Chapter

4. Too Good to Be True? Fiscal Developments in Emerging Economies

Author(s):
International Monetary Fund. Fiscal Affairs Dept.
Published Date:
September 2011
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Some fiscal adjustment is under way in emerging economies this year, especially in Asia and Europe, and this is projected to continue in 2012. Cyclically adjusted deficits are projected to fall by ¾ percent of GDP this year in emerging Asia, driven by declines of close to 1 percent in China and India. The average cyclically adjusted deficit in emerging Europe is projected to decline by 1¼ percent of GDP this year, in line with the pace expected in the April 2011 Monitor (Table 1).

The cyclically adjusted balance is expected to improve by ½ percent of GDP in Latin America, with strengthening in Brazil, Mexico, and Peru. Overall, the cyclically adjusted deficit is projected to decline by ¾ percent of GDP in emerging economies this year and ½ percent of GDP next year. No cyclically adjusted projections are available for the Middle East and North Africa, but headline deficits are expected to increase significantly this year because of slower growth and much higher social spending in response to the crisis in the region. A retrenchment on the order of ¾ percent of GDP is expected in 2012 (see Box 3 for information on oil producers more generally). Is this pace of fiscal tightening in emerging economies sufficient?

Financing costs in many emerging economies remain low, thanks in part to strong capital inflows, but this may not persist. Spillovers from Europe’s debt crisis into emerging markets have so far been limited (Figure 7): while the median credit default swap (CDS) spread for Belgium, Italy, and Spain has risen notably since June as market concerns about the euro area widened, that for emerging markets has seen only a moderate increase. Nonetheless, much of the decline in spreads in emerging Europe since late 2010 has been reversed, and levels continue to be higher than those in peer countries, reflecting ongoing market concerns regarding fiscal adjustment needs. Spreads in Latin America are also higher than they were a year ago. These developments are consistent with evidence suggesting that when global risk aversion rises, emerging economies with high deficits and government debt are penalized for them (Box 4). Accordingly, countries should make progress in reducing fiscal vulnerabilities now to avoid the risk of an eventual backlash in the form of a sharper increase in interest rates, or even a reversal of capital inflows, from continued high global risk aversion.

Figure 7Emerging Economies: Median 5-Year CDS Spreads

(Basis points)

Sources: Markit; and IMF staff estimates.

Note: The shaded area represents the middle 80 percent of the distribution of CDS spreads in emerging economies; in other words, the shaded area excludes countries with the 10 percent highest and 10 percent lowest CDS spreads.

Although fundamentals in emerging economies are improving and are generally better than in advanced economies, differences between the two groups of countries may be less pronounced than many believe. In several emerging economies, cyclically adjusted fiscal balances are weaker than before the crisis (Figure 8), despite the fact that high commodity prices and strong capital inflows—the impact of which is not universally accounted for in cyclical corrections—are boosting revenues in many of them. In addition, while the difference in headline deficits between advanced and emerging economies is dramatic—about 4 percent of GDP on average in 2011—it is far less so when the different cyclical positions of these groups of countries are taken into account: in cyclically adjusted terms, the gap between deficits in advanced and emerging economies stands at just 1¾ percent of GDP. With fiscal adjustment set to continue in the advanced economies for an extended period, and as output gaps in the advanced economies gradually close, the gap in both underlying and headline fiscal positions between the two country groups is set to narrow considerably going forward. Finally, while gross financing requirements in emerging economies are typically well below those of advanced economies, some emerging economies with relatively high gross debt levels, notably Brazil and Pakistan, are expected to face financing needs that are comparable to the advanced economy average (Table 4).

Figure 8Emerging Economies: Differences in Cyclically Adjusted Primary Balances, 2011, Compared with the Precrisis Period

(Percent of potential GDP)

Sources: IMF staff estimates and projections.

Note: Precrisis deficits refer to 2004–07, subject to data availability. For Nigeria and Saudi Arabia, data reflect change in primary balance as percentage of non-oil GDP. For countries with significant commodity revenues (marked with red diamonds), changes in cyclically adjusted primary balances are shown both including and excluding these revenues.

