Abstract
The rise of debt in the past ten years and the recent downgrades call for a strengthening of the fiscal anchor over the medium-to-long term. In many countries with a fiscal rule, an anchor expressed in terms of a stock variable (debt, net debt, or assets) guides fiscal policy over the medium-to-long run, while targets on budget aggregates, like the structural balance or expenditures, guide fiscal policy in the short term. This paper discusses the conceptual framework and international experience with anchoring fiscal policy (particularly via debt ceilings) and describe a way to anchor Chile’s fiscal framework and maintain buffers.
Anchoring Chile’s Fiscal Framework1
The rise of debt in the past ten years and the recent downgrades call for a strengthening of the fiscal anchor over the medium-to-long term. In many countries with a fiscal rule, an anchor expressed in terms of a stock variable (debt, net debt, or assets) guides fiscal policy over the medium-to-long run, while targets on budget aggregates, like the structural balance or expenditures, guide fiscal policy in the short term. This paper discusses the conceptual framework and international experience with anchoring fiscal policy (particularly via debt ceilings) and describe a way to anchor Chile’s fiscal framework and maintain buffers.
A. Introduction
1. Since 2001 Chile’s fiscal framework has been guided by the structural balance rule, but over time the function of the rule as a fiscal anchor has weakened. Chile’s fiscal rule establishes a target for the structural balance of the central government. The target is set within the first 90 days of each new presidential mandate but can be changed with the budget law.2 The parametrization and the calculation of the structural balance is especially complex so that it is difficult to replicate the calculation and assess ex-post whether the target has been met.
2. Chile’s gross public debt to GDP ratio rose 20 percentage points over the past ten years. Undoubtedly, Chile suffered a 3 percent of GDP loss in copper revenues since 2011, amidst declining copper prices. However, the structural balance target under Chile’s fiscal rule was lowered from a balance in 2010 to a 1.8 percent of GDP deficit in the 2011 budget and the target has remained in negative territory since then. At the same time, the overall balance worsened from a surplus in 2011 to a deficit. In addition, the ongoing payout of pension benefits under the discontinued state pension system (in the form of repayment to “the recognition bond”) and the accumulation of government assets contributed substantially to the increase in gross debt over the last ten years. As a result, the debt-to-GDP ratio reached 23.6 percent of GDP in 2017 and is expected to reach about 27 percent in the medium term—under staff’s baseline projections—before it starts to decline.
3. Currently, Chile’s fiscal framework lacks a clear and well-specified medium-term anchor on debt or on the government balance sheet. It is certainly appropriate that a fiscal rule allows fiscal policy to act as a shock absorber in the face of a significant commodity revenue decline, as the one experience by Chile in recent years. However, the current rule does not offer guidance as to the direction of gross and net debt, i.e. whether and how fast debt will return to previous levels to rebuild buffers, whether it should remain constant, or whether it may be allowed to increase in the face of additional shocks. When the Corbo Commission examined Chile’s fiscal rule in 2011 (Larraín and Valente, 2017).
4. The sustained deterioration in the sovereign balance sheet was one of the motivations for the downgrade of Chile’s credit rating. Fitch indicated that “The downgrade of Chile’s IDRs reflects the prolonged period of economic weakness and lower copper prices, which are contributing to a sustained deterioration in the sovereign balance sheet.” Moody’s indicated that “the strength of the government’s balance sheet is no longer sufficiently robust,” while S&P indicated that “The government’s debt burden, although still low compared with most sovereigns, has consistently increased in recent years”.
Central Government Gross Debt
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF WEO 2017.Central Government Gross Debt
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF WEO 2017.Central Government Gross Debt
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF WEO 2017.
General Government Balance, Structural Targets, and Copper Revenue
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF WEO 2017.General Government Balance, Structural Targets, and Copper Revenue
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF WEO 2017.General Government Balance, Structural Targets, and Copper Revenue
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF WEO 2017.5. In this paper we discuss the conceptual framework and international experience with anchoring fiscal policy, review how to design a fiscal anchor, describe the concepts of debt ceilings, debt anchor, and buffers, and, finally, we offer tools to assess debt buffers. In particular, we use the IMF fiscal rule database to illustrate the international experience with fiscal rules in general, and debt rules in particular, and we use IMF 2018a to define a debt ceiling, a debt anchor, and a cash buffer for Chile.
