Assessing Fiscal Sustainability

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Assessing Fiscal Sustainability

• Teresa Ter-Minassian
• Director, Fiscal Affairs Department
• International Monetary Fund
• January 2004

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Overview of the Presentation

• Defining fiscal sustainability
• Specific considerations
• Biases against sustainable fiscal policies
• IMF framework for assessing sustainability
• Description of the sustainability template
• Application of template and stress testing
• Eventual extension to low-income countries

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Fiscal Sustainability

• Literature presents different concepts of fiscal
  sustainability but they all stress intertemporal
  solvency constraints.
• Solvency
• Todays government debt must be matched by an
  excess of future primary surpluses over primary
  deficits in present value terms.
• In practice, there are limits to the magnitude of
  policy adjustment that a borrower is willing or
  able to undertake.
• Thus, it is important to view solvency in
  relation to an adjustment path that is
  economically, socially, and politically
  acceptable, so that default is not a preferred
  option.

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Fiscal Sustainability (contd)

• The most accepted operational criterion
  requireswith current policies and prospects for
  the relevant exogenous variablesthe public debt
  to be constant (or declining) over the
  medium-term in relation to GDP.
• The primary gap measures the improvement required
  in the primary balance to ensure the convergence
  of the public debt to a stationary level over a
  relevant time horizon.

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Fiscal Sustainability (contd)

• Ceteris paribus, the primary gap is higher the
  higher the average real interest rate (expressed
  in domestic currency) on the public debt and the
  lower the real rate of growth of GDP.
• Fiscal sustainability assessments are complex.
  They involve judgments about future developments
  in hard-to-predict variables such as interest
  rates, exchange rates, and real GDP growth rates.

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Fiscal Sustainability (contd)

• Fiscal sustainability assessments typically focus
  on a medium-term (5-7 years) horizon. However
• It may be advisable to extend this horizon
  further if a country faces major fiscal pressures
  over the longer term, e.g., on account of
  demographic trends or other clearly identifiable
  factors, such as the depletion of natural
  resources, climate changes, etc.
• Even if medium-term solvency appears reasonably
  assured, a country may face short-term liquidity
  constraints. This is especially the case if the
  average maturity of the public debt is relatively
  short, and refinancing requirements are
  correspondingly large.

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Fiscal Sustainability (contd)

• While the focus of fiscal sustainability
  assessments tends to be on the gross public debt,
  to the extent possible it is desirable to take
  into account in the assessment
• any liquid financial assets of the government
  and
• any significant contingent liabilities related
  to, e.g., explicit and implicit government
  guarantees and pending judicial actions against
  the government.

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Comparison of Public Debt Levels in Emerging
Market and Industrial Economies

• Public debt in emerging market economies is now
  higher than in industrial countries as a share of
  GDP, and is significantly higher as a share of
  government revenue. External debt also accounts
  for a higher proportion of public debt in
  emerging markets.

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Debt Default and Public Debt Ratios
Default often reflects illiquidity. Sometimes
(e.g., Argentina), default occurs when the
government is still capable of servicing the debt
in the short term, but views the primary
adjustment required to ensure longer-term
sustainability as too costly.
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Why do Governments Pursue Unsustainable Fiscal
Policies?

• If unsustainable fiscal behaviors lead to crises
  so frequently, why do governments pursue them,
  often for extended periods of time?
• Political economy factors
• Voters tend to overestimate the benefits of
  public spending programs, and to underestimate
  their costs
• Voters, and therefore politicians, try to shift
  the cost of public spending to future
  generations
• Distributional conflicts hamper tax and
  expenditure reforms needed to improve the fiscal
  position
• Politicians have high discount rates especially
  when term limits prevent their re-election.

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Why do Governments Pursue Unsustainable Fiscal
Policies? (contd)

• Market factors
• Because of delays or asymmetries in information,
  markets often do not penalize unsustainable
  fiscal behavior early enough
• Markets may also bet on bailouts (e.g., from
  strong neighboring countries, regional blocks, or
  international financial institutions) and
• The narrowness and underdevelopment of domestic
  capital markets may push governments to borrow
  excessively in foreign currencies and/or with
  short maturities.

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Why do Governments Pursue Unsustainable Fiscal
Policies? (contd)

• Institutional factors
• Weak budgetary institutions can be major
  determinants of inadequate fiscal performance
• Antiquated procedures, lack of internal controls
  in tax administration
• Poor budget management systems and practices
• Overbloated, underpaid and under-trained civil
  service
• Lack of transparency in the management of public
  resources
• Lack of accountability of public managers.

