Sep 29 - Oct 12, 2008

In a context of weakening balance of payments and accelerating inflation, fiscal pressures are mounting and the use of nominal exchange rate flexibility has remained limited.

Reduction in fuel taxes and increases in fuel subsidies now dominate fiscal costs. Public sector wages are also increasing. At the same time, many countries continued to be reluctant to increase exchange rate flexibility, despite the useful role it can play as a shock absorber. Countries face difficult choices as they seek to facilitate the inevitable adjustment in their economies. Most will need a combination of price adjustment, involving real depreciation and pass-through of world market prices, and fiscal adjustment to offset the higher budgetary costs. With the rise in headline inflation and wages, the risks of spillover from first-round effects to generalized inflation have become an increasing cause for concern and will require a robust monetary response. The IMF has observed and categorized the country responses in the following categories:


The costs of the fiscal policy responses to increasing fuel and food prices have continued to increase. Countries responded to rising prices primarily by reducing taxes and tariffs, increasing universal subsidies, expanding transfer programs, and increasing public sector wages. The recent increases in fiscal costs stem from further reductions in fuel taxes and increases in fuel subsidies, which now dominate total fiscal costs. In contrast, the median fiscal cost of food-related measures has leveled off, although more countries are using fiscal instruments to cushion the impact of higher food prices.

'Fuel. The number of countries reporting reductions in fuel taxes or higher fuel subsidies has risen, along with the fiscal cost of these measures. Most of the increase in fiscal cost is attributable to higher subsidies and stems from the reluctance of many countries to pass through price increases.

'Food. Although the number of countries reporting reductions in food taxes or increases in food subsidies has increased, the median (as well as the mean) fiscal cost has remained broadly unchanged.

'Transfers and wages. Only a few countries reported an increase in the prevalence or size of transfer programs in response to higher fuel and food prices. The number of countries reporting increases in public sector wages and pensions has risen, although the increases for the additional countries, and the related fiscal costs, probably reflected a broad range of factors, and not just a response to higher fuel and food prices.

'Total fiscal costs. Both the number of countries reporting higher fiscal costs and the magnitude of these costs has increased. The median total fiscal cost incurred since 2006 has increased from 0.6 to 0.7 percent of GDP. Higher fuel subsidies and lower fuel taxes account for nearly two-thirds of the total increase in fiscal cost since 2006.

As reported in a recent IMF Board paper, rising fuel and food subsidies are likely to exert fiscal pressure in a number of countries. The combined fiscal cost of these subsidies in 2008 is expected to exceed 2 percent of GDP in 24 countries. Fuel subsidies present the greater fiscal challenge, as they comprise the bulk of total food and fuel subsidies. These subsidies are almost always poorly targeted; a shift-gradual, if need be-to better targeted programs could protect the poor in a more cost-effective manner. In fuel importing countries, decreases in world fuel prices from recent peak levels would reduce the fiscal burden of subsidies, as long as the decreases are not passed through to consumers and the exchange rate against the dollar does not depreciate. The fiscal cost of subsidies would also fall for oil exporting countries, but this effect would be offset by the loss of revenue from oil exports.

B. Monetary and Exchange Rate Responses, and Trade Policies

Aversion to nominal exchange rate flexibility continues to be strong in many countries that can seemingly least afford it. As a consequence, a large number of countries with de jure floating exchange rates have experienced an appreciation of the real effective exchange rate (REER) at a time when negative terms of trade shocks would call for depreciation. Appreciation of the REER has been particularly pronounced in Cambodia and Sri Lanka. A smaller group of countries has allowed some-mostly modest-depreciation of their currencies, which helped to broadly stabilize their REERs. Countries that use an exchange rate anchor to control inflation face trade-offs, in particular those countries that do not have in place an alternative framework for conducting monetary policy.

Bucking the broader trend, some countries have allowed a substantial turnaround in their currencies this year, relative to 2007. These countries have broadly adequate reserves and had allowed their currencies to appreciate substantially against the U.S. dollar during 2007. By contrast, nominal depreciation so far this year has contributed to a median real effective depreciation of close to 3 percent.

Some low- and middle-income countries that experienced large net inflows witnessed a substantial appreciation of their currencies from January 2007 to June 2008.

These countries have broadly adequate reserves. Among these countries, Argentina, Mongolia, Papua New Guinea, and to a certain extent Uganda experienced an appreciation of their currencies by virtue of higher international commodity prices. Other countries were recipients of large remittances and other capital inflows, which cushioned the impact of the food and fuel price shock (Armenia and the Kyrgyz Republic).

A few major exporters have started to relax some export restrictions; Vietnam and Kazakhstan have recently allowed export bans to expire on rice and wheat, respectively, and the Ukraine has increased quotas on wheat exports.


Fund financial support to help countries manage the impact of the fuel and food price shocks is ongoing, in collaboration with international partners. The Fund's balance of payments support is being delivered through a variety of channels:

'New arrangements for below Middle Income Group Countries (PRGF Countries): Two new PRGF arrangements were recently approved for Burundi and Djibouti, raising to four the number of new arrangements approved in connection with the food and fuel price shocks.

Augmentation of existing PRGF arrangements: More countries are making use of increased access under existing arrangements, which provide a readily available vehicle for covering unexpected balance of payments financing needs. In addition to the six countries reported in the June paper, four more countries were since granted augmentations: Grenada, Guinea, Malawi, and Nicaragua. The amounts granted in the form of augmentations under new and existing PRGF arrangements total over U.S. $230 million.

Exogenous Shocks Facility (ESF): The ESF is intended to provide quick access to concessional support for low-income countries facing short-term, shock-related financing needs. Modifications to this facility are currently under consideration, in order to enable more rapid financing and streamlined requirements for access.