IMF Working paper: A Toolkit to Assessing Fiscal Vulnerabilities and Risks in Advanced Economies

April 27, 2012 · Нийтэлсэн: · Сэтгэгдэл үлдээх   Post to Twitter

ТАЙЛБАР: цахим хуудсаар нийтлэгдэж байгаа албажуулаагүй баримт бичиг нь Монгол Улсын Сангийн яамны албан ёсны байр суурийг илэрхийлэхгүй. Мэдээллийг төсвийн ил тод байдлыг хангах, төсвийн талаарх мэдээллийг олон нийтэд шуурхай, ил тод хүргэх арга хэмжээний хүрээнд нийтэлсэн болно.

Recent developments in international financial markets have reaffirmed that concerns over fiscal sustainability can precipitate a crisis in advanced as well as emerging economies. Persistent fiscal imbalances eventually result in high levels of general government debt that
can raise concerns about sovereign debt rollover and, in the extreme, solvency. High debt can
threaten macroeconomic stability and weigh on economic growth. If fiscal weaknesses are
not addressed, countries could face difficulties in meeting their funding needs and, in the
limit, lose market access altogether. The eventual fiscal adjustment required to restore
stability could entail sharp losses in employment and output.
This paper presents a range of indicators and analytical tools for assessing fiscal
vulnerabilities and risks for advanced economies.23 As these are complex and evolving issues,
there is no single methodology that can summarize all aspects; rather a broad toolkit is
needed. To highlight related but conceptually distinct elements of fiscal risks and
vulnerabilities, the six tools presented here are organized mainly by their time horizon.
Indicators measuring short-term pressures include the size of a country’s gross financing
needs, with a view to capturing its potential funding risks; high frequency market-based
measures of sovereign default risk; and a measure of potential spillovers in distress
dependence among advanced economies. Indicators that assess medium- to long-run
vulnerabilities use lower frequency data. They include a measure of the required fiscal effort
to stabilize debt in the medium and long run; the impact of adverse growth and interest rate
shocks on the baseline debt trajectory; and a probabilistic measure of the debt outlook
reflecting risks associated with baseline debt projections. Together these tools cover a broad
scope and address the different nature of risks to fiscal sustainability, but additional aspects
need to be systematically covered going forward, including by assessing the investor base
1 The authors would like to thank Julio Escolano and Manmohan S. Kumar who have initiated and guided many
of the early steps of the analysis presented in this paper as well as Phil Gerson and Martine Guerguil for helpful
comments and suggestions. One of the authors (G. Callegari) is currently with the European Central Bank, but
the paper was prepared during his time at the IMF and does not reflect views of the ECB.
2 Underlying vulnerabilities and risks are two different concepts (see e.g. IMF, 2012). Underlying fiscal
vulnerabilities—e.g., high rollover needs, high sensitivity to interest rate shocks—is a necessary though not a
sufficient, condition for a crisis. Crises are typically triggered by shocks and significant crisis risks reflect a
combination of sizable underlying vulnerability and a high likelihood of such shocks.
3 While linked to the issue of debt sustainability, the paper does not analyze if a country’s fiscal policy stance
and its public debt trajectory are sustainable. It focuses instead on underlying vulnerabilities and risks that could
ultimately impinge on sustainability. For a proposal to modernize the IMF’s framework for fiscal policy and
public debt sustainability analysis see IMF (2011). The fiscal policy stance is defined in that paper as
unsustainable “if, in the absence of adjustment, sooner or later the government would not be able to service its
debt.” Public debt would become unsustainable “if no realistic fiscal adjustment can prevent this situation from

