Transcript Fiscal Cyclicality in EM Countries

Fiscal Cyclicality in EM Countries
Jeffrey Frankel
Seminar on Macroeconomic Policy
Economics Department, Harvard University
October 18, 2016
Continued from April 28, 2015
Some Emerging Market countries achieved
fiscal counter-cyclicality after 2000.
Procyclicality
• Fiscal policy has historically tended to be
pro-cyclical in a majority of countries,
especially developing countries,
– presumably exacerbating ups & downs in the economic cycle.
• Correlation of government spending & GDP mostly positive:
– Cuddington (1989), Gavin & Perotti (1997), Tornell & Lane (1999),
Kaminsky, Lane (2003), Reinhart & Végh (2004), Talvi & Végh (2005),
Alesina, Mendoza & Oviedo (2006), Campante & Tabellini (2008), Thornton
(2008), Ilzetski & Végh (2008), Medas & Zakharova (2009), Elzetski (2011),
Erbil (2011), Céspedes & Velasco (2014), Avellan & Vuletin (2015).
• Tax policy tends to be pro-cyclical as well:
– Végh & Vuletin (AEJ-EP, 2015).
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Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Adapted from Kaminsky, Reinhart & Végh (2004)
“When it Rains, It Pours”
Pro-cyclical spending
countercyclical
Countercyclical
spending
G always used to be pro-cyclical
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for most developing countries.
Fiscal policy in some EM countries,
• learning from past mistakes,
• turned from pro-cyclical to counter-cyclical after 2000,
– e.g., Chile, Costa Rica, China, Korea, Mexico, Malaysia.
• They took advantage of 2002-08 boom to strengthen
budgets,
• and so created “fiscal space” that allowed them to
moderate the 2008-09 recession.
= the opposite from some Industrialized Country politicians.
Correlations between Government spending & GDP
2000-2015
Adapted from Frankel, Vegh & Vuletin (JDE, 2013)
After 2000,
about 1/4 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
Updated by Guillermo Vuletin, Oct. 2016
Who achieves countercyclical fiscal policy?
Countries with “good institutions”
IQ
”On Graduation from Fiscal Procyclicality,”
Frankel, Végh & Vuletin; J.Dev.Economics, 2013.
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The quality of institutions varies,
not just across countries, but also across time.
1984-2009
Worsened institutions;
More-cyclical spending.
Improved institutions;
Less-cyclical spending.
Good institutions;
Countercyclical spending
Frankel, Végh
& Vuletin, 2013.
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How can countries avoid pro-cyclical fiscal policy?
• What are “good institutions,” exactly?
• Rules?
– Budget deficit ceilings or debt brakes?
• Have been tried many times (97 IMF members). Usually fail.
– Rules for cyclically adjusted budgets?
• Countries are more likely to be able to stick with them. But…
• An under-explored problem:
– Over-optimism in official forecasts
• of GDP growth rates & budgets.
– If boom is said to be permanent,
• there is no perceived need to restrain spending.
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Countries with Balanced Budget Rules
frequently violate them.
BBR: Balanced
Budget Rules
DR: Debt Rules
ER: Expenditure
Rules
Compliance
< 50%
International Monetary Fund, 2014
To expect countries to comply with the rules during
recessions is particularly unrealistic
(and not even desirable).
Bad times: years when output gap < 0
International Monetary Fund, 2014
Greek official forecasts were always over-optimistic.
Frankel & Schreger, 2013.
Data from Greece’s Stability and Convergence Programs.
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The case of Chile
• 1st rule – Governments must set a budget target.
• 2nd rule – The target is structural.
Deficits allowed only to the extent that:
– (1) output falls short of trend, in a recession,
– (2) or the price of copper is below its trend.
• 3rd rule – The trends are projected by 2 panels
of independent experts, outside the political process.
– Result: Chile avoided the pattern of 32 other governments,
• where forecasts in booms were biased toward optimism.
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Chile’s official forecasts were not over-optimistic.
Chilean forecasts of budget balance, one year ahead
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The Pay-off
• Chile’s fiscal position strengthened immediately:
– Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005
– allowing national saving to rise from 21 % to 24 %.
• Government debt fell sharply as a share of GDP
and the sovereign spread gradually declined.
• By 2006, Chile achieved a sovereign debt rating of A,
• several notches ahead of Latin American peers.
• By 2007 it had become a net creditor.
• By 2010, Chile’s sovereign rating had climbed to A+,
• ahead of some advanced countries. Now AA-.
• => It had room to respond to the 2008-09 recession
– via fiscal expansion.
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Some EMs are now again vulnerable to shocks
– because they have backslid on cyclicality since 2010,
• e.g., Brazil, Mexico, Malaysia;
– or never graduated from pro-cyclicality in the first place,
• e.g., Argentina, Ecuador, Venezuela.
Appendices
• (I) Cyclicality of spending for sub-periods
• (II) Optimism bias among advanced countries
• (III) Pro-cyclical tax policy
• (IV) Emerging Market macroprudential regulation:
• reserve requirements on banks
• limits on housing debt
• margin requirements for the stock market.
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Appendix I:
Cyclicality of government spending
in sub-periods
Correlations between Government spending & GDP
2000-2009
Adapted from Frankel, Vegh & Vuletin (JDE, 2013)
In the decade 2000-2009,
about 1/4 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
Updated by Guillermo Vuletin, Oct. 2016
Update of Correlation (G, GDP): 2010-15
Back-sliding among some countries.
Since 2010, some of those countries
have reverted to pro-cyclical fiscal policy.
Updated by Guillermo Vuletin, Oct. 2016
Appendix II:
Optimism bias in official budget forecasts
US official projections were over-optimistic on average.
F & Schreger, 2013
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German forecasts were also usually too optimistic.
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Most European official forecasts have been over-optimistic.
Figure 2 (Frankel & Schreger, 2013):
Mean 2-year ahead budget forecast errors, European Countries
Full Sample Period
For 17 Europeans, the bias is even higher than others, averaging:
0.5% at the 1-year horizon,
1.3% at the 2-year horizon,
2.4% at the 3-year horizon
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Over-optimism in official forecasts
• Statistically significant findings among 33 countries
– Frankel (2011, 2012).

