A call for new fiscal rules

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Advanced and emerging economies alike need new debt sustainability criteria

On Christmas Day 2021, Italian Prime Minister Mario Draghi and French President Emmanuel Macron published an op-ed in the Financial Times on the need to reform the EU’s fiscal rules. Their tone was optimistic: the pandemic has been managed well (from a macro perspective) and the debt-to-GDP ratio has stopped rising. At the same time, they argued that large investments, some of which are public, must be mobilized to meet existential challenges such as climate change and pandemics. It’s hard not to agree. In addition, national debt must be reduced – but not through higher taxes, cuts in social spending or fiscal adjustments. They cited pro-growth structural reforms as the solution, as well as new and better fiscal rules that would not stand in the way of investment. Well, it doesn’t seem to add up.

The old Maastricht rules were considered opaque and complex. Now stop here. For the most part, as far as I can remember, these long-abandoned rules only required a debt ratio below 60 percent and a nominal government deficit of no more than 3 percent of GDP. At the time, the idea was that countries would stay below these limits so that they would have some leeway if needed. It should not be. In 2019, France’s debt ratio was 98 percent, Italy’s 135 percent. Post-pandemic, they are now about 20 percentage points higher. The 3 percent ceiling for budget deficits has largely been treated as a floor.

Tight spreads

What made all this possible? Santa Claus stopped by at the signing of Maastricht 30 years ago and dropped the most amazing series of falling interest rates down the chimney: 10-year Bund yields were over 6 percent then; now they are close to zero. Italian bond spreads over Bunds have traded higher here and there but are now at 136 basis points (neighborhood effect no doubt). France’s spreads to Germany remain very narrow despite a debt ratio that is 43 percentage points higher. The old fiscal rules are long dead. We might as well design new ones.

Meanwhile, while emerging markets have, or should have, benefited from the abundant global liquidity, their overall experience has not been quite as good. Because they don’t have access to as much funding, even in local currency (a welcome change from the 1980s), they have accumulated less debt than their advanced peers. The latest IMF Fiscal Monitor tells us that general government debt in emerging markets now averages 64 percent of GDP, just over half the 122 percent level in advanced economies.

Even the more stable emerging markets have significantly higher bond yields than the advanced economies. At one point in recent years, this group included Brazil, as well as India, Indonesia, Mexico, Russia and South Africa – all with local currency 10-year bond yields around 7 percent. Russia is now at 8 percent; the others are at or below 7 percent, but still higher than in advanced economies.

household slip

At 83 percent, Brazil is at the upper end of the emerging market debt ratio. Fiscal slippage started in the late ’00s. The overall fluctuation of the primary balance from surplus to deficit reached almost 6 percentage points of GDP after the massive fiscal contraction of 2014. Brazil has had primary deficits since 2015. Unlike advanced economies, where real interest rates have been negative for over a decade, Brazil’s 10-year inflation-linked government bonds are yielding over 5 percent (a 6 percent differential versus US inflation-linked Treasuries). Nominal 10-year paper yields more than 10 percent, an even wider range than government bonds. Combined with very low per capita growth, this leads to ominous debt dynamics. From a low of 53 percent in 2014, the debt ratio peaked at 89 percent in 2020. Thanks to low interest rates caused by the recession and higher-than-expected inflation, it is now 83 percent. Now interest rates have risen again and the debt ratio will resume its unsustainable upward trend.

It is worth considering the recent financial history of Brazil. After major reforms in the 1990s, including a restructuring of public finances and a then widely admired tax responsibility law enacted in 2000, Brazil’s finances appeared healthy and sustainable (although the government spending ratio continued to rise). The success didn’t last long. A post-mortem of the Tax Responsibility Act’s demise has yet to be written, but the fact of the matter is it doesn’t bite anymore. Since then, a real spending freeze has been included in the constitution, but even that is now full of holes. Confidence in the fiscal regime is all but gone, and Brazil urgently needs a new one.

Four Pillars

The IMF’s most recent Fiscal Monitor identifies three desirable characteristics for a fiscal framework: “(1) fiscal sustainability; (2) if necessary, stabilization of the economy through anti-cyclical fiscal policy; and (3) simplicity, particularly for tax rules.” Resilience is also mentioned, which I would rank fourth on the priority list.

In a recent comment, I proposed the following pillars for a new tax system for Brazil:

  1. Public debt should be sized to provide access (usually under stress) to finance at a reasonable cost should fiscal expansion be required.
  2. The primary balance should be set in such a way that, in normal times, the debt-to-GDP ratio remains stable.
  3. If the debt ratio deviates from its target value for any reason, the primary balance should be adjusted to gradually bring the debt ratio back to the target level.
  4. Average debt maturity should be long, with limited concentration on the short end. This would correspond to the long-term horizon that governments should have. It would also reduce the risk of run-like financial or currency crises caused by sudden funding freezes.

These pillars would meet the four characteristics recommended by the IMF. Coincidentally, they would also serve the advanced economies. Key parameters like debt spreads and growth differ from country to country, but the same logic applies to all.

The debt target of the 1st pillar is quite subjective. It depends on several economic, political, institutional and historical factors. Therefore, the targets in Pillar 1 and 2 should be revised periodically, but not too frequently and on pre-announced dates, to minimize short-term policy temptations.

The success or failure of a country’s macroeconomic regime can reasonably be measured by the cost of funding its long-term debt. But even when interest rates are low, it’s important to remember that markets are prone to booms and busts. As Benjamin Graham (Warren Buffett’s mentor) famously said, “Mr. The market is manic-depressive, so blind faith in it is poor risk management. Therefore, the current extremely low interest rates in advanced economies should not be viewed as permanent. In this context, I consider the third column adaptive response function to be the most important of the four.

A fiscal regime such as the one outlined here, if properly managed, would provide a resilient and potentially enduring anchor for both advanced and emerging economies.


Arminio Fraga is co-founder of Gávea Investimentos and former President of the Central Bank of Brazil.


The opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.

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