19 June 2015

Debt Worries? Not Asia, Says IMF

June 17, 2015

A new report suggests there is scope for governments to borrow more, with one exception. 

A toxic cocktail of debt, deflation and demographics is stalking some of Asia’s biggest economies. Yet according to International Monetary Fund (IMF) researchers, the region still has plenty of room to ramp up government borrowings, with one notable exception.

Titled “When should public debt be reduced?” the recent IMF staff paper has ranked South Korea second only to Norway in its “fiscal space,” defined as the difference between the debt limit and the actual debt-to-gross domestic product (GDP) ratio, which for South Korea was calculated at 241 percent compared to Norway’s 246 percent.

A number of other Asian nations ranked in the top 10, including third-rated New Zealand (228 percent) and fourth-ranked Hong Kong (224 percent). Despite its heated political debate over budgets, Australia placed sixth at 214 percent, followed by Taiwan at 209 percent and 10th-ranked Singapore (193 percent), according to the paper’s authors Raphael Espinoza, Atish Ghosh and Jonathan Ostry.

While the “green zone” economies had estimated fiscal space exceeding 124 percent, Japan stood out in the “red zone” next to Italy, Greece and Cyprus with zero fiscal space, being classified at “grave risk” of a crisis.

According to the authors, the global financial crisis caused a sharp increase in advanced economy public debt, “on a scale unprecedented in peacetime.” From a relatively modest 53 percent of GDP at the end of 2007, public debt blew out to almost 80 percent by the end of 2012, with much of it attributed to increased welfare spending and reduced revenues, rather than investments in public infrastructure.

Along with the deterioration in public finances has come declining output growth. Projections for 2017, a full decade after the onset of the crisis, indicate that “advanced economies will have barely half their pre-crisis growth rates,” the authors note.

Amid a growing debate on whether governments should ramp up infrastructure spending to help restore growth or instead focus on paying down debt, the authors suggest an alternative approach of simply “living with the debt” for those countries with ample fiscal space.

For nations such as South Korea and Australia, governments could consider paying down public debt “opportunistically,” simply allowing the debt ratio to decline through growth, rather than raising taxes or cutting otherwise productive government expenditure. This is because for such nations, “the distortive cost of policies to deliberately pay down the debt is likely to exceed the crisis-insurance benefit from lower debt,” the authors suggest.

However, should such nations enjoy an asset price boom, such as seen previously with Australia’s mining boom, “the message must be that they should seize the opportunity to pay down public debt” rather than blowing it all on lavish spending.

“Debt should be used to smooth the taxes necessary to finance lumpy government expenditures,” the authors state, suggesting that governments debt-finance projects where the social marginal product “earns at least the market interest rate.”

But before policymakers start rushing out to build the infamous “bridges to nowhere,” the authors warn that a high debt level “represents a deadweight burden on the economy, reducing both its investment potential and its growth prospects.” This is because a higher debt level and associated taxation burden crimps public and private investment, thereby slowing economic growth.

“Stress testing public-sector balance sheets is essential to form judgments at the country level of what constitutes a safe public sector debt level,” they argue. Should a “shock” occur with public debt already high, the troubled nation may face a heavy penalty as sovereign risk premiums rise, and in extreme cases “a shutout from markets would ensue,” the authors warn.

“There is no one-size-fits-all message: be it to pay down the debt to reduce the risk of a funding crisis or to live with the debt, letting the debt ratio decline organically through growth. Countries in the yellow and red zones in terms of fiscal space will not be in a position to ‘live with the debt’. But nor is it the case that countries with ample space – those firmly in the green zone – should rush to pay down their debt,” the authors conclude.

For the Asia-Pacific’s less indebted nations, the message appears to be that government borrowings for infrastructure spending are worthwhile, even at the cost of higher debt. With both South Korea and Australia’s central banks recently cutting official interest rates to record lows to spur increased activity, the unofficial IMF support for increased government spending could prove valuable.

But for Japan, with gross public debt at an estimated 230 percent of GDP (net government debt is a relatively more manageable 130 percent), the authors indicate that the additional fiscal consolidation publicly promised by Tokyo is essential.

According to a recent report by the McKinsey Global Institute, China’s total debt burden has also soared to some 282 percent of GDP, much of it linked to a faltering property market.

As the IMF’s deputy managing director Mitsuhiro Furusawa noted at a recent Tokyo event, “aging populations and falling birth rates are shrinking labor forces in more and more countries, [causing] economic growth to drop. Sound fiscal management becomes more challenging in the face of these demographic changes,” including for Japan, South Korea, Hong Kong, Singapore and China.

Furusawa called for “growth-friendly fiscal policy” measures, such as spending on infrastructure, education, healthcare and social safety nets, while shifting taxes to those that are “least distortionary,” with a focus on consumption and property, and broadening tax bases.

Debt might not always be bad, but most of Asia will be hoping to stay in the “green zone” for a while longer.

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