Chapter 4 Assessing and Mitigating Fiscal Sustainability Risks
- International Monetary Fund. Fiscal Affairs Dept.
- Published Date:
- April 2011
At a Glance
This section summarizes risks to fiscal sustainability and discusses policy options to address them. The analysis draws on earlier chapters, complemented by more formal analysis based on fiscal indicators (see also Appendix 3). It tries to determine how the risk of a fiscal crisis of regional or systemic relevance has changed with respect to the assessment provided in the November 2010 Fiscal Monitor.
How Have Fiscal Sustainability Risks Changed?
There has been limited progress in reducing fiscal sustainability risks. For advanced economies, risks remain high overall, and the divergence across countries has increased since the November 2010 Fiscal Monitor. In many emerging economies, headline fiscal positions are improving, but the underlying fiscal stance is often loose, which could pose a risk in the presence of shocks.
Baseline trends remain weak, especially in advanced countries.
Short- and medium-term fiscal trends remain weak in advanced economies but have improved somewhat in emerging economies. The ongoing consolidation in the euro area and the United Kingdom has occurred at a time of a further weakening of the fiscal position in Japan and the United States. Given these diverging trends, the baseline outlook for advanced economies is on average broadly unchanged compared to six months ago, with risks remaining high (Table 4.1). This is borne out by an analysis of numerical indicators compiled for the Fiscal Sustainability Risk Map in Appendix 3.19 For emerging economies, baseline projections have on average improved somewhat. The indicator analysis confirms that although the overall level of risk has eased, it remains high by historical standards, with cyclically adjusted primary deficits above precrisis levels.
Long-term spending pressures, which are broadly unchanged, remain significant. The risk profile (Table 4.1) reflects limited entitlement reforms. Recent pension reforms in France and Spain contribute to ameliorating long-term spending trends in these economies, but the impact on risk indicators for the advanced economies as a whole is marginal. For emerging economies, the stable baseline of long-term fiscal challenges reflects no significant change in entitlement policies in recent months. Spending pressures are in general lower than for advanced economies, with a key challenge being to improve coverage without incurring unsustainable fiscal costs.
Risks related to the structure of liabilities have on average remained stable in advanced economies but have declined in emerging economies. Financing needs have increased in some advanced economies, including in the United States, despite a general lengthening of debt maturities. This has been partially offset by lower financing needs in many euro area countries owing to lower deficits. Altogether, this risk dimension is little changed (Table 4.1), as confirmed by the statistical indicators in Appendix 3. For emerging economies, the somewhat lower risk profile reflects a reduction in gross financing needs and a decline in the ratio of short-term external debt to reserves, as many of these economies experienced a rapid recovery in exports and capital inflows.
|Advanced Economies||Emerging Economies|
|Short- and Medium-Term Fiscal Indicators|
|Long-Term Fiscal Challenges|
|Financial Sector Risks|
|Policy Implementation Risk|
Risks of shocks to the baseline have moved in divergent directions, but generally remain elevated.
Uncertainty over output growth has eased for advanced economies. For emerging economies, however, where tailwinds have supported positive developments, vulnerability to negative shocks is reflected in an uptick in uncertainty. Concerns about inflationary pressures, as well as the uncertainties associated with the political turmoil in some countries in the Middle East and North Africa, have increased this risk factor. A key source of risk for both groups of countries relates to short- and medium-term developments in regard to interest rates.
Financial sector risk in advanced economies remains elevated but has receded somewhat in recent months. Financial market performance has been favorable thus far in 2011, but balance sheet restructuring is still incomplete, and financial sector leverage and private sector indebtedness are still at high levels (April 2011 GFSR). Financial risk indicators (including the GFSR’s Global Financial Stability Map indicators; Appendix 3) point to financial sector risks being high but gradually falling thanks to a more stable market environment. In emerging economies, the beneficial impact of buoyant domestic financial markets and spillovers from the improved environment for advanced economies is counterbalanced by uncertainties emanating from rapid credit growth in some countries, resulting in an overall unchanged assessment for this indicator.
