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This volume discusses fiscal performance and structural reform in the fiscal area in Latin America since the 1990s, with emphasis on Argentina, Brazil, Chile and Mexico. It is based on the proceedings of a seminar on fiscal adjustment in Latin America organised by the Economics Department of the OECD on 10 November 2004 in the context of its work programme with non-member countries in Latin America. These four countries have relatively diverse experiences with fiscal adjustment, which is on-going, underpinning the consolidation of macroeconomic stabilisation in the region, and face a number of common challenges in the years to come.
Assessment and main challenges
Most countries in Latin America have made considerable progress over the years to put their public finances in order. This has been essential for macroeconomic consolidation, and the perception that fiscal discipline is a pre-requisite for sustained, resilient growth appears to be well entrenched in many countries. Underlying fiscal adjustment is a concomitant effort by the more reform-minded governments in the region to strengthen the institutions for macro-fiscal management, reining in sub-national largesse, enhancing transparency and boosting confidence in fiscal policymaking.
But, despite progress in many areas, numerous challenges remain. On expenditure, the overriding challenge is to increase both flexibility in the allocation of budgetary resources, against a backdrop of widespread revenue earmarking in some cases, and the quality of public spending. This also requires dealing pro-actively with the future expenditure pressures associated with the ageing of the population – akin to the OECD experience – and putting in place adequate, cost-effective social safety nets to cushion vulnerable groups against the adverse consequences of macroeconomic volatility, which remains high in the region. Many countries already spend a relatively high share of GDP on social programmes, given their income levels, but social outcomes are often incommensurate with high spending. Efforts to improve the targeting of social programmes, in particular income transfers to vulnerable social groups, and to ensure that the target population has access to services are relatively recent in the region, but are paying off. In any case, careful empirical analysis is, and will continue to be, needed to assess the efficiency of government spending on social programmes, an area where evidence remains predominantly anecdotal.
At the same time, the need for public investment in infrastructure building and upgrading should not be underestimated. Social rates of return are often high in many infrastructure projects in the region due to a still wide “infrastructure deficit” in many areas, justifying government intervention. Many governments are engaging in public-private partnerships (PPP) to finance investment, but will need to guard against the contingent liabilities that might arise due to poor governance and/or the inadequate sharing of risks between the government and its private-sector partners. Moreover, expenditure rigidity, with an increasing weight of statutory and non-discretionary spending in the budget, continues to constrain fiscal adjustment and the ability of governments to respond to changing macroeconomic conditions and to reallocate scarce budgetary resources to finance more meritorious programmes.
On the revenue side, the main challenges are to broaden tax bases, reducing reliance on the more distorting taxes, such as those on financial transactions and enterprise turnover and payroll, and to improve tax administration in many countries. Revenue earmarking and automatic transfers to sub-national levels of government are pervasive in some countries. As a result, when the central government increases its revenue-raising effort in support of fiscal consolidation, part of this revenue is transferred to the sub-national jurisdictions, which are often free to spend it. The experience of Brazil illustrates this phenomenon, where for many years the federal government focused its collection effort on taxes that are not shared with the states and municipalities. The taxation of exports in Argentina is another example of reliance on distorting taxes whose revenue is not shared between the central government and the provinces. In some countries, revenue-to-GDP ratios are too low, reflecting the government’s inability to bring more dynamic sectors of the economy into the tax net. As suggested by most of the case studies in this volume, the agenda for reform in the tax area is vast in the region.
On public debt management, the main challenge is for governments to keep indebtedness at a sustainable level, especially where foreign currency-linked instruments account for a large share of the stock of bonded debt. Attention should therefore be focused not only on the size of the public debt in relation to GDP, but also on its structure, including its average maturity, currency composition and indexation mechanisms. A healthy debt structure reduces vulnerabilities, but it is important to recognise that no liability management strategy can succeed if the debt-to-GDP ratio remains high. At the same time, a sustained reduction in public indebtedness is only possible when based on credible policies. Many countries have failed to generate the required primary budget surpluses to offset the impact on the debt dynamics of the recognition of previously unrecorded liabilities, usually as a result of court rulings; the realisation of contingent liabilities, including in the form of support for bank recapitalisation and inadequate risk-sharing with the private sector in PPP projects; or the short-term transition costs of structural measures, including pension reform. These reforms can do much to boost transparency in fiscal operations and to improve the public finances over the longer-term, despite the short-term costs they create for the budget.
The thematic chapters
This volume is divided in two parts. The first deals with cross-country thematic issues, including the role of public indebtedness, the market’s perception of fiscal adjustment and the institutional underpinnings of fiscal consolidation. The second is devoted to case studies for the four countries under examination, highlighting successful experiences, areas where further reform is needed and, to the extent possible, comparing and contrasting the Latin American experience with that of OECD countries.