and level of contingent liabilities.4 The choice and development of the tools laid out in this
paper responds to three additional objectives: first, ensuring wide coverage of advanced
economies; second, minimizing the time lag with which data become available; and third,
allowing for a relative assessment (ranking) of countries so as to provide input for the joint
IMF-FSB Early Warning Exercise (EWE).5
The paper complements other IMF work on fiscal vulnerabilities and risks by adding new
tools and covering a larger set of advanced economies. Baldacci, McHugh, and Petrova
(2011) use thirteen key fiscal indicators, clustered into three pillars (short and medium-term
fiscal developments, long-term fiscal trends, and liability management), to capture rollover
risks associated with the fiscal baseline scenario. Going beyond their analysis, our paper also
assesses the risks emanating from shocks to baseline projections, it captures market-based
risk indicators, and analyzes spillover risks. Moreover, many of the indicators used have a
shorter time lag than those used by Baldacci, Mc Hugh and Petrova; thus, allowing to capture
more immediate changes to risks. A comprehensive methodology for assessing fiscal risks
(baseline vulnerabilities and shocks to the baseline) is outlined by Cottarelli (2011) and
applied in the April and September 2011 Fiscal Monitors. These risks include also fiscal
policy implementation risk, macroeconomic uncertainty, and financial sector risk. However,
data availability limits this approach to focusing on country groups rather than individual
countries at this stage. Another widespread approach to capture fiscal risks is early warning
system models. Baldacci et al. (2011) review the literature and build an index of fiscal stress
using the indicators developed in Baldacci, McHugh, and Petrova (2011) as input. Caveats
are those associated with early warning models and the already-mentioned data limitations.
The paper is structured as follows. Section II provides an overview of the tools capturing six
key dimensions of fiscal vulnerabilities and risks. Section III gives illustrative examples for
applying these concepts by using recent advanced economy data. Section IV concludes,
highlights caveats of the current methods, and suggests ways forward. The Appendix
provides technical details on the key methods.
4 Work and data collection in both areas are underway. For example, risks emanating from the type of holders
of government debt was presented in the September 2011 Fiscal Monitor for a subset of countries. For more
detailed analysis and a wider dataset see, see Andritzky (forthcoming).
5 A forthcoming Occasional Paper (IMF, 2012) provides an overview of the EWE process and describes the
main analytical tools deployed in the exercise across all dimensions. In addition to fiscal issues, these include
external, real, financial sector risks, vulnerabilities and potential spillovers. The current paper provides more
details on some of the analytical fiscal tools and expands the methodologies. The EWE does not aim to predict
the timing of crises but rather to identify underlying vulnerabilities and imminent tail risks that predispose a
system to a crisis, so that corrective policies can be implemented and contingency plans put in place ahead of


The analysis of fiscal vulnerabilities and risks includes short-, medium- and long-term
perspectives. Of immediate concern, and requiring immediate policy responses, are shortterm
pressures that could cause financing gaps and impose additional costs if borrowing is
only available at sharply higher interest rates. The three tools presented here to capture these
vulnerabilities are based on relatively high frequency fiscal and financial market data. The
concern arising from medium and long-term pressures on public finances is related more to
debt sustainability and is captured through tools using lower frequency data. Policy responses
to reduce vulnerabilities typically include fiscal structural reforms, which tend to take some
time to be implemented. In practice, however, the distinction between the different time
perspectives is less clear cut. For example, persistent liquidity strains may result in
insolvency. And policy responses aimed to tackle medium-term vulnerabilities, such as
credible growth-friendly fiscal consolidation measures, may also alleviate short-term market
and funding pressures. Because of this interconnectedness a comprehensive set of
vulnerability indicators is needed.

High gross funding needs make economies more susceptible to changes in market sentiment.
Until recently, the possibility that advanced economy governments would be unable to raise
the needed funds was considered remote, though the risk was recognized that some
borrowers—particularly economies with weaker fiscal positions and less liquid bond
markets—may have to pay higher yields. But the recent experience of a number of euro area
economies has illustrated that advanced economies are no longer immune to serious funding
Funding needs are determined by the size of the budget deficit and the maturing debt that
needs to be rolled over. Thus, even when fiscal deficits are small or shrinking, new
borrowing needs may be large if high levels of debt have been accumulated in the past and
which a significant part matures in the near term. Factors that may mitigate the risks are the
government’s level of liquid assets (e.g., deposits held with the central bank or the banking
system), privatization proceeds, and availability of non-market funding.
Two complementary fiscal indicators are used to gauge the vulnerabilities associated with
funding needs.
· A measure of gross financing needs in the current and following year: the
simultaneous need for large new issuance of debt to finance a fiscal deficit, together