Table 4Selected Emerging Economies: Gross Financing Needs, 2011–12(Percent of GDP)
20112012
Maturing debtBudget deficitTotal financing

need
Maturing debtBudget deficitTotal financing

need
Pakistan20.36.526.721.15.326.5
Brazil16.82.519.216.62.819.4
Philippines11.52.914.49.92.512.4
Poland8.45.513.98.33.812.0
Romania9.24.413.69.32.812.1
Mexico8.73.212.07.62.810.3
Hungary13.7−2.011.611.73.615.3
India3.28.011.20.57.68.1
Turkey9.50.910.47.41.08.4
Lithuania4.95.310.27.74.512.2
Thailand6.52.69.14.82.97.7
Latvia3.74.58.24.52.36.8
Argentina16.02.08.04.41.96.3
Malaysia2.95.18.02.94.97.8
Ukraine5.12.87.95.02.07.0
China16.11.67.74.40.85.2
Colombia3.93.06.93.41.54.9
South Africa0.94.35.20.93.94.8
Bulgaria2.42.54.92.52.24.7
Indonesia1.21.83.01.61.33.0
Russia1.11.12.20.82.12.9
Chile2.4−1.41.01.8−1.60.3
Peru1.5−0.60.91.4−0.90.5
Weighted average6.43.09.35.12.67.7
Sources: IMF staff estimates and projections.

A good summary of overall fiscal conditions can be provided through a Fiscal Indicators Index (FII) which draws on a variety of indicators that have been found to be associated with market stress. The index provides a more holistic assessment of overall fiscal conditions than would be possible with any individual indicator. Just as importantly, by being limited to those variables that have demonstrated their relevance statistically, the index helps prevent the analysis of fiscal developments from being led astray by indicators that, although widely cited, have shown themselves to have little predictive power (Box 5).

Box 4Determinants of Domestic Bond Yields in Emerging Economies

While many studies have looked into the determinants of yields on externally issued sovereign bonds of emerging economies, analysis of domestically issued bonds has hitherto been limited, despite their growing relevance.1 New research (Jaramillo and Weber, 2011) finds that the extent to which fiscal variables affect domestic bond yields in emerging economies depends on the level of global risk aversion, proxied by the VIX.2 During tranquil times in global markets, fiscal variables do not seem to be a significant determinant of domestic bond yields in emerging economies. However, when market participants are on edge, they pay greater attention to country-specific fiscal variables—presumably because they are alert to the possibility that fiscal troubles may cause a country to experience repayment difficulties.

Based on a data set of monthly observations for 26 emerging economies between 2007 and 2011—including market expectations for fiscal deficits and debt—the estimation allows the explanatory variables to have differing regression slopes, depending on whether the VIX is above or below a particular threshold, which is chosen to maximize the fit of the model.3

Determinants of 10-Year Domestic Bond Yields in Emerging Economies
Risk aversion (VIX)
HighLow
Expected gross debt t+1 (percent of GDP)0.06***0.02
(0.02)(0.01)
Expected overall balance t+1 (percent of GDP)−0.31***−0.04
(0.09)(0.11)
Expected inflation t+1 (percent)0.190.38***
(0.19)(0.05)
Expected real GDP growth t+1 (percent)0.10−0.35**
(0.08)(0.12)
Domestic Treasury bill rate (percent)0.60***0.37***
(0.10)(0.12)
U.S. 10-year bond yield (percent)0.230.42*
(0.29)(0.20)
Number of observations177333
R20.580.53
Number of countries1415
Note: Robust standard errors in parentheses.***p < 0.01, **p < 0.05, *p < 0.1.

