Documents
Resources
Learning Center
Upload
Plans & pricing Sign in
Sign Out

DocE_Fiscal Sustainability Paper - CBS_

VIEWS: 0 PAGES: 33

									Fiscal Sustainability: Lessons from the European Union for SADC




Authors:           Nehrunaman Pillay, Samuel Dlamini



Contact Details:   Central Bank of Swaziland

                   P. O. Box 546

                   Mbabane

                   H100

                   Swaziland

                   Ph: +268-24082244

                   Email:Nehrup@centralbank.org.sz,

                   Samueld@centralbank.org.sz

Abstract

The global financial and economic crisis in 2008/2009 and culmination in
the sovereign debt crisis in peripheral countries of the Eurozone have lead
economists and researchers of monetary unions to question the historical
convention of the minimal role of fiscal policy in a monetary union. More
specifically economists have attributed the main cause of poor fiscal
sustainability in some countries to large public debts, poor fiscal
management, and incompatibility of independent fiscal policy within a single
currency, single central bank monetary union. The recent developments in
the Eurozone provide valuable lessons on the construction and viability of a
single currency monetary union. SADC a region planning to establish a
monetary union by 2016, will greatly benefit from the current debates and
developments in the Eurozone in an attempt to minimise and mitigate the
risks associated with the long-term viability of a monetary union.




                                     1
1. INTRODUCTION & BACKGROUND

The financial and economic crisis of 2008/2009 saw unprecedented
government interventions to support economic growth and financial
institutions. This was especially the case in the developed countries. This
intervention took the form of injection of liquidity by central banks and
stimulus packages through large fiscal deficits and in some cases resulting
in large public debt-to-GDP ratios.       In the EMU, poor fiscal governance
coupled with persistent fiscal deficits prior to the crisis saw public debt
levels in some countries exceed the original 60% of GDP for government debt
criteria as outlined in the Maastricht Treaty.     Consequently, rising debt
levels in the peripheral EMU states have triggered a decline in investor
confidence in government’s creditworthiness and raised doubts about the
fiscal sustainability in these countries.       The on-going turmoil of the
sovereign debt crisis, specifically in Greece, have led some economists to
question the future existence of the single currency Eurozone in light of the
inability and unwillingness of sovereign states to institute politically
unfriendly austerity measures and the compatibility of the “no bailout
clause” as stated in the treaty.

The sovereign debt crisis has focussed attention on the relationship between
a single monetary policy authority in an environment where each sovereign
state conducts independent fiscal policy.      It is evident that fiscal policy
across the Euro area is uncoordinated and at times incompatible, giving rise
to severe macroeconomic vulnerabilities in some member states.            This
problem, whilst anticipated early in the establishment of the EU, and to
some extent addressed by the 3% of GDP deficit and 60% of GDP public debt
ratio in the convergence criteria, was violated through poor enforcement and
surveillance once country’s became members of the Eurozone, and through
misrepresenting the actual fiscal position - especially in the peripheral
countries.

The evolution of the sovereign debt crisis in the Eurozone, concerns about
fiscal sustainability as well as policy responses and debates in the academic
sphere about the relationship between independent fiscal policy within a

                                      2
monetary union provide valuable insights to existing and potential monetary
unions. The developments in the Eurozone present important lessons for
SADC in its pursuit of a monetary union. To avoid the current questions of
the success and future existence of the EMU, SADC would have to
thoroughly investigate, understand and anticipate all the risks to the
success of a monetary union prior to the full establishment of a SADC
Monetary Union.     This could result in a reform of the policy decision to
establish a SADC Monetary Union by 2016 or establishment of new and
stricter convergence criteria and new fiscal mechanisms.


The main objective of this research is to identify the lessons from the theory,
criteria for establishment of the EMU and evolution of the Eurozone’s
sovereign debt crisis that SADC can apply to the establishment of the SADC
Monetary Union.

The research also explores building blocks necessary for fiscal sustainability
are. What are the appropriate fiscal rules to enshrine and what form fiscal
coordination should take to ensure the long-term viability of the monetary
union.   The research further highlight measures, policies and procedures
that are perceived to undermine or threaten the future of the EMU. Lessons
from the Eurozone are used as evidence to SADC to relook at the process
and redefine the criteria for the establishment of a single currency union.



The paper is organised as follows: section 2 presents a summary of theory of
a Monetary Union-the Optimum Currency Area; section 3 covers literature
on criteria for establishing the EMU and its evolution; section 4 presents an
analysis on Building blocks necessary for fiscal sustainability and
appropriate fiscal rules; section 5 shed light on fiscal coordination under a
monetary union; section 6 presents SADC status of macroeconomic
convergence and concerns; section 7 presents measures, policies and
procedures that are perceived to undermine or threaten the future of the
EMU;


                                      3
2. THEORY AND LITERATURE REVIEW OF A MONETARY UNION


      The Theoretical Concept of the Monetary Union-the Optimum
       Currency Area

The main research question that this study aims to address is: What are
lessons SADC can learn from economic theory on monetary unions,
monetary and fiscal criteria in the establishment of a monetary union and
how this is applied in the Eurozone and the evolution of the Eurozone
sovereign debt crisis 201011, in order to ensure that its proposed Monetary
union 2016 will avoid similar fiscal problems that threaten the long term
sustainability of monetary unions?

      Optimality of the Common Currency Area.
Mundell (1961) observed that there is no standard theory of optimum
currency areas, but rather several approaches. Mundell in his 1961 seminal
paper tried to answer the questions on when countries should have their
own currencies and what the appropriate domain of a common currency
area is.   Mundell emphasized the factor mobility, especially the labour
mobility, as a crucial precondition in forming an OCA. He argued that if an
exchange rate causes unemployment in one region or if it forces one region
to accept inflation as cure to unemployment then the regime is not
optimum. If demand shifts from region A to region B and there are price and
wage rigidities inflation is likely higher in region B and there would be
resultant unemployment in region A. In a fixed exchange rate regime for the
regions to restore equilibrium another adjustment mechanism is needed.
Thus Mundell stressed that labour mobility would be the mechanism that
restores equilibrium. If there is high labour mobility, then labour will move
from region A to region B, then region B will have no need to trade inflation
for employment. There will therefore be no need to have one’s own exchange
rate for equilibrium adjustment purposes but one monetary policy will be
satisfactory. Copaciu (2004) analyzed labour mobility across EMU states
and finds that labour mobility does not act as an effective adjustment
mechanism.

