Download Fiscal Policy in an Emerging Market Economy Andrés Velasco Harvard University

Fiscal Policy in an Emerging
Market Economy
Andrés Velasco
Harvard University
March 2011
Road Map
1.
Fiscal policy in emerging market economies:
the issues
1. Deficit
bias and procyclicality
2. Political economy
2.
Chile´s fiscal rule
1. Initial
3.
conditions
2. The rule at work
3. Some results
Thinking about fiscal rules
1.
Fiscal policy in emerging markets: the
problems
Deficit bias
Procylicality
Deficit Bias
Drop in of government net assets on
average: over the cycle
Drop government net assets even when
standard smoothing considerations
suggest the opposite
See Alesina and Perotti (1995)
Procyclicality
Conventional wisdom: save in booms and
disave in recessions
Reality: save too little in booms or even disave
See Cuddington (1989), Sinnott (2009), Talvi
and Vegh (1995)
Arezki and Brückner (2010a): commodity price
booms lead to increased government spending,
external debt and default risk in autocracies,
and have smaller such effects in democracies
Procyclicality is especially an
issue for commodity exporters
Commodity-linked revenues (taxes, royalties, profits) can be a
large portion of government revenue. See Sinnott (2009)
Commodity price volatility is large (see next slide)
International capital flows are also procyclical: borrowing
constraints are relaxed during booms. See Kaminsky, Reinhart,
and Vegh (2005), Reinhart and Reinhart (2009), Gavin,
Hausmann, Perotti and Talvi (1996), and Mendoza and Terrones
(2008).
Caballero (2002) and Gallego, Hernández, and SchmidtHebbel (2002): highly procyclical capital flows in Chile
Mexico: an extreme example of procyclicality
300
18,0
16,0
250
14,0
200
12,0
10,0
150
8,0
100
6,0
4,0
50
2,0
0,0
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
-
Petroleum Index
Fiscal Deficit
Why fiscal procyclicality?
Economic story: borrowing constraints are
relaxed in good times, bind in bad times
Political story: the voracity effect
In practice, both probably interact
Deficit bias and procyclicality:
political economy elements
Key: fragmented fiscal policymaking. Tornell and Velasco
(1991), Velasco (1998) & (2003), Lane and Tornell (1993)
Imagine n symmetric groups. Ech can be thought of as a
particular constituency or recipient of government resources.
Public expenditure on group i can be interpreted as subsidies to
its members or spending on a public good that only benefits
those in group i.
Expenditure can be financed out of a variable stream of
revenue or by borrowing in the world capital market.
Accumulated debts are a joint liability of all n groups, as would
be the case with the national debt in any country.
Deficit bias and procyclicality:
political economy elements (2)
Each group maximizes utility from expenditure subject to
a shared budget constraint
Find sub-game perfect equilibrium of the game among the N
groups (simple state-dependent strategies)
Results
• Deficit bias: net government assets fall even without shocks
and then rate of discount equals rate of interest
• Procyclicality: too little saving during good revenue shocks
and too much disaving during bad revenue shocks
Deficit bias and procyclicality:
what can you do?
Reduce policy-making fragmentation: give more
power to
• Finance Minister vis à vis spending ministers
• Central government vis à vis sub-national
governments
• Executive versus legislature
Adopt fiscal rule that guides expenditure over long
horizons, and constraints its over the cycle
Chile did both
Hierarchical budget institutions: they
make a difference
Examples
Limit
“initiative” for spending rules to Executive
Set spending ceilings before setting allocation
Place strict deadlines for parliamentary approval of
budget
Set costly “status quo” or “default” rules in case of
parliamentary non-approval: revert to Executive´s
proposal or to previous year´s budget
This
all matters for fiscal performance: Von Hagen
and Harden (1995), Alesina et al (1999)
An index of fiscal institutions
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Source: Alesina et al (1999).
General Govt Balance/GDP (%) (1990
(1990-2000 average)
Fiscal institutions & fiscal performance
0.06
0.04
0.02
0
-0.02
-0.04
-0.06
0.35
0.40
0.45
0.50
0.55
0.60
Index of Budget Institutions
Source: Alesina et al (1999).
