Fiscal Policy Can Promote Economic Stability and Address Risks to Public Finances

IMF Blog, April 12, 2023

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Publication date: April 12, 2023.
Three years since the outbreak of the pandemic, fiscal policy has moved a long way toward normalization.
Governments have withdrawn exceptional fiscal support; public debt and deficits are falling from record levels amid high inflation, rising borrowing costs, a weaker growth outlook, and elevated financial risks.
Debt sustainability is a cause for concern in many countries.
This blog is based on Chapter 1 of the April 2023 Fiscal Monitor: “On the Path to Policy Normalization.”

2020 saw a historic surge in public debt to nearly 100 percent of gross domestic product because of economic contraction and massive government support.
Nearly three-quarters of countries tightened both fiscal and monetary policies last year.
In the last two years global debt posted the steepest decline in 70 years and stood at 92 percent of GDP at the end of last year, still about 8 percentage points above pre-pandemic projections.
Primary deficits are falling rapidly and approaching pre-pandemic levels.
After declining abruptly in 2020, nominal GDP surged over the past two years in many countries, reflecting both a strong economic rebound and the unexpected inflation surge, which fueled higher-than-expected nominal GDP growth and tax revenues.
On average, advanced and emerging market economies (excluding China) experienced debt reductions of about 2 to 3 percent of GDP last year, thanks in large part to inflation surprises.
The pace of deficit and debt reductions varied depending on how quickly countries exited the pandemic and how they were affected by subsequent shocks; countries that confronted a more severe energy or food crisis tightened more gradually.

Inflation surprises reduced debt ratios more in countries with high initial levels of debt combined with large inflation surprises and strong growth.
Exchange rate depreciation, primary deficits, and higher borrowing costs played a larger role in shaping debt dynamics in some emerging market economies and low-income countries, limiting the effects of higher inflation on debt ratios.
Tighter budgetary constraints have exacerbated the balancing act for low-income countries, hampering progress toward the UN’s Sustainable Development Goals.
Countries have been hit hard by the cost-of-living crisis and food insecurity, stalling global poverty reduction.

Amid high inflation, tightening financing conditions, and elevated debt, policymakers should prioritize keeping fiscal policy consistent with central bank policies to promote price and financial stability.
Many countries will need a tight fiscal stance to support the ongoing disinflation process—especially if high inflation proves more persistent.
Tighter fiscal policy would allow central banks to increase interest rates by less than they otherwise would, which would help contain borrowing costs for governments and keep financial vulnerabilities in check.
Tighter fiscal policies require better targeted safety nets to protect the most vulnerable households, including addressing food insecurity, while containing overall spending growth.
Policymakers must be ready to respond quickly to high risks:
- If financial turbulence morphs into a systemic crisis, fiscal policy may need to intervene swiftly to facilitate resolution.
- If economic activity weakens substantially and unemployment rises, governments should allow automatic stabilizers to work (for example, allow deficits to rise as unemployment benefits increase or tax revenues fall), especially if inflation pressures are under control and fiscal space is available.

Reducing debt vulnerabilities and rebuilding fiscal buffers over time is an overriding priority.
Despite envisaged gradual fiscal tightening in the coming years, the IMF projects global public debt will rise, driven by some large advanced and emerging market economies.
Concerns with debt vulnerabilities have intensified in many countries; in low-income developing economies, higher borrowing costs are weighing on public finances, with 39 countries already in or near debt distress.
Recommended actions:
- Step up efforts to develop credible risk-based fiscal frameworks that reduce debt vulnerabilities over time and build up the necessary room to handle future shocks.
- Combine strengthened institutions with revamped fiscal rules.
- Medium-term fiscal plans should include credible policy commitment to achieving debt sustainability by announcing specific spending and revenue measures or reforms, while allowing for flexibility to adjust to shocks.

Low-income countries face particularly severe challenges.
Revamped efforts to increase revenue are critical to restoring fiscal sustainability, dealing with the cost-of-living crisis, and achieving the Sustainable Development Goals.
Despite multiple waves of tax reforms, revenues remain stubbornly insufficient, below levels that enable the state to play its role in sustainable and inclusive development.
International cooperation is crucial to helping these countries resolve unsustainable debt burdens in an orderly and timely manner.

Source: Fiscal Monitor (Chapter 1): “On the Path to Policy Normalization” — blog summary, April 12, 2023.