Posted by Brian Olden and Amanda Sayegh[1]
Events of the past decade serve to underscore how damaging shocks to public finances can be. Financial sector bailouts after the global financial crisis, the fiscal impact of the great recession that ensued, and the more recent collapse in commodity prices have driven public indebtedness to unprecedented levels during peacetime and impaired the ability of governments to exercise good fiscal policy.
The IMF has been working with member countries to improve and inform fiscal risk analysis and management and has also drawn on the experiences of countries with leading edge practices.
Some tools to assist countries better understand and manage fiscal risks are already in place, including the Fund’s debt sustainability analysis tools and the fiscal transparency code, which provides detailed guidance on how fiscal risks should be assessed.
The Fund has released a new report to expand the existing toolkit by providing practical guidance and new analytical tools to help policymakers better understand and manage fiscal risks.
In preparing this report, staff undertook the most comprehensive survey of fiscal risks to date, looking at sources of shocks to government debt in 80 countries during the period 1990-2014. The survey confirmed that fiscal shocks are large and frequent, with countries experiencing an adverse fiscal shock of 6 percent of GDP once every 12 years on average (Figure 1). The results reinforce earlier findings that fiscal shocks tend to be asymmetric and biased downwards, highly correlated with each other, and non-linear, with more extreme events being significantly more costly than smaller shocks.
Figure 1. Costs and Frequency of Fiscal Risk Realizations
Fiscal shocks can be large and frequent…
Sources: Bova and others (2016) and staff estimates.
And tend to be highly correlated during crises
Sources: Bova and others (2016)
While considerable work has been done since the crisis to better understand fiscal risks, a review of existing country practices reveals that more needs to be done. For example, only around one‑quarter of countries surveyed publish balance sheets and in many cases these are incomplete; slightly fewer than one-third publish quantitative macro-fiscal sensitivity analysis; and less than one‑fifth publish quantified statements of contingent liabilities.
Fiscal risk analysis practices also too often focus on modest shocks and assume risks are independent, symmetric and linear. The IMF’s review finds that approaches to mitigating risks are mostly ad-hoc, fragmented and focused on relatively blunt instruments, such as limits on certain activities.
Given the scale and nature of fiscal risks, the paper concludes that countries need a more complete understanding of potential threats to public finances; more sophistical tools to analyze risks and better integrate these into fiscal policy making; and an enhanced capacity to mitigate and manage risks.
To help address these gaps the paper has developed a set of analytical tools for policymakers, including:
- A new fiscal stress test for public finances which examines the impact of multiple correlated shocks on three summary indicators - fiscal solvency, liquidity and the government’s financing burden - and illustrates its application in two case studies (Figure 2);
- An illustration of how probabilistic tools can be used to assist in setting long-run fiscal objectives and medium-term targets for fiscal policy by performing stochastic simulations of the future debt trajectory (Figure 3); and
- An expanded fiscal risk management toolkit to assist countries in their risk mitigation strategies for key sources of specific fiscal shocks.
Figure 2: Illustrative Fiscal Stress Test: Solvency
(percent of 2017 baseline GDP)
Sources: Bova and others (2016) and staff estimates.
Figure 3. Probabilistic Assessments of Public Debt (percent of GDP)
The paper also outlines priorities for countries wishing to strengthen fiscal risk disclosure, analysis and management, taking due account of differences in countries’ level of capacity.
For example, the paper stresses that countries with low capacity should prioritize developing basic financial balance sheet data and disclosing their explicit contingent liabilities. In contrast, countries with higher capacity could focus more on disclosing the size and probability of realization of their contingent liabilities, and carrying out periodic stress tests to estimate the scale of their exposure to extreme events.
Fiscal risk mitigation strategies should also be tailored to reflect country capacity. Low capacity countries should focus on limiting their exposure to guarantees, PPPs and other explicit contingent liabilities. Countries with higher capacity should focus on transferring risks to third parties, e.g., by taking out insurance for natural disasters, where such transfers are cost effective, and on recognizing and provisioning for any remaining exposure to risk in their budgets and fiscal plans.
The paper indicates that the IMF will continue to support ongoing efforts to improve fiscal risk analysis and management among its members, including through its technical assistance programs and fiscal transparency evaluations.
[1] Brian Olden is Deputy Division Chief, PFM1 Division, Fiscal Affairs Department, IMF. Amanda Sayegh is a Technical Assistance Advisor in the same division.
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