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Working Paper Summaries (WP/93/55 - WP/93/95)
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Summary of WP/93/78: “A Framework for Assessing Fiscal Sustainability and External Viability, with an Application to India”

Author(s):
International Monetary Fund
Published Date:
January 1994
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The achievement of balance of payments “viability” is a central objective of most Fund-supported adjustment programs. A viable balance of payments is one in which a country’s current account deficit can be financed, over the long term, by capital inflows on terms that are compatible with its development and growth prospects. Until recently, assessments of whether an economy was externally viable were based almost exclusively on balance of payments and external debt projections. These were used to profile future debt-service obligations and to estimate prospective financing gaps. The relationship between fiscal policy and balance of payments viability received less attention. Yet external projections alone cannot identify whether a country is on a sustainable path. The experience of many countries during the 1980s showed that policies that channel a large share of private savings toward financing government deficits may raise inflation and interest rates, depressing growth. A satisfactory assessment of medium-term viability must entail a careful examination of the public-private resource flows implied by the external, fiscal, and monetary targets.

Over the past decade, a large literature has developed around the issue of fiscal sustainability. Intertemporal models have identified the conditions for government solvency and have highlighted the consequences of untenable fiscal strategies. However, this literature does not address a number of practical questions that confront government authorities in setting fiscal policy: What are the short-run trade-offs between adjustment and deficit financing? What are the implications of alternative fiscal strategies for growth and external viability? This paper presents a simple macroeconomic simulation model that can be used to evaluate alternative fiscal strategies and their implications for medium-term viability. It is a step toward bridging the gap between the literature on fiscal sustainability and the demands of operational work.

The framework, developed in a spreadsheet format, generates estimates of public spending compatible with identified targets for growth, inflation, and government borrowing. The difference between the spending path consistent with these targets and that based on current policies is the fiscal adjustment required to meet the authorities’ macroeconomic objectives. The framework can also be used to assess the implications for inflation, interest rates, and public indebtedness of a given spending path. Finally, one can analyze the impact of financial reform on fiscal and external performance. The principal products of the analysis are mediumterm fiscal, savings and investment, and balance of payments projections. These are accompanied by sensitivity analyses to evaluate their robustness to alternative assumptions about macroeconomic policies, exogenous variables, and the model’s parameters. The model is applied to India in order to illustrate the types of simulations that may be conducted.

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