Session 1B_Public Finance Overview-1 PDF

Session 1 Financing Public Policy—Macroeconomic View B. Public Finance Prof Govinda Bhattacharjee  Session Structure Overview of PFM and its relation Governance; PFM cycle from Budgeting to Audit; PFM Institutional Framework; Benchmark...

Session 1 Financing Public Policy—Macroeconomic View B. Public Finance Prof Govinda Bhattacharjee  Session Structure Overview of PFM and its relation Governance; PFM cycle from Budgeting to Audit; PFM Institutional Framework; Benchmarks of PFM activities; Case studies in failure of PFM.  Background and History The word ‘Public’ in Public Financial Management is significant Post-World War II scenario - resource crunches Money alone was found inadequate for reform and creation of credible infrastructure System was more important Fairness in allocation of work and distribution/ redistribution of rewards Transformation into PFMS PFM is concerned with effective administration of funds collected and spent by governments. PFM underlies all government activities involving a country's budget cycle : Mobilisation and allocation of Resources to different activities (services) Management of expenditure on these activities Accounting for the expenditure incurred Mid-term review and feedback mechanism for course-correction, and finally, Audit, to complete the cycle of public accountability. Efficient public financial management is central to mutual trust and shared consensus between a government and the citizens. 3  PFMS Objectives and Cycle Financial objective of the PFMS is to increase revenue, ensure fairness of taxation process, efficient resource-allocation, transparency Rule of Law and accountability for expenditure, and citizens’ participation. Equity Accountability Economic objectives are to ensure macroeconomic stability and income Good redistribution for reduction of inequality Governance through constitutional processes and mechanisms. Responsiveness Transparency Independent audit and evaluation are integral components of any PFMS. Participation PFMS thus encompasses a broader set of functions than financial management. 4  Media/ Civil Lobby Society Groups Political Research/ Parties Academic Bodies Govern- mental Media/ Civil Policy Society Budget Secret/ Participatory? External Formula- Audit tion Legislature PFM Cycle Account- Budget Legislature CGA/ Accountant ing Approval General’s Office Budget Execu- tion Media/ Civil Revenue / Expenditure Society Internal Audit 5  PFM Institutional Framework Structures Processes Systems Constitutional, Legal and Budgeting, Accounting , Separation of taxing powers, & Regulatory Framework, Auditing, Monitoring and legislative and executive Mechanism for equalisation, Reporting, Management of powers, Internal and External Right to information Assets, Debt and Contingent Controls, Institutional Oversight Administrative architecture Liabilities, Public Accountability by the Legislature Catalysts PFM Management Apolitical Approach to PFM Budget Formulation & Evaluation by Legislature, Execution, Accountability, Independence of Public Audit Budget Evaluation and Institution, Role of Media and Reporting Civil Society  Benchmarks of PFM activities PFM benchmarks can be temporal - against past performance of a country, or in relation to other countries or normative, or according to norms arising out of legal or constitutional structure of a country or internationally. Benchmarks have to indicate The level of correlation between budget and actual expenditure Whether committed liabilities are exceeding a certain limit Whether borrowings and fiscal deficits are contained within reasonable limits Whether contingent liabilities are also within safe limits Adequacy of internal and external controls in PFM systems Benchmarks evolve over time, especially in response to crises, leading to standards. They have lot to do with Social Trust and Consensus 7 8 9 10  Tax: GDP Ratio (%) 20.0 18.0 16.0 14.0 6.6 6.4 6.4 5.9 6.3 12.0 6.0 10.0 8.0 6.0 11.2 11.0 10.3 10.8 10.7 4.0 9.0 2.0 0.0 2017-18 2018-19 2019-20 2020-21 2020-22 2022-23 Central Govt. States 12 Top Marginal Income Tax Rates: 1970-1975 UK - 98% USA - 70% France – 60% Germany 56% Revenue Optimisation – Laffer Curve 14 Income Tax Reforms 15  Indian Experience in Benchmarking India has a poor record of fiscal marksmanship. The budget numbers often lack credibility and fiscal estimates tend to get pronounced with approaching elections. The only way to check this is to frame appropriate fiscal rules and create an independent fiscal council to monitor the implementation of these rules. Attempts at window-dressing the budget is nothing new. Indeed, overstating revenue estimates and understating the expenditure estimates have long been a disturbing feature not only of the Union budgets, but equally of all state budgets. Only recently, the union budget numbers have become a little more credible, by minimizing off-budget borrowings. Poor fiscal marksmanship leads to higher borrowing resulting from larger deficits than estimated affecting the credibility of its public finances with the international rating agencies. There has to be an institutional mechanism to arrest such tendencies. The most common institutional mechanisms used are the so called Fiscal Rules and Fiscal Councils. 