Monday, January 16, 2012

A Toolkit to Assessing Fiscal Vulnerabilities and Risks in Advanced Economies

This paper presents a range of tools and indicators for analyzing fiscal vulnerabilities and risks for advanced economies. The analysis covers key short-, medium- and long-term dimensions. Short-term pressures are captured by assessing (i) gross funding needs, (ii) market perceptions of default risk, and (iii) stress dependence among sovereigns. Medium- and long-term pressures are summarized by (iv) medium- and long-term budgetary adjustment needs, (v) susceptibility of debt projections to growth and interest rate shocks, and (vi) stochastic risks to medium-term debt dynamics. Aiming to cover a wide range of advanced economies and minimize data lags, has also influenced the selection of empirical methods. Due to these features, they can, for example, help inform the joint IMF-FSB Early Warning Exercise (EWE) on the fiscal dimensions of economic risks.

Recent developments in international financial markets have reaffirmed that concerns over fiscal sustainability can precipitate a crisis in advanced as well as emerging economies. Persistent fiscal imbalances eventually result in high levels of general government debt that can raise concerns about sovereign debt rollover and, in the extreme, solvency. High debt can threaten macroeconomic stability and weigh on economic growth. If fiscal weaknesses are not addressed, countries could face difficulties in meeting their funding needs and, in the limit, lose market access altogether. The eventual fiscal adjustment required to restore stability could entail sharp losses in employment and output.

This paper presents a range of indicators and analytical tools for assessing fiscal vulnerabilities and risks for advanced economies. As these are complex and evolving issues, there is no single methodology that can summarize all aspects; rather a broad toolkit is needed. To highlight related but conceptually distinct elements of fiscal risks and vulnerabilities, the six tools presented here are organized mainly by their time horizon.Indicators measuring short-term pressures include the size of a country’s gross financing
needs, with a view to capturing its potential funding risks; high frequency market-based measures of sovereign default risk; and a measure of potential spillovers in distress dependence among advanced economies. Indicators that assess medium- to long-run vulnerabilities use lower frequency data. They include a measure of the required fiscal effort to stabilize debt in the medium and long run; the impact of adverse growth and interest rate shocks on the baseline debt trajectory; and a probabilistic measure of the debt outlook reflecting risks associated with baseline debt projections. Together these tools cover a broad scope and address the different nature of risks to fiscal sustainability, but additional aspects need to be systematically covered going forward, including by assessing the investor base and level of contingent liabilities. The choice and development of the tools laid out in this paper responds to three additional objectives: first, ensuring wide coverage of advanced economies; second, minimizing the time lag with which data become available; and third, allowing for a relative assessment (ranking) of countries so as to provide input for the joint IMF-FSB Early Warning Exercise (EWE).

The paper complements other IMF work on fiscal vulnerabilities and risks by adding new tools and covering a larger set of advanced economies. Baldacci, McHugh, and Petrova (2011) use thirteen key fiscal indicators, clustered into three pillars (short and medium-term fiscal developments, long-term fiscal trends, and liability management), to capture rollover risks associated with the fiscal baseline scenario. Going beyond their analysis, our paper also assesses the risks emanating from shocks to baseline projections, it captures market-based risk indicators, and analyzes spillover risks. Moreover, many of the indicators used have a shorter time lag than those used by Baldacci, Mc Hugh and Petrova; thus, allowing to capture more immediate changes to risks. A comprehensive methodology for assessing fiscal risks (baseline vulnerabilities and shocks to the baseline) is outlined by Cottarelli (2011) and
applied in the April and September 2011 Fiscal Monitors. These risks include also fiscal policy implementation risk, macroeconomic uncertainty, and financial sector risk. However, data availability limits this approach to focusing on country groups rather than individual countries at this stage. Another widespread approach to capture fiscal risks is early warning system models. Baldacci et al. (2011) review the literature and build an index of fiscal stress using the indicators developed in Baldacci, McHugh, and Petrova (2011) as input. Caveats are those associated with early warning models and the already-mentioned data limitations.

The paper is structured as follows. Section II provides an overview of the tools capturing six key dimensions of fiscal vulnerabilities and risks. Section III gives illustrative examples for applying these concepts by using recent advanced economy data. Section IV concludes, highlights caveats of the current methods, and suggests ways forward. The Appendix provides technical details on the key methods.

IMF. Author/Editor:Schaechter,Andrea;Alper, C. Emre;Arbatli, Elif; Caceres, Carlos; Callegari, Giovanni; Gerard, Marc; Jonas, Jiri; Kinda, Tidiane; Shabunina,Anna;Webe,Anke


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