Download Retrospective Sustainability

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.
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.
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?”
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.
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.
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)
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.
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).
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”.
Counterfactual: what would have debt been if some specific shock had
not taken place?
(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
Informal taxonomy for non-policy shocks: Lucky vs. Unlucky
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.
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.
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))
550000
Exchange rate/interest rates explain 97% of
debt variation; 1999 crisis “dummied out”
530000
510000
490000
470000
450000
430000
410000
390000
370000
b (actual)
b (base)
b (omit e,r)
350000
0
1
2
3
4
0
1
2
3
4
5
00
01
02
03
04
r-0
gr-0
gr-0
gr-0
gr-0
gr-0
c-0
c-0
c-0
c-0
c-0
p
u
e
p
u
e
p
u
e
p
u
e
p
u
e
p
A
A
D
A
A
D
A
A
D
A
A
D
A
A
D
A
IV Brazil
Table A.5. Brazil: Summary of Alternative Estimates (Versions (i)–(v))
Version
Sample
Crisis Dummy
98:11–99:3
Flex Regime
Dummy 99:4–05:6
Time Trend
(i)*
(ii)
(iii)
(iv)
(v)
95:5–05:6
95:5–05:6
95:5–05:6
99:4–05:6
99:4–05:6
Yes
Yes
No
NA
NA
Yes
Yes
Yes
NA
NA
Yes
No
No
Yes
No
Figure A.1. Brazil: Observed and Baseline Debt, Alternative Estimates
(Versions (i)–(v))
550000
530000
510000
Observed
Ver (ii)
Ver (i)
Ver (iii)
490000
Ver (iv)
Ver (v)
470000
450000
430000
410000
390000
370000
Ju
l-0
1
O
ct
-0
1
Ja
n02
A
pr
-0
2
Ju
l-0
2
O
ct
-0
2
Ja
n03
A
pr
-0
3
Ju
l-0
3
O
ct
-0
3
Ja
n04
A
pr
-0
4
Ju
l-0
4
O
ct
-0
4
Ja
n05
A
pr
-0
5
A
pr
-
00
Ju
l-0
0
O
ct
-0
0
Ja
n01
A
pr
-0
1
350000
IV Brazil
Scenario 1: Real interest rate ≈12.8% (recent history); GDP growth just under 4 percent
(optimistic assessment - Deutsche Bank (2006)).
Table 4b(i). Brazil: Prospective Sustainability from 2005:6 Onward; Higher Interest Rate
First year primary surplus/GDP ps = 4.5 %
Baseline ps = 4.5%
Statistics
Mean Modest debt increase
Standard Deviation
Median
75th Percent
90th Percent
Time Horizon
1 Year
52.19
6.64
51.82
56.63
60.79
2 Years
52.51
9.95
51.93
58.55
65.98
3 Years
53.05
13.39
51.41
61.29
70.38
4 Years
53.65
16.08
51.28
62.30
74.87
5 Years
54.72
19.35
51.73
64.18
79.31
Time Horizon
More precaution requires more adjustment.
1 Year
2 Years
3 Years
4 Years
5 Years
Stabilizing debt (b) with probability:
50 %; Requires initial ps of:
5.44
5.17
5.14
5.14
5.20
► average debt ratio, end of horizon
51.40
51.40
51.40
51.40
51.40
75 % Requires initial ps of;:
9.31
7.78
7.41
6.85
6.66
► average debt ratio, end of horizon
47.30
45.75
43.85
43.57
42.79
90 %; Requires initial ps of :
12.92
10.55
8.75
8.92
8.60
► average debt ratio, end of horizon
43.52
39.79
39.41
34.13
31.38
IV Brazil
Scenario 2: Lower real interest factor ≈8.5% (market expectations data); GDP
growth ≈3.5% (IMF, authorities)
Table 4b(ii). Brazil: Prospective Sustainability from 2005:6 Onward; Lower Interest Rate
First year primary surplus/GDP ps = 4.5 %
Time Horizon
Baseline ps = 4.5%
Statistics
Debt decreases on average
Mean
Standard Deviation
Median
75th Percent
90th Percent
1 Year 2 Years
3 Years
4 Years 5 Years
48.5
46.3
44.1
41.7
39.5
3.8
5.3
6.7
7.5
8.4
48.4
45.9
43.6
41.3
38.9
51.0
49.6
48.6
46.1
44.5
53.5
53.7
53.1
51.7
50.2
Time Horizon
Somewhat more precaution
Stabilizing debt (b) with probability:
90 %; Requires initial primary surplus of:
► average debt ratio, end of horizon
1 Year
6.6
46.4
2 Years
5.5
44.2
3 Years
5.0
42.5
4 Years
4.6
41.6
5 Years
...
