Sustained economic growth ...
... a critical objective of macroeconomic policy
... depends on a Sound Macroframework
... which depends on a Fiscal Policy
... whose main indicator is the Fiscal Deficit
Why DSA?
• Equity -- income distributional impact of tax and spending,
• Efficiency -- which taxes and spending improve economic efficiency and foster growth?
• Macroeconomic stabilization --consistent with monetary, exchange rate policies – by avoiding fiscal deficits and public debt accumulation
Fiscal Policy has several objectives...
Basic National Accounts
Gross Domestic Product
GDP = consumption(C) + investment(I) + exports(X) – imports(M)
Gross National Income
GNI = GDP - net income paid abroad(YF)
Gross National Disposable Income
GNDI = GNI + net transfers received from abroad(TRF)
GNDI is the amount of income available for an economy to consume and save, so GNDI = C + S
Macro Effects of the Fiscal Deficit Keynes revolution and the role of the fiscal deficit
Basic National Accounts
Given GNDI + YF - TRF = C + I + X – M and GNDI = C + S
we conclude that S – I = X – M – YF + TRF
where the savings-investment gap can be disaggregated into private and public sector gaps
S–I = (Sp–Ip) + (Sg–Ig) = (Sp–Ip) + (T–Cg–TRG–Ig)
Therefore, (Cg+TRG+Ig-T) = (Sp–Ip) + (M – X + YF – TRF)Budget deficit = Private S-I gap + BOP current account deficit
Macro Effects of the Fiscal Deficit
• The Keynesian analysis of fiscal policy must take off from the extreme short-run nature of the Keynesian model.
• Asset stocks are assumed fixed in the model, therefore, the consequences of the method by which the budget deficit is financed are not pursued.
How can the deficit G-T be financed?
Financing the Budget Deficit
There are four ways of financing the public sector deficit G-T:
G-T = money printing (seignorage) + foreign reserve use +foreign borrowing + domestic borrowing.
Financing the Budget Deficit
G-T = money printing + foreign reserve use + foreign borrowing + domestic borrowing.
Remember
• Foreign reserve use + money printing
emphasize the link between G-T and BOP CAD
is equal to the creation of credit by the central bank (which is an alternative to borrowing from markets)
Financing the Budget Deficit
G-T = money printing + foreign reserve use + foreign borrowing + domestic borrowing.
Each of the forms of financing can be associated with a major macro imbalance:
Money printing inflation
Foreign reserve use onset of exchange rate crises
Foreign borrowing external debt crises
Domestic borrowing higher interest rates and possibly explosive debt dynamics as borrowing leads to higher interest charges on debt and larger deficits.
Financing the Budget Deficit
Financing the Budget DeficitMoney printing
GovernmentRevenue
Inflation Rate0
A
Revenues from Seignorage
Run down foreign exchange reserves• This policy appreciates the exchange rate
which may slow down inflation (carried out not only through reserve use but also through increased foreign borrowing)
• It cannot be maintained unless fiscal policy is made compatible with lower inflation
• Use of international reserves to finance the deficit has a clear limit Private sector’s expectation can provoke capital flight
Financing the Budget DeficitUse of Foreign Exchange Reserves
Foreign borrowing• excessive reliance on external borrowing to finance the budget
deficit has led to debt crisis.
Domestic borrowing• may bring high real domestic interest rates• may lead to credit rationing/crowding out of private investments.• link between fiscal and external deficits is close whe the capital
account is highly open• Are there limits, thresholds? How to analyse it?
Long-term consequences of running deficits –we need debt dynamics
Financing the Budget DeficitNew Borrowing and Consequences
Debt Sustainability Analysisat Subnational Level
Debt Sustainability Analysis (DSA) a. Basic notionsb. Debt dynamics
What is Debt Sustainability Analysis (DSA)?
– Analysis of the government’s capacity to meet its future financial obligations given
. fiscal policy (revenues, expenditures)
. financing strategy (sources of budget financing)
– Debt dynamics induced by budget deficits and borrowing decisions
– Forward-looking framework based on. long-term projections of macro/fiscal/debt variables. debt burden indicators driven by macro/fiscal variables. uncertainty deterministic vs stochastic scenarios
Definition of Public Debt
Public sector coverage
Central government (‘national’)
Regional and local government (‘subnational’)
SOEs
Instruments – Investor base - Maturity – Currency - Rates
Bank loans, loans extended by other government entities, marketable securities, arrears in wage payments, arrears in payments to suppliers
Risks and vulnerabilities
Definition of Public Debt
Explicit financial obligationsare backed by enforceable contracts and law
Implicit financial obligationsarise from social expectation (e.g. pension liabilities in PAYG, bank bailouts?)
