This Selected Issues paper examines the need of reformation of the Fiscal Responsibility Act (FRA) in the Slovakia. It is suggested that in light of experience gathered so far, FRA modifications should be considered. Clear guidelines regarding a cost-effective cash management strategy should be established. Debt brake level should be kept at the current limits, rather than lowered over time, to avoid unduly eroding fiscal space. Policies should aim to maintain a safe margin below debt thresholds to allow fiscal policy to play a counter-cyclical role in the future during downturns. Adjustment measures should be more gradual and the bias toward spending cuts should be lessened or removed.

Abstract

This Selected Issues paper examines the need of reformation of the Fiscal Responsibility Act (FRA) in the Slovakia. It is suggested that in light of experience gathered so far, FRA modifications should be considered. Clear guidelines regarding a cost-effective cash management strategy should be established. Debt brake level should be kept at the current limits, rather than lowered over time, to avoid unduly eroding fiscal space. Policies should aim to maintain a safe margin below debt thresholds to allow fiscal policy to play a counter-cyclical role in the future during downturns. Adjustment measures should be more gradual and the bias toward spending cuts should be lessened or removed.

Should the Fiscal Responsibility Act be Reformed?1

A. Introduction

1. To strengthen the credibility of budget goals, the Slovak Republic adopted a Fiscal Responsibility Act (FRA) in December 2011. The FRA came into effect on March 1, 2012. The FRA includes rules and procedures relating to three budget principles: discipline, accountability, and transparency. The FRA overlaps with and tightens the EU fiscal governance framework in some aspects (e.g., debt limits and correction mechanisms).

2. Since the inception of the FRA, public debt has moved rapidly into “red-flag” territory. Although sizeable fiscal adjustments were undertaken during this period, debt rose due to a prolonged period of weak growth following the 2009 crisis. The triggering of a spending freeze in 2014 appeared likely but was avoided thanks to an upward revision of nominal GDP subsequent to ESA 2010 implementation. Had the spending freeze taken effect, it would have implied pro-cyclical tightening despite the absence of market pressure.

3. Experience so far provides an opportunity to consider whether some aspects of the FRA would benefit from refinement. It is also noteworthy that since the introduction of the FRA, the EU fiscal governance framework has evolved substantially. The result is a rather complicated combination of fiscal rules and limits that could reasonably lead to questions about the need for a separate domestic framework.

4. The note is structured as follows. Section B provides a brief overview of the main features of the FRA. Section C investigates whether the FRA meets certain established international norms for these types of rules. Section D comments on the suitability of the particular debt brake levels established in the Act (as distinct from the presence of a debt brake at all). Section E analyzes some definitional aspects of the debt indicator. Section F discusses whether debt brakes should be defined on a net basis. Section G concludes and summarizes a few recommendations.

B. Main features of the Fiscal Responsibility Act

5. The FRA includes rules and procedures relating to three budget principles: discipline, accountability, and transparency.

Discipline

6. The FRA sets specific debt ceilings and defines a set of adjustment measures to be implemented when debt thresholds are breached (Art. 5, paras. 4 to 8) (see text table). In applying those measures, all the entities included in the general government are expected to align their respective budget proposals with the general government budget proposal presented by the government (Art. 5, para. 9).

7. The FRA debt brakes are set to decline over time. Until 2018, the FRA sets the initial debt limit at 50 percent of GDP with a “tolerance” band up to 55 percent of GDP at which point more serious corrective mechanisms kick in. Starting in 2018, the debt ceilings will be gradually reduced by one percentage point of GDP each year until 2027, when the first threshold will be equal to 40 percent of GDP.

The Fiscal Responsibility Act

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Source: Constitutional Act of December 8, 2011 on Fiscal Responsibility.

Starting in 2018, the debt ceilings will be gradually reduced by one percentage point of GDP each year to reach 40–50 percent of GDP by 2027.

8. The FRA debt brakes are based on the Maastricht debt definition.2 The adoption of such an objective yardstick determined by an external institution (i.e., Eurostat) offers the advantage of avoiding concerns about potential manipulation of the accounting treatment of government debt, including the classification perimeter (see below).

9. The FRA includes some escape clauses. The set of exceptional circumstances envisaged by the FRA include the following:

  • a major recession (a decline in GDP growth rates of at least 12 percentage points over two fiscal years; Art. 5 para. 11(a));

  • a banking sector crisis (Art. 5, para. 11(b));

  • a natural disaster, and

  • commitments arising from international treaties exceeding three percent of GDP (Art. 5, para. 11(b)).

The materialization of any of these events would suspend for a period of three years the implementation of the sanctions triggered by breaching the debt brakes. Corrective measures are also suspended for two years in case of a change in government (Art. 5 para.10) or during a state of war (Art.5, para. 12).

10. The FRA strictly limits debt for local governments (municipalities and self-governing regions). Should the debt-to-current revenue ratio of a local government reach or exceed 60 percent, the infringing local government will pay to the Ministry of Finance a penalty corresponding to 5 percent of the debt in excess of that threshold. The only escape clause suspends the penalty payment for two years in the case of local elections.

