## cr1767 ## Source details **Canonical URL:** [cr1767](https://www.imf.org/-/media/files/publications/cr/2017/cr1767.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2017/cr1767.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2017/cr1767.pdf.json) --- ### Mission, Contacts, and Contributors - FAD mission to Asuncion, Paraguay: November 8–21, 2016; team led by Luc Eyraud (FAD) with Felipe Bardella (FAD expert) and Antonio C. David (WHD). - Principal meetings: Mr. Santiago Peña (Minister of Finance); Ms. Lea Giménez (Vice-Minister). Ministry of Finance counterparts: Mr. Humberto Colman (Head of the Macro-Fiscal Unit), Mr. Oscar Llamosas (Treasury Director), Mr. Oscar Lovera (Budget Director), Ms. Stella Guillen (Director of the Debt Policy Unit). - Other stakeholders met: Central Bank of Paraguay (Mr. Miguel Mora), Ministry of Planning (Mr. José Molinas), Mr. Manuel Ferreira (Ex-Minister), Inter-American Development Bank (Mr. Eduardo Almeida), Itaipu (Mr. Miguel Gómez). - External/academic contributors: Mr. Felipe Larrain and Mr. Rodrigo Cerda (Catholic University of Chile). - IMF internal contributors: Mariusz Jarmuzek (EUR), Benjamin Carton (RES), Mercedes Garcia-Escribano and Maximilien Queyranne (FAD); research assistance from Ehab Tawfik (WHD), Kim Young, Kyungla Chae (FAD). ### Executive Summary — Key Findings and Policy Directions - Fiscal framework background: - Fiscal Responsibility Law (FRL) enacted in 2013, in force since 2015; initial implementation complex with slippages. - Current nominal balance rule perceived as excessively rigid given high revenue volatility. - Tight nominal deficit ceilings may constrain capital expenditure and development needs. - Authorities' reform: - Replace nominal balance rule with a structural balance rule (SBR) starting in 2019 to stabilize public expenditure and link it to medium-term objectives. - Consider modifications to FRL to promote public investment while preserving credibility. - Debt anchor and debt management: - Debt anchors guide expectations and cap repeated slippages; simulations suggest a debt anchor in the range of 30 to 45 percent of GDP for Paraguay. - Recommendation: produce and publish an annual medium-term debt management strategy to improve transparency and predictability. ### Setting a Public Debt Anchor — Methods and Simulations - Principles and methodology: - Two principles: (i) a country-specific maximum debt limit beyond which debt dynamics can spiral; (ii) keep debt well below this limit via a safety margin. - Three-stage computation: estimate maximum debt limit; estimate required safety margin via stochastic simulations; infer debt anchor = debt limit − safety margin. - Stochastic simulations: simulate future debt trajectories over 6 years using historical shock distributions; calibrate debt anchor so fan chart stays below debt limit with high probability. - Three approaches to estimate Paraguay’s maximum debt limit: - Approach 1: IMF DSA critical debt benchmark → benchmark of 70 percent of GDP for emerging markets. - Approach 2: Maximum-stabilizable debt = PBmax/(r−g): - Historical data: Highest primary balance (1991-2015) ≈ 3 percent of GDP; international typical PBmax ≈ 2 percent of GDP. - Numerical illustrations: - PBmax = 3 percent; r−g = 5 percent → debt limit = 60 percent of GDP (0.03/0.05*100). - PBmax = 3 percent; r−g = 4 percent → debt limit = 75 percent of GDP (0.03/0.04*100). - PBmax = 2 percent; r−g = 4 percent → debt limit = 50 percent of GDP (0.02/0.04*100). - PBmax = 3 percent; r−g = 6 percent → debt limit ≈ 50 percent of GDP (0.03/0.06*100). - Application yields debt limits ranging from 50 to 70 percent of GDP. - Approach 3: Growth-based model (Checherita-Westphal and others, 2014): - Output elasticity of public capital estimated at around 0.28. - Implied maximum public debt-to-GDP ratio: around 65 percent of GDP. - Aggregate interpretation: - The three approaches suggest maximum debt limits in the range of 50 to 70 percent of GDP. - The operational debt anchor must include a safety margin inferred from stochastic simulations. ### Debt-anchor Simulation Outcomes and Contingent Liabilities - Simulation baseline assumptions: - Debt limit assumed: 60 percent of GDP (central value of 50-70 percent interval). - Foreign-currency share of debt in parametrization: 75 percent. - Debt anchor outcomes: - Debt anchor = 40 percent of GDP when accepting a 5 percent probability of breaching the debt limit. - Debt anchor ≈ 45 percent of GDP when accepting a 10 percent probability of breaching the debt limit. - Incorporating a 10 percent of GDP contingent-liability buffer (lowering debt limit to 50 percent of GDP) and accepting a 5 percent breach probability → debt anchor = 30 percent of GDP. - Contingent liabilities evidence: - Cross-country probability of contingent-liability realization exceeding 1 percent of GDP ≈ 6 percent. - Average fiscal cost of realizations ≈ 10 percent of GDP. - Paraguay total contingent liabilities over a 10-year horizon ≈ 30 percent of GDP (Moskovits, 2015); conjectured medium-term realization ≈ 10 percent of GDP (Larraín and Cerda, 2016). - Recommended contingent-liability buffer for Paraguay ≈ 10 percent of GDP. ### Development Needs, Public Capital Gaps, and Implications for the Debt Anchor - Public capital and gaps: - Paraguay public capital stock in 2015: 44 percent of GDP. - Emerging markets average: 79 percent of GDP. - Latin America average: over 84 percent of GDP. - Efficiency gap relative to frontier: about 40 percent (Paraguay is 40 percent below the most efficient countries on the hybrid indicator). - Authorities’ infrastructure needs assessments: range 50 to 70 percent of GDP. - Ministry of Planning bottom-up estimate: 16 billion US dollars (close to 50 percent of GDP). - Observed capital-to-GDP ratio in 2014: around 240 percent of GDP. - Model-implied optimal capital-to-GDP ratios: 290 to close to 350 percent of GDP. - Aggregate capital gap estimates across methods: from 35 to over a 100 percent of GDP. - Policy implication: - Some additional public debt may be warranted to finance productive public investment given efficiency and equity considerations, but not all capital gaps should be financed by public debt; alternatives include Public-Private Partnerships and revenue mobilization. - Policy judgment may favor choosing a debt anchor in the upper part of the precautionary range to provide space for development needs. ### Debt Management Recommendations - Adopt a transparent, active, and regularly updated Debt Management Strategy (DMS): - Recommended horizon: three-to-five-year DMS. - DMS functions: identify funding targets and instruments; describe desired debt portfolio composition; highlight and manage risks; assess feasibility of servicing debt at low cost and risk. - Paraguay specifics: - Paraguay produced a stand-alone DMS in 2012 but without an explicit debt objective; the debt profile changed materially after 2013 due to large external sovereign bond issuances. - Debt department updating process with the World Bank; institutionalize regular DMS updates. - Recommendation timing for analytical work: mid-2017. ### Recommendation Highlights on Public Announcement and DMS (near-term actions) - Recommendation 2.1: Calibration of the public debt anchor — analytical work necessary to determine appropriate level (mid-2017). - Recommendation 2.2: Authorities should announce a public sector debt objective and consider incorporating it into the fiscal rule framework (end-2017). - Recommendation 2.3: Authorities should publish and regularly update a DMS (starting in the first quarter of 2017 and then updated annually). ### Structural Balance Rule (SBR) — Design, Risks, and Operational Adjustments - SBR objective and context: - Main objective: achieve a more stable path of public expenditure. - Authorities plan to implement SBR from 2019; draft law to be prepared for Congressional approval in 2018. - FAD recommended maintaining current rules while testing revisions for a couple of years; reforms should account for investment, public debt, and revenue mobilization. - Revenue volatility context: - Revenue volatility drivers: business and commodity cycles, weather affecting agriculture and electricity, external demand and exchange rate shocks, formalization process. - Observed consequence: discretionary capital spending has frequently absorbed fiscal adjustment; capital spending more volatile than current spending since 1991. - SBR conceptual forms: - Standard formula: cyclically-adjusted balance correcting nominal balance for business-cycle effects; includes policy measures automatically in structural revenues. - Authorities’ formula (Paraguay): R_S = ∝(Y_S)^γ — structural revenues evolve proportionately to trend output estimated with an HP filter; yields much stronger smoothing and a more stable expenditure path. - Policy risks of authorities’ formula: - Overestimating structural revenues and allowing excessive expenditure because historical revenue growth exceeded trend GDP (estimated γ>1). - Mis-measuring structural revenues when tax policy changes create structural breaks; cointegration estimation may not capture timely breaks. - Disincentive for revenue mobilization because new revenue measures cannot be spent immediately until ex-post re-estimation. - Proposed conservative adjustments: - Do not assume structural revenues will grow faster than trend GDP going forward. - Two operational implementations: - Method 1: Keep authorities’ formula but set unit elasticity (γ=1) and calibrate ∝ as the structural effective tax rate. - Method 2: Interpret SBR as an expenditure rule: cap expenditure growth to trend output growth (if γ=1 structural balance unchanged when expenditure grows at trend GDP). - Incorporate durable discretionary revenue measures immediately into annual expenditure cap (nominal terms) with independent fiscal council review. - Smooth binational dam (Itaipu) revenues separately and exclude them from main SBR formula; smooth separately using a linear trend or other method. ### Treatment of Binational Hydroelectric Revenues (Itaipu) - Rationale for separate treatment: - Historical structural breaks and declining ratio of binational revenue to trend GDP since early 2000s. - Expected structural break from 2023 when Itaipu’s debt is repaid and revenues could increase significantly (by up to 3 percent of GDP, according to the authorities). - If included in main formula, windfalls would not be spendable until re-estimation. - Suggested operational approach: - Split structural revenue calculation: (i) revenues linked to the business cycle estimated excluding binational revenues; (ii) binational revenues smoothed separately to allow flexibility for earmarking or phased spending. ### SBR Threshold, Calibration, and Sovereign Wealth Fund (SWF) Linkages - Debt-consistent SBR ceiling: - Debt simulations suggest public-sector structural deficit should not exceed 2-3 percent of trend GDP assuming a 30-45 percent debt target and 7-8 percent nominal trend growth. - Central government structural deficit ceiling inferred at about 2 percent of trend GDP to allow buffers for sub-central governments, state-owned enterprises, and social security. - Debt-stabilizing formula illustration: a structural deficit of 2 percent of GDP with nominal GDP growth at 7 percent would bring the debt ratio towards 30 percent of GDP (deficit*(1+g/g) = 2*1.07/0.07=30.6). - Role of a Sovereign Wealth Fund (SWF): - SWF explored for