Balancing Fiscal Policy Risks
Author: International Monetary Fund. Fiscal Affairs Dept.
Language:
English
Keywords:
FM; country abbreviation; def; term; financial crisis responsibility fee; item; government debt; interest rate; potential GDP; financial market; short-term debt
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Abstract

Notwithstanding the deceleration in global activity in late 2011 and weaker growth prospects (see the April 2012 World Economic Outlook), fiscal deficits in most advanced economies are projected to continue to decline in 2012 (Table 1). Headline deficits will fall by almost 1 percentage point of GDP among the advanced economies, as countries unwind fiscal stimulus and, in a few cases, implement austerity measures in response to market pressures. At about 1 percentage point of GDP, deficit reduction in cyclically adjusted terms would be slightly higher than that implemented in 2011. In many cases, the challenge will be to ensure continued progress toward sound public finances while avoiding an excessive fiscal drag on activity. Gross financing needs are expected to decline only slightly, hovering around 25 percent of GDP per year over the coming three years in advanced economies, as lower deficits are offset by higher rollover requirements on a larger maturing debt stock (Table 2).

1. Continued Fiscal Tightening Is in Store for 2012, Particularly among Advanced Economies

Notwithstanding the deceleration in global activity in late 2011 and weaker growth prospects (see the April 2012 World Economic Outlook), fiscal deficits in most advanced economies are projected to continue to decline in 2012 (Table 1). Headline deficits will fall by almost 1 percentage point of GDP among the advanced economies, as countries unwind fiscal stimulus and, in a few cases, implement austerity measures in response to market pressures. At about 1 percentage point of GDP, deficit reduction in cyclically adjusted terms would be slightly higher than that implemented in 2011. In many cases, the challenge will be to ensure continued progress toward sound public finances while avoiding an excessive fiscal drag on activity. Gross financing needs are expected to decline only slightly, hovering around 25 percent of GDP per year over the coming three years in advanced economies, as lower deficits are offset by higher rollover requirements on a larger maturing debt stock (Table 2).

Table 1.

Fiscal Balances, 2008–13

(Percent of GDP, except where otherwise indicated)

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Sources: IMF staff estimates and projections.Note: All country averages are weighted by GDP at purchasing power parity using rolling weights, and calculated based on data availability. Projections are based on IMF staff assessment of current policies. ASEAN-5: Indonesia, Malaysia, the Philippines, Singapore, and Thailand; G-20: Group of Twenty.

Excluding financial sector support.

Table 2.

Selected Advanced Economies: Gross Financing Needs, 2012–14

(Percent of GDP)

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Sources: Bloomberg L.P.; and IMF staff estimates and projections.Note: Averages are weighted by GDP at purchasing power parity using rolling weights. Data on maturing debt refer to government securities. For some countries, general government deficits are reported on an accrual basis.

Assumes that short-term debt outstanding in 2012 and 2013 will be refinanced with new short-term debt that will mature in 2013 and 2014, respectively. Countries that are projected to have budget deficits in 2012 or 2013 are assumed to issue new debt based on the maturity structure of debt outstanding at the end of 2011.

Ireland’s cash deficit includes exchequer deficit, other government cash needs, and bank/credit union recapitalization.

  • In the United States, the deficit in 2012 is expected to decline by 1½ percent of GDP in headline terms, or by 1¼ percent of GDP in cyclically adjusted terms. Congressional approval of a full-year extension of payroll tax cuts and emergency unemployment benefits averted a more substantial fiscal withdrawal that would have had significant negative repercussions for economic activity. Additional fiscal consolidation of 1.5 percent of GDP is in the pipeline for 2013, including from the automatic spending cuts expected to be triggered by the failure of the congressional “supercommittee” to agree on a deficit reduction plan. This would be a significant adjustment to undertake, and the overall pace of consolidation could be reduced should growth disappoint and Treasury bond market conditions remain favorable. Moreover, the decline in the overall deficit could roughly double if temporary tax reductions and stimulus measures are allowed to expire. President Obama has unveiled a budget proposal that envisages additional stimulus measures over the next several years and a plan to overhaul the corporate tax code by reducing the corporate income tax rate from 35 to 28 percent and closing loopholes. However, prospects for congressional approval of either of these proposals are uncertain.

  • In Canada, deficits are set to decline in 2012 and 2013 with expenditure restraint and the withdrawal of fiscal stimulus.