Accountability

11. The FRA provides the legal basis for the independent Council for Budget Responsibility (CBR) (Art. 3). To ensure its independence, the CBR operates “under the aegis” of the National Bank of Slovakia (NBS), in terms of both budget funding and its premises.

12. The CBR mandate focuses on fiscal sustainability analysis and the assessment of compliance with fiscal transparency rules (Art. 4). The CBR also might carry out costing analysis but this is not an explicit task.

Transparency

13. To enhance transparency, the FRA provides for the creation of the Tax Revenue Forecast Committee and the Macroeconomic Forecasting Committee (Art. 8). Both committees act as advisory bodies to the Minister of Finance (Art. 8). They publish their forecasts twice a year and contribute to the budget preparation and monitoring process. The FRA also obliges the entities in the general government to prepare their budgets for at least three years.

C. Does the FRA provide a good fiscal rule?

14. In principle, a debt rule can be very effective in enforcing fiscal discipline. A debt ceiling is less subject to “creative” accounting that can plague a deficit objective (for instance, through off-budget spending) or to measurement errors as in the case of structural deficit rules, which depend on uncertain estimates of potential growth and the output gap.

15. Nonetheless, a debt ceiling has some disadvantages. The debt-to-GDP ratio is not under the full control of the fiscal authorities, as it depends on GDP growth and exchange rate changes (when some of the debt is denominated in foreign currency), although the inclusion of escape clauses may mitigate the problem. More importantly, it may heighten fiscal pro-cyclicality when debt is near the ceiling, and can hamper the quality of fiscal adjustment, especially if sanctions are rather punitive. As shown in the Appendix, under a debt rule, a growth shock may generate a more prolonged slowdown than under an expenditure rule or when automatic stabilizers are allowed to operate fully. The resulting wider and more persistent output gap may lead to more depressed inflation and higher real interest rates. The kicking-in of the debt brake may ignite perverse debt dynamics due to the impact of fiscal adjustment on real economic growth and inflation. In other words, a debt rule risks being self-defeating.

16. The FRA broadly complies with accepted criteria for a sound fiscal rule. Kopits and Symansky (1998) define eight conditions that a sound fiscal rule ought to satisfy.

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17. Nonetheless, a few features of the FRA may deserve further consideration.

  • Consistency—The FRA does not provide for (or at least it is not supported by) a clear framework that links debt developments with the operational budget balance, including those of local authorities, except when government debt reaches the “red-flag” zone thereby triggering corrective measures.

  • Flexibility—The escape clauses included in the FRA could benefit from some fine-tuning. On the one hand, the definition of a major recession might be excessively restrictive. The growth shock escape clause is essentially calibrated to the 2009 shock, which was exceptionally large with the growth rate dropping from 10.8 percent in 2007 to -5.5 percent in 2009. Yet, it might be more appropriate to calibrate the definition of major recession in terms of cumulative loss in the level of GDP rather than as the difference between growth rates. In addition, a protracted spell of below par growth together with a low level of inflation might prove quite challenging, as the post-2009 crisis has proved. During 2010–14, while the government deficit was reduced by almost 5 percentage points of GDP, the debt-to-GDP ratio climbed by almost 13 percentage points, largely due to denominator effects from the 2009 contraction followed by periods of low growth and inflation.3 Although fiscal multipliers in an open economy such as Slovakia are estimated to be relatively low, a negative fiscal impulse trigged by the FRA might turn out to be self-defeating, with dynamics from more depressed economic activity pushing up (and not down) the debt-to-GDP ratio in the short-run. Against this backdrop, Slovakia would need in practice to engineer a debt-to-GDP ratio well below the FRA thresholds (see below) in order to maintain space to respond to moderately large negative shock without running up against the debt brake limit. On the other hand, the escape clause in case of general elections or government re-shuffles, if this implies a new political program or manifesto, may provide too easy an escape.

  • Efficient policy action—The FRA corrective measures have a clear bias toward expenditure cuts. However, public expenditure in Slovakia is relatively low compared to peers and its structure is rather rigid with compensation of employees, interest payments, social benefits, and subsidies accounting for over 70 percent of total outlays. Since cutting those spending categories may be challenging, savings may come from lower public investment, which would be at odds with Slovakia’s crucial need to improve its transportation infrastructure.

A01ufig01
1/ CE3 comprise the Czech Republic, Hungary and Poland.2/ General government’s nondiscretionary spending comprises compensation of employees, interest payments, social benefits, and subsidies.

Moreover, although the intensity of corrective measures is graduated, the stage at which a balanced (or in surplus) budget is called for might be quite harmful to economic growth, especially in circumstances of prolonged weak economic activity that, however, do not conform to the definition of “major recession,” as discussed above.