16  Shifting sands of fiscal targets Fiscal deficit limits of the Union are decided by the Fiscal Responsibility and Budget Management Act (FRBMA), 2003. Originally the target was to reduce the fiscal deficit to 3% by 2008, but during the global financial crisis of 2008-09, the deadlines were moved further out. The FRBM Act has been amended in 2004, 2012, 2015 and in 2018, each time shifting the original target of achieving 3% fiscal deficit and zero revenue deficit by March 2008 to farther and farther away. The current budget placed the fiscal deficit at 5.4%. Fiscal consolidation has now become ever more important in view of the fact that Debt ratio of the country now stands at nearly 90% (60% for centre and 30% for the states). The FRBM framework mandates that the Central Govt. to limit the fiscal deficit up to 3% of GDP by 31 March 2021 and urges it to limit the General Government Debt to 60% of GDP and the Central Government Debt to 40% of GDP by the end of FY2025. The IMF now recognizes the FRBMA as BBR and DR. There is no effective enforcing mechanism available to ensure the targets are adhered to by all governments and that they do not exceed them due to populist pressures. The FRBM review Committee as well as the previous Finance Commissions have recommended an architecture for fiscal rules and fiscal council, but nothing has ben done so far.  Fiscal Rules As per the World Bank, a fiscal rule imposes a long-lasting constraint on fiscal policy through numerical limits on budgetary aggregates for arresting the pressures to overspend, and ensure fiscal responsibility and debt sustainability. There are four types of rules: Budget Balance Rules (BBR), Debt Rules (DR), Expenditure Rules (ER), and Revenue Rules (RR). Budget Balance Rules restrict the size of the deficit and thereby control the of the debt ratio. Most countries impose an overall deficit ceiling of 3% of GDP. Debt Rules set an explicit limit on the stock of public debt, generally a debt ceiling of 60% of GDP. Expenditure Rules limit spending, either by putting a ceiling on its growth, or on the relevant ratio to GDP, restricting the real growth of current expenditure within a ceiling of 4% of GDP (Peru). Revenue Rules set ceilings or floors on revenues, or prescribes the use of windfall revenues (21-22% of GDP, Kenya). Debt rules are most frequently used by countries, followed by Budget Balance Rules and Expenditure Rules. Revenue rules are the least used. Many countries also use the rules in combination. 18  International Trends In the aftermath of the financial crisis of 2008, many countries adopted fiscal rules. In 1990, only five countries—Germany, Indonesia, Japan, Luxembourg, and the USA- had some fiscal rules. By 2015, their number has reached 92. Many countries now operate with more than one rule. As serious debt crisis shook most economies all the world over, the major focus was on debt sustainability and containing deficits to provide adequate assurance to the financial markets in respect of sovereign borrowings. The underlying rationale for this lay in the in the distrust of politicians or governments, and to depoliticize the fiscal framework. Effective enforcement of fiscal rules would require financial reporting standards, adequacy of public financial management systems (PFMS), credible budget reporting systems, effective internal and external audit and free availability of budget and public finance data in the public domain released by the government. After the financial crisis, many countries wanted to adopt a Medium Term Fiscal Policy (MTFP) of balancing government revenue and expenditure over a medium term so as to inoculate against the risks which had turned their economies topsy-turvy during the crisis. In India also, we had adopted a MTFP after the FRBMA was enacted in 2003. 