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Policy Research Working Paper 6562

Protecting Public Investment against Shocks in the West African Economic

and Monetary Union

Options for Fiscal Rules and Risk Sharing

Sébastien Dessus Aristomene Varoudakis

The World Bank Africa Region

Poverty Reduction and Economic Management Department &

Development Economics Vice Presidency Operations and Strategy Team

August 2013

WPS6562

Public Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure Authorized

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Produced by the Research Support Team

Abstract

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.

Policy Research Working Paper 6562

West African Economic and Monetary Union

arrangements have been instrumental in helping member countries maintain low inflation. However, a lesser- known characteristic of the West African Economic and Monetary Union, with possible implications for economic growth, is the high exposure to shocks and the pro-cyclicality of fiscal policy associated with these arrangements. Evidence from a panel of 80 low- income and lower middle-income countries over the period 1995–2012 suggests that, in the Union, both public investment and current public expenditure are more pro-cyclical than they are in other countries. In particular, public investment contracts more in “bad times” than it increases in “good times” in order to

This paper is a product of the Poverty Reduction and Economic Management Department, Africa Region; and the Operations and Strategy Team Development Economics Vice Presidency. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at sdessus@worldbank.org and avaroudakis@worldbank.org.

absorb negative shocks to the budget in the context of strict fiscal convergence criteria. The asymmetric response of public investment to shocks could thus be a reason for the relatively low levels of infrastructure in the Union. Comparisons with earlier periods suggest that public investment has become pro-cyclical since the introduction of the fiscal convergence criteria in 1994.

Moreover, the shocks that affect Union member countries appear to be highly idiosyncratic and thus difficult to mitigate by the Union’s common monetary policy.

The pro-cyclicality of public expenditure and the high asymmetry of shocks that affect Union member countries justify exploring options for greater counter-cyclicality of rules-based fiscal frameworks and for risk-sharing.

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Protecting Public Investment against Shocks in the West African Economic and Monetary Union:

Options for Fiscal Rules and Risk Sharing

Sébastien Dessus

Lead Economist and Sector leader, Africa Region, The World Bank Aristomene Varoudakis

Adviser, Development Economics, The World Bank

Keywords: Asymmetric shocks; fiscal rules; pro-cyclicality; public investment; risk sharing.

JEL Classification: E620, H620, H770 Sector: Economic Policy

Acknowledgements: The authors are grateful to Eleonora Mavroeidi and Jose Luis Diaz Sanchez for excellent research assistance, and to Sanjeev Gupta, Aart Kraay, Darryl McLeod, Herve Joly, Tito Cordella, Punam Chuhan-Pole, and the participants in the seminar on “Shocks and Public Investments in WAEMU countries” held at the World Bank for their comments and suggestions. Views expressed in the paper must not be attributed to the World Bank or its Executive Directors.

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2 1. Introduction

1. At past 50, it is time to review the achievements of the West African Economic and Monetary Union (WAEMU). The WAEMU marked its 50th anniversary in 2012, as its immediate predecessor, the West African Monetary Union (WAMU) was established in 1962 (see Box 1). Commenting on this landmark, the governor of the Central Bank of West African States (BCEAO) highlighted the monetary union’s achievements (BCEAO, 2012). He drew particular attention to the preservation of macroeconomic stability throughout the 50-year period, despite the region’s exposure to major shocks.1 Since the devaluation of CFA Franc in 1994, a number of reforms were also introduced. These focused on three main areas: promoting trade integration (through the establishment of the customs union, and the progressive alignment of regulatory frameworks for private sector development)2; encouraging fiscal convergence (through the adoption of the convergence pact that set fiscal and inflation targets, and the progressive alignment of public financial management regulations); and strengthening central bank independence (through the elimination of all possibilities for central bank financing, particularly statutory advances). In the 2000s, all WAEMU countries entered and eventually completed the Heavily Indebted Poor Countries Initiative (HIPC) and Multilateral Debt Relief Initiative (MDRI) processes. External and public debt sustainability consequently improved significantly. Nonetheless, the BCEAO governor also highlighted a number of challenges facing WAEMU, including: (i) low and instable economic growth; (ii) high costs of financing (for firms and governments) in spite of highly liquid private banks (and foreign reserves above minimum requirements at the French Treasury); (iii) a lack of solidarity mechanisms between member States; and (iv) insufficient stabilization mechanisms and financial instruments to channel volatile resource rents to infrastructure investments. Particularly noteworthy is the slow economic growth rate of the WAEMU zone, in comparison with other African countries and low-income countries. This concern was echoed in 2010 by the International Monetary Fund (IMF), which emphasized infrastructure weaknesses in WAEMU as a significant constraint to higher GDP growth.

2. The debt crisis in the Euro Area has revealed new challenges for monetary unions, including for WAEMU. The most important of these challenges is probably the capacity of monetary unions to ensure fiscal convergence, while also developing solidarity mechanisms to deal with asymmetric shocks (i.e. shocks not affecting all members at the same time). Despite a significant integration of goods and factor markets, as well as full central bank independence, the Euro Area has been facing difficulties to contain the emergence of (i) growing divergence among member countries’ external current accounts (core vs. periphery), and (ii) asset bubbles (Spain, Ireland) or unsustainable fiscal deficits (Greece), which point to deeper competitiveness issues and net saving imbalances. Political and economic integration is shallower in the WAEMU than the Euro Area, but harder external financing constraints have probably prevented major macroeconomic divergences so far. Nonetheless, increased opportunities to borrow at non- concessional terms from non-traditional donors could now change the status quo.

3. To date, most of the discussion on the growth impact of WAEMU arrangements has focused on the peg with the Euro and related real-exchange rate (RER) misalignments.

Recent analysis (Devarajan, 2011, updating Devarajan 1997) suggests that, compared with 1994 (assumed to be a year of equilibrium, just after the CFA Franc devaluation), most WAEMU members had seen their RER becoming strongly over-valued by 2009, with likely negative

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consequences on GDP growth. Other papers (Amin, 2000; Gnansounou and Verdier-Chouchane, 2012) explore the same issue. Using different methodologies to compute the real exchange rate, IMF (2013) suggests that the RER has actually stayed aligned to macroeconomic fundamentals.

The level of pooled foreign reserves by end 2012 (five months of imports from non WAEMU partners with 98 percent coverage of short-term liabilities) and the absence of large external current account deficits also imply that the peg with the Euro has not induced major external imbalances for the union as a whole. Nonetheless, the question remains open as to the optimal RER level for promoting growth and job creation for each member country.

