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A balance sheet approach may be needed by the EU following COVID

Author: ICAEW Insights

Published: 05 Oct 2021

The method of reporting deficits and debts by EU Member States may need to change following the disruption of COVID, say Giovanna Dabbicco and Josette Caruana, two researchers who have scrutinised public sector finances and the adequacy of existing reporting mechanisms.

The application of the EU’s Stability and Growth Pact (SGP) may have to be revised and a balance sheet approach adopted instead in the light of the pandemic, says Giovanna Dabbicco, a researcher at the National Statistical Office (ISTAT) of Italy and a former Adjunct Assistant Professor of Planning and Control in Public administrations at University of Roma Tre, Department of Business studies, Italy, but speaking in a personal capacity.

She was assisted in this research by Josette Caruana, a Senior Lecturer at the Department of Accountancy of the University of Malta. The methodology they adopted entailed an analysis of statistical data submitted by EU Member States to the European Commission on general government net lending/borrowing, debt and the Member States’ overall financial position. 

As they expected, there was a substantial difference between the 2020 data and the trend established in prior years. Their conclusion? The SGP rules appear not only too restrictive but their suspension, as soon as the pandemic hit EU member states in March 2020, demonstrated that Member States should perhaps take a more balance-sheet based approach to fiscal management. 

Their research also suggested that the SGP could be more principles-based (instead of rules-based) and then standards could be applied according to each Member States’ circumstances.

So, is the SGP now rendered simply unworkable as a means of maintaining the stability of EU Economic and Monetary Union? Dabbicco responds in the negative: “We do not think that it is unworkable but needs to be revised to introduce some more flexibility.”

She continues: “It is still important to have agreement on ceilings following common benchmarks and standardising practices in the EU. This will promote suitable standardised reporting, and it is very important that whatever is eventually agreed is measurable with a minimum possibility for misreporting.”

She explains that the flexibility element might relate to the type of expenditure in question or the speed at which fiscal imbalances must be corrected, taking into account the balance sheet situation. “This could mean that the terms of the SGP should not remain one-size-fits all,” she says.

The response from the EU Commission in relation to the suspension of the SGP was to set out its key concerns and launch a consultation – which has stalled given the prevailing pandemic situation. “However, I think the next few months will see some complex and possibly controversial discussions,” says Dabbicco. “We don’t think the main part of that discussion will relate to statistical data for recent years, however it is clear that many countries’ debt levels are already well above the 60% of GDP specified in the current SGP. We expect the discussions to focus on the road to recovery from the debt situation, of course based on the circumstances of each Member State and the severity of the pandemic in each state.”

All things being equal, how are the EU Commission’s and Council of Ministers’ recommendations to Member States on remedial fiscal action usually enforced? “The chain of enforcement is from the European Commission to the Council of Ministers, which makes the ultimate decision on remedial action,” says Dabbicco. “The European Central Bank does not have a direct role but is a party to the discussions.”

In terms of this balance sheet approach, what do Dabbicco and Caruana propose? “We have seen in recent years that the Commission’s analysis underlying the SGP has developed from a complete focus on deficit and debt levels to something that is more detailed and nuanced (for example, expenditure benchmarks),” responds Dabbicco. “But this should go further. We propose to extend to the use of information from balance sheets, to make it more complete and reliable. Deficits and debt are not enough. We also need to integrate information from notes and disclosures in the accounts for certain items, such as contingent liabilities and the financials of controlled public entities.”

She explains that balance sheets can give us a full overview, informing on debt positions, and also on the assets side in terms of wealth (that is a calculation of structure, solidity, liquidity and illiquid position, net working capital and other relevant indicators) with relevant ratio analysis. This means governments will have to produce complete balance sheets. “Many EU countries have these, or have started on them, at some levels of government,” says Dabbicco. “But there are many gaps remaining.”

What Dabbicco and Caruana are proposing goes beyond the balance sheet as understood in traditional private-sector financial statements. “In a public sector context, less emphasis may be placed on the extent of fixed assets reported, while there is more focus on liabilities,” says Dabbicco. “Perhaps the recognition principles for assets and liabilities should be different in the public sector. The result may be called something else other than a balance sheet so that it is not confused with the traditional form. One may reach a kind of conclusion that the assets and liabilities sides may not be required to balance at all.”

It is not unusual for the SGP to be the subject of reform proposals, largely to make it more flexible. “Nevertheless, the foundation of the SGP in the Treaty has remained unchanged, but some parallel processes have been added to take into account in the analysis and recommendations (for example, expenditure benchmarks, structural deficits, excluding EU funds),” says Dabbicco. “But it is fair to say that some countries’ proposals, such as excluding military expenditure, have not been taken up.”

The research demonstrates that a comprehensive balance sheet that includes information on contingent liabilities – one that provides a complete picture of a government’s financial situation - should be the basis for recommendations to address fiscal imbalances. But what would a principles based SGP look like? “Any SGP will need thresholds and an alarm system based on commonly agreed measures of fiscal situation. These common measures may come from the statistical or financial accounting worlds,” says Dabbicco.

“The current basis is statistics, which can of course be further developed. To extend to public financial accounting would require common public accounting standards in Europe, and their implementation across countries and levels of government. But this is easier said than done.”

Dabbicco concluded that the pandemic has revealed the importance of flexibility. “We need to be flexible as to how we design and use a balance sheet. Even improvements in the SGP need to incorporate flexibility.”

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