OECD, 35th Meeting of Senior Budget Officials - George Kopits

Fiscal Risks:

New Approaches to Identification,

Management and Mitigation

George Kopits

35th Annual OECD Senior Budget Officials Meeting

Berlin, June 12-13, 2014

G. Kopits, Woodrow Wilson Center

Questions

• Why assess fiscal risks?

• What are fiscal risks?

• How to measure fiscal risks?

• How to manage fiscal risks?

• How to mitigate fiscal risks?


Why assess fiscal risks?

Basic rationale

• Uncertainty of fiscal policies and outlook

• Case for transparency in public finances

Recent developments

• Financial liberalization, integration, crisis

• Fiscal risks partly self-inflicted by governments

• Volatility in sovereign risk; shifts in investor sentiment

Therefore, need to identify risks and explore drivers; manage risks; and mitigate risks

Why assess fiscal risks?


What are fiscal risks?

Definition

• Probable deviation of actual from expected outturn

• At extreme: probability of sovereign default

Types

• Economic, technical, political

• Exogenous vs. endogenous

• Specific, general, systemic



Specific risks

• Tax measures, including tax expenditures

• Expenditure programs

• Decentralized agencies, subnational gov’ts, SOEs

• Contingent liabilities (explicit, implicit)

Efforts to gain fiscal space induce specific risks

e.g. off-budget operations

guarantees, PPPs

unrecorded SOE losses

nationalization of private pension funds


Pension funds

PPPs and other risk sharing

Financial sector

Legal claims

Other liabilities and guarantees

Natural disasters, health-care risks

Relevance of Specific Risks(In percent of each category)

High Medium Low None



General risks (rooted in optimistic bias)

• Fiscal forecasts

• Macroeconomic forecasts

• Structural budget forecasts

• Procyclical expansionary stance

Efforts to gain fiscal space induce optimistic bias

e.g. optimistic macro assumptions, elasticity estimates

no provision for macro shocks

manipulation of output gap estimates

What are fiscal risks? *

Optimistic bias: one-year ahead budget forecast errors (Frankel & Schreger, 2013)

What are fiscal risks? *

Optimistic bias: two-years ahead budget forecast errors (Frankel and Schreger, 2013)


How to measure fiscal risks?

Direct estimates of specific risks

• Identification of risks associated with fiscal measures

• Estimates of probable added cost of fiscal measures

• Estimates of nominal value of contingent liabilities

• Estimates of present value of contingent liabilities, adjusted for probability of realization



Sensitivity analysis

• Estimate of deviation from baseline projections of budget balance or public debt, given: – marginal change in underlying macro variable

– hypothetical policy change

• Stress test for budget balance or public debt, given a macro shock (output, prices, devaluation, etc.)

• Illustration: fan chart for public debt/GDP ratio



Stochastic approach

• Fair spread model, contingent credit analysis (CCA)

• Value-at-Risk analysis (V-a-R)

• Macroeconomic models (structural, DSGE)

• Vector autoregressive model (VAR)

• Fiscal stress index

How to measure fiscal risks? *

Stochastic approach: V-a-R baseline simulation (probability density function for public sector net worth)

-80 -60 -40 -20 0 20 40 60 80 100

Baseline A

Mean

5% Risk


Stochastic approach: V-a-R alternative simulations (probability density function for public sector net worth)

-80 -60 -40 -20 0 20 40 60 80 100

Baseline A

Simulation 1A

Simulation 2A

Simulation 3A


Stochastic approach: fan chart simulation (probability density function for government debt ratio)



Stochastic approach: main characteristics

• Overall: experimental, limited application

• Macro models: theoretically consistent, too specialized

• Other methods: useful as broad indicators of risk, but need country-specific calibration

• V-a-R: consistent and versatile (can capture specific, general, systemic risks), but data intensive

• All exposed to Lucas critique


How to manage fiscal risks?

Scope

• Specific risk: statement of risks

• General risk: sensitivity analyses, stress tests, fan charts

• Specific, general, systemic risks: stochastic approaches

Practices range widely, yet concentrated mostly on

specific risks; some countries focus on general risks, but no attention to systemic risks



Role of government

• Identification and estimation of specific risks to commence in line ministries, decentralized agencies, subnational entities, SOEs

• Finance ministry has overall responsibility for estimates of specific risks (except in relation to implicit liabilities) and estimates of general risks

• Disclosure of estimates of risks in budget bill and specialized bills

Practices vary, but typically finance ministry exercises full responsibility (if at all)



Role of legislature

• Budget committee responsible for commencing and preparing debate on fiscal risks, on the basis of timely information from own staff plus IFI

• Monitoring, debate, and approval of fiscal risks

Practices mixed, but focus on risks and ensuing debate tend to be selective, relatively few countries concluded with explicit approval of risks



Role of IFI

• Oversight and evaluation of government’s assessment of risks (if available)

• Identification / preparation of own estimates of specific and general risks (as part of impact analysis and macro-fiscal projections), including of risks stemming from implicit contingent liabilities

• Estimation of systemic risks, including in close cooperation with macroprudential supervisory authority

Experience is mixed: older IFIs engaged in specific and general risk assessment; some younger IFIs too; none involved in systemic risk assessment


How to mitigate fiscal risks?

Mitigating exogenous risks

• Coordinated and commensurate fiscal / monetary policy stance (if space) to cope with external shocks

• General or earmarked reserves, and hedging instruments to cope with natural disasters and other shocks

• Disclosure of estimates of risks on budget bill and specialized bills

Many governments rely on such tools in anticipation of external shocks, though sometimes with limited fiscal space or insufficient resources


How to mitigate fiscal risks?

Mitigating endogenous risks

• Elimination of creative accounting and forecasting

• Strict limits on off-budget and PPP schemes

• Mandatory insurance, risk-based pricing, and effective regulation of activities prone to moral hazard

• Clarity on, and strict enforcement of, no-bailout clauses for subnational gov’ts, banks, and SOEs

• Well-designed rules-based fiscal framework

• Structural reforms in key areas (taxation, pensions, etc.)

Increasing number of governments rely in different degrees on such practices

How to manage/mitigate fiscal risks?

Statement of risks

Long-term sustainability report

Parliamentary approval of risks

Assessment by independent institution

Countercyclical fiscal stance

Targeting prudent debt level

Fiscal rules

Structural reforms

Pricing guarantees, mandatory insurance

Risk sharing

Credible no-bailout provision

Use and Effectiveness of Risk Management and Mitigation(In percent of each category)

High Medium Low None

Beware of the swan...

OECD, 35th Meeting of Senior Budget Officials - George Kopits

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