Chapter 2: A Daunting Fiscal Challenge
- Mauricio Villafuerte, Cemile Sancak, Jan Gottschalk, S. M. Ali Abbas, Olivier Basdevant, Ricardo Velloso, Fuad Hasanov, Greetje Everaert, Stephanie Eble, and Junhyung Park
- Published Date:
- September 2010
The crisis has resulted in a major increase in fiscal deficits and government debt in advanced economies. Under current projections, which already assume some tightening mainly through the removal of fiscal stimulus measures beginning in 2011 for several advanced economies, the general government gross debt-to-GDP ratio (henceforth “debt ratio”) of advanced economies will rise from 73 percent at end-2007 to 109 percent at end-2014, with most of the increase up front (Figure 2.1). By 2014, debt ratios will be close to or exceed 85 percent in all G7 economies, except Canada. Reversing this debt buildup will be a daunting fiscal challenge:
- The scale of the problem is unprecedented in peacetime. Indeed, government debt in the G7 countries is now as high as in the early 1950s, in the immediate aftermath of World War II (Figure 2.2). Major government debt increases occurred in the 1930s, but starting from lower levels (for example, U.S. federal government debt was 16 percent of GDP in the late 1920s). Moreover, demographic trends were favorable in the 1930s but are unfavorable now: fiscal pressures from an aging population will add significantly to the fiscal challenge of advanced economies over coming decades.
- The fiscal problem will improve only in part with economic recovery. By 2014, the output gap is projected to be close to zero. Yet primary deficits, although declining, will remain sizable even assuming (as in the baseline projection) that the 2009-10 stimulus measures are not renewed and that other temporary measures expire. This is because: (1) Even before the crisis, structural primary balances were weak. (2) In some countries, there has been an underlying increase in spending unrelated to the crisis. And (3) some revenue losses (those related to a decline in potential output and lower tax payments from the financial sector) are expected to be long lasting, if not permanent.
- The higher level of debt will need to be serviced in the years to come. By 2014, taking into account the likely rise in interest rates from current low levels, debt service costs are projected to increase by some 1¾ percentage points of GDP over 2007 levels. The increase in debt ratios reflects mostly large above-the-line deficits, rather than the acquisition of financial assets (financial support operations could perhaps account for 3 percentage points of the about 35-point projected increase in average debt ratios by 2014). Thus, the sale of assets acquired during the crisis could contribute only relatively modestly to lowering gross debt in the years ahead.
Figure 2.1.Advanced and Emerging Economies: Cyclically Adjusted Primary Balance (CAPB), Primary Balance (PB), and Government Debt, 2007–14
Sources: IMF, World Economic Outlook Update (January 2010), where available; otherwise IMF, World Economic Outlook (October 2009), and IMF staff estimates.
Notes: To allow for a focus on fiscal measures with direct effects on demand, the CAPB (top panel) for the United States excludes losses from financial sector support measures and other one-off and temporary factors (estimated at 3.1 percent of GDP in 2009 and 0.3 percent of GDP in 2010). However, to capture the effects of these losses on debt dynamics, the figure also displays the PB, including the costs of financial sector support measures (middle panel).
Figure 2.2.Government Debt in G-7 Countries, 1950–2010
Sources: The data are drawn mainly from the IMF’s World Economic Outlook (WEO) database (2009 and 2010 are projections). They refer to the general government, except for Japan (central government). WEO data are supplemented by the following: Canada (1950–60), federal gross government debt (Haver Analytics); France (1950–77), national debt (Goodhart, 2002); Germany (1950–75), credit market debt and loans (Statistisches Bundesamt Deutschland); Italy (1950–78), national government debt (Banca D’Italia); Japan, central government debt (Ministry of Finance of Japan); United Kingdom (1950–79), national debt (Goodhart, 1999); United States, gross federal debt (Office of Management and Budget; and U.S. Census Bureau). Note: PPP = purchasing power parity.
The fiscal outlook is significantly stronger for emerging economies but is not without risks. Debt ratios in emerging economies are projected to return to pre-crisis levels by 2013. This better outlook reflects more favorable structural primary balances during the crisis and smaller output losses (Horton, Kumar, and Mauro, 2009). In addition, fiscal policy in several emerging economies is projected to begin a tightening cycle in 2010, reflecting some consolidation beyond the simple withdrawal of crisis-related stimulus, supported by stronger growth prospects (IMF, 2009e).
In developing countries, risks to debt sustainability, which had improved substantially in recent years, may be on the rise again. Prior to the crisis, debt ratios in these countries had declined as a result of fiscal consolidation, strong growth, and debt relief. However, this decline came to a halt in 2009, and debt ratios are projected to remain broadly stable into the medium term. More than one-third of developing countries have augmented automatic stabilizers with discretionary fiscal stimulus, particularly on the spending side. Although several developing countries have used the buffers built in before the crisis, debt ratios in some cases are expected to rise markedly in the years to come if fiscal retrenchment or increased levels of highly concessional donor support fail to materialize. Thus, the risk of debt distress could increase in some developing countries, especially in the absence of fiscal adjustment once the recovery is clearly on the move.1
Altogether, the fiscal outlook is weaker in advanced economies, but their problems could spill over to other economies. At best, higher deficits and debt will put upward pressure on real interest rates thereby weakening growth prospects in advanced economies and elsewhere (see also the discussion in Chapter 3). At worst, the weaker fiscal outlook in advanced economies could lead to concerns that debt will be “inflated away” or that default is inevitable. If so, debt maturities would shorten, risk premia would rise, and, ultimately, refinancing crises could emerge. Indeed, as the recent crisis has demonstrated, a loss of confidence in the advanced economies could spill over to emerging and developing economies with weaker fundamentals. Perhaps those with stronger fundamentals could benefit from a “flight to safety,” an effect attenuated by an appreciation of their currencies, which would reduce their competitiveness. In any case, shifts in investments across and out of advanced economies could disrupt financial markets. Moreover, a fiscal crisis could be more severe than a crisis rooted in the private sector, because no entity would be available to bail out the public sector.
At present, financial markets do not seem to be too concerned about the weaker fiscal outlook, but this is no excuse for complacency. Although some risk premium indicators point to increased sovereign risk differentiation (Figure 2.3), markets have not yet reacted more forcefully to the fiscal challenges of high-debt advanced economies. This may reflect myopia: recent experience has shown that markets often react late and suddenly to persistent disequilibrium. A more favorable interpretation is that markets’ contained reaction may reflect an increased supply of private savings or an expectation that policymakers will eventually embark on credible fiscal adjustment. In any event, clarifying the fiscal adjustment strategy would reduce the likelihood of a sudden deterioration in market sentiment.
Figure 2.3.Relative Asset Swap (RAS) Spreads in Selected Advanced Economies