Abstract
This Selected Issues paper analyzes the spillover effects of key external shocks on Paraguay. It presents an overview of Paraguay’s major economic and financial linkages with the rest world, and quantifies the spillover effects of key external factors on the Paraguayan economy, using a vector autoregression approach. The empirical results suggest that global shocks have a significant impact on Paraguay’s growth rate. The paper also highlights that output and exchange rate shocks stemming from Brazil and Argentina are also important, even after controlling for global factors.
Debt Sustainability, Cyclical Stabilization, and the Fiscal Responsibility Law—A Simulation Exercise1
A. Introduction
1. This paper analyzes quantitatively the implications of conducting fiscal policy under Paraguay’s new Fiscal Responsibility Law (FRL). It considers both medium-term fiscal priorities and cyclical stabilization goals. The analysis focuses on possible tensions between (i) the authorities’ plan to scale up public investment over the medium term; (ii) a fiscal stabilization motive which calls for letting automatic stabilizers operate over the business cycle and avoiding procyclical discretionary measures;2 and (iii) the constraints on the headline fiscal balance prescribed by the FRL. To preserve debt sustainability, the FRL establishes that the deficit of the central government must not exceed 1.5 percent of GDP in years with positive GDP growth, and up to 3.0 percent of GDP in years with negative growth. It also stipulates that the growth rate of the public sector’s current primary expenditure must not exceed 4 percent in real terms.3 Taking these constraints as given, this paper presents simulation-based results on a suitable fiscal buffer—in terms of a central government deficit slightly below the FRL’s ceiling—to absorb negative shocks. Without such a buffer, adverse economic developments are likely to necessitate a costly fiscal retrenchment, whether in the form of capital spending cuts or other procyclical tightening measures.
B. Methodology
2. The paper’s starting point is an empirical model of Paraguay’s economy. The purpose of the model is to capture the behavior of the relevant fiscal and real economy indicators over the business cycle. To this end, a Vector Autoregression (VAR) is estimated, including the cyclical components of agricultural GDP (which comprises agriculture, livestock, and forestry) and non-agricultural GDP; government revenue; current primary expenditure; and capital expenditure.4 The estimated model captures the cyclical properties of fiscal policy in Paraguay as observed during the 1990–2014 period.
3. The estimated model is used to generate a large number of simulated projections for different policy scenarios. Each projection consists of data for all five variables for the period 2015–2024. For each scenario, 1,000 simulations are run, each corresponding to a sequence of random shocks drawn from a probability density function estimated from the residuals in the historical data sample. This way, the simulations generate data that reflect historical patterns in terms of the volatility and correlation of individual series. The results are then used to compute probability density functions for each of the variables over the projection horizon. Values for each projected variable in percent of GDP are obtained by projecting a deterministic (and constant) trend growth rate for each. Tracking the overall balance and stock of public debt also requires a projection for interest expenditure. The assumed interest rate path is based on the World Economic Outlook. The debt stock corresponding to each simulation takes the initial maturity structure of debt into account and is computed according to the debt accumulation identity.5
4. The simulations are designed to analyze possible tensions between the planned rise in public investment, a cyclically appropriate fiscal stance, and compliance with the FRL. Starting in 2015, the simulations assume (i) a permanent increase in capital expenditure by 1.5 percentage points of GDP; (ii) an increase in current expenditure of 0.5 percentage points of GDP, meant to capture the cost of maintaining a larger stock of public infrastructure; (iii) an increase in revenue of 1 percentage point of GDP, perhaps achieved by way of improvements in tax administration; (iv) a decline in current primary expenditure of 1 percent of GDP, possibly obtained through civil service reform. Realistically, these reforms and the envisaged increase in investment will take more time to implement and are therefore unlikely to take effect all at once in 2015. However, this simplification is immaterial, given the intended focus on medium-term fiscal dynamics. Importantly, by assuming that the rise in infrastructure spending is fully covered by fiscal savings elsewhere, the simulations abstract from the practical challenge of ensuring a balanced rise in spending and revenue. This assumption serves to highlight the fiscal policy challenges looming even under a fiscally balanced rise in public capital spending.