                                      4
Tanja Broz (2005) notes that “potential members of a common currency area
do have labour force that is mobile, sufficient price and wage flexibility, a
high degree of openness, similar inflation rates and political will to abandon
their own currency and adopt a new one, then the common monetary policy
can be a benefit to all members and therefore the usefulness of nominal
exchange rate adjustments within members is reduced.” McKinnon (1969)
further stresses the point of labour mobility by looking at a case of labour
immobility in the case where negative demand shocks affect region B, then
region B can attempt to make product in region A so that the redundant
labour can be absorbed by type A product. If region B was not able to region
A type product then factor mobility would definitely be necessary to act as
an adjustment mechanism to prevent a fall in income in region B.


Kenen (1969) argued that when regions are defined by their activities perfect
interregional labour mobility requires perfect occupational mobility thus he
suggests that labour should be homogeneous. However, this cannot restore
perfect balance of payments save for the restoration of employment.


Mckinnon (1963) put emphasis on the degree of openness as an important
criterion in the formation of an OCA. Mckinnon defined the degree of
openness as the ratio of tradables to non-tradables. There are more reasons
for countries to have a fixed exchange rate when the economies are more
open. There is a high tendency for the foreign price of tradable to be
transmitted to the domestic cost of living. The nominal exchange rate
illusion would be eliminated by the transmission of prices and in effect the
real effective exchange rate would be fairly stable reflecting the tendency of
foreign prices (trading partner) to be tracked by local prices.


In the region countries like Namibia, Swaziland and Lesotho have pegged
their currencies to that of South Africa precisely for this reason under the
common monetary area (CMA). South Africa is their major trading partner
such that inflation rates in Namibia, Swaziland and Lesotho (NSL) are

                                       5
heavily influenced by inflation rates in South Africa hence the need to peg to
the South African rand. Changes in the exchange rate for this countries vis-
à-vis South Africa will not have an effect on the terms of trade thus
eliminating it as an adjustment mechanism. Mckinnon suggested that such
economies should rely on alternative instruments to solve balance of
payments problems, like fiscal policy.


Kenen (1969) introduced product diversification as an important criterion
for an OCA. Kenen discoursed that perfect labour mobility rarely exists and
in its absence product diversification can act as an adjustment mechanism.
He further said that a well-diversified economy will have a well-diversified
export sector such that if shocks are uncorrelated then there is likely to be a
cancellation of negative and positive shocks and exports would be more
stable. However there should be adequate occupational mobility to absorb
idle labour and capital.


According to Kenen (1969) if the whole export sector is affected negatively
diversification will not help. In this case the argument is that a well-
diversified would not undergo frequent terms of trade shocks as often as a
single product economy. Tanja viewed the point on a well-diversified
economy (export sector) as a transformation into the openness criterion for
countries with a small export sector. Openness for small countries as earlier
observed by Mckinnon (1963) can in the case of the CMA necessitate a fixed
exchange rate.


      Concept of Cost/Benefit in a Monetary Union.
The theory of the optimum currency areas (OCA) explores the costs and
benefits of being in a common currency area, though there is no widely
accepted algorithm to indicate objectively whether a country should joins a
monetary union. Copaciu (2004) looked at the nature of the costs and
benefits of being in a currency union. In literature it is stressed that benefits
refer mainly to monetary efficiency gain which can be:            a) benefits from
increased   macroeconomic      stability     and   growth;   b)    benefits   from

                                         6
improvements in macroeconomic efficiency and those resulting from positive
external effects.


The first type of benefits refer to improved overall price stability, further
inducing reputational gains for members with a history of higher inflation
that benefit from an anti-inflationary anchor and there is also easier access
to more international financial markets increasing the availability of funds.
The second type of benefits refers to the importance of money functions
(usefulness of money as a unit of account, medium of exchange, standard
for deferred payments, and store of value).


There were no inflation pressures that emanated from the introduction of
single currency, but it remains that there are good and bad performers in
the Euro area. The Euro area has benefited from low interest rates
stemming from anti-inflationary credibility of the European Central Bank.
The low interest rates brought relief to previously heavily indebted countries
and those previously subject to high inflation by reducing tax rates and
higher levels of debt service.


3.0 CRITERIA FOR THE ESTABLISHMENT OF THE EMU AND ITS
EVOLUTION OF THE DEBT CRISIS

3.1   Criteria for the Establishment of the EMU
The process of establishing a single European currency began in 1969 with
the Barre Report, produced by the then six-member European Economic
Community (EEC). The Barre Report was further discussed the Heads of
State or Governments in The Hague who then initiated a plan for the
formation of an economic and monetary union. The collapse of the Bretton
Woods System in 1971 and the oil crisis of 1972 delayed the process of
establishing the Union. Despite these challenges the EEC grew to include
nine states, many of which were reluctant to surrender their national
currencies.




                                      7
3.2   Evolution of the Sovereign Debt Crisis in the Eurozone


According to Reinhart and Roggof 2011, before the euro amalgamation
Greece had demonstrated a history of debt defaults, financial contagion,
inflation crises and banking crises. This was demonstrated by high bond
yields, a sort of a risk premium for investing in its debt. Also the spread
between Greek and German bonds remained on the high side. After
introducing the euro the bond yields and the spread came down
significantly, making the Greek debt as safe an investment (financially) as
the German debt. This was attributed to the fact that the ECB ensured that
inflation not a problem of Greece or any other peripheral country. Thus
every eurozone peripheral bond on the market followed the German Bund
trade – the spreads were smaller and the risks were perceived as non-
existent (Basel I and II recognized their debt as zero risk-weighted assets).


