Download Fiscal Policy and Financial Crises

Assessing Fiscal Sustainability
Teresa Ter-Minassian
Director, Fiscal Affairs Department
International Monetary Fund
January 2004
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
2
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.
3
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.
4
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.
5
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.
6
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.
7
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.
Public Debt
(ratio to revenue; average, 1992–2002)
Industrial countries
All emerging markets
Asia
Latin America
Middle East & Africa
Transition countries
0
80
Public Debt
(percent of GDP)
75
Industrial countries
70
100
200
300
400
External Public Debt
(percent of total debt; average, 1992–2002)
2
Industrial countries
All emerging markets
Asia
65
Latin America
Middle East & Africa
60
Emerging markets
1992
93
94
95
96
97
98
99
2000
01
02
55
Transition countries
0
Source: WEO September 2003.
1Unweighted averages.
2
20
40
60
80
8
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.
Distribution of Public Debt Ratios in the Year Before a Default 40
30
500
400
1 Debt
Comparison of Key Indicators of Public
(percent)
Defaulters
Nondefaulters
120
100
80
300
20
60
200
40
10
Share of all defaults
100
0–20
20
Left scale
0
20–40
40–60
60–80
80–100
Public debt/GDP
100+
0
0
Debt/revenues
Right scale
Debt/GDP
Right scale
Right scale
Share of external
Broad
debt/total debt
money/GDP
0
Source: WEO September 2003.
1 Data are an average of 1998–2002. Defaulters refer to countries that have
defaulted
9
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.
10
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.
11
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.
12
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.
13
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:
1.
2.
Alternative scenarios; and
Standard error bands around the baseline.
14
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.
15
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.
16
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.
17
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.
18
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
19
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?
20
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.
21
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.
22
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.
23
Table --. Country: Public Sector Debt Sustainability Framework, 1998-2008
(In percent of GDP, unless otherwise indicated)
1993
1994
Actual
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Projections
2005
2006
2007
2008
I. Baseline Projections
1 Public sector debt 1/
o/w foreign-currency denominated
2 Change in public sector debt
3 Identified debt-creating flows (4+7+12)
4 Primary deficit
5
Revenue and grants
6
Primary (noninterest) expenditure
7 Automatic debt dynamics 2/
8
Contribution from interest rate/growth differential 3/
9
Of which contribution from real interest rate
10
Of which contribution from real GDP growth
11
Contribution from exchange rate depreciation 4/
12 Other identified debt-creating flows
13
Privatization receipts (negative)
14
Recognition of implicit or contingent liabilities
15
Other (specify, e.g. bank recapitalization)
16 Residual, including asset changes (2-3) 5/
Public sector debt-to-revenue ratio 1/
Gross financing need 6/
in billions of U.S. dollars
28.7
27.3
19.6
42.2
20.6
44.8
27.7
54.4
27.7
50.9
36.8
54.9
35.7
50.8
39.0
48.9
36.1
48.0
39.2
49.5
38.8
50.5
39.0
50.6
39.2
49.2
38.7
47.7
37.7
46.1
36.7
44.5
35.5
-1.3
-3.7
-3.5
23.1
19.7
-0.2
-0.2
0.3
-0.5
0.0
0.0
0.0
0.0
0.0
2.4
14.9
10.6
-2.2
22.8
20.6
12.8
-0.8
0.3
-1.1
13.6
0.0
0.0
0.0
0.0
4.3
2.6
-1.5
-4.4
22.8
18.4
2.9
-5.0
-7.0
2.0
7.9
0.0
0.0
0.0
0.0
4.1
9.6
-5.7
-10.3
21.8
11.6
4.6
3.8
5.5
-1.7
0.8
0.0
0.0
0.0
0.0
15.3
-3.5
-4.8
-5.2
22.0
16.8
0.3
-0.5
2.5
-2.9
0.8
0.0
0.0
0.0
0.0
1.3
4.0
5.5
-1.9
20.0
18.1
7.4
-0.6
1.5
-2.1
8.0
0.0
0.0
0.0
0.0
-1.5
-4.1
-4.0
-1.6
20.4
18.8
-2.3
-1.1
0.6
-1.7
-1.2
0.0
0.0
0.0
0.0
-0.1
-1.9
-4.4
-0.7
21.0
20.4
-3.8
-4.0
-1.2
-2.8
0.2
0.0
0.0
0.0
0.0
2.5
-0.9
-0.7
-0.7
21.0
20.2
0.0
1.7
1.5
0.2
-1.7
0.0
0.0
0.0
0.0
-0.1
1.5
5.9
0.2
21.8
22.0
5.7
0.6
1.0
-0.4
5.1
0.0
0.0
0.0
0.0
-4.4
1.0
0.3
-0.3
22.5
22.2
0.6
0.6
1.6
-0.9
...
0.0
0.0
0.0
0.0
0.7
0.0
-0.5
-1.2
21.7
20.5
0.6
0.6
2.3
-1.7
...
0.0
0.0
0.0
0.0
0.5
-1.4
-1.4
-1.9
21.4
19.5
0.4
0.4
2.4
-1.9
...
0.0
0.0
0.0
0.0
0.1
-1.5
-1.5
-2.0
21.2
19.2
0.5
0.5
2.4
-1.9
...
0.0
0.0
0.0
0.0
0.1
-1.6
-1.7
-2.0
21.1
19.1
0.3
0.3
2.2
-1.9
...
0.0
0.0
0.0
0.0
0.1
-1.6
-1.7
-2.0
21.0
19.0
0.3
0.3
2.2
-1.8
...
0.0
0.0
0.0
0.0
0.1
118.1
185.2
196.6
249.2
231.8
275.0
249.2
232.6
228.9
