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Fiscal Space Limited for Many Sovereigns

Reviews & Outlooks	1278 VIEWS
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Thursday, March 12, 2020 / 12:38 PM / Fitch Ratings / Header Image Credit: IMFBlog

Fiscal easing will be part of the optimal policy response to economic shocks or downturns, particularly for sovereigns with strong public finances, Fitch Ratings says. However, fiscal loosening rarely pays for itself, and persistent deterioration in public finances will increase the risk of sovereign rating downgrades.

With sovereign borrowing costs at record lows and monetary policy potentially running out of fire-power, many commentators argue that governments should relax fiscal policy to boost GDP growth and can do so safely without putting public debt sustainability at risk.

Fitch tends to use the term 'fiscal space' primarily to denote the room for governments to run larger budget deficits or increase public debt without triggering a rating downgrade. This is a narrower concept than the IMF's: "the room for undertaking discretionary fiscal policy relative to existing plans without endangering market access and debt sustainability".

One gauge of this 'fiscal rating space' is how close each sovereign's Sovereign Rating Model (SRM) output is to the threshold that could lead to a rating downgrade and therefore what deterioration in public finance variables would precipitate it. An increase in government debt/GDP of 10% would lead to a lower SRM result for 15 countries, in the absence of offsetting factors.

Fitch is more likely to hold off on a downgrade if the fiscal deterioration: is temporary (e.g. reflecting the economic cycle), the country has a record of fiscal consolidation and/or a credible policy framework, it will boost medium-term growth or lower contingent liabilities, and adverse demographic trends are not severe.

All the G7 plus India are among the three weakest sovereigns in terms of public finances in their rating categories. The GDP of the three sovereigns with the weakest public finances in each rating category totals 54% of world GDP, while the three strongest in each category totals just 5%. So countries where fiscal stimulus could provide a fillip to global growth have less fiscal space available for doing so.

The improvement in western Europe's public finances since the global financial and eurozone crises has rebuilt fiscal space in the IMF meaning of the concept. However, sovereign ratings have also improved strongly in recent years in parallel with lower debt burdens and gains from lower interest rates.

Fiscal easing can provide a short-term boost to GDP growth and a medium-term boost if it raises the capital stock. However, this 'fiscal multiplier' is not normally large enough to 'pay for itself' and prevent a rise in public debt/GDP (relative to the counterfactual). Fitch forecasts several countries to experience a rise in government debt/GDP in 2020 despite a real interest rate below the real GDP growth rate, e.g. owing to large primary deficits.

A real interest rate below the real GDP growth rate is supportive for public finances, but not sufficient to stabilise government debt/GDP at sustainable levels. For countries with large primary budget deficits, debt/GDP would only theoretically stabilise at very high levels. In practice, the risk premium would be likely to rise as debt/GDP climbed towards such levels for all but perhaps a handful of sovereigns with exceptional debt tolerance.

Since the late 1990s, nearly four-fifths of cases when government debt increased by 20% of GDP within a five-year period have led to downgrades of sovereigns rated by Fitch at the time. Of 18 defaults by Fitch-rated sovereigns, the median government debt/GDP ratio was 85% the year before the default and median peak was 95% (in the three years centred on the default). The lowest peak was only 23% for Dominican Republic (2005), while Japan ('A') has serviced its debt without difficulty despite it reaching 231%, highlighting that creditworthiness depends on many factors.