These developments provided countries with a conducive environment to
borrow at cheap rates. Thus politicians saw no need to be fiscally
responsible and could decide to populist policies for them to remain in
power. A larger portion of credit from abroad was channelled to
consumption which resulted to an increase in GDP above its potential levels
(see figure 3.1 below). The recession from the US first affected Germany
within the Eurozone. The recession resulted to a drastic decline of borrowing
and exposed the depended peripheral countries to the threat of default.
Therefore fiscal deficits and the surge in public debts acted as a signal to
investors to consider other safe haven and the yields started rising.
Corrective measures of the second round effects resulted to asymmetrically
shock across the zone. In the case of Greece, the government was compelled
to increase its debt to cushion its public sector and win elections through
populist policies. Ireland and Spain (like the US) experienced a housing
bubble of 180 per cent since 1998.




                                       8
Figure 3.1




In a nutshell a country that runs a current account deficit is also
experiencing a surplus in its capital account. Therefore if a country uses
money from abroad to finance investment instead of consumption, the
deficit is likely to increase as the country is using the inflow of capital to
enhance its production facilities and increase growth. On the other hand, if
money from abroad is channelled to boost consumption and government
expenditures directed on politically popular policies, the end results is likely
to be an asset price boom or an untenable fiscal position of the government
who is becoming dependent on foreign capital to finance its over-exaggerated
expenditures. Ireland, Spain and US suffered from the first, while Greece,
Portugal and Italy is a product of the former (see appendix 1 for Current
Account deficit compared with the level of gross government debt).

3.3 Reasons why the Euro Crisis is persistent

According to Schuman (2011), the following are the main reason why the
euro crisis will still be with us, for a long time to come:


      The Eurozone debt crisis is far from resolved. The recent bailout for
       Greece was based on too many unrealistic assumptions that have a
       high possibility of disappointing. Greece is still expected to implement

                                        9
    a politically suicidal austerity plan therefore chances are very slim
    that the Greek government can hold up its end of the deal. In addition
    the believe that Greece will manage to raise more than $40 billion
    from privatization over a short period is too hypothetical.

   Efforts of calming the situation are not yielding fruitful results in the
    Eurozone. For an example the latest bailout agreement has done
    nothing to build confidence in the other ailing economies of the euro
    zone. The cost of borrowing in Italy and Spain are back on the rise.
    Therefore the future course of the euro crisis heavily rely on whether
    or not Ireland and Portugal fulfill the reform pledges made as part of
    their EU bailouts and convince investors to start lending them money
    again. Also this will depend on the ability of Spain and Italy to repair
    their national finances and remain out of bailout programs. There are
    fears that Cyprus could be the next country to enter the bailout
    programme, after Moody’s downgraded its sovereign rating.

   The recent bailout agreement for Greek followed the same pattern as
    all of the other euro zone, debt-crisis agreements. Also there is effort
    to build investor confidence. It is therefore clear that the Eurozone is
    fighting its debt-crisis using strategies that have proved to be failures
    in the past.

   The Eurozone is still not ready to tackle the real problem. For the
    Eurozone to address the current problem there is a need for a wide-
    scale economic reform across the zone to foster the growth and
    investment that would boost weaker economies. The Eurozone should
    realize that they are not faced with a liquidity problem but a
    structural one, therefore they should not expect it to ebb away by
    using bailouts.




                                    10
4.0  BUILDING       BLOCKS       AND        FISCAL   RULES    FOR     FISCAL
SUSTAINABILITY

4.1 Fiscal Sustainability Measurement Issues.

Croce and Hugo (2003) argue the concept of fiscal sustainability is centered
on the future implications of current fiscal policies and, more precisely, to
the question of whether the government can continue to pursue its set of
budgetary policies without endangering its solvency. Solvency defines a
position where the government has enough money to pay debt. A fiscal
policy stance can be thought of as unsustainable if over time it leads the
government away from solvency. Therefore, to measure sustainability the
starting point would be to determine whether the conditions for government
solvency are met or not. Since solvency is one’s ability to service debt,
therefore revenue performance of an entity is critical in meeting solvency
conditions. Projection of variables such as future tax and spending
measures-as well as forecasting the GDP growth and real interest rates-to
determine whether the intertemporal budget constraint is satisfied.


Buiter (1985) maintains that fiscal sustainability measurement should
determine whether the current fiscal policies can stabilize the ratio of public
sector net worth to GDP. Blanchard (1990) claims that such measurement
should demonstrate that current fiscal policies can stabilize the debt-GDP
ratio. A majority of studies on fiscal sustainability follow Blanchard (1990)
approach due to the scarcity in obtaining data for public sector net worth.
Government revenue and expenditure are projected based on current
policies. The estimated primary deficits and tax ratios are then compared
with the permanent primary deficit (primary gap indicator) or the permanent
tax ratio (tax gap indicator) required to keep the debt ratio constant. The
resulting gap provides a measure of the sustainability of the current fiscal
policy stance.


Croce and Hugo (2003) propose an operationally recursive algorithm that is
derived from the law of motion of the debt-to-GDP ratio, subject to the
government’s reaction function. When the actual debt-to-GDP ratio exceeds
                                       11
the target ratio, the government reacts by generating a primary surplus that
is consistent with the convergence of the debt ratio to that target. Once this
is achieved the algorithm is expected to anchor policies to ensure that the
target is maintained over time.


Antonio (2004) assessed sustainability by testing whether both public
expenditures and government revenues may continue to show in the future
their historical growth patterns. Antonio states that if a given fiscal policy
turns out to be unsustainable, it has to change in order to guarantee that
the future primary balances are consistent with the budget constraint.



