Faced with weaker export prospects, an impending rise in global interest rates, and fragile financial market sentiment, developing countries like India need to rebuild fiscal buffers to support economic activity in case of a growth slowdown, the World Bank has said in its latest edition of Global Economic Prospects.
“Many developing countries need to rebuild fiscal space over the medium term, at a pace tailored to country conditions. These include cyclical conditions and constraints to monetary policy, including elevated inflation or financial stability risks,” the report said.
Noting that fiscal policy in developing economies has become increasingly countercyclical (or less procyclical) during the 2000s, the report said this allowed developing economies to build fiscal space in the run-up to the Great Recession of 2008-09, which was then successfully used for stimulus.
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As a result, fiscal space has narrowed and has yet to be restored to pre-crisis levels, the report said.
In countries with elevated domestic debt or inflation, monetary policy options to deal with a potential slowdown are constrained; the report said adding that in the foreseeable future, these countries may need to employ fiscal stimulus measures to support growth.
But many developing countries have less fiscal space now than they did prior to 2008, having used fiscal stimulus during the global financial crisis.
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And in recent years, private debt levels have risen substantially in some developing countries, it added.
A key finding from the analysis in the report is that in countries where debt and deficits have widened from pre-crisis levels, each fiscal dollar spent on activities designed to boost consumption and national income will have roughly a third less impact than it did in the run-up to the global financial crisis.
Because the so-called fiscal multiplier effect is weaker now for many developing countries, they need to rebuild budgets in the medium-term, at a pace determined to country-specific conditions.
For a number of oil-importing countries, lower oil prices offer a chance to improve fiscal positions more quickly than might have been possible before mid-2014, it said.
“With oil likely to remain cheap for some time, oil-importing countries should lower or even eliminate fuel subsidies and rebuild the fiscal space needed to carry out future stimulus efforts.
On the policy front, both the size and the quality of fiscal deficits matter, as do spending decisions,” said Kaushik Basu, Senior Vice President and Chief Economist at the World Bank.
“Emerging market economies would do well to invest in infrastructure and support social schemes vital to poverty reduction.
“Such policies can raise future productivity and reduce the fiscal deficit in the long run. This year’s Global Economic Prospects now goes beyond prediction and deepens our understanding of our global economic predicament,” Mr. Basu added.
“The rebuilding of fiscal buffers will provide the room required to support activity during times of economic stress.
The need for additional fiscal buffers is more pronounced now in an environment of uncertain growth prospects, limited policy options, and likely tighter global financial conditions,” said Ayhan Kose, Director of Development Prospects at the World Bank.
According to the report, governments must have the resources (ie fiscal space) to be able to increase spending during cyclical downturns.
This is easier when fiscal space is ample — governments run surpluses and their debt is low.
In addition, ample space appears to support more effective fiscal outcomes.
In particular, fiscal multipliers (i.e., the impact of fiscal policy on overall activity) in emerging market and frontier market economies tend to be larger when fiscal space is wider, it said.