IMF Cannot Quit Fiscal Consolidation (in Asian Surplus Countries)

In theory, the IMF now wants current account surplus countries to rely more heavily on fiscal stimulus and less on monetary stimulus.

This shift makes sense in a world marked by low interest rates, the risk that surplus countries will export liquidity traps to deficit economies, and concerns about contagious secular stagnation. Fiscal expansion tends to lower the surplus of surplus countries and regions, while monetary expansion tends to increase external surpluses.

And large external surpluses should be a concern in a world where imbalances in goods trade are once again quite large—though the goods surpluses now being chalked up in many Asian countries are partially offset by hard-to-track deficits in “intangibles” (to use an old term), notably China’s ongoing deficit in investment income and its ever-rising and ever-harder-to-track deficit in tourism.

In practice, though, the Fund seems to be having trouble actually advocating fiscal expansion in any major economy with a current account surplus.

Best I can tell, the Fund is encouraging fiscal consolidation in China, Japan, and the eurozone. These economies have a combined GDP of close to $30 trillion. The Fund, by contrast, is, perhaps, willing to encourage a tiny bit of fiscal expansion in Sweden (though that isn’t obvious from the 2015 staff report) and in Korea—countries with a combined GDP of $2 trillion.*

I previously have noted that the Fund is advocating a 2017 fiscal consolidation for the eurozone, as the consolidation the Fund advocates in France, Italy, and Spain would overwhelm the modest fiscal expansion the Fund proposed in the Netherlands (The IMF is recommending that Germany stay on the fiscal sidelines in 2017).

The same seems to be true in East Asia’s main surplus economies.

Take the Fund’s advice on China. The Fund thinks that the right measure of China’s fiscal position is what the Fund calls the "augmented fiscal balance." And the Fund thinks that the augmented deficit is too big, and China should do modest consolidation in 2017.**

"The projected increase in the augmented deficit in 2016 is thus not warranted from a structural perspective. Neither is it warranted from a cyclical perspective given the growth outlook. For 2017, a moderate reduction of the augmented deficit seems appropriate. Only if growth threatens to fall sharply (well below staff’s projection of 6.2 percent) should the deficit widen.”

(emphasis added; paragraph 36, on p. 23 of the staff report)

To be fair, the Fund isn’t calling for on-balance sheet fiscal consolidation, and even seems open to breaching the 3 percent of GDP limit for the headline deficit if that is needed to support more aggressive reforms. Directionally, though, the Fund still wants consolidation.

Take the Fund’s advice on Japan. The first consumption take hike—from 5 to 8 percent—didn’t go that well. Consumption never recovered, and the economy lost momentum.

But rather than reconsider consumption tax based consolidation, the Fund wants Japan to double down and commit to raise the consumption tax to 15 percent (rather than 10 percent):

“a gradual increase in the consumption tax towards at least 15 percent, e.g., in increments of 0.5–1 percentage points over regular intervals, would better balance the objectives of supporting growth and achieving fiscal sustainability in the long run. … Starting the increases as soon as possible and replacing the currently planned 2019 hike with such a pre-announced, gradual path would enhance the credibility of the long-run fiscal adjustment effort..."

(paragraph 23, on p. 14 of the staff report)

That isn’t exactly a call to use the fiscal arrow to relaunch Japanese demand growth. The Fund is calling for slower and more predictable pace of consolidation, but it is still calling for consolidation, and a form of consolidation that would weigh most heavily on households. Monetary and fiscal policies would work in opposite directions.

Japan is a hard case. It has an unusually high level of public debt. It also has an unusually low interest rate on that debt. And fiscal risks are reduced so long as the stock of debt actually held by the public is falling fast: Think of a 5 percent of GDP fiscal deficit and annual purchases by the Bank of Japan (BoJ) of 15 percent of GDP (Or take a look at Figure 3 in Toby Nangle’s paper). With fiscal consolidation at a steady 0.5 percent of GDP pace needed for the next ten to fifteen-plus years according to the Fund (see paragraph 23 of the staff report) it is a little hard to see how the BoJ can stop buying any time soon—so if Japan adopted the Fund’s advice, the fall in debt held in the market would likely be quite fast.***

And what of Korea? The details of the Fund’s advice for Korea are still not out. But there is no real evidence the Fund wants a significant, sustained fiscal loosening in Korea, even though Korea has low government debt, no fiscal deficit to speak of and a $100 billion-plus current account surplus (7-8 percent of Korea’s GDP). The Fund’s forecast, if I read it correctly, projects that Korea’s general government will return to a fiscal surplus of 1.0 percent of GDP over time.**** Korea needs to ease just to avoid tightening, so to speak.

Asia’s two big surplus countries (China and Japan) no doubt present a slightly more complicated case than the eurozone taken as a whole. The eurozone is in primary balance, and in aggregate, has only a modest deficit. The absolute size of China’s augmented deficit and Japan’s primary deficit no doubt bother many at the Fund. On the other hand both China and Japan run significant external surpluses even with sizable fiscal deficits; the obvious implication is that without those fiscal deficits the size of their external surpluses would be much bigger. Korea has no fiscal deficit to speak of, and a current account surpluses that is bigger, relative to its GDP, than the current account of either China or Japan.

Bottom line: if the Fund wants fiscal expansion in surplus countries to drive external rebalancing and reduce current account surpluses, it actually has to be willing to encourage major countries with large external surpluses to do fiscal expansion. Finding limited fiscal space in Sweden and perhaps Korea won’t do the trick. 20 or 30 basis points of fiscal expansion in small economies won’t move the global needle. Not if China, Japan, and the eurozone all lack fiscal space and all need to consolidate over time.

[*] See table 3 of this report for the Fund’s assessment of the gap between a country’s 2015 fiscal balance and its appropriate long-term balance. Sweden should go from a surplus of 0.3 percent of GDP to balance, and Korea from a surplus of 0.6 percent of GDP to rough balance (a deficit of 0.1 percent of GDP)

[**] The IMF is not calling, thankfully, for China to reduce its on-budget fiscal deficit, which is forecast to remain at close to 3 percent of GDP for some time. But the Fund is clearly calling for a significant overall consolidation, along with slower growth in private credit.

[***] I assume the Fund expects that Japan’s supplementary budget will offset the 0.8 percent of GDP fiscal consolidation that the Fund projects for calendar 2017 in Japan. The staff report didn’t seem to warn of the demand side impact of allowing past stimulus packages to roll-off without being replaced with new stimulus. The tendency toward consolidation from the roll-off of past stimulus packages makes it hard to assess the actual fiscal impetus in Japan, as Japan is on a bit of a treadmill where ongoing temporary stimulus has to be replaced by new stimulus just to avoid a negative fiscal impulse.

[****] Korea’s national pension system collects significantly more than it takes in, generating a substantial surplus. The headline fiscal deficit of the government thus differs from the general government’s fiscal balance.

Note: I initially wrote that the IMF forecasts Korea’s general government balance to rise to a surplus of 1.5%. It looks to be 1% (using general government net borrowing/ lending). I also corrected a couple of spelling errors.