Borrowing for Growth: Big Pushes and Debt Sustainability in - PowerPoint PPT Presentation

Introduction The Model Experiments I Experiments II Conclusions Borrowing for Growth: Big Pushes and Debt Sustainability in Low-Income Countries Edward F. Bu¢e ( Indiana University ) Andrew Berg, Catherine Pattillo, Rafael Portillo, Felipe Zanna ( International Monetary Fund ) IGC Workshop on Fiscal and Monetary Policy November 2-3, 2012

Introduction The Model Experiments I Experiments II Conclusions Motivation Many LICs want to—and can—borrow to …nance public investment plans Needs are great and higher aid will likely not be enough How much borrowing for investment should countries do, and how much is sustainable? The IMF-WB DSF provides a framework for thinking about much of this But the linkages are not fully articulated (criticisms by Sachs, 2002, Eaton , 2002, Wyplosz, 2007.....)

Introduction The Model Experiments I Experiments II Conclusions What We Do Construct a dynamic model capturing most of the main mechanisms and policy issues for DSAs in LICs The investment-growth linkages (public capital in production, ine¢ciencies in investment, absorptive capacity constraints) Di¤erent public debt …nancing schemes (concessional, external commercial, and domestic) The …scal policy reactions necessary to ensure debt sustainability Analyze the macro e¤ects of public investment surges and trade-o¤s and potential risks associated with di¤erent …nancing schemes

Introduction The Model Experiments I Experiments II Conclusions What We Find Well-executed high-yielding public investment programs can substantially raise output and consumption and be self-…nancing in the long run Transition problems can be formidable when concessional …nancing does not cover the full cost of the programs Covering the gap with tax increases or spending cuts requires sharp macroeconomic adjustments, crowding out private investment and consumption

Introduction The Model Experiments I Experiments II Conclusions What We Find Covering the gap with Domestic borrowing is not helpful either: higher domestic rates increase the …nancing challenge and private investment and consumption are still crowded out External commercial borrowing can smooth the di¢cult adjustments, but with poor execution, sluggish …scal policy reactions, or persistent negative exogenous shocks, it can easily lead to unsustainable debt

Introduction The Model Experiments I Experiments II Conclusions Literature Growth and public investment without public debt dynamics Endogenous growth: Barro (1990), Sala-i-Martin (1992).... LIC-speci…c: Chatterjee and Turnovsky (2007), Agenor (2010)..... Exogenous Growth and LIC-speci…c: Adam and Bevan (2006), Berg et al. (2010)..... Debt sustainability, in advanced and emerging economies: Bohn (1998), Ghosh et al. (2011), Greiner et al. (2005), and Mendoza and Oviedo (2004).....

Introduction The Model Experiments I Experiments II Conclusions Outline Introduction The Model The Policy Experiments The Long-run Outcome The Medium-run Dynamics Risks Conclusions and Moving Forward

Introduction The Model Experiments I Experiments II Conclusions The Model A real micro-founded dynamic equilibrium model of a small open economy Perfect foresight Exogenous growth at the rate g 2 sectors: traded and non-traded 3 consumption goods: a traded-domestically-produced good ( c x ), a traded-foreign good ( c m ) and a non-traded good ( c n )

Introduction The Model Experiments I Experiments II Conclusions Households Savers are inter-temporal maximizing agents " # ǫ ǫ � 1 β t ( c t ) 1 � 1 ∞ τ 1 ǫ � 1 ∑ ∑ where c t = ρ i ( c i , t ) ǫ ǫ 1 � 1 t = 0 i = x , m , n τ have access to domestic and foreign bonds (portfolio adjustment costs) Accumulate capital subject to adjustment costs Non-Savers live check to check

Introduction The Model Experiments I Experiments II Conclusions Firms in Traded (x) and Non-Traded (n) Sectors Pro…t-maximizing, operating under perfect competition and ‡exible prices, and using a technology that combines labor ( L i , t ), private capital ( k i , t ), and public capital ( z e t ) t � 1 ) ψ ( k i , t � 1 ) α i ( L i , t ) 1 � α i q i , t = A i , t ( z e for i = x , n Other features (externalities), not discussed today

Introduction The Model Experiments I Experiments II Conclusions The Government For simplicity in the exposition g = 0 Invests ( i z , t ) in public capital with some ine¢ciencies ( s ) ( Hulten, 1996, and Pritchett, 2000.... ) z e t = ( 1 � δ ) z e t � 1 + si z , t , with s 2 ( 0 , 1 ] There are also absorptive capacity constraints (costs overruns), not discussed today

