Download - The Relationship between Debt and Deficit: Empirical Evidence of Creative Accounting in EU25
Bucharest, July 2007 1
The Relationship between Debt and Deficit: Empirical Evidence of Creative Accounting in EU25
MSc student: Marius Marsanu
Coordinator: Professor Moisă Altăr
The Academy of Economic StudiesDoctoral School of Finance and Banking
Bucharest, July 2007 2
Contents
Objectives
Introduction to the problem
Preliminary analysis
The model
Empirical specifications
Results
Conclusions
Bucharest, July 2007 3
Objectives
Analyzing the fiscal aggregates in EU25 and their compliance with the limits imposed by the Stability and Growth Pact (SGP)
Comparing between the two groups of countries: EU15 and new member states (NMS10)
Providing empirical evidence for the use of creative accounting in EU25 in order to circumvent fiscal rules
Analyzing the behavior of EU15 and new member states (NMS10) comparatively, with respect to the introduction of the SGP
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Introducing the problem
Purpose of the fiscal rules; Beetsma and Uhlig (1999)
In the run up to the euro; Dafflon and Rossi (1999)
Non-partisan application of the rules and improved transparency for the Stability an Growth Pact; Buti, Eijffinger and Franco (2002)
Restricted vs. unrestricted fiscal positions; Milesi-Ferretti and Moriyama (2004)
Creative accounting in EU15; von Hagen and Wolff (2006)
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The Stability and Growth Pact and EU25
The rationale behind SGP
SGP and the new member states, table A.1
Inflexibility related to the business cycle
Efficiency of the SGP, Table A.3 (page 21ev / 29rv)
Perfectibility
Equivalence of the analyzed periods: EU15:1992 – 2001; NMS10:1998 – 2007;
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Table A.1: Average economic growth in NMS10
Country Average Economic Growth (2001-2007)GDP to GDP of EU25 ratio
(2006)
Czech Republic
6.60% 0.99%
Estonia 11.30% 0.11%
Cyprus 6.40% 0.13%
Latvia 13.20% 0.14%
Lithuania 9% 0.21%
Hungary 9.50% 0.78%
Malta 2.90% 0.04%
Poland 5.70% 2.37%
Slovenia 8.40% 0.26%
Slovakia 8.90% 0.39%
Source: European Commission, AMECO, own calculations
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Table A.3: Stability and Growth Pact criteria breach for EU27
CountryAnnual government
deficit to GDPGross government
debt to GDPPast breach
periods for deficit
Deadline for compliance for
deficit
Past breach periods for debt
Austria -1.90% 62.40% 2003-
Germany -1.70% 68.90% 2003-2006 2007 2003-
France -3.00% 66.90% 2003-2007 2005 2003-
Italy -4.10% 107.40% 2003- 2007 2003-
Luxembourg -1.80% 7.90%
Netherlands -1.20% 51.20% 2004-2005 2005
Belgium -0.30% 89.80% 2003-
Spain 0.90% 40.00%
Portugal -5.00% 68.40% 2002; 2005- 2002; 2008 2005-
Finland 2.80% 39.70%
Ireland 0.10% 27.20%
Greece -2.60% 105.00% 2003-2006 2006 2003-
Slovenia -1.90% 29.90%
Sweden 2.20% 47.60%
United Kingdom -3.00% 44.10% 2006 2007
Denmark 3.90% 30.00%
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Table A.3: Stability and Growth Pact criteria breach for EU27
CountryAnnual government
deficit to GDPGross government
debt to GDPPast breach
periods for deficit
Deadline for compliance for
deficit
Past breach periods for debt
Cyprus -2.10% 61.50% 2004-2006 2006 2004-
Malta -2.60% 65.90% 2004-2006 2006 2004-
Estonia 1.40% 3.60%
Latvia -1.00% 11.30%
Lithuania -0.60% 18.90%
Poland -3.70% 45.50% 2004- 2007
Hungary -6.70% 59.90% 2004- 2008
Czech Republic -3.20% 31.50% 2004- 2008
Slovakia -3.10% 34.30% 2004- 2007
Romania -2.50% 20.30%
Bulgaria 3.10% 29.90%
Source: European Comission, "Public Finances report" Nr. 3/2006
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Preliminary analysis
Accounting identity: In practice (Table 1):
Central pillar: stock flow adjustments (SFA)
SFA rationale: financial operations (example 1)
SFA abuse (example 2)
Other elements: revaluation of debt denominated in foreign currency, time of recording deficits, transactions in financial assets
ttt DBB 1
tttt SFADBB 1
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Stock flow adjustments
Example 1: ZCB issue Issue value: 90 Face value: 110
Year Debt Deficit SFA
t 110 90 20
t+1 110 95 15
t+2 110 100 10
t+3 110 105 5
t+4 110 110 0
Example 2: capital injections into public companies
Example 3: acquisitions of financial assets
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Persistent SFA
Observing the persistence of positive SFA:
Results in Table 2
Positive SFA in most EU15 countries
Budgetary surpluses for Finland and Greece
