The global economic crisis: how to enhance fiscal and policy space in developing countries

Posted by Anis Chowdhury on 11 May 2009

The global economic crisis: how to enhance fiscal and policy space in developing countries

Iyanatul Islam

Anis Chowdhury[1]


Many developing countries lack “policy” and “fiscal” space to deal with the global economic crisis. As a result, ‘there are large asymmetries in global economic policies – counter-cyclical policies are pursued by developed countries, while most developing countries pursue pro-cyclical policies’.[2] Thus, the re-creation of fiscal and policy space for developing countries on a sustainable basis needs to be a central feature of the global development agenda. This would require diversification of the economy and widening of the domestic revenue base. While these are longer term issues, what is urgently needed is the unconditional access to external financing at concessional terms, preferably in the form of grants to mitigate the dire consequences of the current global crisis.

Policy Space: two interpretations

The first strand argues that multilateral rules under the WTO-based international trading system have constrained the capacity of developing country governments to pursue industry and trade policies that are compatible with national aspirations. This thesis is associated with the work of UNCTAD.[3]

A second strand of thinking on policy space – which is the focus of this paper - stems from the implications of capital account liberalization in developing countries with access to private capital markets. Such access can lead to so-called ‘liability dollarization’. This means that the private sector acquires liabilities in foreign currency, although assets are denominated in local currency. This makes the balance sheet of the private sector highly sensitive to shifts in the exchange rate. Significant exchange rate depreciations can lead to large and negative wealth effects as liabilities increase in value relative to assets. Such wealth effects often cannot offset the positive impact on competitiveness engendered by exchange rate depreciations.

Developing countries with access to private capital markets often experience so-called ‘sudden stops’ when there is an unanticipated cessation of capital flows. ‘Sudden stops’ reflect failures and shortcomings in international capital markets rather than policy errors by developing country governments.

The presence of liability dollarization – as well as the lack of preparedness - acts as a binding constraint on policy space. Monetary authorities develop a ‘fear of floating’ and thus are reluctant to allow the depreciation of the exchange rate and engage in expansionary policies because of the rather large negative wealth effect stemming from liability dollarization.

Fiscal space: two interpretations

The first view, associated mainly with the IMF, defines the fiscal space as ‘the room in a government’s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy’.[4] Options to enhance fiscal space that meets the sustainability criteria include: increasing the efficiency with which public expenditure programs are delivered, re-allocating government expenditure programs from low priority areas, such as defence, to high priority areas, such as health, education and infrastructure, using of proceeds from privatisation to fund particular initiatives, public-private partnerships, the use of external grants and raising the revenue share in GDP.

These options have various complications. Raising the revenue share in GDP is a long-term agenda and requires resolute commitment to tax reform. Reallocation of public expenditure and efficient utilisation of existing resources are easier said than done, in view of institutional and political impediments. The use of external grants as a predictable and long-term source of development finance has not materialised in practice.

The use of deficit financing is an area where the IMF approach has demonstrated a great deal of circumspection. Fiscal deficits can be financed by borrowing from domestic and external sources and by seignorage or money creation. The risk of the former is that it can lead to unsustainable debt service obligations, while the risk of the latter is that it can lead to high inflation.

Some analysts associated with the UN proffer an alternative approach.[5] They contend that the orthodox approach is dominated by fiduciary concerns about sustainability at the expense of development objectives. Thus, it focuses on the attainment of short-run fiscal targets (usually using such indicators as debt/GDP ratios and fiscal deficit/GDP ratios). Instead, the primary goal of fiscal policy should be mobilisation of resources to finance public investment to support long run growth and attain MDGs.

The available evidence suggests that public investment as a share of GDP has fallen precipitously across many low and middle-income developing countries. One of the reasons for this decline is the first generation ‘structural adjustment programs’ pioneered by the Bretton Woods Istitutions (BWIs). In the quest to attain fiscal consolidation, developing countries were advised to focus on overall fiscal targets. Little attempt was made to distinguish between the composition of the public budget, or current vs. capital expenditure, and its overall size.

