The Public Finances and the Pacto Fiscal: Comments

Adrienne Cheasty Senior Advisor, Fiscal Affairs Department

International Monetary Fund

CEPAL 20th Regional Seminar on Fiscal PolicySantiago de Chile

January 28-31, 2008

The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management

2

Thank you, CEPAL

• Latin America is in better fiscal shape than considered possible 20 years ago

• Some of the credit must go to CEPAL, and to this seminar, for its success in: – raising awareness of fiscal issues

– becoming a focal point for policymakers and academics to develop their thinking on them

– influencing fiscal strategies by clear-minded thematic agendas and publications

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However, the Agenda of the Fiscal Pact remains valid

• Consolidate the ongoing fiscal adjustment• Raise the productivity of public

spending• Make fiscal activities more transparent• Promote equity• Support the development of democratic

institutions

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Consolidate the ongoing fiscal adjustment (1)

• The good fiscal performance may not be robust to an unfavorable international environment

• More than half the variation in Latin American GDP can be explained by external shocks (Osterholm and Zettelmeyer, 2007)

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Although there is a positive output gap....

-4

-2

0

2

4

6

8

10

1970 1975 1980 1985 1990 1995 2000 2005

-4

-2

0

2

4

6

8

10Output gap

Output growth

Potential output growth

Latin America: Cyclical Position(In percent) 1/

Sources: WEO; and IMF staff calculations. 1/ Potential output levels calculated as an average of all filtered series.

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Downside risk is increasing for the region

Growth Prospects for Latin America and the Caribbean(In percent)

2003 2004 2005 2006 2007 2008

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

90 percent range

50 percent range

Baselineforecast

Sources: WEO; and IMF staff calculations.

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...And recent fiscal gains are tailing off, ...

2002 2003 2004 2005 2006 2007

22

23

24

25

26

27

28

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Revenues

Total Revenues and Primary Spending(In percent of GDP) 1/

Source: IMF staff estimates.1/ Unweighted averages for 17 countries.

Primary spending

Primary surplus

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... mainly because spending continues to grow rapidly

-4

-2

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005 2006 2007

Latin AmericaSouth America & Mexico

Growth in Real Primary Expenditures(In percent) 1/

Central America

Source: IMF staff estimates.1/ Unweighted averages.

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Consolidate the ongoing fiscal adjustment (2)

• Some aspects of the fiscal environment will be different in the coming 20 years.

– Easier access to market financing

– Redemption from original sin?

– More capital flows

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New: easier access to market financing

• More fiscal discipline, or less?

• The less the financing constraint, the greater the possibility for counter-cyclical fiscal policy

• Fiscal multipliers may be different• Crowding out via the interest rate channel is reduced as

capital mobility increases

• Switching from captive sources of financing may mean domestic interest rates become more sensitive to fiscal policy

• Trade openness reduces fiscal multipliers (but not by much)

• Households with better access to credit may become more Ricardian—offsetting a fiscal contraction by increasing borrowing

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A shift towards domestic debt—because of improvements in terms...

Figure 10. Domestic and External Public Debt in Emerging Markets

0

5

10

15

20

25

30

35

40

45

50

1998 1999 2000 2001 2002 2003 2004 2005 2006

External Domestic

Source: World Bank Global Development Finance.

(Average across 28 emerging markets, in percent of GDP)

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... and redemption from original sin

Figure 11. Share of Domestic-Currency Debt Held by Nonresidents

0

5

10

15

20

25

30

Kenya

Korea

Brazil

Malaysia

Mexico

Indonesia

Zam

bia

Poland

Hungary

June 2002 June 2006

Source: World Bank Global Development Indicators.

(In percent)

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... imply improved debt composition and less risk, so debt tolerance has increased

But:• Need to maintain a balance between local and

foreign currency debt, to reduce temptation to inflate away local debt—and to establish borrowing benchmarks

• Ensure government borrowing from the banking system does not lead to inefficiencies and delayed development of domestic capital markets

• Will original sin return if global credit tightens?

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New: more capital flows

• Fiscal tightening is not always appropriate– As a response to inflows when the external current

account is in surplus– As a response to outflows with non-fiscal causes and

consequences

• But it very often is appropriate– Need to ‘pre-position’ fiscal policy, to give it market

credibility, and the flexibility needed to confront the new sources of volatility associated with financial globalization

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Raise productivity of public spending

Pre-positioning largely means savings on the spending side, as revenue is decelerating along with growth– Key pending fiscal reform: tackle budget

rigidities/revenue earmarking– To close the infrastructure gap, make public

investment more efficient rather than cutting it• Remove unintended constraints on high-return

investment by well-run public enterprises

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Raise productivity of public spending (example)

• Remove unintended constraints on high-return investment by well-run public enterprises

• Criteria for permitting low-risk public enterprises to be excluded from fiscal targets (managerial independence, governance, financial sustainability, etc.)

• The criteria create a roadmap for public enterprise reform and reduction of an important category of fiscal risk

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Make fiscal activities more transparent

• Emphasis on transparency is a key innovation of the last two decades ... But still a frontier– Standards and codes (mainstreaming ROSCs/EITI)– Comprehensive oversight and monitoring

• Public enterprises• Public-private partnerships• Guarantees• Other contingent liabilities

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Promote equity

• Fewer gains here, and more at stake

– CEPAL’s tax project– Must fiscal termites win?

• An effective PIT• Better compliance

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Develop democratic institutions

• Fiscal advances: transparency, FRLs – not enough to be democratic, but also need to be responsible.

• We have learned how to make FRLs better– Transparency and accountability– Broad coverage– Procedural rules are more durable than numerical– If the rule has to be numerical, follow best-practice– Effective enforcement mechanisms– Integration with public finance legislation