Policy implementation risk has increased somewhat in the last six months (Chapter 3). The numerical indicators point to a deterioration in this dimension in advanced economies, based on an assessment of the quality of countries’ adjustment plans, the major adjustment efforts implied by the baseline in some large countries, and political developments impinging on policy implementation (including the electoral cycle).
Measures to Mitigate Fiscal Sustainability Risks
Key advanced economies need to accelerate the adoption of credible fiscal consolidation measures and finalize the details of the crisis resolution frameworks. For many emerging economies, rebuilding fiscal buffers to deal with a potential reversal of the current benign conditions is a priority. Many low-income economies need to continue improving their fiscal positions while financing growth-enhancing initiatives in a sustainable manner.
Among the advanced economies, the United States, in particular, needs to adopt measures that would allow it to meet its fiscal commitments. Market concerns about sustainability remain subdued in the United States, but a further delay of action could be fiscally costly, with deficit increases exacerbated by rising yields. Rollover problems for the largest advanced economies remain a tail risk, but one that would entail huge costs for them and the rest of the world. In the United States, the additional fiscal stimulus planned for 2011 means that meeting President Obama’s commitment to halve the federal deficit by the end of his first term would require an adjustment of 5 percentage points of GDP over FY2012—13, the largest in at least half a century. Given cyclical conditions, a down payment in the form of a reduction of the deficit for FY2011 that made the FY2013 objective compatible with a less abrupt withdrawal of stimulus later would be preferable. A commitment to a medium-term debt target as an anchor for fiscal policy would also be welcome. In Japan, the Fiscal Management Strategy envisages maintaining stable reductions in the debt ratio from FY2021. Once the fiscal costs of recent developments are assessed, commitment to a fiscal policy leading to a more rapid adjustment, supported by fiscal measures more clearly identified than in the past, would be appropriate.
In the euro area, fiscal adjustment is proceeding at the right pace, but a paramount objective is to agree on all aspects of a comprehensive pan-European approach to crisis management. The EFSF and the ESM must have the ability to raise sufficient resources quickly at low costs and to deploy them flexibly (April 2011 WEO). Recent progress is welcome, but some details will need to be finalized (see Box 4.1 regarding the recent decisions on the EFSF and the ESM and for more details on the fiscal aspects of the EU governance reforms). To increase the credibility of fiscal consolidation, those countries that have come under renewed market pressure need to stand ready to adopt additional measures to avoid slippages. More generally, several EU countries still need to specify and adopt appropriate policy measures to achieve the commitments within their stability and convergence programs. Efforts should be underpinned by strong national fiscal frameworks with minimum standards to be outlined by the European Commission, as well as structural reforms to boost growth.20
In general, advanced economies should respond flexibly to macroeconomic conditions. In all advanced economies, should growth turn out to be faster than projected in the WEO baseline, additional revenues should be saved. Should growth prove slower than currently projected, those advanced economies with fiscal space should let the automatic stabilizers operate.
Box 4.1.Fiscal Aspects of EU Economic Governance Reforms
On March 24—25, the European Council endorsed several reforms aimed at enhancing policy coordination in the European Union. A final package is expected to take effect by June 2011, after negotiations with the European Parliament. The reforms enhance both the prevention and management of sovereign debt crises through:
Broader policy coordination based on a European semester—which establishes an ex ante peer review of member states’ fiscal and structural reform plans prior to the finalization of national budgets—and the Euro Plus Pact, which formalizes an agreement among euro area members to make specific commitments to strengthen competitiveness and convergence.
A revamped Stability and Growth Pact (SGP): this reform goes a long way in addressing loopholes in fiscal surveillance. First, the reform introduces new sanctions, including deposits amounting to 0.2 percent of GDP in the preventive arm of the pact and fines of the same amount in the corrective arm. Decisions about these new sanctions will be subject to a reverse-majority mechanism by which the Council can only overrule the Commission with a qualified majority. Second, fiscal surveillance would be strengthened through a cap on growth in public spending net of discretionary revenue measures to encourage saving revenue windfalls. Third, the debt criterion in the corrective arm would be operationalized through a minimum debt reduction threshold to be met in addition to the 3 percent deficit ceiling.
