Covid-19: Fiscal Challenges Await Most Governments

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COUNTRIES ARE LIKENING the Covid-19 pandemic to war and indeed, we are observing wartime spending levels across the globe. Malaysia’s RM260bil fiscal stimulus package PRIHATIN is 17% of GDP, easily one of the largest around. Japan’s is still the largest, coming in at 21%. The US’ is 11%, while Singapore’s stands at 12%. Though RM260bil might seem a colossal sum, the good news is that direct cash injections are only RM35bil, or 2.3% of GDP.

The consensus is that this will widen Malaysia’s fiscal deficit, i.e. the difference between the federal government’s revenue and expenditure. The fact that oil prices have plummeted is doing no favours for government coffers either. In 2019 the fiscal deficit1 was 3.4% of GDP (Figure 1). This year, it will likely be somewhere between 4.7%2 and 6.4%.3

Whether the actual figure comes closer to 4.7% or 6.4% will depend on how the government chooses to fund the fiscal stimulus. Some believe that the fiscal injection will come through higher dividends from the nation’s state-owned companies. An idea was floated around for a special dividend from Petronas, but in the face of tanking oil prices and a global recession, the energy company has its own sustainability to think of first. The government could also reprioritise and reallocate funds from its existing budget, and/or raise money by selling its physical assets. These would keep the fiscal deficit relatively low.

But if the government does none of these, and allows the fiscal deficit to grow, then it would need to borrow in order to fund the fiscal stimulus. Government debt, as a percentage of GDP, would exceed the self-imposed 55% ceiling; and many believe this is likely4. As of 2019, debt was already at 52.5% (Figure 1). Not a lot of room for manoeuvering there, if the government is to stick to its own fiscal rule.

Malaysia is no stranger to such challenges. During the 1997 Asian Financial Crisis, government borrowing shot up by 15% and consequently, the debt ratio grew by 4.5 percentage points. When the Global Financial Crisis hit in 2008, it brought about sharp increases in domestic borrowing to fund a RM67bil fiscal stimulus package5. This was complemented by cutbacks in discretionary expenditure and a revision of development projects. The debt ratio that year rose by 12 percentage points (Figure 1).

If history is anything to go by, it would seem that more debts are on the horizon. The only difference now is that our debt level is higher than what it was during the past two crises. This time, Malaysia’s debt will likely exceed its 55% limit, and settle somewhere below the 60% mark.

But is a growing public debt really dangerous? The frustrating answer is that it depends. If fiscal stimulus is done for the wrong reasons at the wrong time, and leads to a fiscal crisis, then the answer is in the affirmative. But what is often unnoticed is the fact that government debt is unlike that of a normal citizen’s. A government that has its own currency like Malaysia can effectively print its own money. As long as the government’s debt is denominated in its own currency, bankruptcy is not a concern.

Another reason why debt is sometimes unavoidable is that in economic downturns like this one, when private sector spending contracts, higher government spending is essential to keep the economy intact and prevent prices from falling. The combination of higher expenditure and lower revenue means that a fiscal deficit is very likely. Generally, the fiscal stimulus should be wound down in stages to prevent undermining fragile growth, indicating that spending will be above normal for a few years.

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Figure 1: Malaysia’s Debt and Primary Deficit through the Decades
Note: The country's debt ratio increased with each crisis. There has been a fiscal deficit every year since the Asian Financial Crisis in 1997.

This, however, does not rule out other dangers. Fiscal crises come in many forms. What then constitutes a fiscal crisis? Crossing the 55% self-imposed debt ceiling is not a fiscal crisis. It will, perhaps, earn the mild disapproval of credit rating agencies but hyperinflation, or being shut out from markets because investors suspect an impending default, most definitely count as fiscal crises. The example of Argentina comes to mind. Its fiscal policies in the 1980-90s led to an inflation that exceeded 20,000%. High probability of default caused interest rates to skyrocket and the country eventually lost access to credit markets.

Many times, when domestic and foreign investors worry about public debt, it is for different reasons. Foreign investors are a jittery bunch, and rightly so. They are first in the firing line if a country does begin to default on its arrears. The ability to repay foreign debtors is also dependent on the size of the external debt, and what proportion of that is short-term. In this regard, the country has been prudent. The Malaysian federal government’s offshore debt was 1.1% of GDP in 2017, and all of it was medium- to long-term debt6.