stabilization, savings (e.g., Itaipu windfalls post-2023), and development financing. - Allocation formula of the SWF must be consistent with and nested in the SBR to avoid conflicts. ### SBR Effects on Nominal Balance Volatility and Public Investment - Nominal balance volatility: - Implementing an SBR with a 2 percent threshold can lead nominal deficit to deteriorate well below 1.5 percent of GDP; counterfactuals show nominal deficits could have reached 3-4 percent of GDP under a long-standing SBR. - With standard formula a “normal” downturn could bring nominal deficit to about 3 percent of GDP; with authorities’ formula nominal deficits could be larger (over 4 percent of GDP in 2002). - Standard deviation of the nominal balance under the authorities’ formula is 40 percent higher than under the standard formula for the series in Figure 3.6. - Public investment interaction: - SBR combined with existing current expenditure rule may indirectly constrain public investment. - To close Paraguay’s public capital gap, the current expenditure growth ceiling must be tightened. - Simulations on closing the public capital gap (target public investment ratio 6 percent of GDP; baseline 4.2 percent in 2015): - Current expenditure growth = 3% (real) → implied public investment growth = 9% (real); time to reach 6% of GDP in first period = 8 years; total time to close half gap = 17 years. - Current expenditure growth = 2% (real) → implied public investment growth = 14% (real); time to reach 6% of GDP = 4 years; total time = 15 years. - Current expenditure growth = 1% (real) → implied public investment growth = 19% (real); time to reach 6% of GDP = 3 years; total time = 14 years. - Assumptions: target public capital ratio set at 60 percent of GDP (initial capital stock 43 percent of GDP in 2015 plus half of gap 17 percent); depreciation = 5 percent per year; second period current expenditure growth = 4 percent (real). ### Public Financial Management (PFM), Cash and Debt Management Implications - Borrowing in downturns: - SBR raises nominal balance volatility and borrowing needs in downturns; debt managers must access markets actively and regularly. - Legal restrictions on borrowing should be relaxed as much as possible. - Cash management and TSA: - Treasury Single Account (TSA, LAFE) established in 1999; covers central government and autonomous entities. - Debt operation resources are managed outside TSA (funding code FF20); tax revenues and current expenditures in TSA (FF10 and FF30) — no fungibility between these resources. - Golden rule (article 40 of LAFE): debt operations can only finance capital expenditure and debt repayment; creates de facto limit on nominal deficit size and potential conflict with SBR in downturns. - Short-term instruments and cash buffer: - Law of Modernization (2013) created Treasury Bills (up to 1-year) but further regulation needed. - Recommendation: create a short-term debt instrument to finance current spending during temporary revenue shortfalls; if legally constrained, use buy-backs to avoid net increase in public debt for current expenditure. - Cash buffer guidance: - General rule: cash buffers sufficient to pay all bills from 30 to 90 days. - Alternative: calibrate buffer using seasonality and worst-month gap over the last two years using daily data. - Legal and economic constraints: - Historical range of sum of capital expenditure and debt repayments (central government): between 3 and 10 percent of GDP depending on year; average 5 percent of GDP over 1991-2015. - Central Bank advances legal limits: LAFE sets maximum at 1 percent of the approved budget; Law 489/2015 establishes advances cannot exceed 10 percent of budgeted tax revenues during the fiscal year. ### Key Recommendations (Recommendations 3.1–3.7 and 4.1–4.4) - Recommendation 3.1: Projection of structural revenues — SBR formula should not assume structural revenues will grow faster than trend GDP (December 2017). - Recommendation 3.2: Incorporate effect of new revenue measures into SBR in real time (December 2017). - Recommendation 3.3: Smooth binational hydroelectric revenues separately and exclude them from main SBR formula (December 2017). - Recommendation 3.4: SBR threshold should be linked to the medium-term debt objective (December 2017). - Recommendation 3.5: Tighten the ceiling of the current expenditure rule when adopting the SBR to help close the public investment gap (December 2018). - Recommendation 3.6: Allocation formula of the future SWF should be consistent with and nested in the SBR (December 2018). - Recommendation 3.7: Put a short-term instrument for cash management in place before implementing the SBR to finance current spending during temporary shortfalls (December 2018). - Communication and reporting recommendations: - Bring forward IFP publication to the first semester (April or May); make it medium-term and forward-looking (Recommendation 4.1, December 2018). - Produce end-year ex-post report assessing execution and compliance with rules based on outturns (Recommendation 4.2, December 2018). - Quarterly execution reports should track in-year compliance and risks (Recommendation 4.3, December 2018). - Fiscal Council (FC) design: MOF and council members should draft charter and communication strategy; create dedicated website (Recommendation 4.4, mid-2017). - Institutional recommendations: - Publish and regularly update a three-to-five-year DMS to operationalize debt management and link debt projections to the medium-term fiscal framework. - Intensify public investment management (project appraisal, implementation, evaluation) to ensure investment raises potential growth. - Pursue PPPs and revenue mobilization (tax reform and revenue administration) to reduce reliance on public debt. ### Communication Strategy and Fiscal Council (FC) Role - Communication objectives and approach: - Start communication early; provide a simple message emphasizing benefits: stabilization, containment of expenditure pressures, and promotion of public investment. - Frame SBR as an expenditure ceiling: “expenditure cannot grow faster than the whole economy unless new and durable revenue measures are taken.” - Use multiple channels and audiences with consistent, document-supported messaging. - Fiscal Council functions and design issues: - FC can contribute to SBR calculation, communicate and explain the rule, and monitor ex-ante and ex-post compliance. - Key features for effectiveness: legal and operational independence, predictable funding, permanent staff, and media presence. - Paraguay’s FC status: - In process of establishment; initially by presidential decree with planned incorporation into amended FRL. - Draft decree mandates three functions (review budget proposal to Congress; review budget modifications; provide analysis on request) but no ex-post compliance monitoring; council of three members nominated by minister of finance with no permanent staff. - Conditions for effectiveness: - Mobilize external resources and public outreach; MOF should provide administrative support but FC must have own operational independence and communication plan. - Create website and secure funding and permanent staff to avoid over-reliance on MOF staff and to enhance perceived independence. ### Appendix Highlights — Rules, Models, and Methodologies - FRL key elements (Appendix 1): - Central government deficit must not exceed 1.5 percent of GDP. - Average deficit over three consecutive budget periods must not exceed 1 percent of GDP (applies to medium-term fiscal plan). - Growth rate of current primary expenditure for the public sector must not exceed 4 percent in real terms. - Headline deficit ceiling can reach up to 3 percent of GDP in cases of national emergency or negative growth (requires congressional approval and in some cases report by central bank). - Growth model and public capital elasticity (Appendix 2 and 5): - Estimated output elasticity of public capital α ≈ 0.28 (Penn-World Tables v9.0; IMF Investment and Capital Stock Dataset). - Ramsey-Koopman-Cass model yields K/Y optimal ratios: - K/Y Ramsey Model in %: 352.6 - K/Y Modified Ramsey Model in %: 289.0 - Current K/Y in 2014 in %: 247.1 (Penn World Table v9.0). - Stochastic simulation methodology (Appendix 3): - Unrestricted VAR quarterly 1994:Q1–2015:Q4 for real interest rates, real GDP growth, exchange rate; fiscal reaction function estimated for panel of 26 emerging economies with maximum primary surplus capped at 2 percent of GDP. - SBR formulation alternatives (Appendix 6): - Standard approach: structural revenue derived by cyclically adjusting actual revenues using output gap and elasticity β (commonly β=1). - Authorities’ approach: R_S = ∝(Y_S)^γ; smooths structural revenues as proportional to trend output; concerns if γ≠1 (system may be explosive) and if historical γ>1 leads to overestimation of future structural revenues. - Equivalence: with γ=1, SBR is effectively an expenditure growth rule where expenditure growth must not exceed trend GDP growth unless financed by new revenue measures. *Italic: Source: cr1767 - IMF staff report and mission materials (excerpts provided).* ### PREFACE _________________________________________________________________________________________ 5 ### PREFACE ### Mission and Timing - A mission from the Fiscal Affairs Department (FAD) of the International Monetary Fund (IMF) visited Asuncion, Paraguay during the period November 8–21, 2016 to provide technical assistance on establishing a structural balance rule and a public debt objective. - The mission was led by Luc Eyraud (FAD) and comprised Felipe Bardella (FAD expert) and Antonio C. David (WHD). ### Authorities and Domestic Counterparts Met - Met with Mr. Santiago Peña (Minister of Finance) and Ms. Lea Giménez (Vice-Minister, Ministry of Finance). - In the Ministry of Finance, met with: - Mr. Humberto Colman (Head of the Macro-Fiscal Unit) and his staff - Mr. Oscar Llamosas (Treasury Director) - Mr. Oscar Lovera (Budget Director) - Ms. Stella Guillen (Director of the Debt Policy Unit) and her staff - Met with members of the fiscal advisory council that is in the process of being formed and held three workshops presenting methodology and preliminary results. ### Other Domestic and Regional Stakeholders Met - At the Central Bank of Paraguay: Mr. Miguel Mora (Chief Economist) and staff. - At the Ministry of Planning: Mr. José Molinas (Minister of Planning) and staff. - Discussions with Mr. Manuel Ferreira (Ex-Minister of Finance). - Met with Mr. Eduardo Almeida (Inter-American Development Bank Resident Representative) and his staff. - Met with Mr. Miguel Gómez (Financial Director of Itaipu). ### External and Academic Contributors Consulted - Benefited from discussions with Mr. Felipe Larrain (Professor, Catholic University of Chile) and Mr. Rodrigo Cerda (Professor, Catholic University of Chile), who previously advised the authorities on the design of the structural balance rule. ### Acknowledgements and Internal IMF Contributors - Expresses sincere gratitude to Paraguayan officials for cooperation; special thanks to Mr. Humberto Colman and Mr. Rolando Sapriza of the Macro-Fiscal Unit for cooperation and logistical support. - Thanks to Mr. Alejandro Santos (Senior Resident Representative, WHD) and his staff at the IMF office in Asuncion for facilitating dialogue with authorities. - Contributions from IMF staff: - Mariusz Jarmuzek (EUR) — contributions on the debt anchor section - Benjamin Carton (RES) — growth model calibration - Mercedes Garcia-Escribano and Maximilien Queyranne (both FAD) — shared expenditure assessment templates - Research assistance from Ehab Tawfik (WHD), Kim Young, and Kyungla Chae (both FAD) --- ### Executive Summary — Key Findings and Policy Directions - The Fiscal Responsibility Law (FRL) was enacted in 2013 and came into force in 2015; it was a major achievement to strengthen Paraguay’s fiscal framework but its implementation has been complex with slippages in the first year of enactment. - Concerns exist that the current nominal balance rule is perceived as excessively rigid, given the high volatility of fiscal revenues; this translates into an unstable path of public expenditure and does not provide sufficient space for countercyclical policies. - Paraguay’s tight fiscal deficit ceiling may constrain capital expenditure plans, possibly to the detriment of overall economic development needs. - The authorities have decided to replace the nominal balance rule with a structural balance rule, starting in 2019, to achieve a more stable path of public expenditure and better link it to medium-term objectives. - The government is considering modifications of the Fiscal Responsibility Law to enhance public investment without damaging credibility of the rule-based framework. ### Setting a Public Debt Anchor — Findings and Recommendation Highlights - Debt anchors provide guidance, an upper limit to repeated fiscal slippages, and can be calibrated to ensure long-term fiscal sustainability. - There is an inherent trade-off: higher debt increases vulnerability to shocks and can undermine market confidence, but additional public investment to close development gaps can justify higher debt for efficiency and equity reasons. - Simulations based on these principles show that a debt anchor for Paraguay could lie in the range of 30 to 45 percent of GDP. - For credibility, the debt anchor should be supported by active debt management that links debt projections to the medium-term fiscal framework. - Recommendation: produce and publish an annual medium-term debt management strategy to improve transparency and predictability of borrowing plans. ### Implementing the Structural Balance Rule — Main Design Issues, Risks, and Adjustments - The high volatility of fiscal revenues has produced unstable and unpredictable public expenditure. - The authorities’ structural balance formula is adapted to Paraguay and differs from standard approaches; advantage: dictates a very stable path of public spending. - Identified policy risks from the authorities’ formula: - Overestimating structural revenues and allowing excessive expenditure because the formula, estimated over the past, assumes revenues grow faster than GDP on average. - Mis-measuring structural revenues when policy changes necessitate re-estimation of the formula. - Disincentive for revenue mobilization, since tax measures cannot be spent immediately under the rule until the formula is re-estimated. - Proposed adjustments to mitigate risks: - Assume structural revenues will grow at the same pace as trend GDP to make the formula more conservative; under this assumption the structural balance rule is broadly equivalent to an expenditure rule constraining spending to grow at trend GDP. - Account for new durable revenue measures in real time, with safeguards for fair estimation. - Smooth revenues from binational dams separately (while still including them in total structural revenues), given their pattern and prospect of windfalls from 2023. - Linking the structural balance rule to the debt anchor suggests that the structural deficit of the central government should not exceed 2 percent of trend GDP per year. - The structural balance rule (a ceiling on total expenditure) combined with the existing current expenditure rule will indirectly constrain public investment; to close Paraguay’s public capital gap in the medium term, the current expenditure growth ceiling will have to be tightened. - Public financial management implications: - Debt managers must be more active in accessing markets in bad times and develop strategies and instruments to borrow large amounts regularly. - Legal restrictions on borrowing should be relaxed as much as possible. - Cash managers must maintain an adequate cash buffer and manage public funds in a consolidated way, overcoming current segmentation of resources. - A short-term debt instrument should be created to finance current spending when temporary revenue shortfalls occur. ### Communication Strategy — Messaging and Institutional Support - The structural balance rule requires a clear, simple communication emphasizing benefits: stabilizing the economy via a more stable public spending path; containing expenditure pressures; and promoting public investment. - Effective framing: present the rule as an expenditure ceiling, e.g., “expenditure cannot grow faster than the whole economy unless new and durable revenue measures are taken.” - To avoid perceptions of weakening the fiscal framework, the government should reaffirm commitment to fiscal discipline; it may be useful to tighten the current expenditure growth ceiling while switching to the structural balance rule. - Reporting improvements under the structural rule: - Bring forward the fiscal planning report (IFP) to the first semester with a focus on medium-term fiscal plans. - Produce an end-year report assessing rule compliance based on outturns. - Track compliance with rules in quarterly execution reports. - Assess rules on an ex-post basis to enhance credibility and transparency. - Independent fiscal institutions can support adoption and credibility of rules; the success of the new Paraguayan fiscal council will depend on its ability to mobilize resources and reach out to the public effectively. --- *Source: cr1767 - PREFACE (IMF, November 8–21, 2016 mission), https://www.imf.org/-/media/files/publications/cr/2017/cr1767.pdf* ### 4. The authorities plan to introduce a structural balance rule (SBR) from 2019 to add ### 4. The authorities plan to introduce a structural balance rule (SBR) from 2019 to add ### SBR objective and context - Main objective of the SBR: achieve a more stable path of public expenditure. - Broader government consideration: modify the FRL to promote public investment without damaging credibility of the rule-based framework. - FAD technical assistance mission: conducted a review of the FRL in April 2016 (Tollini and others, 2016), exploring options to enhance flexibility including an SBR, provided a set of preconditions are in place. - Advice from the report: future reforms of fiscal rules should take into account medium-term objectives of fiscal policy with respect to investment, public debt, and revenue mobilization; maintain current rules in place since 2015 while assessing and testing revisions for a couple of years. - This report’s coverage: - Chapter II: computes a range of medium-term public debt objectives based on precautionary and development needs considerations. - Chapter III: reviews the SBR formula considered by the authorities and examines technical aspects, including calibration of the rule threshold, which must be linked to the public debt anchor. - Chapter IV: outlines components of a communication and fiscal reporting strategy around the new SBR. ### Role of a public debt anchor in the fiscal framework - Well-designed fiscal frameworks have two pillars: - A medium-term fiscal anchor linked to final fiscal objectives (a natural anchor is the debt-to-GDP ratio). - One (or several) operational target(s) on fiscal aggregates under direct government control and closely linked to debt dynamics (one option is the SBR). - Debt-to-GDP ratio advantages: guides expectations and nearer-term policies, creates an upper limit to repeated fiscal slippages, can be calibrated to ensure long-term fiscal sustainability. - Operational targets should be easy to monitor and communicate fiscal stance; SBR considered as such a target. ### Debt anchors in fiscal frameworks worldwide (evidence) - As of 2014, about 70 countries worldwide had a rule-based fiscal framework that included an explicit cap on gross public debt. - More than 80 percent of countries with a debt ceiling also have rules imposing constraints on the (nominal or structural) budget balance. - Among countries with both a debt ceiling and a budget balance rule, almost a third also include expenditure ceilings. - Specific debt ceilings frequently range between 40 and 70 percent of GDP; clustering around 60 to 70 percent reflects strong representation of EU and WAEMU members. - Paraguay’s current public debt level: below 25 percent of GDP (noted as relatively low compared to peers and well below commonly adopted debt ceilings). - Typical practice: debt rules are set in gross rather than net terms because net debt is harder to measure and less transparent. ### Precautionary approach to set Paraguay’s debt anchor (methodology overview) - Safe debt level definition: debt-to-GDP ratio that ensures debt dynamics remain under control even if bad shocks occur. - Two principles: 1. There is a country-specific (maximum) debt limit beyond which debt dynamics can spiral out of control. 2. The fiscal framework should keep debt well below this limit via a safety margin. - Debt anchor computation in three stages: - (i) Estimate the maximum debt limit. - (ii) Estimate the required safety margin. - (iii) Infer the debt anchor as the debt limit minus the safety margin. - Safety margin estimated through stochastic simulations: - Estimate distribution of macroeconomic and fiscal shocks based on historical realizations. - Simulate future debt trajectories under these shocks over 6 years (the medium-term horizon of the WEO projections), producing a fan chart of debt realizations. - Calibrate the debt anchor so the fan chart stays below the debt limit over a 6-year horizon with a high probability. - The debt anchor is thus the largest debt level consistent with a relatively low risk of fiscal distress in the medium-term. - Methodological details: Appendix 2 (model on growth implications) and Appendix 3 (stochastic simulation methodology) referenced. ### Three approaches used to estimate Paraguay’s maximum debt limit - Approach 1: IMF DSA critical debt benchmark for emerging markets — benchmark of 70 percent of GDP (and 85 percent for advanced economies). Debt distress defined as debt defaults, debt restructuring or rescheduling, and IMF financing. - Approach 2: Maximum-stabilizable debt derived from maximum achievable primary balance (PBmax) divided by stressed interest-growth differential (r-g): PBmax/(r-g). - Historical data for Paraguay: - Highest primary balance (1991-2015): around 3 percent of GDP. - International typical PBmax in emerging markets: around 2 percent of GDP (Escolano and others, 2014). - International and regional stressed r-g values: - Relatively high stressed r-g: in the order of 4 to 5 percent. - Observed extremes: r-g reached 6 percent in Paraguay in 2009 and is around 7 percent currently in Brazil. - Numerical illustrations: - Using PBmax = 3 percent and r-g = 5 percent yields a debt limit of 60 percent of GDP (0.03/0.05*100). - If r-g = 4 percent, debt limit = 75 percent of GDP (0.03/0.04*100). - Using PBmax = 2 percent and r-g = 4 percent yields debt limit = 50 percent of GDP (0.02/0.04*100). - If r-g = 6 percent and PBmax = 3 percent, debt limit ≈ 50 percent of GDP (0.03/0.06*100). - Application of this method to Paraguay yields debt