Fiscal stimulus for debt-intolerant countries

Emerging markets on the eve of the sub-prime shock

Fortunately for most emerging markets, this synchronous export and financing shock from the North came once they had built vast war chests of international reserves through the “bonanza” years (Figure 1). Emerging market reserve managers learned the lesson of the Asian Crisis – when times get tough, the advanced economies look inward, so emerging markets’ first type of defence should be their own resources. In the fat years, commodity prices were booming, growth in the North was buoyant, international interest levels were low and stable, and international capital was plentiful. In this environment, fiscal positions in lots of emerging markets improved markedly. Public debt levels were stabilised as well as reduced, and several countries substituted public external debt with domestic debt and lengthened the maturities of their outstanding debt.

Figure 1 . Accumulation of international reserves by emerging market and developing economies, 1980-2008, vast amounts of US dollars

Source: Reinhart and Reinhart (2008)

If the adverse shock to the North have been a short-lived decrease in financing, as much observers believed at that time, the fiscal consolidation and reserve build-up could have put emerging markets in an excellent position to handle the shock. A combined mix of currency depreciation (now possible due to more flexible exchange rate arrangements) plus some international reserve sales appears to be to match the bill. Furthermore, a short-lived fiscal response that entailed increasing government expenditures for a restricted period of time didn’t appear to carry substantive risks to debt sustainability.

Such optimism that fiscal policy could possibly be used to de-couple the South from the North is misplaced in three important dimensions.

  • Fiscal finances and external accounts weren’t as healthy because they appeared in 2007, as explained by the aptly titled All That Glitters MIGHT NOT BE Gold: Assessing Latin America’s Recent Macroeconomic Performance from the Inter-American Bank Development Bank (2008).

The commodity-price boom had papered over many cracks in fiscal accounts. Those governments’ capability to crank up spending will be impaired by the shaky base they are building upon.

  • Funding fiscal deficits with domestic debt is neither new nor riskless.

As Reinhart and Rogoff (2008) show, governments often default on such domestic debts, either explicitly or through unexpectedly high inflation. Furthermore, private debts (both domestic and external) had been rising markedly. As crisis after crisis has consistently shown, private debts grow to be contingent government liabilities.

  • It really is now two years because the onset of the crisis, and the consequences continue steadily to linger (even if recovery reaches hand).

Plainly, this episode hardly classifies as a fleeting shock, so far as market participants, households, or policymakers are worried. “Temporary” stimulus might persist in order to put pressure on funding costs as time passes.

Response to the crisis: Fiscal stimulus, North and South

Led by the united states, both advanced and emerging economies have passed fiscal stimulus packages in a variety of guises and magnitudes. By January 2009, the Global Economic Monitor, published by the Institute for International Finance, detailed the packages either adopted or planned in about twenty advanced and emerging market economies, including China, Korea, Mexico, and Saudi Arabia. Significantly less than 8 weeks later, the set of countries had expanded to add Russia and Turkey, amongst others (Prasad and Sorkin 2009). The IMF, both famous and infamous for advocating fiscal austerity packages in response to financial crises around the world since its inception in 1945, started to advocate a “possible strategy whereby fiscal policy can foster the resumption of normal economic growth while maintaining public sector solvency” (Cottarelli 2009).

To be certain, preventing the acute fiscal policy pro-cyclicality which has plagued most emerging markets for many years is, indeed, progress. As Kaminsky, Reinhart, and Vegh (2003) document, during 1965-2003 the most prevalent pattern in emerging markets during recessions (as opposed to their OECD counterparts) was sharp reductions in real discretionary fiscal spending. It really is difficult to imagine that would not help take into account the higher volatility evident in emerging market output.

Fashions and fundamentals

Fashions are hard to resist, in fact it is now fashionable in a lot of the North to depend on a fiscal engine of growth. Boosting spending in emerging economies, however, at the same time where revenues are contracting or, oftentimes, collapsing for an uncertain time frame is a far more complicated matter. 1 Policymakers in emerging market economies would prosper to keep three risks at heart.

1. Fiscal multipliers: North and South

Although there is little consensus in academic and policy circles on the magnitudes, the discussion of fiscal multipliers generally in most OECD countries reaches least informed by existing analytical and empirical studies. For emerging markets, however, a comparable literature will not exist. Thus, any statement about fiscal multipliers for emerging markets (and developing countries) as a class should be interpreted carefully.

In this regard, there’s been especially timely recent work by Ilzetzki, Mendoza, and Vegh (2009), who calculate such multipliers for advanced high-income economies, emerging markets (middle class), and developing countries (low income) using quarterly data. Their analysis shows that:

  • the fiscal multiplier on impact is larger for developing and emerging market countries than for the advanced high-income countries;
  • the opposite holds true for the peak multiplier;
  • and the cumulative multipliers are far smaller for emerging markets than for advanced economies, as the positive impact of fiscal shelling out for GDP dies out rapidly.

2. Emerging markets and global crowding out

Figure 2 highlights that public debt typically explodes in the years carrying out a systemic financial crisis. Typically, public debt nearly doubles 3 years following the crisis. Recessions result in major revenue losses and fiscal spending expands, as the bailout of the banking sector proves costly and stimulus packages find favour. With severe banking crises, deep recessions, or a combined mix of both in the world’s largest economies simultaneously, international financing for emerging markets may very well be far scarcer than through the bonanza years before 2007. Financing budget deficits will never be easy or cheap.

