Chapter 3 Shocks to the Baseline Fiscal Outlook

International Monetary Fund. Fiscal Affairs Dept.
Published Date:
April 2011
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At a Glance

Deviations from the baseline fiscal outlook presented in Chapters 1 and 2 may occur as a result of macroeconomic, financial sector, and policy implementation shocks. In the period ahead, risks to fiscal developments arise particularly from two shocks. First, an increase in exceptionally low interest rates could complicate the budgetary outlook in both advanced and emerging economies. In some emerging markets, this risk is compounded by a possible reversal of the unusually supportive combination of high commodity prices and strong capital inflows. The second set of risks involves policy implementation shocks in some advanced economies.

Growth uncertainty is lower, but interest rate shocks remain a risk

The risks to the fiscal accounts arising from short-term output shocks have declined in both advanced and emerging economies.13 As growth has picked up in many advanced economies, the risk of a “double-dip” recession appears to have declined, and the dispersion of analysts’ real GDP forecasts has accordingly narrowed in recent months (Figure 3.1; April 2011 WEO). There are of course exceptions: with the ongoing political turmoil in the Middle East and North Africa, and the earthquake and ensuing events in Japan, new macroeconomic uncertainties have emerged for those areas. More generally, global downside risks stemming from higher oil prices have also increased and are not yet fully accounted for in most macroeconomic forecasts (April 2011 WEO).14

Figure 3.1.Dispersion of One-Year-Ahead Real GDP Forecasts Across Analysts

(Percentile rankings)

Sources: Consensus Forecast; and IMF staff calculations.

Note: Country groups are weighted to 2009 PPP-GDP weights.

More sizable risks arise from interest rate shocks. Debt dynamics are critically affected by the interest rate—growth differential (IRGD). In the baseline projections discussed above, the IRGD is projected to remain low by historical standards over the medium term (Table 3.1). While still-weak economic activity makes this plausible, upside surprises cannot be ruled out.

Table 3.1.Average Interest Rate-Growth Differential, 1990-2016(Percentage points)
Advanced Economies1.50.2-0.4
G-20 Advanced Economies3.31.3-0.3
Emerging Economies-1.0-3.3-2.1
G-20 Emerging Economies0.3-3.0-2.8
Low-Income Economies-6.9-7.3-4.7
Source: IMF staff calculations.Note: Adjusted for exchange rate effect. Data are not available for all countries for all years. Unweighted averages.

High debt ratios in many advanced economies leverage the impact of small interest rate shocks. Under a scenario in which interest rates on new debt issuances are 100 basis points higher than in the baseline, by 2016 the interest burden in advanced economies would increase by 1 percentage point of GDP on average (1¼ percentage points for the United States and 1½ percentage points for Japan; Figure 3.2).15 If larger fiscal deficits resulting from this scenario were accompanied by a further increase in interest rates reflecting a risk premium, the effect on debt servicing costs could be even greater. For example, if rates were to rise an additional 20 basis points for each percentage point increase in a country’s deficit-to-GDP ratio—consistent with the existing empirical evidence16—interest payments in 2016 would be 1½ percentage points of GDP higher than the original baseline on average (with increases of 1½ percentage points for the United States and 2 percentage points for Japan). (For some complementary interest rate sensitivity analyses, see the April 2011 GFSR.)

Figure 3.2.Selected Advanced Economies: Budgetary Impact of Interest Rate Increases

(Percent of GDP)

Source: IMF staff calculations.

Lower debt ratios in emerging markets provide some protection from the impact of changes in the interest rate—growth differential, but the IRGD is nevertheless subject to strong medium-term uncertainty and to high short-term volatility in these countries. The baseline projections envisage a sharply negative IRGD in emerging economies, a critical factor explaining why debt dynamics in these economies remain favorable despite persistent negative primary balances over the medium term (Figure 3.3; Statistical Table 2). A negative IRGD is not unusual for emerging economies. Box 3.1 discusses some of the reasons why, noting the importance of financial underdevelopment and repression in driving down real interest rates (and hence the IRGD). These findings suggest that as financial systems in emerging markets develop and are liberalized, interest rates on public debt will likely increase, requiring in turn a strengthening of primary balances over time to keep debt ratios stable. The extent to which these developments will already be felt during the forecasting horizon is unclear, but higher pressure on interest rates is possible, especially as rates normalize in the advanced economies. The box also highlights the greater volatility of IRGD for emerging than for advanced economies, another potential source of shocks to the baseline forecast.

Figure 3.3.Emerging Markets: Budgetary Impact of Interest Rate Increases

Source: IMF staff projections.