19 Countries with Fiscal Councils: 2021 Source: Fiscal Council Dataset (imf.org) 21 Case Studies in PFM Failure  Macroeconomic Policy in Crisis In an ideal world, macro-economic policies should by countercyclical – i.e. expansionary in a downturn and contractionary in in an overheated economy. Ability to enlarge borrowing without creating a crisis will depend on past actions. In a fiscal crisis, there is no alternative but to reduce borrowing, which will hurt the economy in a difficult time. In normal times, deficit reduction is contractionary, but in a fiscal crisis it creates fear in financial markets. The essence of a crisis is fear. Stock prices, real estate prices and currency are all shock absorbers. When governments try to interfere, say by trying to defend a stable exchange rate, investors leave. To achieve macro-economic stability, the essential requirements are: Sound fiscal policy with stable debt: GDP ratio => Primary surplus Inflation targeting to stabilise the macro-economy and the exchange rate Sound financial regulations to address market failures Deep and liquid financial markets ensuring liquidity, resilience, efficiency, predictability and fairness Positive feedback loop works everywhere – when things go bad, they become worse.  Reckless Populism Like all countries, the island nation was hit hard by the pandemic which was exacerbated by the Easter Sunday terrorist attacks in April 2019 that killed 269 people. These two had affected its vital tourism sector - the third largest and fastest growing source of foreign currency after private remittances and textile exports. With tourist arrivals dwindling from 2.3 million to only half a million between 2018 and 2020, earnings from tourism nosedived from $4.4 billion, or 4.9% of its GDP, to a paltry $682 million or 0.84% of GDP. Even long before the pandemic, the import dependent country was highly vulnerable to external shocks owing to inadequate external buffers and high risks to public debt sustainability. Then in November 2019 parliamentary elections, Gotabaya Rajapaksha, who spearheaded the brutal crushing of Tamil Tigers a decade ago, stormed to power on the promise of freebies and massive tax cuts. He reduced the GST rate from 15% to 8% and abolished another 2% Nation Building Tax. While the tax revenues shrank drastically, sweeping loan waivers and subsidies for the farm sector drained the exchequer. The pandemic contracted the real GDP by 3.6% in 2020 and fiscal deficits soared beyond 10% in FY2020 and FY2021.  Crisis Deepens A ruinous organic farming program was launched in 2021 with total ban on chemical fertilisers and pesticides which drastically reduced farm output and pushed up prices of foodgrains. For the past 15 years, every government had issued sovereign bonds without provisioning for repayment. The country’s foreign exchange reserve thus increased by borrowing in foreign currencies, not through the sensible way of export of goods and services. Unlike IMF loans, these International Sovereign Bonds (ISBs) had no strings attached to them, but came at a price - high interest rates, shorter maturity periods, and higher risks. By 2019, commercial borrowings, which were a mere 2.5% of foreign debt in 2004, had ballooned to 56%. The country thus became extremely vulnerable to market shocks and it credit rating was downgraded after the sweeping tax cuts and populist measures when it lost access to ISB market in 2020. With that was gone its ability to roll over its ISBs, and it is now digging into the foreign reserves to meet the debt servicing obligations. The forex reserves thus plummeted from $ 8.8 billion in June 2019 to only $ 2.4 billion in January 2022 - equivalent to just one month’s essential imports which precipitated the 2022 crisis. The country has debt repayment obligations of $4 billion during 2022.  Role of Chinese Loans A part of the problem was over $5 billion loans from China during the past decade, most of which were invested in low-return projects such as construction of ports, airport and coal- powered plants. China has invested $12 billion till 2019 to fund infrastructure projects, like the Colombo Port City for reclaiming 269 hectares of land from the sea that is being executed by its state-owned China Communications Construction Company at a cost of $1.4 billion. It is expected to be completed by 2043, which will yield no revenue till then. Even thereafter, 43% of the reclaimed land will be leased to China for 99 years. It recalls the case of Hambantota, for which China gave an estimated $1 billion loan, while every feasibility study advised against it. Indeed, with 36,000 ships, including 4,500 oil-tankers passing by along one of the world’s busiest shipping lanes, the port drew only 34 ships in 2012. The project distinguished itself by failing, and the country, being unable to service the debt, was forced to lease the port and its surrounding 15,000 acres to China for 99 years. China is also involved in several other infrastructure projects in Sri Lanka like the coal-fired Narocholai power project, Mattala International Airport, Colombo International Container Terminal, etc. Between 2012 and 2018, Sri Lanka’s external debt to China rose from $2.2 billion to $5 billion.  