Fiscal (Public Debt)

Sustainability
Module 8 – Public Finance
 Fiscal Sustainability
• The ability of a country to maintain its current fiscal operations without the
threat of a crisis that would require a drastic change in policy.
• Governments with high ratios of public debt to GDP that seem likely to rise without
limit over time are considered to have unsustainable fiscal positions.
• Fiscal sustainability implicitly involves several related concepts.
1. Solvency
2. Liquidity
3. Vulnerability
 Solvency

• In principle, whether a government could repay all its

debt by running appropriate surpluses.
 Liquidity

• Having the resources needed to meet payment

obligations as they mature.
 Vulnerability

• Weaknesses in revenue structure or expenditure policy

and management that can lead to an unsustainable fiscal
situation.
 Assessing Sustainability: Basic Considerations
• Economists normally assess fiscal sustainability using mathematical formulas
relating the change in the public debt-to-GDP ratio to certain macroeconomic
indicators.
• The key indicators are as follows:
• The average level of real interest rates on total public debt
• The real rate of GDP growth
• The ratio of the primary fiscal balance to GDP
• The ratio of non-debt creating flows, such as privatization proceeds, to GDP
• Where governments have issued debt in foreign currency, the relevant exchange rate and
average rate of debt issued in foreign currency, as well as the average real interest rate on
domestic currency debt.
 Other factors to consider when assessing
sustainability
1. The feasibility of attaining the revenue and expenditure forecasts in the
government budget.
• Sustainability analysis presumes that the key budget aggregates are attainable. It is hard to
assess sustainability if the budget presumes unrealistic forecast of revenue or expenditure.
2. The affordability of key programs.
• The ability to finance significant programs, including large development projects, depends
on the government’s revenue-raising capabilities and the “fiscal space” in the budget to
accommodate these programs. If revenues are insufficient, or if project costs are
underestimated, key programs may be “unaffordable,” thereby undermining fiscal
sustainability.
3. The structure of public debt.
• The structure of public debt can also affect fiscal sustainability. Too
much short-term debt subjects to rollover risk (the difficulty of
refunding debt when it falls due).
• A similar problems arises if debt is “bunched,” meaning that large
segments debt fall due at the same time. In either case, the government
may face liquidity problems. Alternatively, the large amounts of debt
falling due may raise interest rates, possibly crowding out some private
investment.
4. Fiscal contingencies.
• Government guarantees of state enterprise or private sector borrowing
can cause public debt levels to jump if the underlying entity cannot meet
its obligations and the government assume the debt. Public debt levels
may also rise if the government has had to recapitalize banks.
• In each case of these cases, the rise in public debt may force a
reconsideration of the sustainability of fiscal policy. This, in turn, may
require governments to adopt adjustment measure, to reduce the public
debt-to-GDP ratio to a more appropriate level.
 Sustainability: Going Beyond the Basics

