A Reader’s Guide to the Long-Term Fiscal Projections
Expecting a new medium-term fiscal consolidation strategy
Every year in June, we await the publication of a new version of the Basic Policy on Fiscal and Economic Management and Reform, or the Honebuto-No-Houshin. They include additions and revisions to the policy menu that will guide the government in forming and implementing measures and budgets in the medium to long-term.
It is reported that among the topics that are expected to be included in this year’s document is the revision of the medium-term fiscal consolidation strategy. In order to be able to assess the significance of the new strategy which is still to be seen, this month’s column will discuss some of the basic facts and understanding of the long-term fiscal projection that should form the basis of the new strategy.
The current medium-term fiscal consolidation strategy
The current medium-term fiscal consolidation strategy of the government sets the following targets:
Target A: To halve the deficit in the primary balance of the central and local government combined in FY2010, by FY2015.
Target B: To achieve a deficit in the primary balance of the central and local government combined of one percent, at FY2018.
Target C: To achieve a surplus in the primary balance of the central and local government combined, by FY2020.
Target D: To stably reduce the government-debt-to-GDP ratio of the central and local government combined, after FY2020.
Among these targets, target A has already been achieved. What wait to be met are the remaining three targets, B, C, and D.
Long-term fiscal and economic projections released in January
To facilitate the discussion in forming concrete measures that are necessary to achieve fiscal consolidation, the Cabinet Office periodically provides a set of projections of the economic and fiscal situation in the long-term.
The most recent set of projections published in January 2017 offers a set of projections for two alternative scenarios for the period FY2017 to FY2025; a “baseline scenario” and an “economic revitalization scenario”. The baseline scenario assumes that no additional economic and fiscal reform measures will be taken so that real GDP growth rate remains below 1 percent, and nominal GDP growth rate below 1.5 percent in the long-term. On the other hand, the economic revitalization scenario assumes that economic and fiscal measure will be implemented sufficiently, and their effects materializing fully, so that real GDP growth rate will reach almost 2.5 percent, and nominal GDP growth rate almost 4 percent in the long-term.
The result of the fiscal projections for these two scenarios is not so promising. As we can see in Figure 1, even under the economic revitalization scenario, the primary deficit in FY2018 remains to be more than 2 percent, and the primary balance will turn into surplus only in FY2025. Under the baseline scenario, primary balance deficit will not only fail to achieve surplus, but also to deteriorate after FY 2021 to remain in the deficit of about 2.5 percent in FY2025.
Figure 1: Long-Term Projection of Primary Balance
However, the projection for the government-debt-to-GDP ratio provides a somewhat a different picture. While the projection for the baseline scenario shows a gloomy future of a gradually increasing ratio towards FY2025, the projection for the economic revitalization scenario shows the ratio to stably fall after FY2016.
Figure 2: Long-Term Projection of Government Debt
The long-term economic and fiscal projections show, therefore, that more efforts in economic and fiscal policy front need to be taken if we are to achieve fiscal consolidation. Even the measures assumed under the economic revitalization scenario prove insufficient to achieve the primary balance targets B and C.
However, the same projections show that the economic revitalization scenario is nevertheless able to achieve the government debt to GDP ratio as provided in target D.
Why government-debt-to-GDP ratio improves despite primary deficit
From the point of view of Domar’s condition, the fall in government-debt-to-GDP ratio is difficult to understand at first. That is because, it is generally understood that primary surplus is a necessary condition for the decline in debt to GDP ratio to be achieved.
The Domar’s condition is based on the following identity.
where D denotes government debt, Y nominal GDP, G government expenditures excluding interest payment on debt, T government tax revenues, i nominal interest rate on government debt, and g nominal GDP growth rate.
The identity shows that the changes in government debt to GDP ratio depends on a term that is related to the difference between the nominal interest rate on government debt and nominal GDP growth rate, and a term that is related to the primary balance, the difference between government expenditures excluding interest payments on debt and government tax revenues. (Note here that, when the primary balance is in deficit, the term will be positive, and vice versa.)