  • In Germany, the cyclically adjusted deficit fell significantly in 2011, reflecting the expiration of one-off financial sector measures implemented in 2010,1 sizable discretionary fiscal tightening due to both stimulus withdrawal and consolidation measures, and continued structural changes in the labor market (leading to lower payments of unemployment benefits). In 2012 the decline in the headline deficit is projected to be modest; the larger improvement in the cyclically adjusted balance reflects in part tightening measures (amounting to ¼–½ percentage point of GDP), together with cyclical improvements that may not be fully filtered out owing to methodological difficulties.

  • In the United Kingdom, actual and potential GDP growth estimates have been revised down, resulting in weaker projections for both headline and cyclically adjusted balances. In cyclically adjusted terms, adjustment is projected at about 1¼ percent of GDP this year and next, about ½ percent of GDP annually less than previously expected.

  • In France and Italy, the authorities are complementing recent fiscal packages with measures aimed at boosting growth. In France, starting October 1, a “social VAT,” also known as fiscal devaluation, will reduce the labor tax wedge, offset by increases in the value-added tax and taxes on capital revenue. As noted in the September 2011 Fiscal Monitor, such a reform can reduce the cost of exported goods (through lower labor taxes) and increase the relative price of imported goods to consumers (through the higher VAT), like a currency devaluation. In Italy, reforms in the areas of product market liberalization, infrastructure investment, and administrative simplification have been introduced, and the government has submitted to parliament a package of reforms aimed at making the labor market more flexible.

  • In Spain, the authorities have announced in the budget for 2012 measures complementing the fiscal consolidation package of end-2011, in an effort to reach an overall deficit target of 5.3 percent of GDP for 2012. The new deficit target understandably aims for a very large consolidation and is broadly appropriate, although a slightly more moderate adjustment that better accommodated cyclical developments would have been preferable.

  • In Ireland and Portugal, tax increases, revenue-enhancing measures, and expenditure cuts are being introduced to maintain the committed path of deficit reduction over the medium term.

  • In Greece, in line with their commitment to return to a sustainable fiscal position in the medium term, the authorities approved additional fiscal measures amounting to 1.5 percent of GDP in the context of a new program and against the backdrop of a large debt-restructuring operation. The pace of fiscal consolidation, centered on a sizable reduction in public employment, pensions, and health spending, as well as the broadening of the VAT and personal income tax bases, would be more moderate than in 2010–11, with increasing emphasis on structural reforms to boost competitiveness and medium-term growth, including a 22 percent decline and subsequent three-year freeze in the minimum wage. The program also involves a renewed effort to fight tax evasion through stronger enforcement, aligning tax administration operations with international best practices, and raising social security collection compliance.

  • Japan is the only advanced economy in which the cyclically adjusted deficit will increase further in 2012 before returning to slightly below the 2011 level next year.

Front-loaded adjustment in a few advanced economies is being undertaken in the context of severe market pressure, but—as noted in the January 2012 Fiscal Monitor Update—other advanced economies would seem to have more scope for discretion. Policymakers may be hesitant to exploit this apparent “fiscal space” out of concern regarding a potential market backlash to any policy change. This wariness is understandable: in practice, fiscal space is difficult to measure precisely (Box 1), and to the extent that it reflects market perceptions, it can be volatile. Prior to the crisis, there was little differentiation among sovereign bond spreads across advanced economies, but the dispersion and volatility of spreads has since increased markedly (see the April 2012 Global Financial Stability Report), complicating the task of policymakers, who must assess the extent to which policy can be eased without losing credibility (Figure 1). This is especially true because confidence can be more easily lost than restored. Of course, the general macroeconomic environment—such as the risk of overheating pressures—as well as the overall policy mix being implemented is also relevant in determining the appropriate course of fiscal policy. For example, in some economies, a loosening of monetary policy could prove more effective than additional fiscal stimulus at supporting demand. Nevertheless, in 2012 and 2013, advanced economies with fiscal space should at a minimum allow the automatic stabilizers to operate around their currently envisaged adjustment plans in the event that growth slows more than expected. Among these countries, those with a strong position, in terms of fiscal accounts and credibility with markets, can consider going further and slowing the pace of fiscal consolidation to reduce downside risks to growth. In some countries, market interest rates remain relatively high despite significant fiscal consolidation that has been implemented or is in the pipeline. The availability of adequate financing for countries that are undertaking adjustment could provide an important confidence boost while market perceptions gradually adjust to strengthened fundamentals. In this regard, the recently agreed-upon combination of the European Stability Mechanism and the European Financial Stability Facility, along with other recent European efforts, will strengthen the European firewall.

Figure 1.
Figure 1.

