Macroeconomic resilience is a country’s ability to weather economic shocks. This article presents a practical tool—composed of a set of indicators and a means to visualize them—for measuring the macroeconomic resilience of nations. These indicators are based on the widely but loosely used term “fiscal space” and the innovative concept of “monetary space.” The tool helped the U.S. Agency for International Development (USAID) determine which countries needed additional assistance during the financial crisis in 2009, and it has been applied in countries as diverse as Bangladesh, Jordan, Moldova, and Vietnam.
Although no country is completely immune to economic shocks, more resilient countries can insulate their effects. In the midst of the global financial crisis in 2009, USAID and the U.S. Department of State called on DAI to assess the potential need for extraordinary assistance to 13 countries — countries that appeared likely to be among the hardest hit.
The 13 countries assessed were a mix of least-developed countries: Albania, Cambodia, Guatemala, Honduras, Indonesia, Liberia, Mongolia, Mozambique, Senegal, Tajikistan, Tanzania, Ukraine, and Zambia. Because these countries did not have strong links with U.S. or international financial markets, they were not expected to suffer directly from the collapse of the U.S. housing market or financial markets in Europe. Instead, the main concern was their vulnerability to general demand-side collapse. As the U.S. and European economies went into decline, demand for exports from these countries would decline as well, leading to falling aggregate demand and further effects as this demand shock worked its way through the country’s income and spending levels.
DAI assessed the resilience of these countries by measuring their degree of fiscal and monetary space as an indicator of their ability to respond to shocks and implement fiscal and monetary policies to neutralize them. For instance, a country with limited fiscal and monetary space would be unable to implement counter-cyclical stimulus in the event of deteriorating global conditions.
At that time, the terms fiscal and monetary space were not widely known. Institutions such as the International Monetary Fund (IMF), the World Bank, and the United Nations were using the concept of fiscal space in their own circles, but it had not been well-defined, nor was there a clear framework for its measurement. The IMF’s Peter Heller provided the first definition of fiscal space as “room in a government’s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy.”1 The term monetary space, however, had not yet been well-defined.
In 2008, Dominique Strauss-Kahn, then Managing Director of the IMF, linked fiscal and monetary space to the global financial crisis2. In the Financial Times, Strauss-Kahn referred to monetary space as a way for a country to build credibility in its monetary system that could be useful in countering demand shocks, but cautioned that both fiscal and monetary space would be necessary to weather the financial crisis. No specific theory or framework for measuring fiscal and monetary space was presented at that time.
A Framework For Assessment
In the absence of such a theoretical underpinning, DAI had to develop for itself a clearer framework for assessing the economic resilience of nations. The tool we developed is based on indicators that determine fiscal and monetary space, as shown in Figure 1. While many of these indicators are widely known economic and fiscal indicators, on their own they have little meaning. Bringing them together frames the analysis of a system’s fiscal and monetary space and, thereby, its degree of resilience.
DAI then collected data for the 13 countries and compared these in a visual framework, as seen in Figure 2, using a traffic light approach — red, yellow, green — reflecting the degree of space. Red is considered problematic, green favorable, and yellow neither.
The determinants of fiscal space include the following:
- Debt levels: Countries with high debt would find it impossible to borrow their way past the crisis. Indicators: debt as a percentage of gross domestic product (GDP) and debt service as a percentage of exports.
- Budget balance: Governments already spending a large portion of their country’s economy would find it more difficult to expand that spending. Indicator: budget balance as a percentage of GDP.
- Grants dependence: Countries highly dependent on foreign grants would not likely be able to use this route to gain spending power. Of course, there is little reason to believe that countries not currently receiving grants could count on foreign countries to begin providing grants in a time of need. Indicator: grants as a percentage of GDP.
- Tax revenue mobilization: In countries where tax revenue collections are high, increasing taxes is unlikely to be easy. In times of crisis, mobilizing revenue by administrative means, by raising tax rates, or by broadening the tax base provides little opportunity for increasing revenues. These countries instead might be able to stimulate their economies by temporary decreases in taxation, but economic theory and most empirical literature show that temporary tax reductions do little to stimulate demand. Countries where tax collections are low might find room for increasing government revenues by improving compliance and broadening the tax base; generally, raising tax rates during periods of demand downturn is not encouraged. Indicator: tax revenue as a percentage of GDP.
- Saving rate: this includes savings from government or the private sector (firms and households). The higher the savings available in an economy, the greater room for stimulating demand through fiscal policy, without running into supply bottlenecks. Indicator: savings as a percentage of GDP.
Until DAI’s work in 2009, no framework for assessing monetary space had been defined. The indicators that determine monetary space presented below are, therefore, innovative. The determinants of monetary space include the following:
- Inflation: Countries already experiencing high inflation will likely face continued high expectations for inflation, meaning expansionary monetary policy would fuel this expectation and inflation would soar. Indicator: year-end, average percentage change in consumer price index.