Note: Interest rate-growth differential is adjusted for exchange rate effect.

In addition to low interest rates, the fiscal accounts of emerging economies are currently benefitting from additional tailwinds, although to different extents. As noted, the revenues of net exporters have been boosted by rising commodity prices. Asset price booms, spurred by capital inflows, are also raising revenues. Clearly, the more rapid the reversal of these favorable tailwinds, the more severe would be its impact on the fiscal accounts. In this respect, it is noteworthy that portfolio inflows—among the more volatile sources of foreign financing—represent a significant share of the recent increase in capital flows to emerging markets (April 2011 WEO).

The overall effects of a reversal of these favorable conditions on emerging economies could be sizable:

  • Each 100-basis-point increase in interest rates on newly issued debt in emerging markets would raise annual interest payments by ½ percent of GDP on average by 2016.

  • For a sample of nine emerging economies representing a cross-section of commodity exporters, a 10 percentage point across-the-board fall in commodity prices would lead to a decline of more than 1 percent of GDP in budget revenues annually.17

  • A fall in equity prices that returns emerging economy indices to their precrisis levels (about 20 percent in real terms) would result, on average, in a decline of about ¼ percent of GDP in revenues.

The projected strengthening of overall balances in low-income economies is subject to several risks. These include uncertainty in grant disbursements given fiscal pressures in advanced economies; rising debt service costs; and pressure to increase spending on subsidies and public wages, especially for food and fuel importers. Commodity-exporting countries (for example, Angola, Bolivia, and Chad) also face the risk of an abrupt decline in commodity prices.

Advanced economy financial sectors have stabilized, but guarantees are still lurking

Financial sector risk has declined, but remains elevated in advanced economies18 Financial market performance has been favorable over the past six months, but balance sheet restructuring is still incomplete and is proceeding only slowly, with leverage remaining high (April 2011 GFSR). Although, as noted in Chapter 1, the net direct cost of financial sector support has so far been lower than in past crises, risks remain high. Estimates of the net fiscal costs from past banking crises range widely, from close to zero in Sweden (where large gross costs were almost fully recovered, after several years) to more than 50 percent of GDP in the case of Indonesia. In the current crisis, the low direct cost thus far can be explained by the relatively limited use of public recapitalization schemes, partly reflecting the role played by the private sector in the restructuring of assets (Laeven and Valencia, 2010). As a counterpart, there has been wide use of guarantees, asset insurance, and liquidity support, which reduces the need for up-front fiscal outlays but increases risks going forward. One such item is especially large by historical standards: bonds issued by financial institutions with a government guarantee are estimated at over $1.25 trillion at end-2010 for a sample of advanced economies (Figure 3.4), equivalent to 6 percent of GDP for the countries in the sample. The magnitude of these potential further fiscal costs highlights the importance of a coherent strategy to restore banking sector viability, particularly in Europe.

Figure 3.4.Selected Advanced Economies: Volume of Outstanding Government-Guaranteed Bonds

($US billions)

Sources: Dealogic; and IMF staff calculations.

Note: State guarantees on bonds issued by private and public banks and financial institutions. Short-term debt is not included.

For emerging economies, financial sector risk continues to be generally lower than for advanced economies but is broadly unchanged relative to six months ago. While financial market conditions have improved, large capital inflows and easy credit conditions pose risks to the financial system (through rapid credit growth and excessive risk taking) with possible implications for the budget.

Fiscal institutions are under stress in some countries, and political conditions do not favor bold policy action in others

Policy implementation shocks are hard to assess, but many advanced economies will face important challenges. A major adjustment would be needed in the United States in 2012 to put fiscal consolidation back on track (Chapter 1). Similar concerns apply to Japan, where increased spending due to the earthquake may lead to higher medium-term consolidation needs. Elsewhere, protracted delays in resolving uncertainties related to the European Financial Stability Facility and European Stabilization Mechanism put upward pressure on interest rates in some euro area economies. A failure to make adequate progress in resolving outstanding details (which is not in the baseline) risks triggering a sharp rebuke from bondholders. More broadly, there is a risk that the electoral calendar in the United States, France, and Japan, and possibly elsewhere, could complicate policy implementation. Experience with past consolidation episodes has shown that greater fractionalization in the legislature and perceptions of lower political stability are associated with weaker implementation of plans.