CDS Spreads and Sovereign Ratings

Sources: Fitch Ratings; Markit; Moody’s Analytics; Standard & Poor’s; and IMF staff calculations.Note: CDS: credit default swap.1 Sovereign credit ratings and outlooks from Fitch Ratings, Moody’s Investor Services, and Standard & Poor’s are converted to a linear scale, then averaged across the three agencies, with AAA equal to 1; data as of end-2011.

Measuring Fiscal Space: A Critical Review of Existing Methodologies

The notion of fiscal space is closely related to the concept of fiscal sustainability. The fiscal stance of a country is considered sustainable if the present-value budget constraint—in which the current debt is less than or equal to the discounted value of future primary surpluses—is satisfied at all times. In practice, policies aiming to maintain a stable debt ratio in the medium term are considered sustainable. However, when the debt ratio is unsustainable to start with, policies aimed at reducing it to a sustainable level are necessary. In the latter case, fiscal space may be limited even in the presence of a declining debt ratio.

Alternative methods have been proposed to measure fiscal space. One uses sustainability indicators (or fiscal gaps). The index of fiscal sustainability— proposed by Buiter (1985), Blanchard and others (1990), Buiter, Corsetti, and Roubini (1993), and Auerbach and Gale (2011)—compares the current and n-period-ahead debt using predefined projections for the overall balance, the discount rate, and the macroeconomic outlook. It then identifies the fiscal gap, based on the difference between the current balance and the constant balance that stabilizes debt over a medium-term horizon. Under this approach, changes in macroeconomic projections have an important impact on the size of fiscal gaps.

The main limitation of the fiscal gap approach is that its macroeconomic forecasts tend to rely on ad hoc assumptions rather than on a formal, testable model. Projections of government revenues and expenditures are often independent from each other and from private sector behavior, which limits the possibility of accounting for feedback effects between the private and public sectors or making the discount rate time-varying and endogenously determined. The methodology has, however, two main advantages. First, it is forward-looking and draws on the policy plans announced by the authorities. Second, it takes into account synergies between different sectors of the economy. The European Commission (2007) uses this approach for its S1 and S2 indicators. Similarly, the Fiscal Monitor regularly presents a measure of adjustment need (the inverse of fiscal space), calculated as the gap between the current primary balance and the balance needed to bring the debt-to-GDP ratio down to a specified level.

Another group of studies uses stationarity and structural tests of fiscal sustainability. Hamilton and Flavin (1986) show that fiscal policy is sustainable if both debt and primary deficit variables are stationary. Trehan and Walsh (1988) and Hakkio and Rush (1991) argue that if debt and primary deficit ratios are cointegrated, fiscal sustainability is maintained. Wilcox (1989) and Uctum and Wickens (2000) assume a time-varying discount factor and show that stationarity of the primary balance with zero mean is sufficient for fiscal sustainability. Structural tests proposed by Bohn (1998, 2005, 2007)—with recent applications by the IMF (2003), Mendoza and Ostry (2008), and Ostry and others (2010)—claim that fiscal sustainability is maintained if the primary surplus ratio tends to increase as needed when the debt ratio rises. These approaches add a behavioral dimension to the fiscal space assessment that the fiscal gap methodology lacks. But they also have drawbacks. First, they are based on past data, whereas the present-value budget constraint is a forward-looking concept. Hence, they do not consider an infinite horizon and rule out possible future changes in fiscal policy to satisfy the present-value budget constraint. Second, they assume that fiscal policy has been constant over the past (either sustainable or unsustainable), not allowing for the possibility of changes in policy stance over time (although Ostry and others [2010] attempt to address this problem by capping the possible future adjustment based on past experience). Relatedly, they do not provide information on the type of fiscal policy changes required to restore sustainability. And most importantly, with few exceptions (for example, Ostry and others [2010]) they cast as sustainable infinitely growing debt ratios, as long as they are supported by infinitely growing primary balances— which is hardly realistic.

Other recent studies have attempted to account for feedback effects between fiscal and macroeconomic variables using vector autoregression (VAR) models. One stream of studies imposes restrictions on the coefficients of the VAR to ensure the present-value budget constraint (for example, Chung and Leeper, 2007), while another stream attempts to assess from the data whether the present-value budget constraint holds (for example, Polito and Wickens, 2005, 2011; Giannitsarou and Scott, 2006). Although the VAR methodology incorporates interactions between sectors and thus captures the whole macroeconomic framework, it is still backward-looking (relying on how policy was conducted in the past) and does not provide much guidance for future policy design. It is also susceptible to the Lucas critique, as economic agents can change their behavior in response to announced changes in future fiscal policy, making VAR coefficients derived from past data inapplicable for studying effects of future policy changes.