227.2
224.8
233.0
229.9
225.1
218.9
211.7
6.0
24.4
7.2
30.1
7.7
22.0
14.2
47.2
15.6
62.7
18.3
76.9
18.6
89.3
16.2
94.1
17.0
106.2
17.3
109.9
17.2
106.3
16.4
106.1
15.8
107.8
15.3
110.6
14.8
113.0
14.3
115.6
Key Macroeconomic and Fiscal Assumptions
Real GDP growth (in percent)
Average nominal interest rate on public debt (in percent) 7/
Average real interest rate (nominal rate minus change in GDP deflator, in percent)
Nominal appreciation (increase in US dollar value of local currency, in percent)
Inflation rate (GDP deflator, in percent)
Growth of real primary spending (deflated by GDP deflator, in percent)
Primary deficit
2.0
11.0
1.5
0.3
9.5
8.1
-3.5
4.4
9.7
1.4
-41.7
8.3
9.5
-2.2
-6.2
14.2
-23.7
-30.3
37.9
-16.3
-4.4
5.2
49.1
18.3
-2.7
30.7
-34.0
-10.3
6.8
24.6
6.9
-2.9
17.7
55.3
-5.2
5.0
19.6
4.3
-18.1
15.3
12.9
-1.9
3.6
17.2
1.8
3.7
15.4
7.7
-1.6
6.6
10.1
-2.0
-0.6
12.2
15.6
-0.7
-0.3
9.7
3.3
4.7
6.4
-1.0
-0.7
0.9
6.9
2.3
-11.3
4.6
9.4
0.2
10-Year
10-Year
Historical
Average
Standard
Deviation
2.8
17.2
1.4
-9.9
15.8
6.7
-3.0
3.9
12.5
10.4
15.6
10.7
23.0
3.1
Projected
Average
1.9
7.8
3.4
...
4.4
3.0
-0.3
3.5
7.8
5.0
...
2.8
-4.1
-1.2
4.1
8.1
5.1
...
3.0
-1.0
-1.9
4.1
8.2
5.3
...
3.0
2.3
-2.0
4.2
8.1
5.1
...
3.0
3.5
-2.0
4.3
8.2
5.2
...
3.0
3.9
-2.0
3.7
8.0
4.9
...
3.2
1.3
-1.6
Debt-stabilizing
primary
balance 10/
II. Stress Tests for Public Debt Ratio
A. Alternative Scenarios
A1. Key variables are at their historical averages in 2004-08 8/
A2. Primary balance under no policy change in 2004-08
A3. Country-specific shock in 2004, with reduction in GDP growth (relative to baseline) of one standard deviation 9/
A4. Selected variables are consistent with market forecast in 2004-08
Debt-stabilizing
primary
balance 11/
0.9
50.5
50.5
50.5
50.5
47.3
50.6
50.6
50.6
43.7
49.2
49.2
49.2
40.0
47.7
47.7
47.7
36.3
46.1
46.1
46.1
32.7
44.5
44.5
44.5
-0.1
0.9
0.9
0.9
50.5
50.5
50.5
50.5
50.5
50.5
58.9
57.1
54.8
57.6
69.1
60.6
67.1
65.2
58.5
65.2
68.1
59.4
66.1
67.7
57.2
64.0
67.0
58.2
64.8
70.1
55.8
62.7
65.8
56.8
63.5
72.5
54.4
61.3
64.5
55.3
1.2
1.4
1.1
1.2
1.3
1.1
B. Bound Tests
B1. Real interest rate is at historical average plus two standard deviations in 2004 and 2005
B2. Real GDP growth is at historical average minus two standard deviations in 2004 and 2005
B3. Primary balance is at historical average minus two standard deviations in 2004 and 2005
B4. Combination of 2-4 using one standard deviation shocks
B5. One time 30 percent real depreciation in 2004 10/
B6. 10 percent of GDP increase in other debt-creating flows in 2004
1/ Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.
2/ Derived as [(r - g - g + r]/(1+g++g)) times previous period debt ratio, with r = interest rate;  = growth rate of GDP deflator; g = real GDP growth rate;  = share of foreign-currency
denominated debt; and  = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).
3/ The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.
4/ The exchange rate contribution is derived from the numerator in footnote 2/ as (1+r).
5/ For projections, this line includes exchange rate changes.
6/ Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.
7/ Derived as nominal interest expenditure divided by previous period debt stock.
8/ The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.
9/ The implied change in other key variables under this scenario is discussed in the text.
10/ Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
11/ Assumes that key variables (real GDP growth, real interest rate, and primary balance) remain at the level in percent of GDP/growth rate of the last projection year.
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.
25
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
1999
2000
2001
30
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
1994
1995
1996
1997
1998
Sensitivity Range
30
1999
2000
Actual
2001
Baseline
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.
27
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-thanexpected post-crisis fiscal adjustment and lowerthan-expected real interest rates. An unanticipated
large real depreciation was the main contributor.
In Mexico, the outturn in 1995 was above the oneyear-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.
28
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.


The template does not indicate what level of debt is too high.


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.
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.
29
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.
30
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 (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).
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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 country’s policies and
institutions in assessing debt sustainability.
34