May 01, 2012
IMF Working Paper No. 12/137
Summary: Implementation of fiscal consolidation by advanced economies in coming years needs to take into account the short and long-run interactions between economic growth and fiscal policy. Many countries must reduce high public debt to GDP ratios that penalize longterm growth. However, fiscal adjustment is likely to hurt growth in the short run, delaying improvements in fiscal indicators, including deficits, debt, and financing costs. Revenue and expenditure policies are also critical in affecting productivity and employment growth. This paper discusses the complex relationships between fiscal policy and growth both in the short and in the long run.
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Appendix. Short-run Determinants of CDS Spreads in Advanced Economies
Since the global financial crisis and ensuing sovereign crisis in Europe, financial markets’ assessment of credit risk for advanced economies has changed significantly. Before the crisis, the valuation of advanced economy sovereign debt treated default as a very low probability event, and therefore liquidity risk rather than default risk was seen as the dominant driver of financing costs in advanced economies. However, as the recent crisis in Europe unfolded, assessment of credit risk came to the forefront, taking into account country-specific fundamentals. In response, several countries have made progress in adopting fiscal consolidation plans, although this has not always been met with a reduction in sovereign spreads. The current crisis has shown that while markets are concerned with large debt and fiscal deficits, they also worry about low growth and its effect on debt dynamics, as wells as the feasibility of fiscal adjustment in an environment of very weak economic activity.
While a few studies have looked at sovereign spreads in advanced economies since the onset of the global crisis, we focus here on credit default swap (CDS) spreads in advanced economies during 2011, the height of the euro area crisis. Under the assumption that underlying global factors (such as global risk aversion) are behind general co-movements of CDS spreads, our analysis seeks to identify the set of country specific factors that explain the divergence of spreads across countries during the most recent phase of the global crisis. The results highlight the current short-termism of markets, which makes fiscal policy management more difficult.14 In particular, it shows that lower debt and deficit to GDP ratios lead to lower CDS spreads, but so too does faster short-term growth. There is further evidence of a nonlinear relationship between growth and sovereign bond spreads: spreads are more likely to increase if growth declines from an already low rate and the fiscal tightening is large. If growth deteriorates enough as a result of a fiscal tightening, spreads could actually rise even as the deficit falls.
As fiscal fundamentals have become a growing concern of financial markets, the sovereign CDS market for advanced economies has become increasingly large.15 Several European advanced economies are now among the ten largest single name CDS exposures by net notional position (Figure A1), and since September 2009 investors can trade index products on a basket of Western European sovereign CDS.[For further information on Markit iTraxx SovX Western European Index see http://www.markit.com/assets/en/docs/commentary/credit-wrap/SovX.pdf.] With rising size and liquidity, sovereign CDS spreads now provide more reliable signaling of sovereign credit risk.
The literature on the determinants of CDS spreads in advanced economies since the onset of the financial crisis— typically focusing on a narrow set of countries and using data only through 2010—has highlighted the importance of global factors with an increasingly prominent role of country-specific factors as the crisis progressed. Longstaff et al. (2011) show that sovereign credit risk can be linked to global factors, based on a dataset of 28 advanced and emerging economies over the period October 2000-January 2010. Similarly, Fontana and Scheicher (2010) find that the recent repricing of sovereign credit risk in the CDS market is mostly due to common factors. Dieckmann and Plank (2011) find—for a group of 18 advanced economies between January 2007 and April 2010—that the state of the world financial system as well as a country’s domestic financial system has strong explanatory power for the behavior of CDS spreads, with euro area countries especially sensitive. Forni et al. (2012) find that domestic financial and global factors explain movements in CDS spreads, using a panel dataset of 21 advanced economies over the period January 2008-October 2010.
As the crisis has progressed, differentiation across sovereign CDS spreads has increased significantly (Figure A2), underscoring that markets are reassessing the effect of country specific-factors on default risk. This implies that looking at historical correlations can overshadow some of the important relationships that have emerged as the crisis has evolved. In this context, this appendix attempts to shed light on the particular state of the markets in 2011, at the height of the euro area crisis.
Empirical Model Estimation
Sovereign CDS spreads in several European countries reached historical highs during 2011. High deficits and debt to GDP ratios have typically been a precondition for such a surge, as countries that saw their overall deficit to GDP ratio rise into the double digits or a sizeable increase in their stock of debt faced increasing market pressure (mostly in the euro area). However, there are several indications that other elements beyond fiscal fundamentals were at play. First, countries that announced sizeable fiscal adjustment plans in 2011 were not necessarily greeted with a reduction in spreads (Figure A3). Second, countries with weak fiscal accounts (such as Japan, the United Kingdom, and the United States) did not pay high spreads in 2011, which could in part be attributed to the effects of quantitative easing strategies by central banks in these countries (Figure A4).
