Rebuilding ‘fiscal space’

Faced with weaker export prospects, and a likely rise in global interest rates, developing countries should look to rebuild their ‘fiscal space’, according to a new report just released from the World Bank. The recent fall in oil prices is likely to have created an opportunity for them to do just that.  Many developing countries were forced to implement expansionary fiscal policies to counteract the global slowdown – given the difficulty of implementing a monetary expansion in the face of large public debts. However, there is now less fiscal space to maneuver.

A key finding in the report is that in countries where debt and deficits have increased, any net injection of public spending will contribute less to consumption and national income than it would have prior to the global slowdown because the high debt levels have made the fiscal multiplier effect much weaker. Fiscal multipliers relate to the ratio of a change in output (ΔY) to a discretionary change in government spending or tax revenue (ΔG or ΔT). In simple terms, the fiscal multiplier measures the effect of a change in spending or tax revenue on the level of GDP.  Countries with higher debt levels are  likely to suffer from higher levels of uncertainty and pessimism, and hence lower levels of marginal consumption following more government spending or less taxation.

However, the ‘good’ news is that the fall in oil prices provides an opportunity for those developing countries relying on imported oil to rebuild their ‘fiscal buffers’ given that their governments have less need subsidise imports of oil. Such subsidies represent a large drain on public finances.

The report goes on to suggest that well-designed mechanisms, such as fiscal rules, stabilisation funds, and medium-term expenditure frameworks, will help rebuild the fiscal buffers and enable developing countries to better withstand future global shocks.

The study on fiscal space is available at www.worldbank.org/globaloutlook

For more reading, go to a recent IMF working paper on fiscal multipliers.