In emerging economies, only a modest tightening of fiscal policy is expected this year. In several countries, including in Asia, policymakers are focusing on engineering a soft landing amid the expectation that demand growth, which had been fueled by domestic credit and/or high commodity prices, will taper off. In these economies, continued fiscal consolidation is broadly appropriate to safeguard against renewed inflationary pressures once growth resumes, but also to rebuild space to address future shocks. Rebuilding fiscal space is crucial for countries that can only borrow long term in foreign currency, or where nonresident holdings of debt are sizable, as these countries are much more vulnerable to shocks even if they have relatively low debt and deficits. However, if growth weakens further, emerging economies with relatively low debt and deficits, modest financing needs (Table 3), and strong external positions, particularly in Asia, may have space to provide more support to demand.

Table 3.

Selected Emerging Economies: Gross Financing Needs, 2012–13

(Percent of GDP)

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Sources: IMF staff estimates and projections.Note: Averages are weighted by GDP at purchasing power parity using rolling weights. For some countries, general government deficits are reported on an accrual basis.

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

  • In China, consolidation plans for 2012 have been deferred in response to slower growth, with gradual adjustment expected to resume in 2013.

  • In Mexico, fiscal consolidation is expected to continue in 2012, benefiting from higher-than-expected oil revenues.

  • In Brazil, the authorities remain committed to the primary surplus target of 3.1 percent of GDP for 2012 and 2013, consistent with the aim of using monetary policy as the main countercyclical tool as economic activity slows.

  • In India, a ½ percentage point improvement in the cyclically adjusted balance is expected in 2012, with a focus on containing nonpriority expenditure while boosting spending on public investment and health. This tightening is appropriate as the deficit—in headline and cyclically adjusted terms—and the debt ratio are likely to remain well above the emerging market average this year and next.

  • In Indonesia, the cyclically adjusted deficit is projected to continue to decline in 2012 and 2013 and debt is on a declining path.

  • In the Russian Federation, however, the overall surplus is expected to narrow substantially in 2012 as a result of spending increases. The relatively modest headline surplus masks a large— and growing—non-oil deficit, although the debt ratio remains very low.

Fiscal consolidation slowed in 2011 in low-income countries, partly under the weight of increased subsidies in response to the food and fuel price rises earlier in the year (Table 4). In 2012, fiscal deficits are projected to widen in most low-income countries, even though growth is projected to hold up relatively well. Revenue growth will be modest, as both commodity receipts and aid flows are expected to stall. Spending, meanwhile, is projected to accelerate, reflecting in part stepped-up infrastructure investment, particularly in Africa. Higher spending on infrastructure can boost growth, but appropriate investment selection and debt management processes must be in place (see the September 2011 Fiscal Monitor). If growth is sustained, low-income countries could aim at a more ambitious rebuilding of their fiscal policy buffers to reduce their vulnerability to future external shocks.

Table 4.

Low-Income Countries: Selected Fiscal Indicators, 2008–13

(Percent of GDP)

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Sources: IMF staff estimates and projections.Note: All country averages are weighted by GDP at purchasing power parity using rolling weights, and calculated based on data availability. Projections are based on IMF staff assessment of current policies.

  • Bolivia will continue to show a primary surplus of close to 2 percent of GDP thanks to high natural gas prices.

  • In contrast, in Cameroon, declining oil revenues and substantial increases in fuel subsidies and capital expenditure will result in a deteriorating fiscal stance for 2012.

  • In Ghana, stepped-up revenues, including for oil, and current spending containment will prevent a deterioration in the primary deficit despite a boost in externally financed capital spending.

  • The primary balance will widen in Vietnam in 2012 as a continuing decline in capital spending and the projected increase in revenues will be more than offset by a sharp increase in current spending.

2. Debt Ratios Are Still on the Rise, but Peaks Are within Sight

On current plans, about two-thirds of the crisis-induced increase in global fiscal deficits will be unwound by the end of this year, but much higher debt ratios will remain a legacy of the crisis. Indeed, despite continued adjustment, general government debt in advanced economies is expected to increase by a further 5 percentage points of GDP to 109 percent of GDP on average by 2013 (Table 5). Most of this accumulation is driven by persistent primary deficits—close to 80 percent of advanced economies are projected to show a primary deficit in 2012, reflecting in part still-large output gaps, as GDP is expected to return to potential only gradually (Figure 2). Among advanced economies, the contribution of protracted primary deficits is highest in Japan, the United Kingdom, and the United States.

Table 5.

General Government Debt, 2008–13

(Percent of GDP)

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Sources: IMF staff estimates and projections.Note: All country averages are weighted by GDP at purchasing power parity using rolling weights, and calculated based on data availability. Projections are based on IMF staff assessment of current policies. ASEAN-5: Indonesia, Malaysia, the Philippines, Singapore, and Thailand; G-20: Group of Twenty.
Figure 2.
Figure 2.