D. Are the FRA debt brakes reasonable?

18. Unfortunately, there is no clear-cut answer to this question. Debt may have a negative impact on economic activity through different channels: crowding out, market confidence, or reduced fiscal space to offset shocks. However, research shows that the relationship between debt and growth may be non-linear. In other words, there might be thresholds beyond which the negative effects of debt on the economy kick in.

19. Three considerations support the view that a debt level lower than 50 percent of GDP might be appropriate for a small open economy such as Slovakia.4

  • First, Fall et al. (2015) estimate that a “reasonable” debt threshold ranges between 70 and 90 percent of GDP for high-income countries. However, in the case of euro area countries, given their institutional settings (lack of monetary independence, no debt pooling and no bailout clause), the threshold falls to 50–70 percent of GDP. For emerging markets, it is even lower at 30–50 percent of GDP as they are exposed to capital flow reversals. Slovakia, while a member of the euro area, still shares some features of an emerging market economy.

  • Second, despite having one of the smaller debt-to-GDP ratios in the EU and the current low levels of interest rates, interest payments absorb about 5 percent of general government total revenue, which is in broadly in line with the EU average. In circumstances characterized by normal levels of interest rates, the sustainability of the current level of debt (around 53 percent of GDP) would depend on much lower government spending or higher taxation.

  • Third, the share of government debt held by non-residents has steadily increased in recent years, reaching about two-third of the outstanding stock, while domestic banks already hold a sizeable amount of government debt. This situation has increased the vulnerability of the general government debt to sudden stops by foreign investors.

A01ufig02

Debt and Interest Payments

(in percent)

Citation: IMF Staff Country Reports 2016, 014; 10.5089/9781513509310.002.A001

Source: Eurostat.
A01ufig03

General Goverment Debt: Holder Breakdown

(in percent of GDP)

Citation: IMF Staff Country Reports 2016, 014; 10.5089/9781513509310.002.A001

Source: Eurostat.

20. However, reducing the debt thresholds over time might be too restrictive. As indicated above, to allow fiscal policy to play a counter-cyclical role, the authorities should target a debt ratio safely below the FRA debt brakes, perhaps in the 45–50 percent of GDP range based on the current debt thresholds. Lowering the debt band to 40–50 percent of GDP as currently required would erode already narrow fiscal space and imply that an even lower debt ratio should be targeted, despite the need for spending in areas such as infrastructure.

E. Is the definition of government debt appropriate?

21. The FRA uses the Maastricht definition of gross debt. As indicated above, the adoption of a debt metric determined by an external independent institution (i.e., Eurostat) avoids the risk of potential manipulation of the definition of government debt. It also links the domestic FRA to the fiscal rules enforced at the European level since the debt definition is the same as that used for the EU’s Stability and Growth Pact (SGP) framework. However, the domestic debt ceiling is tighter than the one set at the European level (currently 50 vs. 60 percent of GDP). In addition, unlike the FRA, the SGP does not specify similarly automatic corrective measures in case of breach of the debt ceiling. Recent experience has highlighted two issues related to the definition of debt: the public sector entities included and the debt instruments covered.

Institutional coverage

22. The recent shift of the accounting standards from ESA 95 to ESA 2010 has broadened the general government sector. The National Motorway Company, the Emergency Oil Stock Agency, healthcare facilities (i.e., public hospitals), local public transportation companies, and Exim Banka have been reclassified and are now part of general government. The inclusion of these entities had only a small impact on the general government’s debt-to-GDP ratio given the simultaneous upward revision of nominal GDP under ESA 2010. Nonetheless, this change raised the issue of insulating the operational definition of the debt brakes from statistical shocks from changes in the perimeter of the general government.

23. However, it is worth stressing that the general government’s gross debt provides only a partial view of a country’s fiscal risks and sustainability. To have a more comprehensive picture, it would be appropriate for the debt metric to include the financial liabilities of all public corporations and other institutions, for which the state may become responsible in a situation of financial distress.

24. Against this backdrop, two options might be considered:

  • The first option would be to adopt a comprehensive definition of the nonfinancial public sector. The nonfinancial public sector comprises the general government sector plus nonfinancial public corporations. This option would have the advantage of providing fairly comprehensive coverage of the public sector’s operations, excluding only the NBS. However, this approach would have the disadvantage of creating a discrepancy between the debt metric used in the domestic fiscal framework and the one adopted at the EU level, and potentially introducing an element of judgment that use of the Maastricht definition was meant to avoid.

  • The second option would be to amend the FRA by introducing an explicit escape clause. In the event that a revision of the general government perimeter by Eurostat leads to a breach of the debt brakes, the FRA might grant the government a period of one or two years to return to a debt-to-GDP ratio below the relevant FRA threshold.

Debt Instrument Coverage

25. To better assess the sustainability of public finances, data on a country government’s liabilities should be comprehensive. In principle, this would imply that the government’s future liabilities such as unfunded pension schemes and standardized state guarantees would need to be included. However, in practice, these types of liabilities are not always taken into account.

