Assessing Fiscal Sustainability

1. Assessing Fiscal Sustainability Teresa Ter-Minassian Director, Fiscal Affairs Department International Monetary Fund January 2004

2. 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

3. Fiscal Sustainability • Literature presents different concepts of fiscal sustainability; but they all stress intertemporal solvency constraints. • Solvency • Today’s 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.

4. Fiscal Sustainability (cont’d) • The most accepted operational criterion requires—with current policies and prospects for the relevant exogenous variables—the 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.

5. Fiscal Sustainability (cont’d) • 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.

6. Fiscal Sustainability (cont’d) • 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.

7. Fiscal Sustainability (cont’d) • 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.

8. 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.

9. 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.

10. 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.

11. Why do Governments Pursue Unsustainable Fiscal Policies? (cont’d) • 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.

12. Why do Governments Pursue Unsustainable Fiscal Policies? (cont’d) • 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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 country’s 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.

18. 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.

19. 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

20. 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?

21. 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.

22. 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.

23. 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 country’s historical performance, to gauge policy implementation credibility. • The framework also tracks gross financing needs, as a simple way of assessing roll-over risk.

25. 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.

26. Retrospective Debt Sustainability Analysis (Public debt, in percent of GDP) Argentina Brazil 100 100 100 100 90 90 90 90 80 80 80 80 70 70 70 70 60 60 60 60 50 50 50 50 40 40 40 40 30 30 30 30 1999 2000 2001 1998 1999 2000 2001 Turkey Mexico 100 100 100 100 90 90 90 90 80 80 80 80 70 70 70 70 60 60 60 60 50 50 50 50 40 40 40 40 30 30 30 30 1999 2000 2001 1994 1995 1996 1997 1998 Sensitivity Range Actual Baseline

27. 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.

28. Results of Retrospective Analysis (cont’d) • 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. Issues Relating to Possible Extension of Framework to Low-Income Countries (cont’d) • 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).

34. 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 country’s policies and institutions in assessing debt sustainability.