A call for new fiscal rules


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Advanced and emerging market economies need new debt sustainability benchmarks

On Christmas Day 2021, Italian Prime Minister Mario Draghi and French President Emmanuel Macron published an op-ed in the Financial Times on the need to reform EU fiscal rules. Their tone was optimistic: the pandemic was well managed (from a macro perspective) and debt-to-GDP ratios were no longer rising. At the same time, they argued that large-scale investments, including some public ones, must be mobilized to address existential challenges, such as climate change and pandemics. It’s hard not to agree with that. Moreover, the government’s indebtedness must be reduced, but not by raising taxes, cutting social spending or adjusting the budget. They opted for growth-enhancing structural reforms as well as new and better fiscal rules that would not impede investment. Well, that doesn’t seem to fit.

The old Maastricht rules were considered obscure and complex. Now pause here. As far as I remember, these rules, long since abandoned, mostly required a debt-to-GDP ratio of less than 60% and a nominal government deficit of no more than 3% of GDP. At the time, the idea was that countries would stay within these limits, so that they would have some leeway when needed. It shouldn’t be. In 2019, France’s debt ratio was 98% and Italy’s 135%. After the pandemic, they are now about 20 percentage points higher. The 3% cap on budget deficits was essentially treated as a floor.

Narrow spreads

What made all of this possible? Santa Claus stopped 30 years ago when Maastricht was signed and dropped the most incredible series of falling interest rates down the chimney: 10-year Bund yields were then above 6%; now they are close to zero. Spreads of Italian bonds against Bunds have moved here and there but are now at 136 basis points (a neighborhood effect, no doubt). France’s spreads vis-à-vis Germany remain very low, despite a 43-point higher debt ratio. The old fiscal rules are long dead. So much for designing new ones.

In the meantime, while emerging market economies have benefited, or should have benefited, from abundant global liquidity, their overall experience has not been so good. Not having access to as much funding, even in domestic currency (a welcome change from the 1980s), they took on less debt than their advanced counterparts. The latest IMF Financial Bulletin tells us that general government debt in emerging market economies now averages 64% of GDP, just over half the 122% level in advanced economies.

Even the most stable emerging market economies have bond yields well above those of advanced economies. At one point in recent years, this group included Brazil, as well as India, Indonesia, Mexico, Russia and South Africa, all with 10-year local currency bond yields of around 7%. Russia is now at 8%; the others are equal to or less than 7%, but still higher than those of advanced economies.

Fiscal slippage

Brazil is at the high end of the emerging market leverage ratio range at 83%. Fiscal slippage began in the late 2000s. The overall shift in the primary balance from surplus to deficit reached nearly 6 percentage points of GDP after the massive fiscal collapse of 2014. Since 2015, Brazil has recorded primary deficits. Unlike advanced economies, where interest rates have been in negative territory in real terms for more than a decade, in Brazil, 10-year inflation-linked government bonds yield more than 5% (a difference of 6% versus US Treasury inflation-protected securities). Nominal 10-year paper yields more than 10%, an even wider spread over Treasuries. Combined with very low per capita growth, this creates worrying debt dynamics. From a low of 53% in 2014, the debt ratio peaked at 89% in 2020. It is now at 83%, thanks to low interest rates due to the recession and surprisingly high inflation. Now, interest rates have risen and the debt ratio will resume its unsustainable rise.

Brazil’s recent fiscal history is worth reviewing. After major reforms in the 1990s, including a restructuring of state finances and a then widely admired Fiscal Responsibility Law enacted in 2000, Brazil’s finances appeared healthy and sustainable (although the public expenditure ratio continued to grow). The success did not last long. A postmortem of the demise of the Fiscal Responsibility Act has yet to be written, but the fact is, it doesn’t bite anymore. Since then, a public spending freeze in real terms has been added to the constitution, but that too is now full of holes. Confidence in the tax system has all but disappeared, and Brazil too badly needs a new system.

four pillars

The latest IMF Fiscal Monitor presents three desirable characteristics for a fiscal framework: “(1) sustainability of public finances; (2) stabilizing the economy through countercyclical fiscal policy, where appropriate; and (3) for fiscal rules in particular, simplicity. He also mentions resilience, which I would put number four on the priority list.

In a recent editorial, I proposed the following pillars for a new tax regime for Brazil:

  1. Public debt should be sized to allow access to finance (usually in crisis situations), at a reasonable cost, in case fiscal expansion is needed.
  2. The primary balance should be set so that, in normal times, the debt-to-GDP ratio remains stable.
  3. If for any reason the debt ratio deviates from its target level, the primary balance should be adjusted to gradually bring the debt ratio back towards the target.
  4. The average debt maturity is expected to be long, with limited concentration on the short end. This would correspond to the long-term horizons that governments should have. It would also reduce the risk of run-like financial or currency crises caused by sudden stops in funding.

These pillars would offer the four characteristics recommended by the IMF. In this case, they would also serve the advanced economies. Key metrics, such as debt spreads and growth, differ from country to country, but the same logic applies to all.

The Pillar 1 debt ratio target is quite subjective. It depends on several economic, political, institutional and historical factors. Therefore, Pillar 1 and 2 targets should be reviewed periodically, but not too frequently and on pre-announced dates, to minimize short-term political temptations.

The success or failure of a country’s macroeconomic regime can be reasonably measured by the cost of financing its long-term debt. However, even when interest rates are low, it should be remembered that markets are subject to ups and downs. As Benjamin Graham (Warren Buffett’s mentor) said, “Mr. The market is a manic depressive,” so blind faith in him is bad risk management. Thus, the currently extremely low interest rates in advanced economies should not be considered permanent. In this context, I believe that the Pillar 3 adaptive response function is the most important of the four.

A fiscal regime such as the one sketched here would, if properly managed, provide a resilient and possibly lasting anchor for advanced and emerging market economies.

ARMINIO FRAGA is co-founder of Gávea Investimentos and former President of the Central Bank of Brazil.


Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.

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