Public Debt Sustainability Under Uncertainty: A VAR Approach in Brazil, Mexico, and Turkey

1. Public Debt Sustainability Under Uncertainty: A Vector Autoregression Approach, applied to Brazil, Mexico, and Turkey. January 2007 Evan Tanner, International Monetary Fund (INS) Issouf Samake, International Monetary Fund, (AFR) NOTE: The views expressed in this presentation are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management.

2. I Introduction • Sustainable fiscal policy: one that can be continued indefinitely without modification; • No adjustment to primary surplus, no default (by inflation or otherwise). • At minimum: satisfy intertemporal solvency • More often: stabilize the debt stock (ratio to GDP). • Defined thusly, sustainability is difficult to achieve: • Despite good intentions, adverse shocks to interest rates, exchange rates, output, etc, may cause persistent debt increases. • More ambitious objective: preempt future fiscal adjustments for all but most unfavorable circumstances • Surplus exceeds that required to merely stabilize the debt; such a policy will on average reduce the debt.

3. I Introduction • Sustainability of fiscal policy under uncertainty: Brazil, Mexico, and Turkey. Retrospectively:“If historical policies were to be continued into the future, would fiscal policy be sustainable – or will a modification of policies be required?” Prospectively: “What policies should be undertaken today in order to prevent the need for further adjustments in the future?”

4. I Introduction • Previous work (detailed review in paper): • Retrospectively: • Some accounting “naked eye” (i.e. Blanchard et. al (1990) fiscal gap), • Many econometric studies - ‘present value tests’ (started by Hamilton and Flavin (1986)). • Prospectively: • Typically accounting (IMF Template, stress tests); • Recent development: stochastic simulations and ‘fan chart’ (i.e. Celasun, Debrun, Ostry (2005) – some based in econometrics.

5. I Introduction • Our work: • Retrospectively:debt accumulation attributed to (i) baseline policy, (ii) policy-shocks (discretion), (iii) non-policy shocks (luck); (“shocking facts”) • Adverse (beneficial) shocks to non-(fiscal)-policy variables boosts (reduces) debt, country deemed ‘unlucky’ (‘lucky’). • Historical decompositions from simple (near) vector autoregression (VAR). • More than previous work, ours highlights the role of unanticipated shocks in debt increases or decreases.

6. I Introduction • Our work: • Prospectively: Monte-Carlo simulation of model • Assume current fiscal policy (similar to Garcia and Rigobon,2004, Celasun, Debrun, and Ostry,2005); • They summarize debt forecasts with “fan charts” -- mean value and with upper- and lower- confidence intervals that increase with time. • Normative emphasis: Calculate hypothetical primary surpluses that would prevent debt from rising for all but worst 50%, 20%, 10% of outcomes over a given horizon (1 to 5 years). • A menu of options: how much insurance to preempt future adjustments? • Clear precautionary objective to justify debt reduction; • Simple, easily understood rule a la Kydland and Prescott (1977)

7. I Introduction • Organization of rest of the paper: • In Part II: review previous work on fiscal sustainability “roots in literature from 80s, 90s” • In Part III: overview of our methodology. • Part IV Brazil • Part V Mexico • Part VI Turkey • Part VII concludes.

8. III Overview of Our Approach • Like other recent papers we highlight uncertainty policy and luck. • Near-vector autoregression (VAR) model, endogenous variables X: • Xt= [ipt,deft,et, rt] • ip = industrial production index, • def = some measure of the deficit (primary (ps), operational def (Db)) e = real depreciation (bilaterally vs.US dollar) r = real interest rate Exogenous variables: oil price growth, dummy (i.e. crisis periods). Retrospective Sustainability: Historical decomposition well-known representation of VAR model (less widely used than variance decomposition). Each element of X composed of: (i) Baseline projection of that variable, conditional on all information available in the base period M; (ii) impacts of shocks from all variables, accumulated from M+1 forward Alternative presentation: observed value, what would have happened if a certain shock had not occurred (counterfactual).