B. Conceptual Framework and International Experience with Fiscal Rules and Anchors
6. A key objective of fiscal rules is to ensure the sustainability of fiscal policy. By putting a cap on deficits, expenditure, or debt, fiscal rules help building buffers to cope with shocks and preventing excessive deficits (and the consequent debt buildup), which could otherwise be observed under unconstrained policy discretion. Hence, well-designed fiscal rules limit the risk that restoring fiscal sustainability would eventually require measures that threaten macroeconomic stability, such as abrupt and large fiscal adjustments, debt default, or inflation. Fiscal sustainability is indeed an implicit objective in Chile’s fiscal framework and that of other countries.3
7. Fiscal rules can also have complementary objectives. Fiscal rules should support (or at least not impede) the capacity of fiscal policy to foster macro-economic stability and long-term growth. For this reason, and in support of their main objectives, fiscal rules may be designed to facilitate economic stabilization, contain the size of the government, support investment (and other specific type of spending), and—for commodity exporters—improve intergenerational equity.
8. To preserve fiscal sustainability, well-functioning fiscal rules and frameworks should specify an explicit anchor in terms of the stock of either government assets or liabilities (or both, i.e. on net debt). For most countries, the natural choice is an anchor expressed in terms of debt. This is because the level and trajectory of debt are used to assess solvency, which is a necessary (but not sufficient) condition for fiscal sustainability. For commodity exporters, where the objective of fiscal frameworks and rules may also include coping with large revenue (and macroeconomic) volatility and with ensuring intergenerational equity, targets in terms of assets or in terms of net wealth are also important.
9. Anchors should guide fiscal policy over the medium term. Because the dynamics of assets and liabilities depend on factors outside of the direct control of the fiscal authority (GDP growth, interest rates, exchange rate, and valuation changes), anchors should mainly guide fiscal policy over the medium term and not necessarily on a high-frequency basis. Complementary dynamic adjustment rules can help guide fiscal policy over the short term, in order to ensure convergence to the anchor over the medium term. This will help avoid placing unnecessary constraints on fiscal policy, especially during downturns, limiting the output stabilization objective of fiscal policy.
10. Operational rules expressed in terms of limits on budget aggregates should instead provide short-term guidance for the formulation and execution of the budget. These operational rule(s) should set limit(s) on budget aggregates that are under the direct control of policymakers, and that have a close and predictable link to the anchor. These limits should not be considered targets; rather, they should only mark a perimeter within which fiscal aggregates can be set on the basis of policy discretion. These limits should be calibrated to ensure compliance with the anchors over the medium term.
11. In practice, debt-based rules have been amongst the most common types of fiscal rules since the early 90s’. As of 2015, 76 out of 92 countries with a fiscal rule had adopted an explicit cap on debt or a debt target to guide their fiscal framework. Ceilings on public debt or debt targets are present in about 80 percent of rules in Advanced and Emerging Market Economies, and in over 96 percent of rules in Low-Income Countries. Although less frequent, they are also present among the few commodity exporters that have a fiscal rule (IMF 2017 and Lledo and others 2017.) In most countries (including Emerging Market economies) debt rules have always been complemented by other rules defining operational targets for either spending or the budget balance (see next section).
Number of Countries with Debt Rule
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Number of Countries with Debt Rule
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Number of Countries with Debt Rule
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.
Rules in 2015, All Countries
(In percent of countries with a rule)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Note: Number of countries with a rule within parenthesis.Rules in 2015, All Countries
(In percent of countries with a rule)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Note: Number of countries with a rule within parenthesis.Rules in 2015, All Countries
(In percent of countries with a rule)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Note: Number of countries with a rule within parenthesis.
Rules in 2015, Commodity Exporters
(In percent of countries with a rule)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules DatabaseNote: Within parenthesis, number of commodity exporters with a rule.Rules in 2015, Commodity Exporters
(In percent of countries with a rule)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules DatabaseNote: Within parenthesis, number of commodity exporters with a rule.Rules in 2015, Commodity Exporters
(In percent of countries with a rule)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules DatabaseNote: Within parenthesis, number of commodity exporters with a rule.