Decomposition of General Government Gross Debt Accumulation, 2012–13

(Percent of GDP)

Sources: IMF staff estimates and projections.

At the opposite end of the spectrum, primary surpluses are expected to push the debt ratios down in Germany and Iceland. Although the interest rate—growth differential (r – g) is also contributing to debt accumulation, its effect is smaller overall than during 2009–10. Low output growth and rising interest rates are the main factors behind the increase in debt ratios in many euro area economies, whereas in contrast, advanced economies in Asia tend to benefit from low r – g.

Debt ratios are expected to decline in most emerging economies, from 38 percent in 2011 to 35 percent in 2013 on average. In almost all emerging markets (especially India and Kenya), strong growth and low interest rates will continue to contribute to the decline in debt ratios, with the interest rate—growth differential negative in many cases (−5 percent on average in 2012–13).2 Nonetheless, in some countries, including Latvia, South Africa, and Thailand, debt ratios are expected to increase.

Debt-to-GDP ratios are projected to rise in about half of low-income countries. This reflects continuing primary deficits and an increase in the effective interest rate as the share of grants in total aid declines and a growing number of countries contract non-concessional loans to fund investments in infrastructure as well in the energy and mining transport sectors. Although debt ratios in most low-income countries are relatively modest, thanks in part to the debt relief received in the late 1990s and early 2000s, the increase in indebtedness in recent years, if sustained, could become a cause for concern. In Cameroon, Haiti, Maldives, and Mozambique, debt-to-GDP ratios are projected to rise by 5 percentage points of GDP or more in 2012 and (except in Cameroon and Mozambique) to be 20 percentage points or more above their 2008 levels.

By 2015, debt ratios are expected to have stabilized or started to decline in 85 percent of the countries covered in the Fiscal Monitor and 80 percent of advanced economies. However, this is contingent in many cases upon the maintenance of a very favorable interest rate—growth differential over the next few years in most countries, in spite of the high levels of debt (Figure 3). As illustrated in Figure 4, for many advanced economies—including France, Italy, and the United Kingdom—only relatively small shocks to r – g (smaller than those shown in Figure 5) would be sufficient to prevent debt from stabilizing over the medium term, notwithstanding substantial improvements in the primary balances slated through 2015. In a few other countries where primary deficits are expected to persist over the coming years (including Japan, the Slovak Republic, Slovenia, and Spain), the baseline r – g is projected to exceed the level needed to stabilize the debt ratio, and debt ratios are therefore projected to continue to rise through 2017 (Statistical Table 7). For many advanced economies, then, stronger medium-term adjustment efforts could be called for to provide greater assurances about the resilience of the public finances.

Figure 3.
Figure 3.

Interest Rate-Growth Differential (r – g)

(Percent)

Sources: IMF staff estimates and projections.Note: Weighted averages based on 2010 GDP at purchasing power parity. Interest rate-growth differential is defined as the effective interest rate (ratio of interest payments to the debt of the preceding period) minus nominal GDP growth.
Figure 4.
Figure 4.

Difference between Baseline and Debt-Stabilizing Interest Rate–Growth Differential, 2015

(Percent)

Sources: IMF, International Financial Statistics; and IMF staff estimates and projections.Note: The debt-stabilizing interest rate is the real effective interest rate at which the 2015 debt-to-GDP ratio stabilizes, based on the IMF staff’s real GDP, debt, and primary deficit forecasts. The green (yellow) bars indicate that the baseline interest rate–growth differential is below (above) the debt-stabilizing interest rate–growth differential. bps: basis points.
Figure 5.
Figure 5.

Advanced Economies: Range of 10-Year Bond Yields in 2011–12

(Percent)

Sources: Bloomberg L.P.; IMF, International Financial Statistics; and IMF staff estimates.Note: Yellow bars show the range of 10-year bond yields observed since January 2011. Latest observation corresponds to end-March 2012.

Despite generally lower debt ratios and brighter growth prospects, several emerging economies also have little margin for slippages in fiscal outturns or for shocks to r – g, if they are to keep debt ratios from rising. In some cases this reflects primary deficits, and in others high real interest rates. Fiscal vulnerabilities in several of these countries are compounded by fading commodity revenue (for example, the Russian Federation) and relatively high interest rates (for example, Hungary). More broadly, many emerging economies, especially those with weaker fiscal positions, greater financial sector openness, and larger current account deficits, are vulnerable to spillovers from advanced economies (Box 2). In many low-income countries, the lack of a fiscal consolidation strategy restricts policy options in spite of negative r – g, making these countries highly vulnerable to aid shortfalls. To reduce medium-term fiscal risks, the introduction of policies to enhance domestic revenue mobilization and channel public spending toward growth-enhancing investments remains essential.