BOX 1:THE WEST AFRICAN ECONOMIC AND MONETARY UNION:ARETROSPECTIVE

The West African Economic and Monetary Union (“Union Economique et Monétaire Ouest Africaine” -- UEMOA) comprises eight members (Benin, Burkina Faso, Cote d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo) sharing the franc CFA (“franc de la Communauté Financière Africaine”) as their common currency. The CFA franc (named in central Africa “franc de la Coopération Financière Africaine”) is also used by six Central African countries (Cameroon, Central African Republic, Chad, Republic of Congo, Equatorial Guinea and Gabon) that constitute another monetary union, the Economic and Monetary Community of Central Africa (“Communauté Économique et Monétaire de l'Afrique Centrale” -- CEMAC). The CFA franc was created in December 1945, when France ratified the Bretton Woods Agreement and the French franc was devalued against the US dollar. It was then called the “franc des Colonies Françaises d’Afrique”. Upon independence in 1960 the old franc CFA was replaced by the two new regional currencies, issued by the Central Bank of West African States and by the Bank of Central African States. Though each currency is legal tender only within its own region, the two are equivalently defined and have always been jointly managed under the sponsorship of the French Treasury as integral parts of a single monetary union, known as the CFA franc zone.

The West African Monetary Union (WAMU) was established in May 1962, originally comprising seven members: Benin, Burkina Faso, Côte d’Ivoire, Mali, Niger, Senegal, and Togo. WAMU was succeeded by WAEMU, established as an economic and monetary union. WAEMU was founded on 10 January 1994, in response to the devaluation of the CFA franc on 11 January 1994. In May 1997, Guinea-Bissau, a former Portuguese colony, became WAEMU’s eighth (and only non-Francophone) member state. Since France’s membership to the Eurozone in 1999, the CFA franc has been pegged to the Euro, and its convertibility guaranteed by the French Treasury, which also ensures the full cover of balance of payments needs. In return, CFA Franc zone members have to deposit 50 percent of their currency reserves in a pool at the French Treasury, and adhere to fiscal and inflation targets. The central bank of the union, the BCEAO (“Banque Centrale des Etats de l’Afrique de l’Ouest”), is mandated to stabilize prices, and cannot finance governments directly.

4. Another channel through which current monetary union arrangements could affect growth is the pro-cyclicality that they may impose on public expenditure and, in particular, on public investment. Being part of a monetary union entails relinquishing national monetary and exchange rate policies but also subjecting national fiscal policy to restraint. In the WAEMU, fiscal convergence criteria3 impose low fiscal deficits, to be exclusively financed by foreign borrowing – de facto, mostly foreign aid.4 Thus, given the practical difficulties to (i) raise tax and non-tax revenues rapidly, and (ii) alter current public expenditures (wages, social transfers and debt service), WAEMU governments may have little choice but to adjust public investment to maintain fiscal balance in the face of shocks. In turn, highly volatile public investments could impact GDP growth negatively. This could occur through various channels, such as: higher completion costs of delayed investment projects; increased risks for contractors, who may request risk premiums or may not bid for future tenders; and derived impacts on the financial sector through higher non-performing loans. Pro-cyclicality of public investment could also amplify, rather than dampen, volatility of GDP through multiplier effects. Furthermore, unlike the relative ease in cutting investment expenditures in bad times, rapidly converting unexpected

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revenues into new projects is often difficult, reflecting, for example, bottlenecks in project selection or procurement. It is therefore possible that volatility of public investment may well affect its average level too.5 Thus, along with public financial management issues that reduce public investment effectiveness, high volatility could be a major contributing factor to the low levels of infrastructure in WAEMU and to slower growth.

5. In this paper we test these hypotheses by extending previous empirical work on pro- cyclical fiscal policies in Sub-Saharan Africa (Thornton, 2008; Lledo, Yackovlev and Gadene, 2011; Guillaumont-Jeanneney and Tapsoba, 2011). The latter authors found that total public expenditure is more pro-cyclical in WAEMU than in other African countries while pro- cyclicality increased after 1995 when fiscal convergence criteria were established. We examine separately the cyclical patterns of public investment and current public expenditure, comparing WAEMU to a large sample of low-income countries (LICs) and lower middle-income countries (LMICs) in Sub-Saharan Africa and in other developing regions. We compare patterns estimated over 1995-2012 with earlier patterns in 1981-1994 to gain insight on the possible impact of the fiscal convergence criteria adopted in 1994. We also examine how these patterns differ in recessions and booms of economic activity. Our results suggest that (i) both public investment and current public expenditure in WAEMU are pro-cyclical and significantly more so than elsewhere (among LICs and LMICs); (ii) public investment, contrary to current expenditure, responds asymmetrically to recessions and booms, with significant contractions in recessions and only limited upside in booms; (iii) public investment has become pro-cyclical since the introduction of the fiscal convergence criteria in 1994; and, (iv) shocks affecting WAEMU countries are highly asymmetric.

6. Unwarranted pro-cyclicality of public investment in the presence of asymmetric shocks would provide a rationale for revisiting existing fiscal convergence criteria and exploring risk-sharing mechanisms to protect and increase public investment. Fiscal deficit rules allowing for greater counter-cyclicality could help smooth the impact of shocks within member countries, while preserving the fiscal discipline necessary to protect the union. Besides, the greater the asymmetry of shocks among WAEMU members, the greater the gains from risk- sharing mechanisms compared to a policy of self-insurance – the equivalent of using only national resources (or budgets) to offset the shocks. In contrast, monetary policies are considered ineffective to address asymmetric shocks in monetary unions. Risk-sharing mechanisms could include either a move towards fiscal federalism through greater centralization of national budgets, or the design of group insurance schemes, or both.

7. The rest of the paper is organized as follows: Section 2 presents some stylized facts on GDP growth, public investment, and the nature of shocks in the WAEMU. Section 3 discusses the empirical findings on the cyclical patterns of public investment and current public expenditure in the WAEMU and other LICs and LMICs. Section 4 discusses policy implications for greater counter cyclicality of fiscal rules and risk sharing. Section 5 concludes.

