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Theodore Barnhill is professor of finance at the George Washington University and George Kopits is assistant director in the IMF’s Fiscal Affairs Department. The authors are grateful to Gustavo Arteta, James Daniel, Robert Gillingham, Alejandro Izquierdo, Eduardo Ley, Nouriel Roubini, Bob Traa, and other colleagues for useful comments. Farhan Hameed and Marcos Souto provided statistical assistance.
On the fiscal contribution to currency crises in emerging markets, see, for example, Kopits (2000).
In Brazil, under the Fiscal Responsibility Law of 2000, the authorities are required to prepare, as part of the yearly budgetary guidelines, an evaluation of fiscal risks, including: estimates of the quantitative impact (along with its probability) resulting from government decisions and other conditions; estimates of government guarantees and other contingent liabilities; and actuarial, financial, and economic assessment of public pensions, unemployment, and other employee insurance schemes, and various contingency funds.
See the “fiscal-risk matrix,” along with a “fiscal-hedge matrix,” presented for several countries, in Polackova and Schick (2002).
For a comprehensive treatment of the VaR approach, see Jorion (2001). An example of a recent application to the financial sector in South Africa can be found in Barnhill, Papapanagiotou, and Schumacher (2002).
A VaR analysis of borrowing countries, as an integral part of IMF surveillance and crisis-prevention, was first suggested by Dornbusch (1998) in the aftermath of the Asian crisis.
Mandatory expenditures are predetermined by multiyear government programs or by revenue earmarking. Discretionary expenditures are those over which the government has complete flexibility to determine from year to year.
In the context of (3), Z reflects the tax system and primary outlays under mandatory programs. Thus W excludes all discretionary expenditures, occasional levies and seignorage revenue, or any other flows that can be regarded as compensatory or induced to meet the intertemporal budget constraint.
In reality, γ summarizes the probability distribution of the occurrence of the contingency in any given time period.
See Buiter (1985). As an alternative, according to Blanchard and others (1990), a sustainable position obtains if the debt ratio eventually converges to its initial level. Condition (6) can be expanded to incorporate the effect of the real exchange rate by disaggregating debt and output in terms of tradables vs. nontradables; see Calvo, Izquierdo, and Talvi (2002).
See the arguments advanced in Easterly (1999) for using net worth to gauge the need for fiscal adjustment.
See, for example, the calculations for industrial countries over different time horizons in Blanchard and others (1990).
See the papers in Banca d’Italia (2000), undertaken mainly with the purpose of determining the compatibility of fiscal policy with the reference values under the Economic and Monetary Union, in the light of future macroeconomic and demographic prospects.
Examples can be found in Tanner and Ramos (2001) for Brazil, and in Santaella (2001) for Mexico. Less comprehensive calculations (limited mainly to social security finances) are available for other Latin American countries in Talvi and Vegh (2000).
In the formulation of a standardized framework for assessing external and fiscal sustainability by the Fund staff, it is acknowledged that “assessments of sustainability are probabilistic, since one can normally envisage some states of the world under which a country’s debt would be sustainable and others on which it would not. But the proposed framework does not supply these probabilities explicitly; rather, it traces the implications of alternative scenarios and leaves the user to determine the probabilities…. The framework also proposes a set of sensitivity tests, but further work will be necessary to settle on a precise calibration” (see International Monetary Fund, 2002, p. 25). The sensitivity analysis suggested for baseline projections of the public debt ratio include: historical averages, as well as one and two standard-deviation shocks in the growth rate, rate of interest, and primary balance; a 30 percent devaluation; and a 10 percent increase in debt-creating capital inflows.
In this vein, application of the Basle weights to public sector assets would be an arbitrary exercise. For a critique of the proposed new Basel capital requirements for banking institutions, especially in emerging market economies, see Barnhill and Gleason (2002).
For a discussion of alternative applications, see Jorion (2001) and Hull (2000). The mathematics associated with the delta-normal method in assessing central bank vulnerability can be found in Blejer and Schumacher (1998).
Simulation of the financial environment can be viewed as a random draw from an n-dimensional joint density function, where n is the number of stochastic variables.