With this in mind, this appendix assesses in a more consistent way why 5-year CDS spreads differ across a sample of 31 advanced economies,18 by looking at a set of macroeconomic and fiscal fundamentals, based on a simple OLS cross-section regression. A cross-section analysis is preferred to a panel regression given the desired focus on market behavior in the latest phase of the crisis. In particular, a cross-section allows for a larger number of countries to be included, which adds greater variation to the dataset than does the time dimension (as this analysis covers only one crisis episode).19 CDS spreads (average for 2011) are drawn from Markit20 and transformed into logs in line with Edwards (1984). Fiscal variables used as regressors are drawn from the September 2011 Fiscal Monitor (IMF 2011a), while macroeconomic variables are drawn from the September 2011 World Economic Outlook (IMF 2011b). Regressors include:
- Macroeconomic variables: real GDP growth rate and growth squared; projected real GDP in 2014; projected potential real GDP growth, averaged over 2011-16; inflation rate for 2011.
- Near-term fiscal variables: General government primary balance and general government debt as a ratio to GDP. For Australia, Canada, and Japan, net debt to GDP is used, in view of the sizeable amount of their assets.
- Long-term fiscal variables: Net present value of the increase in public pension spending during 2010-50 as a ratio to GDP (from IMF, 2010c); net present value of the increase in public health care spending during 2010-50 as a ratio to GDP (from IMF, 2010d); projected primary balance to GDP in 2014; projected debt to GDP in 2014.
- Investor base: General government debt of the country in question held by its national central bank (from the IMF International Financial Statistics) and, in the case of Japan, the U.K. and the U.S., by foreign central banks, based on the latest available data.
Table A1 provides the results of the model. Column 1 reports a general specification in which all variables are included. The following columns illustrate the specification search, with insignificant variables dropped one by one. Column 5, the preferred specification, provides a relatively good fit with an adjusted R-squared of 0.76. The results illustrate the current short-termism of markets:
- Fiscal variables are important, with markets focusing primarily on short-term developments (the projected primary deficit and debt in 2011). The primary balance is only significant for euro area countries. The coefficients on deficits and debt are broadly in line with what has been found by previous econometric work, though at the lower end of the range.22 For a country with CDS spreads of 200 basis points, a 1 percentage point increase in the debt ratio raises the spread by about 3 basis points and a 1 percentage point increase in the deficit raises the spread by 35 basis points. Given the log-linear specification, the larger the initial level of the CDS spread, the larger the impact on spreads, in basis points, of an increase in deficit and debt ratios; consistently, a weakening of fiscal variables has a more negative impact in countries with higher initial deficit and debt ratios.
- Long-term fiscal variables are not found to be significant. The coefficients on future debt and deficits and on public pension and health spending were not found to be significant. This suggests that reforms to entitlement spending or measures that would only have a long term impact would not necessarily be rewarded by markets in the short run. This result underscores the difficulty of providing credible information to markets in this area and the need for more effective communication of the effect of such reforms on the soundness of public finances.
- Short-term growth is important (higher growth leading to lower spreads), while potential growth and future growth are not significant. This relationship is found to be nonlinear—with a positive coefficient on the squared growth term—as spreads are more likely to increase when growth is already low and fiscal tightening is larger.23 Based on these results, if the fiscal multiplier is sufficiently large (higher than 0.7 based on the estimated coefficients), the improvement in spreads from a lower deficit could be offset by the negative impact of adjustment on short-term growth, which also acts through the short-term rise in the debt to GDP ratio (see Figure 5 in the main text).
- Central bank financing (either from national central banks or from foreign central banks) is important in lowering spreads, as long as it is not inflationary. This coefficient is higher than the one on the debt ratio, implying that the effect of purchases by national central banks (and by foreign central banks for reserve currencies) goes beyond the effect of reducing the overall supply of government bonds sold to the public. This probably reflects confidence effects provided by the presence of the central bank in the market. Note, however, that the central bank holdings variable does not include purchases by the ECB through the Securities Market Program.24 The coefficient for inflation is highly significant, and thus implies that central bank purchases are effective in moderating spreads only if they are not inflationary. Given the large accumulation of excess reserves by banks, inflation pressures currently remain at bay in most countries. The respite in sovereign bond markets, following the long-term refinancing operations (LTRO) of the European Central Bank (ECB) are a further example of the confidence effects of central bank intervention. These results suggest that the availability of financing from an entity with sufficiently large resources could help reduce spreads in the current environment.
The cross-section estimates point to the current short-term vision of markets, with special concern for near-term growth prospects. This could possibly reflect strong risk aversion after four years of market turmoil. These results imply that tighter fiscal policy could actually lead to wider, rather than narrower, spreads in the short term. It is important to note, however, that the euro area crisis is still not fully resolved and financial markets remain unsettled, therefore these results may reflect the particular state of markets in 2011 rather than more permanent features, something that a cross section cannot shed light on. Moreover, it would be important to assess the direct effect on spreads of other variables beyond fiscal fundamentals, such as exposure to contingent liabilities from the banking sector. Potential simultaneity issues (e.g., between spreads and growth) also deserve additional attention.