Public Information Notice No. 08/28

Public Information Notice: IMF Executive Board Holds Seminar on Globalization, Financial Markets, and Fiscal Policy

February 29, 2008

On February 8, 2008, the Executive Board of the International Monetary Fund (IMF) held a seminar on Globalization, Financial Markets, and Fiscal Policy.

Background

The seminar provided an opportunity for an exchange of views on how fiscal policy can contribute to realizing the benefits of two important ongoing developments that have recently been analyzed by Fund staff: globalization and financial deepening.¹ Although much of the staff analysis drew on work that was done in 2006 and 2007, the seminar was timely in light of the turbulence in financial markets and the decline in asset values that started in mid-2007 and has continued through the time of the Executive Board discussion. The staff paper provided an overview of analytical and empirical work in this area. While it drew some policy implications, it also identified areas where questions remain because the likely outcome of globalization and financial deepening is theoretically unclear, relevant empirical work is inconclusive and, for these and other reasons, appropriate policy responses are difficult to determine. While there is a good deal of ongoing work that can inform the surveillance of policies and developments both in the fiscal and financial areas, the seminar identified where further work is needed.

Executive Board Assessment

Directors welcomed the opportunity to discuss the fiscal implications of globalization and financial deepening. They believed that the staff paper contains useful analysis and evidence concerning a broad range of issues, but cautioned against drawing strong conclusions on certain policy issues because of the lack of firm evidence. Directors raised many questions and made a number of suggestions for further work. These will be taken into consideration as management and the staff reflect on the work agenda.

Given the ongoing process of financial integration and the need for further analysis, most Directors broadly supported the work agenda set out in the paper. However, Directors emphasized the need to focus on the Fund's core mandate, draw on the work of other institutions, and prioritize efforts in the context of resource constraints. They noted that the Board recently agreed to enact a Statement of Surveillance Responsibilities and Priorities, and that proposals for new work agendas or reordering of research priorities should occur in the context of that discussion.

Directors noted that, despite the general trend toward lower tax rates—particularly corporate taxes—tax revenue has been relatively strong, partly as a result of the broadening of tax bases and strong economic growth. However, while recognizing that tax competition could be healthy, Directors pointed out that sustained revenue buoyancy should not be taken for granted and that harmful tax competition could undermine members' revenue. Many Directors considered that the assessment of harmful tax practices in a cross-border context is not a macrofiscal issue that the Fund should be concerned with, and stressed that the staff should continue to work with the Organization for Economic Cooperation and Development, which has taken the lead in this area over the last decade. While Directors emphasized that the Fund should not have a general coordinating role in this area, some Directors suggested that the Fund could help support cooperative tax policy initiatives in emerging market and low-income countries, as the staff has recently done in Central America. Directors also emphasized that tax rates are just one of several factors that influence investment decisions, and that priority should also be given to improving the general business environment.

Directors recognized that globalization could place upward pressure on public expenditure because of demands for increased social protection and for more investment in human and physical capital. However, they considered it difficult to draw firm conclusions about the expenditure implications of globalization, partly because of the concomitant impact of other trends. Directors therefore emphasized that further work is needed to better understand how globalization affects the level and composition of expenditure, although some Directors were of the view that this exercise is beyond the Fund's area of expertise.

Directors called for more attention to be paid to financial sector contingent liabilities, noting that timely intervention strategies that emphasize preemptive restructuring of at-risk financial institutions could reduce the fiscal cost of such liabilities. While considerable effort has been put into refining the Fund's approach to debt sustainability analysis (DSA), Directors felt that an assessment of the size of contingent liabilities would be a useful further refinement of the DSA framework. It would be important, however, not to generate expectations that the government will bail out financial institutions.

Directors observed that, to the extent that globalization and financial deepening create fiscal pressures, a prepositioning of fiscal policy could be warranted. This does not necessarily mean that fiscal policy has to be tighter. Rather, it should be flexible and able to respond to such pressures by having room for maneuver with regard to both revenue and expenditure policies. In countries facing debt sustainability risks, there could be a case for early fiscal adjustment. However, the size and speed of the required adjustment would also depend on the way globalization and financial deepening affect debt tolerance. If debt tolerance increases, this would permit more gradual adjustment.

Directors noted that it was unclear whether increased access to external financing would strengthen or loosen fiscal discipline. However, they considered that measures such as increased transparency, and credible political commitment to sound fiscal policies and frameworks, could enhance the beneficial effects of market discipline on fiscal policy, and thus increase the benefits from globalization and financial deepening. To this end, use of fiscal rules and fiscal responsibility laws that emphasize fiscal transparency could boost the credibility of fiscal policy. Directors also agreed that for countries with sound policies, globalization and financial deepening could increase countries' ability to borrow abroad in domestic currency, and thereby increase debt tolerance. However, a full understanding of this effect requires further analysis.

Directors concurred that the stabilizing role of fiscal policy in response to capital inflows depends on country-specific circumstances. They noted that the nature and duration of the capital inflows, and the flexibility of fiscal policy, are of particular importance. If large capital inflows create aggregate demand pressure, and the scope for using monetary policy is limited, fiscal tightening could be appropriate. This would be the case where inflows are supply-determined and temporary, although in practice this is difficult to determine. In some cases, however, adjustment could occur mainly through the real exchange rate or through temporary capital controls, although in these cases fiscal policy can still be useful. A few Directors, however, noted that fiscal policy may not be the best tool to deal with significant shifts in capital flows, given the long lags in the implementation of fiscal measures. Directors supported additional research to provide clearer guidance on policy choices in situations of large capital inflows.

Directors agreed that globalization and financial deepening are likely to influence the effectiveness of fiscal stabilization, but noted that the evidence is inconclusive on whether fiscal policy will be more or less effective. Some Directors called for further work to clarify this issue, given the role of fiscal policy advice in the Fund's surveillance mandate.

Directors acknowledged that globalization magnifies fiscal policy spillovers. Some Directors agreed that these spillovers strengthen the case for enhanced international policy cooperation and coordination in certain areas, although some other Directors were concerned to not endorse a new mandate for Fund coordination efforts. Directors considered that in some issues, such as climate change, surveillance within the Fund's core mandate could help authorities to think through possible fiscal implications.

¹ See IMF (2007), "Reaping the Benefits of Globalization," available at www.imf.org/external/np/res//docs/2007/0607.htm ; IMF (2007), World Economic Outlook, October, Chapter III, Managing Large Capital Flows; IMF (2007), Global Financial Stability Report, October, Chapter III, The Quality of Domestic Financial Markets and Capital Flows.