To set the stage, the overview chapter by Luiz de Mello and Nanno Mulder discusses general trends and stylised facts about fiscal adjustment in Latin America since the 1990s, with particular emphasis on Argentina, Brazil, Chile and Mexico. The chapter highlights the considerable diversity in the size and scope of government in these countries, as well as in the level of public indebtedness, which continues to be a source of vulnerability in the higher-debt countries in the region. The authors argue that in most countries the composition of fiscal adjustment has been tilted towards hiking revenue and compressing public investment, rather than retrenching current spending commitments. This imbalance is likely to affect the sustainability of adjustment over time. Moreover, the chapter discusses the scope for using fiscal policy in short-term demand management, arguing that the fiscal stance continues to have a bias towards pro-cyclicality in most cases, reflecting to a large extent high indebtedness and the ensuing vulnerability to shocks in “bad” times, as well as failure to contain the rise in expenditure in “good” times financed by with cyclical revenue windfalls. Failure to smooth the effects of commodity price volatility on the public finances also impedes counter-cyclicality. The chapter concludes by noting that budget and political institutions have a bearing on the government’s ability to deliver long-lasting fiscal adjustment, the level of indebtedness it can sustain and the extent of counter-cyclicality it can afford.
The chapter by Lisa Schineller focuses on the market’s perception of fiscal adjustment in the region. It reviews the main methodological features of sovereign credit rating and discusses the performance of several Latin American credits. The chapter argues that the sovereign rating methodology is both quantitative and qualitative, reflecting a country’s ability and willingness to repay debt on time and in full. It incorporates an assessment of political/institutional credibility and the transparency and predictability of policy by the current and future administrations. In this respect, the author argues that the level of government debt per se does not “determine” a rating, which is affected by political and institutional strengths, the fiscal authorities’ ability and willingness to adjust policy to shocks or changing economic conditions, the government’s policy track record, the structure of public debt (i.e. domestic versus foreign currency, maturity), the depth of local capital markets, the sources of external vulnerability, and the economy’s growth prospects, among others. In his comments to the chapter, Patrick Lenain focuses on whether credit ratings have contributed to reducing information asymmetry in the case of the Latin American borrowers examined by Lisa Schnieller.
The case studies
The Argentine experience is examined by Pablo Guidotti, who argues against the commonly held view that fiscal management was irresponsible in the 1990s and that the rise in public indebtedness was central to the 2001 crisis. Instead, the author contends that the deterioration of Argentina’s public debt dynamics was due to the implementation of pension reform in the early 1990s, the costs to the budget of refinancing at market rates the debt that had been restructured at concessionary rates under the Brady deal of 1992, and the recognition of previously unrecorded liabilities (fiscal “skeletons”). Instead of being perceived by the markets as instrumental in improving Argentina’s fiscal accounts over the long term, despite its associated short-term costs, the chapter argues that pension reform contributed to the deterioration of investors’ perception of debt sustainability in an environment of macroeconomic volatility and financial crises in other emerging market economies. In his comments to the chapter, Oscar Cetrángolo emphasises the need for further pension reform, including the introduction of a social safety net for the elderly, given the low coverage of Argentina’s “second-pillar” fully-funded regime, a phenomenon that is pervasive in several Latin American countries that have engaged in similar pension reforms.
When reviewing the experience of Brazil, the chapter by Fabio Giambiagi and Marcio Ronci examines the country’s public-sector accounts since the mid-1990s and argues that the authorities’ growing awareness of the need for fiscal discipline was as important as the pace of structural reforms implemented in the period for understanding the dynamics of public indebtedness. Fiscal adjustment intensified after the floating of the real in 1999, in an effort to make fiscal policy consistent with the new exchange-rate regime. The chapter discusses the composition of fiscal adjustment, based predominantly on hiking revenue, against the backdrop of Brazil’s already high tax-to-GDP ratio, and concludes that fiscal austerity will need to be entrenched in fiscal institutions to make hard-won fiscal discipline sustainable over the longer term. In his comments to the chapter, Juan Carlos Lerda suggests that pressure for higher spending, especially in the social area, is likely to constrain the government’s ability to sustain over the longer term the high primary budget surpluses needed to reduce Brazil’s debt-to-GDP ratio.
