Assessing Fiscal Risks:
International Best Practice
Jimmy McHugh
Fiscal Affairs Department
May 2011
Overview
 Motivation for new FAD fiscal sustainability indicator.
 Outline the methodology
 Simple empirical example.
Stylized Phases of Fiscal Policy-Making
a. Understanding
the Fiscal
Position
c. Implementing
through the
Budget Process
b. Medium-term
Fiscal Planning
The role of fiscal risk management
a. Understanding
the Fiscal
Position
b. Medium-term
Fiscal Planning
c. Implementing
through the
Budget Process
Objective: Create a fiscal monitoring
system
 Rollover risk?
 Policies are perceived to be unsustainable,
 Difficulties demonstrating solvency.
 Fiscal crisis
 Disorderly fiscal adjustment.
 Optimal set of fiscal indicators – what should we track?
 Can we derive an index for assessing fiscal sustainability?
Framework outlined in four papers
 Cottarelli (2011)
 Baldacci, McHugh and Petrova (2011)
 Baldacci, Petrova, Belhocine, Dobrescu, and Mazraani
(2011)
 First used in the IMF Fiscal Monitor – April 2011.
Inability to roll over debt
 Depends on the interaction between:
 current level and baseline projections of key fiscal variables;
 shocks around this baseline (macroeconomic or fiscal policy
changes, contingent liabilities),
 Other factors, including country-specific non-fiscal variables.
Early warning system
 Signal about rollover difficulties,
 Give policymakers the opportunity to adjust policies before
extreme fiscal stress events.
 Thresholds beyond which a crisis becomes significantly more
likely.
Key building blocks of early warning systems
How do we identify these thresholds?
 Thresholds vary across countries and time, available
estimates.
 Our approach:
 Probabilistic approach,
 Norms for fiscal variables derived from historical averages.
12 key fiscal indicators
Basic indicators
Long term challenges
Stress index
Liability management
12 key fiscal indicators
Basic indicators
Long term challenges
Vulnerability index
Liability management
Stress index
Vulnerability index
Sustainability index
Factors affecting the baseline
Three clusters
 Basic fiscal variables
 Long-term fiscal trends:
 Liability management
Basic fiscal variables
Are the debt dynamics based on current and expected
medium-term policies consistent with fiscal solvency?
Long-term fiscal trends
To what extent will long-term economic and demographicrelated challenges affect projected fiscal variables and impact
solvency risks?
Long-term fiscal trends
To what extent will long-term economic and demographicrelated challenges affect projected fiscal variables and impact
solvency risks?
Asset and liability management:
Does the composition of government’s assets and liabilities
expose countries to large rollover needs?
Choice of indicators
 Avoid reliance on financial market indicators.
 they tend to lag rather than lead the deterioration of the fiscal
outlook.
 Each indicator is widely used, easily accessible over time and
available for a broad range of countries.
Basic Fiscal Variables
 Gross versus net debt
 Cyclically adjusted primary balance
 Reflects the fiscal stance independent from the effects on the
budget of the output cycle
 Projected growth-adjusted interest rate –
 The difference between the projected imputed nominal interest
rate on government debt and the projected nominal growth rate
of GDP
Long-Term Fiscal Trends
 Future expenditure pressures:
 The projected change over 20 years in key age-related
expenditure items, such as health and pensions,
 The current total fertility rate
 A forward-looking indicator of future demographic pressures
 The projected old-age dependency ratio
 combines long-term demographic trends with the initial
population structure
 Indicator of capacity to bear the costs of supporting the old.
Asset and Liability Management
 Gross financing needs
 Share of short-term public debt as a ratio of total public debt
 Weighted average maturity of outstanding government debt
 Short-term external debt to gross international reserves
 Proportion of debt denominated in foreign currencies, as a
percent of total debt
 Government debt held by non-residents as a proportion of
total debt
MONITORING FISCAL VULNERABILITY AND STRESS
 Fiscal vulnerability index
 Fiscal stress index
Combined into a single fiscal sustainability index
Fiscal vulnerability index
 Measures the degree of fiscal vulnerability as a departure
from historical “norms”,
 Defined as 10-year cross-country averages.