• Besides the basic elements of sustainability assessment,

several other issues are important to consider. These includes:
• “Stress testing” public debt;
• Analyzing fiscal vulnerability; and
• Recognizing the links between financial sector vulnerability and the
fiscal sector.
 Stress testing public debt
• Because the assessment of fiscal sustainability entails projecting debt and
GDP levels over the future, it is useful to test the sensitivity of public debt
forecasts to changes in key macroeconomic indicators. This type of
sensitivity analysis is called stress testing.
• Stress testing public debt involves subjecting forecast values for variables
such as real GDP growth, inflation, the average interest rate on public debt,
and the exchange rate to adverse shocks, either alone or jointly, and seeing
how these shocks affect the forecast ratio of public debt to GDP.
• The International Monetary Fund (IMF) regularly performs
stress tests on public and external debt as part of its periodic
economic surveillance of member countries, and the results are
made public when governments authorize the IMF to post the
Article IV Staff Report for their country on the IMF’s public
website.
 Fiscal Vulnerability
• Fiscal vulnerability describes a situation where a government may be
unable to meet its key fiscal policy objectives, not because of
inappropriate policies, but because of underlying weaknesses in
budgeting, accounting, revenue structure, expenditure control, or fiscal
institutions.
• These factors can make it hard for government to attain future fiscal
objectives. They may also limit the government’s ability to respond to
future fiscal policy challenges, such as the need for fiscal consolidation
as part of a coordinated response to an external shock.
• Fiscal vulnerability involves four (4) different aspects:
1. Incorrect specification of the initial fiscal position;
2. Sensitivity of short-term fiscal outcomes to risk;
3. Threats to longer term fiscal sustainability; and
4. Structural or institutional weaknesses that affect the design and
implementation of fiscal policy.
 Incorrect specification of the initial fiscal
position
• Assessment of the fiscal position is closely related to the quantity and
quality of available information. The less information is available about
the extent of fiscal activities, the more vulnerable is the fiscal position.
• The reason is that the government becomes less able to plan a solid
and flexible medium-term fiscal framework and to respond to short-
and medium-term shocks. Incomplete or inconsistent coverage of
fiscal activity often contributes to the problem.
 Short-term fiscal risks
• The assessment of fiscal risk should take into account not only the initial fiscal
position but a also a short-term forecast that looks at least two years ahead. This
forecast should be fairly detailed, assuming no change in policies and excluded any
temporary measures affecting the initial fiscal position.
• The risk analysis should examine a range of possible short-term macro-fiscal
outcomes, focusing on variations in underlying assumptions and other parameters to
which a likelihood of different events can be attached.
• Situations that cannot easily be accommodated in the current budget framework, or
that would require significant policy adjustment, would provide indications of
vulnerability.
• Short-term fiscal risks can include the following:
1. Unanticipated changes in macroeconomic variables or other sources of economic
risk.
• A change in the macroeconomic environment resulting from an external shock, such as jump in
oil prices or a sudden recession in major trading partners, can undermine revenue or create
pressure for new expenditure to bolster aggregate demand.
2. The exercise of contingent liabilities when no budgetary provisions have been
made.
• The failure to set aside funds in the event that state enterprises default on government-guaranteed
loans can add significantly to government expenditure and debt when such defaults occur.
• Government budgets can also be strained if a major bank fails and deposit insurance is lacking or
the available funds cannot cover the looses of depositors.
3. Lack of clarity about the size of specific expenditure
commitments.
• Cost overruns, which are common for infrastructure projects, or the failure to
anticipate operating and maintenance costs for newly constructed capital projects,
can pose risk for the budget in the form of unanticipated expenditure.
4. Inappropriate debt structure.
• Too much short-term debt, or a bunching of debt falling due, can pose liquidity
problems for the government or require the government to refund debt at higher
interest rates, adding to expenditures.
 Threats to long-term fiscal sustainability
• Even if the initial budget or the short-term fiscal position appears
sustainable, important structural changes in demographics or the economy
can create threats to fiscal sustainability over the long run.
• For example, Oil- and mineral-exporting countries whose resources are likely
to be exhausted over the medium term face long-term fiscal problems, if
revenues rely too heavily on earnings from these sectors and measures are
not taken to raise non-oil or non-mineral revenues to offset the shortfall.
Similarly, countries with aging populations are vulnerable to long-term fiscal
problems if generous public pension programs are not adjusted by increasing
revenues, cutting benefits, or raising the age for receiving benefits.
 Weaknesses in the structure of revenue or
expenditure or in institutional capacity
• Vulnerability can also arise if the structure of
revenue or expenditure is weak, or if key fiscal
institutions, such as the budget process or
expenditure control mechanism, have serious