Non-contingent liabilitiesare payable regardless of circumstances
Contingent liabilitiesare payable if certain events eventually materialize (e.g. PPPs, financial guarantees, coverage of SOE losses, ‘municipalization’)
Gross debt Net debtsubtracting assets hold by the public sector
• Public Sector borrowing requirement Central Government Subnational (local) Government Public Enterprises
• Overall Balance= Total Revenue – Total Expenditure (Cash or Accrual)
• Primary Balance= Overall Balance – Interest Payments
Measuring the Fiscal Deficit
Assessing Debt Sustainability –3 approaches
– Projections of debt burden indicators (‘accounting’)
Identifying macro/fiscal drivers of debt dynamics(primary deficit, interest rates, real GDP growth, inflation, exchange rate)
– Debt sustainability indicators (‘analytical’)
Analytical definitions of solvency (e.g. stable debt, IBC, debt target)
Fiscal adjustment needed to satisfy solvency condition (e.g. debt-stabilizing primary balance, EU indicators S2 and S1)
– Debt thresholds and debt distress risk (‘empirical’)
Estimation of critical values of debt burden indicators that limit zones of acceptable/unacceptable probability of debt distress (e.g. Bank-Fund DSF thresholds for external debt)
Assessing Debt Sustainability – shortcuts
A pragmatic combination of the 3 approaches
– Public debt-to-GDP ratio (exponential trend?)
– Debt service-to-revenue ratio (capacity to service debt, coverage)
– Debt-stabilizing primary balance (adjustment to keep debt stable)
– Analysis of vulnerability/sensitivity to shocks (baseline vs alternative scenarios, deterministic vs stochastic, thresholds?)
– Use your best judgment and analysis
How does the government accumulate debt?
Economic principleBorrowing covers the excess of spending over income
Accounting identityChange in the value of debt D is given by Dt+1 – Dt = expenditures – revenues + other factors
accounting overall balance adjustment factor(deficit or surplus) (e.g. valuation effect)
Debt dynamics
Debt dynamics
+ Primary expenditures (uses of funds)
current expenditures (payroll, transfers, subsidies) and capital expenditure (investments)
- Revenues (sources of funds)
taxes, non-tax income (interest income), transfers from abroad or other government entities
= Primary balance (primary deficit or surplus)
+ Interest expenditure (uses of funds)
= Overall balance (overall deficit or surplus)
+ Adjustment factors valuation and accounting effects, privatizations, exceptional financing, recognition contingent liabilities
= Change in value of debt
Debt dynamics - Analytics
Budget and borrowing flows
D = debt, with f = external and d = domesticG – T = primary deficit
Value of debt and change in the value of debt
i = nominal interest rate, with f & de = exchange rate (NC per unit of FC)
𝐺𝐺 − 𝑇𝑇 + 𝑖𝑖𝑑𝑑𝐷𝐷𝑑𝑑 + 𝑖𝑖𝑓𝑓𝑒𝑒𝐷𝐷𝑓𝑓 = ∆𝐷𝐷𝑑𝑑 + 𝑒𝑒∆𝐷𝐷𝑓𝑓
Debt dynamics decomposition
𝐷𝐷 = 𝐷𝐷𝑑𝑑 + 𝑒𝑒𝐷𝐷𝑓𝑓 → ∆𝐷𝐷 ≈ ∆𝐷𝐷𝑑𝑑 + 𝑒𝑒∆𝐷𝐷𝑓𝑓 + ∆𝑒𝑒𝐷𝐷𝑓𝑓
∆𝐷𝐷 = 𝐺𝐺 − 𝑇𝑇 + 𝑖𝑖𝑑𝑑𝐷𝐷𝑑𝑑 + 𝑖𝑖𝑓𝑓𝑒𝑒𝐷𝐷𝑓𝑓 + ∆𝑒𝑒𝐷𝐷𝑓𝑓
Debt-to-GDP dynamics - Analytics
Debt-to-GDP ratio
Y = nominal GDP d = D/Y is debt-to-GDP ratio dd = Dd/Y is domestic debt ratio df = eDf/Y is external debt ratio
Debt-to-GDP dynamics decomposition
Change in debt-to-GDP
ratio
Primary deficit
as share of GDP
Real interest rate
effect
Real growth effect
Real exchange rate gains/losses
Debt-to-GDP dynamics - Summary
Debt-to-GDP dynamics
Primary balance
Endogenous debt dynamics
Other adjustments
Real interest rates
Real GDP growth
Changes in real exchange rate
Main referencesBurnside, Craig (Editor), 2005. Fiscal Sustainability in Theory and
Practice – A Handbook, Washington, DC, World Bank, Chapters 2, 3 and 4.
Ianchovichina, Elena, Liu, L. and Nagarajan, M., 2006. “Subnational Fiscal Sustainability Analysis - What Can We Learn From Tamil Nadu?” World Bank Policy Research Working Paper No. 3947.
Ianchovichina, Elena, Liu, L., 2008. Subnational Fiscal Sustainability Analysis. Washington, DC, World Bank, PREM Note No. 117.
Stanley Fisher and W. Easterly, 1990. The economics of the government budget constraint. Washington, DC, The World Bank Research Observer, Vol.5, No. 2 (July 1990).
Debt Sustainability Analysis (DSA) Basic notions and Debt dynamics