limits ranging from 50 to 70 percent of GDP. - Approach 3: Growth-based model (Checherita-Westphal and others, 2014) linking debt to growth, deriving debt level beyond which debt negatively impacts growth even accounting for public investment benefits. - Empirical estimate for Paraguay: - Output elasticity of public capital estimated at around 0.28 (using Penn-World Tables version 9.0 and IMF’s Investment and Capital Stock Dataset). - Implied maximum public debt-to-GDP ratio: around 65 percent of GDP. - Caveat: model focuses exclusively on growth implications and assumes absence of borrowing constraints. ### Aggregate results and interpretation - The three approaches suggest maximum debt limits in the range of 50 to 70 percent of GDP for Paraguay. - These ranges indicate where authorities would not want to exceed the debt limit and should not be viewed as the debt anchor itself. - Necessity to infer an appropriate safety margin between the operational debt anchor and the estimated debt limit; this is achieved via stochastic simulations described above. *Source: cr1767 - 4. The authorities plan to introduce a structural balance rule (SBR) from 2019 to add* ### 25. The simulations point to a debt anchor of 40 percent of GDP for Paraguay, if ### cr1767 - 25. The simulations point to a debt anchor of 40 percent of GDP for Paraguay, if ### Debt-anchor simulations and calibration - Simulations indicate a debt anchor of 40 percent of GDP if policymakers accept a 5 percent probability of breaching the maximum debt limit in the medium-term. - The debt limit in the simulations is assumed to be 60 percent of GDP (the central value of the 50-70 percent of GDP interval). - The safety margin below the debt limit is relatively large because of: - the inherent volatility of Paraguay’s economy; and - the large share of debt denominated in foreign currency, 75 percent in the parametrization used in the simulations. - If policymakers accept a 10 percent probability of breaching the debt limit, the debt anchor increases to about 45 percent of GDP. - The underlying econometric sample period is relatively short, includes the global financial crisis, and thus simulated shocks could be biased towards negative outcomes. - Concluding range from simulations under the precautionary approach: debt anchors lie in the range of 30 to 45 percent of GDP, depending on: - (i) the estimate of the debt limit; - (ii) the risks policymakers are willing to accept; and - (iii) whether an additional buffer for contingent liabilities is introduced. ### Accounting for contingent liabilities - Cross-country evidence: the probability of realization of contingent liabilities exceeding 1 percent of GDP is close to 6 percent in a sample of emerging and developed economies (Bova and others, 2016). - Interpretation: on average, a country is likely to experience realization of large contingent liabilities every 20 years or so. - Average fiscal cost of these realizations: around 10 percent of GDP. - Paraguay-specific estimates: - Total contingent liabilities (encompassing a wide range of areas, including natural disasters) are estimated at around 30 percent of GDP over a 10-year horizon (Moskovits, 2015). - Larraín and Cerda (2016) conjecture that out of this total, about 10 percent of GDP is likely to materialize in the medium-term. - A buffer for contingent liabilities in the order of 10 percent of GDP is considered appropriate for Paraguay. - Incorporating a 10 percent of GDP contingent-liability buffer by lowering the debt limit to 50 percent of GDP and accepting a 5 percent probability of exceeding the debt limit yields a debt anchor of 30 percent of GDP. - Caveat: some contingent-liability costs may already be imperfectly accounted for in prior simulations because those simulations include fiscal shocks estimated from deviations in the fiscal reaction function. ### Development needs and capital stock considerations - Cross-country public capital comparisons: - Paraguay’s public capital stock: 44 percent of GDP in 2015 (IMF Investment Capital Stock Dataset). - Emerging markets average: 79 percent of GDP. - Latin American countries average: over 84 percent of GDP. - The public capital stock gap relative to peers has persisted over the past quarter century and widened in per capita terms. - Infrastructure quality and access: - Paraguay lacks access on a number of infrastructure dimensions, except electricity production (large hydroelectric capacity) and water. - Perception-based quality indicators place Paraguay well-below other Latin American and emerging market countries. - Efficiency of public investment: - A hybrid indicator places Paraguay far from the “efficiency frontier.” - Estimated efficiency gap: about 40 percent (Paraguay is 40 percent below the most efficient countries on this synthetic indicator), placing Paraguay in the bottom quartile. - Administrative and implementation capacity constraints are significant barriers to closing the efficiency gap. - Authorities’ own assessments of infrastructure needs: - Authorities’ range: 50 to 70 percent of GDP. - Ministry of Planning bottom-up project list (2013/2014) suggests capital needs of 16 billion US dollars (close to 50 percent of GDP). - Ministry benchmark exercise points to a gap of almost 70 percent of GDP. - Model-based optimal capital stock estimates: - Observed capital-to-GDP ratio (Penn World Table): around 240 percent of GDP in 2014. - Optimal ratios from calibrated Ramsey-Koopman-Cass models: range from 290 to close to 350 percent of GDP. - These model results are sensitive to parameter assumptions and reflect steady-state equilibria. - Summary of capital gaps and implications: - Estimated public and total capital stock gaps vary from 35 to over a 100 percent of GDP depending on methodology. - Closing the gap will require large increases in public investment; some of this financing may appropriately come from debt given distortionary costs of equivalent tax increases and intergenerational equity considerations. - Not all capital gap should be covered by public debt; alternatives include Public-Private Partnerships and revenue mobilization through tax reform and revenue administration improvements. - Policy judgment may favor choosing a debt anchor in the upper part of the precautionary range to provide space for development needs. ### Implications for debt management - An active and transparent debt management policy is needed to support the debt anchor and make it credible. - A three-to-five-year debt management strategy (DMS) is an essential tool to: - identify funding targets and potential financing instruments; - describe desired debt portfolio composition; and - highlight and manage risks. - Main benefits of a credible DMS: reduce debt-servicing costs, strengthen investor confidence, and mitigate market instability. - Suggested components of a public and regularly updated DMS: - Assess impact of the medium-term fiscal plan on borrowing needs and debt trajectory; provide inputs on debt composition, cost, and maturity for fiscal planning. - Show the debt trajectory is feasible and can be serviced over the medium term at low cost and low risk. - Express desirable debt composition (instruments, maturity, currency) and the debt management approach to achieve it. - Manage risk exposure embedded in the debt portfolio. - Paraguay-specific debt management history and needs: - Paraguay produced a stand-alone DMS in 2012, formulated with World Bank support; it did not establish an explicit debt objective. - The 2012 DMS assessed risks and presented four alternative borrowing scenarios to meet projected financing needs until 2017, but none incorporated the large issuances of external sovereign bonds that started in 2013. - The debt profile changed materially after 2013, stressing the need for regular DMS updates. - The debt department has started updating the 2012 DMS with the World Bank and intends to produce a first draft by the end of the year; the updating process needs to be institutionalized. - A regularly updated DMS could inform periodic reassessments and possible recalibration of the debt anchor following large changes in the macroeconomic environment or other factors (for example, windfall gains from the complete amortization of the Itaipu hydroelectric dam’s debt). ### Key numeric findings and scenario outcomes - Debt limit assumed in baseline simulations: 60 percent of GDP (central value of the 50-70 percent interval). - Debt anchor outcomes: - 40 percent of GDP debt anchor when accepting 5 percent probability of breaching the debt limit. - 45 percent of GDP debt anchor when accepting 10 percent probability of breaching the debt limit. - 30 percent of GDP debt anchor when incorporating a 10 percent of GDP contingent-liability buffer by lowering the debt limit to 50 percent of GDP and accepting 5 percent probability of breaching. - Contingent liabilities statistics: - Probability of realization exceeding 1 percent of GDP: close to 6 percent (cross-country average). - Average fiscal cost of realizations: around 10 percent of GDP. - Paraguay total contingent liabilities over 10-year horizon: around 30 percent of GDP. - Portion likely to materialize in medium-term (Paraguay-specific): about 10 percent of GDP. - Public capital stock and gaps: - Paraguay public capital stock in 2015: 44 percent of GDP. - Emerging markets public capital stock average: 79 percent of GDP. - Latin America public capital stock average: over 84 percent of GDP. - Efficiency gap relative to frontier: about 40 percent. - Authorities’ infrastructure needs assessment range: 50 to 70 percent of GDP. - Ministry of Planning bottom-up estimate: 16 billion US dollars (close to 50 percent of GDP). - Observed capital-to-GDP ratio in 2014: around 240 percent of GDP. - Model-implied optimal capital-to-GDP ratios: 290 to close to 350 percent of GDP. - Aggregate capital gap estimates across methods: from 35 to over a 100 percent of GDP. - Debt management timing and instruments: - Recommended DMS horizon: three-to-five-year. - Paraguay’s previous DMS year: 2012. - Recommendation 2.1 timing for analytical work: mid-2017. ### Policy recommendations (extracts and implications) - Recommendation 2.1 Calibration of the public debt anchor: - Analytical work is necessary to determine the appropriate level of the debt anchor (mid-2017). - Choice of the threshold should be guided by three main considerations: insurance against shocks, development needs, and feasibility. - Complementary policy actions: - Adopt a transparent, active, and regularly updated DMS (three-to-five-year horizon) to operationalize debt management, link debt projections to the medium-term fiscal framework, and demonstrate feasibility of reaching the debt anchor. - Intensify efforts to enhance public investment management—project appraisal, implementation, and evaluation—to ensure additional capital expenditures effectively raise potential growth. - Pursue alternative financing strategies for development needs (Public-Private Partnerships) and revenue mobilization (tax reform and revenue administration improvements) to reduce reliance on public debt. - Institutionalize regular updating of the DMS and coordinate its publication with fiscal reports (for example, Informe de Finanzas Publicas) to enhance transparency and predictability. *Source: IMF staff estimates and chapter content.