As noted in previous issues of the Monitor, structural factors are in part behind the persistence of historically very low interest rates in the largest advanced economies despite sharp increases in their general government debt ratios. Econometric analysis suggests that among these factors, the availability of a stable investor base (Figure 6) is particularly important.3 Institutional investors—such as national central banks, foreign central banks, and pension, insurance, and mutual funds—tend to be real-money investors and follow investment practices that would not typically result in abrupt shifts in their portfolios, helping contain the volatility of interest rates, although their presence should not be taken for granted (see the April 2012 Global Financial Stability Report). The positive effect of institutional investor holdings is found to go beyond that of merely reducing the overall supply of government bonds sold to the market, as the regression coefficient on this variable is larger than that on the debt ratio.4

Figure 6.
Figure 6.

Institutional Investor Holdings of Government Debt, 2011

(Percent of GDP)

Sources: European Central Bank; IMF, Currency Composition of Official Foreign Reserves (COFER) database; IMF, International Financial Statistics; national sources; and IMF staff estimates and projections.Note: Data as of 2011:Q3 for Brazil, New Zealand, Spain, and the United States; 2011:Q2 for Australia, France, Iceland, Israel, Japan, the United Kingdom, and emerging economies; 2011:Q1 for Germany; and 2010:Q4 for the remaining countries. Refers to general government gross debt, except in the cases of Australia (Commonwealth government securities, including Treasury notes), Brazil (federal public debt), Canada (Government of Canada bonds and short-term paper, provincial and municipal paper), France (Obligations Assimilables du Trésor [OAT]), Iceland (Treasury bonds and bills), Israel (tradable government bonds), Japan (central government bonds), New Zealand (central government securities), Spain (marketable central government debt), the United Kingdom (central government gilts), and the United States (Treasury securities, including nonmarketable debt).1 For the United Kingdom and United States, foreign central bank holdings are those reported by the national authorities; for the remaining countries, it is estimated using the COFER database.2 Does not include European Central Bank.3 For Japan, also includes Japan Post Bank, 100 percent of which is held by J.P. Holdings, 100 percent of which in turn is held by the government.

3. Easy Does It: The Appropriate Pace of Fiscal Consolidation

Still-high deficits, rising debt ratios, and the volatility of financial markets all argue for continued fiscal consolidation, especially in advanced economies, but the weakened global outlook puts policymakers in a delicate position. Too little fiscal consolidation could roil financial markets, but too much risks further undermining the recovery and, in this way, could also raise market concerns. Are there reasons to fear that the growth impact of fiscal consolidation could be particularly acute in the current environment? What can the experience with the initial fiscal packages implemented by governments in response to the economic crisis tell policymakers about how to craft “second-generation” packages?

Fiscal Fundamentals and Global Spillovers in Emerging Economies

Although their fiscal conditions remain healthier than those in advanced economies, emerging economies would continue to be exposed to negative spillovers if global conditions deteriorate. In some cases, weak fiscal conditions would aggravate these spillovers.

Previous research (see the September 2011 Fiscal Monitor) showed that the impact on domestic bond yields of market expectations of the fiscal deficit and government debt increases when global risk aversion is high. Jaramillo and Weber (2012) find that emerging economy vulnerability to global risks depends on country-specific characteristics closely related to initial fiscal conditions, as well as the degree of financial openness and the size of external imbalances.

chufig02

Emerging Economies: Global Factors and Country-Specific Characteristics

A factor-augmented panel estimation—based on a monthly data set for 26 emerging economies between 2007 and 2011—first identifies the common global factors that affect domestic bond yields in all countries, with other country-specific conditions such as expected fiscal deficits and debt, inflation, and growth controlled for. These underlying factors are found to be associated with global risk aversion (proxied by the Chicago Board Options Exchange Volatility Index, or VIX) and global growth (proxied by market expectations of one-year-ahead real GDP growth in large advanced economies).

