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


Contents

Objectives

Introduction to the problem

Preliminary analysis

The model

Empirical specifications

Results

Conclusions


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


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)


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;


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


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%


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


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


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


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


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


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


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


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


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

*** )(


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


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


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


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


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(

)var(

),cov(

)var(

),cov(1

it

itit

it

ititit

it

ititit

it

itit

sfa

sfad

sfa

sfadsfa

sfa

sfadsfa

sfa

sfab

tT

1

itiitititiitiitttitit sfaCTsfaCCTCsfaTTsfab 76543210


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


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


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)


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

)var(

),cov(1

)var(

),cov()var(

)var(

),cov(

)var(

),cov(2

it

itit

it

ititit

it

ititit

it

itit

d

sfad

d

sfadd

d

ddsfa

d

db

3

2


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


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


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

the relationship between debt and deficit: empirical evidence of creative accounting in eu25

Documents

practice table

growth pact buti

growth pact sgpcomparing

growth pact criteria

sfa abuse example

persistence of positive

nms10positive sfa

sgp sgp