Shifting Gears: Where the Rubber Meets the Fiscal Road

IMF Blog, April 12, 2011

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Undertaking a sizable fiscal adjustment is compared to driving up a tall mountain: it is hard work, can take a long time, and risks running out of fuel partway up the incline.
Countries have begun cutting back government deficits and debt levels, but current plans often are not enough to reach desired fiscal positions.

Advanced country government budget deficits edged down in 2010, largely due to improved economic conditions and lower financial sector support in the United States.
Government debt kept rising fast; by the end of 2010, government debt was as much as 25-30 percentage points of GDP above the pre-crisis (2007) level for several countries.
The crisis was more contained for emerging economies: in 2010 debt ratios had stabilized and started declining, though performance was weaker in some areas like emerging Europe.

One gauge is the improvement needed to stabilize the government’s debt to GDP ratio—the minimum goal of any sustainable policy.
With only two exceptions, no advanced economy had in 2010 a sufficiently strong cyclically-adjusted primary budget balance—total budget balance excluding the effects of the business cycle and interest payments—to keep its debt ratio from continuing to rise.
Emerging economies generally had stronger primary balances and a favorable differential between interest rate and growth, a key driver of the debt ratio, for many decades.
Stabilizing debt at post-crisis levels is not a desirable longer-run outcome: high debt is likely to be associated with higher real interest rates, lower growth, and higher exposure to shocks, and it leaves less policy space to respond to future shocks.

For almost all advanced countries, with the notable exception of United States and Japan, deficits are expected to decline in 2011.
Major adjustment efforts are on tap for 2012 in almost all advanced countries, based on the medium term adjustment plans most countries have produced.
Even with these adjustments, most countries will still be far away from the long term adjustment target.

Risk 1 — Financial sector shocks:
- Possibility of additional support needs for the financial sector in some specific countries; absent additional shocks, this risk seems limited but could trigger broader adverse market reactions.
Risk 2 — Fiscal policy implementation shocks:
- Political-cycle risks and difficulties in implementing large adjustments—especially the daunting adjustment envisaged in 2012, described as one of the largest on record, particularly in the US.
- Medium-term complications from rising spending pressures for pension and health care.
Risk 3 — Interest rate shocks:
- Focus on the differential between the interest rate and growth.
- Baseline assumptions are fairly benign for advanced countries, with the differential projected to be negative during 2011-15, but rising debt stock creates major risks.
- For emerging economies the differential is also projected to remain negative, but financial liberalization could raise interest rates on public debt, requiring adjustments in primary balances.

Prior to the crisis, many emerging economies experienced a largely negative interest rate-growth differential that allowed them to run primary deficits while maintaining a stable debt ratio.
In most emerging economies, the average real interest rate on public debt was negative—suspected to reflect financial market underdevelopment and financial repression (for example, liquidity constraints or interest rate ceilings).
As financial markets liberalize, interest rates on public debt are likely to rise, necessitating adjustments in primary balances; the pace of this process is uncertain and casts a shadow on the fiscal baseline.
The baseline for emerging economies also reflects favorable conditions such as high commodity prices, strong capital inflows and asset prices, and generally strong growth.

The fiscal outlook is more challenging for advanced economies, but there are also risks for emerging markets.
It is difficult to assess the likelihood that weak public finances would lead to major disturbances in some sovereign debt markets, particularly the largest ones; the largest advanced countries have a lot of credibility.
The risk that sovereign debt problems arise in these large markets is characterized as a “tail” or extreme event, one that would have major consequences globally if it materialized.
Even absent tail events, there is a risk that fiscal adjustment in advanced economies will "run out of gas" midway up the mountain, leaving public debt stable relative to GDP but at very high levels—detrimental for real interest rates and growth over the medium term.

Source: Shifting Gears: Where the Rubber Meets the Fiscal Road — Carlo Cottarelli, April 12, 2011