By: Michael Malz
After a little more than one and a half years of efforts to reduce the fiscal deficit to levels consistent with macroeconomic stability, some believe the time has come to pay greater attention to efforts to revitalize growth and reduce debt. They argue that faster growth would decrease the drag that a high and rising debt service burden places on the fiscal account. Essentially, this is a discussion about how a country like Barbados can break out of a cycle of low growth, high fiscal deficits, and high debt. This paper looks at the prospects for growth in the context of fiscal consolidation and high debt.
While the fiscal deficit at March 31, 2015 has been reduced to 7.2% of GDP, it does not yet provide the fiscal space necessary to enable government to carry out normal functions like reversing the trend of accumulating arrears and the resort to off-budget expenditures. Still less does it enable a significant reduction in indebtedness. Whether a return to growth can be achieved in the context of continued fiscal consolidation depends to no small extent on the size and composition of the fiscal consolidation program itself.
For example, expenditure cuts are more likely to have a positive impact on growth than increases in taxes, which can be a disincentive to invest and therefore almost always affect the output of goods and services negatively. Frontloaded fiscal consolidation is more likely to be effective than a program that unfolds only gradually. Cuts in current expenditure are to be preferred to cuts in capital expenditure. Not surprisingly, the chances for success in achieving program goals are helped by an improving and not a deteriorating external environment. A strong private sector response is more likely if investors believe the authorities are committed to implementation of announced fiscal consolidation measures.
Let us look at the Barbados scorecard on the implementation of its fiscal consolidation program compared with design features that are considered to be growth friendly.
At the end of fiscal year 2014-15, the overall fiscal balance was negative $633.4 million, compared with negative $959.0 million at the end of the previous financial year. Expenditure cuts and revenue increases contributed about equally to the improvement in the negative fiscal balance. The bulk of the reduction in expenditures came from a decrease in transfers and subsidies, and to a lesser extent, from wages and salaries. Capital expenditures did increase, but only marginally. In terms of their likely impact on growth prospects, these are all positive trends. Also on the positive side are recoveries in the US and UK economies that have contributed to improving demand for our tourism services.
On the less positive side, Government initially gave mixed signals about its commitment to key features of the announced program – especially those related to reductions in labor costs. Program implementation proceeded only gradually at first, and with emphasis on revenue increases and not expenditure reductions. Experience with fiscal consolidation programs tell us that the authorities will have to show a greater commitment to more energetic implementation and to the expenditure reduction features of the program if private sector/investor confidence in the future prospects of the economy is to be restored.
Some debt is beneficial — even necessary — for growth. As the Bank for International Settlements noted in a working paper on the effects of debt: “Without debt, economies cannot grow and macroeconomic volatility would also be greater than desirable.”
On the other hand, too much debt inhibits growth for the simple reason that the accumulation of debt involves risks. There is the risk that the ability of a borrower to repay will become impaired, either for domestic or for external reasons over which the borrower has no control. There is also the risk that lenders will regard a borrower as no longer creditworthy and stop lending – or lend on terms and conditions that impairs the ability of the borrower to repay the debt as contracted. There is too the consequence of the crowding out of private investment, with negative consequences for growth. Some of these trends are already evident in Barbados.
As debt accumulates, borrowing terms tend to harden. When confronted with increasingly unfavorable borrowing terms and decreasing access to capital markets, a borrower can follow one of two courses. It can:
- strengthen its fiscal adjustment strategy enough to lower public debt ratios to levels that ensure sustainability; or
- add debt restructuring/exchange to the policy framework to address macroeconomic imbalances.
The available evidence suggests that the targets under the fiscal consolidation program would not be sufficient to reduce debt and debt service to sustainable levels. Option two therefore seems a necessary course of action to achieve fiscal balance and restore investor confidence in the policy environment.