A directive to make (or adopt) rules-based national fiscal frameworks compatible with the SGP. This is important to encourage member states to take greater ownership of the common rules and improve their implementation, including by mandating transparent accounting, prudent forecasting and medium-term planning. Since a directive can only provide general guidelines, the commitment included in the Euro Plus Pact to adopt binding national rules is welcome.
A new excessive imbalances procedure (EIP) to deal with macroeconomic imbalances. The EIP—which incorporates a preventive and a corrective arm—recognizes that unsustainable public debts may be rooted in nonfiscal problems—private sector financial excesses, eventually compounded by the realization of implicit or contingent liabilities.
A permanent crisis management procedure. Crisis management will fall under the responsibility of a new institution, the European Stability Mechanism. The ESM essentially makes permanent the existing, strictly conditional assistance scheme (European Financial Stabilization Facility) and expands its instruments (bond purchases in the primary market). It will be helpful in preventing liquidity problems from casting doubts on a member state’s capacity to fulfill its obligations. The effective financing available to the EFSF is also to be increased.
These reforms are an important step forward to encourage fiscal responsibility and prevent the recurrence of sovereign stress. However, some areas of concern persist. First, implementing some of the new SGP rules may prove challenging, in particular, when accounting for cyclical factors in the operation of the debt rule. Second, elements of the reforms need to be clarified, especially those relating to the EIP. Third, some aspects of SGP governance have not been reformed. In particular, the standard decision-making process—whereby the Council’s qualified majority is needed, with abstentions effectively amounting to a negative vote—still applies to the key surveillance decisions, including the initiation of the excessive deficit procedure and the imposition of sanctions already envisaged under the old SGP.
Even though headline balances in emerging economies continue to improve, several considerations suggest that many need to adopt a more cautious fiscal policy. First, favorable tailwinds boosting revenues and containing spending may be short-lived. This is borne out by the experience of many European economies in the run-up to the recent crisis. Second, fiscal buffers were eroded by the crisis and should be rebuilt to protect against sudden reversals in capital inflows. Third, overheating concerns are increasing. In some emerging economies, particularly in Europe, that still face relatively high debt levels and the risk of spillovers from market pressures elsewhere, the need to improve fiscal positions is particularly urgent. These considerations suggest that, at a minimum, spending pressures should be resisted and automatic stabilizers allowed to come into play, thus enabling revenue overperformance to be saved in full. In countries where higher commodity prices are raising outlays on food and energy subsidies, better-targeted measures to protect the poor are needed.
For low-income economies, a key policy priority is to finance growth-enhancing initiatives without jeopardizing fiscal sustainability. The improvement in overall balances in low-income economies is welcome and will help rebuild fiscal buffers. Moreover, given large infrastructure gaps as well as the need to achieve the Millennium Development Goals, increased spending will be needed in the years ahead on public investment, education, and well-targeted transfer programs. To ensure that higher spending is financed in a sustainable manner without crowding out private investment, greater revenue mobilization—beginning with improved tax administration and wider tax bases—will be essential. In addition, reforms to strengthen public financial management would improve the quality of expenditures, including for public infrastructure, and thus their impact on economic growth (IMF, 2010c).
An analysis of past episodes of attempted large fiscal adjustments provides guidance regarding pitfalls to avoid and keys to success in fiscal consolidation. Appendix 4 summarizes the results of a detailed narrative analysis of 21 attempted large fiscal adjustment episodes in the G-7 countries and a cross-country statistical analysis of 66 large fiscal adjustment plans in European Union members over the past few decades. The focus on planned—rather than just successful—adjustment efforts allows the analysis to identify not only what policies aided deficit reduction, but also what policies failed.