0.65
0.70
0.75
Fiscal rules: some definitions
“..Legislated
quantitative constraints on fiscal policy. These limits take
a variety of forms: restrictions on deficit financing, including
balanced budget laws; expenditure ceilings; numerical targets for
fiscal variables; borrowing rules; and restrictions on the issuance of
debt…” (Drazen, 2004)
“A fiscal rule is defined as a permanent constraint on fiscal policy
through simple numerical limits on budgetary aggregates. Each of
the elements in the definition is important: a rule delineates a
numerical target over a longlasting time period with a view to
guiding fiscal policy; it specifies a summary operational fiscal
indicator to which it is applicable; and it is simple so that it can be
readily operationalized, communicated to the public, and
monitored.” (IMF, 2009)
Fiscal rules: new fashion
According to the IMF (200), by 2009
exactly 80 countries had some kind of fiscal
rule in place
However… only 8 of those rules involved
“cyclical” or “structural” adjustments
Prominent example in Europe: Sweden
Ireland is now supposed to get one
2.
Chile´s fiscal rule
Initial conditions
The rule in operation
Some consequences
Fiscal
Otherwise
Chile: initial conditions
Strong
budget institutions
Good fiscal performance since 1990
More surpluses than deficits in 1990-2000
By 2000, gross public debt only 35% of GDP
So why did Chile need rule?
Economic concerns
No longer-term framework for fiscal policy
Contingent liabilities: pensions, infrastructure
Political concerns
Inefficient negotiation inside Executive and in Congress
Subnational governments
Chile: macro results
Output volatility
The real exchange rate
Room for countercyclical policy during
the crisis
Chile: fiscal performance after
the return of democracy
Chile: comparative public debt/GDP performance
Source: Sachs (2011)
Chile: the rule in operation
Dealing with flows: the structural balance
approach
Dealing with stocks: creation of SWFs
Dealing with flows: the structural
balance approach
Come up with parameters for cyclical adjustment
using independent committees
Copper
Trend GDP growth
Apply cyclical adjustment methodology: close to
OECD procedure
Arrive at estimate of “structural” or long term income
Spend X% of GDP less than long term income
Chile: institutional issues
The rule was self-imposed (no legal constraint) in
2001-2006
Fiscal Responsibility Law (2006) made it legal
However, law did not specify
Details of cyclical adjustment methodology
Target for structural surplus or deficit
Over time, government updated to methodology: eg,
correcting for moly prices
Over time, government changed surplus target: from
1% of GDP to 0.5% to 0 when crisis hit
Dealing with stocks
PENSION RESERVE FUND
0.2% of GDP minimum
0.5% of GDP maximum
FISCAL
SURPLUS
CAPITALIZATION OF THE
CENTRAL BANK
0.5% of GDP for 5 years
(optional)
SOCIAL & ECONOMIC
STABILIZATION FUND
Accumulates surplus that
exceeds 1% of GDP
Chile: fiscal results
Fiscal surpluses and the price of copper
Falling public debt
Rising financial savings
The end of procyclicality?
10
350
8
300
% of GDP
6
250
4
200
2
150
0
-2
1
2
3
4
5
6
7
8
9
10
100
-4
50
-6
0
Year
US cents per pound
Copper and fiscal surpluses
Effective fiscal surplus
Average copper price
Public debt: far away from Europe
Net public debt
20,0%
10,0%
-20,0%
-30,0%
-40,0%
-50,0%
Year
2010e
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
-10,0%
1990
% of GDP
0,0%
0
oct-10
nov-10
jul-10
ago-10
sep-10
mar-10
Apr-10
may-10
jun-10
Dec-09
Jan-10
feb-10
ago-09
sep-09
oct-09
nov-09
may-09
jun-09
jul-09
Jan-09
feb-09
mar-09
Apr-09
Fund Balance
oct-08
nov-08
Dec-08
jun-08
jul-08
ago-08
sep-08
mar-08
Apr-08
may-08
Jan-08
feb-08
A stabilization fund that stabilizes
25.000
Cumulative Withdrawals
20.000
US 15.000
Mill
on
10.000
5.000
Chile: macro results
Output volatility
The real exchange rate
Room for countercyclical policy during
the crisis
Falling output volatility: a consequence?
