Major fiscal shocks are by their nature varied, hard to predict, and difficult or very expensive to mitigate entirely. Because no two shocks are the same, responding to them when they crystallise typically requires the rapid and innovative deployment of government resources on a large scale to support households, businesses, and public services. So maintaining sufficient ‘fiscal space’ – defined by the IMF as “the room for undertaking discretionary fiscal policy relative to existing plans without endangering market access and debt sustainability”a – is central to managing fiscal risks. But how can this be translated into a practical guide for policy makers?
In its 2018 Managing fiscal risks report, the Treasury employed an OECD frameworkb to review estimates of public debt ‘limits’, ‘thresholds’ and ‘targets’ for the UK (Chart A). But these metrics generally do not allow for more granular factors that also determine a country’s fiscal room for manoeuvre such as average debt maturities, share of inflation-linked debt, currency of debt issuance, whether bondholders are mostly domestic or foreign, holdings of off-setting liquid assets, extent of non-debt or contingent liabilities, and capacity to adjust fiscal policy to accommodate rising interest costs. Indeed, the IMF has adopted a multi-faceted approach in which many factors are considered, estimates are allowed to vary across country and time, but which yields only a qualitative assessment.c This reflects the importance of taking a broad view of the factors determining fiscal space, the challenges in quantifying some of them, and difficult judgements required in assigning relative weights to those factors for the purpose of coming up with an overall quantified assessment of fiscal space.
Chart A: Estimates of government debt limits, thresholds, and targets
However, for many determinants of fiscal space the sign of the impact is clear even if the scale is uncertain. All else equal, fiscal space increases with: lower levels of debt (so the past decade has diminished space in the UK); more borrowing in one’s own currency (a strength for the UK); a longer maturity of debt (also a strength, although one complicated by the effects of quantitative easing, as discussed in Chapter 4); holdings of high quality liquid assets; lower non-debt liabilities such as unfunded pension obligations and contingent liabilities such as guarantees; a capacity to rapidly adjust fiscal policy in response to shocks; and a track record of meeting debt obligations (another UK strength). All these factors can vary over time and across countries.
The availability of fiscal space will also depend on the nature of the shock to which policymakers are responding. For a common shock, such as the pandemic, countries with an established reputation for meeting their obligations and whose bonds are traded in deep and liquid markets can benefit from being seen as a ‘safe haven’. Beyond some initial market instability in March 2020, this was the UK’s experience during the pandemic, in which all advanced economies were affected. For governments whose debt is considered a safe haven, fiscal space can be highly elastic – as risk appetite shrinks, the demand for relatively safe assets increases and so too does the availability of willing lenders to those safe havens, which increases their fiscal space to borrow and respond to the shock.
But continued safe-haven status cannot be guaranteed and the cost of losing it can be significant. In the face of an idiosyncratic shock, governments – particularly those reliant on foreign investors – can see funds drain away into safer assets in unaffected countries, resulting in higher borrowing costs and a reduction in fiscal space at precisely the moment the government most needs it.
The IMF’s latest assessment of fiscal space in the UK was made in December 2020. It concluded that the UK has “some fiscal space”, but that a “credible medium-term fiscal framework and a credible fiscal consolidation plan” would be needed.