Research & Policy Briefs From the World Bank Malaysia Hub No. 19, November 2018 Fiscal Space: Concept, Measurement, and Policy Implications M. Ayhan Kose, Franziska Ohnsorge, and Naotaka Sugawara Effective fiscal policy depends on the amount of budget resources available to raise spending or lower taxes without jeopardizing fiscal sustainability. This resource availability is often called fiscal space. Since the global financial crisis, fiscal space in emerging market and developing economies has narrowed. This makes these economies more vulnerable to sudden spikes in financing costs and limits their ability to counteract adverse shocks. Governments in emerging market and developing economies Debt service capacity is a critical component of fiscal space. It (EMDEs) are likely to face rising costs of financing deficits and rolling has multiple dimensions, including financing needs that are related over debt as interest rates increase and global financing conditions to budget positions and debt rollover, access to liquid markets, tighten with the “normalization” of monetary policy in major resilience to changes in market valuations of debt, and the coverage advanced economies. Countries with large external liabilities could of contingent liabilities. While loss of market access and even suffer sharp movements in capital flows and exchange rates. vulnerability to changes in valuation can severely constrain debt This would generate financial stability risks and dampen output service capacity in the short run, persistent deficits and growing growth. contingent liabilities can erode it in the medium to long run. In many EMDEs, public sector vulnerabilities to spikes in financing Multiple aspects of fiscal space can be broadly grouped into four cost have risen since the global financial crisis. On average, public categories: government debt sustainability, balance sheet debt levels have increased and sovereign credit quality has composition, external and private sector debt, and market deteriorated (Huidrom, Kose, and Ohnsorge 2018; World Bank perception of sovereign risk. A higher share of nonresident holdings 2018). This may yet limit the budgetary resources available for of government debt may imply liquidity risk as well as currency risk governments to stimulate activity and strengthen safety nets to in the event of losses of confidence among foreign investors. A bolster employment during future recessions. At the same time, it higher share of foreign-currency debt could raise exchange rate risk, may restrict governments’ ability to implement effective fiscal while a high share of short-term debt could raise rollover risks. The policy as a tool for macroeconomic risk management in the event of maturity profile of debt is important because debt principal coming severe adverse shocks, such as natural disasters. The availability of due often constitutes an important portion of an economy’s such budgetary resources to conduct effective fiscal policy is often upcoming financing needs, and a bunching of maturities can called “fiscal space.” constrain fiscal space. External and private sector debt could be a source of contingent liabilities. In light of these observations, this policy brief analyzes three issues. It first explains the concept of fiscal space and its Market participants’ perceptions of sovereign risk reflect and, in measurement. Second, it documents how the concept of fiscal turn, influence an economy’s ability to tap markets and service its space has evolved over time. Finally, it discusses a set of policies obligations. Thus, fiscal space can function as an essential instrument that could help strengthen fiscal space. of macroeconomic risk management (World Bank 2013b). To clarify upfront, this policy brief documents the evolution of While recent research presents indicators related to some of different aspects of fiscal space in general terms. However, it does these four dimensions, no database had systematically brought not make a judgement call on whether fiscal space is “sufficient” to together different aspects of fiscal space until the release of the counter a specific shock. The sufficiency of fiscal space ultimately cross-country database by Kose et al. (2017). The database covers depends on the likelihood of shocks and their severity, as well as the availability of other policy buffers, such as international reserves, Figure 1. Coverage of the comprehensive cross-country and institutional and policy arrangements, such as capital controls database on fiscal space and macroprudential tools. For the same reason, this brief does not aggregate the various aspects of fiscal space measures into a single Number of countries Number of indicators indicator. Such an aggregate indicator would necessarily require a 200 28 weighting scheme. Weights, however, would be highly country-specific and time-dependent; their development goes beyond the scope of this brief. 180 26 What does “fiscal space” mean? For the purposes of this policy brief, fiscal space is simply defined as 160 24 the availability of budgetary resources to conduct effective fiscal policy. Since fiscal space is a complex concept, the literature has Number of countries used different definitions and measures. For example, some studies 140 22 define it as the budgetary room to create and allocate funding for a Number of indicators (RHS) certain purpose without threatening a sovereign’s financial position (Heller 2005; Ley 2009). Some others consider it as an alternative 120 20 way of expressing a sovereign’s intertemporal budget constraint 1990 1999 2008 2017 (Perotti 2007) or as the difference between the current level of public debt and a country-specific debt limit (Ostry et al. 2010; Note: The database is contained in Kose et al. 2017. Ghosh et al. 2013; Nerlich and Reuter 2015). Affiliation: Development Prospects Group, the World Bank. Email addresses: