1. Debt Sustainability and Procyclical Fiscal Policies in Latin America Enrique Alberola and José Manuel Montero II REUNIÓN REDIMA CENTROAMERICA 10 de Noviembre de 2005Santiago de Chile 10 de Noviembre de 2005, Santiago de Chile RED DE DIÁLOGO MACROECONÓMICO (R E D I M A)

2. 2 OUTLINE OF THE PRESENTATION  Motivation  Procyclicality of Fiscal Policy  Debt Sustainability and Fiscal Stance  Conclusions

3. 3 I. Motivation  Empirical evidence shows that Fiscal policy is procyclical in Latin America –During expansions (contractions) cyclically-adjusted revenues decrease (increase) cyclically-adjusted expenditures increase (decrease) –Gavin and Perotti (1997), Alberola and Molina (2003) –Widespread phenomenon: Talvi and Vegh (2000) show that FP is procyclical in a sample of 20 industrial countries and 36 developing countries. Exception: G-7 countries. Kaminsky, Reinhart and Vegh (2004) for a sample of 104 countries.  Destabilizing role of fiscal policy – introduces an additional source of volatility.

4. 4 I. Motivation  PUBLIC SECTOR CREDITWORTHINESS: –Procyclical FP determined by changes in financing conditions Procyclical fiscal policy Loose Fiscal policy Tight Expansion Activity Contraction Loosening Financing Constraints Tightening Improvement Debt sustainability Deterioration Voracity effects

5. 5 I. Motivation  Does the stance of fiscal policy depend on creditworthiness, as measured by debt sustainability perceptions?  Empirical strategy 1)Test the procyclicality of FP in LA Compute output gap and structural primary balance (SPB) Are they correlated? 2)Test how perceptions of credit worthiness, embedded in debt sustainability impinges on fiscal stance Derive indicator of debt sustainability : current threshold balance (CTB) Estimate relationship between fiscal stance and CTB

6. 6 II. Procyclicality of Fiscal Policy  Three steps :  Derive the output gap  Estimate the structural balance –Fiscal Stance= change of SPB as percentage of GDP  SPB associated with  cyclically-adjusted revenues  public spending  contractionary fiscal stance  Is Fiscal policy procyclical?  Test link SPB changes and output gap

7. 7 II. Procyclicality of Fiscal Policy: Output Gap  OUTPUT GAP – Production function: OECD, IMF (EC shifting towards it) Problems: data availability (labour stock, capacity use, K stock), data homogeneity, crises and volatility – Modified Hodrick-Prescott Filter (Kaiser and Maravall, 1999) Pre-adjust the series by removing outliers ==> tackle sharp drops in activity To overcome accuracy problems in both ends of the series we added forecasts and backcasts (actually, original series for backcasts and Consensus Forecasts for forecasts)

8. 8 II. Procyclicality of FP: Structural Primary Balance  STRUCTURAL PRIMARY BALANCE  Simplified scheme differs from OECD  Cycle sensitive revenues, considered as a whole (no data)  Expenditure not depending on cycle (no unemployment benefits)  Account for the importance of commodity-related taxes:  OIL: Colombia, Ecuador, Mexico and Venezuela;  COPPER: Chile

9. 9 II. Procyclicality of FP: Structural Primary Balance 1.- Revenue elasticities wrt GDP and commodity prices 2.- Structural component of public revenues: where both Y* and P* are estimated by applying the Modified H-P filter 3.- Structual Primary Balance (SPB, henceforth):

10. 10 II. Procyclicality of FP: Structural Primary Balance  Sample:  Period: 1980-2004  Countries: Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, Uruguay and Venezuela  Sources: IMF’s GFS and IFS complemented with national statistics  Caveat: fiscal data is for the central government, except for the public debt, which is for the consolidated government

11. 11 II. Procyclicality of FP: Structural Primary Balance

12. 12 II. Procyclicality of FP: Structural Primary Balance

13. 13 II. Procyclicality of FP: SPB vs Output Gap

14. 14 II. Procyclicality of FP: SPB vs Output Gap In a more formal test, procyclicality of FP in LA is confirmed

15. 15 III. Debt sustainability and Fiscal Stance  Why is fiscal policy procyclical?  We focus on sustainability concerns  impinge on perception of credit worthines  are reflected on financial indicators  Financial indicators coupled with debt level determine debt dynamics  Debt dynamics signal debt sustainability and therefore concerns  The level of debt is binding through the cycle if  High enough  Financing conditions are volatile and  closely related to the cycle  affect debt sustainability concerns  Putting these intuitions into testing:  1.- Derive an indicator of fiscal sustainability: current threshold balance  2.- CTB v. Fiscal Stance

16. 16 III. Debt sustainability and Fiscal Stance: CTB  CURRENT THRESHOLD BALANCE (CTB)  Starting point: government’s budget constraint (%GDP)  Simplifying assumptions due to data availability: contingent liabilities, types of debt, seignorage  Hence, current threshold balance = debt-stabilising primary balance (  D=0)  Note: no distinction internal/external debt, equal cost  We use a measure of implicit real interest rate derived from dividing interest payments over the stock of debt, both as %GDP  Overcome problems linked to that simplification

17. 17 III. Debt sustainability and Fiscal Stance: CTB Caution: valuation effects, contingent liabilities, government definition

18. 18 III. Debt sustainability and Fiscal Stance: SPB vs CTB  DOES THE FISCAL STANCE DEPEND ON DEBT SUSTAINABILITY CONCERNS?  Empirical analysis framed within the following regression:   CTB  expected positive sign –Higher required primary balance triggers fiscal contraction (  SPB)  FP reaction to sustainability concerns is expected to be a function of the sustainability problem itself –Larger gap, more impact on changes in SPB  expected negative sign –More evident impact of CTB on SPB  Controls: inflation, terms of trade, output gap, years-in-default dummies  Econometric issues: endogeneity and fixed effects  IV estimation methods

19. 19 III. Debt sustainability and Fiscal Stance: SPB vs CTB Baseline results: GMM difference estimator

20. 20 III. Debt sustainability and Fiscal Stance: SPB vs CTB Robustness: estimation method: “simple” IV

21. 21 III. Debt sustainability and Fiscal Stance: SPB vs CTB Robustness: shorter sample: 1991-2004

22. 22 IV. Conclusions We have presented robust evidence on  Fiscal policy in Latin America is procyclical  This procyclicality is shown to be related to the evolution of fiscal sustainability –Deterioration of fiscal sustainability indicator, as measured by the CTB, leads to a fiscal tightening –The tightening is larger the worse is the level of debt sustainability, as measured by the ECM term –Once we control for debt sustainability fiscal policy is neutral  Extensions –Normative consequences. Is fiscal policy adequate? Long term values of debt dynamics determinants –Why not doing it for CA + R.D?