9. III Overview of Our Approach III.a Retrospective Sustainability Retrospective sustainability: Absent shocks, fiscal policy is sustainable over the period M+1 through M+j if: (10) b(base)M+j/GDPM+j ≤ bM/GDPM. Baseline policy is “unsustainable” if the debt rises under baseline projection (no innovations); otherwise, policy is “sustainable”. (11a) Db(omit i)M+j= DbM+j - z*bij (11b) b(omit i)M+j = b(omit i)M+j-1 + DbM+j - z*bij Counterfactual: what would have debt been if some specific shock had not taken place? Informal taxonomy for non-policy shocks: Lucky vs. Unlucky

10. III Overview of Our Approach III.b Prospective Sustainability • Monte-Carlo simulations of VAR system (randomly generated shocks). • Similar work: Garcia and Rigobon (2004), Celasun, Debrun, and Ostry (2005). • Positive emphasis::debt projections whose forecast variance increases with horizon length – “fan charts.” Similar to adverse scenarios in Fund Sustainability Template. • Normative emphasis: Upper bands of fan charts (or adverse scenarios) represent undesirable outcomes. • Implicit objective: to preempt precisely these bad outcomes for all but some low probability (50% or less); otherwise fan charts / Fund template stress test are uninteresting. * • For prob less than 50%, primary surplus more than debt stabilizing value (ps > rb). • *See Tanner and Carey (2005) “The Perils of Tax Smoothing: Sustainable Fiscal Policy with Random Shocks to Permanent Output,” IMF WP 05/207.

11. III Overview of Our Approach III.b Prospective Sustainability “Value-at-risk”-like approach: government aims for primary surplus in order to prevent an increase in debt for all but worst w-percent of cases (w =insurance level chosen by authority). Baseline scenario: simulated means, standard deviations, and fractiles (median, 75th, and 90th percentiles) of simulated debt/GDP ratios. Menu of policy options: alternative primary surplus required to keep the debt ratio constant for all but the worst w-percent of cases (w = 50%, 75%, 90%) – over a given horizon. Clearer than current approaches? Doesn’t just show bad outcomes – shows how to avoid them.

12. IV Brazil Estimated model January 1995 - May, 2005); dummies for exchange rate regimes. Baseline period for policy mid-2000 (M = 2000:5). Figure 2. Brazil: Real Public Debt Purged of Exchange Rate and Interest Rate Shocks (b(omit e,r); Units are Millions of Constant Reais (1995=100)) Exchange rate/interest rates explain 97% of debt variation; 1999 crisis “dummied out”

13. IV Brazil Figure A.1. Brazil: Observed and Baseline Debt, Alternative Estimates (Versions (i)–(v))

14. IV Brazil Scenario 1: Real interest rate ≈12.8% (recent history); GDP growth just under 4 percent (optimistic assessment - Deutsche Bank (2006)). Baseline ps = 4.5% Modest debt increase More precaution requires more adjustment.

15. IV Brazil Scenario 2: Lower real interest factor ≈8.5% (market expectations data); GDP growth ≈3.5% (IMF, authorities) Baseline ps = 4.5% Debt decreases on average Somewhat more precaution

16. IV Brazil Counterfacutal prospective: A “rear view mirror” for policy makers. Mean debt increases. With hindsight, these numbers not extraordinarily high. “Baseline scenario”: GDP growth ≈ 4%,real interest rate ≈ 12.8%. “Menu of policy options”: primary surplus is initial year; average debt is end of year in column. Note: Debt stabilization (50%) would have required somewhat higher primary surplus than initial target --- but close to later values.

17. V Mexico • Two components to Mexican public debt: • “Traditional” ≈ 18% percent of GDP in 2005; available monthly, used for retrospective. • “Augmentation” includes liabilities associated with bank bailouts and development borrowing, became important after 1994-5 crisis. • “Augmented” (sum) ≈ 45.3% of GDP in 2005 – Used for prspective. Monthly data from mid-1997 to mid-2005. (omits 1994 crisis and aftermath.). (13) X(Mexico)t = [ipt, pst,et,Db, rt], 6 lags; Discrepancies between overall balance (‘above the line’) and change in government debt (‘below the line’); require that operational deficit Dbt be included in X.; VAR filters out effects of ps and r contained therein. Shocks to Dbt are orthogonal to all other variables; thus, they are additional (error) component of primary deficit.

