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ASSESSING FISCAL SUSTAINABILITY:
A NEW APPROACH
Enrique G. Mendoza
Pedro Marcelo Oviedo
Comments by:
Andres F. Arias
Ministerio de Hacienda y Crédito Público
Republic of Colombia
Probabilistic Model = ability to repay
in crisis state
bt 1  b 
*
t
g
r 
min
min
where b* = stock of debt that government is
able to repay in all states of nature 
“Credible repayment commitment”
Very nice approach because…
1. Also captures stock of debt that
government is “willing” to repay if
lender chooses r so that b* reflects a
rationing debt level that enforces the
government’s participation constraint
(i.e. constraint under which the
government always finds it preferable to
repay and maintain credit relationship)
Very nice approach because…
2. Incorporates the role of volatility of
fiscal variables in determining ability to
repay.
f(t)
B
A
t
tBmin=0.10
tAmin=0.18
tmean=0.2
Long-run method  A & B share the same sustainable debt ratio.
Probabilistic method  A has a higher sustainable debt ratio than B.
But…
 Defines a “maximum” debt level and
not a “target” debt level (to be
achieved through policy adjustment).
 Maximum debt level is not equilibrium
or optimal debt level.
Is this a tool for governments or
for Wall Street?
 As a government, I discuss “optimal”
indebtedness and strategic behavior
(i.e. repayment/default) under
different scenarios (critical and noncritical).
 For instance, it may be optimal to
issue b>b* and repay/default under
different states of nature.
 If so (and if markets buy b>b*)
why do I care about b*? I already
did when I defined my optimal
strategy.
 Does this mean that my debt is not
sustainable?
 Should governments (or firms and
households) do debt sustainability
analysis based on their capacity to
repay under the worst case scenario
(i.e. the crisis state)?
 Will they ever do it?
 If so, does this mean that Argentina
never thought about the logic behind
the probabilistic model?
Besides…
How can we operationalize the
probabilistic model?
1. Bail-outs  gmin?
2. Sudden stops/TOT shocks/Balance
sheet effects  r, , gmin ?
3. Inflation tax  tmin?
Colombia…
The coefficient of variation in
revenue is 7.3%, while expenditure
cuts cannot exceed 5% of GDP
because of budgetary inflexibilities
(investment is the only item freely
adjustable, 5% of GDP=60% of
public investment)
Colombia…
t
min
g
min
 23%
of GDP
 23.8% of GDP
(t  2 t )
2002 (net of
interests)
r = 6%
 = 3.7%
b* = -0.4% of GDP
Does this mean that Colombia’s debt
is (or is not) sustainable?
Colombia…
In any case from the point of view of a
sovereign debt issuer, the probabilistic
model is very useful in suggesting that
volatility of fiscal variables must be taken
into consideration.
This can be done with a series of
tools…
Debt projections and sensibilities…
Colombian medium-term debt path
55
50
Base Scenario
45
45.8
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
40
This base projection may
change…
Due to shocks in variables
such as r, , E, fiscal
expenditure and
contingencies.
Debt projections and sensibilities…
% GDP
1
Historical averages
(96-02) for t>=2004
54
52
50
48.7
48
Base Scenario
46
45.8
44
42
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
40
Debt projections and
sensibilities…
2
% GDP
2 std dev shock in 2004 to
r
54
52
51
50
48
Base Scenario
46
45.8
44
42
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
40
Debt projections and sensibilities…
% GDP
60
2 std dev shock in 2004 to
3

58
55.4
56
54
52
50
48
46
Base Scenario
44
45.8
42
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
40
Debt projections and sensibilities…
% GDP
4
60
58
55.1
56
2 std dev shock in 2004 to (t-g)
54
52
50
48
46
45.8
Base Scenario
44
42
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
40
Debt projections and sensibilities…
% GDP
5
65
60.8
60
1 std dev shock in 2004
and 2005 to r,  and (t-g)
55
50
Base Scenario
45
45.8
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
40
Debt projections and sensibilities…
% GDP
6
60
30% devaluation in 2004
54.1
55
50
45
45.8
Base Scenario
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
40
Debt projections and sensibilities…
% GDP
7
65
60
Increase of 10 points in
debt stock
55
58.7
50
Base Scenario
45
45.8
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
40
Statistical significance of
sensibilities…
Sensibilities may be evaluated with p-values
Year
Base scenario
Worse scenario
Debt
P-value
Debt
P-value
Exercise
2003
53.3
86.9
53.3
86.9
-
2004
51.6
82.3
58.0
39.6
6
2005
50.0
82.3
63.7
24.3
5
2006
48.7
81.9
62.5
38.0
5
2007
47.7
80.6
61.8
45.3
5
2008
47.0
79.5
61.4
49.7
5
2009
46.3
78.8
61.0
52.7
5
2010
45.8
77.8
60.8
55.1
5
Financing needs…
The NFPS deficit is financed through internal and
external indebtedness
Net Financing
% GDP
2003
2004
2005
2006
2007
2008
2009
2010
Interno
2.0%
-0.9%
-0.3%
0.3%
1.0%
1.3%
1.0%
1.5%
Externo
1.5%
1.8%
1.5%
1.0%
0.6%
0.3%
0.7%
0.2%
Total
3.5%
1.0%
1.2%
1.3%
1.6%
1.6%
1.6%
1.7%
Source: Public Credit-MHCP
Future external indebtedness
% of net capital inflows to developing
countries absorbed by Colombia…
%
NFPS
2000
2001
2002
2003
2004
95-02
5.5%
2.7%
0.8%
1.3%
2.2%
1.7%
Source: IMF, Central Bank. Calculations DGPM.
Future internal indebtedness
•From forecast of real sector’s portfolio demand and
with assumptions about M3 growth, I can deduce
private sector’s demand for domestic government debt
(TES)
•No signs of crowding out
30%
% GDP
Total stock
25%
Private sector
Consistent with financing
strategy
20%
15%
10%
5%
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
0%
Source: Banco de la República- DGCP- Calculations DGPM
Default probability
Manasse, Roubini and
Schimmelpfennig (2003) 
Binary recursive tree analysis
(sequence of rules) to determine if
country is prone to fiscal crisis
In Colombia…
1. ¿Does total external debt exceed
50% of GDP?
NO (48,6%)
2. ¿Is short-term external debt to
reserves ratio greater than 1.34?
NO (0,98)
In Colombia…
3. ¿Is the public external debt to
revenue ratio greater than 2.15?
NO (1)
4. ¿Is the economy growth rate greater
than -5.45?
YES (3.13)
 Colombia is not crisis-prone
(probability = 2.3%)
ASSESSING FISCAL
SUSTAINABILITY:
A NEW APPROACH
Enrique G. Mendoza
Pedro Marcelo Oviedo
Comments by:
Andres F. Arias
Ministerio de Hacienda y Crédito Público
Republic of Colombia