CHAPTER 4 Assessing Fiscal Risks
- Philip Gerson, and Manmohan Kumar
- Published Date:
- November 2010
At a Glance
This chapter assesses fiscal risks and their evolution since the May 2010 Fiscal Monitor. It focuses on two scenarios: rollover problems, and the stabilization of public debt at post crisis levels over the medium-term. It suggests that overall the risk that these events materialize remains high for advanced economies, especially those that are already under market pressure, while risks are lower but nontrivial for emerging markets. Risks arising from macroeconomic uncertainty are generally higher than six months ago, amid concerns that the global recovery may be losing steam. Global market sentiment has improved toward emerging markets but worsened toward some advanced economies that were already under pressure.
This chapter summarizes the assessment of fiscal risks and their evolution since the May 2010 issue of the Monitor, based on the earlier chapters. The discussion that follows focuses on the likelihood that two unpleasant economic outcomes materialize:
Rollover problems, or potentially a full-blown sovereign debt crisis of regional or global relevance, which could emerge as a result of solvency concerns in the short or medium term.
The stabilization over the medium to longer term of public debt at post-crisis levels. While this may not raise solvency concerns—as debt dynamics would be under control—persistently high debt would lead to high interest rates, low private investment and growth, as well as limited fiscal space to conduct countercyclical fiscal policies (see May 2010 Monitor;Baldacci and Kumar, 2010; Kumar and Woo, 2010).35
Rollover risks remain at high levels in advanced economies and, to a lesser extent, in emerging economies, but have declined in a few dimensions and worsened in others since May. The likelihood of rollover problems depends on three sets of factors: (1) the fiscal baseline (including the long-term outlook, given the forward-looking nature of solvency); (2) the distribution of fiscal outcomes around the baseline, reflecting possible negative shocks (notably macroeconomic shocks, financial sector shocks, and policy shocks, the latter referring to failure or delays in implementing certain plans); and (3) market sentiment, given the baseline and the distribution of fiscal outcomes. These factors are reviewed in turn.
The fiscal baseline
The short- to medium-term baseline is broadly unchanged relative to May, as debt and deficits are evolving more or less along the lines envisaged in the last Monitor, albeit with some variations across countries. As noted in Chapter 1, this baseline is weaker among some European countries currently under market pressure although recent fiscal developments there have been favorable, with the exception of Ireland. The baseline is notably stronger among emerging economies, reflecting their much lower deficits and debt stocks and the expected further strengthening of these variables as the economic recovery there continues robustly.
Not much progress has been made in allaying long-term concerns, primarily related to the evolution of spending for pension and health care.36 The main development in this area has been the approval by Greece in July, and France in October, of a substantial pension reform, which has considerably improved the long-term fiscal baseline in those countries (although a few other countries, including the United Kingdom, have indicated an intention to introduce reforms in this area). Long-term spending pressures are generally lower among emerging markets, reflecting less adverse demographics (in most countries) and projected faster output growth.
The distribution of fiscal outcomes around the baseline
Three kinds of shocks are considered:
Macroeconomic (output and interest rate) shocks: Uncertainty on output growth has generally risen in both advanced and emerging economies since May, and stands at high levels amid concerns that the economic recovery in advanced economies may be losing steam. There is also considerable uncertainty on interest rate developments, also in light of the surge in public debt. A statistical analysis of these shocks, undertaken in Appendix 4 for selected countries, indicates that, under negative shocks, debt ratios would continue to rise rapidly. Going beyond the formal statistical analysis, as discussed in the May Fiscal Monitor, a possible source of positive output surprises relates to the assumption underlying the baseline fiscal projections that the crisis led to a sharp decline in potential output (and revenues)—an assumption that, while based on previous experiences after financial crises, may turn out to be wrong. This upside risk remains in the current projections but is less pronounced because, as noted in Chapter 1, since the last Monitor, IMF staff have already revised upward their estimate of potential output in the United States. On the other hand, a persistent downside risk relates to the pressure that high debt levels could have on interest rates. The current fiscal baseline assumes relatively benign interest rate developments, especially in Europe.
Financial sector shocks: Financial sector vulnerabilities are largely unchanged from May in most advanced and emerging economies, but have increased considerably among European countries currently under pressure. Vulnerabilities reflect the developments in bank balance sheets, as well as liquidity and monetary conditions. While funding conditions are still favorable and the EU bank stress test has provided some reassurance to the markets, potential losses on both private and public asset holdings weigh on the balance sheets of banks. Potential losses from sovereign risk repricing could be more relevant for banks in the European countries under pressure (IMF, 2010g). Appendix 4 includes a statistical assessment of the effect of financial sector shocks on the fiscal accounts of some countries, focusing in particular on the likelihood that guarantees on banking sector obligations are called.
Policy shocks: Risks related to the quality of fiscal plans and policies have declined among advanced economies since May. As noted in Chapter 3, most countries have made progress in setting out fiscal exit plans, and a few have also made progress in strengthening fiscal institutions. Nevertheless, there is considerable room for further progress, including with respect to providing more detail on adjustment measures, identifying long-term targets for the debt ratio, ensuring the prudence of macroeconomic projections, further improving fiscal frameworks, and strengthening safety nets for the most vulnerable. Some key emerging economies have not spelled out their medium-term adjustment plans or have indicated that they do not plan to undertake significant fiscal consolidation, even where this would be appropriate to address long-standing fiscal vulnerabilities or to create space for higher-priority spending.
Market sentiment has become more polarized, weakening for some European countries, and remains a significant source of risk. Although broader market sentiment appears to have stabilized—as captured by a standard measure of market volatility, the VIX index, for instance—risk appetite continues to be weak, as reflected in the declines in sovereign yields for countries traditionally considered safe havens. There is particularly high degree of risk aversion with regard to the European countries under market pressure, where despite the improvement in fiscal fundamentals, uncertainties about growth prospects and contingent liabilities continue to weigh heavily on market sentiment. In contrast, sentiment toward emerging economies has strengthened since May, and these countries continue to experience strong inflows from investors.
Risks of High Long-Term Public Indebtedness
The likelihood that public debt ratios in the advanced economies will stabilize at high levels over the medium term is difficult to quantify but has likely increased. As Appendix 4 illustrates, the odds that public debt stabilizes within the next five years appear low, especially when implementation and guarantee risks are taken into account. As noted in Chapter 3, the main problem is that few governments have yet identified a return of public debt ratios to more appropriate levels within a specific time frame as a specific policy objective. Indeed, despite the initiation of fiscal consolidation in most advanced economies next year, debt ratios on average will continue to rise in most of them over the medium term. Achieving a reduction will require sustained fiscal adjustment over an extended period, and hence, involve substantial political will on the part of country authorities. If governments are unable to make these commitments before “consolidation fatigue” has set in and when debt ratios are continuing to rise, they may be even less willing to do so when debt ratios are stabilizing and voters are weary of protracted cuts in spending and increases in taxes. Moreover, few countries have undertaken measures to counter projected rising health care costs in the medium term. As the present value of these and pension spending increases are expected to vastly outweigh the cost of the economic crisis, the failure of countries to take action to address medium- and longer-term spending pressures provides another reason to fear that debt ratios will stabilize only at very high levels.
Of course, a third unpleasant outcome is that fiscal policy does not provide enough support to economic activity, and recovery is not sustained. This is discussed in IMF (2010f). For an assessment of risks in low-income countries, see the last section of Chapter 3.
An assessment of spending pressures arising from global warming will be incorporated into future issues of the Monitor.