Unsustainable Debt Sri Lanka’s debt in 2022 stood at a dangerous level of 119% of its GDP, with 64% of its outstanding debt stock owed to the external debtors. Over 10% of its total debt stock was owed to China, but unlike the other external debtors like Japan, ADB, World Bank etc., most of its Chinese loans are non-concessional commercial loans commanding interest rates of 6.5% as against 2.5 to 3% for other loans. In fiscal year 2021, its interest payments alone consumed over 95% of its total revenues. With a highly regressive tax system where indirect taxation accounts for over 80% of revenue, over 50% coming from import duties alone, it is sure recipe for disaster. Lack of an equitable tax policy coupled with irrational tax concessions has kept the tax base small, leaving no option for the government than to resort to increasing commercial borrowings. Its tax to GDP ratio has fallen continuously since 2016 from 14.1% to only 8.4% in 2020. The tax cuts in 2019 was the proverbial straw that broke the camel’s back, plunging the country into an inevitable and irrevocable financial catastrophe, the heavy price of which is being paid by the people today.  Crisis Erupts Sri Lanka’s is an overwhelmingly import dependent economy - now it has no forex reserves to buy most of the essential goods like petrol, diesel, food, sugar, lentils, paper, medicines etc. that it imports. Such is the crisis that it had to cancel exams of students due to a crippling shortage of paper. Newspapers have stopped publishing print editions due to shortage of newsprints. Operations at oil refineries have been suspended due to shortage of crude oil. Power cuts have been imposed for 13 hours a day due to shortage of fuel like coal and oil which have to be imported. Queues at petrol pumps and for cooking gas cylinders are more than a kilometre long, with people queueing each day since 4 AM. Limited availability of external financing forced the Central Bank of Sri Lanka (CBSL) to directly finance the huge budget deficits fuelling inflation. In March 2022, the retail inflation rate was 18.7% – way above the target band of 4-6%. Food prices have risen by 30% – one cup of tea now costs Sri Lankan Rupee (SLR) 100, up from SLR 25 in October 2021. One kilogram of rice costs Rs 500, one kilogram of milk powder costs Rs 800. Sri Lanka also had a fixed exchange rate with the SLR pegged to the US dollar; the fixed exchange rate led to the increased use of informal channels to repatriate the earnings of non- residents.  Fixed Exchange Rate and Deficit Financing The current account deficit widened from 1.3% of GDP in 2020 to 3.8% in 2022, and soaring inflation coupled with low forex reserves forced the CBSL to devalue the SLR, which depreciated from SLR 201 to a dollar on 7th March to SLR 298 on 3rd April. Devaluation of currency has increased the cost of imports and consequently rise in prices of goods, with consequent effects on inflation which recorded a new peak during each of the last six months, and is likely to remain in double digits, unless the government rolls back its tax cuts and curtails welfare expenditure, which will trigger further social and political chaos. But the only possible way out of this quagmire to restore macroeconomic stability and debt sustainability, while protecting vulnerable groups through well-targeted social safety nets. It will have to phase out the central bank’s direct financing of budget deficits, besides a gradual return to a market-determined exchange rate to rebuild international reserves. These are the conditions the IMF will certainly impose for bailing the country out of the crisis which will exact their political costs, the reason why the government was so far unwilling to approach the IMF, preferring instead friendly countries like China and India. China had provided a currency swap of $1.5 billion in 2021. India has provided a total assistance of $3.8 billion, including $400 million swap to help boost its reserves.  