...
IV Brazil
Counterfacutal prospective: A “rear view mirror” for policy makers.
4D: Counterfactual Prospective Sustainability: Brazil, 2000:5 - onward
First year pri sur/GDP = 3.1%
Time Horizon
Statistics:
1 Year
2 Years
3 Years
4 Years
Mean Mean debt increases.
49.47
50.63
52.03
53.68
Std. Dev
4.28
6.30
8.37
9.94
Median
49.26
50.53
51.90
53.21
75th Pct With hindsight, these numbers not
52.44
54.58
57.42
59.53
extraordinarily high.
90th Pct
55.22
58.90
63.07
66.83
5 Years
55.80
12.06
54.90
62.50
71.25
“Baseline scenario”: GDP growth ≈ 4%,real interest rate ≈ 12.8%.
Time Horizon
Stabilizing debt with probability
50% requires primary surplus of:
-- average debt ratio, end of horizon
75% requires primary surplus of:
-- average debt ratio, end of horizon
90% requires primary surplus of:
-- average debt ratio, end of horizon
1 Year
3.40
49.22
6.00
46.44
8.44
43.89
2 Years
3.77
49.22
5.45
45.58
7.21
41.79
3 Years
3.94
49.22
5.42
44.34
6.80
39.77
4 Years
4.07
49.22
5.24
43.96
6.45
38.44
5 Years
4.21
49.22
5.21
43.37
6.33
36.82
“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.
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.
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.
1400000
Actual (b)
b(base)
1350000
b(omit e+r)
1300000
1250000
1200000
1150000
1100000
1050000
1000000
950000
900000
Apr-99
Apr-00
Apr-01
Apr-02
Apr-03
Apr-04
Apr-05
Beneficial impacts of interest rate reductions and stronger Peso most important in 2001-02.
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
1400000
Actual (b)
b(base)
1350000
b(omit def)
1300000
1250000
1200000
1150000
1100000
1050000
1000000
950000
Discretionary expansions of fiscal policy 02 – 04;
900000
Apr-99
Apr-00
Apr-01
Apr-02
Apr-03
Apr-04
Apr-05
V Mexico
Table 5b. Mexico: Prospective Sustainability from 2005:6 Onward
Initial period primary surplus/GDP ps = 2.1%
“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.
Time Horizon
Statistics
Mean Modest fall in average debt
Standard Deviation
Median
75th Percent Like a “fan chart”;
90th Percent There are risks.