VIX and Standard Deviation of 10-Year Domestic Bond Yields

Analysis of historical data reveals that domestic bond yields have shown greater cross-country dispersion during times of high risk aversion than in times of low risk aversion, even without significant changes in countries’ fiscal positions. Indeed, at times of low global risk aversion, domestic bond yields are mostly influenced by inflation and real GDP growth expectations. The coefficient on the latter is negative, reflecting lower credit risk, as stronger growth would improve fiscal balances. However, during times characterized by high global risk aversion, expectations regarding fiscal deficits and government debt play a significant role in determining domestic bond yields: every additional percentage point in the expected debt-to-GDP ratio raises domestic bond yields by 6 basis points, and every percentage-point expected worsening in the overall fiscal balance-to-GDP ratio raises yields by 30 basis points.

In view of the ebb and flow of global conditions, these findings underscore the need to remain fiscally prudent in good times, as the favorable conditions facing emerging economies could shift unexpectedly.

1 This box is based on Jaramillo and Weber (2011).2 The Chicago Board Options Exchange Volatility Index (VIX) is a measure of the market’s expectation of stock market volatility over the next 30-day period. It is a weighted blend of prices for a range of options on the S&P 500 index.3 Based on the methodology developed by Hansen (1999).

The FII has worsened in several emerging economies since the mid-2000s and on an aggregate basis currently stands at levels comparable to those observed in the late 1990s. Weakening fiscal positions and rising short-term debt ratios, largely as a result of the crisis, explain most of the increase in the index since 2007, more than offsetting improvements in asset and liability management conditions (Figure 9). The level of the index varies significantly across regions (Figure 10). In emerging Europe, for example, the FII is highest, owing in part to growing concerns about the long-term fiscal outlook, especially as setbacks in pension reform have surfaced. By contrast, the impact of the crisis on fiscal conditions in Latin America has been contained somewhat, as fiscal balances have rebounded—boosted by strong commodity prices and buoyant economic growth—and the use of short-term funding has been reduced. Conditions in emerging Asia have weakened since the onset of the crisis, but remain more favorable overall than in other emerging regions.

Figure 9Components of the Fiscal Indicators Index, 1996–2011

(Scale, 0-1)

Sources: Baldacci and others (2011); and IMF staff calculations.

Note: 2009 PPP-GDP weights used to calculate weighted averages. Larger values of the FII suggest higher fiscal risk.

1 Includes fertility rate, dependency ratio, and pension and health spending.

2 Includes interest rate-growth differential, average debt maturity, and debt held by nonresidents (for advanced economies) and foreign-currency-denominated debt and short-term external debt to reserves (for emerging economies).

Figure 10Fiscal Indicators Index by Region, 2001–11

(Scale, 0-1)

Sources: Baldacci and others (2011); and IMF staff calculations.

Note: 2009 PPP-GDP weights used to calculate weighted averages. Larger values of the FII suggest higher fiscal risk.

Box 5The Fiscal Indicators Index

Rather than relying on a single indicator to identify fiscal sustainability concerns in advanced and emerging economies, the fiscal indicators index proposed by Baldacci and others (2011) combines information from a parsimonious set of variables, taking into account their ability to provide early warning signals about extreme government funding difficulties (i.e., public debt default or restructuring, the need to access large-scale official or IMF support, hyperinflation, or spikes in sovereign bond spreads). Specifically, the index compiles variables that exceed a certain threshold (calculated with a univariate procedure that minimizes the error of misidentifying a fiscal crisis), weighted by their signaling power. The index ranges from 0 to 1, with higher numbers indicating greater cause for concern.

The Fiscal Indicators Index relies on 12 indicators with reasonable signaling power (based on a consistent conceptual framework outlined in Baldacci, McHugh, and Petrova, 2011): the interest rate—growth differential, cyclically adjusted primary balance, gross debt, gross financing needs, short-term debt, foreign-currency-denominated debt, debt held by nonresidents, average debt maturity, short-term external debt, fertility rate, dependency ratio, and long-term public pension and health spending. Early-warning systems typically produce nonnegligible errors. However, the index contains measures that do a relatively good job in detecting fiscal vulnerability. In particular, the analysis finds comparatively strong signaling power in the cyclically adjusted primary balance, the interest rate—growth differential, gross financing needs, and long-term age-related spending. These measures clearly outperform many others, such as interest payments to revenues and the slope of the yield curve, both of which fail to identify fiscal stress episodes in more than 90 percent of the cases.

