Discussion Paper No. 2001/71 Macroeconomics of Fiscal Policy in Developing Countries Raghbendra Jha*

Transcription

1 Dicuion Paper. 200/7 Macroeconomic of Fical Policy in Developing Counrie Raghbendra Jha* Sepember 200 Abrac Thi paper conider ome apec of he effec of fical policy on macroeconomic adumen in developing counrie. Fir, he paper review he noion of he fical defici in he paricular conex of developing counrie. I hen pell ou he condiion under which he inernal and exernal deb are uainable and poin ou he role of he win defici. The paper hen preen ome evidence on he uainabiliy of he inernal and exernal defici in he conex of ome developing counrie. Finally he paper develop he heme of endogeneiy of money upply o fical policy and inernaional capial flow and poin ou he difficulie faced by abilizaion policy under hee condiion. Keyword: fical policy, domeic deb, foreign deb JEL claificaion: O23, H20, H62 Copyrigh UNU/WIDER 200 * Auralia Souh Aia Reearch Cenre, Diviion of Economic RSPAS, The Auralian Naional Univeriy, Canberra ACT 0200, Auralia. Fax: , r.ha@anu.edu.au Thi udy ha been prepared wihin he UNU/WIDER proec on 'New Fical Policie for Growh and Povery Reducion'. Proec Direcor: Tony Addion. UNU/WIDER graefully acknowledge he financial conribuion o he proec by he Governmen of Ialy (Direcorae General for Developmen Cooperaion.

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3 Inroducion Thi paper purpor o examine he macroeconomic effec of fical policy, paricularly defici, in developing counrie. The role of he fical auhoriy in developed and developing counrie vi à vi developed counrie are markedly differen. In boh developed and developing counrie here i a concern for raiing living andard over ime, bu hi need i much more pronounced in developing counrie, given he exen and deph of povery in hee counrie. In he relaive abence or perpeual weakne of iniuion o mobilize and direc aving, he role of he ae i crucial in harneing he reource for developmen. Since he regulaory apparau i weak and marke ignal imperfec, he ae ha an imporan role o play in allocaing invemen fund. Furher, wih widepread povery, here i he expecaion ha fical expendiure would play a maor role in ani povery program. Preure for populim hrough price conrol and he like are coniderable. A he ame ime, and for ome of hee ame reaon, he ae in developing counrie i handicapped in i abiliy o play an acivi role. Fir, he ae in a developing counry i a weaker eniy poliically han in mo developed counrie. Thi mean ha here i ofen very lile conenu on he conour of a ax and expendiure program. (See Heady (2000. Second, he reource available wih he governmen are meagre ince ax bae are mall and ax adminiraion weak. Much of ax revenue come from inefficien and diorionary indirec axe uch a excie duie. Inernaional rade i heavily axed. Effecive peronal income axe are low and eaily evaded and corporae axe are high. Even o expendiure rouinely, and even increaingly, oupace revenue. Wih poor credi and bond marke and fical expendiure ha are inflexible in he downward direcion, ome of he financing of he reulan defici pill over ono he exernal ecor and he cenral bank. Even wihin he developing counry group here i coniderable heerogeneiy in experience wih repec o he fical defici. The difference are more pronounced beween he middle and low-income counry caegorie bu hey exi even wihin he low-income caegory of counrie. For example low income counrie differ harply in regard o he deph of heir financial marke. Thu in 999 in Burkina Fao ne foreign ae a a percenage of broad money were.9%. The correponding figure for India wa 4.3%. Thu here are harp difference wihin counrie in he developing counry group wih repec o he opion available for public borrowing in he even of here being a large fical defici. Indeed he poore among he LDC are caugh in an inidiou reource rap. (UNCTAD (2000. The relaion beween per capia income and aving appear no differen in hee counrie han in he preenly developed naion. However, becaue of low per capia income, aving are low and becaue of hi economic growh i low. In addiion, a UNCTAD (2000 eimae exernal hock have a far more eriou effec in he lea developed counrie han oher developing counrie. To quoe hi repor The Burkina Fao figure i aken from IMF (2000 wherea he figure for India come from he Reerve Bank of India Bullein (2000.

4 The average lea developed counry economy ha, ince he 970, been expoed o advere exernal rade hock wih an impac, in he wor year, more or le double he average of oher developing counrie. The fac ha he lea developed counrie can pare far fewer reource o comba he effec of hee exernal hock, hen, exacerbae hi problem. Exernal finance i he obviou way o ge around hi harp reource crunch. However, uch upplie are meagre. Large, able marke economie uch a India and Souh Africa arac coniderable capial inflow wherea mo poor economize of he ub Saharan region ge poor inflow. Thu in 997 Souh Africa had FDI flow of US$27,483 million and porfolio invemen ae of US$7,87.77 million wherea2 he correponding figure for Bowana were US$404 million and US$204 million. Boh FDI a well a porfolio flow are poor. FDI flow are concenraed largely in reource exracion3. The reaon for uch poor flow are no hard o dicover. Thee are relaed o co of ae developmen, rik which are rooed in he vulnerabiliy of he lea developed counrie o hock, lack of buine uppor ervice, weak phyical, ocial and adminiraive infrarucure, and he mall cale of proec (UNCTAD (2000. Wih rapidly diminihing official aid and poor privae equiy flow, exernal financing of he fical defici in he poore counrie ha o rely increaingly on privae loan. Thee are available a increaingly difficul erm, a Harberger (985 ha noed, a he domeic reource co of ervicing hee goe up wih addiional borrowing. Furhermore, ypically, hi reource co i undereimaed. Oher reaon for difference acro counrie include coninuiy and abiliy of policy regime. Thu Zambia, which ha had a hiory of policy reveral, would be aociaed wih higher rik han Bowana and Mauriiu, which have had credible and able policy regime. The co of borrowing abroad will ypically be higher for counrie wih frequen reveral of policy ance a he rik aociaed wih lending will go up harply. A conequence of hee facor for financing he fical defici i ha many of hee counrie have o rely, o a coniderable exen, on non-bond (moneary financing of he defici. When hi occur, he diincion beween fical policy and he moneary bae of he cenral bank i blurred and he independence of moneary from fical policy i compromied. Thi paper i addreed o everal obecive. Fir, in Secion II, I review he noion of he fical defici in he paricular conex of developing counrie. Secion III develop he noion of uainable fical defici. I alo ariculae a criical defici ha make for a uainable inernal deb. In ecion IV, he noion of uainable exernal deb i ariculaed. Secion V aee he noion of uainable win defici. I apply he uainabiliy e o a cro ecion of low and medium income counrie for he period 2 ThedaaarefromheIFSCDrom. 3 Mo of he lea developed counrie effecively face verical upply curve of exernal capial inflow. Variou reaon can be aribued oward hi. Macro policy diaer uch a hoe in Tanzania have played an imporan role. Oher uch a Guinea are u oo mall. Counrie uch a Angola do manage o ge ome FDI in reource exracion. Angola, for example, borrow exernally by morgaging i poenial oil revenue bu here are limi o hi when deb rie o high level and addiional loan can be obained only a very high inere rae. 2