4.2 Building Blocks necessary for Fiscal Sustainability

There is a strong link between fiscal policy and monetary policy and this
relationship should be observed whether countries feed into a a monetary
union or not. Literature on building blocks necessary for fiscal sustainability
is scarce.   Coeuré and Jean (2005) suggest five building blocks that are
necessary for a fiscal sustainability, namely: concepts, accounts, targets,
procedures, and institutions.


   Concepts
Coeuré and Jean (2005) argue that member states should be educated on
the methodology of the sustainability assessment and on the choice of the
state variable for the monitoring of a government’s fiscal situation. As
articulated in the Maastricht Treaty the relevant scope should entail the
central government, local government and social security, mainly because
these countries have organised transfers between government sub-sectors,
and because government entities are partly financed by taxes


The appropriate state variable should be the net value of the government
sector, which accounts for the variance between its total assets and
financial liabilities (excluding implicit liabilities). Implicit liabilities include
pensions which are not supposed to be aggregated to financial liabilities


                                        12
because they belong to a different class of debt. Worth noting is that the
governments can default on them without suffering financial crisis.
Therefore sustainability should be based on the target for the net value of
the government as a percentage of GDP at a certain point in time. This
period should allow for corrective measures and cater for cyclical
stabilisation.


      Accounts
EU statistical institutes currently release a number of quarterly and annual
national accounts, and they issue general government deficit and gross debt
numbers on a yearly basis. These quarterly and annual release provide
government balance sheet items such as a breakdown of financial debt
(differentiating credit lines, bills and bonds), financial assets (distinguishing
gold, cash, equity, and loans) and non-financial assets (including real
estate). In a nutshell the breakdown of the balance sheet should provide
enough information to help assess the liquidity of the government. In
addition all accounts should be audited by a private auditing company in
the absence of a Statistics Unit.


      Targets

Member states should adopt a target for the government’s net value as a
percentage of GDP. The sustainable net value of the government is a
summation of two components: Age-Related Net Implicit Liabilities (ARNIL)
and the net present value of all other future expenditures, counting the
opportunity cost of holding government assets rather than buying back
debt. Therefore the first step is to set a standard target for the latter, and to
apply a ceiling to ARNIL in order to take into account the fact it does not
denote financial claims and can be defaulted at a lower cost than financial
claims through parametric reforms.




                                       13
      Procedures

In this case, Coeuré and Jean (2005) suggest that every year, each country
should publish a plan consisting in three elements: a fiscal plan, a reform
plan, and a contingency plan.


         -   The fiscal plan should cater for current stability programmes,
             but with a longer horizon and projections of both assets and
             liabilities. It should describe clearly a sequence of deficits and
             balance sheet operations (for example privatisations or asset
             purchases, securitisations and one-off revenues or payments) as
             a way to reach the target level for the government’s net value.
             Therefore the deficit target would vary reflecting that it depend
             both on the target (which differs from one country to another)
             and on the nominal growth rate, which makes it more or less
             easy to reach the target.


         -   The reform plan covers the growth trajectory beneath the fiscal
             plan. This plan should reflect the existing “national reform
             plans”, but with a strong relationship with budgetary policy.
             Thus an ambitious reform plan that has the potential to
             permanently increase output could explain a less ambitious
             fiscal plan. The Commission assess the implementation of the
             reform plan every year: countries that breached their deficit
             target are first warned then sanctioned, if they failed to deliver
             the promised reforms.

         -   The contingency plan provides a clear guide on how budgetary
             policy responds to shocks – positive and negative, such as an
             unexpected    surge   in    tax   revenues   or   a   recession.   The
             contingency plan therefore addresses the inflexibility of a
             medium term-oriented fiscal strategy and act as an instrument
             for the Commission when assessing fiscal developments.



                                         14
      Institutions
The recent development in the Eurozone implies that the SGP was not
properly integrated in member states’ domestic agendas, but it was used as
a scapegoat to justify fiscal adjustment. The fundamental issue is how to
create more political ownership of the SGP. Since the EU is not a standard
representative democracy – Collignon (2004) provides analyses why and how
to make it one – the only way to achieve this goal is through national
parliaments. Therefore fiscal, reform and contingency plans should be
approved by Parliament after they have been discussed by a “fiscal policy
committee”, so that Parliament can take account of the remarks made.


4.3 Fiscal Rules necessary for Fiscal Sustainability

According to Kopits and Symansky (1998), fiscal rule defines the permanent
constraint on fiscal policy usually defined in terms of an indicator of overall
performance. Danninger (2002) further note that it is a constrain on fiscal
policy with a time bound character. Fiscal rules may vary from country to
country or by region but its highly influenced by the specific goal it follows.
In terms of the indicator these refer to public expenditure, public debt and
budget balances.


Fiscal rules can be divided into three groups: (i) budget balance rules which
tracks the overall or current balance (either to the submitted budget,
approved budget or realised budget); (ii) expenditure rules which account for
composition of the budget; and (iii) debt rules.


Balassone and Franco (2001a) claim that the Eurozone fiscal rules replicate
the relationship between the multinational nature of the EU and the lack of
a political authority of federal rank. The Eurozone is criticized for its highly
decentralised setting of fiscal policy which generated moral hazard issues.
The recent outcomes in the EU suggest that the approach adopted by the
EU is stricter compared to solutions taken in some federally structured
countries. This portrays the heterogeneity of the Eurozone and calls for an


                                      15
urgent need for rapidly building up the stability-oriented reputation of the
new policy regime (Balassone and Franco, 1999).


The EMU fiscal rules ensure not only that each country upholds a sound
fiscal stance but also that adequate margin for budgetary flexibility in
critical times are acceptable. Worth noting is that fiscal sustainability is a
central principle of EMU: it is a precondition for financial and monetary
stability. For policy stabilisation, budgetary flexibility is crucial at the
national level more especially because member states can no longer rely
either on a monetary policy tailored to national needs or on exchange rate
adjustments (Franco and Zotteri, 2009)


The Maastricht Treaty (1992) provides rules for all countries to reach in
order to achieve Economic and Monetary Union (EMU) and these entail: low
inflation, low interest rates and controlled public debt and spending. The
Maastricht Treaty articulates that budget deficits cannot exceed 3 percent of
GDP unless (1) under exceptional circumstances, such as severe recessions;
budget deficit should remain close to 3 percent; and excess deficit should
last only for a short period of time. In an event the limit is exceeded the
three conditions are violated, the deficit is deemed “excessive” and it
prompts a procedure intended to force adoption of corrective measures. In
terms of the national debt the treaty emphasis that states should remain
lower than 60% of GDP.


