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Box 1. Conceptual Framework for Fiscal Policy and Public Debt Sustainability
Fiscal policy sustainability and public debt sustainability are two inter-related concepts whose analysis is a
complex and multifaceted exercise. The analysis needs to consider: (i) the trajectory of the debt-to-GDP ratio,
both under a baseline scenario and alternative scenarios exploring key fiscal risks;
1
(ii) whether, at a minimum,
the debt ratio stabilizes at a level consistent with an acceptably low rollover risk and with preserving growth;
(iii) the realism of underlying assumptions; and (iv) debt composition, which also affects the likelihood of debt
distress.
The fiscal policy stance can be regarded as unsustainable if, in the absence of adjustment, sooner or later the
government would not be able to service its debt. Specifically, two cases should be distinguished:
The current level of the primary balance might not be sufficient to stabilize the debt-to-GDP ratio (which
therefore would be on an explosive path) but sufficient fiscal adjustment would be realistic (both
economically and politically) to bring the primary balance to a level that is necessary to service public debt.
In this case, while fiscal policy would be currently unsustainable (in the sense that an adjustment in the
primary balance is needed), public debt can be regarded as sustainable.
Alternatively, the primary balance needed to stabilize the debt ratio is politically and/or economically
infeasible. In this case, not only fiscal policy, but also public debt would be unsustainable (solvency problem)
and debt restructuring would be necessary.
2
The higher the level of public debt, the more likely it is that fiscal policy and public debt are unsustainable. This is
because—other things equal—a higher debt requires a higher primary surplus to sustain it. Moreover, higher debt
ratios are usually associated with higher interest rates (and possibly lower growth; see below), thus requiring an
even higher primary balance to service it.
A proper assessment of fiscal policy and public debt trajectory must be based on certain macroeconomic baseline
assumptions, notably economic growth and the interest rate on public debt,
3
as well as the likelihood that fiscal
risks (including those from contingent liabilities) might materialize. Thus, it is critical that the assessment of fiscal
policy and debt sustainability be based on realistic assumptions. It is equally important to stress test the underlying
assessment of both fiscal and debt sustainability with respect to deviations from baseline assumptions for all these
variables. Higher interest rates (possibly stemming from changes in market sentiment) or lower growth
assumptions could, for example, result in less favorable debt dynamics, requiring an increase in the primary
balance needed to stabilize the debt ratio, which could in turn change the assessment of debt sustainability.
Fiscal policy and public debt may be sustainable in the above sense, but the debt level may still be so high that
bringing it down would be recommended. This can occur for various reasons:
A high debt level exacerbates an economy’s vulnerability to shocks: the higher the initial debt level, the
greater the impact of a given increase in interest rates or of a decline in the growth rate on the primary surplus
needed to maintain debt stable. So, countries with a high debt level are more exposed to interest and growth
shocks.
The risk of a rollover crisis depends on the size of borrowing requirements and hence on the level of the fiscal
deficit (which depends in part on the level of the debt, through the size of the interest bill) and the
composition of the debt (e.g., short maturities) and investor base (e.g., a high share of externally-held debt).
Beyond certain levels, the higher the debt level the lower is long-term economic growth (see, for example,
Kumar and Woo, 2010).
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1
Assuming that the interest rate on public debt exceeds the growth rate of the economy, the government’s intertemporal budget constraint is
met when the debt-to-GDP ratio is stable. For details see Bartolini and Cottarelli (1994).
2
In principle, assessing whether bringing down debt ratios through a primary adjustment is too costly requires looking at the alternative by
evaluating the costs of bringing down debt ratios through debt restructuring.
3
Potential growth is particularly important not only because it affects directly the evolution of debt-to-GDP ratios given a certain primary
balance, but also because sustaining a larger primary balance is likely to be easier when potential growth is higher.
4
At the same time, for countries with substantial infrastructure needs (e.g., low income countries), it is particularly important to assess whether
an increase in debt that finances public investment could have a positive impact on long-term growth.