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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