2.2 Sustainability, liquidity, and debt dynamics
Sustainability - the ability to balance receipts against expenditures over time - forms an overriding goal for fiscal strategy. However, it is liquidity that ultimately limits a government's ability to smooth its spending in a crisis. Liquidity is the ability to source cash at a reasonable cost in order to meet current commitments. Liquidity pressures may represent a loss of access to markets, but more often liquidity pressures are characterised by a rapid spike in the cost of borrowing. In practice, solvency and liquidity are closely related. It is access to credit markets that primarily determines Crown liquidity. However, markets will only lend if they expect the Crown to remain solvent over a reasonable timeframe.
Liquidity crises are costly for governments, taxpayers, and the economy as a whole. The government must act swiftly to restore faith in its long-term solvency. As a result, adjustment costs for taxpayers and the wider economy need to be considered alongside re-establishing access to markets. The experience of European nations through the recent crisis is illustrative. Several European countries are undertaking large fiscal contractions at a time when their economies are still in a recession. The costs of these fiscal contractions are magnified by the underlying weakness of private sector balance sheets throughout the economy. In the extreme, these weak private sector balance sheets can undermine the effectiveness of planned debt reductions if national incomes (GDP) falls faster than debt (refer Appendix 1). This dynamic is usually referred to as a debt spiral (UBS, 2010).
The large adjustment costs associated with re-establishing market access once it is lost underline the importance of an established track record for sound fiscal management. A solid track record affords more leeway as market participants are more likely to treat emerging deficits as temporary. The importance of a track record also explains why nearly half of all debt defaults since the 1970's have occurred at or below 60% of GDP, while other countries have been able to borrow in excess of 80% of GDP (Reinhart et al. 2003). In practice, defaults have often occurred in countries with a poor record for fiscal management, where markets have questioned the size of the adjustment costs, whether the consolidation could be self defeating, and whether the government has the resolve to complete the necessary reforms. In these cases, countries may be forced to either default or access resources through the IMF[2].
Notes
- [2]The IMF as a preferred creditor lends for liquidity purposes. Loans are phased and often come with conditionality aimed at restoring solvency.
