Assessing Fiscal Risks: International Best Practice

1. Assessing Fiscal Risks:International Best Practice Jimmy McHugh Fiscal Affairs Department May 2011

2. Overview • Motivation for new FAD fiscal sustainability indicator. • Outline the methodology • Simple empirical example.

3. Stylized Phases of Fiscal Policy-Making a. Understanding the Fiscal Position c. Implementing through the Budget Process b. Medium-term Fiscal Planning

4. The role of fiscal risk management a. Understanding the Fiscal Position • Fiscal Reporting • Macro-Fiscal Forecasting • Fiscal Risk Management b. Medium-term Fiscal Planning • Fiscal Objectives • Medium-term Budget Framework • Independent Fiscal Agency • Performance Orientation c. Implementing through the Budget Process • Top-Down Budgeting • Parliamentary Approval • Budget Execution

5. Objective: Create a fiscal monitoring system • Rollover risk? • Policies are perceived to be unsustainable, • Difficulties demonstrating solvency. • Fiscal crisis • Disorderly fiscal adjustment. • Optimal set of fiscal indicators – what should we track? • Can we derive an index for assessing fiscal sustainability?

6. Framework outlined in four papers • Cottarelli (2011) • Baldacci, McHugh and Petrova (2011) • Baldacci, Petrova, Belhocine, Dobrescu, and Mazraani (2011) • First used in the IMF Fiscal Monitor – April 2011.

7. Inability to roll over debt • Depends on the interaction between: • current level and baseline projections of key fiscal variables; • shocks around this baseline (macroeconomic or fiscal policy changes, contingent liabilities), • Other factors, including country-specific non-fiscal variables.

8. Early warning system • Signal about rollover difficulties, • Give policymakers the opportunity to adjust policies before extreme fiscal stress events. • Thresholds beyond which a crisis becomes significantly more likely. Key building blocks of early warning systems

9. How do we identify these thresholds? • Thresholds vary across countries and time, available estimates. • Our approach: • Probabilistic approach, • Norms for fiscal variables derived from historical averages.

10. 12 key fiscal indicators Basic indicators Long term challenges Liability management Stress index

11. 12 key fiscal indicators Basic indicators Long term challenges Liability management Vulnerability index

12. Stress index Vulnerability index Sustainability index

13. Factors affecting the baseline Three clusters • Basic fiscal variables • Long-term fiscal trends: • Liability management

14. Basic fiscal variables Are the debt dynamics based on current and expected medium-term policies consistent with fiscal solvency?

15. Long-term fiscal trends To what extent will long-term economic and demographic-related challenges affect projected fiscal variables and impact solvency risks?

16. Long-term fiscal trends To what extent will long-term economic and demographic-related challenges affect projected fiscal variables and impact solvency risks?

17. Asset and liability management: Does the composition of government’s assets and liabilities expose countries to large rollover needs?

18. Choice of indicators • Avoid reliance on financial market indicators. • they tend to lag rather than lead the deterioration of the fiscal outlook. • Each indicator is widely used, easily accessible over time and available for a broad range of countries.

19. Basic Fiscal Variables • Gross versus net debt • Cyclically adjusted primary balance • Reflects the fiscal stance independent from the effects on the budget of the output cycle • Projected growth-adjusted interest rate – • The difference between the projected imputed nominal interest rate on government debt and the projected nominal growth rate of GDP

20. Long-Term Fiscal Trends • Future expenditure pressures: • The projected change over 20 years in key age-related expenditure items, such as health and pensions, • The current total fertility rate • A forward-looking indicator of future demographic pressures • The projected old-age dependency ratio • combines long-term demographic trends with the initial population structure • Indicator of capacity to bear the costs of supporting the old.

21. Asset and Liability Management • Gross financing needs • Share of short-term public debt as a ratio of total public debt • Weighted average maturity of outstanding government debt • Short-term external debt to gross international reserves • Proportion of debt denominated in foreign currencies, as a percent of total debt • Government debt held by non-residents as a proportion of total debt

22. MONITORING FISCAL VULNERABILITY AND STRESS • Fiscal vulnerability index • Fiscal stress index Combined into a single fiscal sustainability index

23. Fiscal vulnerability index • Measures the degree of fiscal vulnerability as a departure from historical “norms”, • Defined as 10-year cross-country averages. • Key advantage - simplicity. • Main shortcoming - economic meaning of the historical “norms” and deviations from them is less straightforward than in model-based indices.

24. Steps • Calculate for each indicator a standardized score: • For each of the three clusters of indicators, calculate an unweighted average. • Use a cumulative normal distribution to calculate a score ranging from zero to ten.

25. Fiscal stress index • Extreme “tail events” such as debt defaults, and large spikes in interest rate spreads. • Summary score that depends on endogenous thresholds. • Derived by minimizing the errors made in using each indicator to predict fiscal stress episodes. • Provides a weighting system of the fiscal indicators into the summary index using their predictive power. • Main shortcomings: • Dependence on the specific definition of crisis • Relatively weak statistical power.

26. Defining a crisis – Four criteria • Public debt default or restructuring; • IMF-supported program • Excessively high inflation rate; and • Exceptionally high sovereign bond yields. A set of 176 episodes among advanced and emerging economies over the past four decades

27. Assessing signaling power • Use statistical methods to define a crisis threshold for each fiscal indicator. • Once indicator is above threshold, assign a value of one. • Define the stress index in terms of the number of indicators exceeding the threshold. • Set indicator to fall between zero and 10.

28. Fiscal sustainability index • Take an unweighted average of the stress and vulnerability indices for each of the three clusters. • Derive an aggregate score using the three clusters.

29. 12 key fiscal indicators Basic indicators Long term challenges Liability management Stress index

30. 12 key fiscal indicators Basic indicators Long term challenges Liability management Vulnerability index

31. Stress index Vulnerability index Sustainability index

32. Empirical application • Rollover risks under the baseline compared for advanced and emerging economies • Spring 2011 and Fall 2010

38. Conclusions • When monitoring fiscal developments, need to shift to a wider set of variables that more accurately capture rollover risk. • two complementary tools for assessing rollover risk: • Fiscal vulnerability index • Fiscal stress index.