IMFSurvey Magazine: IMF Research
GLOBAL FINANCIAL CRISIS
Crisis-Hit Countries To See Sharp Rise in Government Debt
By Carlo Cottarelli
IMF Fiscal Affairs Department
March 6, 2009
- Government debt in advanced G-20 states to see steepest rise since World War II
- Crisis response will result in sharp deterioration in fiscal balances
- IMF proposes four-pillar strategy to maintain fiscal solvency
The cost of fiscal stimulus packages to revive economies battered by the financial crisis, combined with tax revenue losses from output decline and the huge price tag for financial sector restructuring, will be very large, the IMF says in a new study.
Our estimate is that the fiscal balance in advanced and emerging countries of the Group of Twenty (G-20) is expected to deteriorate by, respectively, 6 and 3½ percent of GDP in 2008–09.
Reflecting the full impact of financial support operations—most of which are yet to be included in fiscal balances—government debt is expected to rise even faster, by over 14 percent of GDP in 2008–09 in advanced G-20 countries (see box)—the largest increase since World War II in any two-year period.
Measures essential for recovery
Governments in many countries are providing substantial support to clean up the financial sector and to reignite economic growth through fiscal stimulus. These efforts are essential to recovery.
What is the G-20?
The G-20 brings together important industrial and emerging market countries from around the world. It comprises the finance ministers and central bank governors of 19 countries: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, and the United States, plus the European Union, represented by the rotating Council presidency and the European Central Bank. The IMF and World Bank are also represented.
The effect that fiscal stimulus is likely to have on economic growth is discussed in two IMF staff papers: the first, “The Case for Global Fiscal Stimulus,” focuses on the effect of discretionary fiscal stimulus across the world, while the second, “The Size of the Fiscal Expansion: An Analysis for the Largest Countries,” looks at the effect of the overall fiscal expansion (including the automatic stabilizers) on large economies. Both papers suggest that the supportive effect of fiscal policy is sizable, particularly in a context in which monetary policy can play an accommodative role.
Thus, given the depth of the crisis, avoiding or postponing action is not a viable option and would come with significant downside risks in terms of further deepening or prolonging the recession.
But confidence in fiscal solvency should be preserved
Yet there is also no escaping the fact that the rapid and large weakening of the fiscal accounts, particularly in advanced countries, will raise the question of how governments are going to repay their debt. The IMF Executive Board discussed the fiscal aspects of the crisis at a recent seminar when the IMF’s Fiscal Affairs Department presented a paper on “The State of Public Finances”.
The paper provides detailed projections of public deficit and debt trends for the G-20 countries. It finds that in advanced G-20 countries, public debt is projected to rise over the medium term, by almost 25 percent by 2014 (with respect to pre-crisis levels). Moreover, downside risks are substantial, reflecting further possible needed support to the financial sector, and additional revenue losses if the recession deepens. In addition, in countries saddled with an aging population, a demographic shock is clouding longer-term prospects.
Despite an increase in interest spreads in some countries, the reaction in debt markets to the weakened fiscal outlook has so far been relatively muted. But market reactions are often delayed and abrupt. If investors lose confidence in governments’ creditworthiness, interest rates would start rising, the financial sector would be further destabilized, and the demand impact of the fiscal stimulus would be negated.
IMF’s four-pillar strategy for fiscal solvency
To reduce the risk of declining investor confidence, the IMF argues that there is an urgent need for governments to articulate clear and credible policies to ensure fiscal solvency. The paper proposes a four-pillar strategy that was endorsed by the IMF Board:
• Fiscal stimulus packages should comprise predominantly temporary measures. With an expected prolonged decline in private sector demand, fiscal stimulus will likely have to be relatively long-lasting to be effective. However, it should not become permanent.
• Policies should be formulated within forward-looking medium-term fiscal frameworks, supported by institutional arrangements to enhance their credibility. Medium-term frameworks should ensure that fiscal adjustment takes place once economic conditions strengthen. However, to be perceived as credible, these frameworks must be transparent, realistic, and—to the extent possible—underpinned by identified policy actions. Changes in fiscal institutions may be needed in some countries to bolster these medium-term frameworks, including fiscal rules, fiscal responsibility laws, or independent fiscal councils.
• Growth potential should be enhanced by structural reforms. This recognizes the importance of growth in reducing debt ratios in past episodes of fiscal consolidation. Structural measures in the fiscal arena would include tax reforms to improve incentives to work and invest, as well as to remove tax distortions that may have contributed to excessive leverage in the private sector in the runup to the crisis.
• A clear commitment should be made to address aging-related fiscal pressures by reforming health and pension entitlement systems. Many countries had tried to pre-position their budgets in anticipation of the higher aging-related spending expected over the long run. But the crisis has reinforced the need to directly tackle entitlement reform. Reforms in this area should be implemented in a manner that does not set back efforts to stimulate the economy in the near term.
Cost of inaction
Most of these measures are not new; indeed, some are part of long-standing advice from the IMF. However, the weakened public finance outlook has dramatically raised the cost of inaction.
In their discussions, IMF Executive Directors emphasized the important role the IMF has in monitoring and reporting on the evolving fiscal implications of the crisis and the outlook for public finances. They also encouraged the IMF to continue working closely with its member countries to strengthen country strategies for dealing with the crisis-induced fiscal pressures.
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