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2. Stylized Facts: GDP Growth, Public Investments and Shocks

8. Growth and public investment are comparatively low in the WAEMU. We consider 81 low-income (LIC) and lower middle-income (LMIC) countries, according to the World Bank’s classification, including the 8 WAEMU members, over the period 1995-2012. We compare WAEMU to two other country groups: 31 other Sub-Saharan Africa LICs and LMICs (excluding WAEMU), and 42 other LICs and LMICs in the rest of the world (see Annex A, Table A1 for group definitions). As Table 1 shows, at 3.7 percent on (un-weighted) average, annual real GDP growth in WAEMU ranks well below comparator groups. Growth volatility in WAEMU, as measured by the coefficient of variation of annual GDP growth, has been higher than in other LICs and LMICs, but lower than in other SSA comparator countries. Public investment in proportion to GDP has also been low in WAEMU. At 6 percent of GDP on average, it ranks well below the other two groups. Reflecting weak public investment, unsurprisingly perhaps, WAEMU lags behind the rest of Sub-Saharan Africa as a whole on almost all infrastructure indicators, with most notable gaps in in paved road density, mainline density, and generation capacity (Table 2 and IMF, 2010). Such infrastructure gaps could be partly responsible for WAEMU’s “missing growth”.6

Table 1: GDP growth and Public Investment, 1995-2012 (in %)

WAEMU (8 countries)

Other SSA LIC and LMIC (31 countries)

Other LIC and LMIC (42 countries) GDP growth per year

Average 3.72 4.47 4.60

Standard deviation 4.17 6.4 4.19

Standard deviation/Average 1.12 1.43 0.91

Public Investment/GDP

Average 6.06 7.88 7.19

Standard deviation 2.67 6.08 9.68

Standard deviation/Average 0.44 0.77 1.35

Note: Based on the country groups in Annex Table A1. Standard deviations reflect variations both within and between countries. Source: Authors’ calculations based on data from World Economic Outlook, IMF.

Table 2: Infrastructure Indicators

WAEMU Low-income Sub- Saharan Africa

Other low-income countries

Paved road density 14 31 134

Mainline density 6 10 78

Mobile density 50 55 76

Internet density 2 2 3

Generation capacity 20 37 326

Electricity coverage 17 16 41

Improved water 60 60 72

Improved sanitation 33 34 51

Source: African Infrastructure Country Diagnostic, African Development Bank, adapted from IMF (2010).

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9. Shocks are largely asymmetric in WAEMU. Turning to the degree of synchronization of shocks, as Table 3 shows, over 1995-2012, the average correlation of each WAEMU member country’s annual GDP growth with the un-weighted average annual GDP growth of other WAEMU members was 0.117. Burkina Faso and Togo had the highest GDP growth correlation (0.56 and 0.47, respectively) with average GDP growth of other WAEMU members, while all others had no significant correlations with the rest of WAEMU members. The low correlations of real GDP growth among WAEMU members contrast with the much higher correlations of GDP growth observed in monetary unions among advanced economies where economic integration is much higher.7 The use of terms of trade changes as a more direct measure of exogenous shocks points to a similar conclusion (Table 3, last column). The average correlation of individual WAEMU members’ terms of trade changes with the rest of the WAEMU is 0.21, with only Benin, Burkina Faso and Mali exhibiting relatively high positive correlations with the rest of WAEMU members. This analysis confirms that of IMF (2013). Using comparable techniques8, it concluded that “the frequency and asymmetry of shocks in the region are still high” and that “business cycle synchronization within the WAEMU remains limited”. We next consider how fiscal variables respond to shocks.

Table 3: Asymmetric shocks in WAEMU, 1995-2012

GDP growth (in %)

Comparison with other WAEMU members

Average St. Dev.

Correlation of GDP growth

Correlation of Terms of Trade changes

Benin 4.1 1.0 0.031 0.440

Burkina Faso 5.9 2.0 0.556 0.551

Côte d'Ivoire 1.7 3.6 0.157 -0.120

Guinea-Bissau 1.1 8.9 -0.257 -0.204

Mali 4.2 3.7 0.193 0.556

Niger 4.9 4.6 -0.169 -0.023

Senegal 3.9 1.7 -0.044 0.307

Togo 2.4 2.7 0.469 0.172

Average 3.5 3.5 0.117 0.210

Source: Authors calculations based on data from World Economic Outlook, IMF.

3. The Pro-cyclicality of Fiscal Policy

10. Countries entering a monetary union relinquish the exchange rate as a policy instrument for the benefit of greater integration associated with the union. However, the costs of this instrument loss may be significant to the extent that countries in the union are economically different, and are thus subject to asymmetric shocks. If prices and wages are rigid and factor mobility is limited, countries that form a monetary union will find it harder to adjust to shocks than those countries that can devalue or revalue their currency, and thus indirectly affect relative prices. In the absence of national monetary policy or of transfers through a federal budget (see section 4), national fiscal policy plays a major role in cushioning idiosyncratic shocks.

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11. Yet, despite the need for fiscal flexibility, existing monetary unions (Euro Area, WAEMU, CEMAC) observe strict fiscal rules that typically limit the leeway of national fiscal policies to respond to shocks. The main reasons for subjecting members of a monetary union to fiscal rules are concerns with debt externalities of national fiscal policies, and possibly weak incentives for fiscal restraint (De Grauwe, 1992, see also Box 2). However, fiscal rules may also reduce the quality of fiscal policy because they disregard the composition of fiscal adjustment necessary for compliance. The need to comply with fiscal rules may result in easy cuts in capital spending. These can have two main effects: first, they may amplify pro-cyclicality through the multiplier effect of public investment, and: second, they may have a potentially negative impact on long-term growth (Blanchard and Giavazzi, 2004).

BOX 2:MARKET DISCIPLINE AND THE NEED FOR FISCAL RULES IN MONETARY UNIONS

A precondition for market-driven discipline in monetary unions is that a no-bailout clause can be properly enforced among the members, regardless of their systemic importance or of concerns regarding financial spillovers from debt default. In the absence of effective enforcement, market interest rates will not reflect the default risk of monetary union members. The assumption that no bailout can be enforced has proven unrealistic, as illustrated by the Euro Area debt crisis, with the multiple bailouts of distressed countries in the periphery,. These validated the views implicitly held by the markets in the run up to the crisis.

Because market discipline is likely to fail, fiscal rules seem necessary to deflect debt externalities and strengthen possibly weak incentives for fiscal restraint. Externalities may arise if national fiscal policies lead to unsustainable levels of public debt. This, in turn, would put pressure on the BCEAO to monetize part of this debt, especially if the highly indebted country is a large WAEMU member. Externalities may also arise through the financial sector, as a debt crisis in a fiscally distressed member may spill over to banks of other members that may hold the distressed debt. The more financially integrated the union becomes, the higher this financial spillover risk.

