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IMFSurvey Magazine: Policy

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Vigilance Needed to Strengthen Public Finances

EU flags in front of European Commission headquarters in Brussels. The IMF has called on European countries facing market pressures to press ahead with reforms (photo: Theirry Tronnel/Corbis)

Fiscal Monitor

Vigilance Needed to Strengthen Public Finances

IMF Survey online

October 9, 2012

  • Countries continue to make significant headway in rolling back fiscal deficits
  • Pace of debt reduction is slower than after previous recessions reflecting severity of recession and sluggish recovery
  • Current array of fiscal adjustment measures consistent with stronger medium-term public finances

In many advanced economies, efforts to reduce debts and deficits will need to persist for many years for debt ratios to return to their pre-crisis levels.

In the latest edition of its Fiscal Monitor, the IMF observes that deficits are set to narrow in nearly all advanced economies in 2012 and 2013 even in the face of weak economic growth. In about half of the advanced economies, cyclically adjusted fiscal deficits will be smaller next year than they were in 2007, before the start of the crisis.

“Efforts at controlling debt stocks are taking longer to yield results,” said Carlo Cottarelli, head of the IMF’s Fiscal Affairs department, which produced the report. “Debt reduction is taking longer than after previous recessions, mostly due to the magnitude of the recession and the sluggishness of the recovery afterward.”

In a few cases, high interest rates, which are negatively affected by policy uncertainties, are also to blame, the report notes.

IMF’s Cottarelli with Fiscal Monitor at news conference in Tokyo: ‘Debt reduction is taking longer than after previous recessions’ (IMF photo)

The IMF Fiscal Monitor is published twice a year to track public finance developments around the world. Quarterly updates are issued in January and July.

Keeping commitments

In a recent speech in Washington D.C., IMF Managing Director Christine Lagarde reminded policymakers of the importance of delivering on the policy commitments that have been made.

Lagarde cautioned that many of the big legacies of the crisis risk becoming even more entrenched, including the lasting burden of high public debt, which is now at levels not seen since the Second World War. “For many economies, under present circumstances it will take years of fiscal adjustment to get back to pre-crisis levels,” she said.

The Fiscal Monitor recommends large economies like the United States and Japan act in a timely manner to clear policy uncertainties. The United States should act soon to define a path to avoid the “fiscal cliff”—a very sharp increase in taxes and reductions in discretionary spending at the beginning of 2013—and to raise the federal debt ceiling. Japan, meanwhile, should move ahead with a decisive debt reduction plan that includes further reforms to revenues and entitlements.

Balancing act

In most other advanced economies, the report says near-term policy action has to walk the narrow path that will allow them to continue strengthening the public finances while still supporting the recovery.

Countries facing market pressures, particularly some in Europe, have little choice but to press ahead with planned deficit reductions. In countries that have more room to maneuver, policymakers should allow automatic stabilizers to operate—for example, through higher unemployment compensation and social assistance—tolerating a higher deficit if growth should slow.

If growth should fall significantly below the current projections in the IMF’s World Economic Outlook report, countries with room to maneuver should smooth their planned adjustment over 2013 and beyond.

Emerging markets on hold

Debt-to-GDP ratios peaked earlier in emerging market economies and fell in almost 60 percent of these countries last year—a much faster rate of progress than after previous recessions. With lower levels of deficits and debt than most advanced economies, many emerging market economies and low-income countries have room to put their fiscal consolidation efforts on hold until the global outlook has improved.

Still conditions vary greatly from country to country, and some emerging market economies will need to make further progress to restore fiscal buffers. Medium-term targets in the Russian Federation should be more ambitious, given exposure to oil price volatility. Turkey, which faces large external current account deficits, also needs to take a more ambitious approach. In countries like Egypt, India, Jordan, and Pakistan, cuts in key subsidies and enhanced revenue are needed to contain the deficit.

The report notes the situation is also varied among low-income countries, where ambitious investment plans often contribute to rising debt ratios. Deficits are also expected to rise in most low-income countries because of a combination of slowing external demand and the growing weight of food and fuel subsidies.

Social equity and employment

Fiscal adjustment packages should be tailored to support social equity and reduce long-term unemployment, the report recommends. For example, cuts in generalized transfers should be accompanied by an enhancement of targeted social safety nets. Also, better designed tax and social benefits policies could help reduce unemployment and boost labor supply, while equity could be improved by combating tax evasion to make sure everyone pays a fair share.

In emerging market economies and low-income countries the scope for fiscal policies to foster employment is more limited due to administrative challenges, as well as large informal sectors and the limited reach of social benefit programs. In these circumstances, the IMF recommends the priority should be on the development of well-targeted and well-designed social safety nets, backed by resilient funding sources and institutional administrative capacity building.

Fiscal outlook remains fragile

While substantial progress has been made in terms of deficit reduction, fiscal vulnerabilities remain elevated, the report finds.

In advanced economies, persistently high debt levels coupled with unaddressed medium-term challenges, such as pension and health-care reform in many countries, have exposed budgets to market shocks.

Lower-than-expected growth in advanced as well as emerging market economies would weaken budget positions and complicate debt dynamics across many countries.

In emerging market economies interest rates have remained broadly stable in recent months, but in several cases fiscal projections presume a decline in rates. As such, the fiscal picture in these economies could be weaker than expected should lower rates not materialize.