Official forecasts on average
are over-optimistic, for:
 (1) budgets &
 (2) GDP.

The bias toward optimism is:
 (3) stronger the longer the forecast horizon;
 (4) greater in booms.
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Implication of forecast bias for actual budgets
• Can lead to pro-cyclical fiscal policy:
– If the boom is forecast to last indefinitely,
there is no apparent need to retrench.
• BD rules don’t help.
– The SGP worsens forecast bias
for euro countries
• Frankel & Schreger (2013).
• Private-sector forecasts do help.
• Frankel & Schreger (2016).
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Appendix III:
Pro-cyclical tax policy
Tax policy is also pro-cyclical in most EM countries…
and in Spain, Portugal & Greece!
Vegh & Vuletin (AEJ-EP, 2015).
Correlation of an index of tax rates with GDP
Tax parameter index is based on personal, corporate, VAT rates and
their weight in revenues. Period is 1960-2013 (less for some countries).
Pro-cyclicality of spending tends to go with pro-cyclicality of tax cuts.
Vegh & Vuletin (AEJ-EP, 2015).
Appendix IV:
Emerging Market countries’
macroprudential regulation:
• Banks: reserve requirements
• Housing: loan limits
• Stock market: Margin requirements
Asian & other EMEs take macro-prudential actions
more often than advanced countries do.
Reserve Requirements
Growth
Liquidity
Loan To Value limits
Debt Service to Income
Risk Weighting
Provisioning
Exposure Limits
Kuttner & Shim, NBER WP 19723, Table 1; or Shim, et al, BIS Quarterly Review, Sept. 2013, 83-95,
www.bis.org/publ/qtrpdf/r_qt1309i.pdf, Table
3.
(i) Banks: Emerging Market countries tend to tighten
bank reserve requirements counter-cyclically (2005-2011)
P. Federico, C. Végh, and G. Vuletin, "Reserve Requirement
Policy over the Business Cycle," NBER WP 20612, Oct. 2014.
Example: China’s bank reserve requirements
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Each time China’s
economy showed
signs of overheating
(2007-08, 2010-11),
the PBoC raised
reserve requirements.
API-120 - Prof. J.Frankel, Harvard
Fxtimes.com
(ii) Housing: Korea & China tighten mortgage limits
(ceilings on ratio of Loan to Value & Debt Service to Income)
to dampen housing credit.
Interest rate and credit policies in Korea
Interest'rate
Reserve'Req
Interest rate and credit policies in China
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LTV
20
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10
interest'rate,'%
1
15
DSTI
3
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5
6
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2
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1986 1989 1992 1995 1998 2001 2004 2007 2010
2002
2004
2006
2008
2010
Kenneth Kuttner & Ilhyock Shim, NBER WP 19723 (2013), “Can non-interest rate policies stabilize housing markets?
Evidence from a panel of 57 economies,” published (without these figures), Journal of Financial Stability 26 (2016), 31–44.
cumula/ ve'/ ghtening
25
LTV
cumula/ ve'/ ghtening
interest'rate,'%
DSTI
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Reserve'Req
Chinese housing prices rose sharply in 2010
(as did GDP growth and CPI inflation)
“China's Real Estate Market Entering a Correction Phase: Housing bubble close to bursting” 6/4/14.
Note: Price Indices of Newly Constructed Residential Buildings until December 2010. Price Indices of Newly Constructed Commercial Residential Buildings from January 2011. 70 large
and medium-sized cities is the simple average. Data Source: Compiled based on the CEIC Database (Original data from the National Bureau of Statistics of China)
China tightened macroprudential policies in 2010-11,
particularly in housing finance:
Loan-to-Value and Debt-Service-to-Income limits
Interest rate and credit policies in China
Kenneth Kuttner & Ilhyock Shim, “Can non-interest rate policies stabilize housing markets? Evidence
from a panel of 57 economies,” Fig. 3 in NBER WP 19723. Journal of Financial Stability 26 (2016) 31–44.
(iii) Equities: Little known, but China’s stock market regulator
raised margin requirements during the 2015 bubble,
in January & April and on June 12.