akose@worldbank.org, fohnsorge@worldbank.org, nsugawara@worldbank.org. We are grateful to Norman Loayza and Luis Servén for useful comments, and to Nancy Morrison for editorial assistance. Objective and disclaimer: Research & Policy Briefs attempt to synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. The database discussed in this Research & Policy Brief is periodically updated and available at: http://www.worldbank.org/en/research/brief/fiscal-space. Fiscal Space: Concept, Measurement, and Policy Implications Figure 2. Four measures of fiscal space since 2000 a. Government debt sustainability: General government b. Balance sheet composition: General government debt gross debt held by nonresidentsa Percent of GDP Percent of total 90 50 All countries All countries Advanced economies Advanced economies EMDEs 45 EMDEs 70 40 50 35 30 30 2000 2003 2006 2009 2012 2017 2000 2003 2006 2009 2012 2017 c. Contingent liabilities: Domestic credit to the private sector d. Market perceptions: Long-term foreign-currency sovereign debt ratingsb Percent of GDP Index, 1 - 21 [best] 180 21 19 140 All countries 17 All countries Advanced economies Advanced economies 100 15 EMDEs EMDEs 13 60 11 20 9 2000 2003 2006 2009 2012 2017 2000 2003 2006 2009 2012 2017 Source: Kose et al. 2017. Note: Simple averages. The year of global recession (2009) is shaded in gray. One representative indicator from each of the four dimension of fiscal space in Kose et al. (2017) is chosen, partly because of the data availability. However, the overall trend is shared by other indicators in each of four dimensions of fiscal space. Kose et al. (2017) present further details. EMDEs = emerging market and developing economies. a. Data are not presented in some years because the sample size is smaller than in the other years. b.The sovereign debt ratings are converted to a numerical scale ranging from 1 to 21 (higher, better rating). The horizontal line at an index value of 12 is the border between investment grade (above the line) and non-investment grade (below the line). up to 200 economies—41 advanced economies and 159 EMDEs— Balance sheet composition—such as by sources of funding, and is periodically updated to provide a readily available, up-to-date currency structure, and maturity profile—determines exposures to resource to researchers interested in fiscal issues (figure 1). As the risks of a sudden change in financial market conditions. Sharp research questions in this field vary widely, the database is swings in interest rates or exchange rates, or a sudden stop in deliberately comprehensive without adding any country-specific capital inflows, might undermine liquidity and solvency if features. It focuses on fiscal measures that are most relevant for government liabilities are heavily exposed to these risks. Indicators debt service capacity and that have been extensively discussed in in this category include the average maturity of sovereign debt, as the literature. The latest version of database (updated in May 2018) well as the share of government debt denominated in foreign covers data from 1990 to 2017. In order to ensure data quality, currency, held by nonresidents, held on concessional terms, or consistency, and comparability across countries, most series are maturing in 12 months or less. obtained from cross-country sources. Contingent liabilities may eventually arise from private sector debt, The database covers the four dimensions of fiscal space with 28 both domestic and external, if explicitly or implicitly guaranteed by indicators: 12 indicators for government debt sustainability; 6 governments. These guarantees would force governments to indicators for the balance sheet composition; 8 for external and assume private liabilities in the event of the failure of the borrower private sector debt; and 2 for market perception. Cross-indicator (Cebotari 2008). The costs associated with such interventions would correlations support this grouping into four distinct categories. rise with the overall size of private sector obligations, and maturity Within each group, the correlations across various individual or currency mismatches. For example, one channel through which indicators are considerably larger, on average, than across groups, private obligations generate fiscal costs is the resolution of failing and many of them are found to be statistically significant. banks. This may include explicit guarantees, nationalization, recapitalizations, and the set-up of asset management companies. Government debt sustainability captures the longer-term capacity In turn, high external debt can lead to private sector stress when of the government to finance its obligations. Indicators include private firms are hit by sharp depreciations or asset price collapses general government debt and fiscal balances. Because the because currency mismatches and excessive borrowing can feed sustainability of government debt depends not only on debt and into their solvency problems (Hausmann and Panizza 2011). To deficits but also on growth and borrowing costs, indicators in this capture these risks, the database includes total external debt, category include measures that compare a country’s fiscal balance private external debt, short-term external debt, external debt in with the balance that stabilizes government debt at a target level foreign currency, and domestic credit to the private sector. under different assumptions of output growth and long-term interest rates—so-called sustainability gaps (Ley 2009; Escolano Market perception of sovereign risks reflects an economy’s ability 2010). For example, the debt burden generated by sustained fiscal to tap markets and service its obligations, and measures investor deficits would be easier to service if interest rates are lower and sentiment about sovereign credit risks and borrowing costs in the growth is stronger. The sustainability gap indicator provides a simple market. Indicators in this group include the five-year sovereign snapshot of the adjustments that may be needed to reach debt credit default swap (CDS) spread and foreign-currency long-term 2 targets under different macroeconomic conditions. sovereign debt ratings by major international rating agencies. Research & Policy Brief No.19 How has fiscal space evolved over time? Since 2011, fiscal space has shrunk in EMDEs. Partly as a result of steep revenue losses in commodity-exporting EMDEs, Fiscal space improved during 2000−07, but has shrunk around the sustainability gaps and fiscal deficits widened to 3 to 5 percent of world since the global financial crisis. As illustrative examples, figure GDP in 2016, on average, with some improvements in 2017. 