5. Two alternative scenarios for fiscal policy behavior are considered to analyze debt sustainability and the role of the FRL. First, the unconstrained baseline scenario assumes that all variables take the values simulated by the model, without imposing any of the constraints implied by the FRL. These results shed light on the fiscal sustainability risks that could materialize in the absence of the current fiscal rules. Second, the FRL-constrained scenario assumes that the variables are constrained by the expenditure ceiling mandated by the FRL. Specifically, government revenue is allowed to take the simulated values, but if simulated current primary expenditure grows by more than 4 percent in real terms, its growth is capped at 4 percent. With the expenditure ceiling being enforced, the simulations are used to measure the probability and size of any additional fiscal adjustment required to also meet the deficit ceiling. This additional adjustment can be thought of as a forced slowdown in the execution of public investment.
6. Thus, the simulation exercise sheds light on the need for ad hoc fiscal consolidations to remain in compliance with the FRL. Compliance with the FRL is monitored over the entire projection horizon. In each simulation exercise two results are highlighted. First, there is the frequency of cases in which the deficit ceiling is breached, or, put differently, where ad hoc fiscal tightening would be needed to remain compliant. Second, particular attention is given to the frequency of cases in which the deficit ceiling becomes binding while non-agricultural GDP is below potential.6 This measure is used to quantify the probability and scale of forced fiscal consolidations during the low phase of the economic cycle—a particularly problematic outcome, given the higher marginal value of fiscal spending during cyclical downturns from a stabilization perspective.
7. The paper also studies how the probability and size of forced fiscal consolidations depends on the targeted fiscal buffer, i.e., the margin between the programmed deficit and the hard FRL deficit ceiling. Intuitively, a fiscal buffer represents a form of insurance. The price of this insurance is determined by the cost associated with creating additional fiscal space, whether in the form of expenditure restraint or increased tax pressure. The benefit of the insurance can be viewed alternatively in terms of improved prospects for fiscal sustainability, or a lower probability of disrupting the execution of public investment as the FRL limits bind less frequently.
C. Results
Central Government Debt Dynamics under Unbalanced Fiscal Expansion Scenario 1/
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Sources: Author’s calculations.1/ Scenario assumes permanent increase in public investment by 1.5 percentage points of GDP, coupled with an increase in current expenditure by 0.5 percentage points of GDP and no offsetting fiscal measures (except application of the FRL ceiling on overall primary current expenditure growth in the calculations underlying the right-hand chart).Central Government Debt Dynamics under Unbalanced Fiscal Expansion Scenario 1/
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Sources: Author’s calculations.1/ Scenario assumes permanent increase in public investment by 1.5 percentage points of GDP, coupled with an increase in current expenditure by 0.5 percentage points of GDP and no offsetting fiscal measures (except application of the FRL ceiling on overall primary current expenditure growth in the calculations underlying the right-hand chart).Central Government Debt Dynamics under Unbalanced Fiscal Expansion Scenario 1/
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Sources: Author’s calculations.1/ Scenario assumes permanent increase in public investment by 1.5 percentage points of GDP, coupled with an increase in current expenditure by 0.5 percentage points of GDP and no offsetting fiscal measures (except application of the FRL ceiling on overall primary current expenditure growth in the calculations underlying the right-hand chart).8. To begin with, the simulation results underscore the need to create fiscal space for the intended increase in public investment, lest debt sustainability be compromised. Consider, as a starting point, a simulation that projects an increase in public investment by 1.5 percentage points of GDP coupled with an increase in current expenditure of 0.5 percentage points of GDP but without any additional revenue and expenditure measures. This experiment can be thought of as an “unbalanced” fiscal expansion and is readily seen to be unsustainable. In fact, even if the FRL expenditure ceiling is imposed, public debt would follow an increasing trajectory in about 75 percent of the simulations. This point being established, all subsequent simulations will reinstate the assumption that the envisaged rise in public investment is fully covered by fiscal savings elsewhere.