* ### 48. Recommendation 2.2 Public announcement of the debt anchor. Authorities should ### cr1767 - 48. Recommendation 2.2 Public announcement of the debt anchor. Authorities should ### Recommendations and near-term actions - Recommendation 2.2: Authorities should announce a public sector debt objective and consider incorporating it into the fiscal rule framework (in the form of a debt ceiling) to enhance its credibility (end-2017). - Recommendation 2.3: Authorities should publish and regularly update a DMS to support the debt anchor (starting in the first quarter of 2017 and then updated annually). - The authorities plan to replace their nominal balance rule with a structural balance rule (SBR) to achieve a more stable path of public expenditure; the new SBR is expected to come into effect by 2019. A draft law will be prepared next year to be approved by Congress in 2018. ### Revenue volatility and its fiscal impact - High volatility of fiscal revenues in Paraguay results in unstable and hard-to-predict public expenditure. - Sources of revenue volatility identified: - Interplay of the business and commodity cycles. - Weather conditions affecting agricultural and electricity production. - Prevalence of external demand and exchange rate shocks. - Structural factors, such as the gradual process of formalization of the economy. - Observed consequences: - Discretionary capital spending has frequently borne the burden of fiscal adjustment. - Instability of expenditure has had destabilizing effects on the economy and complicated budget preparation and management. - Empirical notes: - Revenue volatility in Paraguay is higher than in many peers (see coefficient of variation figures in Figure 3.1). - Capital spending has been more volatile than current spending since 1991. ### Structural Balance Rule (SBR): design considerations - Purpose: Disconnect path of expenditure from actual revenues to stabilize expenditure. - Simplest SBR: “cyclically-adjusted balance rule” insulates expenditure from the business cycle; more sophisticated variants also smooth one-off factors and unconventional cycles (commodity, asset prices). - Key dependence: The degree of expenditure stabilization depends fundamentally on the formula used to compute structural revenues. When the rule’s threshold is zero, the SBR requires that the amount of expenditure be capped by structural revenue. ### Standard formula for structural revenue (conventional approach) - Mechanism: Corrects nominal balance for the effect of the business cycle by assuming a stable relationship between cyclical revenues and the cyclical component of GDP. - Implication: All volatility of actual revenues is transmitted to structural revenues except fluctuations associated with the business cycle. - Examples: - An increase in Itaipu revenues due to heavy rainfalls is treated as structural and thus spendable under the SBR. - A cyclical increase in revenues due to the business cycle must be saved. - Applicability concerns for Paraguay: - Automatic stabilizers are limited by the small size of the public sector as a share of GDP. - Many sources of revenue volatility in a small open economy mean the standard formula would transmit much volatility to structural revenues, providing limited smoothing. ### Authorities’ formula for structural revenue (used by Paraguay) - Construction: Assumes a stable relationship between structural revenues and the structural component of output estimated with an HP filter. Structural revenues evolve proportionately to trend output. - Practical result: Produces much stronger smoothing of revenues and therefore a more stable path of expenditure (shown in simulated historical comparisons in Figure 3.2). - Noted econometric detail: Under the authorities’ formula, structural revenues associated with proceeds of the binational hydroelectric plants are assumed to follow the same stable relationship with trend GDP as other revenue items. ### Policy risks of the authorities’ formula - Risk of overestimating structural revenues and authorizing too much expenditure: - Revenues have, on average, grown faster than GDP in Paraguay in the past 20 years, yielding estimated elasticities 훾>1. - If this historical relationship is assumed forward, the formula may imply future expenditure grows faster than the size of the economy, risking steady fiscal deterioration unless revenue collection coincidently increases. - Simulation setup note: The simulation in Figure 3.3 assumes the revenue-to-potential GDP ratio remains constant at 2016 levels over 2017-36. - Risk of mis-measuring structural revenues when there are tax policy changes: - The relationship between structural revenues and trend output breaks when new policy measures are introduced. - The authorities’ estimation method (cointegration) measures long-term relationships and may not capture policy-induced breaks timely; results are sensitive to the elasticity estimate. - Table 3.1 sensitivity example (simulations based on zero threshold SBR and authorities’ formula with varying elasticity): - Elasticity Estimate 1.090 → Allowed Expenditure (% of GDP) 17.1 → Nominal Balance (% of GDP) 1.3 - Elasticity Estimate 1.096 → Allowed Expenditure (% of GDP) 18.5 → Nominal Balance (% of GDP) -0.1 - Elasticity Estimate 1.100 → Allowed Expenditure (% of GDP) 19.3 → Nominal Balance (% of GDP) -0.9 - Elasticity Estimate 1.105 → Allowed Expenditure (% of GDP) 20.5 → Nominal Balance (% of GDP) -2.1 - Risk of creating a disincentive for revenue mobilization: - Because the formula is re-estimated ex post, new revenue-enhancing measures cannot be spent immediately until the estimated elasticity is revised upward; conversely, revenue-diminishing measures may be less immediately penalized. ### Proposed changes and operational adjustments to the formula - Conservative assumption recommendation: - The SBR formula should not assume structural revenues will grow faster than trend output in the future. - Given recent underperformance, revenues have systematically underperformed compared to plans in the past 4 years. - The tax structure is mainly proportional in Paraguay, suggesting an elasticity of one relative to trend output going forward. - Two practical ways to implement a more cautious assumption: - Method 1: Keep authorities’ formula but set unit elasticity (훾=1) instead of estimated 1.096; calibrate the other coefficient (∝) as the structural effective tax rate (proxied by the authorities’ “steady state” tax burden). - Method 2: Interpret the SBR as an expenditure rule (expenditure benchmark): if 훾=1, structural balance remains unchanged if expenditure grows at the same pace as trend GDP; thus cap expenditure growth to trend output growth. - Adjustment for new revenue measures in real time: - Incorporate durable discretionary revenue measures immediately into the annual expenditure cap (in nominal terms) rather than waiting for ex-post re-estimation. - Operational formula proposed: Allowed expenditure in the budget = ∝(Y_S)^훾 + yield of new revenue measures - The independent fiscal council could review government methodology and estimates to mitigate risk of overestimating yields of measures. ### Treatment of binational hydroelectric revenues (Itaipu and similar) - Recommendation: Exclude binational dam revenues from the general formula and smooth them separately. - Rationale: - Historical structural breaks in binational revenues mean the assumption of a stable relationship with trend GDP is weak for these revenues. - Since the early 2000s, ratio of binational revenue to trend GDP has declined, primarily because dam production growth was 0.5 percent a year in volume—well below trend GDP growth—and electricity prices are contractually fixed. - A further structural break is expected from 2023 onwards when Itaipu’s debt is repaid and revenues could increase significantly (by up to 3 percent of GDP, according to the authorities). - If included in the authorities’ formula, the SBR would not allow spending the extra revenues for many years until re-estimation captures the break. - Suggested operational approach: - Split structural revenue calculation into two parts: - Revenues linked to the business cycle: estimate with the standard/adjusted formula using trend output (re-estimating while excluding binational revenues). - Binational revenues: smooth separately using a different method (for example, a linear trend) to give flexibility on earmarking or phased spending of windfalls. _Italic: Source: IMF staff report (cr1767), chapter on “A Structural Balance Rule for Paraguay” (excerpts provided)._ ### 65. The authorities are exploring the possibility of establishing a sovereign wealth fund ### The authorities are exploring the possibility of establishing a sovereign wealth fund (SWF) associated with the SBR ### SWF purpose and design considerations - The SWF is being explored in connection with the SBR; its exact function is not yet finalized. - Possible functions of the SWF: - Stabilization: manage fiscal surpluses generated by the SBR to insulate the budget from revenue volatility; build assets during years of high fiscal revenues to prepare for leaner years. - Savings: save part of the extra revenue from the Itaipu dam, which are expected to materialize after 2023; invest savings in a diversified portfolio of international financial assets to achieve long-term objectives. - Development: allocate resources for and manage priority socioeconomic projects, such as infrastructure. - Key design principle: the allocation formula of the SWF must be consistent with the SBR so the SWF and SBR formulas do not conflict. - Operational relationship to the SBR: - The SBR will determine how much revenue is saved or spent; part of that pool of savings could be allocated to the SWF. - Example: Chile nests SWF allocations within the SBR—any fiscal surplus generated by the rule is allocated to various funds based on predetermined thresholds. ### Structural Balance Rule (SBR) threshold and calibration - Debt-consistent ceiling: - The ceiling of the SBR should be linked to the debt objective; short-term operational rules should be consistent with and support the medium-term public debt objective. - Inconsistency between debt ceiling and other rules is a common problem (example cited: European framework 3 percent nominal deficit vs 60 percent debt anchor). - Debt-sustainable structural deficit range: - Debt simulations suggest the structural deficit of the public sector should not exceed 2-3 percent of trend GDP, assuming a 30-45 percent debt target for the public sector and 7-8 percent nominal trend growth. - If authorities target a smaller debt ratio, they should reduce the structural deficit ceiling; a higher debt target would allow a higher ceiling. - Central government ceiling: - This range translates into a structural deficit ceiling for the central government of about 2 percent of trend GDP. - Rationale for lower central government cap: - Fiscal deficits are not concentrated at the central government level; other parts of the public sector can generate deficits, so a buffer is needed for local governments, state owned enterprises, and the social security system. - A safety margin is needed to account for future deviations from the rule; absent correction mechanisms, deviations may accumulate and cause upward drift in public debt. - Conclusion: structural deficit of the central government could be capped at 2 percent of trend GDP. - Debt-stabilizing formula and numeric example: - Debt-stabilizing overall deficit is computed as d*g/(1+g) where d = debt-to-GDP ratio and g = trend GDP growth