The Growth and Stability Pact enacted in 1997 complemented the
Maastricht rules by introducing that each country should also aim at a
medium-term objective of a budget which is close-to-balance or in surplus.
The SGP reinforced the surveillance of budgetary positions (the preventive
arm of the Pact) and specified the implementation of the excessive deficit
procedure (the corrective arm of the Pact). The SGP obliges member states to
chooses a budgetary target in structural terms and let programmed
stabilisers or discretionary action operate symmetrically around it. A
relatively low budget balance with respect to the 3 percent threshold,

                                     16
increase the leeway for countercyclical policy without the risk of an
excessive deficit. Thus compliance with the deficit threshold and the ceiling
for the debt-to-GDP ratio, would avert the public finances of EU member
states from taking unsustainable paths.


EU fiscal rules also emphasis that each member state submit its budgetary
targets in multiyear budgetary documents. Updates and assessments are
done annually by the European Commission to ensure consistency with EU
fiscal rules. Assessments include a midyear examination of public finances
and an ex-post evaluation of results, as compared to planned targets. In
case there are anomalies the European Council makes recommendations to
governments on the need to assume corrective measures. Countries with
excessive deficit are expected to implement corrective measures according to
a fixed timetable. Sanctions are imposed who not in a position to comply and
such may destroy reputation, which can turn into a higher risk premium in
yields of government securities.


The EU fiscal rules suggest that while rules are aimed at fiscal discipline in
the medium term, they do not overlook the relationship between fiscal
discipline and sustainability of public finances. This is ostensible in the role
that debt and long-term reforms play both in the definition of the country-
specific medium-term targets and in the European Commission assessment
of a deficit exceeding 3 percent.


4.3.1 Other Empirical Reviews on Fiscal Rules


Empirical literature on fiscal rules shed light on the following themes: (a)
whether fiscal rules are effective; (b) how the features of fiscal rules are
linked to their effectiveness; (c) whether fiscal rules restrict a government’s
ability to engage in countercyclical fiscal policy; and (d) the relationships
among political and budgetary institutions and fiscal consolidation.




                                      17
Effectiveness of fiscal rule
Kneebone and McKenzie (1997) investigated the Alberta government’s
experience to unanticipated shocks to expenditures and revenues. The study
provides evidence of asymmetric behaviour – unexpected losses in revenue
did not affect the current budget, but unexpected increases in revenue were
built into current revenue plans. They conclude that Alberta’s legislation at
the time may have been a response to this asymmetry, as it required higher
than estimated revenues for debt reduction.


Eichengreen and Bayoumi (1994) explore the impact of fiscal rules on state
general obligation bond yields. The results suggest that, for average levels of
debt-to-gross state product, tax rates, and lagged state unemployment, if a
state without a tax and expenditure limit applies harsh tax and expenditure
limits, interest costs are bound to decline. Eichengreen and Bayoumi
conclude that fiscal rules on tax and expenditure turn to reduce the
possibility of future borrowing increases and defaulting.


Fiscal Rules and Effectiveness
Von Hagen (1991) explored the effectiveness of debt limits and balanced
budget requirements in US by comparing fiscal performance indicators in
states with and without debt strictness and in states with fluctuating
degrees of limits in terms of their balanced budget requirements. The results
provides   evidence    that    debt   limits   or   stringent   balanced   budget
requirements affects the distributions of per capita state debt, the debt-to-
income ratio, and the ratio of nonguaranteed to guaranteed debt. The study
provides evidence of higher percentage of states with high ratios of
nonguaranteed to guaranteed debt in the state groups with more stringent
balanced budget requirements.


Another study by Bohn and Inman (1996) provides different conclusions for
US. Their study examines the effectiveness of different types of rules using
data from 1970-199. Bohn and Inman argue that no conclusion can be
made that balanced budget rules shift deficits into other fiscal accounts.

                                        18
Instead they conclude that tighter balanced budget rules are highly related
to higher state surpluses.



Fiscal Rules versus Stabilization
Bayoumi and Eichengreen (1995) provide evidence that states with relatively
smaller cyclical offsets are likely to have more stringent fiscal constraints.
Basically, they identified that a transition from no fiscal restraints to the
most stringent restrictions reduce the fiscal offset to income fluctuations by
around 40 per cent (where the fiscal offset is a measure of the sensitivity of
the level of the fiscal balance to real output).


Levinson (1998) argues that the size of the state is associated with its
capability to influence business cycle fluctuations through countercyclical
fiscal policy. Levinson also demonstrated that although states with stricter
rules do not have higher volatility on average, the difference in fluctuation
between states with lenient and strict rules is indeed greater among large
states compared to smaller states. Levinson concludes that there it clear
that strict balanced budget rules do aggravate business cycle fluctuations.


Link between Political, Budgetary Institutions and Fiscal Consolidation
Bayoumi and Eichengreen’s (1995), Corsetti and Roubini (1996) emphasize
on the role of central governments in providing fiscal stabilization. Alesina
and Bayoumi (1996) further suggest that if stringency of fiscal rules does
not affect state output variability, it implies that the state’s role in
stabilization is not very important. If the latter is true then balanced budget
rules may be effective for subnational governments not for national
governments.