For an extension of a portfolio simulation approach for assessing integrated market and credit risk to estimate bank capital requirements and compare them to those required under the proposed new Basel Capital accord in the case of Latin America, see Barnhill and Handorf (2002).
See the extension of the Vasicek model for stochastic risk-free interest rates in Hull and White (1994).
In a risk-neutral world, investors require no compensation for risk and the expected return on all assets is the risk-free interest rate.
For a fuller discussion of modeling risk-free and risky interest rate term structures, along with the application of a diffusion-based methodology for assessing the VaR of a portfolio of fixed-income securities (with correlated interest rate, interest yield spread, exchange rate, and credit risk), see Barnhill and Maxwell (2002).
The current application of VaR to the government balance sheet abstracts from counterparty credit risk. However, Barnhill, Papapanagiotou, and Schumacher (2002) have shown that it is possible to simulate correlated market and credit risk and undertake risk assessments of banks using a contingent-claims framework. In principle, this can be extended to conduct a simultaneous government and banking sector risk analysis.
In practice, firms are observed to often default before the value of the firm falls below the value of the outstanding debt (i.e., before the firm’s net worth becomes negative). Although less frequently, a solvent government may default in a liquidity crisis.
α = instantaneous expected rate of return on the firm per unit time,
C = payout by the firm per unit of time to shareholders or liability holders,
σ2 = instantaneous variance of return on the firm per unit of time, and
Δz = movement under a standard Gauss-Wiener process.
More than one half of revenue is estimated to be constitutionally or legally earmarked for primary expenditures by specific government institutions and/or purposes—in addition to payroll contributions for social security, which, by their very nature, are fully earmarked. In practice, actual earmarking falls short of the prescribed proportions because of considerable fiscal stress.
For evidence of procyclical fiscal behavior in Latin America, aggravating the effects of the volatility of output, commodity prices, and capital flows, see Gavin and others (1996).
For trading portfolios, with good liquidity position, often a one-day time step is utilized. Alternatively, for banks with less liquid portfolios a time step of up to one year is more appropriate.
Since 2000:3, the standard deviation of the listed variables is as follows (estimates for the period up to 1999:4 are shown in parentheses): yield spread, 0.07 (0.08); oil price, 0.26 (0.24); and non-oil GDP, 0.02 (0.04).
Although ordinarily the target limit on the public debt is expressed in proportion to GDP (40 percent in the case of Ecuador), the ratio of debt to tax receipts reflects more accurately the government’s debt-servicing capacity. The argument for measuring the public debt ratio in terms of tax revenue rests on the much higher macroeconomic volatility in Latin America than, for instance, in the OECD; see Hausmann (2002).
Specifically, the following structural measures, among others, are envisaged: comprehensive tax reform, civil service reform, and significant reduction in revenue earmarking—except where mandated by the Constitution or warranted on grounds of the benefit principle, for example, under social security programs.
Both the mean and variance of yield spreads shows a slightly significant decline after the phase-in of the U.S. dollar (in the first quarter of 2000), despite the disappearance of the currency risk. In fact, since then, the spread has remained well above 1000 basis points, spiking to twice that level in mid-2002.
Ecuador’s Fiscal Responsibility and Transparency Law, enacted in September 2002, provides for a set of macro-fiscal rules (consisting of limits on the non-oil budget deficit, primary expenditure growth, public debt), an oil stabilization fund, and transparency requirements—broadly in line with internationally accepted good practices (as discussed in Kopits and Symansky, 1998).
See, for example, the discussion of a proposed expenditure rule in Hausmann, Powell, and Rigobon (1993), and the case for adopting the Norwegian approach in Venezuela in Bjerkholt and Niculescu (2002).
For a discussion of various hedging instruments used in commodity risk markets, see Davis and others (2001).
For computational convenience—given the availability of all balance sheet information in U.S. dollar terms—simulation 1 provides the foundation for all simulations. Thus, for the baseline, simulation 1 is converted from dollars into sucres at the prevailing exchange rate; furthermore, the simulation is subject to the volatilities of the exchange rate, domestic inflation, and domestic interest rate, in addition to the other stochastic variables incorporated in simulation 1.