Domestic investors, on the other hand, worry about inflation and austerity. Large debts tempt governments to allow higher inflation, since those erode away mounting credits. But inflation is not always bad; central banks like Bank Negara Malaysia target slight inflation because it helps to keep prices stable (provided the masses believe the targets). Allow it to get out of control, however, and the economy goes into a slump. Employees will start demanding higher wages and employers will have to cut down on hiring, resulting in less production. A recent study7 associated fiscal crises with a permanent loss of 2% in GDP. Is inflation a threat for Malaysia in the near future? This is unlikely. Based on past inflation patterns, it does not seem as if the government has succumbed to the temptation of inflating away its debt.

What is certain is that financing these large
fiscal stimulus packages will not be
painless. High inflation can be
prevented with fiscal
discipline, but austerity
measures are inevitable.

And what of austerity? Citizens would naturally wonder if the high public debts will be paid down with higher taxes in the future, or painful cuts in expenditure. These, too, will adversely affect economic growth and productivity. It matters as well for societal equality on whom those taxes and expenditure cuts effectively fall on. The Goods and Services Tax that was abolished in 2018, for example, impacted lower income households disproportionately8. Austerity measures will come, but not until the economy has somewhat recovered from the shock.

Some may also worry about reaching high-debt levels, because government debt tends to be “sticky”. Once people are used to higher government expenditure, cutting it would prove to be a highly unpopular political move. Malaysia’s case seems to provide some evidence to support this. With each crisis, debt spiked and remained at a fixed level until the next crisis pushed it higher up (Figure 1). It occurred during the 1997 Asian Financial Crisis and in 2001, following the US economic slowdown and yet again, in 2008 when the Global Financial Crisis hit.

The size of public debt does matter. But so does the sustainability of it – whether it is shrinking and stabilising, or if it is on an explosive path. And the primary determinant is the interest differential, i.e. the difference between real interest rate charged on the debt and GDP growth rates. For debt to be sustainable, the interest differential should be negative. The logic behind this is intuitive. Imagine if next year, the government borrows nothing. Two forces are at work here. A growing GDP implies that the debt ratio is falling, but at the same time, because of interest payments, the debt ratio would increase. If GDP growth outstrips real interest rate, then the debt ratio declines.

Fortunately for Malaysia, the interest differential has been mostly negative for the past decade. Hence, Malaysia’s debt is reassuringly on a stabilising trajectory. The only times debt ratio increases are when the fiscal deficit more than offsets the decline that a negative interest differential brings. Between 1990 and 2019, this happened 13 times and is usually caused by expansionary fiscal policy to combat an economic downturn, carried out over a few years.

Few countries will escape this pandemic with unscathed public debt levels. In the economic crunch that has paralysed the private sector, fiscal expansion is a lifeline. Though Malaysia’s debt ratio will increase, there are no fiscal meltdowns lurking on the horizon yet. Under the previous government, reforms were made to improve fiscal governance. Even if it is hard to stick to fiscal rules for the time being, we should not waver in our commitment to better fiscal governance. These are uncertain times we live in; it is important to borrow wisely, bearing in mind that fiscal space is still needed.

What is certain is that financing these large fiscal stimulus packages will not be painless. High inflation can be prevented with fiscal discipline, but austerity measures are inevitable. As the saying goes, “ain’t no such thing as a free lunch”. And that applies to money too.

Jo-yee is a research analyst at Penang Institute whose interests range from development issues to behavioural economics. Her latest goal is to bake the perfect sourdough loaf.
1‘Fiscal deficit’ is used loosely here – the correct terminology is primary deficit, the deficit before interest on existing debt is added on.
2Estimate by Ministry of Finance Malaysia. https://www.reuters.com/article/health-coronavirus-malaysia-economy/malaysia-says-2020-budget-deficit-to-rise-to-47-after-new-stimulus-state-news-agency-idUSK7N2AN00E
3World Bank, 2020, “East Asia and Pacific in the Time of COVID-19”, World Bank. This estimate was made before the government announced an additional RM 10 billion to aid SMEs.
4The Star, 15 April 2020, “Wider fiscal deficit due to stimulus package, Moody's says” New Straits Times, 31 March 2020, “Malaysia's 250bil stimulus package appealing but widen budget deficit”
5Economic report 2008/2009, 2009, Ministry of Finance Malaysia. https://www1.treasury.gov.my/index.php/en/archives/2009/item/4809-economic-report-2008-2009.html
6Ministry of Finance, Bank Negara Malaysia. https://www.epu.gov.my/en/economic-statistics/public-sector
7Medas, Paulo & Poghosyan, Tigran & Xu, Yizhi & Farah-Yacoub, Juan & Gerling, Kerstin, 2018. "Fiscal crises,"Journal of International Money and Finance, Elsevier, vol. 88(C), pages 191-207.
8Press Statement, 2016, Penang Institute. https://penanginstitute.org/press-releases/797-united-nations-report-reaffirms-penang-institute-s-findings/



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