with the need to refinance large amounts of maturing debt, could signal a
vulnerability to short-term financing pressures.6
· The current stock of general government debt divided by the average debt maturity:
This indicates the average amount of debt that needs to be refinanced or repaid in
future years and thus provides an indicator of medium-term vulnerability. Countries
with a high stock of debt and low average maturity are more exposed to financing
Markets’ Perceptions of Sovereign Default Risk
Investors’ concerns about fiscal sustainability are captured by high-frequency financial
market indicators. Two widely used indicators are sovereign Credit Default Swap (CDS)
spreads and Relative Asset Swap (RAS) spreads.
· CDS spreads measure the direct cost of seeking insurance against sovereign default.
A sovereign credit event may include debt restructuring, missed payments and other
types of breaches of the original contract. CDS spreads are quoted as a percentage of
the notional amount insured. For sovereign issuers, this spread is often considered as
the default risk premium associated with insurance against a specific type of
government bond. Indeed, in deep competitive markets, CDS spreads should reflect
the expected default-related loss, i.e. the probability of default times the loss given
· The RAS spread indicator corresponds to the spread between sovereign bond yields
and the fixed interest rate arm in interest rate swap contracts.8 Because the swap rate
and the bond yield are applied to principals denominated in the same currency, the
RAS spread allows for a comparison of the risk premia attached to various
government bonds by abstracting from exchange rate risk or other currency-specific
6 In practice, two assumptions are used for calculating gross financing needs. First, for the current year it is
assumed that the fiscal deficit is financed linearly over the year (i.e., when the indicator is calculated at end-
June, it is assumed that half of the projected deficit for the current year still needs to be financed). Second,
short-term debt projected to mature in the current year is assumed to be refinanced by new short-term debt,
which then falls due in the next year.
Sovereign CDS contracts are quoted in U.S. dollars, except for the United States for which they are quoted in
euros. Five-year sovereign CDS contracts are generally the most liquid markets. Sovereign CDS contracts do
not trade on their local currency due the potential of the country issuing money to prevent a credit event.
Protection bought in local currency tends to be cheaper than in the standard currency because of the absence of
protection against this risk
8 The RAS indicator is computed as follows: RASi = Ri – RSWi with Ri indicating the yield on 10-year
government bonds issued by country i; and RSWi indicating the 10-year fixed rate on interest rate swaps in the
currency of country i.

factors.9 Negative RAS spreads indicate that investors assess government paper to be
less risky than the flow of funds exchanged between big commercial banks as part of
the interest rate swaps.
Caution is needed when interpreting high-frequency financial market indicators and they
should only be viewed as a relative assessment of countries’ sovereign default risk. A recent
empirical analysis (Alper, Forni, and Gerard, 2012) covering 22 advanced economies during
2008-11 suggests that both indicators provide consistent pricing across the cash and
derivatives market, although the risk measured by these indicators depends not only on fiscal
vulnerabilities but also on global and financial factors. These include short-term interest
rates, large scale sovereign bond purchases of major central banks, the relative perceived
strength of financial sectors as evidenced by relative stock price movements and expected
global growth, and volatility of equity prices as measured by the VIX index. Another caveat
is that financial market indicators tend to lag rather than lead the deterioration of the fiscal
outlook. Compared to CDS and RAS spreads, government bond yields are an even weaker
measure of sovereign default risk since they depend on a wider range of economic and
financial developments, including the current position in the business cycle, inflation
expectations and exchange rate risks.

