Fiscal adjustments for a country with unsustainable debt

Published:

Explain the circumstances in which a country’s level of debt is

unsustainable and discuss how governments should implement fiscal

adjustments to move to a more sustainable position.

Deadline date: 24 June 2014.

  1. Circumstances in which a country’s level of debt is unsustainable

Debt sustainability and unsustainability

This is a situation where a borrowing country is able to service its debts as and when due without an undue interference with the country’s balance of payments (BOP) i.e income and expenditure. On the other hand, a country’s level of debt is unsustainable when it accrues at a faster rate than the capacity of the borrowing country to service it.

In order to determine the extent of sustainable debt, a country would need to assess how likely events such as outstanding stocks of liabilities would occur, and also, suppositions on interest and exchange rates, and revenue path.

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Depending on the regulatory authority, level of debt level can be referred to as unsustainable where debt to export levels exceeds a certain fixed percentage ratio. It could also be due to open economies where the exclusive dependence on external pointers does not adequately replicate the fiscal burden of external debt.

Brooks, et al (1998) and Daseking and Powell (1999) explain certain factors in which debt crisis in low-income developing countries, can be traceable to:

  1. Exogenous shocks (such as; adverse trade terms or unfavorable weather), which impacted states that fully depends on supplies
  1. Lack of suitable reactions to shocks relating to macro-economic and operational policy
  1. Advancing and re-financing by investors, most times on non-concessional terms (that is on commercial terms with short pay-back periods), however from the 1980’s, moving to concessional aid and grants;
  1. Borrowing countries lack regulations relating to sound debt management. Excess usage of loans on doubtful projects, which undermined the capacity of countries to repay loans; and, political factors such as wars and social discord in affected countries.

Manasse, Roubini and Schimmelpfennig (2003) explain that indicators of debt burden, growth in gross domestic product, and certain measures of rules and institutions, to a large extent affects debt crises.

They describe debt unsustainability as when the following occurs:

  • A country’s sum of arrears of principal and interest is majorly relative to the accrued debts
  • A country obtains debt relief via debt rescheduling or debt reduction (i.e discount) from “Paris Club of bilateral creditors”
  • A country obtains considerable BOP support from the International Monetary Fund under its non-concessional standby arrangements or extended fund facilities
  1. How governments should implement fiscal adjustments to move to a more sustainable position

For a fiscal adjustment to be implemented successfully, the following important factors should be considered:

  1. Composition- A long-lasting deficit reduction can be sustained via “spending cuts” and is probable to develop a progressive macro-economic effect
  1. Status of public finances
  1. Timeframe/duration- A multi-year approach have been proven to be successful
  1. Preliminary stages of spending and taxation
  1. Size- A successful adjustment size is recommended to be large. Adjustments which larger sizes have been proven to attract positive effects

Deficit reduction plans

Governments have adopted such plans in order to sustain public finances. Such plans include; eliminating politically sensitive aspects such as; transfers, subsidies, and fiscal consolidation via spending cuts i.e taxes, and timely adjustments.

It is important because a country’s fiscal management is been relied upon by stakeholders such as tax payers and investors to enable them continually finance public expenditures.

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Advantages

  1. It helps a country to sustain its fiscal policies by putting such finance in an orderly manner.
  1. It helps a country reassure its investors and taxpayers in a transparent manner that, it is prudently managing its fiscal house.
  1. It helps a country create fiscal space that is able to address future economic, monetary shocks and to finance new exigencies.

Strategies for reduction in deficits include:

  • Regulatory reform

Efficiency and productivity can be attained via avoidance of insecurity and unnecessary regulations. Complex legislations create insecurity with respect to future business start-up costs, which affects investment decisions.

  • Budgetary reform

Budgetary rules could be employed by enacting new legislations/programs that would be financed through cutting expenditure or increasing taxes.

  • Outsourcing based on sound economic analysis could lead to savings
  • Promotion of economic development and employment

A rapid developing economy proffers a “win-win” result of a more renowned economic cycle is shared, with increased taxes and employment, reduced security after deducting expenditure and a sustainable economy (i.e low debt-to-GDP ratio).

  • Provide fair trade-offs

Budgetary decisions are usually a “win-lose” results, showing the distribution of government proceeds, with benefits and expenses incurred. E.g., eliminating benefits from those in or near retirement may be deemed unfair, while phasing out retirement benefits for younger employees may be deemed less.

  • Keep short and long term issues in view- Long-term deficit initiatives include healthcare cost inflation and aging population while short term initiatives include: unemployment, expenditure policy decisions and tax.
  • Curb excess expenditure- Policy decisions may concentrate on avoiding future rises through restrictions or reduction in annual rates
  • Productive investment- Certain investments reduces deficits. Such as, installing devices that reduces cost of energy rather than increases energy.

References:

  1. Alesina, A. and S. Ardagna (2010) “Large Changes in Fiscal Policy: Taxes versus Spending” Tax Policy and the Economy, Issue 24, NBER and University of Chicago Press. 34–68.
  1. Alesina, A., and S. Ardagna, “Tales of Fiscal Adjustments”, Economic Policy, October (1998): 489–545.
  1. McDermott, J. and R. Wescott, “An Empirical Analysis of Fiscal Adjustments”, IMF Staff Papers, 43, n.4 (1996) 723–753.
  1. Mountford, A. and H. Uhlig, “What Are the Effects of Fiscal Policy Shocks?” NBER working paper 14551, 2008.
  1. OECD (2010), Restoring Fiscal Sustainability: Lessons for the public sector
  1. Ramey, V., “Identifying Government Spending Shocks: It’s All in the Timing,” NBER working paper 15464, 2009.
  1. United Nations Conference on Trade and Development,