DIY Fiscal Sustainability Analysis

I apologise for the lack of posts, but I’ve been very busy this last week and will be busier still this week. BNM will be releasing their 2011 annual report this Wednesday and very likely we’ll see a reassessment of the government’s 2012 growth forecast of 5%-6% – watch this space.

In the meantime, here’s something that’s been on my “must blog about” list for the past week – I’ve taken the liberty of reproducing the entry in full:

IMF Unveils Template for Computing Structural Fiscal Balances

The IMF has created a new online template to help countries form a clearer picture of their true budget position and, as a result, get a better idea of how much they can spend or save.

The innovation is now more relevant than ever as many advanced economies strive to bring debt down to sustainable levels. In the following interview, Abdelhak Senhadji (Assistant Director), Iva Petrova (Economist), and Marcos Poplawski-Ribeiro (Economist) of the IMF’s Fiscal Affairs Department talked about what the tool does and how it can help policymakers.

IMF Survey online: The IMF has been doing some interesting work on how to get a better picture of countries’ fiscal balances. What has been taking place?

Senhadji: For the past two years, we’ve been working on a tool that will help economists estimate a country’s underlying fiscal position. By removing cyclical and other transitory elements from revenues and expenditures, policymakers can get a clearer picture of their country’s actual fiscal situation—and, as a result, be able to derive more robust policy conclusions. This Excel-based template—which has just gone live on our website—helps them do this. Our work builds on a technical note on this same topic published last year by Fabian Bornhorst and other IMF staff.

IMF Survey online: How does this new method improve upon the existing way of computing the fiscal balance?

Petrova: Governments used to consider only the overall, or “headline,” fiscal balance, which can give a misleading picture of a country’s medium-term fiscal position. In the past five to ten years, economists have started looking at what we call the cyclically-adjusted fiscal balance—that is, the fiscal balance corrected for the business cycle. This correction is important because revenues tend to move in tandem with the business cycle. During the boom phase of the cycle, for example, revenue tends to be very strong. If policymakers were to make spending decisions based solely on those revenue numbers, they might overspend, because they would think that the fiscal balance was healthier than it actually is.

A weakness of the cyclically-adjusted fiscal balance is that it adjusts only for the business cycle and not for other transitory factors. Take, for instance, terms-of-trade shocks. If you’re a policymaker in a copper-exporting country such as Chile, adjusting for this factor is important. The commodity cycle is not necessarily highly correlated with the domestic business cycle, because it’s mainly driven by external factors. So if you limit your correction to the business cycle and the price of copper doubles, you might have an overly optimistic view of your country’s fiscal position. And based on that, you may spend more. If you give a wage increase to the workforce based on the fact that copper prices are high, you will be in trouble when the copper price falls.

In sum, our new tool allows policymakers to compute what’s called the structural fiscal balance. This goes one step further than the cyclically-adjusted fiscal balance and corrects for transitory factors besides the business cycle, such as terms-of-trade shocks or one-off factors (large one-time revenues, sales of concession rights, write-offs related to recapitalization of banks, and so on).

IMF Survey online: What does this tool mean for fiscal policy?

Poplawski-Ribeiro: During a boom, the headline fiscal balance will show a healthy fiscal position, which might lead the government to scale up expenditures or slow down needed fiscal consolidation—even when the increase in revenue is only temporary. As a result, fiscal policy may become “procyclical”—that is, providing stimulus during a boom and withdrawing demand during a recession—which is exactly the opposite of what you want. Such a fiscal policy only amplifies the effect of the business cycle and leads to boom-bust cycles, which are undesirable.

It’s all about having a dashboard with the right indicators. The headline balance is just a fuzzy indicator that does not necessarily show you where the economy is heading over the medium term. That’s why we encourage policymakers to look at the structural fiscal balance, which strips from the headline balance as many of the transitory factors as possible.

IMF Survey online: What are the implications for countries experiencing fiscal pressures?

Senhadji: The crisis has highlighted the need to enhance fiscal discipline. This in turn requires a measure of countries’ fiscal position that is not overly distorted by transitory factors. In this context, many countries use fiscal rules to discipline spending and policymakers are increasingly using fiscal rules that are based on the structural fiscal balance in order to avoid the procyclicality of fiscal policy. In the recent European Union Summit, for example, countries agreed on a fiscal compact to ensure that structural deficits would not exceed 0.5 percent of GDP.

IMF Survey online: How do you go about estimating the structural fiscal balance?

Petrova: We have prepared a user-friendly Excel template for the calculation of the structural balance both on a disaggregated basis—adjusting each revenue and expenditure item separately and adding them into an adjusted measure of the fiscal balance—and on an aggregated basis, adjusting directly aggregate revenues and expenditures. The template—which is flexible enough to take into account country specificities—can be found on our website. The tool is still evolving; there is room for further refinement and research. So we invite you to visit our website and send us any questions or suggestions you may have.

There’s a whole bunch of terminology surrounding fiscal sustainability, such as the structural balance mentioned here. Getting the different definitions of the fiscal balance straight can be a bit of a head-spinner.

The structural balance is probably more complex than most, but it directly addresses some of the problems with using the overall balance as a measure of fiscal sustainability, and the public arguments arising therefrom.

Plenty of people are worried over Malaysia’s rising public debt level, pointing to its rapid average growth over the past 5-6 years. I’d point out that much of the increase relative to GDP occurred in 2009 due to a sharp drop tax revenues, something which a structural approach would cater for.

You could equally point out the on-going impact of high commodity prices (particularly oil) on government revenues and subsidies, again something a structural approach would take into account.

So if you want to know just how sustainable Malaysia’s deficits really are, the IMF Excel spreadsheet template is available online (website link, and file link). I’m going to have a go at it…assuming I ever find the time.