Enhancing fiscal frameworks and governance issues

Brian OldenIMF Regional Public Financial management

Advisor “FISCAL CONSOLIDATION, POLICY FRAMEWORK AND

GOVERNANCE”

POLICY WORKSHOP

UMAR/IMAD

2

Fiscal Challenge: Where are we?

• Still not out of the woods, but there are some good news

• A better appreciation of the size of the problem

• More attention to fiscal risks and long-term fiscal challenges—as highlighted in the November and April IMF Fiscal Monitors

– Advanced economies, L-T adjustment needs remain large

– spending on pensions—and especially, health care—constitutes a key challenge to fiscal sustainability

– Challenges to reforms still considerable (i.e. Slovenian pension reform)

• With the exception if Ireland, net cost of supporting financial institution less than expected

Fiscal Outlook Advanced Countries-November 2010 IMF Fiscal Monitor (percent of GDP)

-8

-6

-4

-2

0

2

4

2000 2003 2006 2009 2012 2015

-10

-8

-6

-4

-2

0

2

2000 2003 2006 2009 2012 2015

Overall Balance

60

70

80

90

100

110

120

2000 2003 2006 2009 2012 2015

Primary Balance

Cyclically Adjusted Primary Balance

Gross Government Debt

3

4

Change in debt-to-GDP Ratios: Advanced and Emerging Economies 2006 - 2016

Source –IMF Fiscal Monitor April 2011

Market Indicators

• Government financing needs remain exceptionally high in most advanced economies.

• Financing needs remain more “moderate” among emerging economies including SEE but not by any means negligible

• Yields and spreads have evolved favorably for emerging economies relative to advanced countries particularly peripheral Eurozone countries

– With increased risk appetite and an associated search for yields, demand for emerging economy sovereign debt rose sharply, leading to shrinking emerging market spreads.

– The changing perception of sovereign risk is also reflected in a divergence of CDS spreads between advanced and emerging economies

• But will it last?

Fiscal Risks for SEE economies

• A less favorable interest rate-growth differential a key source of risk for emerging economies-including SEE.

• Projected declines in debt ratios assumes a negative interest rate-growth differential, which offsets the continued primary deficit.

• Less accommodating developments

– possibly due to ongoing deterioration in public finances in advanced economies

– Could lead to higher global interest rates and a lower growth rate—public debt ratios in emerging economies could start rising again.

– Some criticism of over-optimistic forecasts authorities –growth, government revenues-by country has been noticeable (e.g. 2010 EC EFP evaluations)

• Increased government guarantees to financial and real sector as response to the fiscal crises

Is Living With Higher Debt an Option?

7

Source IMF Fiscal Monitor –May 2010

So what will be the impact on public finances?

• Initial post-crisis growth momentum looks to be slowing-both in advanced and SEE countries.

• Economic recovery will be gradual when growth resumes

• Increased debt levels have reduced fiscal space-even for those with relatively low levels-needs to be restored over the medium-term

• Financing options uncertain, both due to domestic banking) and external (competition for capital) factors.

• Fiscal risks remain elevated due to continued uncertainty over financial and real sectors of the economy

• Downside risks still high-contagion is still a worry if Eurozone sovereign debt crises exacerbates.

Medium-Term Fiscal Consolidation Process

• Strengthening fiscal institutions will be a key factor – Independent fiscal council-gaining in popularity in the CE

and SEE region (Hungary, Slovenia, Romania)– Strengthening existing fiscal institutions

• Need for medium-term fiscal consolidation strategy– Existing capacity to produce medium-term fiscal

frameworks needs to be strengthened and augmented by realistic medium-term budget frameworks

• General consensus that introduction of fiscal rules will help– Fiscal Responsibility Legislation?

Strong budget institutions increase the probability of successful consolidation

• Enable better understanding of the scale and scope of the fiscal challenge through

– comprehensive, timely and credible reporting,

– robust medium-term fiscal projections,

– quantification of longer-term structural issues that raise sustainability concerns), and

– disclosure and management of fiscal risks

• Improves capacity to monitor and enforce fiscal discipline

Strong budget institutions increase probability of successful fiscal consolidation

• Assist with development of credible fiscal consolidation strategy through

– Commitment to transparent medium-term fiscal objectives or rules.

– Medium-term budget framework setting limits on medium-term spending commitments.

• Improves capacity to Implement the consolidation strategy through the budget process.

Increasing use of independent fiscal agencies (Fiscal Councils)- including SEE region

• Fiscal Council objective to hold government accountable to meeting policy objectives and ensure the realism of underlying assumptions, forecasts and policies.

• Role of Fiscal Councils differ -3 main models

– Agencies that provide objective analysis of current fiscal developments, and costing of budgetary initiatives- e.g. Netherlands CBP.

– Bodies that produce independent projections and forecasts regarding both the budgetary variables as well as the relevant macroeconomic variables -Romania, (Hungary until disbanded)

– Institutions that, in addition to the above tasks, have the mandate to provide normative assessments, including on the appropriateness of fiscal policy stance -US, Korea

• But need to be realistic about what is achievable in low capacity environments.

– Risk of shifting too many fiscal responsibilities to an independent council, usurping functions that are rightly the responsibility of the executive, and leaving substantial gaps in the MoF

What is medium-term budgeting and why is it important?