Distribution of Public Debt Ceilings
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules DatabaseDistribution of Public Debt Ceilings
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules DatabaseDistribution of Public Debt Ceilings
(In percent of GDP)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database
Number of Countries by Combination of Rules
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Number of Countries by Combination of Rules
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Number of Countries by Combination of Rules
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.
Number of Emerging Market Economies by Combination of Rules
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Number of Emerging Market Economies by Combination of Rules
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.Number of Emerging Market Economies by Combination of Rules
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Source: IMF, Fiscal Rules Database.12. In 72 out of 76 countries with a debt rule, the debt anchor is specified in terms of an explicit numerical cap or target. Caps and targets are predominantly concentrated between 60 and 70 percent of GDP (these levels are the common targets among supranational rules). Only four countries do not have an explicit numerical target: in Australia, the rule aims at improving net financial worth; in New Zealand, at keeping debt at prudent level; in Luxemburg, at keeping debt substantially below the limits foreseen in the Stability and Growth Pact; and in the United Kingdom, at putting the debt-to-GDP ratio on a downward trend. Only in Namibia the target is set in terms of an interval (between 25 and 30 percent of GDP).
13. To address intergenerational equity concerns and/or have additional cash buffers, some commodity exporters implicitly use financial wealth to anchor fiscal policy. When debt is not used as an explicit anchor, the fiscal framework and the operational rule is generally designed with the objective of building or preserving a certain amount of financial wealth. For example, East Timor’s fiscal rule is implicitly anchored on the concept of net wealth, as it provisions that transfers from the national wealth fund (the Petroleum Fund) to the budget cannot exceed what is needed to maintain the expected value of the nation’s net wealth, which includes both net financial wealth and the expected value of mineral wealth in the ground. Norway’s fiscal rule is not explicitly anchored on debt, assets, or net financial wealth; however, by design, it guarantees that all resource revenues be saved for future generations as only the financial return on assets (up to a cap) can be transferred to the budget.
14. Virtually everywhere, the debt rule constrains gross debt and covers at least the general government sector. Out of 76 countries with a debt rule, assets are only considered in the rules of Australia (which targets net worth), New Zealand (via an additional target of maintaining a total net worth buffer), the United Kingdom, and Uruguay. Until 2006, Canada used to have a balanced budget rule explicitly aimed at eliminating net debt by 2021. Also, in only 1/3 of countries with a debt rule, such rule covers the central government. In the remainder of countries, it covers the general government or the public sector.
Institutional Coverage
(2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Institutional Coverage
(2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Institutional Coverage
(2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Economic Coverage
(2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Economic Coverage
(2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Economic Coverage
(2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
C. Debt Anchor Design
15. Incorporating a debt (or net wealth) anchor into a fiscal rule requires decisions about the appropriate operational target, the economic and institutional coverage of the anchor, and provisions that offer further short-term guidance. The choice of the appropriate operational limit is complex and involves considerations about the economic stabilization function, simplicity, and flexibility of the entire set of rules. Because this is by itself a vast topic, we only summarize here some main lessons (see IMF 2009). However, practical considerations about designing, monitoring, and enforcing the same rule at different institutional levels may warrant limiting the coverage of the rule to the central or the general government only. Finally, because deviations to the medium-term anchor may occur even if the operational target is met (for example, if exchange rate depreciation increases the debt-to-GDP ratio), additional provisions can be designed to provide further short-term guidance as debt (or net wealth) become un-anchored.
Operational Targets
16. Budget rule, often combined with expenditure rules, are the most common operational complement to debt rules. Out of 76 countries with a debt rule in 2015, 30 countries complement such a rule with a budget rule, 3 with an expenditure rule, and 35 with both a budget and expenditure rule. Nominal budget balance rules can be very effective in preserving debt sustainability, by constraining a fiscal aggregate that primarily influences debt dynamics (IMF 2018b). To prevent that a budget balance rule limits the ability of fiscal policy to foster macroeconomic stabilization, the rule corrects the balance for the cycle in 54 out of all the 78 countries with a budget rule (and in 15 and 34 countries, respectively, out of 30 and 35 countries mentioned above). Expenditure rules set limits on total, primary, or current spending, and the limits apply to nominal or real expenditure. They are typically set in absolute terms (levels) or growth rates and occasionally in percent of GDP, with a time horizon that typically ranges from three to five years (Lledó and others 2017). Expenditure rules can support macroeconomic stabilization, provided that the limits are defined in percent of potential output or growth rates. This is because, spending growth is constrained during economic booms (when revenues are high and limits to the deficit are easier to comply with) but it is preserved when output contracts (when otherwise sluggish revenue would force spending cuts to meet the deficit target).
