Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
IMF Survey: Fiscal Boosts May Create Problems for Developing Countries
December 31, 2008
Fiscal stimulus may boost demand in developing countries but not lead to supply response due to other weaknesses in business sector (photo: Newscom)
FISCAL STIMULUS PACKAGES
Dear IMF Survey:
I presume that, despite the title "global" fiscal stimulus, your interview ("IMF Spells Out Need for Global Fiscal Stimulus," December 29, 2008) is focused on the merits of fiscal stimulus for developed countries, not for developing countries.
Most developed counties do not need to be unduly concerned about the currency denomination of their domestic and foreign debt and have strong tax bases that may allow them to serve future debt service that would be incurred to finance the stimulus. This may not be the case with most developing countries.
Unfortunately, many developing countries are interpreting this IMF advice as applying to them. Therefore, they are using or are proposing to use loose monetary policies and fiscal stimulus to revive their economies. But without strong tax base and with significant foreign debt (denominated in foreign currencies), these monetary and fiscal measures are likely to lead to a collapse of their currencies and to loss of confidence by investors.
Deeper problems
Furthermore, the fiscal stimulus may increase demand but may not lead to a supply response due to other weaknesses in the business environment. Instead of reviving their economies, they may just deepen the problems.
It would be useful if the IMF were to make a more clear statement about the merits of these policies for developing countries. It is already creating a lot of problems for some of us that are working with developing countries.
I know that the public IMF declarations on this matter do make some references to the fact that not all emerging markets (Ems) can afford to have fiscal stimulus packages, due to debt sustainability. But the problem with EMs is deeper: facing a financial banking crisis, developed countries and EMs have different priorities:
Maintain confidence
Most EMs' companies have significant foreign debt denominated in hard currencies and therefore, in order to avoid widespread bankruptcies, EMs' priority is to try to avoid the collapse of foreign exchange rates. This means that they need to maintain the confidence of foreign investors to avoid further capital outflows and convince investors to roll over foreign debt. Faced with a possible collapse of domestic banks and companies through large devaluations, the revival of economic growth is only a second priority.
Developed countries, on the other hand, are not too concerned with exchange rate devaluations, since their foreign debt is normally denominated in their own hard currency. Therefore, a large devaluation will not cause widespread bankruptcies in their own countries.
On the contrary, devaluation would improve their competitiveness and export prospects. Therefore, the first priority in developed countries is to revive economic growth and reduce unemployment. Containing a currency devaluation is only a second priority. The risk of future inflation is a risk that would be faced only in a period that at this time appears quite distant.
Different measures
Therefore, faced with a financial crisis, the economic measures to be taken by developing countries and EMs will differ.
Developed countries will give priority to
• Re-establishing credit operations of banks to allow them to sustain private sector credit and production
• Carrying out loose monetary policies to lower interest rates and encourage investments
• Providing fiscal stimulus to revive the economy through public investments or tax reductions, despite the risk of large fiscal deficits and higher public debt (again denominated in their own hard currencies).
Emerging economies will give priority to
• Containing currency devaluation pressures by reducing the demand for foreign exchange. This requires reducing aggregate demand, which calls for lower domestic credit (with higher interest rates) and fiscal austerity
• Containing inflationary pressures to maintain the confidence of both local and foreign investors, which is needed to roll over debt. This also calls for tight fiscal and monetary policies.
Only large EMs that have the luxury of having the bulk of their debt denominated in their own currency can afford to follow the course taken by developed countries.
Edi Segura
Former country director, World Bank
McLean, Virginia, United States
Editor's note: The IMF has made clear that the response of each country to the crisis should be based on individual country circumstances. In their research note, Olivier Blanchard and Carlo Cottarelli write: "Moreover, while a fiscal response across many countries may be needed, not all countries have sufficient fiscal space to implement it since expansionary fiscal actions may threaten the sustainability of fiscal finances. In particular, many low income and emerging market countries, but also some advanced countries, face additional constraints such as volatile capital flows, high public and foreign indebtedness, and large risk premia. The fact that some countries cannot engage in fiscal stimulus makes it all the more important that others, including some large emerging economies, do their part."