What MTBFs Do How They Do It Who Benefits

1. Reinforce aggregate fiscal

discipline

presenting deferred effects of today’s decisions imposing restrictions on future budgets

Finance Ministers

Taxpayers

Future Generations

2. Facilitate a more strategic allocation of

expenditure

early reaction to future adverse developmentsabstracting from annual legal and administrative constraintsprovide an additional dimension in policy making

Prime Ministers

Line Ministers

Parliamentarians

3. Encourage more efficient inter-

temporal planning

providing greater transparency and certainty to budget holders about

their likely future resources

Line Ministries

Agencies

Local Governments13

Key Pre-requisites in delivering Medium-term budget Frameworks

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Fiscal Responsibility Legislation

• What is an FRL?

A law (or part of a law) with organic or “standing” status which aims to improve fiscal discipline by requiring governments to declare and commit to a monitorable fiscal policy strategy

• Key features of FRLs

–Fiscal Rules

–Medium-Term Budget Framework

–Top-down Budgeting mechanisms

–Requirement for transparency in fiscal policy implementation

–Sanctions for non-compliance

–Escape clauses-to cater for unexpected macro-fiscal events.

1. Source Fiscal Rules: Anchoring Expectations for Sustainable Public Finance-IMF Board paper 2009

Fiscal Responsibility Legislation

• However , in designing FRL need to be sure what weaknesses in fiscal policy-making is an FRL meant to solve? Cookie cutter approach is unlikely to work

• Political commitment to implementation is crucial

– Many examples of failed efforts.

– Need for comprehensive exit strategies from crises may help to focus the effort

– Increased usage in SEE countries (Romania, Serbia, Croatia)

Examples of Procedural FRLs

Country Fiscal Principles Statement Contents Sample Rules/Objectives

Australia

Charter of Budget Honesty (1998)

• Keep debt at prudent levels

• Adequate national savings

• Moderate cyclical fluctuations

• Ensure stable tax system

• Regard to future generations

• LT fiscal objectives

• ST fiscal targets

• Budget priorities

• Stabilization measures

• Accounting basis

• Balance on ave over cycle

• Surpluses over forecast period

• No increase in tax burden from 1996-7 levels

• Improve net worth over M-LT

New Zealand

Public Finance

Act

(1989)

• Keep debt at prudent levels

• Balance operating budget over reasonable period

• Maintain adequate net worth

• Prudently manage fiscal risks

• Ensure stable tax system

• LT fiscal objectives

• ST fiscal intentions

• S & LT fiscal projections

• Assessment of consistency w/ principles

• Operating surplus on ave over cycle

• Keep net debt below 40% of GDP & reduce to 30% by early 2020s & 20% over the LT

• Net worth rising by early 2020s

United Kingdom

Code for Fiscal

Stablity (1998)

• Transparency

• Stability

• Responsibility

• Fairness

• Efficiency

• LT fiscal objectives

• Fiscal rules for Parliament

• ST econ & fiscal outlook

• LT fiscal projections

• Analysis of cyclical impact

• Golden Rule: Balance the current budget over the cycle

• Sustainable Investment Rule: Keep debt below 40% of GDP

Fiscal Rules

• Fiscal rules increasingly popular among advanced and emerging markets-By 2009 80 countries had fiscal rules in place1

• Seen as a key element in many countries consolidation strategies

• Question as to appropriateness of different fiscal rule options

– Procedural vs. Numerical

– Revenue, Expenditure, Deficit, Debt

• Successful fiscal rules need credibility to help deliver the required adjustment and put debt on a sustainable path.

• Need to examine prerequisites needed prior to introduction of fiscal rules.

– Important in countries with limited capacity and weak PFM systems

Types of numerical Fiscal Rules

Objective Type of Rules Country Example

Debt Reduction Debt Brake Switzerland

Debt Sustainability Debt Ceiling SGP

Deficit Reduction Overall Balance SGP

Countercyclical Policy Structural Balance Chile

Reduce Expenditure Expenditure Ceiling Sweden

Reduce Taxes Revenue Ceiling Denmark

Protect Investment Golden Rule UK

Characteristics of good fiscal objectives/ rules

Characteristic Rationale Good Practice Bad Practice

Medium-term horizon

• Separate fiscal policy and budget decisions in time

• Allow flexibility to deal with volatility or shocks

• Over the cycle (UK)• Over the Parliament (NL)

• Annual deficit ceiling• Debt reduction path

Comprehensive in scope

• Limit scope for burden shifting or creative accounting

• General govt (SGP)• Public sector (UK, NZ)

• Budgetary Central Govt• Central Govt

Binding on outturn

• Reduce optimism bias in forecasts

• Ensure deviations are made up in future

• “Debt brake” rule (Swiss)• Maintain debt below 40%

of GDP (UK)

• Aim for balance over the forecast horizon

• Real expenditure growth targets

Stable over time• Build public support• Raise reputational cost of

breaking the rule

• Procedural FRLs (Aus, NZ)

• Frequent amendments to numerical FRLs in LA

Precise & transparent

• Provide clear guide for policy-making

• Facilitate evaluation of compliance

• 1% surplus over the cycle (Sweden)

• Increase net worth over time