- Money supply (M2) growth rate: Economists refer to this measure as “broad money,” representing the main means for making payments in an economy. In countries where broad money has been expanding rapidly, inflation can be expected. An economy with slow money growth can more easily accommodate accelerating the growth rate. However, adding money growth in a country where money has already been growing beyond the rate of growth of the economy would, in general, add fuel to the fire. Indicator: the difference in M2 from one year end to the next.
- M2 velocity: Velocity refers to the number of times a unit of money is used in transactions versus being held as an asset. Where money velocity is slowing, expansions of monetary policy will have less impact on inflation and balance of payments. Money velocity had been declining in most of the countries evaluated because the demand for holding money balances had been increasing in these countries as their economies, and especially their financial systems, were modernizing. Indicator: the ratio of M2 to the country’s nominal GDP.
- Exchange rates: A country’s real effective exchange rate (REER) is a measure of the value of its currency against a weighted average of several of its trading partners’ currencies and adjusted for the effects of inflation. In countries where the REER index has been increasing, representing a real appreciation—essentially, in countries where inflation is outpacing that in their trading partners, and where exchange rates have not adjusted to account for this rapid inflation—expansionary monetary policy would not be recommended, because it will reduce the competitiveness of such countries and likely result in international balance of payments difficulties. Indicator: weighted average of the national exchange rate with respect to currencies of its main trading partners and adjusted for inflation.
- Currency dependence: Currency dependence indicates whether a country has its own currency or uses that of another country or country grouping. Of the countries evaluated, only Senegal uses an external currency, the CFA franc. This field is red for Senegal because of its inability to create new currency or other high-powered money, whereas the other countries have some degree of leeway. Even countries such as Jordan, where the currency is anchored are able, albeit in limited fashion, to pump up or slow money growth. Indicator: dummy variable 0 or 1.
- International reserves: This indicator relates to the adequacy of a country’s net official international reserves, expressed in terms of the number of months of imports that could be covered by current reserves. For instance, if a country can no longer generate exports but needs to import $1 billion in product per month and is holding $4 billion in reserves, then it would be able to import four months’ worth of products. Any country with less than four months of reserves is in the warning zone and shown as red. Liberia, Tajikistan, and Zimbabwe were all in the danger zone. Indicator: net international reserves.
- GDP growth: All the countries in the sample had been experiencing adequate GDP growth in the respective periods, except for Zimbabwe, whose economy was in free fall. However, Jordan’s economic growth was slowing considerably, and Moldova’s was on a clear downward trend, which by the end of 2009 had actually declined by nearly 10 percent. Negative growth scores red; yellow indicates low but positive growth rates; green indicates growth rates greater than 3 percent. Indicator: annual percentage growth rate of GDP, adjusted for inflation.
Implications For Resilience Across Nations
We assessed all the countries in Figure 2 by means of the framework presented. A country with mostly green indicators is considered resilient; that is, fiscal and monetary conditions allow for expansionary policies to be used to counterbalance demand shock. A country with several red indicators is considered less resilient; that is, macroeconomic policy instruments would likely be impotent to countervail external demand shocks.
For USAID’s purpose, a country with mostly red indicators is considered in need of ramped-up assistance in order to help it avoid a precipitous decline. As is evident in the chart, most countries display favorable or neutral conditions, the exceptions being Liberia, Mozambique, and Zimbabwe. Problems tend to fall in the fiscal space. Not surprisingly, the most frequent problematic indicators in these developing countries include high debt and low tax revenue collections.
The assessment framework has also proved to be a useful tool in advising finance ministers in Moldova and Jordan on their macroeconomic conditions. Additionally, Bangladesh’s Parliament launched its Budget Analysis and Monitoring Unit, with USAID assistance, using this tool for macroeconomic analysis in the midst of the global financial crisis.
While the tool represents practical wisdom in economics, it should not be used in isolation from other models, but rather as a complement to other models for assessing macroeconomic impact. Whether or not a country decides to follow the policy prescriptions derived from the resilience assessment tool, the dynamics in any given country may still represent a challenge for implementing counter-cyclical policies, as has been the case even in developed economies such as the United Kingdom.
While the global financial crisis reignited interest in counter-cyclical policies, any such policy has to be appropriate to the reality of the country. Factors besides those presented in this model are also important, including the quality of institutions and governance. When it comes to improving the economic resilience of nations, the policy recommendation must be for countries to strive to improve both monetary and fiscal space during good times, in order to counter the shocks that will inevitably come when times are not so good.
- No country is immune to economic shocks, but resilient countries can counter their effects.
- Macroeconomic resilience is a function of fiscal and monetary space—responsible governments will work to improve both during good times, in anticipation of crises to come.
- The resilience assessment tool should not be used in isolation from other models, but as a complement to them.