26. Slovakia’s contributions to European firewalls have raised issues regarding debt coverage. As a euro area member, Slovakia contributed to operations undertaken by the European Financial Stability Fund (EFSF), and Eurostat has determined that country contributions to the EFSF must be recorded in the gross government debt of members participating in support operations, in proportion to their share guarantees given.5 The EFSF is considered a mere accounting and treasury tool acting on the behalf of euro area member states. Consequently, the EFSF operations, together with Slovakia’s contributions to the European Stability Mechanism (ESM), have added almost 3½ percentage points of GDP to Slovakia’s gross general government debt. As a result, the FRA debt threshold of 55-percent-of-GDP was temporarily breached at the end of 2013. Only the upward GDP revision, resulting from ESA 2010 adoption, avoided a freeze of government spending the following year.

A01ufig10

General Government Debt and EU Firewalls

(in percent of GDP)

Citation: IMF Staff Country Reports 2016, 014; 10.5089/9781513509310.002.A001

Sources: Eurostat and IMF staff estimates.

F. Gross or net debt?

27. But governments do not just have liabilities: they also have assets that can be used to settle existing debts, thus raising the question of whether the debt limit should be expressed in gross or net terms. For instance, the government’s liability arising from the EFSF lending is matched by credits vis-à-vis the euro area member states that have requested the activation of the mutual support mechanism. Consequently, the net position of a country participating in a support operation through the EFSF does not change. Similarly, other assets held by the government, such as cash holdings or bank deposits, or equity participations, could be considered, thus moving toward a net concept of government’s financial position.

28. However, taking into account the government’s asset position would complicate the picture. In principle, the gross debt indicator serves to monitor government contractual liabilities. Netting out government’s assets would blur underlying debt developments owing to potentially sharp swings in asset prices, and could complicate an assessment of risks to the extent that assets are not fully liquid.

29. On the other hand, using a gross measure for debt brakes may unduly constrain debt management. In the case of Slovakia, since the gross debt-to-GDP ratio has been dangerously close to the 55 percent threshold, the Slovak debt management agency (ARDAL) has not been able to take full advantage of the current favorable market conditions to pre-fund future financing needs or beef up government’s cash balances, which would mitigate roll-over risk.

30. Consideration might be given to an intermediate approach of netting out cash balances from the headline debt indicator. The government holds cash balances with the purpose of smoothing out possible lags between government cash inflows and outflows. In addition to this transaction motive, a government can hold cash balances for precautionary purposes. As mentioned above, pre-funding forthcoming financial needs might help mitigate rollover risk and provide some buffers should financial market conditions become too tight or more volatile. Sound guidelines for cash management would be needed to avoid wastage or idling of resources. Too low a level of cash balances undermines their function as a liquidity buffer. Too high a level increases the debt service burden. It would thus be prudent to establish clear guidelines regarding a cost-effective strategy for managing cash balances.

G. Conclusions

31. In light of experience gathered so far, FRA modifications should be considered. In principle, one could argue that amending the relatively new fiscal framework, especially soon after it has become binding for the first time, might undermine its credibility. On the other hand, since the inception of the FRA, the EU fiscal governance structure has been strengthened, thus raising the question of whether it is necessary to have a domestic fiscal framework on top of EU rules. Moreover, if elements of the FRA’s design lead to sub-optimal results, such as excessive pro-cyclical adjustment or a reduction in spending on priorities such as infrastructure, this could also undermine support for the FRA. Against this backdrop, some aspects of the FRA might be refined over time while preserving fiscal discipline:

  • Debt ratios for the FRA debt brakes might net out cash balance holdings to allow sensible pre-funding activity. Clear guidelines regarding a cost-effective cash management strategy should be established.

  • Debt brake level should be kept at the current limits, rather than lowered over time, to avoid unduly eroding fiscal space. Policies should aim to maintain a safe margin below debt thresholds to allow fiscal policy to play a counter-cyclical role in the future during downturns.

  • Adjustment measures should be more gradual and the bias toward spending cuts should be lessened or removed. The low level of public spending compared to peers implies that focusing on spending restraint could be difficult or undesirable.

  • Escape clauses should be better calibrated. The escape clause for a negative growth shock might be made more realistic and a clause to address prolonged periods of sub-par growth might be considered. On the other hand, the suspension of the FRA in case of a new government (or a new manifesto) might be shortened, or the escape clause might be tightened or removed.

  • Attention should be devoted to the share of total revenue absorbed by interest payments. As in the case of macroprudential policies, debt-to-income indicators should be complemented by the analysis of developments in debt-service-to-income ratios. In light of the relatively low level of public spending, the relatively high share of revenue absorbed by interest payments – despite a low debt ratio – points to the need to strengthen government revenues over time.

Annex. The Model1

In steady state, the Slovak economy is assumed to grow at a (given) constant rate (g¯)), while domestic inflation (π) is equal to the ECB’s target (π¯).

