L-6 Fiscal Policy and Debt
Sustainability
Presenter
Clinton Shiells
Joint China-IMF Training Program
Course on Macroeconomic Management
and Financial Sector Issues
CT
Lecture Outline
How do we measure fiscal policy?
Fiscal policy for short-term macroeconomic stability
Fiscal policy to reduce vulnerability
Fiscal policy for growth and poverty reduction
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How Do We Measure
Fiscal Policy?
3MMF
How do we measure fiscal policy?
• Fiscal policy is the use of government spending and
taxation to influence the economy.
• Flow indicators
• Overall fiscal balance: difference between total revenue
(including grants) and total expenditures plus lending minus
repayments
• Primary balance: revenue minus non-interest (primary)
expenditure
• Current balance: difference between current revenue and current
expenditures
• Cyclically adjusted balance: nominal fiscal balance net of the
cyclical component of the budget
4MMF
How do we measure fiscal policy?
• Stock indicators
• Net worth: difference between assets and liabilities
• Off-balance-sheet items ., contingent liabilities, public-private
partnerships (PPPs)
Assets Liabilities
• Financial (.,
government deposits)
• Nonfinancial (.,
public roads)
• Government debt
5MMF
What is fiscal policy used for?
• Short-term macroeconomic stabilization
• Reducing vulnerabilities
• Growth and poverty reduction
Relative importance of these objectives depends on
country circumstances.
6MMF
Fiscal Policy for Short-Term
Macroeconomic Stabilization
7MMF
Fiscal policy for macroeconomic stabilization
Fiscal policy can be used for:
• Mitigating cyclicality (recurrent booms and recessions)
• Taming inflation
• Reducing external current account imbalances
• Managing financial crises
8MMF
Fiscal policy versus monetary policy
• Fiscal policy and monetary policy should be designed in
tandem to get the right mix.
• Which is more effective in moderating cyclicality?
– Monetary policy can be implemented faster but fiscal policy may
affect output more immediately.
– In general, fiscal policy should play a bigger role when monetary
policy is constrained (., with a fixed exchange rate, or when
nominal interest rates are close to zero, or when financial
systems are less developed).
9MMF
1. Countercyclical fiscal policy
Two channels:
• Automatic stabilizers
• Discretionary measures (fiscal stimulus)
10MMF
(ii) Discretionary fiscal policy
Key considerations:
• Size of the fiscal stimulus
– Multiplier
• Timing
• Composition
• Duration
Fiscal stimulus measures should be timely, targeted,
and temporary (TTT)
11MMF
What determines the size of the multiplier?
The size of the multiplier is larger if:
• “Leakages” are few
– High marginal propensity to consume (c), low marginal
propensity to import (m)
– No Ricardian equivalence
• Monetary conditions are accommodative
– Small or no increase in interest rates (no crowding out)
– Small or no exchange rate appreciation
• The country’s fiscal position after the stimulus is
sustainable
12MMF
2. Fiscal policy and inflation
• Fiscal policy can affect inflation through many channels:
– In the short run, fiscal policy affects the price level through its
impact on aggregate demand.
– Fiscal policy can lead to sustained inflation if the fiscal deficit is
monetized.
– Fiscal adjustment can also affect inflation via the demand for
money, including through inflation expectations, interest rates,
and confidence.
13MMF
3. Fiscal policy and the current account
balance
14MMF
• The government’s saving-investment balance is linked to
the current account balance through the ex post income
identity:
• Fiscal consolidation contributes to external adjustment
but a one-for-one improvement in the current account
balance is unlikely.
– In the case of expansionary fiscal consolidation the current
account balance could even deteriorate.
4. Fiscal policy and financial crises
• When a capital account crisis hits, fiscal consolidation is
usually unavoidable because external financing dries up.
• If fiscal problems are the root cause of the financial crisis
(loss of confidence), fiscal consolidation is necessary to
regain market access and lower the cost of borrowing.
• If fiscal problems are not the root cause, fiscal
contraction may be counterproductive; fiscal expansion
may be needed instead.