2 shows the evolution of a subset of the measures in each of the Government debt has risen to 54 percent of GDP, on average, in four dimensions. While the choice of a single measure is presented 2017. It now exceeds 2000 levels in more than one-third of EMDEs for illustrative purposes, larger correlations between indicators and has increasingly been held by non-residents. within each group than between groups suggest that indicators shown in the figure are fairly representative of these dimensions. External and private sector debt have increased from 2007 levels in the majority of EMDEs. A rapid increase in private sector The improving trend before the crisis was widely shared, as virtually credit, especially for corporates, since the global financial crisis has all indicators of fiscal space changed positively in more than half of been accompanied by weaker solvency and profitability (Alfaro et al. EMDEs and most indicators improved in more than half of advanced 2017; World Bank 2018). Reflecting deteriorating debt economies in the Kose et al. (2017) dataset. After the crisis, sustainability, balance sheet risks and credit ratings of EMDEs have however, debt sustainability indicators, including government debt (marginally) worsened on average. and fiscal sustainability gaps, have deteriorated in at least three-quarters of countries in the world. External and private debt How can fiscal space be improved? stocks have also increased in more than half of all countries and perceptions of market participants on sovereign credit risks have Policies worsened. Fiscal space is critical in managing aggregate demand (box 1) and as a tool of macroeconomic risk management in the event of adverse Before the global financial crisis, government debt sustainability shocks such as natural disasters or bouts of violence. Hence, policy improved significantly in EMDEs, and to a considerably lesser extent measures to shore up fiscal sustainability have become a priority as in advanced economies, as rapid growth reduced deficits and fiscal space has deteriorated since the global financial crisis. helped bring debt stocks down. In low-income developing countries, relief initiatives such as the Heavily Indebted Poor Fiscal sustainability could be improved by increasing the Countries Initiative and the Multilateral Debt Relief Initiative helped efficiency of revenue collection and spending. Measures to reduce debt burdens. These improvements contributed to a decline strengthen revenue collection could include broadening tax bases in general government gross debt by 32 percentage points of GDP to remove loopholes for higher-income households or profitable over 2001−07 in EMDEs, to 45 percent of GDP. Government debt in corporates. In countries with high levels of informality, taxing the informal sector—for example, by promoting a change in payment advanced economies stabilized at about 46 percent of GDP. methods to non-cash transaction and facilitating collective action by In some dimensions, the balance sheet composition of EMDE informal sector associations—could help raise revenues directly, as governments became more resilient before the crisis, but private well as indirectly, by encouraging informal firms to join the formal and external debt grew. In EMDEs, the share of debt held by sector with better growth prospects (Joshi, Prichard, and Heady nonresidents declined by 3 percentage points over 2004−07. By 2014; Awasthi and Engelschalk 2018). In EMDEs, reforms to 2007, the external debt-to-GDP ratio was below the levels of the broaden revenue bases and strengthen tax administration can early 2000s in three-quarters of EMDEs, but external debt became generate revenue gains (Akitoby 2018). increasingly short term. While, on average, still well below that of On the spending side, governments can consider shifting the advanced economies, private credit in EMDEs rose over 2001−07. reallocation of expenditures away from less efficient expenditures Sovereign ratings stabilized during the precrisis period. toward more growth-enhancing or better-targeted ones, such as Box 1. Fiscal space and the effectiveness of fiscal policy Countries with ample fiscal space can use stimulus measures Figure B.1. How fiscal space affects fiscal multipliers more extensively to mitigate an adverse impact of global financial stress than those with narrower space. In addition, every dollar of fiscal stimulus implemented by a government Change in output with ample fiscal space is more effective at raising output than 0.6 On impact 2 years by a government with limited fiscal space. The effectiveness of fiscal policy can be evaluated by the 0.3 fiscal multiplier—a change in output for a dollar increase in government consumption. The more positive the multiplier, the more effective fiscal policy. Recent research finds that the size of 0.0 multipliers varies significantly, depending on macroeconomic conditions, especially the state of the business cycle, and country characteristics (Auerbach and Gorodnichenko 2013). For EMDEs, multipliers are found to be modest, ranging from -0.4 -0.3 10th percentile Median 90th percentile to 0.9, over the long run (World Bank 2015; Huidrom, Kose, and