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
Vol. 1980-1989
Vol. 1990-1999
Vol. GDP
Vol. 2000-2009
RER
RER Average (1986-2009)
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
Avoiding Dutch disease?
The real exchange rate
120
110
100
90
80
70
60
The January 2009 fiscal stimulus
Overall: 2.8% of GDP
Additional spending
Infrastructure
Transfers
to poor households
Temporary tax cuts
Stamp
taxes
PPMs for SMEs
Individual tax rebates
Capitalization of Codelco: state-owned copper
producer
Fiscal and monetary stimulus
Paquetes de Estímulo Fiscal 2009 (%PIB)
4.5%
Rusia
Corea
4.0%
3.5%
Arabia Saudita
3.0%
2.5%
Chile
Japón
Australia EE.UU.
Canadá
Alemania Sudáfrica
México
Indonesia Gran Bretaña
Perú
Francia
India
Brasil
2.0%
1.5%
1.0%
0.5%
Turquía
Italia
0.0%
0
-200
-400
-600
-800
-1,000
TPM fines 2009 v/s TPM máxima en período 2007-2009 (bps)
-1,200
3.
Thinking of optimal rules
What to correct for?
Cyclical adjustment versus PIH
Degree of countercyclicality
Ex post v. ex ante rules
What to correct for?
OECD and other standard adjustments only correct for GDP
cycle
Chile procedure includes copper prices and other metals
prices
Is this enough? Probably not (Lane, 2010)
What are we leaving out?
Activity cycles that are linked to expenditure, not output:
what do do with consumption booms and large current
account deficits? Recall the Talvi effect.
Sectoral booms (real estate in Spain and Ireland)
Effects of movements in asset prices (again, land)
Effects of movements in the real exchange rate
Changes in the stock of government-held assets
As usual…tradeoff between accuracy and simplicity
Cyclical adjustment v. PIH
Cyclical adjustment corrects for deviations of GDP, copper
prices and other variables from their long term levels
To this rule one must add PIH criteria
How much to spend of accumulated assets? The interest
rate? Which interest rate?
Need to take a stance on temporary policy fluctuations
Temporary tax cuts (or increases)
Temporary spending (natural disasters)
Current debate in Chile
With no stance on temporary policy, all temporary shocks
are treated as permanent
With no stance on interest rate, one can consume too much
(or too little) of accumulated assets
Degree of countercyclicality
Rule based on cyclical adjustment + PIH is largely
acyclical
Optimal to have decidedly countercyclical rules
Engel, Neilson and Valdés (2010): need to have
switching regime –different spending coefficients in
different states (normal, good, bad)
Challenges
Simplicity:
the taxi driver test
Legitimacy: use of independent fiscal board?
Ex ante versus ex post rules
Whatever the rule –acyclical, countercyclical— it
typically involves an ex ante committment
Spend according to criteria X and Y and get
projected outcome Z
Results ex post (outcomes) depend on a host of factors
other than actions and committments
Actual economic prices and quantities
Varying elasticities of revenue to those Qs and Ps
Behavior of endogenous components of expenditure
Conclusion: the probability that the ex-post result will be
exactly equal to the ex-ante target is close to zero.
Ex ante versus ex post rules (cont)
Central banks recognized this problem long ago.
Therefore..
They set ranges, not points, as targets
They set variable time spans for achieving targets:
from 18 to 24 months….
Fiscal authorities have to move in the same direction
Alternatives:
The CB route: set target with band, longish time horizon
The Fiscal Board route: set tight target with escape
clause, triggered by decision of independent board
A few last words…
Fiscal rules, if designed and applied well, can do
a great deal of good
Can help change the political economy of the
budget process
Can reduce deficit bias and procyclicality
But… the more we do the better we can hope to
do
Recent experiences have taught us a lot
Great opportunity for a country like Ireland
Fiscal Policy in an Emerging
Market Economy
Andrés Velasco
Harvard University
March 2011