9. Even with a balanced rise in spending and revenue, unfavorable shocks are likely to create fiscal sustainability problems. This is illustrated in Figure 1, which summarizes the results for simulations that incorporate additional permanent revenue of 1 percentage point of GDP and an equal amount of structural current expenditure consolidation measures. The charts in the left column correspond to the simulations which impose none of the FRL constraints, allowing revenue and expenditure to behave according to historical cyclical patterns. The results show that disregarding the FRL limits leads to a rising debt trajectory in around 75 percent of the simulations. Further, in more than half the simulations, ad hoc fiscal consolidation would become necessary to meet the FRL deficit ceiling. On average, these forced fiscal consolidations amount to slightly more than 2 percentage points of GDP. Moreover, a significant share of these forced consolidations would occur during economic downturns, i.e., when non-agricultural GDP is below potential.7 Overall, the results underscore that, in the interest of securing debt sustainability, the FRL imposes constraints that turn out to be binding across a wide range of scenarios. In other words, simply following established fiscal policy patterns of the past would not ensure debt sustainability in a robust fashion, given the end-2014 starting point and the high volatility of Paraguay’s economic environment.
Fiscal Dynamics under Balanced Fiscal Expansion with Different Policy Assumptions 1/
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Source: Author’s calculations.1/ Scenario assumes that the increase in public investment is fully offset by fiscal savings elsewhere. Assumed policy is “no FRL constraint imposed” (left side) and “FRL expenditure ceiling observed” (right side).2/ Lines indicate expected trajectories of the simulated variables. Shade colors around expected trajectories indicate probability of ocurrenee of 50, 75, 90 and 95 percent respectively.3/ Refers to unconditional probability of exceeding deficit ceiling and being in an economic downturn (defined as agricultural GDP below potential).Fiscal Dynamics under Balanced Fiscal Expansion with Different Policy Assumptions 1/
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Source: Author’s calculations.1/ Scenario assumes that the increase in public investment is fully offset by fiscal savings elsewhere. Assumed policy is “no FRL constraint imposed” (left side) and “FRL expenditure ceiling observed” (right side).2/ Lines indicate expected trajectories of the simulated variables. Shade colors around expected trajectories indicate probability of ocurrenee of 50, 75, 90 and 95 percent respectively.3/ Refers to unconditional probability of exceeding deficit ceiling and being in an economic downturn (defined as agricultural GDP below potential).Fiscal Dynamics under Balanced Fiscal Expansion with Different Policy Assumptions 1/
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Source: Author’s calculations.1/ Scenario assumes that the increase in public investment is fully offset by fiscal savings elsewhere. Assumed policy is “no FRL constraint imposed” (left side) and “FRL expenditure ceiling observed” (right side).2/ Lines indicate expected trajectories of the simulated variables. Shade colors around expected trajectories indicate probability of ocurrenee of 50, 75, 90 and 95 percent respectively.3/ Refers to unconditional probability of exceeding deficit ceiling and being in an economic downturn (defined as agricultural GDP below potential).10. Compliance with the FRL expenditure ceiling would improve fiscal sustainability considerably, though adverse shocks continue to pose a challenge. The charts in the right column of Figure 1 assume that the FRL expenditure ceiling is respected. Adding this assumption implies that public debt would follow a stable or decreasing trajectory in about 75 percent of the simulations. Meanwhile, the probability of forced fiscal consolidations (plausibly involving disruptions to public investment execution) to comply with the FRL deficit ceiling declines to about 20 percent; and only in about 5 percent of cases, these forced consolidations occur during economic downturns. Despite these significant improvements relative to the scenario where the expenditure ceiling is not respected, the fiscal position still does not appear very resilient to negative shocks: not only do forced fiscal consolidations remain fairly common, but their average size is around 1 percent of GDP, implying a significant ad hoc tightening.