5 ince 950. Secion VI conider ome problem aociaed wih he problem of inernaional capial flow and indicae he difficuly of puruing abilizaion policie under hee condiion and he role ha fical policy can play o ameliorae hi difficuly. Secion VII conclude. 2 The fical defici: wha doe i meaure? The convenional meaure of he fical defici a he difference beween oal governmen expendiure and curren governmen revenue while being clear a an accouning concep, i no above conrovery a an economic eniy. Tanzi (993 for, example, menion he following hree difficulie: (i he convenional meaure of he defici fail o recognize ha differen ax and expendiure caegorie have differen ype of effec on aggregae demand. For example, an exce of expendiure on he infrarucure creae producive capaciy and will have a differen impac han an exce of expendiure due o conumpion ubidie4. (ii A econd problem arie becaue ax revenue are no exogenou of expendiure. The level of public expendiure deermine naional income, which hen deermine ax revenue, a lea in par. I i in hi conex ha during he Kennedy-Johnon preidencie in he US a period of full employmen he noion of a full employmen budge urplu wa defined and ued. In he conex of developing counrie, uch a noion would be upec ince he binding conrain on oupu in heir cae i no he upply of labor. A more relevan conrain would be he availabiliy of credi in erm of hard currencie5. (iii Finally here i he problem of ource of financing he defici. In developing counrie everal ource of financing have been ued e.g., cenral bank financing, commercial bank financing, domeic ale of governmen bond o cover he defici and foreign financing. Each of hee ha differen macroeconomic conequence. Cenral bank financing raie he moneary bae and he money upply, hereby blurring he diincion beween moneary and fical policie. Foreign financing will raie he co of ervicing exernal deb wherea domeic bond iue will raie inere rae. An addiional difficuly i ha ome ource of finance are available only under cerain circumance. For example, a counry wih a hin bond marke (which i he cae in almo all of ub Saharan Africa excep Souh Africa can hardly afford o iue bond o cover he fical defici and may have o rely on cenral bank financing or ome uch meaure. A counry wih large exernal deb would, in all probabiliy, be able o finance i defici exernally only by borrowing hor erm a high rae of inere. Thi would make i difficul o finance he exernal deb and may pu preure on he currency. Some auhor uch a Buier (985, 993 have gone much furher ahead and argued ha even cyclically adued and inflaion adued meaure of he defici are only imprecie indicaor of he rue defici. For example, he capial gain/loe on governmen ae and liabiliie are no included in he convenional flow of fund accoun. Example of hee would include change in relaive price (ay change in 4 For a furher elaboraion of hi poin ee Herme and Lenink (2000 and Gemmell ( The diincion i harply illuraed by he recen experience of he US. For he pa five year or o, ax revenue in he US have been very buoyan following high employmen condiion. A a reul a ubbornly high US budgeary defici ha urned ino a urplu. The US economy, of coure, doe no face a foreign exchange conrain o ha hi ranformaion wa poible. 3

6 mineral price and change in he real value of nominal deb during an epiode of inflaion.6 Paricularly in hoe developing counrie where public invemen ha played a ignifican role in he economy, a diincion i made beween revenue or curren defici and capial defici. The former i he defici on expene of a recurren naure afer neing ou invemen expendiure. Surely, if a counry i running a large and growing defici on uch curren ranacion i i a reaon for worry. However, i hould be poined ou ha he diincion beween capial and curren expendiure i ofen an arificial one (for example, in aid dependen economie, large amoun of aid-financed curren expendiure conneced wih aid financed proec are placed in he capial expendiure caegory he cae of Mozambique, for example. I would be meaningful only if i wa clear ha all capial expendiure were producive in naure. Alhough capial expendiure are aociaed wih capaciy building aciviy, i migh be he cae ha ome uch expendiure are waeful in naure. Thi would ypically be he cae if he proec in queion ha no been evaluaed carefully and/or involve equipmen ha i highly capial inenive or ha an unduly impor inenive or i, in ome oher way, inappropriae for he economy. For example, a ubanial par of Nigeria public invemen have low ocial rae of reurn, reflecing inappropriae echnology choice and long anding overvaluaion of he currency ha cheapened he co of capial equipmen. Furhermore, hi curren or revenue defici ay nohing abou he impac of he defici on he balance of paymen or on economic growh. There are ome oher problem aociaed wih he meauremen of defici ha are worh menioning. Fir, i he problem of arrear. Thi become paricularly relevan in he cae of repaymen of foreign deb. If, for example, he inere paymen on he foreign deb i recheduled which i he cae in many Heavily Indebed Poor Counrie (HIPC uch a Tanzania hould we ay ha he defici ha gone down? Similarly, if he governmen delay ome paymen (ofen he public wage bill wherea i ake in all i revenue doe fical defici go down? Thee queion become paricularly relevan during a period of high inflaion when delaying paymen denominaed in nominal erm can have ignifican impac on he real value of uch paymen. For example, Angola governmen receive large reource revenue from oil bu in he recen pa i ha neverhele accumulaed large wage arrear, he real value of which would have declined rapidly wih hyperinflaion. (See Aguilar (2000. A furher imporan problem arie when he fical defici repored i only ha of he cenral governmen. In counrie wih differen level of governmen hi would be an inappropriae indicaor of he defici. Even if he defici of ae and lower level of governmen are included, here may be oher governmen agencie ha are running a defici, which doe no ge refleced, in he meaured fical defici. Example would include he defici of cenral bank in ome Lain American counrie, he defici of local (paricularly municipal governmen in India and he o-called oil pool defici in India where excee of paymen for peroleum impor over wha i colleced from 6 Recen argumen along he line uggeed by Buier include hoe by Eaerly (999 who argue ha fical adumen can be illuionary. In paricular, hi would be he cae when uch adumen lower he public deb bu leave unchanged he ne worh of he governmen. In oher word, governmen may find way of mainaining heir conumpion even when hey are acually involved in a proce of reducing public deb. 4

