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Int Inter erdep epend endenc ence b e between een Fi Fiscal cal an and d Mo Monetar ary Poli licy cy: th the case se for or Costa Costa Rica Valerie Lankester Catalina Sandoval CEMLA XXV Meeting of the Central Bank

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Int Inter erdep epend endenc ence b e between een Fi Fiscal cal an and d Mo Monetar ary Poli licy cy: th the case se for

  • r Costa

Costa Rica

Valerie Lankester Catalina Sandoval

CEMLA XXV Meeting of the Central Bank Researchers Network October 30th, 2020

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The ideas expressed in this paper are those of the authors and not necessarily represent the view of the Central Bank of Costa Rica.

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  • Relationship between the effectiveness of monetary policy and fiscal policy

coordination (Sargent and Wallace, 1981).

  • Tradeoffs between the degree of independence of the policies and their

effectiveness (Aiyagari and Gertler, 1985).

  • This is especially relevant for Costa Rica where the central government’s debt

level has reached levels over 50% of its GDP and the Central Bank has made remarkable efforts to strengthen its independence. Motivation

3

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Analyzing the interdependence between monetary policy and fiscal policy in Costa Rica in period 1991-2019:

  • 1. Fiscal dominance test: analyze the relationship between primary fiscal

balance and public sector liabilities.

  • 2. To estimate the effect of fiscal variables on the Central Bank's monetary

policy rate.

  • 3. To estimate the effect of the fiscal deficit on the inflation rate.

Objectives

4

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Inflation and fiscal deficit, 1991-2019

5

Source: Central Bank of Costa Rica.

  • 4
  • 2

2 4 6 8 10 12 14 Percentages (%) 1990q1 2000q1 2010q1 2020q1 Quarters Inflation (QoQ variation) Fiscal deficit (% of GDP)

Series

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Costa Rica: monetary policy and fiscal events

MONETARY POLICY FISCAL EVENTS

1992 1994 1995 2006 2009 2011 2015 2018

Openness

  • f capital

account Banco Anglo’s bankruptcy Crawling band Monetary policy rate Managed float Inflation target Expansionary fiscal policy Fiscal reform Capitalization of BCCR deficit (80s) Central Bank Law

6

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Inflation and exchange rate regime

7 Source: Central Bank of Costa Rica

  • 10

10 30 50 70 90 110

  • Jan. 80
  • Feb. 81
  • Mar. 82
  • Apr. 83
  • May. 84
  • Jun. 85
  • Jul. 86
  • Aug. 87
  • Sep. 88
  • Oct. 89
  • Nov. 90
  • Dec. 91
  • Jan. 93
  • Feb. 94
  • Mar. 95
  • Apr. 96
  • May. 97
  • Jun. 98
  • Jul. 99
  • Aug. 00
  • Sep. 01
  • Oct. 02
  • Nov. 03
  • Dec. 04
  • Jan. 06
  • Feb. 07
  • Mar. 08
  • Apr. 09
  • May. 10
  • Jun. 11
  • Jul. 12
  • Aug. 13
  • Sep. 14
  • Oct. 15
  • Nov. 16
  • Dec. 17
  • Jan. 19
  • Feb. 20

Inflation Period average Crawling peg Mean inflation: 13.4% Crawling band Mean inflation: 5.5% Managed float Mean inflation: 1.3%

Central Bank has modified its monetary policy regime toward inflation targeting

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De Deficit of

  • f the Central Bank (% of
  • f GDP)

GDP), 1983 983 - 20 2019

8

BCCR has a deficit since the crisis of the 80’s, but it has decreased over time

3,0% 1,5% 0.6% 0.0 1.0 2.0 3.0 4.0 5.0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Percentages Deficit (% GDP) Average deficit

Source: Central Bank of Costa Rica

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Ce Central Government Debt, 2000-2020*

9

Public finance’s behavior changed significantly after the financial crisis in 2008

Note: *IMF projection Source: Central Bank of Costa Rica

  • 6%
  • 4%
  • 2%

0% 2% 4% 6% 8% 10% 0% 10% 20% 30% 40% 50% 60% 70% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020* YoY change Central Goverment Debt (% of GDP) Debt(% of GDP) GDP growth

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Fi Fisc scal and d pr primary balance e of the e Cen entral Gover ernmen ent (% of GDP), 2000-2020*

10

The country has reached a critical fiscal situation

Note: *IMF Projection Source: Central Bank of Costa Rica

  • 10.0
  • 8.0
  • 6.0
  • 4.0
  • 2.0

0.0 2.0 4.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020* Percentajes of GDP Primary balance(% of GDP) Interest payment Fiscal deficit

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Data suggests a different relationships through time

Policy interest rate vs primary deficit (% GDP), 1991-2019

Source: Central Bank of Costa Rica. 5 10 15 20 25 30 35 Policy rate (%)

  • 5

5 10 Primary deficit (% of GDP) 1991-1999 2000-2008 2009-2019

Period

Banco Anglo’s bankruptcy Policy interest rate

11

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  • Budget identity of the government for one period (Wahls,2010):

𝑕! + 𝑠!"#𝑐!"# = 𝜐! + 𝑐! − 𝑐!"# + 𝑡!

