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January 18, 2012

A Toolkit to Assessing Fiscal Vulnerabilities and Risks in Advanced Economies

Posted by Andrea Schaechter

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Recent developments in international financial markets have reaffirmed that concerns over fiscal sustainability can precipitate a crisis in advanced as well as emerging economies. Assessing fiscal vulnerabilities and risks with a view to formulate early policy responses, is no simple feat, however. A number of short- and medium-term factors can be at play, such as the level of financing needs or the susceptibility of public finances to economic shocks. A new IMF Working Paper
 (WP/12/11)[1] presents a range of indicators and analytical tools for assessing fiscal vulnerabilities and risks for advanced economies.

While linked to the issue of debt sustainability, the paper does not analyze if a country’s fiscal policy stance and its public debt trajectory are sustainable. It focuses instead on underlying vulnerabilities and risks that could ultimately impinge on sustainability and which, as recent developments in international financial markets have reaffirmed, can precipitate a crisis in advanced as well as emerging economies. As these are complex and evolving issues, there is no single methodology that can summarize all aspects; rather a broad toolkit is needed.

To highlight related but conceptually distinct elements of fiscal risks and vulnerabilities, the six tools presented in the paper are organized mainly by their time horizon. Indicators measuring short-term pressures include (i) the size of a country’s gross financing needs, with a view to capturing its potential funding risks; (ii) high frequency market-based measures of sovereign default risk such as CDS spreads; and (iii) a measure of potential spillovers in distress dependence among advanced economies. Indicators that assess medium- to long-run vulnerabilities use lower frequency data. They include (iv) a measure of the required fiscal effort to stabilize debt in the medium and long run; (v) the impact of adverse growth and interest rate shocks on the baseline debt trajectory; and (vi) a probabilistic measure of the debt outlook reflecting risks associated with baseline debt projections. Together these tools cover a broad scope vulnerabilities and risk. The necessary data are available for most advanced economies with little time lag. Going forward additional aspects will need to be systematically covered, e.g. the investor base and level of contingent liabilities.

The paper presents the intuition of the various tools as well as technical details. Moreover, it illustrates how the tools can be used to gauge fiscal vulnerabilities and risks based on the data from the September 2011 Fiscal Monitor.

The illustrative application of the indicators and tools highlights the complexity and interconnectedness of different dimensions of vulnerabilities and related policy options. While for a few countries fiscal vulnerabilities appear large on all fronts, for most others vulnerabilities are concentrated in particular areas. Expanding the existing strengths can be one way of mitigating vulnerabilities in other dimensions. The use of a set of indicators and tools, as well as a comparison of countries against their peers can be a useful way of identifying and communicating key areas of concern as well as policy requirements and options.

[1] Prepared by Andrea Schaechter, C. Emre Alper, Elif Arbatli, Carlos Caceres, Giovanni Callegari, Marc Gerard, Jiri Jonas, Tidiane Kinda, Anna Shabunina, and Anke Weber.

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By "gross financing need", we're talking CAB Current Account Deficit plus external debt service?

The view from Lisbon is that the crisis is moslty about the external deficit, more than about the budget deficit.

The fiscal austerity remedy will only work with a big assist from rebalancing the external imbalances among Eurozone trading partners which have reached the limit of divergence. See the blog PPP Lusofonia http://ppplusofonia.blogspot.com/2011/12/eurozone-crisis-tests-limits-of.html

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