ASSESSING FISCAL SUSTAINABILITY: A NEW APPROACH Enrique G. Mendoza Pedro Marcelo Oviedo Comments by: Andres F. Arias Ministerio de Hacienda y Crédito Público Republic of Colombia

Probabilistic Model = ability to repay in crisis state where b* = stock of debt that government is able to repay in all states of nature  “Credible repayment commitment”

Very nice approach because… 1.Also captures stock of debt that government is “willing” to repay if lender chooses r so that b* reflects a rationing debt level that enforces the government’s participation constraint (i.e. constraint under which the government always finds it preferable to repay and maintain credit relationship)

Very nice approach because… 2.Incorporates the role of volatility of fiscal variables in determining ability to repay. Long-run method  A & B share the same sustainable debt ratio. Probabilistic method  A has a higher sustainable debt ratio than B. B A t B min =0.10 t A min =0.18 t mean =0.2 t f(t)

But…  Defines a “maximum” debt level and not a “target” debt level (to be achieved through policy adjustment).  Maximum debt level is not equilibrium or optimal debt level.

Is this a tool for governments or for Wall Street?  As a government, I discuss “optimal” indebtedness and strategic behavior (i.e. repayment/default) under different scenarios (critical and non- critical).  For instance, it may be optimal to issue b>b* and repay/default under different states of nature.

 If so (and if markets buy b>b*) why do I care about b*? I already did when I defined my optimal strategy.  Does this mean that my debt is not sustainable?

 Should governments (or firms and households) do debt sustainability analysis based on their capacity to repay under the worst case scenario (i.e. the crisis state)?  Will they ever do it?  If so, does this mean that Argentina never thought about the logic behind the probabilistic model?

Besides… How can we operationalize the probabilistic model? 1.Bail-outs  g min ? 2.Sudden stops/TOT shocks/Balance sheet effects  r, , g min ? 3.Inflation tax  t min ?

Colombia… The coefficient of variation in revenue is 7.3%, while expenditure cuts cannot exceed 5% of GDP because of budgetary inflexibilities (investment is the only item freely adjustable, 5% of GDP=60% of public investment)

Colombia… r = 6%  = 3.7% b* = -0.4% of GDP Does this mean that Colombia’s debt is (or is not) sustainable? of GDP 2002 (net of interests)

Colombia… In any case from the point of view of a sovereign debt issuer, the probabilistic model is very useful in suggesting that volatility of fiscal variables must be taken into consideration. This can be done with a series of tools…

Debt projections and sensibilities… Base Scenario Colombian medium-term debt path

This base projection may change… Due to shocks in variables such as r, , E, fiscal expenditure and contingencies.

Debt projections and sensibilities… Base Scenario Historical averages (96-02) for t>=2004 % GDP 1

Debt projections and sensibilities… Base Scenario 2 std dev shock in 2004 to % GDP 2

Debt projections and sensibilities… Base Scenario 2 std dev shock in 2004 to % GDP 3

Debt projections and sensibilities… Base Scenario 2 std dev shock in 2004 to (t-g) % GDP 4

Debt projections and sensibilities… Base Scenario 1 std dev shock in 2004 and 2005 to r,  and (t-g) % GDP 5

Debt projections and sensibilities… Base Scenario 30% devaluation in 2004 % GDP 6

Debt projections and sensibilities… Base Scenario Increase of 10 points in debt stock % GDP 7

Statistical significance of sensibilities… Sensibilities may be evaluated with p-values Year Base scenarioWorse scenario DebtP-valueDebtP-value Exercise

Financing needs… Interno 2.0%-0.9%-0.3%0.3%1.0%1.3%1.0%1.5% Externo 1.5%1.8%1.5%1.0%0.6%0.3%0.7%0.2% Total 3.5%1.0%1.2%1.3%1.6% 1.7% Source: Public Credit-MHCP Net Financing % GDP The NFPS deficit is financed through internal and external indebtedness

Future external indebtedness % NFPS 5.5%2.7%0.8%1.3%2.2%1.7% Source: IMF, Central Bank. Calculations DGPM. % of net capital inflows to developing countries absorbed by Colombia…

% GDP Consistent with financing strategy Source: Banco de la República- DGCP- Calculations DGPM Future internal indebtedness From forecast of real sector’s portfolio demand and with assumptions about M3 growth, I can deduce private sector’s demand for domestic government debt (TES) No signs of crowding out

 Manasse, Roubini and Schimmelpfennig (2003)  Binary recursive tree analysis (sequence of rules) to determine if country is prone to fiscal crisis Default probability

1.¿Does total external debt exceed 50% of GDP?  NO (48,6%) 2.¿Is short-term external debt to reserves ratio greater than 1.34?  NO (0,98) In Colombia…

3.¿Is the public external debt to revenue ratio greater than 2.15?  NO (1) 4.¿Is the economy growth rate greater than -5.45?  YES (3.13)  Colombia is not crisis-prone (probability = 2.3%) In Colombia…

ASSESSING FISCAL SUSTAINABILITY: A NEW APPROACH Enrique G. Mendoza Pedro Marcelo Oviedo Comments by: Andres F. Arias Ministerio de Hacienda y Crédito Público Republic of Colombia