What To Do When Countries With Fiscal Space Won’t Use It?

This isn’t another post about Germany.

Rather it is about Korea, in many ways the Germany of East Asia.

Korea has a current account surplus roughly equal to Germany’s—just below 8 percent in 2015, versus just over 8 percent for Germany.

Like Germany, Korea has a tight fiscal policy. Korea retained a structural fiscal surplus throughout the global crisis (it relied on exports to drive its initial recovery, thanks to the won’s large depreciation in the crisis).* After sliding just a bit between 2012 and 2015, Korea’s fiscal surplus is now heading up again.

Korea’s public debt is below that of Germany.

And as I noted on Monday, Korea’s real exchange rate is well below its pre-crisis levels. So for that matter is Germany’s real exchange ate. According to the BIS, Korea’s real exchange rate so far this year is about 15 percent below its 2005-2007 average; Germany’s real effective exchange rate is about 10 percent below its 2005-2007 average.

The IMF—in its newly published staff report on Korea—recognizes that Korea has fiscal space, and encourages the Koreans to do a bit of stimulus. The IMF also, smartly, recommends beefing up Korea’s rather stingy social safety net.

The Koreans though do not seem all that interested in spending more.

Yes, there is officially a stimulus. But as the Fund notes it will be funded by “revenue over-performance”* rather than any new borrowing.**

I think (based on footnote 26, on p. 18 of the staff report) that the “no new borrowing” stimulus is built into the IMF’s fiscal baseline.

And that baseline, to my mind, should be characterized as an ongoing fiscal contraction. The central government’s surplus (using net lending and borrowing from table 2 of the staff report; other measures of the general government’s balance will show the same trend) rises from 0.3 percent of GDP in 2015 to 0.8 percent of GDP in 2016 and 1.0 percent of GDP in 2017.

Korea’s external surplus is fairly clearly a function of policies that could be changed.

Especially as Korea continues to intervene in the foreign exchange market. Counting the rise in its forward book, Korea looks to have bought over $3 billion in the market in July. And by all accounts it also intervened in August.

The IMF is pushing in the right direction. But, for now, with no real impact.

And that brings up another issue—sort of a pet peeve of mine.

The IMF forecasts that Korea’s central government fiscal surplus will go up by about 2 percentage points between 2015 and 2020 (from 0.3 to 2.3 percent of GDP, using a measure that counts the surplus in the social security funds). The IMF generally believes that fiscal consolidation should raise a country’s external surplus (table 2, on p. 28). A 2 percent of GDP consolidation should—as a general rule, using the IMF’s standard coefficients—raise the current account surplus by about a percent of GDP.

Yet the IMF is forecasting Korea’s current account surplus will fall by about 2 percent of GDP (from 7.7 percent of GDP to 5.6 percent of GDP) over this period.

The issue is more general.

The IMF is forecasting China’s (augmented) fiscal deficit will fall over the next five years. That directionally would tend to push up China’s external surplus. Yet the IMF is forecasting a significant fall in China’s current account surplus over the next several years (see table 2 and table 5). Japan is projected to do about two percentage points of GDP in fiscal consolidation in the IMF’s baseline forecast.*** Japan’s current account surplus is expected to be flat (it actually is forecast to fall a bit; see table 3).

All this could happen.

Fiscal policy alone doesn’t determine the current account (even if tends to be the biggest factor in the IMF’s own model). A boom in domestic demand, for example, would improve the fiscal balance and lower the current account surplus, just as a fall in private demand improves the current account balance while raising the fiscal deficit.

And, well, a significant share of many countries’ current account is now coming from investment income earned abroad, and that can fluctuate in strange ways.

But there is a potential adding up issue if all the large surplus economies in East Asia deliver on their planned fiscal consolidations.

The first order impact of fiscal consolidation in all three should be a bigger external surplus in all three. By forecasting that away, the IMF runs the risk of understating the drag fiscal consolidation in East Asia might pose to global demand.

* The data comes from the IMF’s WEO data tool, using either the series on general government net borrowing or the general government’s structural balance.

** The revenue over-performance smells a bit fishy to me. Revenues are basically where the IMF estimated they would be in 2015 (compare table 4 here to table 3.a here). The economy has if anything disappointed a bit. The Bank of Korea has eased. So it is hard to see why revenues over-performed unless they were initially under-estimated to build a bit of fiscal consolidation into the budget.

*** Although it isn’t clear that the Fund actually expects Japan do deliver on the planned consolidation, now that Japan has pushed back the consumption tax hike -- hence the Fund’s desire for a series of small consumption tax hikes.