Distress Dependence Among Sovereigns

Sovereign CDS spreads have in the past few years exhibited not only a significant degree of
volatility but also high synchronicity. This strong co-movement may partly be explained by
strong links across sovereigns. That is, an increase in the distress level of one country can be
accompanied by an increase in the distress level of other countries. This distress dependence
among sovereigns might be due to several factors. For instance, trade linkages might play an
important role in an environment of slowing global demand. Capital flow linkages represent
another possibility. And, most importantly in the current environment, many sovereigns had
to almost simultaneously provide support to banks and other systemic financial institutions
operating on their domestic markets. Furthermore, financial institutions tend to engage in
important cross-border activities, and can therefore be another channel of contagion.
Nevertheless, common factors, such as an increase in global risk aversion (or risk appetite),
could also affect the different sovereign CDS markets concurrently.
A tool has been designed to quantify the dynamics of distress dependence between different
sovereigns; it computes a spillover coefficient that measures the probability of sovereign
distress in one country given default in another country. The methodology is based on
empirical estimates of the linkages among different countries on the basis of sovereign CDS
spreads as follows (see Caceres, Guzzo, and Segoviano, 2010): (1) for each country,
9 Interest rates on swaps are effectively free from the risk of default of sovereign issuers, although they entail
some residual counterparty risks. Swap contracts specify agreements to exchange a flow of interest payments at
a fixed rate for one at a floating rate.

marginal probabilities of default are extracted from each individual CDS spread series at
each point in time; (2) joint and conditional probabilities of default are computed using a
non-parametric technique; (3) the spillover coefficient is computed as the weighted sum of
the probability of distress of each country given distress in the other countries in the sample.
The spillover coefficient can be seen as a measure of exposure of each country to distress
dependence from the other countries in the sample (see Appendix B for more details).
The tool has two main caveats. First, since the spillover coefficient uses market CDS spreads
as an input, market perceptions of the vulnerability of each of these countries play an
important role in the ranking. As discussed in the previous section, these market perceptions
reflect more than national fiscal vulnerabilities. Nevertheless, this measure provides
important information as market tensions can, at some point, become self-fulfilling. Second,
the country coverage of this tool is currently restricted to fourteen countries at a time due to
computational/program limitations.
B. Medium- and Long-Run Pressures and Susceptibility to Shocks
Medium- and Long-Term Adjustment Needs to Ensure Fiscal Sustainability
Large primary deficits and high debt levels can become unsustainable if not corrected. The
scale of the fiscal adjustment required to achieve certain debt targets can be used as an
indicator for this type of vulnerability. It indicates the size of fiscal consolidation that needs
to be undertaken over a long time horizon, if these illustrative benchmarks are to be
achieved. Since entitlement spending, in particular for pensions and health care, is projected
to rise significantly in most advanced economies in the coming years, this additional
spending pressure needs to be accounted for in the calculations.
Two indicators help gauge the medium and long-term adjustments needs. The first indicator
targets a given level of debt to be reached in a given period of time; the second indicator
specifies the required primary balance to stabilize the path of the debt-to-GDP ratio. The
methodology used for both indicators (see for details Appendix C) is similar to the one
applied by the European Commission to calculate sustainability indicators in its regular
Sustainability Report for EU member states. Practical applications have been calculated as
· The first indicator (I1) shows the cyclically-adjusted primary balance needed to reach
a certain debt target by a reference date. For illustrative purposes, the calculations
shown in Section III cover the next two decades, i.e. the primary balance that has to
be realized by 2020 and maintained until 2030 so as to achieve a given debt ratio by
2030. The gross debt target is set at 60 percent of GDP by 2030 (which corresponds
to the pre-crisis median of advanced economies) or the end-2012 level if the gross
debt-to-GDP ratio that year is less than 60 percent. For some countries with large

financial assets net debt targets are assumed.10 The required primary balance (I1) is a
function of (i) the initial and target level of debt; (ii) the path of the cyclical
component of the primary balance; (iii) the projected increase in age-related
spending; and (iv) the initial level of the cyclically adjusted primary balance.
Section III illustrates how these sources of the medium-term spending pressures differ
across countries.
· The second indicator (I2) shows the primary balance in 2016 that would be consistent
with stabilizing the debt level in the very long run, in order to satisfy the
intertemporal budget constraint. Since this indicator includes an infinite-horizon
projection, it gives much more weight to long-run rather than short- or medium-term
projections of the primary balance. As a consequence, countries with larger increases
in age-related spending will tend to have a higher required primary balance.
Vulnerabilities to Adverse Growth and Interest Rate Shocks
Debt dynamics are sensitive to the economic outlook. Since the interest rate-growth
differential is key for the future debt path, countries can be analyzed according to their
susceptibility to changes in both variables. Uncertainty regarding the likely pace of economic
recovery and the impact on countries’ public finances has increased during the summer
months of 2011. At the same time, with the increase in debt levels, most advanced economies
have become more sensitive to interest rate shocks even though yields are still low for many
of them.