7 conumer i recorded. The oil pool defici, for example, can become large during a period of rie in he inernaional price of peroleum produc and difficulie in raiing he domeic price of uch produc. In he Indian7 cae, for example, par of he burden of hi adumen ha been hifed o he fuure by iuing oil bond. Such ranacion do no ge refleced in he fical defici. All hi hen end o make he fical defici a no enirely aifacory meaure of he exce of governmen expendiure over revenue. The difficulie in meauring and inerpreing he defici nowihanding, i i ueful o underand wheher he underlying fical ance i uainable. The lieraure on hi iue i growing rapidly. In he nex ecion I develop he exan noion of inernal deb uainabiliy and apply i o elec developing counrie for which coninuou daa are available. Subequenly he noion of exernal deb uainabiliy i dicued. 3 Suainabiliy of he domeic fical deb Rapid accumulaion of domeic deb can lead o evere macroeconomic problem, and can impede conrol of he fical defici ielf. To ake only one example, Zimbabwe fical defici i eimaed o be cloe o 20 percen of GDP in Public deb i riing rapidly, wih new deb being iued o mee inere paymen (he o-called Ponzi game. Inere paymen on domeic public deb are expeced o exceed 50 percen of oal governmen revenue by end-2000, hereby queezing developmen and ocial pending. (ource EIU (2000. Thi ecion develop he imple analyic of uainabiliy for he domeic a well a he exernal defici and applie i o a pecrum of developing counrie. 3. The governmen ineremporal budge conrain The mo raighforward way o ae he uainabiliy of a public deb iuaion i o ar from he governmenal ineremporal budge conrain. Thi i wrien in nominal erm a: G T r B = B B ( Where G i he value of governmen expendiure (purchae of good and ervice plu ranfer paymen; B i he governmen deb a he end of period, T i he 7 In India he price of peroleum produc are adminiered by he governmen hrough an oil pool mechanim. The aed purpoe of hi i o provide uniform and able price of uch produc o conumer wihin he counry and reaonable profi margin for he oil companie. The oil pool accoun are uppoed o be elf financing. The inflow ino he pool accoun are from collecion of urcharge on he ale of peroleum produc while he ouflow i for meeing he variaion in he elemen of andard co. The difference beween inflow and ouflow repreen he urplu/defici poiion of he ol pool accoun. And i no included in he budgeary defici of he cenral or ae governmen. In recen year hi accoun ha perienly been in defici ince reviion o conumer price of peroleum produc have been farr from complee. Thi endency ha been exacerbaed wih he recen harp rie in world peroleum price. Some of he defici in he oli pool accoun i covered by he iue of oil bond iued by he governmen and bough by oil companie, which can redeem hee bond a pecified fuure dae. See Miniry of Finance (997. 5

8 governmen ax revenue and r i he one-period rae of inere payable on he governmen deb. ( ae ha in he abence of money finance, he governmen budge defici mu be financed by new deb creaion8. Hence, expreing ( in erm of raio o gro GDP we will have: b = ( r ( π η b ( g τ (2 Where he lower cae leer denoe he raio of he correponding uppercae variable o nominal GDP: b = B / P Y ; g = G / P Y ;andτ =T / P Y ; wih P and Y being he price level and real GDP repecively. π =(P -P - P - i he rae of inflaion and η = (Y -Y - /Y - i he rae of growh of real GDP. In he derivaion of (2 we have ued he relaion ha: PY = ( π ( η P Y ( π η P Y (g -τ i he primary defici expreed a a percenage of GDP. We have he following cae: Cae : r -π < η In hi cae in (2 he deb raio will abilize and he economy will remain olven if: lim E( b = 0 If he iniial deb o GDP raio (b 0 i ricly poiive, hi require wo condiion: r -π < η for all o ha he deb raio abilize raher han explode. Thi i he ocalled uainabiliy condiion and make any able pah of he primary defici conien wih a able public deb o GDP raio. In addiion we have condiion (b ha g τ 0 on average, if no in every period, o ha he deb burden i ulimaely liquidaed. Thee wo condiion are neceary and ufficien and enure ha he deb, no maer how large, can be paid off hrough ax increae or expendiure cu or inflaion. Thu he governmen i olven. The eady ae (finie value of he deb-gdp raio i b = b = b = ( η π ( η ( r π ( g τ if r π < η (3 8 The lef hand ide of he governmen budge conrain mu alo include exchange rae change and privaizaion which reflec change in governmen ne deb due o revaluaion of he governmen financial ae. In he empirical work repored in hi paper hi broader definiion i ued. 6

