Posted By Vitor Gaspar and Jason Harris[1]
Of all the major economies hit by the turbulent events of the global financial crisis, few were hit as hard and by as large a range of shocks as the United Kingdom.
A housing bust, banking failures amid widespread financial market meltdown, and a large and persistent decline in output all played havoc with the public finances. The deficit blew out to 10 percent of GDP, government debt more than doubled to 89 percent of GDP, and the state’s balance sheet ballooned after the bailouts of some of the country’s largest commercial banks. Yet, prior to the crisis, the fiscal risks that became reality with such dire consequences had only been loosely considered.
Taking a big step forward in recognizing and managing future risks, the UK’s Independent Office of Budget Responsibility (OBR) has released its first Fiscal Risks Report. This landmark document identifies, quantifies and provides an estimated likelihood of the risks to which the UK public finances are exposed, including:
- Macroeconomic—that growth might be lower, inflation higher, or interest costs more expensive, including the uncertainty related to Brexit
- Spending and revenue related—such as the potential for larger than expected increases in welfare spending, and the concentration of tax receipts among a small number of payers,
- Contingent liabilities—such as the potential cost of nuclear decommissioning and clinical medical negligence costs; and
- Implicit risks stemming from the financial sector—which the report notes have been reduced due to post-crisis regulatory reforms, but whose liabilities still represent almost 900 percent of GDP.
This level of risk recognition, analysis and assessment brings the UK to an advanced level, as measured against the IMF’s Fiscal Transparency Code, joining countries such as New Zealand, the Philippines, Australia and Finland. The publication of this report is consistent with the recommendations of the 2016 Fiscal Transparency Evaluation of the UK.
But what extends the UK beyond the current leading edge of international practice is the inclusion of a fiscal stress test, which demonstrates the public finance’s exposure to a large tail risk event. This tool is inspired by the widely-used banking sector stress tests, and was developed in last year’s IMF Fiscal Risk policy paper.
The fiscal stress test brings these risks together in a combined shock scenario, in which a large macroeconomic shock occurs alongside a sharp fall in asset prices. These events are assumed to require significant state intervention in the private sector. In addition to quantifying the UK’s potential exposure to large fiscal risks, the fiscal stress test identifies the channels through which such an event could impact the public finances, directing attention to where the government’s risk management efforts should be focused, such as the considerable exposure to inflation coming from the government’s debt portfolio.
The UK fiscal stress test assumes that GDP falls by 4.7 percent, with output remaining 9 percent below the pre-shock trend. This recession is accompanied by a 30 percent drop in sterling, and a resultant spike in inflation, combined with an unemployment rate rising to almost 10 percent. House prices fall by a third, and the value of equities almost halve. These conditions result in the realization of massive contingent liabilities from the private sector requiring government interventions worth £94 billion.
In the absence of any discretionary fiscal policy response, these events would push the deficit to 8 percent of GDP, raise public debt levels to 114 percent of GDP, and increase the government’s financing needs to 19 percent of GDP. Of course, these results are not necessarily much of a surprise—putting bad economic news into fiscal models simply generates bad fiscal news—the worse the inputs, the worse the outputs. But the analysis also reveals some important insights that would not otherwise be considered:
- How multiple shocks interact through the economic and fiscal systems;
- The extent to which the effects of the recession on tax receipts persist in subsequent years due to carry-loss provisions in the corporate tax code;
- The large exposure of government expenditure to the inflationary impact of the depreciation of sterling, due to the widespread use of inflation-indexed bonds; and
- The major asset price effects on the government’s own balance sheet—not least how interest rate increases reduce the value of the Bank of England’s large gilt holdings. These effects could have broader political implications—not just in the UK, but more generally amongst other central banks with large quantitative easing operations.
Many of the risks identified in fiscal stress tests exist in parts of the balance sheet that are not usually considered within the standard debt and deficit framework. Exposure to entities outside the general government perimeter, valuation changes to government assets, and contingent liabilities emanating from the private sector are risks that only become evident in advance by taking a broader balance sheet approach to fiscal policy. The fiscal stress test is the first of a range of tools and frameworks incorporating balance sheet considerations that the IMF is developing to both broaden and strengthen fiscal policy making.
The UK Fiscal Risk Report raises the bar on the assessment and quantification of fiscal risks to a new level that other countries should look to meet. By identifying the potential scale and channels of fiscal risk realization that the UK could face, it raises a set of questions for the UK government to consider about how it should reduce, mitigate, or manage these risks within its overall fiscal framework.
Those risk management efforts have already begun in the UK, where an increased focus on identifying and reducing risks has become an explicit part of the policy making process. This can be seen in the management of contingent liabilities - which are now subject to a stricter approval and monitoring regime - and actions taken to insulate the public finances from future bank failures.
More broadly, the IMF’s Fiscal Risk policy paper outlined a risk management toolkit that provides guidance on how countries can avoid, transfer, or provision for risks. And where fiscal risks are deemed appropriate for the state to carry, the paper demonstrates how they can be incorporated into the fiscal policy framework through better design of fiscal rules that provide room for fiscal buffers.
[1] Vitor Gaspar is the Director of the IMF’s Fiscal Affairs Department; Jason Harris is an Economist in the Department.
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