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IMF Sustainability Framework

• Assessing debt sustainability has become a
  central element of the work of the IMF. This
  encompasses both the assessments of external and
  fiscal sustainability.
• These assessments are complemented by analyses of
  balance sheet vulnerabilities for the private
  (financial and non-financial) and public sectors.

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Sustainability Assessments are Inherently
Probabilistic

• Any assessment of sustainability is probabilistic
  in nature, as the debt dynamics depend on
  uncertain macroeconomic and fiscal developments
  and on future movements in asset prices and
  returns.
• Thus, one should think of sustainability
  assessments as analyses of the probability that
  debt dynamics become unstable. This points to a
  need for stress testing by considering
• Alternative scenarios and
• Standard error bands around the baseline.

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Applications of the Framework for Assessing
Fiscal Sustainability

• In countries with moderately high indebtedness
  the framework can help identify vulnerabilities
  far enough in advance so that policy corrections
  can be implemented.
• In countries on the brink, or in the midst, of a
  crisis the framework can be used to examine the
  plausibility of the debt-stabilizing dynamics
  articulated in the authorities policies.
• In the aftermath of a default the framework can
  be used to examine the sustainability of
  alternative options for debt restructuring.

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IMF Sustainability Framework

• The framework includes templates for the analysis
  of both external and fiscal sustainability, in
  four main blocks
• a variety of indicators of debt and debt service
  
• the baseline medium-term projections (with
  particular attention to ensuring the consistency
  of these projections and greater clarity about
  the assumptions)
• a set of stress tests for deviations from the
  baseline and
• a set of alternative scenarios using different
  assumptions.

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Framework Templates

• The templates have several functions
• Illustrate the realism of the existing
  projections by laying bare the assumptions that
  underlie the projected debt dynamics.
• Show the evolution of a countrys debt burden
  over the medium term under the baseline
  projections of growth, interest rates, and fiscal
  deficits.
• Provide upper-bound estimates of the likely
  evolution of the debt stock, showing whether the
  debt burden remains reasonable under a variety of
  plausible macroeconomic shocks.

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Disaggregation of effects

• The templates model separately the effects of
  growth, real interest rate, and exchange rate
  movements on public debt and debt service ratios,
  to assess their relative importance in terms of
  the evolution of the indicators and also for the
  stress tests.

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Key Macroeconomic and Fiscal Assumptions

• Real GDP growth
• Inflation rate (GDP deflator)
• Average nominal interest rate on public debt
• Nominal appreciation/depreciation
• Primary balance
• Growth in real primary public spending

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Alternative scenarios

• Attempt to answer the following questions
• What if history (for growth, inflation, interest
  rates, primary balance) repeats itself?
• What if there is no policy change in terms of
  the primary balance?
• What if there is a country-specific shock that
  results in a downward step adjustment (one
  standard deviation) in GDP growth?
• What if market expectations or consensus
  forecasts (where available) are used to project
  the medium term?

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Bound tests

• Using the baseline scenario as a starting point,
  consider the following shocks
• Separate adverse two-standard deviation shock
  lasting two years to the real interest rate, the
  real growth rate, and the primary balance.
• A combined shock the real interest rate, real
  growth rate, primary balance, and exchange rate
  are simultaneously subject to a one-standard
  deviation shock.
• Two different exogenous shocks
• A 30 percent depreciation
• An increase in debt ratio by 10 percent of GDP,
  reflecting e.g. the recognition of implicit or
  explicit contingent liabilities.

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Bound Tests Calibration

• The magnitude of the individual shocks (two
  standard deviations) assumed in the stress tests
  was calibrated to mimic movements in growth,
  interest rates, and the U.S dollar value of the
  GDP deflator observed in the run-up to previous
  debt crises.
• The two-year one-standard deviation combined
  shock is also very much consistent with the
  historical evidence on debt crises.
• The resulting upper bounds of the debt ratio that
  are derived from the bound tests correspond to
  approximately a 95 percent confidence interval.

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Additional Features of the Framework

• The template presents a measure of the constant
  steady state primary surplus that stabilizes
  the debt ratio at its value at the end of the
  projection horizon. This indication of the needed
  fiscal adjustment effort can be cross-checked
  against a countrys historical performance, to
  gauge policy implementation credibility.
• The framework also tracks gross financing needs,
  as a simple way of assessing roll-over risk.