1 Year
45.0
2.1
44.9
46.5
47.7
2 Years
3 Years
43.5
3.4
43.3
45.7
47.9
41.9
4.2
41.5
44.6
47.6
4 Years 5 Years
40.2
4.9
40.0
43.1
46.6
38.7
5.6
38.1
42.0
46.0
Time Horizon
Somewhat more precaution
Stabilizing debt with probability:
75 % requires primary surplus of:
► average debt ratio, end of horizon
90 % requires primary surplus of:
► average debt ratio, end of horizon
1 Year
3.2
42.7
4.4
42.7
2 Years
3 Years
2.3
43.1
3.2
41.2
1.9
42.6
2.8
39.9
4 Years 5 Years
1.6
42.3
2.4
39.1
1.5
41.9
2.3
38.0
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”
VI Turkey
Figure 7. Turkey: Real Public Debt Purged of Deficit Shocks
(b(omit ps, Db); Units are millions of 2001 Turkish Lira)
1.E+08
Actual (b)
1.E+08
b(base)
b(omit def)
9.E+07
8.E+07
7.E+07
6.E+07
5.E+07
4.E+07
3.E+07
Expansionary fiscal policy increased debt in 98-2000, 01-02
Ap
r-9
6
Oc
t-9
6
Ap
r-9
7
Oc
t-9
7
Ap
r-9
8
Oc
t-9
8
Ap
r-9
9
Oc
t-9
9
Ap
r-0
0
Oc
t-0
0
Ap
r-0
1
Oc
t-0
1
Ap
r-0
2
Oc
t-0
2
Ap
r-0
3
Oc
t-0
3
Ap
r-0
4
Oc
t-0
4
2.E+07
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)
1.E+08
Actual (b)
1.E+08
b(base)
b(omit e, r)
9.E+07
8.E+07
7.E+07
6.E+07
5.E+07
4.E+07
3.E+07
Shocks to real interest rate (combined real exchange rate) increased debt;
Ap
r-9
6
Oc
t-9
6
Ap
r-9
7
Oc
t-9
7
Ap
r-9
8
Oc
t-9
8
Ap
r-9
9
Oc
t-9
9
Ap
r-0
0
Oc
t-0
0
Ap
r-0
1
Oc
t-0
1
Ap
r-0
2
Oc
t-0
2
Ap
r-0
3
Oc
t-0
3
Ap
r-0
4
Oc
t-0
4
2.E+07
VI Turkey
6C: Prospective Sustainability, 2005:5 - onward
First year pri sur/GDP = 6.6%
Time Horizon
Statistics:
1 Year
2 Years
3 Years
Cautious optimism: modest rise in average debt 57.85
Mean
58.95
59.64
Std. Dev
7.44
11.81
15.43
Median
57.38
57.47
56.99
75th Pct Like a “fan chart”;
62.56
65.59
68.12
90th Pct Risks appear substantial
67.90
74.82
79.44
To be updated
4 Years
60.26
19.77
56.78
69.76
84.54
5 Years
60.65
23.28
56.62
72.29
90.96
4 Years
8.83
49.99
11.21
38.91
5 Years
8.69
48.14
10.74
35.75
“Baseline scenario”: GDP growth ≈ 5%,real interest rate ≈ 12½%.
Stabilizing debt with probability
75% requires primary surplus of:
-- average debt ratio, end of horizon
90% requires primary surplus of:
-- average debt ratio, end of horizon
Time Horizon
1 Year
10.48
53.99
14.82
49.66
2 Years
9.79
52.21
13.03
45.32
3 Years
9.38
50.41
11.79
42.34
“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.
VI Turkey
Table 6b. Turkey: Prospective Sustainability from 2005:5 Onward
Average primary surplus/GDP ps ≈ 6.5 Percent (Years 1 through 5)
“No adjustment fatigue.”
Sustained adjustment is critical.
Statistics
No Shock Scenario Non linearities – less debt
Mean
reduction under unertainty.
Standard Deviation
Median
75th Percent
90th Percent
Time Horizon
1 Year
49.6
51.3
6.3
50.9
55.3
59.9
2 Years 3 Years 4 Years 5 Years
45.5
49.2
9.7
48.0
55.0
61.9
40.8
46.0
11.7
44.8
52.9
61.3
36.2
42.8
13.5
40.4
50.9
60.8
31.7
39.4
15.1
37.3
47.2
58.9
Time Horizon
More precaution requires more adjustment.
Stabilizing debt with probability:
90 %; Requires first year primary surplus of:
► average primary surplus/GDP, years 1–5
► average debt ratio, end of horizon
1 Year
10.8
10.3
47.4
2 Years 3 Years 4 Years 5 Years
9.5
9.1
43.8
8.5
8.0
41.2
8.1
7.6
38.2
7.5
7.1
36.5
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.
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).
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?