How Should Developing Countries Respond to the Current Crisis?

Developing countries considering a fiscal response to the financial crisis should heed the lessons
of the past
The prospect of a deep global slump has brought attention to discretionary fiscal policy as a potential tool for mitigating the severity
of the slowdown. Developing countries, however, have a decidedly mixed record in using fiscal policy to stabilize fluctuations in output. Institutional
weaknesses, the limited role of automatic stabilizers, and limited access to financing for expansions have often led to mistimed or ineffectual
fiscal measures in the past. A recent paper by Servén and Kraay identifies some key lessons that have emerged from these experiences, and suggests that policy makers should take these into account before initiating
a fiscal response.
• Any fiscal response should be commensurate
with the shock experienced. The speed and magnitude of the growth slowdown will differ greatly across developing
economies, varying with their dependence on trade, foreign investment,
and remittances. Thus each country should first carefully assess its expected exposure to the crisis to avoid an unnecessary or excessive fiscal
response.
• Monetary policy options should also be considered. Policy makers need to coordinate
monetary and fiscal interventions.
In many developing countries the central bank’s policy interest rates are still high and inflation is modest, suggesting that there may be room for traditional easing measures. Yet decision makers need to recognize that relaxing monetary policy also entails risks, including downward pressure on exchange rates and the loss of anti-inflationary credibility in countries with a history of monetary recklessness.
• Fiscal expansions need to be sustainably
financed. Otherwise, stimulus measures can backfire and lead to
Luis Servén and Aart Kraay. 2008. “Fiscal Policy Responses to the Current Financial Crisis: Issues for Developing Countries.” World Bank, Development
Research Group, Washington, DC.high inflation, if fiscal deficits are monetized,
or a debt crisis, if developing countries borrow excessively at high sovereign spreads. Only governments with strong fiscal positions and large reserve stocks are well placed to undertake
a successful fiscal response to the crisis.
• Fiscal policy responses to the crisis should be either reversible or likely to yield long-term productivity gains. This is crucial to ensure that long-run fiscal and debt sustainability is not jeopardized by a countercyclical spending increase. Projects that act as automatic stabilizers
are one way to achieve this. For example,
workfare programs with below- market wage offers will attract participants
in downturns but will not be appealing once the economy recovers. Another way of reducing the risk of unsustainable
public debt accumulation is to increase spending in areas with reasonable expectations of long-term growth benefits. For example, China’s successful fiscal expansion in response to the East Asian financial crisis of 1997–98 spent heavily on infrastructure projects for which there was strong local demand. Similarly, spending on social safety nets is particularly crucial in areas in which short-term coping mechanisms (such as selling assets or cutting back on caloric intake) can reduce
productivity and well-being in the long run (through an inability to produce
or through stunting and reduced cognitive abilities).
• Fiscal expansion must be timely but not rushed. To minimize the potential for waste and fraud, policy makers should not rush into new and untried public spending projects. They should first consider expanding existing and well-functioning programs and financing preappraised and “shovel ready” new projects. This is particularly true in developing
countries in which the capacity
to appraise and adequately oversee untried projects is limited. But while it is important to act circumspectly, policy
makers should keep in mind that fiscal interventions need to be timely
FOCUS
How Should Developing Countries Respond to the Current Crisis?to be effective and can be counterproductive
otherwise. In Argentina, for example, a mistimed fiscal impulse in 1996–98 spent public resources when a recovery boom was already under way, undermining the state’s room for maneuver
in the crisis that followed.
• The success of a fiscal expansion depends
greatly on how it is delivered. In a deflationary environment, increases in spending on public projects will generally
be more effective at stimulating aggregate demand than tax cuts or direct transfers to households, which tend to be saved rather than used for consumption. In developing countries with large informal sectors there is the additional problem that tax cuts and social insurance transfers will fail to reach many of the poorest households and firms, thereby increasing inequality
and social tension. Yet public spending programs can be wasteful, captured, and hard to reverse if institutions
are weak. Fiscal policy should factor in such constraints and choose delivery channels tailored to the characteristics
of the economy.
For most developing countries, expansionary
fiscal policy has not been an effective tool for responding to economic downturns in the past. This does not mean that fiscal policy can play no role in mitigating the effects of the current crisis. Instead, it implies that countercyclical fiscal measures should take into account the lessons from past experience to provide successful
short-term relief without undermining
long-term development.

source:http://siteresources.worldbank.org