Combination of Rules, by Type of Country (2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Combination of Rules, by Type of Country (2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Combination of Rules, by Type of Country (2015)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Economic Coverage
17. In principle, fiscal anchors should encompass both government’s liabilities and assets, and, in theory, for commodity exporters, resource wealth. Because assets can be sold, if necessary, to enable the government to meet financing needs, a net debt ceiling offers a more comprehensive coverage of balance sheet items directly connected to solvency and liquidity concerns. For commodity exporters, because resource wealth—that is, the present value of future resource revenues—can be used as a collateral (for borrowing or for financing investment to raise potential GDP), net wealth offers an even more appropriate measure of solvency. Also, it allows addressing concerns about intergenerational fairness.
18. However, for practical purposes, net debt and wealth do not often constitute an appropriate fiscal anchor. Because it is difficult to define which government assets are truly liquid, especially under stress (IMF 2016), net debt can be complicated to define and communicate, may be less transparent, and would be harder to compare across countries. Similarly, evaluating the value of resource wealth is difficult and highly uncertain, because long-term commodity prices (which are necessary to project future resource revenue) are difficult to estimate and it is hard to separate temporary from permanent price changes. Also, it is difficult to assess the actual amount of exploitable reserves and of production, as the latter can depend on conjunctural factors (including the price of the commodity).
19. In any case, not all assets should be included in the measures of “net debt” or “net wealth”. Assets should only be included if:
they are under the government’s direct control (assets of sub-national governments and public corporations may be beyond central government control);
they are liquid (for example, accounts receivable should not be included since they may not be easily sold);
it is possible to value them accurately and fairly, to ensure that the measure of net debt accurately reflects fiscal sustainability risks;
it is possible to evaluate them timely, since measures of net debt will be used in debt rules that are monitored on an annual basis.
By these principles, the fiscal anchor should hardly include resource wealth, nor certain types of financial assets. Also, only countries with comprehensive and precise public finance statistics should consider moving their fiscal anchor from a gross to a net debt rule. Lacking the conditions described above, “net debt” should be used as a complementary fiscal indicator (to assess fiscal sustainability), rather than a substitute for the gross debt rule.
20. In the case of Chile, not all official central government assets should be accounted towards a possible net debt anchor. For example, assets of the Stabilization Fund should be included, as they meet all the criteria above. On the contrary, assets of the Pension Reservation Fund are legally earmarked to cover the solidarity pillar of the pension system, and can be transferred to the budget only up to a limit;4 that is, these assets are not freely and fully disposable. A similar exclusion applies to the assets of other specific purpose funds (such as the Education Fund, the Regional Support Fund, and the High Cost Treatment and Diagnosis Fund).
Institutional Coverage
21. Fiscal rule should cover all entities that carry significant risks to the budget. A broad coverage is important to correctly assess exposure to vulnerabilities that arise beyond the central government and could have a significant impact on public finances. Specifically:
Non-financial public enterprises that play key fiscal policy functions (or that, from an economic point of view, are part of the general government) should be covered by the rule.
Where subnational governments do or can account for a large share of spending, and are not subjected to a balanced budget rule, establishing adequate coverage of fiscal aggregates in the national rules can help bring general government finances under control. This is because three factors make fiscal discipline challenging for subnational governments: (i) limited revenue authority and dependence on central government transfers create moral hazard and accentuate common pool problems; (ii) differences in the timing and size of economic cycles across subnational governments may spur procyclical fiscal behaviors at the subnational level; and (iii) higher-spending jurisdictions (the central government) can spill spending over to lower-spending jurisdiction (for example, the municipalities) (IMF 2009).
22. In practice, broadening the institutional coverage of rules may be difficult and require establishing complementary sets of rules with the risk of complicating the rule framework. Specifically:
Rule for public companies should not infringe on their financial autonomy and operations, which may greatly complicate the rule design. Also, obtaining timely data may be problematic for rule monitoring and compliance.
