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Special Topic: European fiscal consolidation and implications for New Zealand

As the world has begun to emerge from the worst of the recession, attention is shifting to the increased fiscal challenges facing many developed economies in the aftermath. In an effort to reassure the markets in the wake of the sovereign debt crisis, many European governments have announced measures to address fiscal sustainability. This article provides a brief summary of some of the major consolidation developments announced in Europe in recent weeks and the context in which debate about fiscal policy is occurring. It then considers the economic implications and risks associated with these consolidation moves.

An accelerated pace of consolidation ...

The intensification of Greece’s debt crisis during the last week of April, which left Greece unable to issue government bonds, the sharp rises in bond yields and the sovereign credit rating downgrades of Greece, Portugal and Spain have all prompted their governments to act swiftly to try to restore confidence and address fiscal sustainability. The new European Stabilisation Fund was an important complement to these fiscal adjustment efforts, designed to minimise the risk of other European countries facing a crisis like Greece’s.

In May 2010, as part of an IMF-EU support programme, Greece announced an ambitious reform programme, entailing not just putting its public finances in order but also liberalising its economy. The government pledged to make fiscal cuts totalling 11% of GDP to reduce the fiscal deficit from its current level of 13.6% to below the EU maximum of 3% of GDP by 2014. If achieved, this would be one of the largest fiscal consolidations in so short a time. Soon after that, Italy and Spain announced a series of corrective measures - totalling €24bn (1.6% of GDP) for Italy and €65bn (6.5% of GDP) for Spain - as the market increased its attention on their large fiscal imbalances. Portugal also announced a new plan to reduce its deficit faster.

The fiscal consolidation momentum has now spread to other “core” European states, which had not faced immediate adverse market pressures. On 7 June, the German government announced an €80bn (3% of GDP) savings package by 2014. France also announced plans to cut its deficit by €100bn (5% of GDP) of which €42bn will be delivered through spending cuts. Underlying banking sector vulnerabilities in core Europe, and the risk that further state support may yet be needed, are an important part of the backdrop to the European fiscal adjustment.

On 22 June, the new UK government introduced an emergency Budget aimed at delivering fiscal savings of around £128bn (8% of GDP) by 2014/15. Many of the specifics have still to be announced. At a global level, there has also been a shift towards fiscal consolidation. At the G20 summit in late June, leaders endorsed some non-binding targets that envisage material reductions in deficits over the next three years.

... but will it suppress global growth?

International fiscal consolidation is occurring against a difficult backdrop. On the one hand, countries need to preserve access to funding markets and do not want to leave consolidation so long as to be forced into panicked adjustments under extreme market pressure. On the other hand, the recovery from the recession appears quite fragile, and the huge overhang of private debt left over from the boom years makes it difficult to envisage a strong and sustained recovery in private demand.

While fiscal concerns themselves are far from allayed, investors are now focusing on increasing signs of the fragility of the recovery and worrying that simultaneous fiscal consolidation across a wide range of larger countries could further undermine the fledgling global economic recovery.

While the move by many European governments to put their fiscal positions on a more sustainable footing will benefit the global economy over the longer term, the reduction in demand in the near term is likely to have a negative impact on growth in these economies. However, the growth impacts are likely to vary across countries. Countries with floating exchange rates and independent monetary policy (such as New Zealand) are likely to experience reduced impacts as a result of any fiscal consolidation measures undertaken by their governments. This is because a floating exchange rate enables nominal currency depreciation and therefore increased competitiveness and reallocation of resources to the tradable sector, with this assisting recovery.

Impact may not be as great as expected …

The impact of the fiscal cuts may be less than it first appears. The value of tightening is equal to 5.5% of GDP in Greece, 2.2% in Spain, 2.1% in Portugal and 3.2% in Ireland in 2010. However, these are fairly small economies in the Euro-zone, together accounting for less than one-fifth of the region’s economy. Thus, their fiscal consolidation will have a correspondingly small effect on the euro-zone economy.

Other programmes, especially in the larger EU countries, are scheduled to occur over a longer period. Germany’s €80bn cuts will be made over the next four years, while the UK’s plan will be over five years. Most of the savings are concentrated in later years when projections suggest that the pick-up in underlying growth will be more robust. In 2011, the consolidation will amount to only €11.2bn in Germany, less than 0.5% of GDP.

The wider global situation is also mixed. In the US, the Administration is resisting early consolidation, although in Congress and at state and local government levels, some material consolidation is already becoming apparent. In emerging economies, which now make up a larger share of world activity than previously, the overall stance of policy appears to remain relatively accommodating.

Taking into account both the demand and confidence effects, Credit Suisse1 estimated output in the Euro area would be reduced by half the amount of the fiscal consolidation, e.g. fiscal cuts of 1% of GDP would lower GDP by only 0.5% (Table 1).