in nominal terms (Escolano, 2010). - Numeric illustration: in the steady state, a structural deficit of 2 percent of GDP would bring the debt ratio towards 30 percent of GDP (deficit*(1+g/g) = 2*1.07/0.07=30.6) if nominal GDP grows at 7 percent a year. ### Implications of the SBR for nominal balance volatility and public investment - Nominal balance volatility: - Implementing a structural balance rule with a threshold of 2 percent can lead the nominal deficit to deteriorate well below 1.5 percent of GDP; this is an expected effect of the SBR since greater expenditure stability implies more volatility of the nominal balance. - Counterfactual simulations indicate that if the SBR had been implemented since the early 1990s, the nominal deficit would have deteriorated up to 3-4 percent of GDP (Figure 3.6). - With the standard formula, a “normal” downturn would bring the nominal deficit to about 3 percent of GDP. - Under the authorities’ formula nominal deficits could be larger (over 4 percent of GDP in 2002) because expenditure is more stable and nominal balance more volatile; the standard deviation of the nominal balance under the authorities’ formula is 40 percent higher than under the standard formula for the series in Figure 3.6. - Note on the “normal” downturn proxy: assumes a negative output gap of -5 percent and a share of spending to GDP of 20 percent, yielding a nominal deficit deterioration of 5*0.2 = 1 percent of GDP relative to the 2 percent structural deficit ceiling. - Effect on public investment: - The effect of the SBR on public investment depends on interaction with the existing rule on current expenditure. - By itself, the SBR could create more space for public investment if its ceiling is set above 1.5 percent (the ceiling of the existing nominal balance rule). - However, if both total expenditure and current expenditure growth rates are capped by trend GDP growth (the former because of the SBR; the latter because of the current expenditure rule), public investment would: - Grow approximately at trend growth, so remain stable as a share of trend GDP. - Maintain an unchanged ratio of current to capital spending over time. - Under these conditions Paraguay would not close the investment gap with emerging markets, where the public investment ratio averages closer to 6 percent of GDP. - Simulations on closing the public capital gap (Table 3.2 summary): - Baseline: public sector investment ratio in Paraguay is 4.2 percent of GDP in 2015; target benchmark is 6 percent of GDP (emerging market benchmark). - Simulations apply tighter current expenditure growth ceilings (real) of 3 percent, 2 percent, and 1 percent in the first period, and a second period where investment ratio stays at 6 percent until half of the public capital stock gap is closed. - Key simulation outcomes: - Current expenditure growth = 3% (real) → implied public investment growth = 9% (real); time to reach public investment ratio of 6% of GDP in first period = 8 years; time to get to 60% public capital stock in second period = 9 years; total time to close half of the capital stock gap in the two periods = 17 years. - Current expenditure growth = 2% (real) → implied public investment growth = 14% (real); time to reach 6% of GDP = 4 years; time to get to 60% public capital stock = 11 years; total time = 15 years. - Current expenditure growth = 1% (real) → implied public investment growth = 19% (real); time to reach 6% of GDP = 3 years; time to get to 60% public capital stock = 11 years; total time = 14 years. - Assumptions and caveats: - Targeted public capital ratio set at 60 percent of GDP (initial capital stock 43 percent of GDP in 2015 plus half of the gap with emerging markets estimated at 17 percent of GDP). - Depreciation rate of public capital assumed at 5 percent per year. - During the second period, current expenditure growth assumed at 4 percent a year (real), so investment grows at trend GDP and investment ratio remains constant at 6 percent of trend GDP. - Assumes the shift toward higher public investment does not increase trend GDP growth (so years to close gap might be overestimated); assumes no deceleration of trend GDP growth over simulation period. ### Structural Balance Rule implications for public financial management (PFM) and cash/debt management - Additional PFM requirements under the SBR: - Ability to borrow in economic downturns: - SBR increases nominal fiscal balance volatility; nominal deficits can deteriorate substantially in downturns, raising borrowing needs. - Debt managers must be more active in accessing financial markets and develop strategies and instruments to borrow large amounts on a regular basis. - Ability to access all available cash: - Smoothing public expenditure is inconsistent with excessive segmentation of fund sources and/or high revenue earmarking. - Cash managers must manage public funds in a consolidated way and maintain an appropriate cash buffer to meet outflows, especially when borrowing is constrained. - Paraguay’s progress: - Treasury single account (TSA) established in 1999 (LAFE) and expanded; operated at the Central Bank; currently covers central government operations (executive, judiciary, legislative) and autonomous entities. - TSA improves consolidated management and reduces costs. - Law of Modernization of the Financial Administration (2013) created Treasury Bills as short-term (up to 1-year) debt instrument to support TSA operations; further regulation needed for operability. - Debt management reforms: 2013 issuance of US$500 million in ten-year Treasury Sovereign Bonds marked first international market access; subsequent issuances increased share of sovereign bonds to exceed 40 percent of total debt portfolio by June 2016. - Constraints to cover large fiscal deficits with debt issuances: - Legal constraint: - Golden rule (article 40 of LAFE): resources from debt operations can only be used to finance capital expenditure and debt repayment; applies to central government and public sector as a whole; well institutionalized and little desire to modify. - In practice, golden rule imposes a de facto limit on nominal deficit size and could conflict with the SBR in downturns. - Historical range: sum of capital expenditure and debt repayments (central government) fluctuated between 3 and 10 percent of GDP depending on the year, with an average of 5 percent GDP over 1991-2015. - Economic constraint: - Market access can be constrained during downturns; recent successful access does not guarantee future demand. - International markets may become restrictive and domestic market size is limited. - Cash management issues: - Segregation of resources: - Debt operation resources are managed in separate bank accounts and are not covered by the TSA; a specific funding code (FF20) is applied to resources from debt operations. - Treasury effectively manages two independent cash processes: - Tax revenue inflows and current expenditure outflows consolidated in TSA (funding codes FF10 and FF30). - Debt operation resources and capital expenditures managed outside TSA (code FF20). - No fungibility between these resources; e.g., a wage expense cannot be paid through debt even temporarily. - Limited cash buffer: - TSA cash management cannot use debt instruments to build/maintain a cash buffer, making cash management for current spending a simple matching of payments to tax revenue inflows. - In a downturn, MOF may have to cut spending when revenues fall, violating the spirit of the SBR. - Treasury may finance cash flow mismatches with temporary cash advances from the Central Bank, subject to limits. - Legal provisions: National Constitution, LAFE (article 26), and Central Bank Organic Law (Law 489/1995) include the mechanism with different limits: - LAFE sets maximum amount to 1 percent of the approved budget. - Law 489/2015 establishes advances cannot exceed 10 percent of the budgeted tax revenues during the fiscal year. - In practice, the Treasury has used such advances at the beginning of the fiscal year to pay arrears accumulated in the previous year. - Need to develop steady funding flow: - T-bond/T-bill instruments should be continuously developed; regular market access via bond issuances improves demand for Paraguayan securities. - A forward-looking debt strategy is needed to access markets in downturns. - Government should finalize T-bills regulation to add instrument to the debt portfolio. - Ideally, T-bills should be available as unrestricted cash management tools, including for accumulation of the cash buffer. - If T-bills cannot be used for this purpose for legal reasons, MOF should create another debt instrument to finance current spending during temporary revenue shortfalls; to comply with the golden rule any issuance of this new instrument would have to be offset through buy-backs by the end of the year to avoid net increase in public debt for current expenditure. - Cash buffer guidance: - Prudent TSA cash buffer recommendation: - General rule of thumb: accumulate cash buffers sufficient to pay all bills (all spending, including debt amortizations if no rollover assumption) from 30 to 90 days. - More sophisticated method: analyze seasonality of payments and revenue collections in the last 2-3 years (preferably daily data) to calibrate buffer as the size of the gap during the worst month in the last two years. - Buffer size depends on quality of cash flow projections and soundness of financial market to tap gaps. - Best practice guidance references: Lienert (2009), Pessoa and Williams (2012), and IMF (2013b). *Source: cr1767 - 65. The authorities are exploring the possibility of establishing a sovereign wealth fund (excerpt). * ### 79. Recommendation 3.1: Projection of structural revenues. The SBR formula should not ### Recommendation 3.1: Projection of structural revenues. The SBR formula should not ### Key recommendations (Recommendations 3.1–3.7) - Recommendation 3.1: Projection of structural revenues. The SBR formula should not assume that structural revenues will grow faster than trend GDP in the future (December 2017). - Recommendation 3.2: Effect of new revenue measures. The SBR formula should be adjusted to incorporate the effect of new revenue measures in real time (December 2017). - Recommendation 3.3: Revenues from binational hydroelectric dams. Binational revenues should be smoothed out separately and excluded from the main SBR formula (December 2017). - Recommendation 3.4: Threshold of the SBR. The threshold should be calculated by linking the SBR to the medium-term debt objective (December 2017). - Recommendation 3.5: Ceiling of the current expenditure rule. The expenditure ceiling should be tightened when the new SBR is adopted to reaffirm the commitment to fiscal discipline and ensure that the combination of the two rules contributes to close the public investment gap (December 2018). - Recommendation 3.6: Allocation of funds to the future SWF. The allocation formula of the SWF should be consistent with and nested in the SBR (December 2018). - Recommendation 3.7: Short-term instrument for cash management. A short-term debt instrument should be in place before implementing the SBR to finance current spending when there are temporary revenue shortfalls (December 2018). ### Communication strategy: challenges and objectives (paragraphs 86–90) - Moving to a SBR raises communication challenges because: - The output gap concept is abstract and structural balance computation is complex. - The