9 (3 emphaize a rong link beween he governmen indebedne and i primary defici. Cae 2: r -π > η In hi cae he deb i unuainable and he deb ock will become infinie no maer wha equence of primary defici are choen unle he deb ock ielf can be offe by maching he equence of increaing bu dicouned primary urplu in he fuure. To conider uainabiliy furher here ranform (2 o ge: b = ( θ b ( g τ (4 Where we have ued he fac ha: ( r ( π η = r π η θ = r -π -η i he real inere rae minu he rae of growh of real GDP. (4 will alway hold ex po. Looking forward we can wrie he ideniy in (4 for ime period a: b [ θ b ( g τ ] (5 = E ( where b i known in period. For hi one period conrain o hold in expecaional erm, hi mu equal he expeced dicouned ne deb-o-gdp raio in period condiional on informaion a ime. For fical policy o be uainable for one ime period (5 mu hold. Wriing he budge conrain of (5 for ubequen ime period 2, 3 ec. and olving forward we ge b = E ( θ i ( τ g E ( = 0 i= i= θ i b (6 I i apparen ha i= ( θ i i a ime-varying real dicoun facor adued for he growh of real GDP wih θ >0. A neceary and ufficien condiion for uainabiliy i ha a he dicouned value of he expeced deb-o-gdp raio converge o zero. Thi i a ranveraliy condiion and can be expreed a: lim E i= ( θ i b = 0 (7 (7 implie ha a governmen i olven if he ranveraliy condiion guaranee he non- exploivene of he public deb and when no Ponzi game are allowed, i.e., no 7

10 new deb i iued by he governmen o mee inere paymen. Hence i follow ha he curren deb i offe by he um of he curren and expeced fuure dicouned urplue, implying ha he budge conrain hold in preen value erm wih: b = lim E = 0 i= ( θ i ( τ g (8 3.2 The criical value of he deb-gdp raio Given (8 and uing z m (=τ max g min a a definiion of he maximum level of he governmen primary urplu we can deermine he criical value of he public deb raio (b C, which will aify he uainabiliy condiion: b b C = z m ( r π η (9 We can alo deermine he neceary primary urplu, given he iniial deb raio, b 0,he real inere rae and he growh rae of real GDP, o abilize he fuure deb o GDP raio. When r-π > η we can ue (2 o define he finie value (b 0 owhichb converge a: z = ( r π η( η π b0 (0 The gap beween he abilizing primary urplu (z ** and he acual primary urplu (τ -g may be ued a a uainabiliy indicaor. Thi indicaor give he magniude by which eiher revenue mu be increaed or expendiure mu be cu relaive o income o op he deb raio from growing. (0 eem helpful when aeing empirically he fical policie and he deb iuaion for developing counrie. For example, i would be ueful o compare hi wih he deb ceiling he IMF may have precribed for hee counrie a he ime of heir agreeing o abilizaion program.9 From he above analyi i i clear ha uainabiliy of he public deb i eenially an ineremporal queion. In paricular, every emporary defici can be uainable o long a i i mached by an adequae fuure urplu. Mo empirical e on uainabiliy 9 The ak of uaining a deb ceiling i eaier aid han done, paricularly in low income counrie wih poor ax iniuion. Thi i primarily becaue invemen and produciviy of ax iniuion would probably grow a a lower rae han he public deb ielf. Thu counrie rying o cu he deb by raiing more revenue would probably need o raie axe paricularly diorionary axe uch a rade and indirec axe. Thi may cu he deb/gdp raio in he hor erm bu may end up huring growh and, herefore, he ax poenial in he medium run. Hence he bulk of adumen mu come from cu in expendiure. Thi i ypically aociaed wih cu in ocial expendiure and pending on infrarucure. If inernaional donor are willing o provide more conceional loan (or ourigh gran where he inere rae charged i lower han ha prevailing, hen ome of he deb can be reired uing hee foreign fund and cu i domeic inere bill. Thi policy ha ye o be ried in a ignifican way anywhere. 8

11 apply ime erie mehod and ak wheher he oberved characeriic of deb-relaed variable aify he olvency condiion in (7. Thi olvency condiion can be eed in a variey of way depending on he procee poulaed for he primary defici (g -τ and he real inere rae adued for oupu growh (θ. Hamilon and Flavin (986 and Trehan and Walh (988, among oher, examine he cae where (g -τ i ricly exogenou and θ i conan. Wilcox (989 conider he cae wih exogenou (g -τ bu variable θ. Ucum and Wicken (997 conider he cae where θ i ochaic and (g -τ could be exogenou or endogenou. For he ake of impliciy, we will aume ha he real inere rae adued for oupu growh, θ, i conan wih an uncondiional mean. To proceed furher now ake he fir difference of (6, ubiue for b uing (4 and implify o ge: b = d τ = = 0 lim( θ ( θ E b E ( τ d lim( θ E b ( where b = g θb - -τ = d -τ wih d = g θb - defined a oal governmen expendiure incluive of expendiure on good and ervice, ranfer paymen and inere on he deb. If he governmen aifie i ineremporal budge conrain hen he expeced limi erm in ( i zero o ha he um of he curren budge urplu (τ -d and he expeced preen dicouned value of fuure urplu will equal he amoun needed o repay he principal and he inere on he iniial deb. When hi condiion hold, i can be aid ha he curren expeced pah of governmen pending and axaion are uainable. A Papadopoulo and Sidirpoulo (999 demonrae if he limi erm on he righhand-ide of ( are zero, hen a cerain coinegraing relaionhip emerge. Hence coinegraion i a neceary condiion for he ineremporal budge conrain o hold. To ee hi aume ha d and τ follow random walk wih drif. Thu hee variable follow he following ime erie procee: d τ = α = d α τ v v d, τ, (2 (3 where α d and α τ are conan and v d and v τ are zero-mean aionary procee. Hence ( can be rewrien a: α = v = = 0 = 0 ( θ ( θ ( α α ( v d d, τ v τ, S wih 9

12 d τ = α lim( θ E b lim( θ E b v (4 Given ha d and τ are I( and given ha (2 and (3 imply aionariy on he righ hand ide of (, he lef hand ide of ( mu alo be aionary for which a neceary condiion i ha (4 be aionary, which will be he cae when d and τ are coinegraed. Thu a e for uainabiliy of he deb would check for he coinegraion of hee wo variable if hey are I(. Thi coinegraing regreion would ake he form: τ = α βd v (5 Formally, hen, if d and τ are I(, he null hypohei i ha d and τ are coinegraed and ha β =. If hi null hypohei i no reeced hen he public deb i uainable. According o Hakkio and Ruh (99 he condiion 0<β alo guaranee uainabiliy. To ee hi ubiue α*βd for τ in (2 o ge b = b - k wih k (-β*d α*. By ieraing forward we will ge: E b = = 0 [( θ ( β ( θ ] E k [( θ ( β ( θ ] E b (6 Uing (6 he limi erm lim E b in (4 mu equal lim E ( = 0 [( θ ( β ( θ ] k [( θ ( β ( θ ] b Uing hi relaion and a imilar expreion for lim E b i can be hown ha he expeced limi erm on he righ-hand-ide of (4 are equal o zero o long a 0<β*. However, alhough he limi erm equal zero, he limi of he undicouned value of b equal infiniy when β* <. Thu hi noion of uainabiliyi no a unambiguou a ha which require ha β*=. Te for uainabiliy of he fical defici were conduced for he ample of low and middle-income counrie. The daa e ued wa ha provided by he IFS CD rom. Annual daa for he period wa conidered. Time erie analyi of he or 0

