When It Comes to Public Finances, Credibility Is Key

IMF Blog, October 7, 2021

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Authors: Raphael Espinoza, Vitor Gaspar, Paolo Mauro
Publication date: October 7, 2021
Core message: Commitment to budget discipline and clear communication of policy priorities pays off; credibility in fiscal policy reduces borrowing costs, attracts investment, and creates room for maneuver in crises.

Immediate priority: Ending the health crisis and addressing its immediate fallout remains the top priority; fiscal support will be invaluable until the recovery is on a strong footing.
Timing for consolidation: "The appropriate timing for starting to reduce deficits and debt will depend on country-specific conditions."

When lenders trust that governments are fiscally responsible, they make it easier and cheaper for countries to finance deficits.
Quantified impact: "When budget plans are credible (as measured by how close professional forecasters’ projections are to official announcements), borrowing costs can fall temporarily by as much as 40 basis points."
Non-market benefits: Even for governments that do not borrow from markets, fiscal credibility can attract private investment and foster macroeconomic stability.

Observed debt jumps: Debt sometimes increases beyond what is forecast in the baseline; these jumps "typically range between 12 and 16 percent of GDP at five-year projection horizons."
Underlying drivers of negative shocks: "Disappointing medium-term GDP growth and other drivers of debt, including bailouts of businesses and exchange rate depreciation."
COVID-related risks: "Many countries now face heightened fiscal risks as a result of record loans, guarantees, and other measures taken to protect firms and jobs from the fallout of COVID-19."
Policy design implication: Fiscal rules and institutions need flexibility to allow for larger deficits when needed while also ensuring debt reduction in good times.

Examples of risk-mitigation measures: "Restrictions on loan eligibility or limits on loan size and maturity" can reduce risks or limit fiscal costs if they materialize.
Trade-offs in rule design:
- Goals for budgetary rules and institutions: sustainability; economic stabilization; and, for fiscal rules in particular, simplicity.
- Numeric rules: "Simple numerical rules can sometimes be rigid" but "promote fiscal prudence."
- Empirical example: Countries that follow debt rules generally manage to reverse debt jumps of "15 percent of GDP in about 10 years in the absence of new shocks"—"significantly faster than countries that do not follow debt rules."
- Alternative indicators: "Other indicators, such as the interest bill or the net worth of the government, can complement traditional debt and deficit indicators."
- Procedural rules: Offer more flexibility than numerical fiscal rules, but may be harder to communicate and monitor compliance without numerical targets, particularly in the absence of sound fiscal institutions.

Evidence on transparency: Many countries suspended their fiscal rules in 2020 to increase health care and social spending; "analysis of newspapers shows that media reporting of the suspension of fiscal rules was more positive in places with higher fiscal transparency."
Role of communication: "A country’s commitment to budget discipline and clear communication of policy priorities—backed by transparency about government spending and revenues—pays off."
Political support: "Ultimately, fiscal frameworks are only effective if they have sufficient political support," but they "help focus discussions and can thus help reach political consensus on credible fiscal policies."

Commit to sound public finances through credible rules and institutions to lower borrowing costs and attract investment.
Design fiscal rules that balance sustainability, stabilization, and simplicity; consider complementary indicators (interest bill, net worth).
Build flexibility into rules to accommodate crisis-driven deficits while ensuring steady debt reduction in good times.
Implement risk-mitigation measures for contingent liabilities (restrict loan eligibility; limit loan size and maturity).
Enhance fiscal transparency and clear communication to bolster public and market confidence and to secure political support for frameworks.

When It Comes to Public Finances, Credibility Is Key — Raphael Espinoza, Vitor Gaspar, Paolo Mauro; October 7, 2021.