structural balance lacks a direct link to budget items, increasing perception risk of “creative accounting.” - Without an effective communication strategy, the SBR may undermine credibility and complicate the budget process (paragraph 86). - Core communication objectives: - Provide a simple but clear message educating the public on the objectives, requirements, and benefits of the SBR. - Start communication early, well before finalizing reform and implementation (paragraph 87). - Disseminate the message across multiple vehicles (speeches, press interviews, conferences) and audiences (politicians and congressmen, private sector, trade unions, investors, donors) with consistent, document-supported messaging (paragraph 88). - Use well-structured fiscal reporting and an independent Fiscal Council (FC) to support credibility and public understanding (paragraph 89). ### Crafting the message: emphasized benefits (paragraphs 90–96) - The message should emphasize how the SBR improves the fiscal framework and reaffirms fiscal discipline, focusing on three main advantages (paragraph 90): - (i) enhancing the stabilization of the economy; - (ii) containing expenditure pressures; - (iii) promoting public investment. - Stabilization argument (paragraph 91): - The SBR mitigates procyclicality by generating savings in favorable times (e.g., peak of the cycle; soybean price booms; higher Itaipu dam revenues) to be used in worse times. - Chile introduced its SBR in 2000 and used it to stabilize expenditure over 15 years despite two recessions, a boom, and an earthquake (Marcel, 2013). - Applicability to Paraguay (paragraph 92): - The procyclicality argument is less persuasive for Paraguay because fiscal policy showed slight countercyclicality over 2000-09 (Frankel and others, 2013). - David and Novta (2016) find a positive “fiscal stabilization coefficient” for Paraguay, indicating some degree of countercyclicality (paragraph 92 and Figure 4.1). - SBR as a “smart” expenditure ceiling (paragraphs 93–94): - SBR functions like an expenditure ceiling adjusted annually with trend growth; easier to explain and monitor. - The SBR implies “expenditure cannot grow faster than the whole economy.” - Example: Peru translates the medium-term structural balance objective into an expenditure ceiling determined after forecasting structural and cyclical revenue; communication focuses on the ceiling (paragraph 94). - Public investment argument (paragraph 95): - The SBR can protect public investment by stabilizing expenditure and by allowing a less restrictive threshold compared to the existing nominal balance rule of 1.5 percent of GDP, thereby creating fiscal space for capital expenditure. - Reaffirming fiscal discipline (paragraph 96): - Authorities should avoid perceptions of weakening the fiscal framework when switching to an unobservable structural target by: - Highlighting areas where the framework is more stringent (e.g., creation of a SWF to save some windfalls). - Possibly tightening the current expenditure growth ceiling when adopting the SBR. ### Fiscal reporting under the SBR (paragraphs 97–100) - Current practice in Paraguay (paragraphs 97–98): - The annual report on public finances (IFP) used the structural balance indicator for the first time in 2016. - The IFP presents the structural balance as an indicator (not yet a rule), describes methodology (following Larraín and Cerda, 2016), includes formulas, revenue elasticity calculations to trend GDP, compares nominal and structural balances over 1990-2015, and discloses projections for 2016-19 (paragraph 97). - The IFP is the only comprehensive report on the fiscal rule framework; MOF produces in-year budget execution reports but Paraguay does not publish an ex-post end-year compliance report (paragraph 98). - International practice (paragraph 99): - Countries with SBRs provide ex-ante and ex-post reporting: ex-ante fiscal planning reports (timing varies: April in Peru and Europe; June in Colombia; October in Chile) and ex-post compliance reports that describe methodology, assess compliance, and may trigger correction mechanisms. - Chile, Colombia, and Peru present end-year reports on compliance (paragraph 99). - Recommended improvements for Paraguay (paragraph 100): - Produce the fiscal planning report earlier with a medium-term focus: - Move IFP publication forward from September to earlier in the first semester. - Make the planning report forward-looking with macroeconomic assumptions and medium-term fiscal forecasts; incorporate FC reviews when available (paragraph 100, first bullet). - Publish an end-year report on compliance and methodology: - State clearly if fiscal outcomes were consistent with the rules. - Provide explanations and corrective actions for deviations; compare assumptions with outcomes. - Discuss methodological reviews of the SBR and incorporate FC reviews; submit the report to Congress and conduct a hearing (paragraph 100, second bullet). - Monitor fiscal rules in quarterly execution reports: - Include a short write-up tracking in-year performance versus annual rules, flag risks of deviation, and make corrective recommendations. - Quarterly hearings in Congress could strengthen enforcement (paragraph 100, third bullet). ### Box 4.1 — Fiscal reporting under the SBR in Latin America (Peru example) - Countries with SBRs in Latin America: Chile (introduced 2001), Colombia (2011), Peru (2013) (Box 4.1). - Peru’s reporting framework under the SBR: - April – Marco Macroeconómico Multianual (MMM): - Ex-ante report on SBR. - Fiscal framework for ten years ahead. - Budget proposal for the following year. - Macroeconomic assumptions. - Structural and cyclical revenue forecasts. - Nominal balance and structural balance forecasts. - Medium-term debt objective. - Expenditure ceiling consistent with the SBR. - Review by the Fiscal Council. - May – Declaración de Cumplimiento de Responsabilidad Fiscal: - Ex-post report on SBR assessing compliance with the expenditure ceiling. - Reviewed by the Fiscal Council and submitted to Congress. - August – Revised MMM (MMMR): - Ex-ante updated report; MMM is usually revised in August (only 2 out of the past 15 MMM reports have not been updated). - Reviewed by the Fiscal Council. - Quarterly – Reporte Fiscal Trimestral: - In-year execution report. - Alerts on the risk of noncompliance and corrective action recommendations. *Source: cr1767 - 79.* ### 101. International experience shows that fiscal councils (FC) can help support the ### cr1767 - 101. International experience shows that fiscal councils (FC) can help support the ### Role and functions of Fiscal Councils (FC) - FC is an independent public institution informing the public debate on fiscal policy. - FC can support implementation of structural balance rules (SBRs) by performing one or several functions (IMF, 2013): - Contributing to the calculation of the structural balance: - Some FCs produce or review/validate the macroeconomic assumptions and fiscal forecasts used in the calculation of the SBR. - Examples: - Dutch FC (Bureau for Economic Policy Analysis, CPB) produces macro assumptions used in budget formulation (including inflation, economic growth rates, and output gap). - Independent commissions in Chile and Colombia make forecasts of commodity prices and trend GDP. - Peruvian and Portuguese FCs review macro assumptions prepared by the Ministry of Finance and present a qualified opinion. - Communicating and explaining the rule to the public: - FC can produce technical notes and reports describing the objectives and benefits of the rule and how it can affect the population. - Strong media presence: continuous interaction with press and opinion makers; regular press notes and articles. - Example: Dutch CPB provides a significant volume of media articles and research reports on the SBR, particularly during budget preparation. - Monitoring the SBR, including calculation of the rule and ex-ante and ex-post compliance: - Examples: Dutch, German and Chilean FCs actively monitor compliance; Dutch CPB has produced methodological papers on SBR calculation. ### Features ensuring FC effectiveness - Legal and operational independence and strong media presence are key features. - Legal independence prevents political interference and increases public perception of neutrality and non-partisanship. - Operational independence requires staffing with qualified and experienced professionals and predictable funding commensurate to the council’s mandate. - Media presence is essential to influence public debate and to raise alarms when budget proposals/outturns deviate from rules or when macro forecasts are over-optimistic. - For SBRs, FC must review and provide independent opinion on estimation of trend (or potential) output: - Risk: Overestimating trend output growth in the budget could lead to excessive expenditure increases under the SBR. - Consequence: When trend output is revised down ex-post, the structural position can suddenly appear worse and an SBR that seemed complied with ex-ante can be breached ex-post (see Eyraud and Wu, 2015). ### Paraguay: establishment and mandate of the FC - Status and legal basis: - Paraguay is in the process of setting up a FC which could facilitate the transition towards the SBR. - Initially established by presidential decree; MOF plans to incorporate the design and mandates of the council in the amended FRL to give stronger legal support. - Presidential decree is drafted and under review at the presidency; authorities expect the decree to be released by the end of this year. - Draft mandate (Tollini and others, 2016): - Three mandates described in the draft decree: i) review the budget proposal sent to Congress by the MOF; ii) review modifications to the budget proposal and the approved budget by Congress; iii) provide analysis on specific fiscal issues at the request of the MOF. - The FC will not assess fiscal outturns or monitor budget execution; no provision to assess ex-post compliance with fiscal rules (reflecting current FRL which assesses fiscal rules based on budgetary plans, not outturns). - Composition and staffing: - Council composed of three members nominated by the minister of finance. - Members should come from the private sector or academia and are nominated for a three-year period, extendable. - The FC will not have permanent staff. ### Conditions for effectiveness of the Paraguayan FC - Dependence on mobilizing external resources and public outreach: - Decree provides administrative and technical support from the macro-fiscal department of MOF, which has qualified personnel. - Members have personal connections to universities and economic consulting companies and could contact specific professionals for requests. - FC must establish a communication plan: define documents and reports to be produced, frequency and forms of participation in public events (press interviews, conferences, hearings at Congress etc.). - MOF in collaboration with council members should draft a charter describing FC organization and operations. - Need to expand and secure independence: - Reviewing key stages of the budgetary process is demanding and time-consuming; successful FCs are staffed with permanent personnel and have financial resources. - Reliance on MOF staff could strain MOF macro-fiscal department resources and potentially undermine public perception of FC independence. - Access to funding is essential for infrastructure: phone line, email address, website, organization of public