Ohnsorge 2018). Distribution of fiscal space Fiscal multipliers are positive and significant for low levels of debt, both on impact—in the same quarter as the fiscal stimulus Source: Huidrom et al. 2018. is implemented—and over the longer run (Ilzetzki, Mendoza, Note: The figure shows the conditional median fiscal multipliers, on impact (at the and Végh 2013; Huidrom et al. 2016, 2018). For example, the moment when a change in government consumption takes place) and over the two-year horizon, in the 10th, 50th (median), and 90th percentiles of a distribution of multiplier over the two-year horizon is close to 0.5 when debt is fiscal space, represented by government debt as a share of GDP. The corresponding low (there is more fiscal space), but is negative for high levels of debt-to-GDP ratios are 17 percent of GDP (10th percentile), 45 percent of GDP (median), and 92 percent of GDP (90th percentile). Therefore, fiscal space is ample debt (there is less fiscal space), as shown in figure B.1. The (narrow) when government debt is low (high). These are based on estimates from an difference in the estimated multipliers for low and high levels of interacted panel vector autoregressive model, where model coefficients are conditioned only on fiscal space. debt is particularly significant at longer horizons. 3 Fiscal Space: Concept, Measurement, and Policy Implications investment or means-tested income support. Increases in the designs and strong institutional environments that support their spending composition of infrastructure and education projects operations are crucial factors for their success, as in the cases of could have long-term gains in the economy (Gemmell, Kneller, and Norway and Chile (Schmidt-Hebbel 2012; Stone and Truman 2016). Sanz 2016). Pension reforms could also support fiscal credibility and generate long-term fiscal gains with limited short-term impact on Medium-term expenditure frameworks are intended to establish growth. or improve credibility in the budgetary process. The frameworks seek to ensure a transparent budgetary process, where government Instruments agencies allocate public resources based on strategic priorities. Robust implementation is closely related to linkages with broader In addition, credible and well-designed institutional mechanisms economic and social policy objectives and the forecasting capability can help support fiscal discipline and strengthen fiscal space. Three based on reliable data (Allen et al. 2017). In South Africa, the arrangements have been widely introduced: fiscal rules, framework was introduced in the context of high government debt stabilization funds, and medium-term expenditure frameworks. and a combination of underspending by the central government Fiscal rules impose numerical constraints on budgetary aggregates— and overspending by provincial governments. Underspending and debt, overall balance, expenditures, or revenues. Rules often allow overspending were both reduced following the introduction of the for flexibility in meeting budget targets by taking into account medium-term framework (World Bank 2013a). temporary cyclical deviations, such as a large output gap, or structural adjustments, such as changes in the medium-term price Conclusion of a key export. Fiscal rules, and in particular cyclically adjusted or Amid tightening global financing conditions, EMDEs need to shore structural balance rules, have become increasingly popular in up fiscal positions to prevent sudden spikes in financing costs from EMDEs, especially since the global financial crisis (Schaechter et al. forcing them into fiscal tightening. They need to maintain budgetary 2012). Implementation of balanced budget rules can be improved resources to counteract such cyclical downturns or unexpected by a well-designed framework, a simple enforcement structure shocks as natural disasters and heightened risks of violence. The without any off-budget government guarantees, flexibility, availability of budgetary resources to implement effective fiscal transparency, and support by surveillance arrangements. policy is often loosely called fiscal space. Fiscal space is a complex Compliance with fiscal rules can be monitored by fiscal councils and multi-dimensional concept, and therefore, needs to be (Debrun and Kinda 2017). Chile’s use of a technical fiscal council captured from different directions. and fiscal rule that targets fixed structural balance is a good example of a well-designed, credible, and successfully operated The comprehensive, cross-country database introduced by Kose fiscal rule. et al. (2017) includes 28 indicators related to fiscal space, which are grouped into four broad categories: government debt sustainability, Stabilization funds set aside receipts from natural resource balance sheet composition, external and private sector debt, and revenues. Amounts saved during favorable times are released to market perception of sovereign risk. Because each of these cushion potential revenue shortfalls and to mitigate negative shocks categories covers a different dimension of fiscal space, the database to government expenditures. Funds were adopted widely in the serves researchers interested in a wide range of fiscal issues. 2000s, when high oil prices, along with the discovery of oil in a number of EMDEs, facilitated their establishment. Many stabilization Fiscal space has been shrinking in EMDEs since the global funds are integrated with the budget, with clear rules to guide the financial crisis. It needs to be strengthened. This requires well- accumulation and withdrawal of fund resources. The effective use designed policy frameworks with clear and broad objectives and, of stabilization funds requires government commitment to fiscal most importantly, strong commitments of policy makers in each discipline and macroeconomic management (Gill et al. 2014). Proper country. 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