South Asia: Is There a Need for Counter-cyclical Fiscal Policy?

June 9, 2009

  • Is there a need for counter-cyclical fiscal policy?
  • Infrastructure spending can provide an effective stimulus
  • South Asia should expand safety nets

June 9, 2009 — The ongoing global financial crisis has significantly reduced South Asia’s growth prospects for 2009-10. “The initial fear of high inflation has now been replaced by declining growth and the ensuing impact on South Asia’s poor,” said Ejaz Ghani, World Bank’s Economic Advisor for South Asia Region. The poorest segment is more vulnerable to economic downturns.

Unlike developed economies, South Asian countries do not have automatic stabilizers or social safety nets that take effect to minimize adverse effects during economic slowdowns,” he added. Thus the question South Asian policymakers must consider is how to use discretionary fiscal measures to boost demand and protect growth, consistent with medium-term macroeconomic stability. “Given the high levels of public debt, the options are limited for most South Asian countries.”

In developed countries, discretionary fiscal policies have typically been counter-cyclical - that is, taxes are cut and spending increased during downturns to promote economic recovery and growth. In emerging economies, unfortunately, fiscal policies tend to be pro-cyclical. Governments are too complacent to tighten fiscal policies during good times, which leave less room for fiscal stimulus during downturns.

In order to appropriately use fiscal stimulus to protect growth and the poor, South Asian countries need to answer the following three questions,” said Ghani.

First, is there a need for counter-cyclical fiscal policy in South Asia?

Second, what proportion of the fiscal stimulus should be spent on physical infrastructure and human infrastructure including social safety nets?

Third, is there an exit strategy and will such measures meet the criteria of the 3Ts (timely, temporary and targeted) in ensuring the success of the fiscal stimulus program?

Is there a need for counter-cyclical fiscal policy?

In the current credit crunch environment, a loose monetary policy is less powerful in protecting growth. This is illustrated by the experience of the United States, where the Federal Reserve began with monetary easing which was quickly followed by fiscal stimulus by the Department of the Treasury. “However, discretionary fiscal measures are typically slower to arrive than monetary policy responses, which entail changes in interest rates or exchange rates,” said Ghani.

South Asian countries may have missed the opportunity to strengthen their fiscal position during good times, which would have enhanced their capacity to counter downturns. Timing is of the essence. Any counter-cyclical policy needs to be tailored to conditions in individual countries. The capacity of a country to undertake counter-cyclical fiscal policy depends on its ability to finance the resulting fiscal deficit, which is easier when public debt is low and external balances are in good shape.

Countries need to be careful that fiscal packages introduced to encourage economic activity during a slump should be phased out as the upturn begins. “If fiscal measures become permanent, public debt creeps upward,” warned Ghani.

It is essential to protect core public spending in social and physical infrastructure in the face of declining revenues. Spending targeted at vulnerable groups may need to increase. This would require reallocation of expenditures from other areas, as well as greater reliance on borrowing or grants. However, it will always be a risky proposition especially for countries with a weak track record of controlling spending and where there are fears of inflation. Once introduced such spending may be hard to reverse.

Infrastructure spending can provide an effective counter-cyclical stimulus in South Asia.

Counter-cyclical public spending in infrastructure such as roads, schools, and hospitals, is an effective tool both to provide the foundation for rapid recovery and job creation. However, dramatic decline in availability of international financing for infrastructure has already been felt across South Asia. Specific infrastructure policy reforms will depend on the fiscal conditions in that particular country. Countries such as Pakistan and Sri Lanka with no fiscal space will have fewer options.

The main difficulty that major infrastructure projects face is the long process involved in its preparation, design, construction, and review. In addition, countries should not trade the potential of long-term sustainable growth for short-term benefits. Infrastructure investments should be subject to careful economic and governance analysis to ensure that they are economically sound over the long-term and funds are not misused.

South Asia should expand safety nets as part of counter-cyclical fiscal policy

Social safety net programs in South Asia suffer from many weaknesses that make them ineffective in reaching the poorest people and households affected by disasters. Bhutan and Afghanistan do not have public safety nets while Pakistan, Sri Lanka, and Nepal have one or two cash-transfer based safety net programs. On the other extreme are India and Bangladesh with several safety net programs. Program coverage varies, from 2% of the population in Pakistan to 30% of the population in India to almost 40% of the population in Sri Lanka.

However, some of these safety net programs do not efficiently benefit the poorest segments of society. “There are considerable leakages and distortions in many of these programs. Food price controls take away the incentive of the farmers to increase food output. Loan waivers weaken the financial sector. These policies are neither good for the poor nor good for growth. Policy makers should seriously consider cash transfer programs,” said Ghani.

Global experience shows that countries with effective safety nets, which strategically target the poorest, are most successful in responding to crisis. It is easier to scale up an existing safety net program than to design a new one, particularly when responding to a current crisis.

Fiscal Stimulus: Timely, Targeted, and Temporary

According to a number of Economists, a fiscal stimulus program for countering an economic downturn needs to fulfill the 3-Ts; it needs to be timely, targeted, and temporary in order to be effective.

A recent IMF study (World Economic Outlook 2008) shows that on average, for all economies, a discretionary stimulus package equivalent to 1 percent of country's GDP is associated with GDP increases of about 0.1 to 0.2 percent above the amount of the initial investment. The challenge for policymakers is to ensure that the fiscal policy measures constituting the stimulus — an increase in discretionary spending or reductions in taxes — are delivered quickly. Tax cuts are less effective in comparison to spending increases. However, spending increases that make debt unsustainable are likely to cause output to fall, not rise.