Lessons for SADC

   Fiscal rules and its effectiveness are heterogeneous across countries. This suggest that
    there is no perfect rule applying to all countries, therefore fiscal measures should be
    country tailored.
   Fiscal rules can make policies more time consistent. They reflect “a formal expression of
    the political will to maintain fiscal discipline”
   A balanced budget is a radical but effective way to send messages about debt and
    sustainability. The trade-off between having simple and economically-relevant rules is
    still there.
                                            19
   Fiscal rules should embraced by the member states as valuable contribution for the
    success of their fiscal policy.
5.0 FISCAL AND MONETARY COORDINATION FOR LONG TERM VIABILITY
OF A MONETARY UNION

In the past decade the limitations of the euro area’s framework for fiscal
policy had been exposed and this has triggered a number of debates
amongst researchers. The arrangement allows that fiscal policy had to
remain a national responsibility and coordination heavily relies on finance
ministers within member countries. The Stability and Growth Pact (SGP)
provided a sufficient framework for the coordination of fiscal policy. Worth
noting is that fiscal coordination in the Eurozone is actually weak and this
is reflected by the magnitude of spillovers that emanates from the member
countries. Economist maintains that effects of a fiscal expansion are two
fold on partners: a positive one as it stimulate demand for imports, and a
negative one as a fiscal expansion puts pressure on interest rates, which will
tend to lower demand in the entire area.


Bordo et al (2011), claim that literature on the interaction of fiscal and
monetary policies suggest that there are various mechanisms which may
lead to spillover effects across member states. Dixit and Lambertini (2001)
demonstrate that if monetary and fiscal authorities have different ideal
output and inflation targets, Nash equilibrium output or inflation or both
are suboptimal. Chari and Kehoe (2004) suggest that without a central
monetary authority commitment to a future policy path, the free rider
problem is likely to yield incompetent outcomes, such as extreme inflation in
the whole monetary union and uncontrollable debt issued by each member.


Bordo et al (2011) concludes that in a single monetary authority and
numerous fiscal authorities a compulsory fiscal policy constrain is crucial to
prevent massive deficits at sub-central level. Any default at subnational
government trigger negative externality upon other subnational governments
by stimulating the cost of borrowing for all fiscal units. As long as the
subnational government do not perceive a chance of a bailout from a central
government or central bank, market forces would always work efficiently.
Bailouts are the reason behind the failure of market discipline because once

                                     20
they destroy market forces that are crucial in preventing fiscal units from
excessive borrowing (Lane, 1993).


In conclusion, the interaction between several fiscal coordinations and one
monetary authority within a federation creates free riding problems. This
emanates from the fact that individual authorities turn to under estimate
the contribution on the common monetary policy. This implies that member
states fiscal policy is driven by national interests. Therefore the impact of a
shock from one member state is absorbed by all member state like in the
case of the Eurozone (Bordo et al, 2011).


6.0 SADC STATUS OF MACROECONOMIC CONVERGENCE
In August 2004, SADC members launched the Regional Indicative Strategic
Development Plan (RISDP) in the Summit held in Arusha, United Republic of
Tanzania.   Currently   member      states    implementing     a   macroeconomic
convergence programme which four macroeconomic indicators set for 2008,
2012, 2015 and 2018. To date SADC countries have made substantial
progress towards achieving the macroeconomic convergence targets. A
majority of member countries have managed to reduce inflation to single
digit levels. To some extend the current account and budget deficits have
been reduced together with public debt (Integrated Paper on Recent
Economic Development in SADC, 2011).


Figure 6.1 below presents a summary on the status of macroeconomic
convergence within SADC.

Figure 6.1: Macroeconomic Convergence Targets (see appendix 2 for
details)
Primary convergence targets                            Status in 2010
1. Inflation less that 5%                    11 recorded a single digit (but not <5)
2. Budget Deficit to GDP less than 3%                          5
3. Public Debt to GDP less than 60%                           13
Secondary targets                                           Status
4. International Reserves (at least     6    11 member states below the threshold
months in 2012)
5. Real GDP growth (not less than 7%)        5 member states surpassed the growth
                                                            target
6. Current Account to GDP (less than 9%)     9 member states were within the target

                                        21
                                          level
Source: SADC RED Paper, 2011




6.0 EMU FUTURE THREATS AND LESSONS FOR SADC

6.1 Policies and procedures potential to undermine the the EMU
The arrangement within the Eurozone presented some fragile elements from
the on onset. A number of research claims that lack of a centralized fiscal
policy to ensure sustainability within the Eurozone proved to be the major
cause to the present crisis. Failure to ensure a strong coordination between
the fiscal and monetary policy stimulated a spending pattern which is
contrary to the convergence program.

The lack of a common monetary policy coupled with the loss of monetary
and exchange rate tools increased the vulnerabilities and tensions because
members of the Eurozone are constrained in how they respond to economic
shocks. External shocks and shocks that emanates within a zone are likely
to affect member countries asymmetrically, for an example during recession
countries are prone to suffer different macroeconomic fluctuations (Ahearn
et al, 2011).



6.2 Lessons for SADC

As SADC continue with its preparation to establish a Monetary Union, the
should entail the following crucial strategies to avoid what the Eurozone had
suffered recently


   A sound government finance and macro-economic policy remain
    preconditions for sustainable development.
A sound government finance and macro-economic policy is necessary to
reduce the risk of fiscal policy spillover to other member states and
complement EU monetary policy. This is also crucial to promote the


                                     22
flexibility (dampening business-cycle fluctuations) and adaptability of the
economy.


   A pool of funds to deal with adverse shocks in the region

The Eurozone need to adopt a pan-European approach oriented to
strengthen institutions and stimulate investment. There is evidence that
resources are available, but still governments are operating in silos,
therefore there is need to pool resources, reform budgetary procedures,
mobilise and leverage unused EU cohesion and structural funds, and
eliminate the country-by-country approach.


   The Fiscal Authority should enforce fiscal discipline
The Eurozone requires a down-top fiscal discipline approach on sovereign
governments. The top-down approach which is implemented through the
Stability and Growth Pact proved to be a failure in the Eurozone. Since an
injury to one is an injury to all, Fiscal Authority should be in a position to
instruct defaulting countries and enforce necessary austerity measures.
Fiscal discipline enforcement is important in the short-run to ease markets
and for the survival of the EU in the long run.