July-Aug, 2022 Debt : $51 bn ; Usable Forex : only $25 million Defaulted on $7 bn loan repayment out of $ 25 bn to be repaid by 2026 Currency collapse: 80%; 1USD = SLR 360 Inflation : 64%; Food Inflation 94%. Amid mass public protests, Mr. Gotabaya Rajaparska had to flee the country and Ranil Wickremesinghe was appointed President in July, 2022. Human suffering WFP says 9 out of 10 are skipping meals or skimping to stretch out their food 3 mn are receiving emergency humanitarian aid Govt. workers have been given one extra day off to grow food Queues stretching more than a km in gas stations; People don’t have fuels to cook or petrol to take the sick to the hospital Prices are skyrocketing, with most commodities being outside the reach of most people as economic activities and tourism are at a standstill 31  GDP growth Debt : GDP 2.90% 1.90% 120% 2022 2023 2024 2025 104% 101% -2.30% forecast Forecast 2022 2023 2024 forecast -7.80% Inflation Exchange rate (US$1) 46% 363 323 304 200 17% 8% 6% 2022 2023 2024 2025 forecast Forecast 2021 2022 2023 2024  July 2022 to September 2024 Sri Lanka secured an IMF bailout package of $2.9 billion in March 2023. But people’s suffering continues. As conditionalities for the IMF bailout, Government was focussing on restoring macroeconomic stability by driving tough but much-needed structural reforms. As the turbulent political situation stabilised, decisive economic measures by the new government and timely Indian aid helped reverse the tide. Inflation fell. But negative growth in 2022/2023 meant job losses across the economy, a doubling of income poverty to 25% of population and child malnutrition as families are forced to switch to less nutritious diets. Sri Lanka’s economy is on the road to recovery. But sustained efforts to mitigate the impact of the economic crisis on the poor and vulnerable are critical. It is not only stinging austerity that angers them; they are also fed up with the corruption and cronyism amongst the country’s elites. In September 2024 elections, the leftist leader of the People’s Liberation Front, A K Dissanayake, was declared winner with a margin of 1.3 million votes, promising to alleviate people’s sufferings, but has to negotiate the next tranche of IMF loan worth $350 mn in October. He probably realizes the task when he said in his inaugural address: “I am not a magician; I am not a miracle-worker.”  Failure of PFM in Venezuela Venezuela was the richest country in Latin America in the 1970s, with a GDP higher than that of Spain, once its colonial master. But during the 1980s, falling oil prices driven by global oil glut sent the country’s economy into freefall. Ruled by a corrupt and degenerate oligarchy for decades, Venezuela was convulsed by prolonged economic woes and stinking political corruption during the 1980s and 1990s. The Bolivian Revolution put Hugo Chávez to power in 1998, when he won the first of his four Presidential elections. The oligarchy, in a last attempt to recapture power, captured the Presidential Palace of Miraflores and kidnapped Chavez in April 2002, but was itself overthrown within 48 hours by spontaneous mass uprising. Oil is the mainstay of Venezuela’s economy, accounting for 40% of government revenues, 50% of GDP, and 95% of exports. The succeeding decades saw oil revenues subsidising the welfare for the poor, which ensured successive election victories of Chávez. But he failed to utilise the huge popular support to radically transform the economy by pushing serious structural reforms. Instead, he continued using national resources for doling out subsidies, and Venezuelans are today paying the price. 35  Chavez Years Chávez did initiate several programs to redistribute wealth, provide necessities, build infrastructure and to create jobs. They did improve the lot of the poor - unemployment rate halved, per capita income more than doubled, the poverty rate fell by more than half and infant mortality rates declined. But they did not address the entrenched social and economic issues that needed structural reforms to make these programmes economically sustainable. Besides, these were solely dependent upon the country’s oil wealth and soaring international oil prices that closely followed Chávez’s ascendance to and consolidation of power, which rose from $10 per barrel when he took office, to over $100 when he died in 2013. Chávez nationalised private oil companies and merged them into the state owned PDVSA, besides nationalising telecom and banking sectors, thus crippling industrial competition. While the oil profits continued to subsidize his welfare programmes, corruption and cronyism ballooned, and productivity and profit nosedived. As assets of oil companies like Exxon Mobil and Conoco Philips were seized and foreign companies were expelled, the nationalisation choked the industry by depriving it of much- needed foreign capital and technology. 