Introduction The Model Experiments I Experiments II Conclusions The Government Budget Constraint (GBC) P t ∆ b t + ∆ d c , t + ∆ d t = r t � 1 P t b t � 1 + r d d t � 1 + r dc , t � 1 d c , t � 1 | {z } | {z } Borrowing Interest Payments � � δ z e + P z , t i z , t + T t � h t P t c t � f |{z} | {z } t � 1 | {z } | {z } Transfers Taxes Investment User fees ∆ d t � concessional; ∆ d c , t � external commercial; ∆ b t � domestic r f r dc , t = + F ( d t / y t + d c , t / y t } ) |{z} | {z free-risk world rate risk premium t ] 1 / τ � 1 r t = 1 / β [( 1 + h t + 1 ) / ( 1 + h t )] [ c s t + 1 / c s

Introduction The Model Experiments I Experiments II Conclusions Fiscal Adjustment and Reaction Functions Concessional borrowing ∆ d t is exogenous Today, the …scal burden falls exclusively on h (i.e., T t = T o ) Today, 2 types of …nancing schemes Free tax adjustment: h t adjusts to satisfy GBC and not need to borrow ∆ d c , t = 0 and ∆ b t = 0 Constrained tax adjustment supplementing with external commercial borrowing. Cap on h t and ∆ b t = 0

Introduction The Model Experiments I Experiments II Conclusions Constrained Tax Adjustment with Commercial Borrowing In the long run taxes adjust to cover the gap In the short/medium run Taxes n o h rule h t = Min , ceiling t t ( d c , t � 1 � d target ) = h t � 1 + λ 1 ( h target c h rule � h t � 1 ) + λ 2 t t y t with λ 1 , λ 2 > 0 and h target is the VAT that would be required t to satisfy the GBC when ∆ d c , t = 0 When h t hits the ceiling then the government is "forced" to borrow ∆ d c , t Why can debt be explosive?

Introduction The Model Experiments I Experiments II Conclusions Experiments: Calibration to an "average" LIC E¢ciency s = 0 . 6 ( Pritchett, 2000 ) Return on public capital R = MP z ( s , ψ , ... ) � δ = 0 . 25 ( Dalgaard and Hansen, 2005, Foster and Briceño-Garmendia, 2010 ) User fees recoup 50 % of recurrent costs f = 0 . 5 ( Briceño-Garmendia et al., 2008 ) VAT h o = 0 . 15 ( IMF, 2011 ) A front-loaded surge which in the long run reaches 3 % of GDP and only 50 % of it is covered by concessional loans

Introduction The Model Experiments I Experiments II Conclusions Experiments: The Long Run Outcome Public Investment scaling-ups may be self-…nancing in the long run, depending on structural conditions Long-run E¤ects of ∆ i z of 3% of GDP o Base Case Optimistic Troublesome R = 0 . 25 R = 0 . 35 R = 0 . 1 f = 0 . 5 f = 1 f = 0 . 2 s = 0 . 6 s = 1 s = 0 . 2 Taxes (%) 16.29 12.81 18.73 Public Capital 50.00 83.33 16.67 Private Capital 13.23 27.98 2.49 Real GDP 13.45 28.50 2.48 Real Wages 13.53 28.76 -1.24 Consumption 9.29 23.73 -3.33

Experiments: The Medium-Run Dynamics 2 types of experiments Free tax adjustment Constrained tax adjustment supplementing with external commercial borrowing

Free Tax Adjustment Challenging transition even if these are good projects Investment and Borrowing (% of GDP) Public Capital Private Capital 60 10 Public Investment 20 Concessional Loans 40 5 10 20 0 0 0 -5 5 10 15 20 25 30 5 10 15 20 25 30 5 10 15 20 25 30 Wages Real GDP Growth (%) Public Debt (% of GDP) 10 4 Total 100 Concessional 5 3 80 0 2 60 -5 1 40 5 10 15 20 25 30 5 10 15 20 25 30 5 10 15 20 25 30

Free Tax Adjustment Challenging transition even if these are good projects Investment and Borrowing (% of GDP) Public Capital Private Capital 60 10 Public Investment 20 Concessional Loans 40 5 10 20 0 0 0 -5 5 10 15 20 25 30 5 10 15 20 25 30 5 10 15 20 25 30 Wages Real GDP Growth (%) Public Debt (% of GDP) 10 4 Total 100 Concessional 5 3 80 0 2 60 -5 1 40 5 10 15 20 25 30 5 10 15 20 25 30 5 10 15 20 25 30 VAT Rate (%) Consumption Private Investment 22 6 10 20 4 5 2 18 0 0 16 -2 5 10 15 20 25 30 5 10 15 20 25 30 5 10 15 20 25 30

Constrained Tax Adjustment Supplementing with external commercial borrowing can smooth the transition VAT Rate (%) 20 18 16 5 10 15 20 25 30 Total External Public Debt (% of GDP) Consumption 6 80 4 2 60 0 40 -2 5 10 15 20 25 30 5 10 15 20 25 30 Real GDP Growth (%) Private Investment 4 10 3 5 2 0 1 5 10 15 20 25 30 5 10 15 20 25 30 Free Tax Adjustment