problems.
 Weaknesses in Revenue Structure
• A good tax structure is one where revenue comes from a range of
taxes with broad bases, ideally related to large macroeconomic
aggregates. Such a structure allows the rates for any one tax to be
reasonable, thereby reducing the incentives for evasion. It can also
make the tax system relatively elastic, allowing revenue to keep up
with economic growth and facilitating countercyclical fiscal policy,
as revenue automatically rises in good times and contracts during
recessions.
• A revenue structure dominated by a very few large taxes, especially if
these taxes have narrow bases, creates vulnerability. Revenue from these taxes
is likely to be volatile.
• Frequent tax law changes make it harder for taxpayers to comply, because
of unfamiliarity. They also complicate the job of tax administration. In
addition, frequent changes in exemptions and the creation of tax holidays
and similar measures can undermine the tax base and reduce the yield of key
revenue items.
• Extensive earmarking limits the scope for discretionary tax
changes, because taxes are already dedicated to funding specific
expenditure activities, and tax rates cannot be raised to provide
revenue for new activities or to cover revenue shortfalls arising
from weaknesses in general taxes. In addition, heavy reliance on
nontax revenues, such as oil leases, may also increase
vulnerability, as these revenues may not be stable, and it may be
hard to adjust revenues through policy measures.
 Weakness in the Structure of Expenditure
• On the expenditure side of the budget, having a high share of non-
discretionary spending is a key source of vulnerability. This situation limits
the government’s flexibility to cut spending when necessary and makes it
hard for the budget to adjust to new demands or spending priorities.
• There may also be latent expenditure needs that become apparent only
after a shock or discontinuity of some kind. For example, the need for a
social safety net may become apparent only following an economic crisis.
Once in place, however, it may become permanent, adding to the total
expenditure.
 Weaknesses in Institutional Capacity
• The fiscal position can also be vulnerable if serious institutional problems
hobble the government sector. These include:
1. Problems regarding the roles and responsibilities of government;
2. Inadequate public availability of information;
3. Weaknesses in the budget process;
4. Questions about the integrity of fiscal information;
5. Weak revenue or expenditure management; and
6. Corruption.
 Inappropriate roles and responsibilities of
government
• Can be a major source of vulnerability if they impose heavy expenditure
burdens that outstrip the ability of revenues to support them.
• for example, guaranteeing jobs to university graduates may lead to a bloated
civil service and provide incorrect signals to students, encouraging many to
choose easier but less marketable fields of study in place of more rigorous
studies in science and engineering that could lead to a more capable national
workforce and promote foreign direct investment.
 Problems with the Public Availability of
Information
• May make it difficult for legislators and the public to assess fiscal problems
and develop reasonable responses to fiscal challenges.
• Hidden costs and the difficulty of anticipating performance problems may
make it hard to assess public-private partnerships as a way of providing
expensive public services, such as new highways or electrical power plants.
Similarly, the classified nature of many military programs may make it
difficult for legislators and the public to undertake a reasonable assessment
of benefits in relation to costs.
 Problems with the Integrity of Fiscal
Information
• Can make it hard to develop reasonable budgets, or to track
spending effectively. As a result, the government may be plagued
with chronic overestimates of revenue or underestimates of
expenditure, requiring disruptive expenditure cutbacks that reduce
the effectiveness of public services
 Weaknesses in Revenue or Expenditure
Administration
• Are also important sources of fiscal vulnerability. A poor
system of tax administration makes it hard for the
government to collect sufficient revenue, contributing to
budget shortfalls and requiring higher tax rates from
those who do pay to fund public services. Weak
expenditure management allows cost overruns that can
also add to budget deficits and public debt.
 Corruption
• Can contribute to fiscal vulnerability where it leads to cost
overruns or weak enforcement of the tax laws.
• Corrupt practices make it difficult to execute public programs
efficiently, adding to public expenditure and reducing the quality
of public services.
 Interactions with the financial sector
• Interactions between the government and the financial sector can also
make the fiscal position more vulnerable, particularly in the case of a
fragile banking system.
• An unsustainable fiscal position in an economy with a poor secondary
market in government securities can mean that government bonds
absorb a high percentage of bank resources. This, in turn, can lead to
financial instability if fiscal overruns lead to a sizeable increase in
government debt.
• By comparison, a heavy external debt exposure among the banks could
trigger a currency crisis, subsequent bank failures, and the need for heavy
government outlays to recapitalize the banking system, as in the Asian crisis
of 1997-98.
• More generally, a fragile banking system, whether from nonperforming loans
or the acquisition of highly risky financial assets, as in the 2007-2009
financial crisis, can lead to widespread bank failures and the need for massive
government expenditure to prevent a systemic collapse.
END