The model—recalculated to include the VIX and global growth as explanatory variables—goes on to show that the impact of these variables on financing costs varies across countries. Specifically, the coefficient on the VIX for each country is closely linked to the strength of that country’s fiscal position and financial sector openness, as countries with weaker fiscal fundamentals and greater foreign participation in their local sovereign bond markets would consequently be more susceptible should markets suddenly retreat. In addition, periods of global uncertainty (high VIX values) are generally associated with declines in commodity prices, which would have a greater impact on countries with weak fiscal positions. Meanwhile, the global growth coefficient for each country is found to be closely linked to its external current account deficit, as countries with greater public and private sector reliance on external financing would be faced with a sudden shortfall in available resources should growth abroad slow.

chufig03

Global Factors, Fiscal Conditions, Financial Openness, and External Current Account

Sources: Baldacci and others (2011), Chinn and Ito (2008); Bloomberg L.P.; Consensus Economics; and IMF staff estimates. Note: LAC: Latin America and the Caribbean; VIX: Chicago Board Options Exchange Volatility Index.1 Fiscal indicators index as measured by Baldacci and others (2011), standardized. Higher values indicate greater fiscal risk.2 Financial openness index as measured by Chinn and Ito (2008), standardized. Higher values indicate greater capital account openness.

Fiscal tightening can generally be expected to reduce short-term growth, but the negative impact of tightening may be amplified by some features of the current economic landscape. In other words, fiscal multipliers—which measure the ratio of a change in output to the discretionary change in the fiscal deficit that caused it—can for many reasons be expected now to be above the average multipliers identified in earlier studies.5 In particular, households are facing liquidity constraints, there is excess capacity in many countries, and there is little room for monetary policy to become more accommodative. In the euro area, the share of trade denominated in the single currency is high, and governments are relying heavily on spending cuts instead of revenue increases given the high level of taxation, the international mobility of tax bases, and age-related spending pressures.

In addition, fiscal adjustment is likely to have a larger adverse impact on economic activity when implemented while output gaps are negative than when gaps are positive. In downturns, fiscal consolidation measures reinforce the economic cycle and thereby exacerbate the slump in growth, making an up-front fiscal contraction particularly harmful. As illustrated in Appendix 1, for an average of Group of Seven (G-7) economies, simulations show that when the output gap is initially negative, fiscal adjustment implemented gradually has a smaller negative impact on growth (cumulative over two and one-half years) than does an up-front consolidation of the same overall size. This suggests that when feasible, a more gradual fiscal consolidation is likely to prove preferable to an approach that aims at “getting it over with quickly.”

Simulations also suggest that when multipliers are large and/or the initial level of public debt is high, fiscal adjustment may affect debt ratios only with a lag and may even appear counterproductive in the short run. Figure 7 shows the hypothetical change in the public debt ratio with respect to the baseline after a government introduces a package of discretionary fiscal measures of 1 percentage point of GDP.6 Assuming an average first-year fiscal multiplier of 1.0, in countries where government debt is above 60 percent of GDP, the direct effect of fiscal consolidation on the debt ratio is likely to be more than totally offset in the first year by the indirect effect of a lower GDP.

Figure 7.
Figure 7.

Impact on the Debt Ratio in the First Year of a 1 Percent Package of Discretionary Fiscal Measures

Source: IMF staff estimates.Note: The simulations depicted in the figure measure the change in the debt ratio relative to the baseline. Multipliers refer to discretionary fiscal measures. First year: maximum multiplier = 1.3; downturn multiplier = 1.0; minimum multiplier = 0.1.

Relatedly, it may take time for financial markets to reward fiscal tightening. Fiscal fundamentals are key determinants of market confidence, as countries with low debts and deficits have typically been spared a sharp rise in financing costs (Figure 8). Nonetheless, recent announcements of austerity packages, in particular by some euro area countries, were not immediately greeted with a corresponding reduction in bond spreads. Analytical work by the IMF staff on the short-run determinants of credit default swap (CDS) spreads in advanced economies shows that when countries tighten fiscal policy and the fiscal multiplier is high, some of the gains in terms of market credibility from lower deficits are lost through the impact on spreads of any initial rise in the debt ratio and of lower short-term growth.7 Therefore, if growth falls enough as a result of a fiscal tightening, borrowing costs could actually rise as the deficit narrows. This relationship is found to be nonlinear, as spreads are more likely to increase when growth is already low and the fiscal tightening is greater (Figure 9).

Figure 8.
Figure 8.

Advanced Economies: General Government Deficit and Debt, 2012

(Percent of GDP)

Sources: Markit; and IMF staff estimates and projections.Note: Bubble size represents five-year credit default swap spreads as of March 2012.
Figure 9.
Figure 9.