Incentives for fiscal discipline may weaken when a country joins a monetary union because the interest rate on its debt declines as the risk premium reflecting the exchange rate devaluation risk vanishes. The risk premium reflecting the risk that the member defaults on its debt still remains relevant. However, if there is an implicit insurance that a distressed member will be bailed out — because of financial spillover risks — even the risk premium of debt default will decline, thus leading to sharply lower interest rates on members’ debt. This is likely to be the case in WEAMU with the guarantee of convertibility provided by the French Treasury. A factor that plays in the opposite direction of strengthening fiscal discipline is that WAEMU members surrender the option of financing budget deficits through money creation. As a result, WAEMU members face a harder budget constraint compared to countries with monetary autonomy, and thus have less incentive to run deficits.

12. Fiscal policy has typically been pro-cyclical in developing countries, but whether fiscal rules amplify pro-cyclicality is an empirical matter. Evidence suggests that, contrary to high-income countries where fiscal policy is mostly uncorrelated with the business cycle, in developing countries fiscal policy is pro-cyclical: it turns expansionary in good time and contractionary in bad times (Talvi and Vegh, 2005). The pro-cyclicality of fiscal policy is often explained by the loss of international capital market access during bad times, which, in the absence of fiscal space through accumulated savings, makes it expensive, if not impossible, to finance expansionary policies during downturns (Aizenman et al, 2000; Gavin and Perotti, 1997).9 The pro-cyclicality of fiscal policy has been also documented in African countries:

Government consumption has been found to be pro-cyclical, the more so when dependence on foreign aid is high (Thornton, 2008). Pro-cyclicality of total public expenditure has been confirmed by Lledo, Yackovlev and Gadene (2011), but with a mitigating impact of foreign aid and debt relief.

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13. Whether fiscal rules exacerbate pro-cyclicality will depend on the design of these rules and the incentives they create for policymakers. Strict fiscal rules that target the overall fiscal balance on an annual basis may, arguably, amplify volatility as shocks would trigger immediate expenditure and tax adjustments to meet the fiscal targets. By contrast, fiscal rules aiming for structural deficit targets or deficit targets over the cycle would not necessarily amplify volatility. Importantly, fiscal rules could mitigate volatility if they change the incentives of policymakers, by helping create fiscal space in good times for counter-cyclical response in bad times. There is factual evidence that policy incentives do change over time: Experience with credit rationing during bad times, especially after the East-Asian crisis in the late 1990s, prompted many developing countries to self-insure by building buffers of savings during good times. This has made it possible for several emerging economies to respond counter-cyclically to the 2008-09 global financial crisis, including, to some extent, in Africa (Krumm and Kularatne, 2012).

14. There is evidence that total public expenditure has been pro-cyclical in the WAEMU since the fiscal convergence rules have been introduced in 1995 (Guillaumont-Jeanneny and Tabsoba, 2011). In what follows, we extend previous research by comparing WAEMU to a large sample of other low-income and lower middle-income countries and by analyzing separately the pro-cyclicality of the two components of public expenditure, public investment and current expenditure. Our analysis spans over 1995-2012, covering the period since the introduction of the fiscal convergence rules. We compare the estimated patterns over this period with the period 1981-1994, preceding the fiscal convergence rules. In addition, we examine more in detail the pro-cyclicality of public investment and current expenditure in recessions and economic booms.

15. As we are interested in how shocks affect public investments and current expenditure in the short run, we regress the annual growth rate of public investment and current expenditure on the annual GDP growth rate, without considering other potential determinants of these fiscal variables over the medium term (such as, for example, the level of public debt or of foreign aid).10 We include country specific effects, to account for different average growth across countries, and time-specific effects, to capture the impact of possible symmetric shocks. To account for possible simultaneity between GDP growth and the fiscal variables we use a Generalized Method of Moments (GMM) estimator, with the lagged independent variable used as an instrument. Regression coefficients for the WAEMU countries are estimated separately from the other countries of the sample. We estimate the regressions for public investment and current expenditure in terms of both nominal and real growth rates for the dependent and independent variables. Results are shown in Table 4.

16. Public investment is pro-cyclical in WAEMU, as it is in other LICs and LMICs (Table 4, columns 1 and 2). When variables are measured in nominal terms, the elasticity of public investment to GDP growth is significantly higher (at a 95% confidence level) in WAEMU than in the other countries considered. Current public expenditure also varies pro-cyclically with GDP in both groups of countries (Table 4, columns 3 and 4). There is evidence of higher pro- cyclicality of current expenditure in WAEMU, when variables are measured in real terms (Table 4, column 4). Moreover, in all regression specifications the pro-cyclicality of public investment in WAEMU is significantly higher than the pro-cyclicality of current expenditure. This supports the perception that public investment, more than current expenditure, is a major shock absorber, or residual fiscal variable. As to the fiscal balance, there is evidence of pro-cyclicality in other

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LICs and LMICs but not in WAEMU (Table 4, column 5). The absence of pro-cyclicality of fiscal deficits in WAEMU may reflect the large compensating changes in public expenditures when fiscal revenues are affected by shocks: In bad (good) times, when fiscal revenues shrink (expand), a contraction (increase) of public investment or current expenditure offsets the impact of the shock on the budget, resulting in only small changes in the fiscal deficit in proportion to GDP.

Table 4: The Pro-cyclicality of Fiscal Policy (1995-2012)

1 2 3 4 5

Dependent Variable D(LN(NFIG)) D(LN(KFIG)) D(LN(CURX)) D(LN(KCURX)) (DEF/NGDP) C 0.007 (0.45) -0.056 (-3.85) 0.038 (9.33) 0.014 (4.05) -0.027 (-10.41)

(1-W)*D(LN(NGDP)) 0.869 (10.74) 0.632 (26.21)

W*D(LN(NGDP)) 3.070 (5.80) 0.754 (4.17)

(1-W)*D(LN(KGDP)) 2.302 (8.71) 0.626 (10.13) 0.104 (2.22)

W*D(LN(KGDP)) 3.539 (5.36) 1.438 (5.26) 0.132 (0.71)

Instrumental variables 1 lag of the explanatory variable for each regression Country-specific

effects Yes Yes Yes Yes Yes

Time-specific effects Yes Yes Yes Yes Yes

Countries included 68 68 80 80 80

Observations 1144 1144 1206 1206 1241

R-Squared 0.225 0.129 0.618 0.227 0.419

Note. D and LN denote the first difference operator and the natural logarithm operator respectively. NFIG: nominal public investment; KFIG: real public investment; NCURX: current nominal public expenditure (total expenditure excluding public investment); KCURX: current real public expenditure; DEF: fiscal balance; NGDP: nominal GDP; KGDP: real GDP; W: dummy variable for WAEMU countries. T –Student statistic in brackets.