Growth shocks

The impact of a “low growth” scenario can be gauged by adjusting the real GDP assumptions
that enter the debt dynamics equations. Shocks of different sizes can be considered, for
example based on historical growth patterns, by accounting for the level of debt11 or by
applying the same relative or the same absolute shock to all economies. The latter approach
has the advantage of allowing to compare countries’ susceptibility to the same size of shock.
A practical assumption is to lower real GDP growth by one percentage point compared to the
baseline projections,12 and to assume that potential GDP is not affected by the adverse growth
developments and that governments do not take any corrective discretionary actions to
smooth their impact. As a consequence, the shock affects the deficit and debt-to-GDP ratios

through higher automatic stabilizers and the change in the GDP base (see Appendix D for
more details).
The impact of lower growth varies depending on structural country differences, in particular,
with respect to three main factors: trend growth, the size of the pre-shock stock of public
debt, and the size of the automatic stabilizers. The first factor, trend growth, matters
particularly for countries with projected low average growth rates such as Italy and Japan.
The second factor, the initial stock of debt, is also relevant for these two countries as well as
several countries where debt ratios have surged as a result of the crisis (for example Greece,
Ireland, Portugal, the United Kingdom, and the United States). The third factor matters more
for many European countries, where the size of automatic stabilizers is bigger.
Interest rate shocks
A country’s sensitivity to an interest rate shock in the short to medium run depends on its
gross financing needs. For any given maturity structure of debt, countries with higher debt
levels or higher fiscal deficits will face higher financing needs, thus exposing them to higher
interest rate risk. The nature of interest rate shocks also matters. In particular, the persistence
of the shock and whether there are feedback effects from higher debt levels or higher gross
financing needs to interest rates in the form of a risk premium can potentially be very
Similarly to the adverse growth scenario, calibrating the size and duration of the shock
involves trade-offs. Countries may be sensitive to shocks of different magnitudes given the
differences in their debt levels, maturity structures, and budget balances. Applying countryspecific
shocks would require making assumptions on the determinants of interest rates and
risk premia. While the literature provides some guidance on these links,13 such an exercise
adds a level of uncertainty and complicates a country comparison. Thus, a simpler, and
possibly more transparent, option is to apply a common shock, e.g. 100 basis points over the
medium term, to all countries.
To assess the vulnerability to interest rate shocks, two indicators are particularly useful. The
first indicator measures the impact of a permanent increase in interest rates on average
financing costs over the next five years (in percent of GDP) compared to the baseline. The
second indicator measures the total average level of financing costs during the five year
period. Although the first indicator reflects the impact of a permanent increase in interest
rates, the implied total financing costs are relevant as they capture the magnitude of resources
that need to be channeled towards financing the debt as opposed to other types of