Strengthening fiscal institutions, including public financial management frameworks, fiscal rules, and fiscal councils, can reduce the risk of policy slippages. Regrettably, recent developments in this area are mixed:

  • In Hungary, the nonpartisan independent fiscal agency was effectively closed. In contrast, however, a few advanced economies have strengthened their fiscal plans and institutions. For example, the United Kingdom approved legislation for the Office for Budget Responsibility and issued its Spending Review, which details medium-term spending. Greece adopted a new Fiscal Management Law, and Serbia adopted a Fiscal Responsibility Law. In France, plans for a fiscal rule have not yet been implemented.

  • Fiscal transparency seems to be increasingly at risk in some countries. With fiscal results facing heightened scrutiny, there is a growing tendency for governments to enter into transactions that sacrifice fiscal transparency (and, in some cases, long-term fiscal health) to make short-run budget outturns appear more positive. Moves by Argentina and Hungary to renationalize previously privatized second-pillar pension schemes are one example of this phenomenon. Likewise, Ireland’s bank crisis resolution entity has been designated as a private sector organization, even though nearly all of its expenses will be financed with government-guaranteed debt. Appendix 2 reviews other examples of accounting stratagems that make the fiscal accounts appear stronger than is actually the case. These include securitizations of future income streams (or accounts receivable) that make borrowing look like revenue, deferral of spending through public-private partnerships, and sales of financial assets that treat the current proceeds as revenue but take no account of the resulting loss of future dividends or interest payments. Fundamentally, a clear resolve on the part of national authorities to maintain transparent and accurate fiscal accounts is the only surefire way to prevent misleading accounting tricks: almost any rule or standard can be evaded if governments set out to do so. However, the temptation to participate in these types of transactions can be limited by ensuring that governments prepare their fiscal accounts according to broadly accepted principles and use as wide a definition of the public sector as feasible. More can be done to encourage compliance with standards, as well.

Box 3.1.Debt Dynamics and the Interest Rate-Growth Differential

For decades, a negative interest rate-growth differential has been a feature of most emerging and low-income economies (first figure). Statistical evidence indicates that the IRGD is strongly correlated with the level of economic development. It is positive (averaging about 1 percent) for G-20 advanced economies and negative for emerging economies (about –4 percent) and lower-income countries (about -1 percent).

Interest Rate-Growth Differential, 1999-2008 Average

Sources: Country authorities;and IMF staff estimates and projections.

Note: Includes currency valuation effects.

Real Interest Rates and Financial Developments, 1999-2008 Average

Sources: Country authorities; and IMF staff estimates and projections.

Economic theory does not offer any obvious reason for this marked correlation, since both growth and interest rates should normally be higher in emerging and low-income economies than in advanced ones. In practice, however, real interest rates in these economies are generally lower than in advanced economies (and often are largely negative), and this is the main cause of negative IRGDs. In the case of developing economies, both econometric and qualitative evidence suggest that negative real rates on domestic debt are due to a lack of financial development and to financial repression and distortions, including captive domestic markets for government debt, directed lending, and government involvement in credit markets (second figure).

Rising Real Interest Rates in Recent Decades

Sources: Country authorities; and IMF staff estimates and projections.

Note: Country sample is based on data availability. Advanced economies are defined as in the Fiscal Monitor with the exception of Slovenia and the Slovak Republic, which were not members of the Organization for Economic Cooperation and Development during most of the analyzed period.

An array of financial development and capital account openness indicators are positively correlated with the IRGD, mainly through their impact on interest rates, while their relation with growth is weaker. In particular, high inflation and the apparent inability of investors to incorporate it into nominal interest rates (or shift investment to alternative assets with positive real returns) appear to have been instrumental in driving down real interest rates on government debt. High savings rates have also often contributed (Escolano, Shabunina, and Woo, 2011).

Real Interest Rates and Financial Reform Index

Sources: Country authorities; and IMF staff estimates and projections.

If so, it would be a mistake to assume that negative IRGD will persist over the long term, and indeed real interest rates have been rising in emerging markets since the 1990s in parallel with financial globalization and increasingly integrated international financial markets (third figure, on preceding page). This process also occurred in advanced economies during the financial liberalization and capital market deepening of the 1980s (fourth figure). Declines in saving rates or broader domestic investment opportunities would add to this process.

Interest Rate-Growth Volatility, 1999-2008

Sources:Country authorities;and IMF staff estimates and projections.

Note: Includes currency valuation effects.

Moreover, even in the short term, unsound underlying fiscal positions can result in pronounced abrupt changes in the IRGD of emerging and developing economies. Within-country IRGD volatility is substantially higher (and IRGD persistence lower) for economies with lower income and IRGDs—increasing debt dynamics uncertainty (fifth figure).

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