In federal states or where subnational governments enjoy a high level of independence, establishing fiscal rules at the subnational levels requires a broad political agreement across all levels of government. In centralized states, where establishing broad rule may be legally easier, designing enforcement mechanism can be challenging. For example, the case of Italy demonstrated that financial sanctions of noncompliant subnational governments could exacerbate their financial difficulties and be politically difficult or even unconstitutional. In addition, administrative sanctions may also be difficult to design, due to information asymmetries. Differences in local government sizes and historical and cultural aspects also complicate the design of sanctions that may fit all subnational governments (Joumard and Kongsrud, 2003).
23. For Chile, the central government is probably the appropriate level of coverage. Chile can be classified as a unitary country (OECD/KIPF 2016). Although municipalities share responsibilities with the central government on public health, and primary and secondary education, municipalities cannot borrow, hence they do not pose risks to central government debt. Similarly, all of Chile’s 26 public non-financial corporations are commercial in nature. Although their consolidated deficit amounted to 0.7 percent of GDP in 2017, all of them have a net asset position, and are not expected to pose risk to the government balance sheet.
Intermediate Arrangement and Triggers
24. Operational rules on budget aggregates can be complemented with provisions linked to the deviation of debt (or net wealth) from the anchor, to provide further short-term guidance to fiscal policy. In a few countries (such as Armenia, the Slovak Republic, Poland) the debt rule specifies actions that are triggered when debt gets closer to the limit imposed by the rule. Specifically:
In Armenia, where public debt may not exceed 60 percent of GDP in any given year, if the ratio of public debt over the previous year’s GDP exceeds 50 percent, the deficit in the following year should be lower than 3 percent of GDP (where GDP is calculated as the average of the previous three years).
In the Slovak Republic, where the debt rule establishes a 60 percent of GDP cap on debt, when debt exceeds 50 percent of GDP the Minister of Finance is obliged to report to parliament and suggest measures to reverse the debt growth. At 53 percent of GDP, the cabinet has to pass a package of measures to trim the debt. At 55 percent, expenditures are cut automatically by 3 percent and next year’s budgetary expenditures (with few exceptions) are frozen. At 57 percent of GDP, the cabinet has to submit a balanced budget, and, at 60 percent of GDP, the cabinet faces a confidence vote in parliament. The law also includes numerically defined escape clauses for a major recession, banking system bailout, natural disaster, and international guarantee schemes.
In Poland, the Constitution establishes a debt limit of 60 percent of GDP. In addition, the Public Finance Act establishes triggers and corrective actions if public debt crosses certain thresholds. If public debt is between 43 and 48 percent of GDP, the draft budget cannot propose a higher deficit-to-revenue ratio than in the current year. If the debt is between 48 and 53 percent of GDP, the draft central budget must not increase the ratio of central government debt to GDP in the following year. If debt exceeds 53 percent of GDP, the fiscal balance should be in balance or surplus.
25. In addition, an adjustment path can be specified in case debt exceeds the rule-based cap. For example, the Stability and Growth Pact establishes Medium-Term Budgetary Objectives (MTOs) for those countries where debt exceeds the 60 percent of GDP limit. The MTOs are set to allow debt to converge to the limit in 20 years, and annual budgets are expected to be formulated to make the overall deficit converge to the MTO within three years. In 2016, Pakistan adopted a Fiscal Responsibility Law that specified a 15-year debt reduction path to 50 percent of GDP.
D. How to Calibrate the Numerical Anchor(s)
26. For a resource rich country such as Chile the fiscal anchor could combine a debt anchor and a floor on liquid financial assets. Copper prices (and, consequently, copper revenue) are intrinsically unpredictable, not just over the short term but mostly over the long run. Differently from a country where the major uncertainty is about the state of the economic cycle, in Chile the fiscal anchor(s) should be set taking into account that the structural (or long-run) copper prices could change. A debt anchor would allow Chile to keep debt safe when assets and resource revenues are low. At the same time, a floor on assets would allow Chile to maintain a safety buffers to smooth the budgetary impact of large declines in copper prices over time, which tend to coincide with periods when the cost of financing increases. These anchors could be complemented with a dynamic rule on the structural balance, to help rebuild buffers when assets are used or return debt below the anchor after adverse economic conditions justified running large overall deficits.
