Flexible fiscal planning key to preventing debt distress, says IMF working paper

By Reshmi Basu

New York, Dec. 20 - Flexible fiscal planning is one way to prevent episodes of debt distress, according to an International Monetary Fund working paper titled "Assessing Debt Sustainability in Emerging Market Economies Using Stochastic Simulation Methods."

Debt sustainability has become increasingly important in the analysis of macroeconomic policies for emerging economies, according to the working paper, which was written by Doug Hostland and Philippe Karam. Indeed, debt sustainability assessments have become standard gages for review used by the International Monetary Fund and used by Paris Club members during negotiations.

"Financial crises differ greatly in their causes and consequences," the authors write in the working paper, which does not represent the views of the IMF.

"Empirical studies have shown that it is difficult to predict debt distress episodes with a reasonable amount of confidence."

The prevailing belief is that since the 1997-98 Asian financial crisis and the 1998 Russian crisis, emerging market economies have become less vulnerable to external debt crisis. Fundamentals have improved, ushering in numerous credit ratings upgrades. Low global rates coupled with structural reforms have helped spreads fall to record lows.

Nonetheless, there is a concern that public debt burdens have shot up in some economies, egged on by the development of domestic debt burdens.

The paper looks to assess debt sustainability in emerging markets and supply probability measures for projections of the external and public debt burden over the medium term.

To do so, the authors have designed a stochastic simulation model to give insight into why so many more emerging market economies with moderate debt levels have defaulted on debt as compared to advance economies with higher debt burdens.

The stochastic model incorporates four factors: macroeconomic volatility, financial fragility such as the dependency on short-term foreign currency borrowing, the endogenous response of the risk premium, and sudden stops in private capital flows, since these interrelated factors play a role in sizing up the country's debt vulnerability.

The authors find that the vulnerability of external debt is sensitive to the determination of the exchange rate and to the pricing of traded goods.

Through the stochastic simulation model, the authors show that fiscal policy "can act in a preemptive manner to prevent the public burden from rising significantly over the medium term."

The problem is that this requires flexibility, something which many emerging markets lack.

"Emerging market economies therefore face a difficult trade-off between managing the risk of a public debt crisis and other important fiscal policy objectives," which may explain why emerging markets are more prone to debt distress, the report said.

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