17. Public investment has become pro-cyclical since the introduction of the fiscal convergence criteria. Estimating the same set of regressions over the period 1981-1994, preceding the introduction of the fiscal convergence criteria in WAEMU, provides evidence on the possible impact of this fiscal framework on the cyclical patterns of public investment and current expenditures. As Annex A Table A2 shows, both public investment and current expenditure were pro-cyclical in other LICs and LMICs in 1981-1994 as well. In WAEMU, public investment was pro-cyclical only when measured in nominal terms but not when measured in real terms. Current public expenditure was also pro-cyclical in the earlier period.

However, in WAEMU, in notable contrast to the earlier period 1981-1994, the elasticity of public investment with respect to GDP has significantly increased in the more recent period 1995-2012 (Table 5). There is no evidence of a similar increase of the pro-cyclicality of current expenditure over time. This confirms the perception that, since the introduction of the fiscal convergence framework, public investment, more than current expenditure, has responded pro- cyclically in the face of shocks that affect the budget.

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Table 5: Elasticity of public investment and current expenditure to GDP in the WAEMU (confidence intervals, 1995-2012 vs. 1981-1994)

1981-1994 1995-2012

Nominal GDP Real GDP Nominal GDP Real GDP

Nominal Public Investment 0.23-1.63 2.01-4.13 (*)

Real Pubic Investment -0.98-3.14 2.22-4.86 (*)

Nominal Current Expenditure 0.10-1.26 0.39-1.11 (*)

Real Current Expenditure 0.26-1.94 0.89-1.97 (*)

Note. The table indicates intervals of elasticities to GDP at a 95% confidence level, based on the estimation results reported in Table 4 and Annex Table A2. (*) indicates a confidence interval for the estimated elasticity in 1995-2012 significantly higher than in the estimated interval in 1981-1994.

18. The pro-cyclicality of fiscal policy in developing countries has often been found to be asymmetric in good and bad times. For example, Gavin and Perotti (1997) found that the pro- cyclicality of fiscal balances in Latin America was stronger in bad times, when negative deviations of GDP growth from average were large. In WAEMU, Guillaumont-Jeanneney and Tapsoba (2011) found total public expenditure to be more pro-cyclical in recessions than in good times. In a similar vein, in our larger sample we break down total public expenditure and examine whether the elasticity of public investment and current expenditure to GDP is different when countries face negative and positive shocks. For each country we identify periods of negative shocks as years with below-average real GDP growth (over 1981-1994 and 1995-2012) and periods of positive shocks as years with above-average real GDP growth. Regressions of real public investment growth on real GDP growth are estimated separately on periods of negative and positive shocks, while distinguishing the elasticities for WAEMU and non-WAEMU countries. Similar regressions are estimated for real current public expenditure growth. We use a GMM estimator with the lagged real GDP growth as instrument.11

19. In both WAEMU and other LICs and LMICs, the elasticity of public investment to GDP is not significant in good times (Table 6, column 1). By contrast, in bad times, the elasticity of public investment to GDP is significant for both groups of countries (Table 6, column 2). Public investment seems thus to respond asymmetrically to growth shocks in all countries: It contracts more in recessions than it expands in booms. Contrary to public investment, current public expenditure is pro-cyclical in both bad and good times. In the two groups of countries, the estimated elasticities of real current expenditure to GDP are significant in both recessions and booms (Table 6, columns 3 and 4). Moreover, while the point estimates of elasticities are higher in “bad times” (column 4), these differences are not statistically significant, indicating the absence of asymmetric response of current expenditure. It is notable, however, that the estimated elasticity of real current expenditure to GDP is higher for WAEMU countries in bad times. Summing up, distinguishing among periods of recession and boom leads to the following conclusions:

(i) Public investment responds asymmetrically in recessions and booms, with contractions in recessions but no significant increases in booms;

(ii) Current consumption is pro-cyclical both in bad times and good times;

(iii) Current consumption in bad times is reduced more in WAEMU than elsewhere.

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Table 6: The pro-cyclicality of public expenditure in “good” and “bad” times (1995-2012)

DLN(KFIG) DLN(KCURX)

Dependent Variable GDP growth > Avg GDP growth <Avg GDP growth > Avg GDP growth < Avg

C 0.059 (1.56) -0.063 (-3.10) 0.033 (3.57) 0.012 (2.87)

(1-W)*D(LN(KGDP)) 0.553 (0.97) 2.167 (3.25) 0.322 (2.36) 0.513 (3.77) W*D(LN(KGDP)) 2.846 (1.47) 3.144 (2.56) 1.650 (2.76) 2.248 (3.13)

Instrumental Variables 1 lag of the explanatory variable for each regression

Country-specific effects Yes Yes Yes Yes

Time-specific effects Yes Yes Yes Yes

Countries included 67 67 79 78

Observations 625 518 665 540

R-Squared 0.137 0.183 0.258 0.310

Note. D and LN denote the first difference operator and the natural logarithm operator respectively. KFIG: real public investment; KCURX: current real public expenditure; KGDP: real GDP; W: dummy variable for WAEMU countries. Average annual GDP growth (Avg) calculated over 1995-2012. T –Student statistic in brackets.

20. The asymmetry in the response of public investment in bad and good times suggests that shocks could have affected the level of public investment, in addition to increasing its volatility. The overall public investment level would thus be lower with negative and positive shocks of equal variance than without shocks. Moreover, given that the point estimate of the elasticity of public investment to GDP is significantly higher in WAEMU than in non-WAEMU countries when variables are measured in nominal terms (Table 4, column 1), the impact of GDP growth shocks on the level of public investment can be expected to be higher in WAEMU. This phenomenon could contribute to partly explaining why WAEMU countries record lower average public investment levels than other low-income and lower middle-income countries (as documented in Table 1). On average, negative shocks in WAEMU over 1995-2012 (in 58 instances out of 136; or for 42 percent of observations in the sample) were equivalent to a 2.8 percentage point drop in the GDP growth rate. Positive shocks (78 observations) averaged an additional 2.1 percentage points of GDP. Simulating public investment using these WAEMU averages conservatively suggests that had public investment in WAEMU countries responded to shocks as in non WAEMU countries, public investment would have been 15 to 20 percent higher, or one percentage point of GDP higher.