Framework for Setting the Debt Anchor
27. A debt anchor should be set below a debt limit, so as to leave a sufficient and prudent “safety buffer” that ensures that debt remains sustainable even if bad shocks occur (IMF 2018a). The principle idea is that fiscal sustainability is ensured if debt remains below a certain limit even under adverse shocks. The limit can be the level of debt above which the drag on growth rises, or the risk of debt distress increases substantially, or the risk premium escalates. Targeting a level of debt close to the limit would not be prudent. First, there would be little space to respond to shocks with expansionary fiscal policy. Second, the intrinsic randomness of the debt dynamic would risk pushing debt above the limit. The fiscal anchor should be set sufficiently below the limit so that, for a given fiscal response to shocks and given the intrinsic randomness of the debt dynamic, debt remains below the limit with a high probability.
28. Past cases of large increases in public debt provide a justification for a prudent approach to setting a fiscal anchor. Since 1980, there have been many cases of countries where debt increased from below 25 percent of GDP to over 50 percent of GDP within five years (Table 1). In about half of the cases, the increase was associated with a large depreciation of the currency. In other cases, it was mostly associated to the un-expected realization of contingent liabilities (for example, in Iceland and Ireland), and a combination of support to the financial sector and deficits (Slovenia).
List of countries where, since 1980, debt-to-GDP increased from below 25 to over 50 percent of GDP, and the cumulative deficit was above 15 percent of GDP, over a 5-year period.
| Country | Episode | Starting level of debt | Increase in Debt | Change due to Nominal GPD Change | Sum deficits (not discounted by GDP growth) | Exchange rate Change (+ is depreciation) |
|---|---|---|---|---|---|---|
| Argentina | 1980–1985 | 12.6 | 47.9 | -12.5 | 33.3 | 327,339.2 |
| Bhutan | 1986–1991 | 15.2 | 43.5 | -8.7 | 23.4 | 80.3 |
| Burundi | 1981–1986 | 22.7 | 32.0 | -8.3 | 45.0 | 26.9 |
| Ecuador | 1980–1985 | 24.0 | 29.8 | -2.5 | 15.6 | 0.0 |
| Gabon | 1983–1988 | 23.9 | 53.0 | 3.3 | 31.8 | -21.8 |
| Gabon | 2011–2016 | 17.3 | 46.9 | -0.5 | -9.7 | 25.3 |
| Iran, I.R. of | 1984–1989 | 9.2 | 47.1 | -4.2 | 31.4 | -21.9 |
| Ireland | 2006–2011 | 24.8 | 79.3 | 1.9 | 49.8 | -9.8 |
| Lesotho | 1980–1985 | 24.8 | 47.5 | -11.5 | 16.6 | 181.6 |
| Qatar | 1991–1996 | 17.9 | 32.7 | -4.3 | 26.5 | 0.0 |
| Slovenia | 2007–2012 | 23.1 | 29.8 | -0.6 | 16.2 | 6.6 |
| Thailand | 1996–2001 | 10.7 | 46.4 | -14 | 16.0 | 75.3 |
| Trinidad & Tobago | 1983–1988 | 11.0 | 39.0 | 0.9 | 38.2 | 60.2 |
| Ukraine | 1994–1999 | 24.9 | 36.1 | -22.6 | 24.6 | 1161.1 |
| Zimbabwe | 2002–2007 | 20.1 | 45.0 | 7.6 | 17.4 | 0.0 |
Setting the Debt Limit
29. The level of the debt limit should be chosen on the basis of a range of considerations, related to the risks that debt brings to the economy. Specifically, the limit could be related to the risk of debt distress, the risk of solvency, the negative impact that debt could have on growth, or the influence of debt on cost of financing and sovereign credit ratings.
30. A strand of the empirical literature on debt uses the signal approach to derive “benchmarks” for debt distress indicators. For example, the IMF MAC DSA framework (Kaminsky and others (1998) to find the level of general government debt-to-GDP ratio that best predicts the occurrence of a debt distress event.5 In this approach, “best” is defined as the threshold that minimizes the sum of the missed crises and false alarms. A noise-to-signal ratio below 100 suggests that the indicator is an efficient predictor of debt distress. The approach finds an indicative benchmark of 60 percent of GDP for emerging market economies.
