Fiscal Policy Management in an Open Capital Regime

This paper discusses how countries should manage fiscal policy as they move to the uncertain world of more open capital regimes. The possibility of both significant inflows and outflows may lead to calls for additional fiscal adjustment, compared with what was considered appropriate for a closed capital regime, particularly when the exchange rate adjustment is constrained. The appropriate fiscal stance in an open capital regime should thus be more conservative than when capital is immobile. Preemptive tightening is required when the capital regime is opened. This would not preclude the need for further fiscal adjustment in the face of large and volatile capital flows. However, the required changes would be smaller. Reducing the size of the needed fiscal response has important virtues, since fiscal policy is poorly adapted as a useful instrument of short-run macroeconomic adjustment. Many fiscal variables are difficult to manipulate flexibly in the short-run, such that fiscal interventions can involve high transaction costs and create distortions in resource allocation. If a fiscal response is unavoidable, some components of fiscal policy are easier to manipulate, more effective, and less distortive than others. Also, shifts to an open capital regime make it difficult to determine the actual stance of fiscal policy, underscoring the need for transparency about the .fiscal rules. governing the fiscal stance, the fiscal policy response to capital flows, and the actual fiscal position. A more open capital environment also constrains the sustainable fiscal structure, forcing a reevaluation of government expenditure and revenue policies.