7. Conclusion

International Monetary Fund. Fiscal Affairs Dept.
Published Date:
September 2011
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Taking all of these developments together, and viewed from the perspective of the Fiscal Sustainability Risk Map presented in the April 2011 Fiscal Monitor, there is an increasing divergence between developments in fiscal deficits and perceptions of risk by market participants. The potential for fiscal conflagrations resulting from a loss of market confidence has clearly escalated this summer, notably in some European countries. Yet on the basis of recent developments in fiscal deficits and baseline fiscal projections more generally, risks would seem to have remained largely unchanged, on balance, in both advanced and emerging market economies relative to April (Table 6). Indeed, on the whole, although downside risks to the macroeconomic environment continue to predominate and may have increased in severity, fiscal adjustment and reforms are proceeding gradually but broadly as expected in both advanced and emerging market economies. In addition, the liability structures of advanced economies have been generally stable, and some emerging economies have somewhat improved their asset liability management, with a small reduction in short-term debt and foreign-currency-denominated debt.

Market participants seem to be focusing on factors that go beyond recent developments in fiscal data. Worsening perceptions of sovereign risks, which have contributed to a rise in financial sector risks (see the September 2011 GFSR), seem to reflect four factors. First, worries about growth in the advanced economies—recently fueled by data releases pointing to a slowdown and by sharp declines in asset prices—have risen. Second, there is an increasing focus on the two-way relationship between sovereign and financial risk, as banks in some countries hold large amounts of government bonds, and government support to the banks could in turn be costly. Third, despite declining fiscal deficits in many countries, there are growing concerns about governments’ ability to implement fiscal adjustment in the years ahead without succumbing to adjustment fatigue. Fourth, as noted earlier, the protracted delay on the part of euro area policymakers in developing a comprehensive and consistent crisis resolution framework played a significant role in allowing the crisis to spread from smaller economies to larger ones. Indeed, despite some progress, significant policy challenges will need to be faced not only in the euro area and the United States but in advanced, emerging, and low-income economies more broadly. A failure to respond to these challenges promptly and decisively, and to maintain clear and consistent communication, courts the risk that investor concerns will become self-fulfilling, with rising interest rates and liquidity pressures driving a worsening of fundamentals. The results could prove far more difficult and costly to contain than they might have been to prevent. These risks cannot be ignored, and action to address them cannot be delayed.

See the September 2011 Global Financial Stability Report for a further discussion of market spillovers.

More generally, the current debt maturity in Italy implies that a 1 percentage point increase in interest rates causes an increase in interest payments of 0.2 percent of GDP within one year of the shock, and 0.5 percent of GDP within three years.

The baseline projections reported in the tables in the Statistical Appendix currently assume spreads vis-à-vis Germany of about 240 basis points for the next few years for both Italy and Spain.

There is, of course, a link between the two, as higher debt ratios tend to raise interest rates and depress investment and growth (see the November 2010 Fiscal Monitor).

Of course, measures to boost potential growth do not directly offset the contractionary effect of fiscal tightening on aggregate demand. However, over the medium term, stronger potential growth reduces the need to introduce tightening measures.

If there is a productivity gain from operating in private hands rather than in the public sector, privatization would also result in an increase in the government’s net worth. Consistent with that, the net present value of privatization revenues would be somewhat larger than the stream of foregone transfers to the government from a (profitable) public enterprise.

If fully adopted by Congress, the AJA would significantly reduce short-term fiscal tightening while being fully offset in the medium term. About 40 percent of the stimulus resources proposed in the AJA are already incorporated in the IMF staff’s baseline projections.

Appendix 3 notes that both net and gross debt are relevant indicators for assessing fiscal positions.

Japan’s current account surplus renders it less dependent on foreign financing.

Japan Post Bank is 100 percent held by J. P. Holdings, which in turn is 100 percent held by the government. Its holdings of debt are included in the consolidated general government debt reported in the Fiscal Monitor (see Box A3.2). By contrast, the U.S. Social Security Fund is within the general government, and its holdings of Treasury securities are not included in the consolidated general government debt data reported in the Monitor.

The legislation—the Budget Control Act of 2011—establishes caps on discretionary spending through 2021 with an estimated cumulative impact of some US$900 billion and a Congressional Joint Select Committee on deficit reduction to propose further deficit reductions, with the stated goal of achieving at least US$1.5 trillion in additional budgetary savings over 10 years. It establishes automatic procedures for reducing spending by as much as US$1.2 trillion if legislation originating with the new joint select committee does not achieve such savings. The act also allows for certain amounts of additional spending to reduce improper benefit payments, makes changes to the Pell Grant and student loan programs, requires that the House and the Senate vote on a joint resolution proposing a balanced-budget amendment to the Constitution, and reinstates and modifies certain budget process rules.

These policy recommendations have been proposed as part of the AJA.

Stock-flow adjustment are defined as the residual in the customary identity linking changes in the debt ratio to the deficit (in continuous time for simplicity): d = pd + (r—g) d + sf, where d is the change in the public debt-to-GDP ratio, pd is the primary deficit as a share of GDP, g is the GDP growth rate, r is the interest rate on public debt, and sf is the stock-flow adjustment as a share of GDP.

Note that these illustrative simulations are based on simplifying assumptions and may well differ from adjustment scenarios and policy recommendations provided by the IMF in individual countries.

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