part II: Background Papers, IMF Occasional Paper No. 129 (Washington: International Monetary Fund).

    Daniel, James A., Jeffrey M.Davis and Andrew M.Wolfe,1997, “Fiscal Accounting of Bank Restructuring,” IMF Paper on Policy Analysis and Assessment no. 97/5 (Washington: International Monetary Fund).

    Daniel, James, and MatthewSaal,1997, “Macroeconomic Impact and Policy Response,” in Systematic Bank Restructuring and Macroeconomic Policy,ed. byWilliam E.Alexander, Jeffrey M.Davis, Liam P.Ebrill, and Carl-JohanLindgren, (Washington: International Monetary Fund).

    International Monetary Fund1998, World Economic Out-look, October 1998: A Survey by the Staff of the International Monetary Fund, World Economic and Financial Surveys (Washington).

    Kochhar, Kalpana, LouisDicks-Mireaux, BalazsHorvath, MauroMecagni, ErikOfferdal, and JianpingZhou,1996, Thailand: The Road to Sustained Growth,IMF Occasional Paper No. 146 (Washington: International Monetary Fund).

    LaneTimothy D.,1996, “The First Round Monetary and Fiscal Impact of Bank Recapitalization in Transition Economies,” IMF Paper on Policy Analysis and Assessment no. 96/8 (Washington: International Monetary Fund).

    MolhoLazaros E.,1994, “Fiscal Adjustment in an Oil-Exporting Country: The Case of Indonesia,” IMF Paper on Policy Analysis and Assessment no. 94/21 (Washington: International Monetary Fund).

    Other Resources Citing This Publication