Fiscal Adjustment and CDS Spreads with Alternative Fiscal Multipliers

Sources: IMF staff estimates and projections.Note: The figure illustrates the relationship between fiscal adjustment and changes in sovereign credit default swap (CDS) spreads based on a regression estimated for 31 advanced economies. It is based on a representative country with a debt-to-GDP ratio of 100 percent, a primary deficit of 3.5 percent of GDP and annual GDP, growth of 1.5 percent. Each graph line represents the relationship between adjustment and spreads based on a different assumption about the multiplier for spending (that is, the impact of discretionary fiscal tightening on growth), ranging from 0.1 to 1.0. A larger multiplier weakens—or even fully reverses, for larger adjustments—the impact of lower deficits and debt on CDS spreads.

Recent experience with large fiscal consolidations points to additional implementation challenges. Although it is still too early to draw fully fledged empirical conclusions, some common features do emerge from a review of recent experience (Appendix 2). For example, the size of the required adjustment has often had to be revised upward shortly after the launching of fiscal consolidation plans. This has mostly been due to overly optimistic growth forecasts, but also to the materialization of sizable contingent liabilities (for example, in Ireland and Portugal) and substantial statistical revisions (most prominently in Greece). The authorities have then had to select and put in place stopgap measures that in most cases shifted, even if temporarily, the composition of the adjustment mix, putting pressures on the timetable of the consolidation plan, its equity objectives, and the political support for it. Although shocks are often unforeseen, comprehensive taxation and expenditure reviews (as in Ireland) could enhance the quality of fiscal adjustment and avert the need to resort to quick fixes in response to surprises, by providing policymakers with a menu of quality measures that could be quickly mobilized.

Policymakers may also want to pay increased attention to the way they communicate their policies and targets to markets and the broader public. Some countries have stepped up their communication strategies to counter the risk that policy slippages or unmet fiscal targets will erode confidence and credibility. Measures to this end have included increased transparency and broadened access to fiscal data, efforts to build political consensus behind specific “headline” measures, and the introduction of commitment controls. Cyclically adjusted indicators of performance can reduce undue focus on short-term fiscal management, but they raise their own communication challenges. These targets are harder for the public to understand and monitor than are headline numbers, and if not explained carefully, can provoke suspicions of data manipulation. A transparent methodology, possibly backed by independent certification, and extensive dissemination efforts can help facilitate the acceptance of such indicators. The application of a common methodology across countries, as in the European Union, can also help in this regard.

4. High Gross Debt Levels May Overstate Challenges in the Short Run …

The focus on headline debt ratios may also overstate—in some cases, by sizable margins—the degree of short-term financial pressure faced by some governments. This is the case, for example, when the central bank is pursuing an expansionary monetary policy. Specifically, quantitative easing strategies undertaken for monetary policy purposes by the Bank of England, the Bank of Japan, and the U.S. Federal Reserve have led to a notable increase in central banks’ holdings of government securities, both as shares of total issues and as shares of GDP (Figure 10). The Eurosystem of central banks’ holdings of sovereign debt are at 6.5 percent of GDP, of which about one-third (2.2 percent of GDP) is due to monetary policy operations under the Securities Market Program and the balance is held in the investment portfolios of national central banks. In 2011, central bank purchases accounted for 27 percent of sovereign debt issues in the United Kingdom, 15 percent in the United States, and 6.1 percent in Japan—with the stock of central bank claims on the government reaching 18.4, 11.1, and 19.4 percent of GDP, respectively (Table 6). If they are not sterilized, these purchases reduce the gross consolidated government debt and the central bank debt by the same amount.8

Figure 10.
Figure 10.

Trends in Central Bank Claims on Government

Sources: National authorities; and IMF staff estimates.Note: Based on latest data available.
Table 6.

Components of Consolidated Government and Central Bank Debt, 20111

(Percent of GDP)

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Sources: European Central Bank; IMF, International Financial Statistics, and IMF staff estimates and calculations.

Net consolidated government and central bank debt is computed as the net debt of the general government (excluding central bank net claims on the government) plus nonmonetary liabilities of the central bank (excluding currency in circulation and reserves) minus central bank assets (foreign assets and central bank claims on other sectors). The nonmonetary liabilities of the central bank consist of deposits that are not part of base money and central bank securities. See Buiter (1995, 2010).

Excludes central bank gross claims on government and includes central bank nonmonetary liabilities, for example, deposits not part of base money or central bank securities.

Gross general government debt minus financial assets, excluding shares and other equity and financial derivatives.

Central bank data based on latest available.

In the Eurosystem, profits and losses from most monetary policy operations are pooled and shared among national central banks according to their respective capital shares in the European Central Bank. For calculation of the net consolidated debt of euro area countries, the assets and liabilities of the consolidated Eurosystem are split among individual member states, on the basis of their capital shares. The only exception is the liquidity assistance provided by the national central banks to domestic banks, which is excluded from these sharing arrangements.