(1)g=g¯
(2)y¯t=y¯t-1(1+g¯)(real potential output)
(3)π=π¯
(4)Y¯t=Y¯t1(1+g¯)(1+π¯)(nominal potential output)

In the simulation, it is assumed that Slovakia’ potential growth rate is equal to 3 percent while the inflation objective is set equal to 2 percent.

Slovakia’s long-term nominal interest rate (i) is driven by the long-term nominal interest rate in Germany (iDEU) augmented by a spread, which is assumed to depend on the debt dynamics in a non-linear way. This assumption captures the empirical evidence that spreads tend to increase rapidly when a country loses market confidence. In steady state, the debt-to-GDP ratio (d) is equal to the authorities’ target/objective.

(5)i¯iDEU+eφd¯

Germany’s long-term nominal interest rate is set equal to 4.45 percent. This value is broadly in line with the ECB’s long-term price stability objective and a real interest rate of 2.4 percent, which is consistent with Germany’s long-term growth (Johansson and others, 2013). At this stage, Slovakia’s steady-state debt-to-GDP ratio is assumed equal to 50 percent, slightly lower than the current level of 53 percent of GDP. The coefficient ϕ is calibrated to yield a steady-state spread for Slovakia’s borrowing costs of 110 basis points over German interest rates (ϕ = 0.00191). This value of the spread is higher than current market levels – which are exceptionally compressed reflecting the ECB’s unprecedented monetary easing – but broadly in line with the 2004–14 average (about 100 basis points). Given these assumptions, the steady-state levels of Slovakia’s nominal and real interest rate are equal to 5.55 percent and 3.48 percent, respectively. In the scenario analysis, it is assumed that the spread reacts with a lag to the debt-to-GDP ratio

(5)it=4.45+e0.0019×dt1

The steady-state level of general government’s total revenue is assumed to be a constant fraction (β) of nominal GDP, which is set equal to the current level of 38 percent.

(6)τ¯t=R¯tY¯t=β

The long-run level of the general government’s primary expenditure is determined by the debt-stabilization condition.

Dt=Dt1(RtEt)+itDt1Dt=(1+it)Dt1(RtEt)DtYt=(1+it)(1+πt)(1+gt)Dt1Yt1RtYt+EtYtdt=(1+it)(1+πt)(1+gt)dt1β+et

In steady state, dt=dt1=d¯;gt=g¯;πt=π¯;and it=i¯. Therefore, we have:

(7)e¯=β+[1(1+i¯)]

with e¯β depending on whether 1(1+r¯)(1+g¯)0, that is whether g¯r¯.

Given the previous assumptions, in the steady state the real interest rate is indeed higher than potential growth. Consequently, the general government has to run a small primary surplus (0.2 percent of GDP) in the long run, with steady-state primary expenditure at 37.8 percent of GDP. Nonetheless, the general government can sustain a net borrowing position of 2.4 percent of GDP.

Although these back-of-the-envelope results depend on a number of simplified assumptions, they highlight some tensions in the current fiscal governance framework of Slovakia. Unless total revenues are increased in a sustainable way, the current level of government spending (41 percent of GDP) may be inconsistent with the objective of keeping the debt-to-GDP ratio below a 50 percent threshold in a more normal interest-rate environment. Yet, the need to shore up domestic infrastructure and population aging are potential sources of expenditure pressure over the medium-to long-run. On the other hand, a medium-term objective of maintaining a structural deficit of 0.5 percent of GDP might be too tight for an economy such as Slovakia in more challenging macro-economic conditions than the current ones.

In the short-run, Slovakia’s economic growth rate depends on its potential growth, changes in financial conditions, which are proxied by the changes in the real interest rate, the stance of fiscal policy, and a random productivity or external shock, which follows an autoregressive process.

(8)gt=g¯ηΔrtμ1Δpbt1s+ut;ut=ρut1+εt

where: 𝜂=0.3; 𝜇1=0.3; 𝜇2=0.2 In line with the literature according to which fiscal multipliers in an open economy are lower than one, it is assumed that fiscal policy, as measured by the changes in the structural primary balance (pbs), has an overall multiplier of 0.5. More than half of the impact (60 percent) takes place in the first year and the remaining part (40 percent) in the following year.

Inflation is anchored to the ECB’s target in the long run and also depends on lagged inflation and the current and lagged levels of output gap (gap).

(9)πt=ωπ¯+(1ω)πt1+θgapt

where: ω=0.36;θ=0.15.

The general government’s revenue and primary expenditure are affected by cyclically sensitive items (automatic stabilizers) and the authorities’ discretionary policies, which for sake of simplicity are assumed to fall only on the expenditure side.

(10)τt=β+δgapt
(11)et=e¯γgaptψt

where δ and ψ are the aggregate revenue and expenditure elasticity with respect to the output gap, which based on recent estimates (Price and others, 2014), are set equal to 0.88 and 0.12, respectively.2 The discretionary component of government primary expenditure is modeled taking into account two policy rules. The first policy rule is a simplified version of the FRA and assumes that if the debt-to-GDP ratio exceeds 55 percent at time t, primary expenditure at time t+1 is frozen at the nominal level recorded in the previous year. The second policy rule assumes that deviation between the actual and the steady-state level of primary expenditure is corrected in the subsequent budget although automatic stabilizers in that year are allowed to operate fully. Consequently, equation (11) becomes:

(11)et=e¯0.12gaptα(et1e¯)

The following identities close the model:

(12)bt=τtetitdt1General government's overall balance
(13)dt1bt
(14)pbts=βe¯+ψt.