21. The pro-cyclicality patterns discussed above reflect the characteristics of reforms engaged in WAEMU over recent years. Slow progress in domestic revenue collection and adherence to fiscal convergence rules (see IMF, 2013) that do not provide for cyclical flexibility help plausibly explain why governments are prompt to cut public investment expenditures in bad times while adjusting current expenditure pro-cyclically in both bad and good times. What seems more surprising at first glance is the difficulty governments have in increasing capital budget execution in good times, especially given the significant amount of effort that they and their development partners devote to supporting public financial management and procurement reforms in WAEMU. Indeed, judging by the Country Policy and Institutional Assessment (CPIA) data, as well as by the evidence available through Public Expenditure and Financial Accountability (PEFA) programs, these efforts have resulted in significant improvements to

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public financial management and procurement institutions, as well as legal frameworks, policies and systems. This has been the case in particular for the WAEMU countries, which have followed a harmonized set of policy reforms contained in two waves of procurement and public financial management directives since the end of the 1990s. However, progress has been uneven – stronger on upstream budget processes (budget preparation, budget classification) than on downstream ones (procurement, budget and contract execution, financial reporting, oversight);

more evident in central finance agencies than in line ministries and at lower levels of government; and generally more focused on the ‘de jure’ than on the ‘de facto’ dimensions of public financial management and procurement.These reforms have arguably improved aggregate fiscal discipline compared to the situation that prevailed in the 1990s. That said, as illustrated by our results, the extent to which they have translated into a more strategic allocation of resources (to investment in particular) and, crucially, into more efficient and effective public spending, remains less clear.

4. Options for Protecting Public Investment and Cushioning Asymmetric Shocks

22. Fiscal adjustment episodes during the recent global economic crisis suggest that protecting public expenditure in bad times did generate some positive impacts. 12 Sub- Saharan African countries that decided (and had the financing space) not to fully adjust to the negative shocks (i.e. not to reduce public spending by a magnitude similar to foregone public revenue) did not generate crowding out effects or higher inflation, did not significantly worsen their debt sustainability prospects, and did not strongly aggravate BOP imbalances. The macroeconomic cost of protecting public programs was thus modest, and probably offset by the longer-term developmental benefits of maintaining such programs. At the same time, countries that tried to stimulate the economy13 through larger public spending than anticipated before the crisis faced difficulty scaling up public investment and social programs. This was largely due to lack of preparation and problems with implementation.

23. Cushioning the impact of shocks on public expenditure and improving resilience in the face of asymmetric shocks would call for adopting counter-cyclical instruments and developing risk-sharing mechanisms among WAEMU members. Rules are important as anchors of medium-term fiscal policy over the cycle so as to preserve fiscal discipline at the aggregate level. However, injecting some flexibility to existing fiscal convergence criteria could create room for counter-cyclical policies. As noted earlier, because of the pro-cyclicality of public expenditure, the fiscal deficit has been largely uncorrelated to GDP growth in the WAEMU and other low-income countries (Table 4, column 5). A countercyclical fiscal rule would allow for some negative correlation, with smaller deficits in booms and larger deficits in contractions. At the same time, because shocks affecting WAEMU countries are highly asymmetric, they could not be addressed by the common monetary policy of the WAEMU.

There is thus room for establishing fiscal federalism arrangements or for adopting a form of risk sharing (or group insurance) against these shocks. Risk-sharing mechanisms would aim to allocate larger financial resources to the members exposed to negative shocks. As countries facing difficulties seem compelled to cut back investment more during negative times, such mechanisms would also help raise average public investment rates in WAEMU. Options to establish such mechanisms and possible combinations are discussed in more detail below.

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13 Options for Counter-cyclical Fiscal Rules

24. Fiscal rules affect the way fiscal policy can respond to shocks. Rules that target the overall budget balance and (binding) public debt rules impart pro-cyclicality to fiscal policy, as expenditures and/or taxes have to be adjusted in order to comply with the rules. A pro-cyclical fiscal stance in bad times will exacerbate economic contractions. At the same time, such rules may not lead to sufficient restraint in good times. This is because they are unlikely to be binding due to strong cyclical tax revenues that may help meet targets concerning the overall budget balance. Pro-cyclical rules would thus risk making the fiscal stance over expansionary. At the same time, they would fail to help realize savings for bad times. By contrast, a cyclically adjusted budget balance rule would allow the automatic fiscal stabilizers to operate. Nor would it trigger expenditure or tax adjustments, as long as deviations from the target are due to cyclical effects. Budget balance rules defined “over the cycle” provide room for the operation of automatic stabilizers, as well as for some discretionary fiscal response to shocks.

25. Existing fiscal convergence criteria in WAEMU could be amended to allow greater cyclical response. In the likely absence of sufficient market discipline in WAEMU,14 fiscal rules remain important to preserve fiscal discipline and guard against debt externalities and weak incentives for fiscal restraint (see Box 2). However, as documented, fiscal policy, and especially public investment, has been pro-cyclical in WAEMU, more than elsewhere in low-income countries. The existing fiscal convergence framework that requires balancing the annual budget of domestically financed expenditure does not guarantee debt sustainability as it excludes expenditures financed through the accumulation of foreign debt. IMF (2013) recommends using a fiscal convergence rule based on the determination of the overall deficit (including all sources of financing) as a better safeguard for debt sustainability. Moreover, excluding foreign-financed expenditure from the definition of the basic budget balance has not succeeded in protecting at least part of public investment from volatility, as total public investment has remained pro- cyclical. For these reasons, we consider fiscal rule options based on a comprehensive definition of public expenditure, regardless of the source of financing.

26. There are various options to amend fiscal rules to allow some cyclical flexibility. At least four different options can be considered for setting the budget balance target:

(i) Overall budget balance with ad hoc adjustments.

(ii) Cyclically adjusted (structural) budget balance.

(iii) Overall budget balance over the cycle.

(iv) A “Golden rule” with exclusion of the capital budget from the target.

In any case, when considering flexibility, it is important to distinguish temporary from permanent (or persistent) shocks. While temporary shocks can be accommodated to the extent there is fiscal space for counter-cyclical response, adjustment to permanent shocks is inevitable.

Such adjustment has to happen through some combination of price, labor, and capital movements. Fiscal policy can only delay, often unproductively, the necessary adjustment to permanent shocks.

27. When fiscal rules target the overall budget balance, some degree of cyclical flexibility is possible on an ad hoc basis. That can be provided through changes in the numerical value of the balance budget target to accommodate shocks. Adjustments made to fiscal

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rules during the global financial crisis provide examples of such attempts to accommodate cyclical shocks (see Schaechter et al., 2012). Latin American countries — especially Peru, Colombia, and Panama — offer recent examples of rules-based fiscal policies that target the overall budget balance, as well as changes designed to accommodate the incidence of external shocks (see Annex B and also Berganza, 2012). The main risk is that such ad hoc flexibility could come at the expense of the credibility of the rules-based fiscal policy. This would then undermine the role of the rule as an anchor of expectations about medium-term fiscal sustainability.