 Key advantage - simplicity.
 Main shortcoming - economic meaning of the historical
“norms” and deviations from them is less straightforward
than in model-based indices.
Steps
 Calculate for each indicator a standardized score:
 For each of the three clusters of indicators, calculate an
unweighted average.
 Use a cumulative normal distribution to calculate a score
ranging from zero to ten.
Fiscal stress index
 Extreme “tail events” such as debt defaults, and large spikes in




interest rate spreads.
Summary score that depends on endogenous thresholds.
Derived by minimizing the errors made in using each indicator to
predict fiscal stress episodes.
Provides a weighting system of the fiscal indicators into the
summary index using their predictive power.
Main shortcomings:
 Dependence on the specific definition of crisis
 Relatively weak statistical power.
Defining a crisis – Four criteria
 Public debt default or restructuring;
 IMF-supported program
 Excessively high inflation rate; and
 Exceptionally high sovereign bond yields.
A set of 176 episodes among advanced and emerging
economies over the past four decades
Assessing signaling power
 Use statistical methods to define a crisis threshold for each
fiscal indicator.
 Once indicator is above threshold, assign a value of one.
 Define the stress index in terms of the number of indicators
exceeding the threshold.
 Set indicator to fall between zero and 10.
Fiscal sustainability index
 Take an unweighted average of the stress and vulnerability
indices for each of the three clusters.
 Derive an aggregate score using the three clusters.
12 key fiscal indicators
Basic indicators
Long term challenges
Stress index
Liability management
12 key fiscal indicators
Basic indicators
Long term challenges
Vulnerability index
Liability management
Stress index
Vulnerability index
Sustainability index
Empirical application
 Rollover risks under the baseline compared for advanced and
emerging economies
 Spring 2011 and Fall 2010
G20 and GIPS, PPP weighted, Fiscal Scores, 2010-11
Basic Fiscal
Variables
Fall 2010
Long-term
Asset and
Fiscal Trends
Liability
management
Overall Score
Basic Fiscal
Variables
Spring 2011
Long-term
Asset and
Fiscal Trends
Liability
management
Overall Score
Aggregate Score
G20 Advanced plus GIPS
G20 Emerging economies
7.5
7.0
6.6
4.9
7.2
5.0
7.0
5.5
7.5
6.7
6.4
4.8
7.0
4.5
6.9
5.2
Fiscal Vulnerability
G20 Advanced plus GIPS
G20 Emerging economies
7.7
6.9
6.0
5.0
6.0
6.0
6.5
6.0
7.8
6.4
5.9
4.8
5.8
5.0
6.5
5.4
Fiscal Stress
G20 Advanced plus GIPS
G20 Emerging economies
7.2
7.1
7.3
4.8
8.3
3.9
7.4
5.0
7.2
6.9
6.9
4.7
8.3
3.9
7.3
4.9
1/ Weighted averages based on constant GDP-PPP values
Source: IMF Staff Estimates
0.5
G20 Advanced plus GIPS
(change in index between Fall 2010 and Spring 2011)
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
Basic Fiscal Variables
Long-Term Fiscal Trends
Asset and Liability
Management
Aggregate score
0.5
G20 Emerging Market economies
(change in index between Fall 2010 and Spring 2011)
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
Basic Fiscal Variables
Long-Term Fiscal Trends
Asset and Liability
Management
Aggregate score
G20 Advanced plus GIPS
Basic Fiscal Variables
8.0
7.0
6.0
5.0
Fall 2010
Spring 2010
4.0
Asset and Liability Management
Long-Term Fiscal Trends
G20 Emerging Market Economies
Basic Fiscal Variables
8.0
7.0
Fall 2010
Spring 2011
6.0
5.0
4.0
Asset and Liability Management
Long-Term Fiscal Trends
Conclusions
 When monitoring fiscal developments, need to shift to a
wider set of variables that more accurately capture rollover
risk.
 two complementary tools for assessing rollover risk:
 Fiscal vulnerability index
 Fiscal stress index.