The simulation assumes that growth is affected by a negative shock of 1.5 percentage points, which is equivalent to less than half of the standard deviation of economic growth over the 1998–2014 period. The shock declines by one-fifth in each of the following years. It then reverts so as the output gap virtually closes after 10 periods/years.

Under the debt rule, the economic slowdown is more prolonged than under the expenditure rule (or when automatic stabilizers are allowed to operate fully). The resulting wider and more persistent output gap leads to more depressed inflation and higher real interest rates (Figure 1A).

Figure 1.
Figure 1.

Slovak Republic: Shock Scenario–Macro Variables

Citation: IMF Staff Country Reports 2016, 014; 10.5089/9781513509310.002.A001

The kicking-in of the debt brake ignites perverse debt dynamics. Despite curtailing primary expenditure, which generates growing structural primary balances, the debt-to-GDP continues to escalate steadily and interest payments absorb an increasing share of total revenue due to the perverse effect of fiscal adjustment on real economic growth and inflation. In other words, a debt rule risks being self-defeating.

Figure 2.
Figure 2.

Slovak Republic: Shock Scenario–Fiscal Variables

Citation: IMF Staff Country Reports 2016, 014; 10.5089/9781513509310.002.A001

Under the expenditure rule (or the full operation of automatic stabilizers),3 the fiscal adjustment is more contained as is the impact on the real economy. Nonetheless, the debt-to-GDP ratio climbs above 60 percent before starting to stabilize.

This simple scenario analysis shows that the authorities needs to keep debt-to-GDP ratio well below the FRA first threshold (50 percent of GDP) to allow automatic stabilizers to operate fully. For example, under the debt rule, to avoid the debt-to-GDP ratio reaching the 55-percent threshold, the steady-state level of debt has to be about 41 percent of GDP (about 44 percent of GDP under the expenditure rule).

References

  • Fall, Falilou, Debra Bloch, Jean-Marc Fournier, and Peter Hoeller, 2015, “Prudent Debt Targets and Fiscal Frameworks,” OECD Economic Policy Paper No. 15, July (Paris: Organization for Economic Co-operation and Development), available at http://www.oecd-ilibrary.org/economics/prudent-debt-targets-and-fiscal-frameworks_5jrxtjmmt9f7-en.

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  • Koptis, George F., and Steven A. Symansky, 1998, “Fiscal Policy Rules,” IMF Occasional Paper No. 162 (Washington, D.C.: International Monetary Fund), available at http://www.imf.org/external/pubs/cat/longres.aspx?sk=2608.

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  • Múčka, Zuzana, 2015, “Is the Maastricht Debt Limit Safe Enough for Slovakia?,” Working Paper No. 2 (Bratislava: Council for Budget Responsibility), available at http://www.rozpoctovarada.sk/download2/wp2_2015_fiscal_limits_01.pdf.

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  • Price, Robert W., Dang Thai-Thanh, and Yvan Guillemette, 2014, “New Tax and Expenditure Elasticity Estimates for EU Budget Surveillance”, OECD Economics Department Working Papers No. 1174, December 11 (Paris: Organization for Economic Co-operation and Development), available at http://dx.doi.org/10.1787/5jxrh8f24hf2-en.

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  • Sorbe, Stéphane, 2012, “Portugal—Assessing the Risks Around the Speed of Fiscal Consolidation in an Uncertain Environment,” OECD Economics Department Working Papers, No. 984, September 19 (Paris: Organization for Economic Co-operation and Development), available at http://dx.doi.org/10.1787/5k92smzp0b6h-en.

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1

Prepared by A. Giustiniani.

2

Maastricht debt is defined as gross debt of consolidated general government. It covers government liabilities in the form of currency along with deposits, loans and securities other than shares. The Maastricht debt excludes certain financial instruments such as financial derivatives and other accounts payable (e.g., trade credits). Apart from the difference in the coverage of financial debt instruments, the main difference compared to the System of National Accounts debt definition is that debt instruments are reported at their nominal rather than market value. Consequently, the debt figures are not affected by market fluctuations.

3

A small fraction of the increase (corresponding to about 3½ percentage points of GDP) was due to Slovakia’s contributions to the European Financial Stability Fund and the European Stability Mechanism.

4

See, for example, Múčka (2015).

5

Eurostat decision on “The statistical recording of operations undertaken by the European Financial Stability Facility,” January 27, 2011 (http://ec.europa.eu/eurostat/en/web/products-press-releases/-/2-27012011-AP).

1

The model draws on Sorbe (2012).