11. Targeting a somewhat stronger fiscal balance over time would facilitate compliance with the FRL in the business cycle without the need for frequent procyclical fiscal consolidations. Programming a small fiscal buffer—defined as a margin between the targeted deficit and the hard deficit ceiling of 1.5 percent of GDP—naturally makes the public finances more resilient; reduces the need for ad hoc consolidation to comply with the FRL in the face of adverse shocks; and thereby allows a smoother execution of the governments’ investment plans. To investigate these features, the previous simulations are modified to incorporate specific amounts of assumed additional revenue. The extra revenue improves the overall fiscal balance relative to the scenario considered before. The following chart displays the probability and extent of fiscal consolidations required to comply with the FRL, as a function of the targeted fiscal buffer. Specifically, moving to the right along the x-axis implies incremental improvements to revenue and the overall balance. The simulations confirm that the probability and size of forced fiscal consolidations decline as the fiscal buffer increases.
Probability of Exceeding the FRL Deficit Ceiling and Implied Consolidation Need as a Function of the Targeted Fiscal Buffer
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Source: Author’s calculations.Probability of Exceeding the FRL Deficit Ceiling and Implied Consolidation Need as a Function of the Targeted Fiscal Buffer
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Source: Author’s calculations.Probability of Exceeding the FRL Deficit Ceiling and Implied Consolidation Need as a Function of the Targeted Fiscal Buffer
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A002
Source: Author’s calculations.12. A fiscal buffer on the order of 0.5–1.0 percent of GDP appears sufficient to reduce the risk of forced fiscal consolidations to around 10 percent if the FRL expenditure ceiling is observed. As seen from the above chart, the need for ad hoc fiscal tightening becomes relatively rare as the fiscal buffer approaches 1 percentage point of GDP, corresponding to an overall deficit target of 0.5 percent of GDP. Moreover, almost none of these episodes would be observed during economic downturns. As such, seeking even a moderate-size fiscal buffer could prove instrumental in securing debt sustainability—via compliance with the FRL—without the potential drawback of forced fiscal consolidations that could disrupt the envisaged build-up of public infrastructure.
Prepared by Alejandro Guerson.
Given the limited scope of social transfers, these automatic stabilizers are relatively small in Paraguay and mostly limited to tax revenue losses during economic downturns.
The FRL establishes that the expenditure ceiling applies to the broader public sector, rather than just the central government. However, the simulations in this paper assume that the limit applies to the central government, whose expenditure (i) represents a large share of overall public sector expenditure; and (ii) is more directly under the authorities’ control. The analysis also disregards the FRL requirement that the average fiscal deficit over three consecutive years must not exceed 1 percent, as this constraint only applies on an ex ante basis.
The cyclical components used in the empirical model are calculated as the ratio of the variable to its estimated trend. The cyclical components of GDP are estimated using the Hodrick-Prescott filter on annual data for 1990–2014. All variables are transformed into real terms using the GDP deflator and expressed in logarithms. The identification of shocks is performed using the Choleski decomposition, according to the ordering presented above.
The calculation of the implicit interest rate assumes that new debt issuance has the same maturity structure and sovereign and exchange rate risk premia as the existing debt stock at end-2013. This is a simplifying assumption, as interest rates are likely to be affected by the state of the cycle and debt dynamics.
The focus on non-agricultural GDP captures the idea that this aggregate better reflects the economic welfare of the typical household than total GDP, given that agricultural income is highly concentrated among a small number of households and lightly taxed.
The consistent finding that forced fiscal consolidations are relatively less likely during economic downturn may appear surprising. It is explained by two factors: (i) the FRL allows the deficit to widen to 3 percent of GDP when GDP growth is negative, which reduces the need for procyclical tightening during recessions; and (ii) government expenditure in the model is procyclical, reflecting the behavior of the series in historical data.
