A toolkit to assess fiscal vulnerabilities and risks in advanced economies

Abstract

This article presents a range of tools and indicators for analysing 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.

Keywords:

• fiscal vulnerabilities
• fiscal risk
• fiscal indicators
• sustainability

JEL Classification:

• E62
• H10

Acknowledgements

The authors would like to thank Peter Clays, Julio Escolano, Phil Gerson, Martine Guerguil, Manmohan S. Kumar and participants of the Banque de France and BETA conference on September 13–14, 2012 (Strasbourg) for helpful comments. The views expressed here are those of the authors and do not necessarily represent those of the IMF or IMF policies.

Notes

¹ Underlying vulnerabilities and risks are two different concepts (see, e.g. IMF, 2012). Underlying fiscal vulnerabilities – e.g. high rollover needs, high sensitivity to interest rate shocks – is a necessary though not sufficient, condition for a crisis. Crises are typically triggered by shocks and significant crisis risks reflect a combination of sizeable underlying vulnerability and a high likelihood of such shocks.

² IMF (2012) provides an overview of the EWE process and describes the main analytical tools deployed in the exercise across all dimensions. In addition to fiscal issues, these include external, real, financial sector risks, vulnerabilities and potential spillovers. The current article provides more details on some of the analytical fiscal tools and expands the methodologies. The EWE does not aim to predict the timing of crises but rather to identify underlying vulnerabilities and imminent tail risks that predispose a system to a crisis, so that corrective policies can be implemented and contingency plans put in place ahead of time.

³ While linked to the issue of debt sustainability, the article does not analyse if a country’s fiscal policy stance and its public debt trajectory are sustainable. It focuses instead on underlying vulnerabilities and risks that could ultimately impinge on sustainability. For a proposal to modernize the IMF’s framework for fiscal policy and public debt sustainability analysis, see IMF (2011). The fiscal policy stance is defined in that paper as unsustainable ‘if, in the absence of adjustment, sooner or later the government would not be able to service its debt’. Public debt would become unsustainable ‘if no realistic fiscal adjustment can prevent this situation from arising’.

⁴ The RAS indicator is computed as follows: RAS_i = R_i – RSW_i with R_i indicating the yield on 10-year government bonds issued by country i; and RSW_i indicating the 10-year fixed rate on interest rate swaps in the currency of country i.

⁵ Interest rates on swaps are effectively free from the risk of default of sovereign issuers, although they entail some residual counterparty risks. Swap contracts specify agreements to exchange a flow of interest payments at a fixed rate for one at a floating rate.

⁶ In line with calculations in the IMF Fiscal Monitor, for Japan, the net debt target is 80%, which corresponds to a gross debt target of 200%. For Australia, New Zealand and Canada, the net debt target is 40%.

⁷ For example, Kumar and Woo (2010)  find that for countries with debt ratios above 90% of GDP, a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year.

⁸ See, for example, Baldacci and Kumar (2010), Gale and Orszag (2003) and Engel and Hubbard (2004).

⁹ Some rating agencies consider the financing costs to revenues as one measure of default risk. If financing costs increase beyond a certain threshold, governments may become less able or less willing to service their debt.

¹⁰ For more details, see Alper et al. (2012).

¹¹ The US real long-term bond yield is used to proxy foreign rates for all countries excluding the US and European Union economies (with the exception of Germany). For the latter economies German real rate is used.

¹² To summarize the relative vulnerabilities of countries, one can consider ranking them or assigning ‘warning flags’ (e.g. ‘low’, ‘medium’ and ‘high’) depending on their relative position to other countries. This approach is followed in the joint FSB–IMF Early Warning Exercise (see IMF, 2012).