(1)

  • Intertemporal budgetary balance:

1 + 𝑠 𝑐!"# + ∑$%&

' ($%& #)* & = ∑$%& ' +$%& #)* & + ∑$%& ' ,$%& #)* &

(2)

𝑆𝑐!"# = −∑$%&

' (𝒉"𝝊"𝒕)$%& 2&

𝑆 = 1 + 𝑠 and primary deficit = 𝑕 − 𝜐 − 𝑡

Theoretical framework: consolidated government's budget identity Expenditures Revenues

12

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Theoretical framework: consolidated government's budget identity

  • Government budgetary constraint:

𝑐!"# = 𝑆"# ∑$%&

' 𝑆"$(𝜐 − 𝑕)!($ + 𝑆"# ∑$%& ' 𝑆"$ 𝑡!($

(3)

  • If debt is positive (𝑐>0) the present value of incomes (𝜐 , 𝑡) should be higher than

expenditures (𝑕).

  • The adjustment can be done through reducing expenditures or increasing revenues

from taxes or seigniorage.

  • Who adjusts to maintain balance define dominance :
  • Monetary dominance (MD)
  • Fiscal dominance (FD)

13

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Evidence suggests that the scope for monetary policy has been contingent on fiscal policy:

  • Primary balance is found to be exogenously determined from public

liabilities (Tanner and Ramos, 2005; Jevđović and Milenković, 2018)

  • Monetary policy rate reacts to fiscal variables:
  • Positively (Kuncoro and Sebayang (2013), Ahmed et al. (2019))
  • Not significantly (Zoli, 2005) Afondo et al. (2019)
  • Fiscal deficit seems to have a significant long-run effect on inflation (Catao

and Terrones, 2005; Jalil, Tariq and Bib, 2014) Previous literature from developing economies

14

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Quarterly data from 1991-2019

15

  • Monetary variables:

monetary policy interest rate1, inflation rate, core inflation rate, inflation target2, monetary base, nominal exchange rate, international reserves

  • Fiscal variables:

Fiscal deficit, primary deficit, central government debt (total, external, and internal debt)

  • Other variables:

Product gap, public liabilities, Central Bank deficit, WTI oil prices

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Objective 1: Fiscal dominance test

16

To estimate the relationship between primary balance and liabilities

  • VAR Model:

𝑞𝑠𝑗𝑛𝑐𝑏𝑚! = 𝛽' + ∑()# 𝛽( 𝑞𝑠𝑗𝑛𝑐𝑏𝑚!"( + ∑()# 𝜸𝒌 𝑚𝑗𝑏𝑐!"( +𝜁! (1) 𝑚𝑗𝑏𝑐! = 𝛿' + ∑()# 𝜺𝒌 𝑞𝑠𝑗𝑛𝑐𝑏𝑚!"( + ∑()# 𝛿( 𝑚𝑗𝑏𝑐!"( +𝜕! (2)

Sign

  • Prim. Balance

response (𝜸𝒌) Liabilities response(𝜺𝒌) Zero FD FD Negative FD MD Positive FD or MD MD Granger causality Dominance Primary balance à Public liabilities Fiscal Public liabilities à Primary balance Monetary Impulse Response Functions Granger causality test

  • Classifying the results on fiscal or monetary dominance regimes:
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Objective 1: Fiscal dominance test

17

Granger causality test results

Notes: VAR satisfices stability condition. Source: Central Bank of Costa Rica.

Empirical considerations:

  • Variables as GDP percentages and in first differences (unit root)
  • Number of lags: 4 according to HQIC and SBIC information criteria
  • Controls for seasonality effects including dummies
  • Controls for Banco Anglo’s bankruptcy in 1994, international financial crisis in 2008 and 2009 fiscal events

Period H0 of NO causality AàB Chi2 P-value Conclusion 1991-2019 Liabilities à PB 2.21 0.70 Ambiguous PB à Liabilities 6.47 0.17 1991-2007 Liabilities à PB 5.32 0.26 Fiscal dominance PB à Liabilities 10.32 0.04 2008-2019 Liabilities à PB 3.73 0.44 Ambiguous PB à Liabilities

3.29 0.51

Granger causality test results by period

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Objective 1: Fiscal dominance test

18

Impulse Response Function test

Impulse-Response Functions 1991-2019

Notes: VAR satisfices stability condition. Source: Central Bank of Costa Rica.

Results suggest fiscal dominance, but:

  • PB response to cicles
  • Identification problem

Sign

  • Prim. Balance

response (𝜸𝒌) Liabilities response(𝜺𝒌) Zero FD FD Negative FD MD Positive FD or MD MD

  • .4
  • .2

.2 .4

  • 1

1 2 2 4 6 8 10 12 2 4 6 8 10 12

Response of PB to Liabilites var1, pasivo_var1, pasivo_var1

95% CI

  • rthogonalized IRFs

step

  • .5

.5 1

Response of Liabilities to PB

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Objective 2: reaction function of the Central Bank

General approach: considering the fiscal space

  • Taylor Rule (1993)
  • Evidence for Costa Rica between 1991-2002: a positive and significant effect of

domestic debt (0.23) on the basic passive interest rate was found (Muñoz and Sáenz, 2003).