events, physical production and dissemination of reports, travel. - Creating a website is particularly important to disseminate FC opinions and analyses to the public. ### Recommendations (D. Recommendations) - Recommendation 4.1: Ex-ante fiscal reporting. - The MOF should bring forward the publication of the IFP to the first semester (April or May) and, possibly, revise it at the beginning of the budget process (August or September). - The IFP should focus on presenting medium-term fiscal plans (December 2018). - Recommendation 4.2: Ex-post fiscal reporting. - The MOF should produce an end-year report assessing budget execution and compliance with fiscal rules based on outturns, even if this is not required by the FRL (December 2018). - Recommendation 4.3: Execution fiscal reporting. - Quarterly execution reports should track compliance with the rules throughout the fiscal year (December 2018). - Recommendation 4.4: FC regulation. - The MOF, in collaboration with the council members, should draft a charter describing its organization and operations. - Council members should devise a communication strategy, which should include the creation of a dedicated website (mid-2017). ### Appendix highlights: Fiscal rules and model-based analyses - Appendix 1. Fiscal Rules in Paraguay (2013 Fiscal Responsibility Law): - The deficit of the central government must not exceed 1.5 percent of GDP. - The average deficit (budgeted) over three consecutive budget periods must not exceed 1 percent of GDP. This rule only applies to the medium-term fiscal plan presented with the budget. - The growth rate of current primary expenditure for the public sector must not exceed 4 percent in real terms. - Any salary increase for civil servants is limited by the percentage increase in the minimum wage. - Headline deficit ceiling can reach up to 3 percent of GDP in cases of national emergency, international crises, or negative growth; this increase requires congressional approval and in some cases a report by the central bank and the approval of the national economic team. - 1999 Law on Financial Administration: - Institutes the golden rule: resources from debt operations can only be used to finance capital expenditure and debt repayments; rule applies to central government and public sector as a whole. - Appendix 2. Estimating a Debt Limit from a Growth Model: - Production function includes labor (L), private capital (K), and public capital (Kg): Y = L^γ K^(1−γ) ( (Kg/K) )^α where α is output elasticity of public capital stock. - Assuming public debt is used exclusively for public capital financing (“golden rule”), optimal debt-to-GDP ratio: d* = ( α (1−α)^2 )^(1−α). - Using Penn-World Tables version 9.0 and IMF Investment and Capital Stock Dataset for Paraguay (1960-2013), two specifications estimate α ≈ 0.28. - Estimated α of around 0.28 would imply an optimal debt-to-GDP ratio target of about 65 percent. - Appendix Table 2.1. Estimates of Output Elasticity of Public Capital: - ln(Kg/K): 0.285*** [0.051] in both Model 1 ln(Y/K) and Model 2 ln(Y/L). - ln(L/K): 0.418*** [0.082] (Model 1). - ln(K/L): 0.582*** [0.082] (Model 2). - Constant: 0.731*** [0.154] in both models. - Observations: 54 in both models. - R-squared: 0.391 (Model 1) and 0.886 (Model 2). - Note: *** denotes statistical significance at the 1 % level. Standard errors are in brackets. - Appendix 3. Determining a Safety Margin for Public Debt Using Stochastic Simulations: - Methodology: - Estimate an unrestricted VAR at quarterly frequency for Paraguay over 1994: Q1-2015:Q4 for real interest rates, real GDP growth, and the exchange rate. - Use estimated variance-covariance matrix of residuals to calibrate random shocks. - Incorporate random shocks into VAR to obtain consistent forecasts. - Estimate a fiscal reaction function for a panel of 26 emerging economies (including Paraguay) linking primary balance to public debt and output gap: - Functional form: pb_{i,t} = α_i + β_1 pb_{i,t−1} + β_2 ygap_{i,t} D_{i,t} + β_3 ygap_{i,t} (1−D_{i,t}) + β_4 d_{i,t−1} + ε_{i,t} - pb = ratio of primary fiscal balance to GDP; d = gross public debt-to-GDP ratio at end of previous year; ygap = contemporaneous output gap; D = dummy equal to 1 when output gap is nonnegative. - Fiscal policy shock φ_{i,t} ~ N(0, σ_{φ_i}^2) calibrated to country-specific variance of residuals. - Maximum primary surplus capped at 2 percent of GDP for emerging market economies (Escolano and others, 2014). - Combine shocks with fiscal reaction function and debt accumulation equation to generate large number of debt paths over a 6-year forecasting period and compute probabilistic distributions and shares crossing debt limits. - Validity conditioned on quality of statistical model; shortcomings include potential structural change and goodness-of-fit concerns. - Appendix 4. Indicators of Public Investment Efficiency in Paraguay: - Paraguay has limited access to infrastructure except for electricity and water, and lags peers on quality indicators. - Paraguay is well-below the efficiency frontier for the hybrid infrastructure index and is in the bottom quartile of the cross-country distribution in terms of the efficiency gap. - Average efficiency gaps presented: Average Efficiency Gap of 27% (LAC?), Average Efficiency Gap of 29% (EME?), Average Efficiency Gap of 27% (All Countries?) — values presented in figure captions. - Appendix 5. Using the Ramsey-Koopman-Cass Model to Derive an Optimal Capital-Output Ratio: - Cobb-Douglas production function: Y = A K^α [E.L]^(1−α); definitions and equilibrium condition lead to K/Y = α/(r+δ). - Solow model “golden rule”: r = n + g, optimal K/Y = α/(n+g+δ). - Ramsey-Koopman-Cass “modified golden rule”: r = n + ρ + σ g, optimal K/Y = α/(n+ρ+σ g + δ). - With a risk premium ζ: r = n + ρ + σ g + ζ, optimal K/Y = α/(n+ρ+σ g + δ + ζ). - Appendix Table 5.1. Paraguay: Optimal Capital/Output Ratios (K/Y): - Parameters and sources: - g (growth rate of technical progress) in %: 1.50 (IMF staff calculations and Central Bank of Paraguay) - n growth rate of employment: 2.50 (IMF staff calculations and Central Bank of Paraguay) - δ (capital stock depreciation) in %: 5.00 (Penn World Table version 9.0) - α (capital share in Cobb-Douglas production function): 0.40 (Central Bank of Paraguay) - β (subjective discount factor): 0.97 (Asumption) - σ (intertemporal eslasticity of substitution): 0.50 (Asumption) - ρ (rate of time preference): 0.03 ((1/β-1)) - ζ (risk premium) in percent: 2.50 (EMBI spread) - Optimal capital stock estimates: - K/Y Ramsey Model in %: 352.6 (α/(n+ρ+σg+δ)) - K/Y Modified Ramsey Model in %: 289.0 (α/(n+ρ+σg+δ+ζ)) - Current capital stock estimates: - K/Y in 2014 in %: 247.1 (Penn World table version 9.0) *Italic: IMF staff summary as presented in the source document.* ### Appendix 6. Alternative Formulations of the Structural ### Appendix 6. Alternative Formulations of the Structural Balance Rule ### Standard Approach to the Structural Balance - Core formula (assumes steady relationship between cyclical revenues RG and output gap OG): - 푅 푆 /푅=(푌 푆 /푌) 훽 ⇔ 1/(1+푅퐺)=1/(1+푂퐺) 훽 - 훽 denotes the elasticity of the RG to the OG; 푅 and 푌 denote actual revenue and GDP; 푅 푆 and 푌 푆 denote structural revenue and trend GDP. - Interpretation and implications (taking 훽=1 for simplicity): - 푅 푆 =푅/(1+푂퐺). - All volatility of current revenues is transmitted to structural revenues except fluctuations associated with the business cycle, filtered by 1/(1+푂퐺). - Policy measures (reflected in 푅) are included in 푅 푆 , so new revenue measures automatically modify the amount of expenditure allowed under the rule. - Advantage: - Includes policy measures within structural revenue, allowing automatic adjustment of allowed expenditure. - Downside: - If revenues remain volatile after cyclical correction and accounting for policy measures, that volatility is transmitted to 푅 푆 and thus indirectly to expenditure. ### Authorities’ Approach to the Structural Balance - Core formula (Larrain and Cerda (2016) approach): - 푅 푆 =∝(푌 푆 ) 훾 - 푅 푆 and 푌 푆 denote structural revenues and trend GDP; ∝ and 훾 are coefficients estimated econometrically over past data. - Implication: - 푑푅 푆 /푅 푆 =훾.푑푌 푆 /푌 푆 — the growth rate of structural revenues is proportional to trend GDP growth. - Advantages: - Intuitive: structural revenues can be seen as effective tax rate ∝ times tax base 푌 푆 (adjusted by 훾). - By construction, 푅 푆 evolves like trend output, implying a smooth evolution of structural revenues and a stable path for expenditure. - Comparison: standard method implies 푅 푆 =(R/푌).푌 푆 (more volatile because R/푌 is not constant); authorities’ formula yields 푅 푆 =∝.푌 푆 (smoother). - Main concerns and limitations: - Theoretical: if 훾≠1, then 푑푅 푆 /푅 푆 =훾.푑푌 푆 /푌 푆 implies the system is explosive and 푅 푆 /푌 푆 will move toward zero or infinity in steady state. - Empirical/calibration risk: if historical 푅 푆 grew faster than 푌 푆 , estimation may yield 훾>1; using that elasticity to calibrate future allowed expenditure can overestimate structural revenue growth and lead to growing expenditure share relative to trend GDP and steady deterioration of the nominal fiscal balance. - Breaks when new policy measures are introduced: the assumed stable relationship between 푅 푆 and 푌 푆 is not robust to tax-policy changes. The authorities’ formula may over-smooth and filter out policy changes that should be reflected in structural revenues. ### Equivalence of a SBR with an Expenditure Rule in Growth Rate - Assumption and identity (unit elasticity of structural revenues to trend GDP, ratio 휑): - 푆퐵=(푅 푆 −퐸 푆 )/푌 푆 ⇔ 푆퐵=휑−E/푌 푆 - 푅 푆 , 퐸 푆 , E, 푌 푆 , g denote structural revenues, structural expenditure, actual expenditure, trend GDP, and trend GDP growth. Assumption: no cyclical component in expenditure so 퐸 푆 =퐸. - Equivalence conditions: - ∆푆퐵=0 ⇔ dE/E=g - ∆푆퐵>0 ⇔ dE/Eg - Where ∆푆퐵=푆퐵 푡 −푆퐵 푡−1 ; dE/E denotes expenditure growth; g denotes trend GDP growth. - Practical interpretation: - If government complies with SBR in structural terms, it can maintain it by letting expenditure grow in line with trend GDP (both in real terms). - If initial structural balance is not at target, letting expenditure grow like trend GDP stabilizes the structural balance at its current level. - To move the structural balance toward the target: if initial structural balance is above (below) target, expenditure should grow above (below) trend GDP temporarily. - Relaxing unit elasticity and introducing new revenue measures: - Replace “expenditure growth” with “net expenditure growth” — growth of expenditure not financed by corresponding changes in revenue measures. - Connection to European fiscal framework: - Formulation used under the name “expenditure benchmark”: “Annual expenditure growth should not exceed a reference medium-term rate of potential GDP growth, unless the excess is matched by discretionary revenue measures.” (European Commission, 2016). - Compliance assessment under this formulation: - If government complies structurally, maintain by letting expenditure net of new revenue measures grow in line with trend GDP. - To improve structural fiscal position, let expenditure net of new revenue measures grow below trend GDP. - To allow structural deterioration, let expenditure net of new revenue measures grow above trend GDP. *Appendix 6. Alternative Formulations of the Structural Balance Rule (cr1767)* --- _Source: https://www.imf.org/-/media/files/publications/cr/2017/cr1767.pdf_