Table 1: Budget cuts and impact on growth
  Budget cuts
(% of GDP)
Impact on
GDP (%)*
% of NZ
export values
  2010 (f) 2011 (f) 2011 (f)
France -0.4 0.6 -0.3 1.3
Germany -2.3 0.5 -0.3 2.0
Greece 5.5 1.6 -0.8 0.2
Ireland 3.2 1.2 -0.6 0.1
Italy 0.2 1.0 -0.5 1.1
Portugal 2.1 2.6 -1.3 0.1
Spain 2.2 3.2 -1.6 0.7
UK 0.5 1.0 -0.5 4.1
OECD -0.5 1.4 -0.7 59.9

Sources: UK Budget, Barclays Capital, Statistics NZ; Treasury estimate for OECD
* A multiplier of 0.5 is assumed.

… and there are some offsetting factors

Governments have tried to design policies that will promote growth in the long run. For example, in the UK three-quarters of the savings will come from spending restraint. This approach is consistent with the IMF and OECD research which suggests that fiscal adjustments which rely primarily on spending cuts are more likely to promote growth than those based on tax increases.

In the short to medium term, growth will also receive support from continued expansionary monetary policy. Recent concerns related to the sovereign debt crisis have seen the Federal Reserve and ECB maintain their interest rates at low levels. The Bank of England has also said that it regards fiscal consolidation as a top priority, and will facilitate it by keeping monetary policy expansionary. There is also increasing speculation on the possibility of additional quantitative easing to help support aggregate demand and facilitate the fiscal adjustment that clearly needs to occur over the next few years.

Rebalancing necessary for long-term growth

An accelerated pace of fiscal consolidation is needed to reduce the substantial structural imbalances in many economies. Over the last couple of years, governments have increased fiscal deficits to offset reduced private sector demand (Figure 8), but the ability of many governments to provide ongoing support is now coming to an end due to high and rapidly rising levels of government debt and large primary budget deficits.

Figure 7: Change in cyclically-adjusted primary balance for G20 countries
Figure 7: Change in cyclically-adjusted primary balance for G20 countries.
Source: IMF

The consolidation programme may dampen growth for affected economies, especially in the Euro-zone and the UK, in the short term. If the global recovery is already beginning to lose momentum (and markets are increasingly concerned that it is), it could make for a difficult period in the next year or two. However, there is little choice but to begin the fiscal consolidation process, and - done well - such consolidation should help support a more sustainable economic recovery in the longer term.

Implications for New Zealand’s growth

As a small open economy, New Zealand is significantly influenced by global developments. New Zealand also has very high levels of private external debt and a relatively large cyclically-adjusted fiscal deficit, reinforcing our exposure to international developments. Concerted fiscal consolidation policies can impact on New Zealand’s economic growth if its main trading partners’ growth is depressed. This could translate into lower volumes and values of New Zealand’s exports, worsening our terms of trade and thereby undermining domestic spending growth.

Despite expected slower growth in the Euro-zone, New Zealand’s increasing links to faster-growing economies in Asia mean that the external stimulus remains relatively strong. June Consensus forecasts revised up New Zealand’s trading partner growth by 0.1% point from May to 3.9% for 2010 while 2011 remained unchanged at 3.5%. These revisions imply that New Zealand’s economic growth, at least in the short run, will continue to benefit from a strong rebound in Asia and Australia, which together account for more than 60% of our merchandise exports. There are, however, signs that the strength of the recovery in China may be beginning to ease, partly as the authorities reduce their support measures.

While a global recovery remains our main forecast, and therefore suggests the New Zealand economy will take a path similar to the Budget Forecasts, downside risks have intensified. Recent developments in Europe have highlighted the underlying weaknesses, not only in sovereign balance sheets but also in the private sector. Indeed, the crisis in the financial sector has not gone away, as the latest problems in the Spanish banking sector and pressures for the publication of Europe-wide bank stress tests have shown.

Sovereign risks remain considerable ...

While most troubled European governments have announced fiscal adjustment plans, in most cases concrete measures have not yet been defined in detail, especially for the outer years. Thus questions have been raised about governments’ ability to deliver the extent of adjustment needed, and this is reflected in the high and rising bond spreads for peripheral European countries’ sovereign debt.

There are fears that some governments, faced with the difficulties of sustained austerity programmes, and perhaps renewed banking sector stresses, might eventually prefer to default on debt. There is a risk that mounting unease, or a serious default, could trigger a more serious global funding crisis. From New Zealand’s perspective, heavily dependent on continued access to international funding markets, the risk of harm from a significant re-intensification of global financial stresses would be much greater than that from a concerted European fiscal consolidation programme in isolation.

Notes

  • [1] Global Equity Strategy, 18 June 2010
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