  • Model
  • Empirical considerations:
  • Controls for seasonality effects including dummies
  • Controls for Banco Anglo´s bankruptcy in 1994, international financial crisis in 2008 and

2009 fiscal events, also for exchange regime

  • Trend variable included
  • Newey-West standard errors

𝑗" = 𝛾# + 𝛾$𝑗"%$ + 𝛾&(𝜌 − 𝜌∗)"%$ + 𝛾((𝑧 − 𝑧∗)"%$+𝛾)𝑓"%$ + 𝜸𝟔𝑔𝑗𝑡𝑑𝑏𝑚"%$ + 𝛾+𝑒𝐽𝑆"%$ + 𝑣"

19

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Estimated relationship between policy rate and primary deficit

20

.2 .4 .6 Estimated coefficient 1991-2019 Before 2009 After 2009 Coefficient 95% CI

Period

Estimated effect of primary deficit on policy rate, 1991-2019

Inclusion of nonlinear effects, controlling for risk rating variable and internal and external debt.

Notes: Quaterly data. Newey-west standard errors in brackets. Controls for seasonality effects and crisis and fiscal events. Source: Central Bank of Costa Rica.

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Estimated relationship between policy rate and public debt

21

Notes: Quaterly data. Newey-west standard errors in brackets. Controls for seasonality effects and crisis and fiscal events. Source: Central Bank of Costa Rica.

  • .1
  • .05

.05 .1 .15 Estimated coefficient 1991-2019 (level) Before 2009 (level) After 2009 (level) 1991-2019 (growth) Not significant Significant 95% CI

Period

We also included external and domestic debt separately, nonlinear effects, and other variables.

Estimated effect of public debt on policy rate, 1991-2019

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Objective 3: Fiscal deficit and inflation

22

Error Correction Model

∆𝝆!= 𝛽' + 𝜚 𝝆!"# − 𝜾′𝒚! + <

()# +"#

𝜇( ∆𝝆!"( + <

,)#

  • "#

𝛾′, ∆𝒚!", + 𝜁!

where:

𝝆𝒖 is the inflation rate

𝒚" is the vector of explanatory variables that includes fiscal deficit, monetary base, oil prices growth, an openness index and real exchange rate, and Central Bank’s deficit. 𝝔 is the speed of adjustment to the long-run value of a change in 𝒚" 𝜾 represents the equilibrium relationship between the explanatory variables included in 𝒚" and 𝝆"

  • Autoregressive distributed lag (ARDL) model with error correction :
  • Catao and Terrones (2005) and Jalil et al. (2014)
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Objective 3: Fiscal deficit and inflation

23

Estimates of fiscal deficit on inflation (scaled by GDP), 1992-2019

Long-run Coefficient (θ) 1 2 3 1992-2019 1992-2007 2008-2019 Fiscal deficit 0.291** 0.450** 0.134 [0.117] [0.154] [0.100] Constant 0.394 4.179**

  • 10.491**

[2.280] [3.053] [4.476] EC coefficient (φ)

  • 0.768***
  • 0.690***
  • 1.059***

[0.083] [0.111] [0.166] Observations 111 63 48 R2 0.631 0.643 0.769

Notes: Quarterly data. Standard error in brackets. Controls for seasonality effects, financial crisis and fiscal events. Source: Central Bank of Costa Rica.

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Final remarks

24

1991-2007 2008-2019

There is no evidence of a statistically significant relationship

  • Primary balance Granger causes public liabilities
  • Policy rate increases to primary deficit increses
  • Fiscal deficit is inflacionary in the long-run

We used three methodological approaches :

  • From the VAR analysis, primary balance seems to be exogenously determined.
  • Primary deficit seems to affect positively the policy rate.
  • Fiscal deficit seems to have a significant log-run effect on inflation.

In general, there is evidence of a statistically significant effect of fiscal policy

  • n monetary variables, but not a full accommodation of the monetary
  • policy. That indicates policy objectives are not coordinated.

1991-2019

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Int Inter erdep epend endenc ence b e between een Fi Fiscal cal an and d Mo Monetar ary Poli licy cy: th the case se for

  • r Costa

Costa Rica Th Thanks s for

  • r you
  • ur att

ttenti tion

  • n, com
  • mments

ts and su suggesti stion

  • ns

Valerie Lankester CEMLA Intermediate Conference Catalina Sandoval October 30th, 2020

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Lineal effect

Annex: Reaction function estimation

26

Variables TPM MPR_{t-1} 0.774*** [0.043] Inflation deviation from target (CPI)_{t-1} 0.013 [0.086] Product gap_{t-1} 0.445*** [0.158] Nominal devaluation _{t-1} 0.147** [0.068] Primary deficit (% GDP)_{t-1} 0.292*** [0.073] Reserves gap_{t-1}

  • 0.578***

[0.179] Trend

  • 0.077***

[0.023] Constant 5.062*** [1.439] Observacions 114 R2 0.968