2

Slovakia’s aggregate tax elasticity (tax-weighted average) is estimated at 1.11. However, the revenue items that are cyclically sensitive (income tax, corporate tax, indirect tax and social security contributions) represent about 80 percent of general government total revenue (hence 1.11 ×0.8=0.88). The elasticity of unemployment-related spending and social benefits relative to the output gap are estimated at -2.98 and -0.57, respectively. Taking into account that the shares of those two items in total current primary expenditure are 2.95 percent and 6.03 percent, respectively, an overall elasticity of -0.12 is derived.

3

In this simple exercise, it is assumed that ∝ =1.

References

  • Aiyar, Shekhar, Charles Calomiris, and Tomasz Wieladek, 2014, “How Does Credit Supply Respond to Monetary Policy and Bank Minimum Capital Requirements?Bank of England Working Paper No. 508 (London: Bank of England).

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1

Prepared by A. Jobst.

2

Non-financial corporate borrowing has only picked up recently (and still lags behind sales growth); year-on-year credit from banks to non-financial corporates only recently turned positive. Rising corporate leverage is less concerning as it largely reflects intercompany lending with foreign parents.

4

A prudent LTV ratio should be the outcome of a well-managed credit decision process in each lender; unfortunately, experience shows such prudence cannot be relied on and that a policy overlay which would inhibit the emergence of imprudent lending is desirable.

5

A small change in the housing stock is estimated to have a significant impact on house prices (OECD, 2009).

6

The NBS is the national competent authority (NCA) for the implementation of macroprudential policy in Slovakia reflecting its statutory mandate in relation to the overall stability of the financial system. This includes the mandate for the implementation of certain macroprudential tools in the Capital Requirements Regulation (CRR) and Capital Requirements Directive IV (CRD-IV) as per Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 [2013] OJ L 321/6 and Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC [2013] OJ L 176/338.

7

The EU Mortgage Credit Directive also recommends the use of limits on LTV and LTI ratios based on the historical experience of a sharp increase in the losses of defaulted loans at high originating LTV ratios in stressed economies during the recent financial crisis. See Directive 2014/17/EU on credit agreements for consumers relating to residential immovable property and amending Directives 2008/48/EC and 2013/36/EU and Regulation (EU) No 1093/2010 [2014] OJ L 60/34.

8

A summary of the NBS’ retail lending recommendations can be found at: http://www.nbs.sk/_img/Documents/_Dohlad/Makropolitika/Recommendation_Retail_Lending_summary_EN.pdf.

9

The NBS previously also introduced a counter-cyclical capital buffer (as part of EU-wide macroprudential requirements under CRD-IV) but set it to zero percent.

10

Since the global financial crisis there has been a growing literature on the effectiveness of macroprudential policy objectives and the design and goals of corresponding instruments and measures supporting financial stability surveillance, but, a thorough understanding of the interaction between the financial system and the economy and how it might be affected by macroprudential policy is still lacking (Galati and Moessner, 2011). However, there are several papers that estimate the impact of changes in capital requirements or limits on LTVs on credit growth. For example, using bank-specific and time-varying capital requirements imposed by the regulator, Aiyar and others (2012 and 2014) show that capital measures have a significant impact on credit growth in the UK. Quint and Rabanal (2013) quantify the optimality and effectiveness of macroprudential instruments in the euro area.

11

A lower LTV ratio implies a higher down payment requirement, which could force some marginal homebuyers out of the property market (Zumpano and others, 1986). The LTV ratio can also have a positive impact on loan supply since the actual price of a mortgage loan is determined not only by the mortgage rate, but also by other contractual terms, such as LTV ratio and maturity (Stiglitz and Weiss, 1981). So, banks can shift the aggregate supply of loans by adjusting these non-price mortgage terms.

12

These caps can be introduced on all new lending or on a proportion of new lending.

13

Empirical evidence regarding the effectiveness of limits on LTV ratios is mixed. Cerutti and others (2015) find that macroprudential instruments can be effective in mitigating the risk from credit booms during financial cycles. This is consistent with Crowe and others (2011), who focus on dynamic provisioning as an effective way of strengthening banks against the effects of a bust, but also acknowledge that they can do little to stop the boom itself. More specifically, the econometric analysis from Wong and others (2011) suggests that LTV policy has reduced the systemic risk associated with boom-bust cycles of the property market in Hong Kong SAR. Igan and Kang (2011) find that in Korea, LTV and DTI limits were associated with a decline in house price appreciation and transaction activity.

14

The implementation of a DSTI ratio on net income is operationally difficult since it involves a comprehensive view of debt service costs, including all the borrower’s loans, under different interest rate scenarios.

15

Also note that the introduction of maximum maturity terms for consumer loans has prevented lenders from circumventing the debt affordability requirement for mortgages by increasing the term on consumer loans that are used as down payment on mortgage loans in order to satisfy the LTV limit.

16

In non-euro EU countries that exhibit degrees of financial deepening and effectiveness of debt enforcement regimes that are similar to those of Slovakia, LTV limits do not exceed 80 percent.

