Damaging control

The author is a faculty member of the Department of Economics of Ateneo de Manila University.

Six months into the year, the government has already incurred a deficit
of P119.7 billion or 92% of its P130-billion target for the whole year.
This is unfortunate, as the current administration has staked its
credibility on a fiscal discipline platform. Its pronouncements
encourage the market to herd around expectations generated by deficit
ceilings; unfortunately, breaches would then be perceived as signals of
fiscal irresponsibility, leading to a weakening of capital inflows.

True to form, the International Monetary Fund has supported the deficit
stance, and (while it has yet to comment publicly on the matter) is no
doubt troubled by the overshooting. Contrary to stereotype, the fondest
wish of the Fund is to make itself irrelevant to developing countries.
Precisely this orientation accounts for its conservative attitude:
fiscal deficits are seen as temptations to fiscal and monetary
imbalance, and are best warded off by an ascetic fiscal policy.

Now the government is deep in damage control. To keep its reputation in
the financial market, and frustrated by anemic tax collection, the
government may be forced now to take the knife to expenditures. If so
then its challenge is to spare social and capital spending. Aggressive
expansion in these items, now or in the near future, is simply out of
the question.

A pity, as the Philippines has suffered perennially from underspending
on infrastructure, social development, and poverty reduction. Moreover,
spending restrictions forego the economic stimulus from additional
aggregate demand. Due to these macro and micro benefits, economists at
Ateneo de Manila have argued for more spending, even at the risk of a
higher deficit (see their two papers on the issue, available by e-mail
from the author upon request). This flies in the face of a near
consensus among analysts that government should stick to its deficit
targets, even at the risk of spending contraction.

There are three major arguments behind this consensus. These are:
inflationary effects of a deficit, crowding out effects of a deficit,
and unsustainable finance of a deficit. The first two concerns have
been soberly addressed in the aforementioned Ateneo papers: the gist of
the reply is that the current environment is one of low interest rates,
undercapacity, feeble lending, and stable prices, conditions that
preclude serious inflationary and crowding out effects from a larger
deficit. I shall now deal with the third argument for deficit
contraction, that of financial sustainability.

A sustainable finance of the debt requires a sustainable trend for the
national debt. One way to state such a trend is that the national debt
must remain constant. Since a deficit that is financed by borrowings
adds to the national debt, then a popular statement of a sustainable
deficit is simply that of a balanced budget, or at least a deficit
trend that runs to zero in the medium term. Currently the government
targets a balanced budget by 2006.

However, the balanced budget condition may be unnecessarily stringent:
given that national income provides the wherewithal to repay the
national debt, long term fiscal sustainability may simply entail that
debt and GDP grow at the same rate; alternatively, one must observe a
constant debt-to-GDP ratio. This leads to a broader condition for a
sustainable deficit: ignoring the nonborrowing component of debt
increase, the deficit-to-debt ratio should not exceed nominal GDP
growth.

So much for the principles of fiscal sustainability. What are the facts?

First, it is true that the debt-to-GDP ratio has been increasing from
56% in 1998 to 65% 2001 (November). The debt-to-GDP ratio was declining
during the high growth years (1994-1996) but began escalating from the
Asian crisis onward. However, the current ratio is still below the 76%
posted in 1993. Furthermore, across countries there are tremendous
variations in the debt ratios. It is difficult to find a pattern
correlating debt ratios with indicators of development and economic
performance: for example, among developed economies in 2001, the ratios
might range from 33% for UK, to as much as 203% for the US. Even for a
country as conservative as Germany in terms of fiscal and monetary
policy, the debt ratio of 60% is comparable to the Philippines.

Second, the recent deficit trend began in 1998, where it stood at 3.3%
of debt; in 2001 the deficit was 6.2% of the debt. This was not
entirely the source of debt escalation however: within this period the
deficit averaged only 45% of debt expansion, with the remainder due to
nonborrowing components. However by 2001 the nonborrowing component
fell to 30% of the incremental debt.

Third, the major source of deficit expansion was not profligate
spending: from 1997 onward the spending/GDP ratio was fairly stable at
a little over 19%. Rather, there was a marked deterioration in the
revenue/GDP ratio, beginning from 1998 and continuing up to 2001, and,
it seems, even within 2002. Non-interest expenses were actually lower
than revenues for most years (except 1999 and 2000); meanwhile interest
payments from 1993 to 2001 have been stable at around 6.3% of national
debt.

Purely for illustration, some figures for 2002 can be extrapolated from
the 2001 figures: given that nominal GDP grows at 10.3%, and the
nonborrowing component of the debt stock is 2.6%, then the deficit
should account for 7.7% of the debt in 2001 in order to keep the
debt/GDP ratio constant in 2002. This is equivalent to P182 billion,
which is 40% larger than the current target. The P50 billion difference
is the amount that can be added onto government spending, assuming
revenue expectations are met.

This back-of-the-envelope calculation of a sustainable deficit of
course should be modified under alternative assumptions, i.e. downward
if the nonborrowing component of debt changes were higher (the
assumption of contingent liabilities is a genuine concern), or upward
if nominal GDP growth is faster this year (which is likely).
The deficit may be increased even to the point of raising the
debt-to-GDP ratio; I do not see anything fundamentally wrong with this
as long as the trend can be halted in the medium term, preferably with
aggressive reforms in tax structure and administration.

” Fundamentals” is a dreadfully abused word in finance. It is
misleading to cite the deficit-to-GDP ratio, the trend in the size of
the deficit, the current size of the debt, or the current debt-to-GDP
ratio, as signs of weak “fundamentals”, when the relevant fundamental
is the long run trend in the debt/GDP ratio.

If a widening deficit is not fundamentally bad or good in itself, why
are financial markets watching it so intently? Well, back to my opening
paragraph: because this government has declared a strong commitment
about its own borrowing limits. In a world of deep uncertainty about
fundamentals, where prodigality can be concealed by a populist veneer,
a good reputation is the ascendant virtue. The market and multilateral
institutions are watching whether the government’s word on the deficit
can still be trusted. One hopes the price to be paid for winning this
trust is not too steep.

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