13 conidered in hi paper require long daa e. For everal of he counrie uch daa wa no available. In Table I repor reul on he inernal defici uainabiliy e for all counrie for which a reaonable long daa e wa available.0 Table. Suainabiliy of inernal defici of low and middle income counrie Counry Period Characeriic of revenue and expendiure Coa Rica Revenue: I( Expendiure: I( Dominican Republic Revenue: I( Expendiure: I( Ecuador Revenue: I( Expendiure: I( Egyp Revenue: I( Expendiure: I( El Salvador Revenue: I( Expendiure: I( Fii Revenue: I( Expendiure: I( Ghana Revenue: I( Expendiure: I( Guaemala Revenue: I( Expendiure: I( Guyana Revenue: I( Expendiure: I( Hondura Revenue: I( Expendiure: I( India Revenue: I( Expendiure: I( Indoneia Revenue: I( Expendiure: I( Iran Revenue: I( Expendiure: I( Ivory Coa Revenue: I( Expendiure: I( Coinegraion beween revenue and expendiure Ye Ye Ye (a 0% Ye Ye (a 0% Ye Ye Ye Ye Suainabiliy Rericion Saified (rericion reeced a 7.2% 0 A relevan apec of he e for uainabiliy i o acerain wheher he ime erie involved have a break. Te along he line of Gregory, Hanen and Bruce (996 were conduced bu are no repored here ince he daa e involved are no long enough o give robu reul. However, reul of hee e are available from he auhor.

14 Table. Coninued Jordan Revenue: I( Expendiure: I( Kenya Revenue: I( Expendiure: I( Morocco Revenue: I( Expendiure: I( Nepal Revenue: I( Expendiure: I( Nigeria Revenue: I( Expendiure: I( Pakian Revenue: I( Expendiure: I( Paraguay Revenue: I( Expendiure: I( Philippine Revenue: I( Expendiure: I( Souh Africa Revenue: I( Expendiure: I( Sri Lanka Revenue: I(0 Expendiure: I(0 Tanzania Revenue: I( Expendiure: I( Thailand Revenue: I( Expendiure: I( Tuniia Revenue: I( Expendiure: I( Uganda Revenue: I( Expendiure: I( Zambia Revenue: I(0 Expendiure: I( Ye Ye Ye (a 0% Ye Ye. The reul in Table are quie riking. In almo all counrie boh governmen expendiure a well a governmen revenue are non aionary. In he cae of Sri Lanka boh expendiure a well a revenue are aionary wherea in he cae of Zambia, revenue i aionary wherea expendiure i no. Thu Sri Lanka appear o have a able fical iuaion wherea he Zambian defici iuaion i worriome. In he re of he counrie only in he cae of Paraguay and Souh Africa i he defici uainabiliy condiion aified. In all he oher counrie, eiher governmen expendiure and revenue are no coinegraed or, if coinegraed, he uainabiliy rericion doe no hold. Thu, he fical defici in hee counrie i no uainable in he long run. 2

15 4 Suainabiliy of he exernal deb In line wih he argumen developing he noion of a uainable inernal defici, a cae can be made o acerain he uainabiliy of he exernal defici (ypically he curren accoun balance or rade balance of a counry. Ju a a governmen canno borrow in he domeic marke indefiniely o finance i budgeary defici, i canno borrow indefiniely in global capial marke o finance i rade accoun defici. Thi noion can be formalized in a manner imilar o ha expreed above. I hould be noed ha i i only raher recenly ha he noion ha large curren accoun defici may caue problem ha achieved accepance. A lae a 994, Max Corden epoued he virue of he Lawon docrine. Thu Corden (994 wroe: The curren accoun i he ne reul of aving and invemen, privae and public. Decenralized opimal deciion on privae aving and invemen will lead o a ne balance he curren accoun which will alo be opimal. There i no reaon o preume ha governmen or ouide oberver know beer how much privae agen hould inve and ave han hee privae agen hemelve, unle here are governmen- impoed diorion. I follow ha an increae in a curren accoun defici ha reul from a hif in privae ecor behavior hould no be a maer of concern a all. On he oher hand, he public budge balance i a maer of public policy concern and he focu hould be on hi. wihanding he Lawon docrine large curren accoun imbalance were aociaed wih currency aack in Chile (in early 980, in he UK and rdic counrie (lae 980; in Mexico and Argenina (mid 990 and in everal Aian counrie and Ruia in 997 and hereafer.2 Hence, here eem o be ome problem wih he Lawon docrine. The lieraure li he following five reaon for he failure of hi docrine: i When here i Ricardian equivalence,3 a public ecor defici will be inerpreed by raional, forward-looking agen a implying higher axe in he fuure. In repone, curren conumpion will fall o pay for hee higher axe. Afer Nigel Lawon, UK Chancellor of he Exchequer, who in 988 dimied he poibiliy of any caual link beween inernal defici and he curren accoun defici. 2 I i imporan o undercore he poin ha here i a uble difference beween low and middle income counrie wih repec o he link beween exernal uainabiliy and currency crie. Surely, large curren accoun defici financed by capial flow are poible only in counrie ha are ucceful in aracing uch flow. Thi would ypically be poible primarily in middle income counrie. The banking yem in mo low income counrie, wih he poible excepion of India, are imply no robu enough o arac and reain uch flow. Even in India maor capial flow, paricularly in crucial infraruural area are araced by he cenral governmen providing couner guaranee o he inveing corporaion. Thi hen creae difficulie for Indian balance of paymen imilar o hoe for middle income counrie. Thee problem may become more common wih more low-income counrie exploring he couner guaranee roue o aracing capial flow. Hence upplemening domeic aving wih foreign aving i a raegy open only o a few counrie and even hen hi i fraugh wih ome difficuly. 3 For evidence on Ricardian Equivalence in he developed counry conex ee, for example, Bayoumi and Maon (998. 3