31. A large literature on debt limits is based instead on assessing solvency either via a partial equilibrium framework, or through model-based approaches of the way fiscal policy endogenously reacts to the debt dynamic. The September 2003 WEO used both approaches to compute a debt limit for emerging market economies. Using the first method, the WEO computed the level of debt that the average emerging market economy would be able to sustain, compatibly with the historical averages for primary balances, interest rates, and growth rates. It concluded that, based on past fiscal performance, the sustainable public debt level for a typical emerging market economy may only be about 25 percent of GDP (IMF 2003). Introducing estimates of a fiscal reaction function, they concluded that the sustainable debt for a typical emerging market economy is as high as 50 percent of GDP. Ostry and others (2010) proposed a unifying empirical framework for the partial equilibrium-based approach and the model-based approach and concluded that sustainable debt limits for advanced economies ranged between 50 and 63 percent of GDP.
32. There is evidence that debt exerts negative effect on growth when it surpasses certain thresholds. At low levels, debt does not negatively affect growth. However, using a sample of 40 advanced and emerging market economies, Chudik and others (2015) show that in an average country growth is lower when debt surpasses a threshold between 30 and 60 percent of GDP. Based on a study of 93 countries, Pattillo, Poirson, and Ricci (2011) find that this threshold is 35 percent of GDP for external debt. They also show that the marginal (as opposed to average) effect of external debt on growth turns negative when debt reaches 25 percent of GDP, a result confirmed also by Cordella, Ricci, and Ruiz-Arranz (2010) when looking at the net present value of public debt.
33. An increase in debt has also negative implications for sovereign credit ratings and spreads. This literature does not offer a nonlinear analysis necessary to identify limits or thresholds, but rather assesses the effect associated with a change in debt. Hadzi-Vaskov and Ricci, 2016), an effect that may be somewhat mitigated (down to 80–90 basis points) for emerging markets with strong institutions, such as Chile (see other Selected Issues Paper).
Computing the Debt Buffer and Setting the Anchor
34. Once the debt limit is set, the debt anchor and buffer are estimated through stochastic simulations. A simple approach consists of estimating the distribution and covariance of fiscal and macroeconomic shocks using past data for Chile (IMF, 2018a). For the macroeconomic shocks we consider those to growth, the implicit interest rate on debt, the exchange rate, and the deviation of copper prices from their long-run average. For all, we use annual data going back to 1990. Using a Cholesky decomposition of the variance and covariance matrix of these shocks it is possible to construct Monte-Carlo simulations of the fundamental macroeconomic variables governing the debt dynamic around their long-run average (or baseline projections). A fiscal reaction function (that is, the way fiscal policy would react to the output gap and the level of debt) is estimated using a panel of Emerging Market Economies. Combining the Monte Carlo simulations of the shocks and the estimate of the fiscal reaction function it is possible to simulate future debt trajectories starting from different levels of debt.
35. We estimate that the appropriate debt buffer is between 10 and 15 percent of GDP, suggesting that the debt anchor should be 10–15 percent of GDP below the desirable debt limit. For each starting level of debt, we obtain the probability distribution of debt six years into the future. We calibrate the debt anchor as the initial level of debt so that public debt remains below the limit with a given probability (95 percent) over a six-year period. In most cases, the difference between the 95th percentile of the debt distribution and the median ranges between 10 and 15 percent of GDP.
Chile: Example of Debt Limit and Safe Debt Anchor
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Chile: Example of Debt Limit and Safe Debt Anchor
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Chile: Example of Debt Limit and Safe Debt Anchor
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Computing the Liquid Asset Buffer
36. To estimate a suitable floor on liquid financial assets, we adopt a risk-based approach, instead of a framework based on intergenerational equity. Copper production in Chile is at a mature stage, and proven reserves (U.S. Geological Survey, 2018) are estimated to allow current production levels for the next 90 years. Hence, consideration about intergenerational equity, which are traditionally used to determine a fiscal anchor in countries where production is at an early stage or where the production horizon is limited (see a review in IMF 2012), are less relevant for Chile. However, more important is the need to build a liquid buffer to protect fiscal policy from large shifts in long-term prices. Additional considerations would of course relate to the cost of holding assets, which are beyond the scope of this paper.