18. V Mexico Figure 4 Mexico: Real Public Debt purged of exchange rate and interest rate shocks. b(omit e,r); Units are millions of 1995 Pesos. Beneficial impacts of interest rate reductions and stronger Peso most important in 2001-02.

19. V Mexico Figure 5 Mexico: Real Public Debt purged of deficit shocks. b(omit def); Units are millions of 1995 Pesos. End period – about ½% of GDP Discretionary expansions of fiscal policy 02 – 04;

20. V Mexico “Baseline scenario”: GDP growth ≈ 3%,real interest rate ≈ 5%; unlike staff report, PS stays at about 2.1% throughout scenario; Debt reduction close to staff report. Modest fall in average debt Like a “fan chart”; There are risks. Somewhat more precaution Not analyzed here (work in progress): preservation of oil wealth. Primary surplus due to oil (non-oil primary surplus ≈ 4 – 5% of GDP. This may be “too high” to preserve net wealth (oil wealth minus debt); “Stay tuned”

21. VI Turkey Figure 7. Turkey: Real Public Debt Purged of Deficit Shocks (b(omit ps, Db); Units are millions of 2001 Turkish Lira) Expansionary fiscal policy increased debt in 98-2000, 01-02

22. VI Turkey Figure 6. Turkey: Real Public Debt Purged of Exchange Rate and Interest Rate Shocks (b(omit e,r); Units are millions of 2001 Turkish Lira) Shocks to real interest rate (combined real exchange rate) increased debt;

23. VI Turkey Cautious optimism: modest rise in average debt To be updated Like a “fan chart”; Risks appear substantial “Baseline scenario”: GDP growth ≈ 5%,real interest rate ≈ 12½%. “Menu of policy options”: primary surplus is initial year; average debt is end of year in column. Note: Debt stabilization at 75%, 90% levels requires higher primary surplus than currently observed; Longer horizon implies less stringent initial fiscal policy – end period debt reflects cumulative effects of adjustment.

24. VI Turkey “No adjustment fatigue.” Sustained adjustment is critical. Non linearities – less debt reduction under unertainty. More precaution requires more adjustment.

25. VII Summary/Conclusions This paper has examines the sustainability of fiscal policy under uncertainty in three emerging market economies: Brazil, Mexico, and Turkey. Retrospective assessment -- decomposes effects of a baseline policy, luck, and discretionary policy on debt accumulation. Prospective assessment incorporates uncertainty in way that differs from Fund template, but is similar to other recent papers cited herein. Two advantages over currently used frameworks: 1. Econometric framework: permits us to combine prior beliefs/assumptions on mean (i.e.growth, interest rates, the primary surplus) with data’s own information on volatilities thereof; data thus informs policy process in richer, more sophisticated way than generally is the case.

26. VII Summary/Conclusions 2. Prospectively: framework clearly communicates a menu of options for policy makers. Recognizes both costs and benefits to higher surpluses. The optimal primary surplus -- and hence the optimal path of debt reduction -- will depend on the policy maker’s objective function – and ultimately will differ across countries according to specific circumstances in any country. 3. Our precautionary regimes will reduce the debt – not a novel policy. However, debt target per se is arbitrary, may be difficult to defend. Clearly articulated safeguard against perm adverse shocks and future adjustments may foster clearer more understandable, more credible fiscal polices -- echoing Lucas (1976) and Kydland and Prescott (1977).

27. VII Summary/Conclusions • There is plenty of room for further work: • Refinement of econometric modeling. • Simulations of alternative fiscal rules within equilibrium model (see for example Hostland and Karam (2005)). • Long-run interest rate response to changes in fiscal policy? • Length of horizon – difficulty of commitment?