Figure 2 . Cumulative upsurge in real public debt in the 3 years following a banking crisis

Source: Reinhart and Rogoff (2009)
Notes: Each banking crisis episode is identified by country and the start year of the crisis. Only major (systemic) banking crisis episodes are included, at the mercy of data limitations. The historical average reported will not include ongoing crisis episodes, which are omitted altogether, as these crises begin in 2007 or later, and debt stock comparison here’s with three years following the start of the banking crisis.

It really is noteworthy that the last time the world experienced an emergency of the proportion (the fantastic Depression), governments in the advanced economies could actually continue borrowing (Figure 3), as recovery remained elusive for pretty much ten years. Debt rises by 44% in the first 3 years and by another 40% through the next three years. In comparison, the general public debt of emerging markets remained frozen following the third year. This is not the consequence of rebounding revenues balancing the budget – in several cases it was the consequence of sovereign defaults.

Figure 3 . Cumulative upsurge in real public debt three and six years following onset of the fantastic Depression in 1929: Selected countries

Source: Reinhart and Rogoff (2009)
Notes: The start year of the banking crises range between 1929 to 1931. Australia and Canada didn’t have a systemic banking crisis but are included for comparison purposes, as both also suffered severe and protracted economic contractions. The entire year 1929 marks the peak in world output and, hence, can be used as the marker for the start of the depression episode.

3. Most importantly – remember debt intolerance!

Historically, emerging market defaults took place at degrees of debt that would seem to be safe and even conservative by advanced economy standards. The defaults of Mexico in 1982 and Argentina in 2001 weren’t exceptions. Table 1 demonstrates external debt exceeded 100% of GNP in mere 16% of the default or restructuring episodes, that a lot more than one-half of most defaults occurred at levels below 60% – which could have satisfied the Maastricht criteria – and that defaults occurred against debt levels which were below 40% of GNP in nearly 20% of the cases. In place, the external debt-to-GNP thresholds reported in Table 1 are biased upwards as the debt-to-GNP ratios corresponding to the entire year of the credit event are driven up by the true exchange rate depreciation that typically accompanies the function. Real exchange rate depreciation typically accompanies a default, of course, as locals and foreign investors flee the currency. The fiscal “space” to implement ambitious stimulus plans in emerging markets is a lot more limited than that of advanced economies – not that policymakers in the latter may underestimating these constraints aswell.

Table 1 . External debt during default: Frequency distribution, 1970-2008

External debt-to-GNP range at the first year of default or restructuring Percent of total defaults or restructurings in middle class countries
Below 40% 19.4
41% to 60% 32.3
61% to 80% 16.1
81% to 100% 16.1
Above 100% 16.1

Source: Reinhart and Rogoff (2009) update of Reinhart, Rogoff, and Savastano (2003).

Final reflections

Taken together, these risks have broader implications than for fiscal policy alone – they are risks to macroeconomic policy most importantly, especially in emerging market countries where central bank independence is of recent vintage. Several countries have an unfortunate background where fiscal officials having difficulty funding large deficits turn to the central bank for help. As a result, financing deficits with money creation has played a significant role in shaping the road of monetary policy, the exchange rate, and inflation. Moving away from that treadmill and gaining credibility is a long and difficult process. Losing that credibility to a fashion for fiscal stimulus can occur fairly quickly. A far more cautious alternative is to be sure that fiscal policy will not have a tendency to the excesses that ultimately could threaten the quest for price stability. It really is enough of a victory that fiscal policy is no more pro-cyclical.


Cottarelli, Carlo (2009). “Paying the Piper” Finance and Development, (Washington, DC: International Monetary Fund, March).
Ilzetzki, Ethan, Enrique Mendoza, and Carlos Vegh (2009). “What size (small) are fiscal multipliers?” Mimeograph. University of Maryland College Park
Institute for International Finance (2009). Global Economic Monitor (Washington, DC: Institute for International Finance, January).
Inter-American Development Bank (2008). All That Glitters WILL NOT BE Gold: Assessing Latin America’s Recent Macroeconomic Performance (Washington, DC: Inter-American Development Bank, March).
Kaminsky, Graciela L., Carmen M. Reinhart and Carlos A.Végh (2004). “When It Rains, It Pours: Procyclical Capital Flows and Policies” in Mark Gertler and Kenneth S. Rogoff, eds. NBER Macroeconomics Annual 2004. Cambridge, Mass: MIT Press, 11-53
Prasad, Eswar, and Isaac Sorkin (2009). “Assessing the G-20 Economic Stimulus Plans: A Deeper Look.” Mimeograph. (Washington, DC: Brookings Institution, March).
Reinhart, Carmen M. and Vincent R. Reinhart. (2008). “Capital Inflows and Reserve Accumulation: The Recent Evidence,” NBER Working Paper 13842, March.
Reinhart, Carmen M., and Kenneth S. Rogoff (2008). “The Forgotten History of Domestic Debt,” NBER Working Paper 13946, April.
Reinhart, Carmen M., and Kenneth S. Rogoff (2009). THIS TIME AROUND It’s Different: Eight Centuries of Financial Folly Forthcoming (Princeton: Princeton University Press)

1 This is simply not intended to underestimate the issue and (usually) controversy of undertaking almost any change in fiscal policy in the advanced economies.

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