Bridging the Gap: How Official Financing Can Ease the Pain of Adjustment

IMF Blog, August 3, 2012

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Authors: Nicols Eyzaguirre
Published: August 3, 2012

Personal reflections and context

After three and a half demanding and fulfilling years at the International Monetary Fund, the author shares reflections on adjustment under fixed exchange rates.
These reflections are personal and not an institutional view.
The central issue: why lend to a country trying to bring down its government debt and deficit? Answer given: to give the reforms needed to make economies competitive again time to kick in.

Financing constraints, spending adjustment, and regaining competitiveness

Financing stress prevents an economy from maintaining its spending plans; with creditors unwilling to extend financing, reductions in government spending become unavoidable.
Spending above the level of production, the root cause of debt accumulation and financing stress, needs to be reversed for financing to start flowing again.
Without demand to make up for spending cuts, production will fall; producers need new buyers to replace financing-constrained ones.
If excess debt and financing constraints affect both public and private sectors, new buyers need to be found abroad through exports.
Exports do not appear automatically; goods need a combination of quality and price attractive to foreigners.
Excess spending harms the trade balance, and inflates the prices of non-tradable goods and services—including wages; higher wages make exports less competitive.
When governments have a hard time financing themselves, the economy is no longer competitive enough to automatically capture foreign demand. Part of the problem arises from the high costs of non-traded inputs.
Booms in nontradables—typically housing—may have masked an underlying lack of competitiveness in exports, fostering complacency about needed reforms.

Vicious circle of adjustment without financing

Adjustment entails austerity and structural reforms.
Austerity is needed to fit spending to available financing and bring down non-tradable prices to restore competitiveness when currency devaluation is not an option.
A coordinated reduction of non-tradable prices including wages, agreed between labor unions and businesses, would mitigate the shrinkage in spending needed to realign non-tradable prices; such agreements are often difficult to achieve.
Structural reforms (labor and product market reforms) increase flexibility and competition and facilitate downward adjustment of non-traded goods prices; if competitiveness is very weak, additional reforms may be needed to spur comparative advantages in new sectors.
Structural reforms take time to boost exports; if austerity is the only response, the economy will experience a severe downturn.
Consequences of contraction: output contracts, government revenue contracts (feeding creditors’ fears of default and crimping financing), asset values fall, firms’ borrowing ability weakens, banks face sizable loan losses, defensive deleveraging exacerbates private demand contraction, deflationary pressures increase the real value of debts.
Eventually, falling non-tradable prices will make exports profitable again and boost import-competing home goods, but the output loss will be needlessly large.
As structural reforms mature, exports surge, domestic demand is partially revived, the trade surplus allows reduction of foreign debt, and recovery in tax collection repairs the government balance sheet, restoring access to market financing.

How to avoid excessive output loss

Excess output loss occurs because prices are slow to adjust, the exchange rate is inflexible, and financing is tight—placing the up-front burden on output and employment.
Such excess output loss can strain the social fabric and introduce perceptions of political and default risks.
Official financing— for instance in the form of an IMF-supported program—during the economic transition while structural reforms mature will help avoid this fate, supported by steps to reduce non-tradable prices.
Conditionality will be needed to prevent structural reforms from stalling; reforms are difficult and require governments to spend significant political capital, so the risk of backsliding will be present for some time.
The European Union and the International Monetary Fund are now trying to provide financing to many besieged economies in Europe to avoid excessive output losses.
Adjustment without financing may fail and, even if it succeeds, it will impose needless sacrifice, often on the more vulnerable segments of the population.
At the same time, the problem cannot be solved without adjustment and sacrifice; markets sometimes finance unsustainable expansions and later over-penalize when they respond, leaving austerity to stay.

Bridging the Gap: How Official Financing Can Ease the Pain of Adjustment — Nicolás Eyzaguirre, August 3, 2012.