16 Thi will hen impac on he curren accoun defici. By auming ha he curren accoun defici will be imperviou o change in he fical defici, he advocae of he Lawon docrine aume ha Ricardian Equivalence doe no hold a all. ii Typically in he cae of developing counrie, many privae ecor (foreign liabiliie are coningen liabiliie, which, in a crii, can be changed ino public liabiliie under preure from exernal credior. Thi would hen have impac on he fical defici. Thi ha happened explicily in he cae of privae banking liabiliie in he cae of he Aian counrie and implicily in he cae of o called couner guaranee given o independen producer of elecriciy in India. A Kaminky and Reinhar (996 oberve, he diincion beween privae liabiliy and public liabiliy eem o ge blurred when he financial iniuion concerned i oo large o fail. iii Thi follow from Harberger (985. He argue ha here i an exernaliy in ha a developing counrie (paricularly hoe wih poor credi raing borrow more, hey face an upward loping chedule for foreign credi. Furhermore, a McKinnon and Pil (995 argue, developing counrie may have overly opimiic eimae of he increae in heir permanen income in repone o a policy hif. Thi over opimim may lead o higher foreign borrowing, which may exacerbae curren accoun and fical defici. iv A he curren accoun defici woren here would arie he need o arac more capial inflow. Thi would hen lead o an appreciaion of he real exchange rae. In a globalizing world in which expor promoion i an inegral par of he developmen raegy, uch appreciaion would lead o a drop in growh rae and, herefore, poenial ax revenue. Thu Agoin (994 find large wing in he real exchange rae becaue of emporary capial flow o ignificanly depre machinery and equipmen invemen, and hu long run growh. Thi hen ranlae ino lower ax revenue. v Finally, marke ypically look a a counry oal deb and u i inernal public deb. Once he curren accoun defici exceed ome level, a given exchange rae, i become ever more aracive, from he perpecive of an individual borrower o borrow abroad. Thi migh lead o a peculaive bubble. We now dicu he andard approach o deermining he uainabiliy of he exernal defici. Le F be he foreign liabiliie of a counry. Thi i ypically defined a exernal deb le foreign ae including inernaional reerve denominaed in real foreign currency erm. Furher le TB denoe he real rade balance expreed in domeic currency. Foreign liabiliie (expreed in domeic currency will hen evolve a: e F = ( r * e F TB (7 Where e i he reciprocal of he average real exchange rae, and r *iheworldinere rae. Clearly a poiive rade balance would reduce hi counry exernal indebedne wherea an increae in he world inere rae would woren i. To implify he algebra define (r * a R *. To obain hi counry exernal conrain along he line of Hakkio and Ruh (99 and Chalk and Hemming (2000 we olve (7 forward o ge 4

17 F = R* (, TB limr*(, e T F T = 0 T (8 Where R*(,= k= 0 R * k e (8 i o be inerpreed a hi counry ineremporal exernal uainabiliy condiion. Meaningful aiical e of uainabiliy have o be derived from (8. For exernal uainabiliy we mu rule ou Ponzi game wih exernal deb. In oher word ne foreign liabiliie canno grow faer han he inere rae, i.e. lim R *(, T e F = 0 T T T i a neceary condiion for exernal uainabiliy. Thi require ha F = R *(, TB = 0 (9 (9 make explici he fac ha exernal deb i uainable only inofar a i can be financed by fuure rade urplue. In he exan lieraure hi requiremen ha been inerpreed o imply aionariy of he curren accoun defici or he coinegraion of expor and impor incluive of ne inere paymen, if expor and impor are I(. A imple way of inerpreing he uainabiliy of (9 i o divide boh ide by oupu o ge (q (η f = R* f -b (20 where lower cae leer denoe value a proporion of GDP and q i he real appreciaion of he domeic currency. Ne foreign liabilie a a raio of GDP are reduced by a poiive rade balance, an appreciaing currency, or by faer economic growh.w,if f = b = r * q η f (2 Then, when > f f 5

18 6 ne foreign liabiliie will increae relaive o oupu over ime. Thi can be regarded a unuainable. 5 The win defici I i raighforward o connec uainabiliy on he domeic fical and he exernal ide he o-called win defici. To ee hi wrie he naional income ideniy a: Y = C I G T X M where Y i naional income, C i privae conumpion, I i invemen, and X and M are expor and impor repecively. Defining privae aving a income minu conumpion we have: S I D = TB (22 where D i he governmen budgeary defici. Uing covered inere pariy and umming (22 over all ime period in ne preen value erm we have = = = = (23 (, (, (, *( I S R D R TB R e where (r =R. Uing he inernal and exernal uainabiliy condiion, we can wrie (23 a ( ( = = 0 (24 (, (, ( lim, *( lim T T T T T I S R B T R B F e T R F e Wih boh fical and exernal uainabiliy he lim erm in (24 will diappear and we will have: (25 (, ( 0 = = I S R B F e If here i domeic fical uainabiliy bu he exernal defici i unuainable hen he R* erm ge added o (25. Thu: (26, *( lim (, ( 0 = = T T B T R I S R B F e If he exernal defici i uainable bu he domeic defici i no, hen we will have (27, ( lim (, ( 0 = = T T B T R I S R B F e