15MMF
Achieving medium-term fiscal credibility
• Fiscal rules to constrain future behavior
• Reasonable multi-year spending ceilings
• Fiscal transparency; open and accountable budgeting
– Establish a politically-independent fiscal agent to monitor fiscal
policy making
– Provide the public with comprehensive information on the state
of public finances
• Disciplined budget preparation and execution
MMF 16
MMF 17
Fiscal policy has played a significant role in supporting
demand since the crisis, with off-budget and LGFV
spending becoming especially important countercyclical
tool…
Fiscal Policy to Reduce
Vulnerability
18MMF
Fiscal policy to reduce fiscal vulnerability
• A country’s public finances may appear sound, but may
be vulnerable if underlying weaknesses threaten its
future fiscal position and limit the government’s ability to
respond to fiscal policy challenges.
• Examples:
– Debt sustainability
– Contingent liabilities and debt structure
– Fiscal rigidities
– Emerging fiscal pressures, ., demographic changes
19MMF
Debt sustainability
• Public debt is sustainable when the government can
continue servicing it without the need for an
unrealistically large future correction to its revenue or
primary (non-interest) expenditure path.
• Market expectations are important too—governments
that are able to assure markets about future fiscal
policies may be able to maintain larger levels of debt
than otherwise.
20MMF
MMF 21
Augmented fiscal debt has risen to above 45
percent of GDP…
22MMF
2005 2007 2009 2011 2013 2015
35
40
45
50
55
60
65
70
Historical 40
Baseline
43
Baseline and historical scenarios
2005 2007 2009 2011 2013 2015
35
45
55
65
i-rate shock 46
Baseline 43
Interest rate shock (in percent)
China: Public Debt Sustainability: Bound Tests
(Augmented debt in percent of GDP)
23MMF
China: Public Debt Sustainability: Bound Tests
(Augmented debt in percent of GDP)
2005 2007 2009 2011 2013 2015
35
45
55
65
Growth shock
44
Baseline
43
Growth shock (in percent per year)
2008 2010 2012 2014 2016 2018
35
45
55
65
PB shock
51
Baseline
43
59
Primary balance shock (in percent of GDP) and
no policy change scenario (constant primary balance)
No policy change
24MMF
China: Public Debt Sustainability: Bound Tests
(Augmented debt in percent of GDP)
2005 2007 2009 2011 2013 2015
35
45
55
65
Combined
shock 50
Baseline 43
Combined shock 2/
2008 2010 2012 2014 2016 2018
35
45
55
65
30 % depreciation
Baseline
43
contingent
liabilities shock
50
Real depreciation and contingent liabilities shocks 3/
Longer term fiscal pressures
• Demographic changes (mainly aging populations) will pose
increasing burdens on public finances of many developed and
some
developing countries.
Source: Heller (F&D 2006)
Old age
dependency
rate (%)
25MMF
Fiscal Policy for Growth and
Poverty Reduction
26MMF
Fiscal policy for growth and poverty
reduction
• A sound fiscal position is key to achieving
macroeconomic stability, which is critical for sustained
growth and poverty reduction.
– Perceptions and investor confidence
• High-quality fiscal adjustment can also mobilize domestic
savings, increase the efficiency of resource allocation,
and help meet development goals.
– Government saving
– “Fiscal space”
27MMF
Mobilizing and allocating resources
• Economic growth depends on accumulating physical and
human capital, which in turn requires savings.
• As private sector savings are often low in developing
countries, fiscal policy can play a central role in
mobilizing resources by raising revenue and reducing
less productive spending.
• But the mobilized resources must be invested
productively.
– Public spending should be directed to areas with the highest
social return and should complement, rather than compete with,
the private sector (., health, education, and pensions in
China).
28MMF
29MMF
High social security contribution rates are an
impediment to domestic rebalancing in
China…
Fiscal space
• Fiscal space in the immediate term
– Need to find resources to finance pressing expenditures today
– Link to fiscal sustainability
• Fiscal space in the medium term
– Need to ensure that future budgetary resources are not
exhausted by government expenditure commitments, in order to
have scope to respond to unanticipated fiscal challenges
MMF 30