36  A Failed State Naturally, when the oil prices started plummeting, the economy tanked, and by the time Chávez’s successor Nicolás Maduro took over as President in 2013, oil prices had plunged by more than 50%, leaving him with few options. Fiscal deficit had reached 20% in 2015, and the growing fiscal deficit pushed the country deeper and deeper into debt, to repay which it needed revenue from oil that was tumbling. Restricted access to external financing owing partly to US sanctions, combined with the socialist agenda of price and currency controls and the collapse of the private sector led to huge shortages of basic goods like food and medicine, to import which the country did not have enough forex. The market value of the bolivar became worthless, with the country being unable to service its foreign debt. All these factors cumulatively led to the spiral of hyperinflation and recession as there was no capacity created in the economy to sustain such a shock. The inflation of Venezuela was 274% in 2016, 863% in 2017 and 1,300,000% in November 2018. Salaries have become worthless. Venezuelan economy had contracted by nearly 50% of its GDP since 2013. Price of the dollar on the black market reached 3.5 million bolivars (06/2018). Poverty was almost 87% and extreme poverty 61%. 37  Bleak Present and Future With the richest reserves of oil and gas in the world, Venezuela today is the world’s worst- performing economy. The country is in deep recession with economy having contracted by more than a third since 2013. More than 2 million Venezuelans have already fled the flailing economy and the fading state, in an exodus that rivals those of war-ravaged Syria, Afghanistan and South Sudan. Basic services like electricity, water, electricity and transport have collapsed and daily demonstrations and social unrest have become the order of the day. Like all dictators, Maduro is bent on clinging to power at any cost–only the loss of support from the armed forces might weaken his iron grip on power. As “a really impressive magic formula” to end the economic woes, he has announced the removal of five zeroes from the country's worthless currency (Bolívar fuerte) and to switch over to a new currency – the “sovereign bolívar” (Bolívar soberano) in 2018. The bolivar was also devalued from the official rate of 250,000 “old” bolívares to a dollar to the prevailing market rate of 6 million. These measures which Maduro calls the paquetazo rojo (big red package) did not end people’s woes or rescued the pulverized economy. The bolivar had earlier lost 3 zeroes in 2008 under Chavez also. 38  Sliding Towards an Abyss - 2021 9 out of 10 people are trapped in starvation 64% of people have lost 12 kilograms, on average, due to malnutrition 5.3 million people fled the country by the end of 2019 and are living a refugees in Brazil, Columbia and other countries Two thirds of Venezuelans have little or no access to water - crowds collect water around leaking sewage pipes to drink and bathe. A rigged election returned Maduro to power in 2018, results of which have been rejected by the National Assembly which elected its President Juan Guaido as the Acting President of Venezuela in January 2019, recognized by 54 countries. Civil War ensued, but the pampered military stood behind Maduro. In 2020 national assembly elections, Maduro’s manipulated to win the majority in National Assembly, having already packed the judiciary with loyals. In October 2021, Venezuela again slashed 6 zeroes from its currency as hyperinflation continues to plague the country. The new 100 dollar would be the highest denomination, equivalent to 100 million of the current bolivar. More than 7 of such notes would buy only a 5-litre bottle of water. 39  June 2023 In November 2022, partly to help offset rising global energy prices due to the war in Ukraine, the USA permitted Chevron to resume limited operations in the country. In exchange, the Maduro government and the opposition agreed to continue dialogue. In October 2023, Caracas agreed to a roadmap for a free and fair presidential election in 2024, following which US sanctions were further eased and Venezuela was allowed to export oil and gas products for six months. After eight years of economic contraction, Venezuela’s GDP started to grow again, hyperinflation abated along with food shortages. Exchange rate was stabilised by injecting dollars and heavily restricting credit and spending: banks were allowed to lend only 27% of their total cashflow. But the economy continued to be in dire straits: the private sector needs around $6 billion in credit, but Venezuelan banks’ loan portfolio had around $730 million. The wages of private and public employees—60% were still paid in bolivars— plummeted by half, from a $170 monthly salary to $85 per month. 30% of Venezuelans earned less than $100 per month in July 2022; in June 2023, that share was 52.6%. Inflation was 190% in June 2023. Public spending reduced from 40% of GDP to