19 (26 and (27 make i explici ha boh he inernal and exernal defici figure in he governmen budge conrain. We repor ome reul on uainabiliy of he exernal defici in Table 2. Time erie properie of expor, impor and he rade balance are repored. Some counrie like Nepal for which he inernal uainabiliy reul could be worked ou do no have long enough exernal daa erie o ha hey are no repored in Table 2. Even middle income counrie uch a Souh Africa and low-income wih well developed marke uch a India, do no perform well in he exernal uainabiliy e. Paraguay eem o aify exernal a well a inernal defici uainabiliy. In addiion, Ecuador, Egyp, Ghana, Iran, Thailand and Tuniia have aionary rade balance o heir exernal defici would appear uainable on hi coun. However, in he cae of Tuniia and Iran expor and impor are no coinegraed o exernal uainabiliy become upec. Even in he cae of Sri Lanka he coefficien on impor i much higher han ha on expor. In he cae of Zambia hi coefficien i fify ime higher.4 Table 2. Suainabiliy of exernal defici of low and middle income counrie Counry Period Characeriic of Expor and Impor Coinegraion Properie Characeriic of Trade Balance Coa Rica I( Coinegraed. The null I( ha impor are hree ime he ize of expor i acceped. Dominican Republic I(. Coinegraed wih each I( oher and wih ne facor paymen from abroad. Ecuador I(0 I(0 Egyp I(0 I(0 Fii I( coinegraed. I( Ghana I( coinegraed I(0 Guaemala I( Coinegraed. I( Guyana I( coinegraed I( 4 One largely unreolved iue i wheher ne FDI flow hould be included in he calculaion for uainable curren accoun defici. Frankel and Roe (996 find in a panel of 00 developing counrie from 97 o 99 ha a high raio of FDI o deb i aociaed wih a low likelihood of a currency crah. Beween 970 and 982, for example, Singapore ran a curren accoun defici beween 2.% o 20% of GDP. Almo one half of he gap conied of FDI. The aving rae wihin hi period doubled from 2% o 40%, he economy grew a an average rae of 8% and here wa no currency crah. Hence, here i ome preumpion ha ince FDI i deermined by long-erm conideraion, generae poiive exernaliie and doe no exer preure on he real exchange rae if i i he oucome of a privaizaion program, i in a differen caegory when reckoning uainabiliy of curren accoun defici. However, if capial i fungible hi opimim may be miplaced a Reien (999 argue. 7

20 Table 2. Coninued Counry Period Characeriic of Expor and Impor Coinegraion Properie Characeriic of Trade Balance Hondura Expor I(0, Impor I(. I( India I( coinegraed. I(; Curren accoun balance I( Indoneia I( Coinegraed wih each oher. I( Iran I( coinegraed. I(0 Ivory Coa I( Coinegraed. Null hypohei I( ha impor are en ime expor no reeced. Jordan I( coinegraed I( Kenya I( coinegraed I( Morocco I( Coinegraed wih each oher I( and wih ne facor paymen from abroad. Nigeria I( Coinegraed wih each oher I( and wih ne facor paymen from abroad. Pakian I( Coinegraed wih each oher I( and wih ne facor paymen from abroad. Paraguay I(0 I(0 Philippine I( Coinegraed wih each oher I( and wih ne facor paymen from abroad (a 7%. 8

21 Table 2. Coninued Counry Period Characeriic of Expor and Impor Coinegraion Properie Characeriic of Trade Balance Souh Africa I( coinegraed. I( Sri Lanka I( Coinegraed, wih coefficien I(0 of impor ignificanly larger. Tanzania I( Coinegraed wih each oher I( and wih ne facor paymen from abroad. Thailand I( Coinegraed. The rericion I(0 ha he coefficien on impor i half ha on expor i acceped. Tuniia I( coinegraed. I(0 Zambia I( Coinegraed. The rericion I( ha he coefficien on impor i 50 ime ha on expor i no reeced. I i quie apparen, hen, ha developing counrie have coniderable difficulie in meeing inernal and exernal defici uainabiliy condiion. The fac ha exernal uainabiliy condiion5 are hard o mee would imply he need for coninual capial inflow in order o keep he balance of paymen in equilibrium. Thi would neceiae he mainenance of a ubanial rae of reurn wedge beween domeic and foreign rae of reurn. In paricular, hi would ranlae ino ubanially higher domeic rae of inere a compared o global inere rae. Thi ac a a drag on higher growh and make he problem of deb ervicing harder, which, in urn, exacerbae he problem of inernal fical defici.6 5 There i an argumen ha financial bailou by inernaional bodie uch a he IMF lead o an advere elecion problem in ha counrie know ha ince hey will be bailed ou hey may follow impruden macroeconomic policie. IIF (999 however, repor ha he evidence on hi i weak paricularly in he cae ha ha ofen been cied a he mo imporan example of uch impruden macroeconomic behaviour he Mexico financial uppor package of 995. I ha been argued ha hi package caued moral hazard ha wa a force behind he large volume of lending a low pread ha occurred in emerging marke in 996 hrough mid-997. On he conrary, he udy find ha he empirical evidence doe no uppor he moral hazard diagnoi. Inead, he decline in emerging marke pread can be explained aiically by buoyan inernaional liquidiy condiion (a meaured by high-yield US corporae pread and (o a much maller exen by improving economic fundamenal in borrowing economie. 6 A good illuraion of hi poin come from Souh Africa. The governmen ha been quie pruden in erm of domeic financing, depie facing large demand for public pending o recify he inequaliie of aparheid and accelerae employmen growh. Bu he need o defend he rand again peculaive aack, ha led o domeic inere rae ignificanly above world rae for he la hree o 9