Among the episodes analyzed, powerful shocks, especially to economic growth, often resulted in sizable deviations of fiscal outcomes from plans, thus highlighting the importance of spelling out up front how policies will respond. Plans need to incorporate explicitly mechanisms to deal with unforeseen circumstances, permitting some flexibility while credibly preserving medium-term consolidation objectives. Examples of helpful mechanisms include multiyear spending limits or, where feasible, cyclically adjusted fiscal targets. Contingency reserves also helped ensure successful outcomes: the creation of such reserves—or of backup measures to be implemented in the event that shortfalls begin to emerge—would be especially critical in economies under close market scrutiny, which have limited margin for error.
Although most adjustment programs evaluated aimed primarily at expenditure reduction, the latter often did not materialize, and in several cases deficit objectives were salvaged by revenue overperformance.21 This suggests that countries that are planning primarily expenditure-based adjustments need to ensure that expenditure ceilings are adhered to by devising institutional mechanisms and implementing supporting structural reforms—key factors for success of past fiscal consolidations. In addition, countries would do well to consider supplementary, high-quality options on the revenue side, to be deployed in the event of expenditure overruns (IMF, 2010b).
Ideally, revenue increases would be achieved by widening tax bases and removing distortions, rather than by raising tax rates. In many countries, the elimination of tax expenditures can contribute to this objective. As noted in Appendix 5, the use of tax expenditures has grown significantly in recent years, and foregone revenues associated with such expenditures are estimated at 5 percent of GDP or more in many countries. Although tax expenditures can serve worthwhile goals—such as encouraging investment in particular industries or activities like research, or stimulating individuals to consume merit goods (like education) or to make charitable donations—policy objectives would in many cases be better served by a more transparent allocation of government resources (for example, via a direct subsidy from the budget rather than preferential tax treatment). In addition, the introduction in the United States of a value-added tax, and an increase in currently very low VAT rates in Japan (as part of the ongoing reform of taxation), could yield significant resources while minimizing distortions associated with other types of tax increases.
The history of failed consolidation attempts also points to the importance of strong fiscal institutions. Good institutions—accurate and timely monitoring of fiscal outturns, coordination across levels of government, and fiscal rules—can play a critical role in preventing spending overruns or drawing attention to them in time for offsetting measures to be introduced. More is needed in this area, including in the largest advanced economies. Both Japan and the United States should underpin their fiscal consolidation efforts with institutional reforms. In the United States, more binding multiyear restrictions on spending are needed, along with effective top-down budgeting that helps ensure that plans are implemented. For Japan, the new medium-term fiscal framework needs to spell out the measures that will be taken. Greater commitment could also derive from breaking with the past practice of repeated recourse to supplementary budgets, except in emergency circumstances like those prevailing in the aftermath of the earthquake. In all countries, ensuring fiscal transparency is critical to maintaining credibility.
Tackling long-term spending pressures in advanced economies requires deep entitlement reforms, which should not be postponed further. The major spending pressures and policy challenges relate to health care; policymakers will have to balance the need to ensure access with the requirement of preserving sustainability of public finances. The most-promising reforms combine top-down budget control with bottom-up reforms to improve efficiency. In emerging economies, the main challenge will be to improve health safety nets while preserving long-term fiscal sustainability, as health indicators are substantially lower than in advanced countries. By contrast, pension spending pressures look more manageable, thanks to reforms already enacted. However, relatively optimistic baseline assumptions in some countries, including those regarding productivity growth, imply risks. In addition, several countries, including some emerging European economies (e.g., the Russian Federation and Ukraine), face rapid demographic changes and still need to conduct important reforms.
For advanced and emerging economies facing funding pressures and high debt levels, public debt management needs to be strengthened further. Efforts to lengthen maturities and smooth redemption profiles need to proceed, and strategies need to be developed that consider a diversified investor base, with a view to mitigating rollover risks.
Finally, building public support for large adjustment efforts will be key. The analysis of past consolidation attempts reveals that public support, rather than the presence of a strong legislative majority, was a major determinant of successful fiscal adjustments. Thus, a priority going forward should be to better explain to the public the rationale for and scale of the needed fiscal measures. Just as critically, it will be essential to ensure that the burdens of adjustment, as well as the benefits of the recovery, are distributed equitably across society. In this context, ensuring adequate social safety nets to protect the most vulnerable is of the utmost importance.