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Retrospective Debt Sustainability Analysis in
Four Capital Account Crises

• The sustainability framework has been applied
  retrospectively to the crises in Argentina
  (1999), Brazil (1998), Mexico (1995), and Turkey
  (1999), to see whether actual outcomes would fall
  within the stress test range.

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Results of Retrospective Analysis

• The 2001 debt ratio in Argentina turned out to be
  slightly above the upper bound of the stress test
  range. If the projection had been extended to
  2002, the debt ratio would have moved far beyond
  the upper bound of the stress test range.
• For Turkey, the outcome for 2001 was well above
  the upper bound of the stress test range, despite
  the beneficial impact of stronger fiscal
  adjustment and lower real interest rates than
  expected.

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Results of Retrospective Analysis (contd)

• The post-crisis debt ratio in Brazil was at the
  upper end of the stress test range, despite a
  better-than-expected post-crisis fiscal
  adjustment and lower-than-expected real interest
  rates. An unanticipated large real depreciation
  was the main contributor.
• In Mexico, the outturn in 1995 was above the
  one-year-ahead program baseline projection,
  because of a larger real depreciation, higher
  real interest rates, and slower growth than
  anticipated, and because of the securitization of
  contingent and unfunded liabilities.
  Nevertheless, the outturn was within the stress
  test range.

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What the Template Will Not Do...

• The framework presents only the implications of
  alternative scenarios. It does not provide
  probabilities of debt crises this is left for
  the user to determine.
• Early warning models are being developed, but
  still need to be fine tuned in terms of the
  balance between failing to identify crises and
  generating false alarms.
• The template does not indicate what level of debt
  is too high.
• However, a recent IMF empirical study suggests
  that there is an appreciable increase in the
  conditional probability of a crisis (to about
  15-20 percent) when the external debt level rises
  over 40 percent of GDP.
• The framework does not contain information at the
  level of detail needed to fully capture balance
  sheet mismatches, which have had a significant
  impact on debt financeability (liquidity) in
  recent debt crises.

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Balance Sheet Vulnerabilities are also Important

• Attention needs to be paid to
• Liquidity mismatches in terms of the maturity
  structure of assets and liabilities
• Currency denomination mismatches between assets
  and liabilities
• Capital structure mismatches, including possible
  overreliance on borrowing relative to equity
  (such as FDI)
• Intersectoral imbalances, such as overreliance on
  the domestic banking system as a holder of
  government paper. This would weaken banks
  balance sheets in a restructuring situation and
  would add to contingent liabilities for the
  government in the case of a bail-out.

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Where has this framework been applied so far?

• To date, this framework has been applied to most
  countries with access to private financial
  markets, as well as all users of IMF resources
  (except PRGF countries).
• Work is underway to extend the framework to
  low-income countries (including PRGF), though
  there are likely to be some modifications, as the
  issues are somewhat different.

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Issues Relating to Possible Extension of
Framework to Low-Income Countries

• Most financing to LICs comes from bilateral
  donors and international financial institutions.
• Debt of LICs tends to be on fixed and
  concessional terms, implying longer repayment
  periods.
• In order to meet the Millennium Development
  Goals, many LICs are likely to require
  substantial external financing in the period
  ahead.
• Thus, the issue of how much additional debt these
  countries can afford to accumulate is of critical
  importance.

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Issues Relating to Possible Extension of
Framework to Low-Income Countries (contd)

• The serviceability of the debt in LICs depends
  more on the willingness of official creditors and
  donors to provide net transfers through
  concessional loans and grants than on market
  sentiment (as reflected in interest rate
  spreads).
• Vulnerabilities may be more acute both on the
  external and domestic sides (e.g., narrowness of
  production and export bases policy deficiencies,
  poor governance, weak institutions, inadequate
  debt management, political developments with
  adverse economic consequences such as civil war
  and social strife).

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Possible Considerations in Extending the
Framework to Low-Income Countries

• Focus on an NPV measure of debt (rather than the
  nominal stock), given that borrowing is in large
  part on concessional terms
• Look at the ratios of NPV of debt to GDP, exports
  and revenue, to address issues of narrowness of
  base.
• Similarly for debt service, look at the ratio of
  debt service to exports and to revenue.
• Extend the projection period due to the typically
  longer maturity of concessional debt.
• Consider the quality of a countrys policies and
  institutions in assessing debt sustainability.