Signaling Power of Selected Fiscal Indicators

(Average for all countries in sample)

Source: IMF staff estimates.

Note: Type I error is the frequency with which each indicator falsely signals a crisis; Type II error is the frequency with which each indicator fails to signal a crisis. Signaling power is defined as 1 minus the sum of Type I and Type II errors, showing the frequency with which each indicator correctly identifies a crisis. Included/excluded refers to whether an indicator is part of the Fiscal Indicators Index. The sample consists of 29 advanced economies and 52 emerging economies.

Although conditions in emerging economies generally remain healthier than in advanced economies, risks in some emerging economies may be on the rise. Thus, continued fiscal adjustment remains appropriate and in some cases would need to be accelerated. Inflationary pressures and widening current account deficits in several key emerging economies (e.g., Argentina, India, and Turkey) suggest that they are operating at close to full capacity and that fiscal tightening would be appropriate (Figure 11). (See also the September 2011 World Economic Outlook [WEO] for details on cyclical conditions in emerging economies.) In addition to helping to contain overheating, this would also allow for rebalancing of macroeconomic policies, taking some of the pressure off monetary policy. Moreover, it would allow countries to begin restoring policy buffers, which could be deployed again to accommodate a countercyclical response to future adverse shocks (including the possibility of spillovers from a further deterioration of the situation in advanced economies). However, should downside risks to growth materialize, fiscal consolidation could slow in countries with low debt and deficits to provide support to domestic consumption. The needed tightening of policies in some countries is complicated by the fact that high commodity prices have led to significant social pressures in many emerging and low-income economies. Meeting the challenge of rebuilding fiscal space while addressing social needs will require greater targeting of subsidies and other measures, as well as enhancing revenue mobilization.

Figure 11Emerging Economies: Change in Cyclically Adjusted Primary Balance and in Output Gap, 2011

(Percent of potential GDP)

Sources: IMF staff projections.

Note: The output gap is defined as the difference between actual and potential GDP. If the output gap is deteriorating, there is greater spare capacity in the economy. Circles denote countries with output level above potential in 2011.

Beyond the differences across emerging economies in cyclical conditions, substantial variation remains in the extent of medium-term challenges. Among the G-20 emerging economies, for example, gross general government debt levels are relatively high in some cases; combined with relatively large shares of short-term debt, this can result in significant gross financing needs, which are largest in Brazil (Figure 12). Medium-term fiscal adjustment needs also vary significantly and are largest in India, where the cyclically adjusted primary deficit is highest. Long-term pressures are sizable in Russia, where the debt position is otherwise relatively comfortable. Thus, while adjustment strategies will vary among these economies, it is clear that favorable cyclical positions should be used to meet medium-term challenges specific to each country.

Figure 12Comparing Fiscal Fundamentals across Emerging Economies, 2011

Sources: Bank for International Settlements; Bloomberg L.P.; and IMF staff estimates and projections.

Note: Debt refers to gross general government debt in percent of GDP; GFN is gross financing needs in percent of GDP; ST Debt is short-term debt securities at remaining maturity as a percentage of total debt securities, as of end-2010; CAPD is cyclically adjusted primary deficit in percent of potential GDP; Pensions is the change in long-term public pensions spending from 2010 to 2030 in percent of GDP; Health is the change in long-term public health spending from 2010 to 2030 in percent of GDP; and r-g is the average interest rate-growth differential from 2012 to 2016 in percent. As each indicator is expressed in different units, the size-of-the-bars differential is standardized.

1For details, see “Data and Conventions” in the Methodological and Statistical Appendix.

2GFN and ST Debt data are not available. A Hodrick-Prescott filter is used to estimate potential output, and CAPB is estimated assuming growth elasticities of 1 and 0 for revenues and expenditure, respectively.

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