Advanced economies face high interest rates and market turbulence unless they take radical measures to reduce ballooning government debt burdens, the IMF has warned.
All the advanced economies, except Canada, will have a debt ratio of more than 90% – and “this is a new and different situation for the world,” Carlo Cottarelli, head of IMF fiscal affairs department, told Emerging Markets in Istanbul yesterday.
Over the past two years, rich nations have embarked on a deficit-financed fiscal stimulus to raise demand amid a collapse of consumption and investment. Meanwhile, revenues have plummeted.
The IMF has projected that advanced countries’ public debt would balloon by a further 40% of GDP between 2007 and 2014 unless action is taken. Only 5% of the increase is expected to come from the interventions in the financial sector.
Cottarelli said a withdrawal of fiscal stimulus may be premature as the global economy looks fragile, but urged a timely and transparent road map for fiscal consolidation.
“The G20 communique noted the need to formalise fiscal exit strategies and not yet to implement them, but I don’t think there has been a clear definition by governments on how they are going to tackle the problems,” he said.
He was concerned that as global savings rates decrease while governments carry huge debt burdens, short- and long-term interest rates could rise unexpectedly.
“Now interest rates are low, because private-sector demand is weak” – but the longer you wait to fix public finances the more difficult it gets, he argued. “The effects [of interest rate increases] may not be large initially, but they may rise rapidly.”
The IMF’s economic counsellor and research director Olivier Blanchard told Emerging Markets that, if fiscal crises were to develop, this could force governments to undertake painful “structural reforms” that they have been reluctant to make up to now.
Blanchard said that such reforms could include the need to adjust social security and health system burdens. He did not elaborate, or say which countries could be involved, but these are key issues for leading economies including the US, Japan and even China at present.
Cottarelli argued that to avoid a fiscal crisis, governments need to slash public spending commitments. Advanced economies should seek to bring down debt to GDP levels to 60% over the next 20 years, he said. To achieve this, the primary fiscal balance – the budget before debt servicing costs – needs to move from a 3.5% deficit to a 4.5% surplus in the next ten years, and then be frozen for the next decade.
Governments can save 1.5% of GDP by simply not renewing stimulus measures, he said. A further 3.5% of fiscal improvement can be achieved by freezing public spending in real terms and “key reforms are needed to offset higher spending demands on health and pensions by aging populations”. Finally, a 3% structural tax increases, perhaps by looking at carbon taxes, should be implemented.
Cottarelli feared government deficits would crowd out the capital available for private sector expansion once the composition of the economic recovery is biased towards private-led investment and consumption. “Once demand recovers, there will be a crowding out problem for the private sector – as well as sovereign borrowing for emerging markets.”