By 2020, at the nadir of the COVID-19 pandemic, Latin American and Caribbean governments had spent so much on health and transfers to keep people and firms afloat that the average primary balance (the budget balance without interest payments on debt) had soared to -4.8% of GDP. Then a positive thing happened. Rather than lingering in deficit, as it had after the 2009 response to the global financial crisis, the average primary balance increased dramatically to 0.1% of GDP in 2023, a level even better than the pre-pandemic one of -1%. Governments keenly aware of the errors of the past and the dangers of persistent negative fiscal balances on capital flows, had undone the spending increases. Citizens, understanding that those increases had been enacted for exceptional circumstances, went along.
Now another fiscal challenge looms. Public debt as a share of GDP remains larger than its pre-crisis level, and elevated interest rates globally have conspired to keep interest payments on debt large. As a result—despite large adjustments in the primary balance—the overall fiscal balance, which includes interest payments on debt, stands at -2.8% of GDP, very much in line with the pre-pandemic level of -3.4%.
So far markets have rewarded this return to positive primary balances: the perception of risk for the region, as reflected in credit default swaps, is better than it was during the previous two years. However, there remains the risk that if interest rates in the United States stay where they are instead of following a downward path until inflation is tamed, it will be more challenging to reduce fiscal deficits. Moreover, higher public debt can represent a drag on growth. And current low growth in the region will call for additional resources for pro-growth reforms.
As pointed out in the IDB’s Latin American and Caribbean Macroeconomic Report, all this means that fiscal consolidation must continue to ensure fiscal sustainability. Ensuring sustainability requires addressing structural and cyclical concerns. Fiscal rules are an essential tool to deal with both. They tackle cyclical concerns—as they put a constraint on spending so that it does not correlate with the business cycle—as well as structural ones, for at least two reasons: 1) they prevent spikes in current spending in good times followed by cuts in public investment in bad times. This reduces structural problems in expenditure composition, which is systematically biased against public investment. 2) to the extent that they work, fiscal rules stabilize debt-to-GDP ratios and ensure sustainability.
High-Quality Fiscal Rules
Fiscal rules, which curb politician’s ability to increase spending under political and electoral pressure and base fiscal policies instead on structural indicators, have become a fundamental tool for many countries in the region over the last decade or so. But not any fiscal rule will work. Their mere existence is no guarantee that they will restrain debt growth. According to an IDB study, the average debt-to-GDP ratio grows three percentage points less per year with high quality rules, compared to low quality ones, and debt volatility is much lower as well. Good quality fiscal rules require strong institutional backing, a solid legal basis, flexibility against shocks, and good monitoring and enforcement mechanisms.
Yet another critical consideration is that fiscal rules be well anchored with debt limits. It can be very helpful to set prudent debt thresholds that activate fiscal adjustment when hit, thus reducing the likelihood of reaching the debt limit. As indicated in the IDB’s Latin American and Caribbean Macroeconomic Report, including a debt anchor in a fiscal rule can lead to expected reductions of 4.8% of GDP in debt for the average Latin American country.
Flexibility—obtained by including escape clauses in fiscal rules—is also essential, helping to protect public investment from cuts during recessions or other periods of fiscal adjustment. The fiscal multiplier for public investment is close to two. This means that for every dollar spent a country gets a $2 boost in output and even more in countries with little capital stock. Indeed, public investment can be expansionary even in the midst of a consolidation, yielding significant results over a medium term of about two years and making fiscal rules that protect public investment important for growth. However, to ensure sustainability, it is crucial that countries also add reentry conditions after escape clauses are activated, something that is still lacking in most fiscal rules today.
Fiscal Councils
Fiscal councils—nonpartisan, technical bodies that serve as watchdogs for enforcement of fiscal rules—can play a significant role in making fiscal rules work. Such councils need sufficient tools, resources, and staff to do their job and the authority to impose reputational costs on governments that fail to comply with established rules. They may also intervene in projections used for estimation of structural income and spending, putting a check on optimist projections from ministries of finance. And they can have a say on how rules are enforced after periods of noncompliance.
The Road to a More Sustainable Future
Latin American and Caribbean governments on the whole have done a good job recently. Their improved fiscal adjustment efforts have helped bring the region’s primary deficit down in recent years, preventing significant increases of risk perception and withdrawals in financing. But high interest rates still prevail worldwide. Low growth, high debt-to-GDP ratios and substantial overall fiscal gaps still afflict the region. This leaves Latin America and the Caribbean little choice: it must continue down the road of fiscal consolidation to ensure fiscal sustainability.