Chile’s experience is reviewed by Jose Pablo Arellano, who discusses the driving forces behind the move from chronic budget deficits to structural surpluses and low public indebtedness. The author argues that structural reform since the return to democracy in 1990 has been facilitated by a high degree of political cohesiveness. A key element behind Chile’s track record in fiscal rectitude has been the progressive concentration of policymaking powers in the fiscal area on the executive branch of government. The extent of central government control over sub-national finances is in sharp contrast with the other countries examined in this volume. The ban on revenue earmarking is highlighted as a means of rendering fiscal management more flexible. The author posits that the use of fiscal policy as a demand management instrument is due to the introduction of mechanisms to deal with the impact on the budget of fluctuations in copper prices and in the business cycle, an achievement that owes much to Chile’s low level of public indebtedness. Financial market scrutiny, an independent central bank and reliance on independent expert panels to set the key parameters to be used in the application of the fiscal rule and the copper price stabilisation mechanism have enhanced transparency and discipline in fiscal policymaking. In his comments to the chapter, Joaquim Oliveira Martins discusses the policy complementarities, particularly in the social and fiscal areas, that may contribute to enhancing Chile’s growth potential.
The Mexican experience is analysed by Rogelio Arellano and Fausto Hernández. During the 1970s and early 1980s, persistent budget deficits left the economy ill-prepared to implement the macroeconomic adjustment required in the aftermath of the 1982 debt moratorium. Since then, the authorities have worked towards achieving and sustaining fiscal discipline, including after the 1994-95 Tequila crisis. The chapter discusses different scenarios for Mexico’s debt dynamics, arguing that the country has been relatively successful at containing expenditure pressures, while facing important challenges. These include the need to ensure fiscal sustainability over the longer term, given the existence of remaining unrecorded contingent liabilities associated with the public enterprises and the pension system, and to boost revenue performance, against a backdrop of continued reliance on oil revenue. The chapter also discusses the microeconomic aspects of fiscal adjustment, focusing on the need for improving the cost-effectiveness of government spending on infrastructure and social programmes. In her comments to the chapter, Bénédicte Larre argues that it would be interesting to measure the real effort at fiscal consolidation made by the successive administrations through discretionary action, a task that would require the calculation of structural fiscal indicators as those available at the OECD for a number of its Member countries.
Panel discussions
In recognition of the political-economy dimensions of fiscal adjustment, a panel discussion followed the presentation of the case studies. The panellists were asked to discuss their experiences in policymaking in periods of fiscal adjustment. The panel was chaired by Val Koromzay and included José Pablo Arellano, Mario Blejer, Jorge Braga de Macedo, Pablo Guidotti and Teresa Ter-Minassian, whose experience as a senior negotiator and overseer of several IMF-supported programmes in the region offered a complementary perspective on the political economy of reform to that of the other panellists.
Various panellists stressed the fragilities that remain in fiscal adjustment in the region, as well as noting that public opinion support for reform has waned in several countries in recent years. While acknowledging that fiscal adjustment has been impressive in some countries, in the sense of delivering a move from chronic budget deficits to sizeable surpluses in a relatively short time span, the panellists noted that the main weakness of fiscal adjustment in the region has been the reliance on cuts in public investment and, in some cases, social safety nets, which are difficult to sustain over time. Revenue-raising measures have often focused on distorting taxes, such as those on financial transactions and enterprise turnover. Public opinion support has faltered, encouraging the adoption of populist measures in some cases, because the reforms’ pay-off in terms of higher, more resilient growth and an improvement in the quality of public services and living standards, has not always materialised as swiftly as expected.
Panellists were of the view that several conditions need to be fulfilled for fiscal adjustment to be sustainable. These include:
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The process of discussing, approving and implementing structural reform is very important, an area where the legislature has a key role to play. To this end, policymakers should create constituencies in support of reform, which can be achieved by adequately compensating those who are likely to be affected most adversely by the reforms, including through the introduction of social safety nets, as well as communicating effectively to society at large and other stakeholders the benefits of reform.
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Although budget institutions are deeply rooted in history and legal traditions, control over the budget process should preferably be concentrated in few stakeholders who have strong incentives to commit themselves to fiscal discipline.
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The timing of reform also affects its likelihood of success. While financial stress highlights the urgency of reform, it may also make fiscal consolidation less likely to be sustainable, including by encouraging a focus on short-term, one-off measures which may not be conducive to fiscal discipline over the longer term.
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The maintenance of fiscal discipline requires sound institutions, which can make fiscal policymaking predictable and transparent. The introduction of fiscal rules, with the enactment of “Fiscal Responsibility” legislation in many countries, is not a sufficient condition for the strengthening of institutions, unless the law is respected both in letter and spirit. A constructive relationship between the executive branch of government and the legislature and the judiciary is also important to make the process of institutional reform more co-operative and therefore less prone to capture by interest groups.
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For further information please contact the South America Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was edited by Luiz de Mello.
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