28. A cyclically-adjusted, or structural budget balance, can provide a natural target to allow for flexibility to respond to output shocks. Estimating the structural budget balance requires an estimation of the output gap (i.e. the deviation of GDP from its potential level). It also requires reliable knowledge of tax elasticities and of the elasticities of cyclically sensitive expenditures with respect to the output gap. The structural budget balance will reflect how discretionary tax and expenditure policies affect the budget after removing the impact of the cycle through taxes and cyclically sensitive expenditures. A target for the structural budget balance can be established with a view to ensuring debt sustainability over time. This would take into account growth, inflation, and interest rate projections and associated risks. A properly selected target can also help achieve any debt objective in proportion to GDP over a certain period of time. The fiscal rule would provide sufficient room for the fiscal automatic stabilizers to operate and cushion downturns. If the cycle is regular, the budget deficits in downturns should be matched by surpluses in upturns. This would allow the structural budget deficit target to be met over the cycle.15 One drawback of structural budget balance rules is that cyclically adjusted budget balances are difficult to estimate with sufficient reliability. This is especially true for developing countries. Targeting of overall budget balances has thus been common practice, including in the Euro Area and the WAEMU zone. This is despite targets for the cyclically adjusted fiscal balance gaining ground more recently, as evidenced, for example, by the adoption of the “Fiscal Compact” in March 2012 by all but two members of the European Union.

29. A variant of the structural budget balance rule consists in targeting the overall budget balance over the cycle. This variant would require the government to achieve budget balance on average over the cycle (or any level of overall deficit or surplus deemed consistent with debt sustainability). The rule would leave room for counter-cyclical action (automatic or discretionary) in downturns, while requiring fiscal tightening in upturns. A possible drawback could be a requirement for pro-cyclical tightening towards the end of the cycle. This could arise if fiscal policy were too loose in the earlier phases (IMF, 2009). Another drawback is that the rule requires accurate timing of the cycle and stable national accounts data to preserve the credibility of the fiscal policy framework.

30. A frequently used approach focuses on the so-called “golden rule”, which excludes capital expenditure from the targeted budget balance. Protecting this category of expenditure from the adjustments required for an overall budget balance target can be justified on the grounds that public investment contributes to long-run growth. It can also be justified if changes in public investment have multiplier effects on GDP that may amplify the pro-cyclicality of fiscal rules targeting the overall budget balance. The downside of this approach is that it reduces the comprehensiveness of the budget balance target and, in turn, weakens its link with the objective of debt sustainability. Moreover, it implicitly assumes that all capital expenditure is

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productive, while at the same time excluding current expenditures (especially in human development) that may also raise productivity growth. A golden rule, coupled with a debt ratio target, was followed in the UK from 1997 to 2011 with mixed results. It was replaced by a cyclically adjusted budget balance rule over forward-looking five-year periods.

31. Gradual adjustment to deviations from fiscal rules targets could be warranted. The size and timing of corrective action to be taken in case of deviations from fiscal targets could be set by a rule. Alternatively, corrective actions could be decided by discretion in view of the amount of debt accumulation that is likely to result over time and the associated risks for debt sustainability. Correcting the deviation only gradually may be necessary in order to preserve the counter-cyclical properties of the fiscal rule. A precipitous correction may risk creating pro- cyclicality because excessive fiscal tightening could exacerbate the contraction and lead to unwarranted debt accumulation. A gradual correction may call for a temporary increase in the targeted structural budget balance, with the adjustment towards the initial target calibrated to achieve a decline in the debt ratio over a longer period of time.

32. The Swiss and German fiscal rules are noteworthy examples of gradual adjustment mechanisms to deviations from fiscal rule targets. Both rules allow for counter-cyclical flexibility by targeting the cyclically adjusted budget balance. The Swiss “debt brake”

framework (initiated in 2003) sets annual expenditure targets consistent with balanced structural budgets that reflect estimations of cyclically adjusted revenues (Beljean and Geier, 2012).

Deviations from the target are accumulated in a notional control account. If the negative balance in this account exceeds 6 percent of expenditures (about 0.6 percent of GDP), then corrective action is required to reduce the account balance below this ceiling within three years. A deviation from this rule can be authorized in exceptional circumstances by a supermajority in the parliament. The recently revised (in 2011) German fiscal rule sets the structural federal budget target at 0.35 percent of GDP. Negative or positive deviations from the target are stored in a notional control account. When a negative balance in this account exceeds 1.5 percent of GDP, corrective adjustment is required. However, adjustment can only occur during recoveries so as to avoid pro-cyclicality of fiscal policy. Exceptional emergencies may allow the suspension of corrective action.

33. Using a notional control account for deviations from fiscal targets may be a useful shock absorber for WAEMU. Targeting the structural fiscal balance may be difficult in the WAEMU zone. Flexibility could be introduced through a framework similar to the Swiss or German fiscal rules, targeting the overall budget balance—not the structural balance—inclusive of foreign-financed expenditures. This would create incentives for WAEMU countries to exercise fiscal restraint in good times in order to accumulate credits in their “notional control accounts”. These savings could be used as fiscal space in bad times to offset the impact of adverse shocks. The “debt brake” associated with the rule would require corrective action to be exercised once accumulated deficits have reached a certain limit in proportion to GDP. It should be noted, however, that in the case of resource-rich countries where a large fraction of fiscal revenues comes from primary commodity exports, focusing on the overall balance over the cycle may not suffice. For short-run stabilization purposes, the fiscal framework would need to be supplemented by a focus on the non-resource primary fiscal balance, possibly targeted over the cycle.16

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34. The mechanism could postpone corrective fiscal action for a certain time during recessions, which would provide some breathing space for countries to adjust to temporary shocks. The necessary degree of flexibility in the fiscal rule would need to be estimated so as to accommodate moderate temporary shocks and help preserve capital expenditures from unnecessary volatility over time. Financing could be secured from multilateral donors, regional financial markets, and some form of risk sharing mechanism that would allow interregional transfers, possibly through a shared credit facility. Options for such a mechanism, as a complement to a counter-cyclical fiscal rule, are reviewed below.

Fiscal Federalism and Risk Sharing

35. Cushioning the impact of asymmetric shocks on monetary union members typically calls for fiscal federalism, in the form of significant centralization of national budgets at the level of the union. A centralized budget would work as a shock absorber, by allowing countries hit by negative shocks to receive larger transfers from, and/or pay less tax to, the federal budget.