The usual usage of this identity is to assume that nominal long-term interest rate is equal to nominal GDP growth rate so that the first term vanishes. The result is that whether the government debt to GDP ratio falls or not depends on whether primary balance can achieve a surplus or not. That is where the usual understanding comes from.
The importance of interest rate and growth rate differential
Needless to say, the usual understanding will not hold if the nominal interest rate on government debt and nominal GDP growth rate is different. It is important because the projections reveal that they are indeed different. As a result, the projected profile of the changes in the government debt to GDP ratio in the long term depends on how the two terms in the identity develop. Figure 3 shows the breakdown of the changes in the-government-debt-to- GDP, under the economic revitalization scenario, into the two factors.
Figure 3: Contributing Factors to the Changes in Government Debt
(Economic Revitalization Scenario)
It shows that, while the primary balance factor provides an upward pressure to the government debt to GDP ratio, the interest-rate-and-growth-rate differential term provides a downward pressure to the ratio.
It may seem to be a natural consequence of the projected profiles of nominal market long-term interest rate and nominal GDP growth rate. As Figure 4 shows, according to the long-term projections, nominal GDP growth rate is expected to exceed nominal market long-term interest rate until it is overturned in FY2023.
Figure 4: Nominal GDP Growth Rate and Market Long-Term Interest Rate
(Economic Revitalization Scenario)
Importance of the effective interest rate vs. market interest rate
However, this is not the whole story. It cannot explain the difference of the timing: While the nominal long-term interest rate starts to exceed nominal GDP growth rate after FY2023, the interest-rate-and-growth-rate differential term continues to exert a negative pressure even after FT2023 (Figure 3).
The difference of the timing comes from the difference between the nominal “effective” interest rate paid on government debt, which is actually what “i” in the identity means, and the nominal “market” long-term interest rate which is the market rate at the time. Nominal effective interest rate paid on government debt is a weighted average of the long-term interest rate that applies to the government debt that had been issued in the past. If some of the government debt had been issued when the nominal long-term market interest rate was high, the nominal effective interest rate paid on government debt will be high even though the nominal market long-term interest rate at the time is low. The nominal effective interest rate paid on the government debt will only change when some of the government debt reaches maturity, and is refinanced at the nominal market long-term interest rate at the time.
This seems to be what actually is taking place in the projection. If the nominal effective interest rate paid on the government debt is estimated from the projection results, and compared to the projected nominal GDP growth rate, we obtain Figure 5.
Figure 5: Nominal GDP Growth Rate and Nominal “Effective” Interest Rate
Paid on Government Debt
(Economic Revitalization Scenario)
It shows that interest-rate-and-growth-rate differential remains to exert a negative pressure on the government-debt-to-GDP ratio throughout the period, which is consistent with what we saw in Figure 3.
The importance of achieving primary surplus remains
The above discussion leads us to the following conclusions;
First, the reason why economic revitalization scenario provides a rosy picture in terms of the government-debt-to-GDP ratio, despite recording primary deficit, is because of the fact the nominal effective interest rate paid on the government debt is slow to rise relative to the nominal GDP growth rate.
Second, however, since the nominal market long-term interest rate is on a rising-trend and will exceed the nominal GDP growth rate in the long-term, the effective interest rate paid on the government debt will eventually follow suit as well.
Third, since the interest-rate-and-growth-rate differential is expected to eventually exert an upward pressure on the government-debt-to-GDP ratio, it becomes all the more important to offset that pressure and further provide a net downward pressure on the ratio by achieving sufficient primary surplus.
Achieving sufficient primary surplus remains to be an important target to pursue if we are to achieve a steady and sustained decline in the government debt to GDP ratio in the longer term.
We will know how the new medium-term fiscal consolidation strategy deals with these issues when it comes out by the end of the month.