Allan, William, 2000, “Linking Transparency and Vulnerability Assessments—The Role of IMF’s Fiscal Transparency Code” (unpublished: Washington: International Monetary Fund).
Bird, Richard M., and Susan M. Banta, 1999, “Fiscal Sustainability and Fiscal Indicators in Transitional Countries,” paper presented at the USAID Conference on Fiscal Reform and Sustainability, Istanbul, Turkey, June.
Downes, Patrick T., Dewitt D. Marston, and Inci Ötker, 1999, “Mapping Financial sector Vulnerability in a Non-Crisis Country” IMF Policy Discussion Paper PDP/99/4 (Washington: International Monetary Fund).
Easterly, William, 1999, “When is Fiscal Adjustment an Illusion?” in Economic Policy: A European Forum (U.K.), No. 28 (April), pp. 57–86.
Skilting, David, 1999, “How Should Governments Invest Financial Assets and Manage Debt?” paper presented at the 20th Annual Meeting of Senior Budget Officers, Organization for Economic Cooperation and Development, Paris, France.
Talvi, Ernesto, and Carlos A. Végh, 2000, “Tax Base Variability and Procyclical Fiscal Policy,” NBER Working Paper No. 7499 (Cambridge, Massachusetts: National Bureu of Economic Research).
This paper draws on a companion paper by Iraj Abedian and has been prepared with significant input from William Allan, John Crotty, and Steve Symansky. It has also benefited from comments made by many colleagues in the Fiscal Affairs Department and by seminar participants at the European Central Bank and the World Bank.
This is illustrated by recent work which points to variables related to fiscal imbalance—e.g., high domestic credit growth and large current account deficits—as being among the strongest predictors of an external crisis (IMF, 1999).
Allan (2000) describes and discusses in more detail the links between assessments of fiscal transparency and fiscal vulnerability.
The World Bank refers to these as level 1, 2, and 3 operations of fiscal policy (World Bank, 1998).
In addition to these general objectives, a country may have specific fiscal policy objectives a government has set for itself (e.g., as reflected in a fiscal rule) or that may have been agreed with others (e.g., as part of IMF conditionality).
Justification for stability of tax rates is based on the result that the distortionary cost of taxation is reduced by smoothing tax rates over time. Tax smoothing is consistent with countercyclical fiscal policy.
Prudence is consistent with the usual approach in accounting, where financial statements consistently err on the side of caution in recording events or transactions that are likely to have a favorable impact, while being less cautious when the results are likely to be unfavorable.
While lower levels of government which set their own objectives and are subject to market discipline can be viewed as independent of central government from an economic perspective, from a vulnerability perspective consolidation is desirable (although vulnerability could be assessed independently for lower levels of government).
Easterly (1999) finds evidence from an analysis of countries borrowing from the IMF and the World Bank, and European countries covered by the Maastricht Treaty, that fiscal adjustment often takes the form of privatization and cuts in government investment, so that changes in reported fiscal deficits represent illusory rather than real adjustment because there is an offsetting balance sheet transaction.
Public pension obligations are not treated as a contingent liability, because their aggregate level can generally be established from pension scheme rules, demographic trends, and economic and labor force projections. This does not mean that public pension plans do not give rise to contingent liabilities. For example, a guaranteed minimum rate of return to a funded scheme does create a contingent liability.
Depending on a country’s circumstances, other such measures might include the structural balance, the operational balance, the primary balance, or the augmented balance.
These risks are the same as those discussed in the fiscal transparency manual, since a requirement of the fiscal transparency code is that all governments should publish a fiscal risk statement with the annual budget.
However, if the focus of a vulnerability assessment is on short-term fiscal outcomes alone, stress testing should be part of such an assessment.
However, they cannot substitute for such analysis, or for vulnerability assessments more generally, since there is little evidence that either debt ratings or interest rate premia adequately reflect fiscal sustainability. They are influenced more by external sustainability, level of development, and the depth of the market for a country’s debt.
The difficulty can be illustrated by reference to the discussion of fiscal policy in Asia in IMF (1998), where in distinguishing discretionary from nondiscretionary fiscal measures it had to be decided whether holding nominal spending constant when it had in the past increased represents changed or unchanged policy.
Stress testing clearly goes beyond the usual scenario analysis, which in the fiscal area tends to involve producing higher growth and lower growth scenarios to illustrate the benefits of stronger fiscal policies and the costs of weaker fiscal policies than in the baseline.
There is a parallel here with risk assessment in the private sector. Standard value at risk methodologies used in financial analysis show how much a bank or firm could potentially lose over a specified time period for likely market movements. Stress testing is used to assess and manage extreme risks.
Of course, not all nondiscretionary spending is necessarily a problem. For example, spending on unemployment compensation is cyclically sensitive. It therefore acts as an automatic stabilizer during a cyclical downturn, reducing the need for discretionary fiscal policy.
Talvi and Végh (2000) find that fiscal policy in developing countries is for such a reason highly procyclical. They suggest that attention should be paid to designing fiscal arrangements (such as stabilization funds) aimed at ensuring that fiscal savings generated during good times are saved for when times turn bad.
The weakness of survey-based indicators is that surveys fail to reflect the strength with which views are held, and hence the weight of opinion. However, they can incorporate information from a wider range of sources.
In this connection, Bird and Banta (1999) suggest indicators for transition economies that take account of their special circumstances.
This is analogous to the differentiation often applied to companies to distinguish those with short-term cash flow problems but positive net worth from those with negative net worth.
These sources of micro-structural vulnerability also affect what Tanzi (1999) refers to as the quality of the public sector.