One consequence was cuts in public infrastructure expenditure to meet overall fiscal targets as it is politically difficult to cut current, non-discretionary expenditure pertaining to wages and salaries of civil servants as well as income transfer programs. The expectation of the BWIs was that private investment would increase to compensate for the shortfall in public investment, but this not happened.

The critique of the IMF approach has merit. But if developing countries are hampered by poor initial conditions leading to high fiscal deficits and debt service obligations, what are the options for increasing fiscal space in a sustainable fashion?

The option of foreign-aid financed interventions to scale up public investment has some inherent limits. The external and volatile nature of aid can undermine country ownership and increase vulnerability to shocks.

Thus, there has to be a renewed commitment to domestic resource mobilization in developing countries to increase fiscal space. Here, the evidence is disappointing. One study finds that the share of revenue in GDP for all low-income countries fell between 1990 and 2004 and is below the 15% benchmark proposed by the IMF.[6]

This development can be attributed to several factors. Trade liberalisation, by reducing tariffs, has eroded a traditional and major source of revenue in developing countries. This ‘fiscal shock’, amounting to 2% of GDP according to some estimates, has not been compensated by other sources of tax revenue, most notably value-added and income taxes, mainly because of limited institutional capacity and of lack of political will.

High aid dependence in some developing countries seems to have reduced tax efforts. The global agenda on downsizing the public sector, the need to provide tax incentives to attract foreign direct investment and the rise of international tax havens have all worked against the idea of increasing the share of revenue in GDP through the taxation system.

Thus, many developing countries face a so-called ‘tax gap’ in which their actual tax collection efforts fall well below their potential. This is a major development agenda that deserves renewed attention in light of continuing debates on lack of fiscal space in developing countries.

Coping with the problem

As the experience of some successful examples of crisis management in Latin American and Asian countries have shown, it is possible to pursue counter-cyclical policies to mitigate external shocks by triggering restrictions on capital flights. It is also possible to supplement the policy space thus created with enhanced fiscal space. It is done though instituting some degree of ‘self-insurance’ by accumulating fiscal resources during ‘boom’ periods and using such resources to finance expansionary policies or targeted interventions during a downturn. It needs to be emphasised that ‘self-insurance’ schemes, especially when held in the form of low interest-bearing foreign exchange reserves, can be costly and inefficient. Reducing costly and inefficient forms of ‘self-insurance’ requires regional and global cooperation in undertaking reforms to tackle shortcomings in global capital markets. This, however, is a long-term agenda.

What is needed now is an external financing facility for developing countries to support their countercyclical interventions. Since the current crisis is not caused by developing countries, and the shrinkage of their fiscal and policy space is mainly due to exogenous factors, they should not be forced to bear the burden of recovery by increasing their external or internal debts. Hence, the external financing should be largely in the form of grants. Additionally, developing countries should not face undue barriers to entry to the industrial country markets. These initiatives will lead to a fair distribution of the adjustment costs unleashed by the global recession.[7]


[1] Iyanatul Islam, ILO, Geneva and Griffith University, Australia. Anis Chowdhury, UN-DESA, New York and University of Western Sydney, Australia. The views expressed here are strictly personal and do not necessarily reflect the views of the United Nations or any of its agencies/funds/programs.

[2] Commission of Experts of the President of the UN General Assembly on reforms of the international monetary and financial system, January 6, 2009

[3] Overseas Development Institute (2007) ‘Policy Space: Are WTO Rules Preventing Development?’ Briefing Paper, January: London.

[4] Heller, P (2006) ‘The Prospects of Creating ‘Fiscal Space’ for the Health Sector’, Health Policy and Planning, 21(2): 75-79

[5] Roy, R, and A. Heuty. (eds.) (2009) Fiscal Space: Policy Options for Financing Human Development, London: Earthscan

[6] Culpeper, R and Kappagoda, N (2007: 12) ‘Domestic Resource Mobilization, Fiscal Space, and the Millennium Development Goals: Implications for Debt Sustainability’, 27 March, North-South Institute: Toronto.

[7] See Barry, C. (2009), ‘The G-20’s Global Hit-and-Run’, Policy Innovations, Carnegie Council, April 24.