Various results across NMS10
Positive SFA in Estonia, Lithuania and Cyprus
1
0
)(n
iitnttt DBBSFA
1
0
n
iitntt DBB
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Countries Unit Debt 1991 Debt 2001 Sum of deficits 1992-2001 SFA 1992-2001
Belgium %(GDP2001) 0.83 1.06 0.24 -0.01
Denmark %(GDP2001) 0.39 0.48 0.06 0.03
Germany %(GDP2001) 0.28 0.59 0.20 0.12
Ireland %(GDP2001) 0.32 0.36 -0.06 0.09
Greece %(GDP2001) 0.43 1.13 0.54 0.16
Spain %(GDP2001) 0.29 0.55 0.15 0.12
France %(GDP2001) 0.24 0.56 0.29 0.03
Italy %(GDP2001) 0.75 1.09 0.42 -0.09
Luxembourg %(GDP2001) 0.02 0.07 -0.25 0.30
Netherlands %(GDP2001) 0.42 0.51 0.11 -0.02
Austria %(GDP2001) 0.37 0.66 0.23 0.06
Portugal %(GDP2001) 0.31 0.53 0.33 -0.11
Finland %(GDP2001) 0.15 0.42 0.05 0.22
Sweden %(GDP2001) 0.54 0.54 0.17 -0.17
United Kingdom %(GDP2001) 0.17 0.39 0.12 0.10
Table 2: Preliminary evidence of systematic positive SFA
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Table 2: Preliminary evidence of systematic positive SFA
Countries Unit Debt 1997 Debt 2007 Sum of deficits 1998-2007 SFA 1998-2007
Czech Republic %(GDP2007) 0.05 0.31 0.29 -0.03
Estonia %(GDP2007) 0.02 0.03 -0.10 0.11
Cyprus %(GDP2007) 0.28 0.62 0.24 0.09
Latvia %(GDP2007) 0.03 0.10 0.06 0.00
Lithuania %(GDP2007) 0.05 0.20 0.09 0.06
Hungary %(GDP2007) 0.24 0.61 0.47 -0.09
Malta %(GDP2007) 0.30 0.67 0.47 -0.10
Poland %(GDP2007) 0.19 0.43 0.31 -0.07
Slovenia %(GDP2007) 0.11 0.28 0.17 -0.00
Slovakia %(GDP2001) 0.12 0.27 0.26 -0.10
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The model Based on von Hagen and Harden (1995, 1996) and developed by Milesi-
Ferretti(2003)
Government allocates its taxes and expenditures optimally over time
denotes the optimal change of public debt
If actual change deviates from optimal change, a cost incurs
represents the cost of deviating from optimal fiscal policy at different points of the business cycle
If no constraint is imposed on the deficit, then: where denotes an exogenous random variable, SFA, and deficits and SFA are assumed to be uncorrelated
*t
2*11 )( ttttt BBK
t
tttttt DBB *
1
t
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The model (2) DL is a limit imposed on the budget deficit
When the government breaks the limit ( ) a cost incurs:
where is assumed to be positive
As it is assumed the government may use SFA strategically, we let denote the strategic component of stock flow adjustments
If the strategic use of SFA becomes known to the public, the government incurs a reputational cost:
)(102 DLDK tt
DLDt
1
tS
tt SK 103
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The model (3) The government disposes of two instruments to optimally derive debt change:
Dt and St
It needs to solve the following optimization problem: min( )
taking into account the restrictions: and
The Lagrange multiplier method is employed to derive the optimal Dt and St :
ttt KKK 321
ttttt SDBB 1 DLDt
t
tttt
DLSD
1
1**
* )(
t
tttt
DS
1
*** )(
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Pearson coefficients
No systematic relationship is expected between SFA and deficits before 1998 and 2004, respectively
A negative correlation between SFA and deficit is expected afterwards
Pearson coefficients, as a preliminary test:
Countries1992 - 1997 / 1998 -
20031998 - 2001 / 2004 -
2007
EU15 -0.06 -0.43
NMS10 -0.31 -0.48
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Variables used
Variables are taken from AMECO database and transformed
All variables are expressed in percentage of the GDP of the year they refer to
The methodology employed was Excessive Deficit Procedure (EDP)
Variable Symbol
debt change
deficit
stock flow adjustment
cyclically adjusted deficit
cyclical deficit
itb
itsfa
itd
sitd
citd
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Arellano Bond dynamic GMM panel estimator
Few time periods, many cross sections
The process can by dynamic and autoregressive
Independent variables do not have to be strictly exogenous
Heteroskedasticity and autocorrelation between idiosyncratic errors are allowed
Poor estimator for small samples
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Arellano Bond dynamic GMM panel estimator
Testing with instrumental variables
The adequacy of instrumental variables
Sargan test of overidentifying restrictions
Efficiency of Sargan test
Testing for autocorrelation of the errors
Instrumental variables used: the lags of order one for all regressors, and the lags of order one and two for the dependent variable
Two steps difference GMM