   Strict enforcement of deficit and public debt rules are needed.
SADC should enforce strict rules related to the fiscal deficit and public-
sector debt to avoid shocks that are similar to those that are affecting the
Eurozone.    This implies that SADC should be in a position to address
excessive deficits dynamics and debt levels timely. Therefore this calls for an
establishment of SADC fiscal union to complement the proposed monetary
union. Contrary, fiscal measures should implement with great caution
because shared responsibility for defaults could lead to divisions among
SADC members, causing some members to reconsider the costs and benefits
of membership.




                                      23
   Validation of fiscal and other data from member states
There a need for an assessment to validate data submitted potential member
countries of the SADC Monetary Union. There is evidence in the Eurozone
that governments like Greece did not only far surpassed agreed ceilings on
fiscal deficits and debt in a lingering way after joining the European
Economic and Monetary Union in 2001 but also fiddled their fiscal data to
secure membership in the union. SADC on the other hand still rely on the
updates (data) from members states and these data is not validated.



7.0 CONCLUSION

In order for the Eurozone to come out of the existing problem, leaders
should consider to implement reforms cantered on strengthening fiscal
coordination and integration in a way that caters for members’ autonomy to
make their own spending and tax decisions feeding to the EU. Such reform
should be coupled with the creation of liquidity facilities and active ECB’s
involvement in crisis management.




                                    24
   1. References


Afonso, José Roberto and Luiz de Mello, (2000), "Brazil: An evolving
federation", paper prepared for the IMF/FAD Seminar on
decentralization, Washington, DC.
http://www.imf.org/external/pubs/ft/2002/fiscal/afonso.pdf


Alesina, A. and T. Bayoumi (1996), “The Costs and Benefits of Fiscal
Rules: Evidence from U.S. States”, NBER Working Paper,No. 5614.


Auerbach, A. J. (2011), Long-Term Fiscal Sustainability in Major
Economies, BIS Annual Conference: Fiscal Policy and its Implications for
Monetary and Financial Stability, 23-24 June 2011, Lucerne, Switzerland


Bayoumi, T. and B. Eichengreen (1994), “The Political Economy of Fiscal
Restrictions: Implications for Europe from the United States”, European
Economic Review, Vol. 38, No. 3-4, pp. 783-91.


Blanchard,   O.   Dell’Ariccia,   G.   and   Mauro,   P.   (2010),   Rethinking
Macroeconomic Policy, IMF Staff Position Note SPN10/03, IMF


Bordo, M. D. Jonung, L. and Markiewicz, (2011), Does the Euro need a
Fiscal Union: Some Lessons from History.


Coeuré B and Jean P. (2005)             Fiscal   Policy in    EMU:Towards a
Sustainability and   Growth             Pact?     Bruegel     Working  Paper
2005/01December 2005

Collignon, S, (2004,a) Fiscal policy and Democracy; paper presented at
Monetary Workshop, Österreichische Nationalbank, Vienna; published as
ÖNB Discussion paper No. 4, November: www.stefancollignon.de




                                       25
Dixit, Avinash and Lambertini Luisa, (2001), “Monetary-fiscal policy
interactions and commitmentversus discretion in a monetary union”,
European Economic Review, vol. 45, 977-87.


Daniel, B. C. and Shiamptanis, (2009), Fiscal Policy in the European
Monetary Union, Central Bank of Cyprus, Working Paper Series 2009-1,
Central Bank of Cyprus


Debrun, X. Celasun, O. and Ostry, J. D. (2010), Debt Sustainability in
Emerging Market Countries: A “Fan Chart” Approach, Bank of Italy
Seminar on Public Finance. Bank of Italy


Dixit, A. and Lambertini, L. (2001), Monetary-Fiscal policy interactions
and commitment versus discretion in a monetary union, European
economic Review, vol 45, 977-987


Enzo   Croce   and   V.   Hugo   Juan-Ramon     (2003),   “Assessing   Fiscal
Sustainability: A Cross Country Comparison” IMF Working Paper
WP/03/145.


Franco, D. and Zotteri, S (2009), Ensuring fiscal sustainability: which role
for fiscal rules? The experience of European countries, Bank of Italy
research Department mimeo, Bank of Italy.


Kneebone, R.D. and K.J. McKenzie (1997), “Alberta’s Budgetary Response to
Fiscal Shocks”, in C.J. Bruce, R.D. Kneebone, K.J.McKenzie (eds.), A
Government Reinvented: A Study of Alberta’s Deficit Elimination
Program, Oxford University Press, pp. 231-47.


Levinson, A. (1998), “Balanced Budgets and Business Cycles: Evidence
from the States”, National Tax Journal, Vol. 51, No. 4, pp. 715-32.




                                     26
Michel, P. von Thadden, L and Vidal, J-P. (2006), Debt Stabilising Fiscal
Rules, European Central Bank Working Paper Series No 576, European
Central Bank

Mussa, M. (2010), Beware of Greeks bearing Debts, Peterson Institute for
International Economics, mimeo

OECD (2010), Restoring Fiscal Sustainability: Lessons for the Public
Sector, Public Governance Committee, OECD

Ostry, J. D. Ghosh, A. R. Kim, J. I. and Qureshi, M. S. (2010), Fiscal Space,
IMF Staff Position Note SPN/10/11, IMF



Richard Baldwin (2006), “The Euro Trade Effects”, European Central
Bank, Working Paper series No 594.



Rodden, J. (2004), Achieving fiscal discipline in federations: Germany
and EMU, Workshop paper: Fiscal Policy in EMU: New Issues and
Challenges, European Commission, Brussels, November 2004.

Shuknecht, L. (2004), EU Fiscal Rules Issues and Lessons from Political
Economy, European Central Bank Working Paper Series No 421, ECB.

Tanja Broz (2005), “The Theory of Optimum Currency Areas: A
Literature Review” The Institute of Economics, Zagreb.



