Monday, September 12, 2011

12/09/2011: IMF admits failures in debt risk forecasting frameworks

In the analysis published just minutes ago, the IMF ("Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis" by the Fiscal Affairs Department and the Strategy, Policy, and Review Department, dated for internal use from August 5, 2011) implicitly admits deep errors in the methodology for analyzing public debt dynamics. Given the magnitude of errors reported by the IMF (see table summary below), the entire exercise puts the boot into the EU-led attacks on the Big 3 ratings agencies - it turns out that the wise and uncompromisable IMF was not much good at dealing with fiscal sustainability risks either.

Here are the core conclusions: "Modernizing the framework for fiscal policy and public debt sustainability analysis (DSA) has become necessary... [This paper] proposes to move to a risk-based approach to DSAs for all market-access countries, where the depth and extent of analysis would be commensurate with concerns regarding sustainability..."

DSA could be improved, according to the IMF report, through a greater focus on:
  • Realism of baseline assumptions: "Close scrutiny of assumptions underlying the baseline scenario (primary fiscal balance, interest rate, and growth rate) would be expected particularly if a large fiscal adjustment is required to ensure sustainability. This analysis should be based on a combination of country-specific information and cross-country experience." (Note that in Ireland's case such analysis would probably require, in my view, using GNP metrics in place of GDP).
  • Level of public debt as one of the triggers for further analysis: "Although a DSA is a multifaceted exercise, the paper emphasizes that not only the trend but also the level of the debt-to-GDP ratio is a key indicator in this framework. [Apparently, before the level of debt didn't matter much, just the rate of growth in debt - the deficit - was deemed to be important] The paper does not find a sound basis for integrating specific sustainability thresholds into the DSA framework. However, based on recent empirical evidence, it suggests that a reference point for public debt of 60 percent of GDP be used flexibly to trigger deeper analysis for market-access countries: the presence of other vulnerabilities (see below) would call for in-depth analysis even for countries where debt is below the reference point." [So, now, folks, no formal debt bounds, but 60% is the point of concern. Of course, by that metric, IMF would have to do country-specific analysis for ALL euro area states]
  • Analysis of fiscal risks: "Sensitivity analysis in DSAs should be primarily based on country-specific risks and vulnerabilities. The assessment of the impact of shocks could be improved by developing full-fledged alternative scenarios, allowing for interaction among key variables..." [Another interesting point, apparently the existent frameworks fail to consider interacting risks and second order effects. That is like doing earthquake loss projections without considering possibility of a tsunami.]
  • Vulnerabilities associated with the debt profile: IMF proposes "to integrate the assessment of debt structure and liquidity issues into the DSA." [Again, apparently, no liquidity risk other than maturity profile analysis is built into current frameworks]
  • Coverage of fiscal balance and public debt: "It should be as broad as possible, with particular attention to entities that present significant fiscal risks, including state owned enterprises, public-private partnerships, and pension and health care programs." [It appears that the IMF is gearing toward more in-depth analysis of the unfunded state liabilities, such as longer-term liabilities relating to pensions and health expenditure, as well as more explicitly focusing on unfunded contractual liabilities, such as specific contractual exposures on state pensions. If that is indeed the case, then there is some hope we will see more light shed on the murky waters of forthcoming sovereign exposures that are currently outside the realm of exposures priced in the market.]

Now, several interesting factoids on sovereign debt forecasts and sustainability as per IMF paper.

Here's the summary of IMF own assessment of its forecasting powers when it comes to Ireland: "The 2007 Article IV staff report included a public DSA, which showed that government net debt (defined as gross debt minus the assets of the National Pensions Reserve Fund and the Social Insurance Fund) was low and declining. In the baseline scenario, net debt was projected to fall from 12 percent of GDP in 2006 to 6 percent of GDP by 2012. The medium-term debt position was judged to be resilient to a variety of shocks. The worst outcome-a rise in net debt to 16 percent of GDP in 2012-occurred in a growth shock scenario. Staff identified age-related spending pressures as the most significant threat to the long-run debt outlook. The report noted that, although banks had large exposures to the property market, stress tests suggested that cushions were adequate to cover a range of shocks. Net debt to GDP subsequently increased nearly fivefold from 2007 to 2010, owing to a sharp GDP contraction and large fiscal deficits linked mainly to bank recapitalization costs."

No comment needed on the above. The IMF has clearly missed all possible macroeconomic risks faced by the Irish economy back in 2007.

On Greece: "In the 2007 Article IV staff report, staff indicated that fiscal consolidation should be sustained over the medium term given a high level of public debt and projected increases in pension and health care costs related to population aging. ...In the baseline scenario, public debt to GDP was projected to fall from 93 percent in 2007 to 72 percent in 2013. All but one bound test showed debt on a declining path over the medium term. In the growth shock scenario, debt was projected to rise to 98 percent of GDP by 2013. Two years later, staff warned that public debt could rise to 115 percent of GDP by 2010-even after factoring in fiscal consolidation measures implemented by the authorities-and recommended further adjustment to place public debt on a declining path."

So another miss, then, for IMF.

Here's the summary table on these and other forecast errors:

Next, take a look at a handy summary of debt sustainability thresholds literature surveyed by the IMF (largely - sourced from IMF own work):
So for the Advanced Economies (AE), debt thresholds range from 80-150 percent of GDP, the range so wide, it make absolutely no sense. Nor does it present any applicable information. By the lower bound, every euro area country is in trouble, by the upper bound, Greece is the only one that is facing the music. Longer term sustainability bound is a bit narrower - from 50% to 75%, with maximum sustainable debt levels of 183-192%.

And, for the last bit, off-balance sheet unfunded liabilities and actual debt levels chart:
Here's an interesting thing. Consider NPV of pension and health spending that Ireland is at - in excess of aging economies of Italy, Japan and close to shrinking in population Germany. One does have to ask the question: why the hell does the younger economy of Ireland spend so much on age-linked services and funds?

Another thing to notice in the above is that there appears to be virtually no identifiable strong statistical relationship between debt levels and pensions & health expenditures. This clearly suggests that the bulk of age-related spending looking forward is yet to be factored into deficits and debt levels. Good luck with getting that financed through the bond markets, I would add.

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