22 The higher inernal fical defici in many of hee counrie alo conribue oward higher inere rae and he crowding ou of privae invemen. In addiion, in everal of hee counrie he fac ha he domeic bond marke i raher hin, implie ha he proporion of he defici ha i covered by money or non-bond finance a oppoed o bond finance remain diurbingly high. Thi i repored in Table 3 for elec counrie for he 990. Thi able compare non-bond financing in he developing counrie ued in hi udy wih ha in a few OECD counrie. Table 3. Form of financing of he governmen defici Counry NBF DF F raio raiof NBF DF F raio raiof NBF DF F raio raiof NBF Coa Rica Dominican Republic Ecuador Egyp El Salvador Fii Ghana Guaemala Guyana Hondura India* Indoneia Iran Ivory Coa Jordan Kenya Morocco 0.27 Nepal Nigeria Pakian Paraguay Phillippine Souh Africa Sri Lanka Tanzania Thailand E05 -E Tuniia Uganda 0.26 Zambia OECD 0.07 Auralia Auria Finland France UK USA Source: Governmen Financial Saiic, IMF e: DF= Domeic Finance, F=Foreign Finance, Raio =NBF/DF, Raiof=NBF/F, NBF = DF minu Shor erm and long erm bond financing plu local governmen financing *997 and 998 are proviional figure To he exen ha non-bond finance i relied upon, here exi an auomaic link beween he fical defici and he credi ide of he cenral bank balance hee. The governmen iue bond o be bough by a capive cenral bank. Thi change he moneary bae and, hence, he money upply in he economy. The independence of four year wih damaging effec on privae ecor invemen and growh. For aid dependen economie uch a Tanzania hi problem may be le evere inofar a hey rely on aid inflow o finance he curren accoun defici on conceional or gran erm. In he cae of Mozambique, for example, much of he exernal defici which widened during reconrucion a eenial impor exceeded war-damaged expor i aid financed. In hi cae, hen, he focu of aenion hould ideally be he inerenal and no he exenal defici. 20

23 moneary and fical policy i compromied and he abiliy of he cenral bank o purue abilizaion policie7 i reduced.8 Some have argued ha, if hi effec wa quaniaively rong, here would be a link beween he fical defici and inflaion paricularly if developing counrie wih o ue eignorge revenue o cloe he budgeary gap.9 However, in developing counrie hi aociaion i weak. Thu, de Hann and Zelhor (990 and Eaerly and Schmid- Hebbel (993 find a poiive correlaion beween inflaion and he fical defici in developing counrie only when he inflaion rae i high and here i a clear eignorage moive o ge addiional revenue from money creaion. However, Buffie (999 argue ha hi reul can be acribed o he behaviour of he public ecor wage cycle and ha he relaion beween he fical defici and inflaion remain inac once hi i facored ou. Buffie argumen i ha once public expendiure i rerained, perhap a par of an IMF abilizaion program, here i he clear expecaion ha any cu in he real wage in he public ecor ha hi involve would no be expeced o la long. I would be expeced ha once he ricure of he program are lifed, he real wage would climb back up. The diinflaionary program, herefore, lack credibiliy. Buffie conider wo poible cae: i in which he low wage phae i followed by a high wage phae of equal lengh o a o leave he average wage remain unchanged over he wage cycle. ii The low real wage phae i followed by a reurn of he real wage o i preabilizaion level. In he fir cae, ince he marke expec he real wage rae o rie, inflaion pick up even a he defici fall. I i indeed poible ha defici and inflaion will be inverely correlaed wih high inflaion prevailing hrough he low defici phae. In he econd cae hi reul i weaker and depend upon money and conumpion being Edgeworh ubiue. The upho of hi argumen ha he link beween fical defici and inflaion remain inac even when here i lile oberved correlaion beween he wo.20 7 Schuknech (999 argue ha uing a nominal anchor like a fixed exchange rae regime may no be ufficien o purue abilizaion obecive. He model elecoral buine cycle in he cae of 25 developing counrie and how ha governmen indeed ry o improve elecoral propec by puruing expanionary fical policie around elecion ime. Thi i more likely o occur, ceeri paribu, in an economy wih a nominal anchor uch a a fixed nominal exchange rae. Thee epiode would han be followed by higher inflaion and exacerbaion of fical defici preure. 8 In hi conex, Sargen (999 argue ha moneary policy can be conrained by fical policy whenever fical defici grow large enough o require moneizaion. Thi can happen in developed a well a developing counrie and irrepecive of wheher he cenral bank i independen or no. In uch iuaion he cenral bank loe i abiliy o influence income or inere rae and can influence only he ime pah of price. 9 Iler and Lima (2000 illurae he imporance of hi phenomenon in he cae of Brazil. They how ha no only i Ricardian Equivalence imporan (o ha he fical defici and he curren accoun defici are linked, bu alo ha wihou eignorage revenue he Brazilian defici would no be uainable. 20 To be ure, Buffie argumen i valid principally for he non ub Saharan Africa region counrie. In low income counrie of hi region uch a Zambia, low real wage phae have no ypically beeen followedbyhighrealwagepahe. 2

24 6 Fical policy, capial flow and he money upply proce In he preenly rapidly globalizing world economy, a liberal capial regime i ofen promoed in he inere of opimal inernaional allocaion of capial. Thi change ha been aied by an emerging conenu, boh in academic and policy making circle, on he ype of policie ha promoe growh wih equiy. The new developmen model emphaize macroeconomic abiliy, compeiive marke rucure, globalizaion (inegraion ino he world economy and a role for he governmen and fical policy ha emphaize faciliaing he growh of he marke and he privae ecor. To achieve hee obecive public finance mu be pu in order and hi paper ha pel ou ome of he condiion under which hi will be poible. Exchange rae policy hould emphaize a reducion in he rae of inflaion. Furher, abilizaion policy package advocaed by he IMF and he dire neceiy of aracing inernaional capial flow ha emped many developing counrie o purue fical policie o arac capial inflow. Thee include mainaining inere rae differenial, providing favorable ax reamen o foreign capial and he like. Saring from he lae 980, developing counrie have experienced urge in capial flow. According o he World Economic Oulook (996, ne capial inflow ino developing counrie, a meaured by he capial accoun urplu (incluive of error and omiion increaed from $8 billion in 988 o $64 billion in 993 and $250 billion in 995. Mo of hi increae ha occurred in he privae ecor. Ne privae capial flow o developing counrie coniing of FDI, porfolio equiy, bond iue, loan and oher liabiliie, roe from $33 billion in 988 o $67 billion in 995. FDI and porfolio invemen accoun for over 70% of hee flow. Some informaion on hee flow i provided in Table 4. Some apec of he regional diribuion of uch flow are porrayed in Table 5. Table 4 Ne Capial Flow o Developing Counrie, (in billion of US dollar Year Official Flow Privae Flow Inernaional Capial Flow FDI Ne long erm reource Flow Ne hor erm reource flow Source: Global Developmen Finance, The World Bank (