37. Under a risk-based approach, assets should allow to finance a gradual adjustment to a permanent loss in commodity revenues (see IMF 2012 and 2015). Specifically, the anchor on assets could be specified as a multiple of the copper revenues that fund the budget. The multiple should be set so that, with a high probability, financial assets are enough to absorb a permanent decline in copper revenue within a certain amount of years and with a cap on the implied adjustment to spending (say, spending should not decline by more than 0.25 percent of GDP per year in structural terms). During copper price booms, when the buffer needs to be replenished, only a fraction of headline (structural) copper revenues could be spent. During busts, the assets can be drawn down and spending can be gradually adjusted.
38. Hence, the desirable size of the buffer would increase with:
Higher level of copper revenue in the budget: this is the maximum loss in case copper prices were to drop.
Lower tolerance for the size or the duration of adjustment (that is, the smaller the maximum annual adjustment, or the number of years of painful adjustment the authorities are willing to tolerate): a permanent loss of revenues would eventually have to be absorbed by a contraction of spending.
Higher volatility of structural prices: this determines the probability and extent of the possible copper revenues losses.
Stronger risk aversion (i.e. lower risk tolerance).
Once again, the cost of holding assets should also be taken into account in the policy decision about the desirable level of assets.
39. As an example, assuming no tolerance for risk, a buffer of 7 percent of GDP as liquid financial assets would allow to smooth the adjustment of a 2 percent of GDP permanent loss of copper revenues in 8 years. A permanent loss of copper revenue is an extremely rare event. However, if there is no tolerance for risk, the government would seek protection against permanent revenue losses. In this case, the size of the buffers would depend on the tolerance for the size of the annual adjustment (or, the speed of the adjustment). If the government were willing to adjust immediately, there would be no need for assets. However, depending on the size of the adjustment, this could be highly costly in terms of the impact on activity. Hence, the government would likely prefer to smooth the adjustment over time, which requires some buffers.6 The graph offers alternative calculations for the size of the necessary buffers assuming no tolerance for risk, as a function of the size of the revenue loss (in the horizontal axis) and the tolerance for the size of the annual adjustment (the colored lines). For example, with a tolerance for a maximum adjustment of 0.25 percent of GDP per year, it would take 8 years to absorb a sudden and permanent loss of 2 percent of GDP of copper revenues. During this period, the cash buffer would be used to cover the part of spending that remains to be adjusted: 1.75 percent of GDP in the first year, 1.5 percent of GDP in the second year, so on so forth. In this case, the cash buffers would have to be 7 percent of GDP.
Buffers Required to Smooth Adjustment to a Permanent Copper Revenue Losse
(No Risk Tolerance)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Sources: 2017 WEO and IMF Staff calculations.Buffers Required to Smooth Adjustment to a Permanent Copper Revenue Losse
(No Risk Tolerance)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Sources: 2017 WEO and IMF Staff calculations.Buffers Required to Smooth Adjustment to a Permanent Copper Revenue Losse
(No Risk Tolerance)
Citation: IMF Staff Country Reports 2018, 312; 10.5089/9781484383919.002.A003
Sources: 2017 WEO and IMF Staff calculations.References
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Prepared by Paolo Dudine.
The Decree establishing the target may also just set the target for the end of the presidential mandate, leaving space for each budget to define the annual targets. A new Decree may also be issued with new annual or end-of- mandate targets.
In Chile, Mensaje Nº 259–353/2005 mentions fiscal sustainability as one of the goals of the fiscal rule. In the European Union, the set of rules that constitute the Stability and Growth Pact aim at inducing member countries to pursue “sound fiscal policies”, prevent fiscal policies from heading in “potentially problematic directions”, and correct excessive budget deficits or debt. Similarly, the objective of New Zealand’s Fiscal Responsibility Act is to reduce total debt to “prudent levels”, and the U.K.’s Code for Fiscal Stability indicates that fiscal policy should be conducted to ensure that “the fiscal position is sustainable over the long term”.
The use of resources of the Pension Reservation Fund cannot exceed one third of the increase, relative to 2008, in the spending on the solidarity pillar of the pension system.
For emerging market economies, episodes of debt distress are defined as period of default (including incurrence of arrears on principal or interest payments to commercial or official creditors), restructuring and rescheduling (that is any operation which alters the original terms of the debtor-creditor contract) or IMF financing.
To the other extreme, if there is no tolerance for the adjustment, the government would need to have enough assets, such that the yields on the assets are as large as the revenue loss. This can be thought of a rationalization of the policy of saving all resource revenue and spend only the yields on the accumulated assets.