Uhlig, H. (2002), One money but many fiscal policies in Europe: What
are the consequences?, Discussion paper 3296, Centre for Policy Research,
London.

von Hagen, J. (1991), “A Note on the Empirical Effectiveness of Formal
Fiscal Restraints”, Journal of Public Economics, Vol. 44, No. 2,pp. 199-210.




                                     27
APPENDIX 1

Current Account deficit compared with the level of gross government debt.




                                     28
29
30
APPENDIX 2


Figure 1: Budget Balance as % of GDP


  9%

  6%

  3%

  0%
                               DRC




                                                                                                        Mauritius
                                                                                        Malawi




                                                                                                                                                                                                                                Tanzania
                                                                                                                        Mozambique




                                                                                                                                                                                                                                                               Zimbabwe
                                                                                                                                         Namibia




                                                                                                                                                                                                                                               Zambia
        Angola




                                                                                                                                                            Seychelles
                                                                  Madagascar




                                                                                                                                                                                                               Swaziland
                   Botswana




                                           Lesotho




                                                                                                                                                                                     South Africa
  -3%

  -6%

  -9%

 -12%
                                                                                    2010                                             SADC Target

Source: SADC RED Paper, 2011



Primary Convergence Indicator Targets

Figure 2: Average Annual Inflation Rates (%)
  18%
  16%
  14%
  12%
  10%
   8%
   6%
   4%
   2%
   0%
                                                                                            Mauritius

                                                                                                           Mozambique
                              DRC




                                                                               Malawi




                                                                                                                        Namibia
         Angola




                                                                                                                                                                                                    Tanzania

                                                                                                                                                                                                                       Zambia

                                                                                                                                                                                                                                    Zimbabwe
                                     Lesotho




                                                                                                                                      Seychelles




                                                                                                                                                                                                                                                SADC Average
                  Botswana




                                                                                                                                                                         Swaziland
                                                     Madagascar




                                                                                                                                                   South Africa




                                                                                   Inflation Rate                                          SADC 2012 Target

Source: SADC RED Paper, 2011




                                                                                                        31
                                                                                                                            100%




                                                                      10%
                                                                            20%
                                                                                        40%
                                                                                              50%
                                                                                                    60%
                                                                                                          70%
                                                                                                                80%
                                                                                                                      90%




                                                                 0%
                                                                                  30%
                                                                                                                                                                                                                    -12%
                                                                                                                                                                                                                                                  0%
                                                                                                                                                                                                                                                       3%
                                                                                                                                                                                                                                                            6%
                                                                                                                                                                                                                                                                 9%




                                                                                                                                                                                                                           -9%
                                                                                                                                                                                                                                  -6%
                                                                                                                                                                                                                                          -3%
                                                       Angola                                                                                                                                                                            Angola

                                                    Botswana                                                                                                                                                                       Botswana

                                                         DRC                                                                                                                                                                               DRC

                                                      Lesotho                                                                                                                                                                           Lesotho




     Source: SADC RED Paper, 2011
                                                                                                                                                                       Source: SADC RED Paper, 2011
                                                      Malawi                                                                                                                                                                     Madagascar

                                                    Mauritius
                                                                                                                                                                                                                                        Malawi
                                                                                                                                                                                                      2010




                                    2010
                                                                                                                                   Figure 4: Public Debt as % of GDP
                                                  Mozambique
                                                                                                                                                                                                                                   Mauritius




32
                                                                                                                                                                                                                                                                      Figure 3: Budget Balance as % of GDP




                                                     Namibia
                                                                                                                                                                                                                                 Mozambique

                                                    Seychelles
                                                                                                                                                                                                                                        Namibia
                                                  South Africa
                                                                                                                                                                                                      SADC Target




                                                                                                                                                                                                                                   Seychelles




                                    SADC Target
                                                    Swaziland
                                                                                                                                                                                                                                 South Africa
                                                     Tanzania
                                                                                                                                                                                                                                   Swaziland
                                                      Zambia
                                                                                                                                                                                                                                    Tanzania
                                                    Zimbabwe
                                                                                                                                                                                                                                        Zambia
                                              SADC Average
                                                                                                                                                                                                                                   Zimbabwe
Secondary Convergence Indicators Targets

 Figure 5: Reserves in months of import cover
  16

  14

  12

  10

   8

   6

   4

   2

   0
                                                                                                    Mauritius

                                                                                                                            Mozambique
                                                  DRC




                                                                                  Malawi




                                                                                                                                                                                                                                                           Tanzania
                                                                                                                                                      Namibia




                                                                                                                                                                                                                                                                                 Zambia

                                                                                                                                                                                                                                                                                                   Zimbabwe
          Angola

                            Botswana




                                                                                                                                                                          Seychelles
                                                              Lesotho




                                                                                                                                                                                                                                   Swaziland




                                                                                                                                                                                                                                                                                                                     SADC Average
                                                                                                                                                                                                     South Africa
                                                                                              Import Cover 2010                                                                                     SADC 2012 Target

 Source: SADC RED Paper, 2011



 Figure 6: Current Account Balance as % of GDP
   15.0

   10.0

    5.0

    0.0
                                                                                                                Mauritius
                                                        DRC




                                                                                           Malawi




                                                                                                                                         Mozambique




                                                                                                                                                                                                                                                                      Tanzania

                                                                                                                                                                                                                                                                                          Zambia
                                                                                                                                                                Namibia




                                                                                                                                                                                                                                                                                                          Zimbabwe
                   Angola

                                       Botswana




                                                                                                                                                                                                                                                                                                                                SADC Average
                                                                                                                                                                                                                                               Swaziland
                                                                        Lesotho




                                                                                                                                                                                       Seychelles

                                                                                                                                                                                                                    South Africa




   -5.0

  -10.0

  -15.0

  -20.0

  -25.0

  -30.0
                                                                                                                                           2009                               2010
  -35.0
 Source: SADC RED Paper, 2011




                                                                                                                                    33

								
To top