Credibility is essential for sound fiscal policies
In response to COVID-19, advanced and emerging market economies have implemented large fiscal stimulus programs that have pushed public debt to historically high levels. The combination of higher debt and difficult economic conditions increased default risks, tightened borrowing constraints and triggered a wave of debt downgrades, particularly in emerging market economies. These developments have increased the need to plan for future debt reduction strategies, or debt reduction plans as they are commonly called.
Debt reduction plans are often centered on budgetary rules that limit public spending. The IMF Tax monitor (October 2021) highlighted the value of a credible commitment to fiscal sustainability to improve market access conditions and thus reduce the debt burden. He encouraged governments to signal such commitment by improving their compliance with fiscal rules, engaging in IMF-supported programs or legislating fiscal policy changes before tightening public finances (e.g. in 2021, the UK legislated an increase in corporate tax rates for large companies which was due to start two years later). More generally, a government can be considered to demonstrate a high level of commitment to fiscal policy if it can anchor public expectations around the government’s fiscal goals. The government can gain budget credibility through clear communication, political will, strong budget frameworks, and building a reputation over time by building a strong track record of achieving its stated goals.
In this vein, David, Guajardo and Yepez (2022) show that successful episodes of fiscal consolidation – measured by falling sovereign spreads (the difference between the interest rate on a US Treasury issue and a similar US Treasury issue) other government) – have generally been accompanied by IMF-supported programs. Similarly, End and Hong (2022) show that yields – government debt yields – respond more to announcements of fiscal consolidation in countries with more credible fiscal reputations. Yet, since there is little formal analysis regarding desirable debt trajectories during deleveraging and the role of engagement, in our new paper we calculate optimal borrowing trajectories for governments facing default risk (Hatchondo, Martinez and Roch 2022). We thus provide a benchmark to inform the design of debt reduction plans for highly indebted countries, and against which to compare simpler policies to strengthen fiscal discipline.
Eaton and Gersovitz (1981) developed a standard endogenous sovereign default model (default risk is determined in the model and depends on national fundamentals) which was extended by Aguiar and Gopinath (2006) and has been widely used in studies fiscal policy for countries at risk of default. When a government lacks commitment to future fiscal policies (the standard assumption in this literature), the standard model presents a debt dilution problem that generates a deficit bias and, therefore, inefficient borrowing. Debt dilution refers to the reduction in value of existing debt triggered by the issuance of new debt. A deficit bias refers to the tendency of governments to allow deficit and public debt levels to rise.
Rational investors anticipate that higher future budget deficits will increase the risk of default on debt issued by governments in the present and therefore demand a higher spread. The inability of governments to commit to reducing future deficits reduces their ability to borrow today. Our model is calibrated to capture the historical relationship between aggregate income levels, sovereign debt and spreads in economies facing default risk. Thus, the model’s predictions fit the average sovereign debt and spread levels, the countercyclicality of spreads (default risk increases during recessions and decreases during booms), and the implied procyclicality of fiscal policy in developing economies. emerging markets (primary deficits tend to increase during economic expansions).
Our main contribution is to consider in this framework a government that has a credible commitment to future borrowing plans, which allows us to measure the value of the commitment for the design of fiscal policy. Committed government improves welfare because it internalizes the debt dilution problem explained above when choosing its borrowing plan.
The table shows the model simulations for governments with and without commitment. A government with commitment is deemed to achieve its announced fiscal plans, while a government without the commitment would deviate from the plan and overborrow. The table shows that when lenders believe governments are fiscally responsible, it is easier and cheaper to finance deficits. Switch from without at with the commitment eliminates more than 80% of the average level and volatility of the spread. While the average level of indebtedness is lower for the committed government, the average market value of receivables is higher, indicating that it is not borrowing less on average to reduce the risk of default.
We also quantify the importance of a credible commitment in a debt reduction plan. We show that from a high level of indebtedness, a committed government has a higher probability of successfully deleveraging (without default). Our simulations suggest that
- The implementation of the optimal plan with commitment halves the probability of default in the 10 years following the start of the consolidation episode. The lower probability of default with deleveraging under commitment immediately translates into lower sovereign spreads (Chart 1). Furthermore, we find no cases in which a strongly committed government would choose to default or a weakly committed government would choose to repay.
- By effectively reducing the risk of future default, a high-commitment government can afford to smooth the initial adjustment during the deleveraging trajectory compared to the low-commitment government (Chart 2): it chooses a slower deleveraging over the first year and reduces the debt at a faster pace from the second year onwards.
- The lower spreads allow the highly committed government to implement a more effective debt reduction plan with less fiscal austerity (Chart 3). During the first six years of deleveraging, although the low-commitment government starts with a median savings rate (the ratio of savings to income) of 5% that is eventually reduced to 3%, the high-commitment government starts with a median savings rate of around 3 percent that only declines slightly over time.
A common practice in debt reduction plans, with the help of international financial institutions, is to set targets for fiscal targets such as primary deficit or debt. We approach these policies by considering a government constrained by a trajectory of debt targets. For this, we envision a government that would not be committed to fiscal responsibility when unconstrained (a non-commitment government) but which must comply with a lasting fiscal constraint (e.g., under a IMF-supported program). In this scenario, we consider a debt limit trajectory that consists of an optimal long-term debt ceiling and a sequence of debt ceilings during the transition to the long-term goal.
We find that the constrained government imposes excessive austerity relative to the optimal plan chosen by the high-commitment government (Chart 3). The latter imposes austerity only when economic conditions are such that spreads are most sensitive to austerity, while imposing lighter constraints otherwise. In contrast, a debt limit restricts borrowing for almost all times, even when not totally necessary. It is therefore deleveraging much more quickly (Chart 2).
Strongly committed government is more successful in reducing the spread than constrained government (Figure 1), consistent with the results of David, Guajardo, and Yepez (2022) and End and Hong (2022). Inability to fine-tune when stronger austerity should be imposed leads to less welfare gain than a highly committed government: optimal deleveraging with debt limits reaches 60% of gains of well-being obtained by the optimal plan.
Overall, these results point to the quantitative importance of strengthening fiscal discipline over the long term for reducing sovereign risk and for the success of fiscal programs aimed at reducing debt levels. According to End and Hong (2022), a medium-term fiscal consolidation plan is considered credible when the public expects the government to achieve its objectives (for example, when private forecasts are aligned with official announcements). Clear communication, strong fiscal institutions (eg, fiscal rules and fiscal councils), a good record of past fiscal performance, and political will are all needed to build fiscal credibility.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
Aguiar, M., and G. Gopinath. 2006. “Debt Defaults, Interest Rates and the Current Account”. Journal of International Economics 69 (1): 64–83.
David, A., J. Guajardo and J. Yepez. 2022. “The Rewards of Fiscal Consolidations: Sovereign Spreads and Confidence Effects.” Journal of International Money and Finance 123 (May): 102602.
Eaton, J., and M. Gersovitz. 1981. “Debt with potential repudiation: theoretical and empirical analysis”. Review of economic studies 48 (2): 289–309.
Fin, N., and G. Hong. 2022. “Trust What You Hear: Policy Communication and Budget Credibility.” Unpublished.
Hatchondo, J., L. Martinez and F. Roch. 2022. “Limited Effective Borrowing with Sovereign Default Risk.” Unpublished.
International Monetary Fund (IMF). 2021. “Strengthening the credibility of public finances. tax monitor, Washington, DC, October.