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IMFSurvey Magazine: Policy

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Amid Improving Fiscal Outlook, IMF Advises Caution

Reconstruction project in Kitakami, Japan—where fiscal deficit is projected to decline by just 0.1 percent of GDP in 2012 (photo: Everett Brown/EPA)

FISCAL MONITOR

Amid Improving Fiscal Outlook, IMF Advises Caution

IMF Survey online

April 17, 2012

  • Many countries remain vulnerable to demand slowdown
  • Confidence boosted as countries set up fiscal rules
  • Sizeable fiscal adjustment still needed over medium term

Fiscal tightening has become the order of the day in many economies, but cutting deficits by too much and too quickly could pose risks as well.

The latest edition of the IMF’s Fiscal Monitor says that continued efforts to put public finances on a sounder footing over the medium term are key to sustainable economic growth.

Yet in countries with some room to maneuver fiscally, the pace of planned cuts may need to be adjusted to avoid undue pressure on economic growth and employment.

In 2012, overall deficits in the advanced economies are projected to decline on average by close to 1 percentage point of GDP, and slightly faster in 2013. In the United States, the overall deficit in 2012 is expected to decline by 1.5 percent of GDP, with an additional reduction of 1.8 percent of GDP in the pipeline for 2013. Japan’s deficit will decline by only 0.1 percent of GDP in 2012 as it continues to meet the costs associated with earthquake and tsunami reconstruction.

“It is critical that the adjustment proceeds at the right speed—not too fast, not too slow, and with a medium-term plan,” said Carlo Cottarelli, head of the IMF’s Fiscal Affairs Department.

Cautious approach

The IMF says continued adjustment in advanced economy deficits is necessary if countries hope to regain the freedom to respond to future downturns. However, countries with strong fiscal positions and market credibility could consider slowing the pace of adjustment this year to reduce downside risks, while maintaining their medium-term adjustment commitments. The IMF cautions that if economic growth turns out to be slower than expected in the coming year, countries with adequate financing should allow their deficits to rise rather than tightening further.

In contrast, in emerging economies, the IMF sees fiscal adjustment slowing considerably this year. For many of these countries, the slowing is appropriate given somewhat weakening growth and their relatively favorable fiscal positions vis--vis the advanced economies.

For low-income countries, progress on improving the fiscal situation slowed in 2011, partly under the weight of increased subsidies in response to the food and fuel price rises earlier in the year. In 2012, deficits are projected to widen in most countries, even though growth is projected to hold up fairly well.

The IMF Fiscal Monitor is published twice a year to track public spending and government debt and deficits around the world.

Striking a balance

The IMF sees the challenge in many advanced economies as one of ensuring continued progress toward sound public finances while avoiding an excessive fiscal drag on activity.

What is “fiscal space?”

Fiscal space refers to the degree to which countries have room for fiscal maneuvering—for example, lowering taxes or increasing spending when gloomy economic conditions may warrant.

Fiscal space is closely related to the concept of fiscal sustainability, which itself depends on the level of public debt and its cost, the size of the budget deficit, and the growth rate of the economy. The higher the debt, the interest rate, and the deficit, and the lower the growth rate, the more constrained fiscal space will be.

In the current recessionary context, the negative impact of deficit reduction measures on economic activity is large. As long as they have the fiscal space, governments should strive for a gradual but steady pace of adjustment, instead of trying to do too much all at once, the IMF said.

Striking the right balance will be determined by the overall economic outlook. The implications of fiscal tightening in the face of an economic downturn could be particularly severe and result in unwanted outcomes, such as higher rather than lower interest rates and to a worsening rather than an improvement in debt-to-GDP ratios.

Into the future

Most advanced and several emerging economies will need to undertake substantial adjustment over the coming decades to reduce the very high debt burden that built up during the crisis. In spite of recent adjustment efforts, public debt in advanced economies remains, on average, higher than GDP—a level not observed since World War II—and sizeable primary budget surpluses will have to be built and maintained for many years to bring debt down to a more sustainable level.

Fiscal consolidation will face additional challenges down the road.

• Debt servicing costs will likely rise as financial markets recover and central banks unwind their support.

• It will also be necessary to contain the increase in pension and healthcare spending, as demographic pressures in many countries will see more and more retirees in the coming years and health care costs continue to rise.

Fiscal rules

In recent years, countries have renewed efforts to strengthen fiscal frameworks, many of them through fiscal rules like balanced-budget laws, which can serve to strengthen the credibility of policymakers and prevent runaway spending.

Overall, the IMF notes the average number of fiscal rules has increased in both advanced and emerging economies alike. Some “next-generation” fiscal rules try to be more flexible in allowing response to economic cycles, while at the same time ensuring that deviations are only temporary and quickly corrected for. More flexible fiscal rules give fiscal policy some needed space but are also more complex, raising new enforcement and monitoring challenges.<