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The impact of the introduction of the fiscal rule
is a dummy variable that takes the value 1 after the introduction of the fiscal rule and 0 before. can be rewritten as follows:
To test for significant differences for the new member states, the following equation is employed:
Ci is a dummy variable taking the value 0 for EU15 member states and 1 otherwise
ititittitit TsfaTsfab 3210
)var(
),cov(1
)var(
),cov()var(
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),cov(
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),cov(1
it
itit
it
ititit
it
ititit
it
itit
sfa
sfad
sfa
sfadsfa
sfa
sfadsfa
sfa
sfab
tT
1
itiitititiitiitttitit sfaCTsfaCCTCsfaTTsfab 76543210
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The impact of the introduction of the fiscal rule
itiitititiitiitttitit sfaCTsfaCCTCsfaTTsfab 76543210
1
2
3
4
5
6
7
Coefficient NMS10 EU15 EU25 EU25* EU25*OLS EU25*GLS
0.92 1.16 1.10 1.14 1.04 0.95
-1.39 -1.62 -1.91 -1.38 -3.97 -3.77
0.09 -0.21 -0.17 -0.17 -0.29 -0.42
dropped dropped -0.20
-0.09 -0.18 -0.20
-0.79 2.17 2.13
-0.13 0.32 0.05
Creative accounting is obvious in EU25, though not very obvious in NMS10
An increase of SFA by one percentage points leads to a decrease in deficit by 0.17 percentage points
SFA became a policy variable to control to control deficits when the fiscal rule is in place
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The impact of binding fiscal rule
Augmented approach empirically separates the effect of the introduction of the rule on governments whose policy objective is to spend more than 3% of GDP in excess of their revenues
is a dummy variable taking the value 1 if the expected change in debt is larger than 3% of GDP and 0 otherwise
Correlation between SFA and deficits should be negative when fiscal rules are in place and zero when expected debt change is below 3% of GDP
Governments will engage in creative accounting when the expected debt change is larger than 3% of GDP. A negative is expected.
itiiteittit
eit
eitt
eititttitit sfaRTsfaRRTRsfaTTsfab 76543210
eitR
7
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The impact of binding fiscal rule
is not significant because the rule is not binding when deficits are below 3% of GDP
SFA contributes to the increase in debt change with a roughly 1:1 ratio
6
1
2
3
4
5
6
7
3
itiiteittit
eit
eitt
eititttitit sfaRTsfaRRTRsfaTTsfab 76543210
7
Coefficient EU25 EU25 OLS EU25 GLS
0.86 0.57 0.23
-1.45 -1.78 -0.75
0.01 -0.02 0.06
1.64 2.95 4.82
-1.08 0.03 -0.41
0.11 0.32 0.57
0.04 -0.45 -0.55
discussion: countries with a lower change in debt show a negative covariance between deficits and SFA , while for debt level changes above 3% of GDP the coefficient is close to 1, implying no correlation
discussion: negative covariance between deficits and SFA when countries intend to breach the limit (creative accounting)
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The impact of business cycle
can be rewritten as follows:
should be of the same sign as and of similar size since most part of the deficit is structural
3
ititcit
citt
sit
sittit TddTddTb 543210
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),cov(1
)var(
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d
sfad
d
sfadd
d
ddsfa
d
db
3
2
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The impact of business cycle
and relatively close to 1
Creative accounting is not used very much with structural deficits
5
Coefficient EU25 EU25 OLS EU25 GLS
1.24 0.89 0.89
1.47 1.19 1.46
1.27 0.64 1.17
-0.25 -0.12 -0.3
-1.15 -0.55 -0.785
4
3
2
1
ititcit
citt
sit
sittit TddTddTb 543210
2 4
is strongly negative: an increase in cyclical deficit is almost completely offset by reductions in stock flow adjustment; creative accounting is used with the business cycle
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Conclusions
After the introduction of the fiscal rules , stock flow adjustment became a policy variable to control the evolution of the deficit
Stock flow adjustment are mostly used with the business cycle in order to reduce its impact on the deficit
Creative accounting seems to prevail in EU15 countries, for which the rules of the Stability and Growth Pact were designed
Behavioral equivalence between EU15 and NMS10
Bucharest, July 2007 28
The Academy of Economic StudiesDoctoral School of Finance and Banking
The Relationship between Debt and Deficit: Empirical Evidence of Creative Accounting in EU25
MSc student: Marius Marsanu
Coordinator: Professor Moisă Altăr