Appendix 3 Assessinǵ Fiscal Sustainability Risks: Derivinǵ a Fiscal Sustainability Risk Map
- International Monetary Fund. Fiscal Affairs Dept.
- Published Date:
- April 2011
Assessing a country’s susceptibility to fiscal sustainability risks requires tracking a number of internal and external factors. The methodology elaborated in this appendix presents a framework to assess fiscal risks in a forward-looking manner along multiple dimensions based both on high- and low-frequency data and information. The results are presented in a Fiscal Sustainability Risk Map (Figure A3.1) that includes six dimensions: The first three refer to expected fiscal developments under the baseline scenario: short- and medium-term fiscal fundamentals (core fiscal indicators), long-term fiscal challenges, and asset and liability management. The other three dimensions refer to shocks that may affect the baseline arising from unexpected macroeconomic developments, financial sector problems, and policy implementation shortfalls or errors.27
Figure A3.1The Fiscal Sustainability Risk Map
Source: IMF staff estimates.
Note: Greater distance from center indicates higher risk.
The Six Dimensions of the Map
The indicators used to capture the six dimensions of the Fiscal Sustainability Risk Map are summarized below.
Core fiscal indicators. They include the current year general government gross debt ratio (net debt for Australia, Canada, and Japan), the current year cyclically adjusted primary balance, and the projected growth-adjusted interest rate (five years ahead).
Long-term fiscal challenges. Measures used to capture long-term fiscal challenges are the projected increases in pension and health care spending through 2050 compared to current year, the current year fertility rate, and the 20-year-ahead old-age-dependency ratio.
Liability structure. This dimension includes gross financing needs, the share of short-term general government debt in total general government debt, the weighted average maturity of outstanding government debt, the ratio of short-term external debt to gross international reserves (for emerging economies only), the share of debt denominated in foreign currencies, and the share of general government debt held by nonresidents.
Macroeconomic uncertainty. Near-term uncertainty is captured by the dispersion of one-year-ahead real GDP forecasts across analysts based on Consensus Forecasts. Medium-term uncertainty is assessed by the dispersion over time in countries’ interest rate growth differential projections based on the semiannual WEO exercises.
Financial sector risks. The indicators draw on the Global Financial Stability Map of the GFSR. For advanced economies, the GFSR’s credit and market/liquidity risk index is used, complemented by a measure of contingent liabilities approximated by outstanding bonds of banks with government guarantees. For emerging economies, risks are captured by the GFSR’s emerging market risk index.28
Policy implementation risk. The risk measure is based on an assessment of the quality of countries’ fiscal plans, using five criteria, and supporting budgetary institutions (based on the November 2010 Fiscal Monitor and Bornhorst and others, 2010).29 Moreover, a measure of “government stability” enters, as captured by the corresponding component of the International Country Risk Guide risk indicator.
The indicators have been summarized using the following conventions. Indicators cover the G-20 advanced and emerging economies and some smaller advanced economies with large adjustment needs, with country group aggregations based on purchasing power parity GDP weights. Each dimension is an average (often weighted) of the subindicators and ranges from 0 to 10, with higher rankings signifying higher risks. A value of 5 should be interpreted as a broadly “neutral” outcome. In most cases, percentile rankings are used for each country compared to its historical values, with the historical average corresponding to the “neutral” level of 5. For the fiscal baseline variables, the normalization is not only over time but also compared to other countries; the related scores are combined with a fiscal stress index that assesses a country’s susceptibility to extreme tail events. The index maps fiscal indicators into a summary score that depends on endogenous thresholds derived by minimizing the errors made in using each indicator to predict fiscal stress episodes (Baldacci and others, 2011).
Informed judgment enters into the final calibration of a country’s position on the Fiscal Sustainability Risk Map. Staff judgment aims to account for the most recent information, which either may not yet be reflected in the data available or is difficult to capture quantitatively in the variables, and to reflect greater importance of certain risk factors at a given time.
Analysis of the indicators yields mixed results with regard to risks emanating from the baseline.30
Core fiscal indicators. Risks stemming from short- and medium-term fiscal trends, as reflected in the core fiscal indicators, remain broadly unchanged across advanced economies, but are somewhat lower across emerging market economies. For the advanced economies, a worsening in the general government gross debt ratios and in the interest rate—growth differential is offset by a small improvement in cyclically adjusted primary balances (in 2011 compared to 2010).
Long-term fiscal challenges. Risks from long-term fiscal challenges have remained broadly unchanged across both advanced and emerging market economies, reflecting limited reforms except most recently in France and Spain regarding pensions. All advanced economies continue to face significant risks due to spiraling health care costs.
Liability structure. Rollover risks linked to the liability structure are also little changed in advanced economies, but have declined in emerging economies. For advanced economies, the broadly unchanged risk reflects an increase in financing needs, including in the United States, which has been offset by an improved debt structure. For emerging economies, smaller gross financing needs are projected for 2011, and higher reserves have helped lower the risk profile further.
With regard to shocks around the baseline, developments have diverged across advanced and emerging economies.
Macroeconomic uncertainty. Near-term macroeconomic uncertainty has eased somewhat for advanced economies, but remains above its historical average. As activity has picked up in many advanced economies, the dispersion of real GDP forecasts for 2011 across analysts has narrowed markedly in recent months. This, however, does not yet reflect the amplified global downside risk stemming from higher-than-expected oil prices. In addition, there is somewhat greater volatility of medium-term projections regarding the interest rate growth differentials, reflecting increased uncertainty about the timing and strength of a potential shift from historically low interest rates. For emerging economies, macroeconomic uncertainty is still below that of advanced economies but has increased compared to six months ago. While the one-year-ahead real GDP growth dispersion indicator has fallen in recent months, overheating and inflationary pressures in some economies and rising food and commodity prices, as well as the uncertainties associated with the political turmoil in some countries in North Africa and the Middle East, have increased as risk factors.
Financial sector risk. This risk remains elevated in advanced economies, but has receded somewhat, reflecting favorable financial market performance. Contingent liabilities, when measured by bonds issued by banks with government guarantees, have remained broadly stable compared to November 2010 at around 6 percent of GDP, on average. In emerging economies, financial sector risk has stabilized at its historical average, while risk appetite has risen further.
Policy implementation risk. In contrast to financial sector risk, policy implementation risk has increased somewhat since November 2010 in advanced economies, reflecting a weakening of existing policy frameworks in some economies, and greater political uncertainty about government stability and the ability to implement fiscal plans. The increase in risk due to these developments has been partially offset by a strengthening of fiscal plans and institutions in some countries.
Several additional factors have a bearing on fiscal sustainability risk, and although they are not explicitly incorporated here, they are reflected in various parts of the risk map. For example, market sentiment or risk appetite affects governments’ ability to raise funding and the price at which they can do so. Until the earthquake and ensuing events in Japan, and the political turmoil in the Middle East, market sentiment had improved significantly in advanced economies and risk appetite for emerging market assets had increased. Over the past weeks, however, the sentiment has weakened somewhat, and the indicator for implied volatility of equity markets, which peaked temporarily in the autumn of 2010, has increased again. Market sentiment is in part reflected in the financial sector risk assessment. Nonfiscal imbalances, such as current account imbalances or large private sector balance sheet exposures, can also heighten fiscal risks and are reflected in macroeconomic uncertainty and financial sector risks (Cottarelli, 2011).
In sum, the indicator-based approach and the Fiscal Sustainability Risk Map signal that the fiscal sustainability risk is high in advanced economies, while it is generally lower for emerging economies, although new risk factors have emerged for the latter.