17

The cross-country comparison of LTV ratios is not straightforward. The LTV limit could be higher in countries with more effective debt enforcement and insolvency frameworks, which helps improve asset recovery and, thus, reduces the importance of higher ex ante collateralization via the LTV ratio.

18

However, a cap on a LTI ratio might not capture over-indebtedness due to additional secured or unsecured borrowings from multiple sources and could result in leakage through additional non-mortgage borrowing.

19

The recurrent tax on immovable property is effectively the only property tax levied in Slovakia. Rates are relatively low and taxation does not respond to changes in the market value (Harvan and others, 2015), creating strong bias towards home ownership. Also, real estate transfers are tax-free as gifts and inheritance of property is not taxed. However, mortgage interest payments are not tax deductible.

20

However, Constâncio (2015) points to the existence of several problems with capital-based measures. Aside from the CCB, capital-based measures tend to have more indirect and limited effects on cyclical adjustments and the costs of loans, which can make them less effective in restraining excessive credit demand in environments of house price appreciation.

21

On April 28, 2015, in its regular decision on setting the CCB, the NBS decided to maintain the current rate of zero percent on account of the continued heterogeneity of the domestic credit market.

22

N’Diaye (2009) finds that binding counter-cyclical prudential regulations can help reduce output fluctuations and reduce the risk of financial instability.

23

CCBs are generally assessed on a consolidated reporting basis and must be met fully by Common Equity Tier 1 (CET1) as the simplest and most effective way to increase the going-concern loss-absorbing capacity of a bank.

24

Both the trend and the gap obtained from the trend-cycle decomposition are unobservable and are thus subject to uncertainty; there are different possible decompositions depending on the properties (definition) of the trend and the time-varying dependence between the trend and the cycle.

25

Two main alternatives are the one-sided HP filter using a recursive estimation approach as suggested by the Basel Committee (BCBS, 2010a and 2010b), and an alternative that applies the (two-sided) HP filter to forecast-augmented data. Both approaches apply a smoothing parameter of λ=1,600.

26

Note that an appropriate threshold for the credit gap might be higher than the general norm of two percent in an environment of financial deepening where a lower long-term trend of household lending might make a high deviation from the credit-to-GDP ratio more likely.

27

Replacing the concept of a normative threshold (of 2.0 percent) with a statistical threshold (based on the historical volatility of the credit-GDP ratio) provides a more comprehensive diagnostic of excessive credit growth using the credit gap measure. Given that the credit-to-GDP ratio tends to be non-normally distributed, the Generalized Extreme Value (GEV) distribution is applied to identify a statistically significant deviation of the credit gap from the long-term trend (see right chart in third row of Figure 12 and Box 2).

28

However, based on a broader measure of credit (and prudential data), NBS staff estimates (2015b, p. 58) indicate that the “deviation of the credit-to-GDP ratio from its long-term trend […] continued to increase and [has already] exceeded 1 percentage point [by mid-2015].”

29

The robustness of our results based on both a one- and two-sided HP filter might be due to the small deviation from trend; however, they also contrast with Edge and Meisenzahl (2011), who compare the credit gaps obtained from one-sided and two-sided filters and suggest that one-sided filtered (ex ante) estimates of the credit gap are unreliable due to substantial differences. In response, van Norden (2011) points out that the BCBS (2010b) as well as Drehmann and others (2010) rely largely on the leading indicator properties of one-sided filters rather than ex post revised estimates using two-sided filters.

30

Setting λ to 400,000, implies that financial cycles under consideration are four times longer than conventional business cycles. Drehmann and others (2011) argue that this is appropriate as crises occur on average only every 20–25 years in their sample.

31

Other practical measurement problems relate to the choice of the starting point of the HP filter estimation, especially if the data history is limited. For two-sided HP filters, specification challenges are amplified by potential end-point bias.

32

Also, during periods of slowing real activity, a rapid expansion of credit will be flagged by the measure as periods of vulnerability due to changes in the business cycle (rather than the financial cycle).

33

The credit-to-GDP measure has been criticized as an indicator for the calibration of a CCB because it increases even in absence of positive credit growth if real growth declines, thus, suggesting a pro-cyclical [increase] in the CCB (Drehmann and Tsatsaronis, 2014). We find that a positive credit gap is positively correlated with growth (see third row, left chart in Figure 12), confirming its counter-cyclical properties as useful signal for the activation of a CCB.

34

This could be further supported by a shift to value-based taxation of residential property (which would also reduce the strong preference for owner-occupied housing) and by a reduction in regulatory and administrative burdens for housing construction in order to increase responsiveness of housing construction and forestall potential excesses in the housing market (Harvan and others, 2015).

35

In the case of Norway and Sweden, the national competent authorities announced the activation of the CCB (i.e., raising the requirement from 0 to 1.0 percent) at least half a year prior to implementation.

Slovak Republic: Selected Issues
Author: International Monetary Fund. European Dept.