This would be equivalent to an interregional transfer within the union from countries affected by positive shocks. These countries would pay more tax to the central budget—thus financing transfers to those countries hit by negative shocks—or, alternatively, would receive fewer transfers from the central budget. Fiscal federalism through pooling part of national budgets would enable union members to share risks when faced with asymmetric shocks.

36. Different combinations of inter-temporal transfers through counter cyclical fiscal rules, coupled with interregional transfers through fiscal federalism, would shield to different degrees WAEMU members from asymmetric shocks. Arguably, similar levels of protection could be provided by combinations of high interregional and low inter-temporal transfers (extensive fiscal federalism with rigid national fiscal rules), or by combinations of low interregional and high inter-temporal transfers (weak fiscal federalism with flexibility granted to national budgets). Such combinations are portrayed, illustratively, in Figure 1. However, contrary to transfers engineered through fiscal federalism, relying on decentralized national budgets to offset shocks reduces the degrees of freedom of future national fiscal policy. This is because the debt issued to counter the shocks will need to be serviced in the future. Interregional transfers through an element of fiscal federalism can increase the degrees of freedom of monetary union members when smoothing out asymmetric shocks. Interregional transfers can therefore be complementary to inter-temporal transfers achieved through some degree of national budget flexibility. Current WAEMU arrangements match a situation at the bottom left corner of Figure 1, with non-existent interregional transfers and low inter-temporal transfers through national budgets—to the extent public expenditure is financed from foreign sources.

Consequently, the mitigation of asymmetric shocks is very low, while public expenditure, and notably public investment, turn pro-cyclical in response to shocks. Better mitigation of asymmetric shocks would call for a movement towards the middle of Figure 1, as illustrated.

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Figure 1: Fiscal Transfers with Different Combinations of Fiscal Rules and Federalism

37. There is space for pooling resources in the WAEMU, but large-scale fiscal federalism through budget centralization would be premature. Pooling resources to finance regionally important expenditure programs – especially in infrastructure so as to facilitate trade and regional integration – might produce economies of scale, as well as providing a step towards fiscal federalism. This would also shield part of the national public investment budgets from the pro-cyclicality that they currently suffer. Fiscal federations typically also pool resources for social protection and cyclically sensitive programs such as unemployment insurance. However, these programs are not well developed in the WAEMU.17 On the revenue side, although centralized expenditures can be funded from transfers of member states, all fiscal unions rely on their own tax revenues in practice. Typically, fiscal unions depend upon a central corporate income tax and a central personal income tax, although state personal and corporate income taxes are also possible.18 Because corporate and personal income tax revenues are highly cyclical, their centralization contributes to consolidating a significant part of the action of automatic stabilizers at the level of the fiscal union. This creates the necessary space for interregional transfers through the federal budget that cushion asymmetric shocks to member states. At the same time, this shrinks the size of automatic stabilizers at the level of national budgets. Although this could potentially reduce the advantages of fiscal federalism for mitigating asymmetric shocks, benefits would still come from centralization to the extent that member states face binding financing constraints, which limit the operation of automatic stabilizers at the national level (Cottarelli, 2012). However, it remains questionable as to whether significant centralization of corporate or personal income tax revenues is feasible in the WAEMU. This is because of the narrow fiscal bases and the weakness of tax mobilization mechanisms.

38. The risk sharing implicit in fiscal federalism can also be achieved through different mechanisms. One way that risk sharing can be achieved is through group insurance in the form of solidarity fiscal funds. Such funds could perform transfers to adversely hit monetary union members. In its simplest form, a solidarity fund would be financed by contributions from all

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members. Adversely hit members in bad times would be entitled to withdrawals from the fund.

This would enable them to cover revenue shortfalls or other insured fiscal risks, according to the fund’s mutually agreed charter and operating guidelines. The greater the asymmetry of shocks that affect union members, the greater the gains from pooling resources (or from contributing to a group insurance scheme such as a solidarity fund). This compares positively to a policy of self- insurance, which would be equivalent to using only national resources (or budgets) to offset the shocks. Intuitively, as all members are not affected at the same time by the asymmetric shocks, the pooled resources necessary to cushion shocks affecting union members at any time would be lower than the sum of resources that individual members would need to put aside to cushion shocks under self-insurance. Hence, for the same level of risk coverage, the contributions of individual union members to a solidarity fund would be lower than the amounts that member states would have to set aside under self-insurance schemes.

39. A solidarity fiscal fund would collect contributions from all WAEMU member states during good times, with the objective of redistributing resources to member states when they face idiosyncratic shocks. As with all insurance schemes, this would raise the issue of moral hazard. It would also require verification that idiosyncratic shocks affecting the budget are exogenous and not policy-induced by systematic slippages or manipulation of the budget. In addition, such an approach would need incentives to ensure that fiscal insurance does not dilute efforts to maintain fiscal discipline through adequate revenue mobilization and spending controls. To address these concerns, the fund could feasibly cover fiscal revenue shortfalls attributable to measurable shocks up to a certain amount or up to a proportion of the shock. One option would be to cover a certain proportion of shortfalls in revenue that derive from terms of trade shocks. It was calculated that the initial financial buffer necessary to cover up to 70 percent of revenue shortfalls linked to terms of trade would amount to around 13 percent of trend GDP in WAEMU (dos Reis, 2004).

40. Different operating and financing arrangements for a solidarity fiscal fund could be envisaged. The fund could operate as pure group insurance, with payment of flat premiums from member countries (depending on country size and exposure to terms of trade shocks). This would most closely resemble a federal fiscal arrangement, as the scheme would generate interregional fiscal transfers. The fund could alternatively function as a contingent credit line for member states, with charges for the repayment of withdrawn funds. In this case, the solidarity fiscal fund would be closer to a common pool of resources to facilitate inter-temporal transfers in countries affected by asymmetric shocks. It could be financed with initial contributions from WAEMU member countries and flat periodic premiums in the case of a pure insurance scheme.

In parallel, bilateral and multilateral donors could co-finance the fund. Contributions of member states could be leveraged through guarantees provided by bilateral and multilateral donors, which would enhance the fund’s ability to borrow and mobilize additional resources.

41. A risk-sharing mechanism could be designed with the aim of facilitating compliance with a rules-based fiscal framework. An option would be to condition a member country’s access to the fund on its compliance with a counter-cyclical fiscal rule, if such a rule were to be applicable to the monetary union. This can be illustrated by assuming that a fiscal rule targeting the overall budget deficit is established, with a correction framework for deviations from targets similar to the “notional control account” discussed above. Each year member countries would have different balances in their notional control accounts, depending on the degree of compliance

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