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 ID: 765027
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Fiscal Cyclicality in EM Countries Jeffrey FrankelSeminar on Macroeconomic PolicyEconomics Department, Harvard UniversityOctober 18, 2016Continued from April 28, 2015
Some Emerging Market countries achieved fiscal counter-cyclicality after 2000.
3 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).
4 Correlations between Gov.t Spending & GDP 1960-1999 procyclical } G always used to be pro-cyclical for most developing countries. countercyclical Adapted from Kaminsky, Reinhart & V é gh (2004 ) “When it Rains, It Pours” Pro -cyclical spending Counter - cyclical spending
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 After 2000, about 1/4 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP.Adapted from Frankel, Vegh & Vuletin ( JDE , 2013) Updated by Guillermo Vuletin, Oct. 2016
7 ”On Graduation from Fiscal Procyclicality ,” Frankel, Végh & Vuletin; J.Dev.Economics, 2013. Who achieves countercyclical fiscal policy? Countries with “good institutions” IQ
The quality of institutions varies, not just across countries, but also across time. 8 1984-2009 Frankel, Végh & Vuletin , 2013 . Good institutions; Countercyclical spending Worsened institutions; More-cyclical spending. Improved institutions; Less-cyclical spending.
9 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 forecastsof GDP growth rates & budgets.If boom is said to be permanent,there is no perceived need to restrain spending.
Countries with Balanced Budget Rules frequently violate them. International Monetary Fund, 2014 BBR: Balanced Budget Rules DR: Debt Rules ER: Expenditure Rules Compliance < 50%
To expect countries to comply with the rules during recessions is particularly unrealistic (and not even desirable). International Monetary Fund, 2014 Bad times : years when output gap < 0
12 Greek official forecasts were always over-optimistic . Frankel & Schreger, 2013. Data from Greece’s Stability and Convergence Programs .
13 1 st 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.The case of Chile
14 Chile’s official forecasts were not over-optimistic . Chilean forecasts of budget balance, one year ahead
15 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 recessionvia fiscal expansion.The Pay-off
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.
17 (I) Cyclicality of s pending for sub-periods (II) Optimism bias among advanced countries (III) Pro-cyclical tax policy(IV) Emerging Market macroprudential regulation:reserve requirements on bankslimits on housing debtmargin requirements for the stock market.Appendices
Appendix I: Cyclicality of government spending in sub-periods
In the decade 2000-2009, about 1/4 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP.Correlations between Government spending & GDP 2000-2009 Adapted from Frankel , Vegh & Vuletin ( JDE , 2013) Updated by Guillermo Vuletin, Oct. 2016
Update of Correlation (G, GDP): 2010-15 Back-sliding among some countries. Updated by Guillermo Vuletin, Oct. 2016 Since 2010, some of those countries have reverted to pro-cyclical fiscal policy.
Appendix II: Optimism bias in official budget forecasts
22 US official projections were over-optimistic on average. F & Schreger, 2013
23 German forecasts were also usually too optimistic.
24 Figure 2 ( Frankel & Schreger, 2013): Mean 2-year ahead budget forecast errors, European Countries Full Sample Period Most European official forecasts have been over-optimistic. 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
25 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.
26 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 countriesFrankel & Schreger (2013).Private-sector forecasts do help.Frankel & Schreger (2016).
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). Tax parameter index is based on personal, corporate, VAT rates and their weight in revenues. Period is 1960-2013 (less for some countries).Correlation of an index of tax rates with GDP
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. 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. Liquidity R isk Weighting Exposure Limits Growth ProvisioningReserve RequirementsLoan To Value limitsDebt Service to Income
(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.
API-120 - Prof. J.Frankel, Harvard Fxtimes.com Each time China’s economy showed signs of overheating (2007-08, 2010-11), the PBoC raisedreserve requirements. ? Example: China’s bank reserve requirements
(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 China Interest rate and credit policies in KoreaKenneth 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.
Chinese housing prices rose sharply in 2010 (as did GDP growth and CPI inflation) 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's Real Estate Market Entering a Correction Phase: Housing bubble close to bursting” 6/4/14.
China tightened macroprudential policies in 2010-11, particularly in housing finance:Loan-to-Value and Debt-Service-to-Income limitsKenneth 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. Interest rate and credit policies in China
(iii) Equities: Little known, but China’s stock market regulator raised margin requirements during the 2015 bubble, in January & April and on June 12.