government expenditures.14 The level of financing costs certainly depends on the baseline
projections as well as the impact of the interest rate shock. Therefore, countries with high
financing costs in the baseline scenario will also tend to show higher average financing costs
under the shock scenario.
The impact of the interest rate shock over time depends on the amount of new borrowing that
becomes subject to the higher interest rates, which is related to the gross financing needs and
the structure of issuance. The impact of the interest rate shock accumulates over time as a
larger fraction of debt becomes subject to the higher interest rate. To calculate the total
impact one needs to account for the amount of debt maturing each year and being refinanced
at a higher rate, thus the future maturity structure of debt (see Appendix D). In practice,
however, such details are not always available, requiring instead to make an assumption,
such as a constant maturity structure. This simplification could be a potential shortcoming of
the computations as countries may actively seek to lengthen their average maturity to reduce
existing vulnerabilities.
Finally, one needs to account for the fact that some countries hold assets which generate
interest income. Depending on the nature and the term to maturity of these assets, higher
interest rates would also have an effect on interest income. For transparency and comparison
reasons, it is practical to assume that interest rates for financial assets and new liabilities
increase by the same amount.
Stochastic Simulations: Medium-Term Risks to Public Debt Trajectories
Assessing the uncertainties around countries’ debt projections through stochastic simulations
is another tool to analyze their vulnerabilities. Unlike the previous tool, where a common
shock is applied to the baseline growth and interest rate projections and fed through to debt
dynamics assuming unchanged policies, this approach uses a stochastic model of debt
sustainability. It relies on simulations calibrated on past constellations of macroeconomic and
financial shocks affecting debt dynamics (growth, interest rates, and the exchange rate) and
on the average policy response to these shocks. Uncertainty surrounds particularly the
magnitude, timing, and composition of the future medium-term course of fiscal policies as
well as the future path of growth-adjusted effective interest rates, especially if it will be
fundamentally different in the aftermath of the crisis.15
A risk-based approach to debt sustainability involves first an estimation of a fiscal reaction
function, followed by an unrestricted VAR model to derive the stochastic path of the general
government debt. Shocks to the key macroeconomic variables are random draws from the

joint normal distribution with zero-mean and the variance-covariance matrix of the
unrestricted VAR estimates. The same VAR is used to generate macroeconomic projections
consistent with each series of shocks and the underlying economic dynamics. A key output
from these simulations is a series of probability distributions of public debt depicted in “fan
charts” of debt dynamics (Figure 1, see Appendix E for more details). They indicate for each
year the likelihood of deviations from the planned debt trajectory.

To assess risks to medium-term
public debt dynamics, two
indicators are used measuring
“good” and “bad” outcomes. The
“good” outcome is defined as the
medium-term stabilization of the
public debt ratio. The indicator
measures the probability that the
five-year-ahead model-based
projected debt ratio will not be
greater than the maximum median
debt level observed during the
seven years prior. This indicator,
however, is mute to the level of the
debt ratio at which the stabilization
takes place and it does not fully account for the tail risks. Therefore, we supplement it with a
“bad” outcome (“tail event”) indicator that is measured as the model-based projected fiveyear-
ahead debt ratio corresponding to the 90th percentile value. The country can reach this
debt level only if a large share of adverse shocks materializes and the parameters of the fiscal
response function do not change.
This section illustrates how the methods described above can be used to gauge fiscal
vulnerabilities and risks. Key indicators are provided for selected advanced economies, with
a view to demonstrating the various dimensions of fiscal challenges that most economies
face. For illustrative purposes this section focuses on five countries—Germany, Greece,
Japan, the United Kingdom, and the United States—but includes data also for other selected
advanced economies to provide a basis for comparison. The objective is not to give an up-todate
or comprehensive assessment of fiscal vulnerabilities but rather an illustration on the
type of information that these indicators and tools can offer for the analysis of fiscal
challenges. Data for macroeconomic variables draw on the September 2011 Fiscal Monitor
and the World Economic Outlook.

A. Gross Funding Needs, Market Perceptions, and Susceptibility to Spillovers
A range of advanced economies faces high rollover and financing needs (Figure 2, first
panel). For Japan, the financing needs in the remainder of 2011 and 2012 are by far the
highest and exceeded 60 percent of GDP by the time of the data cut-off, followed by Greece
and the United States (about 30 percent of GDP). For Japan, this reflects its large fiscal
deficit and debt stock as well as the relatively short maturity profile of its debt. In Figure 2, it
is thus positioned in the far right hand corner, followed by Greece and the United States, with
the size of the bubble indicating their relatively high debt levels. For Japan and the United
States, mitigating factors for these vulnerabilities have been low yields which reflect in part
structural factors, such as a stable investor base. However, market access at low rates cannot
be taken for granted and the impact of interest rates increases on debt dynamics can be
powerful in the medium run (see third panel in Figure 3).
The examples of gross funding indicators for Germany and the United Kingdom show that
relying on a single measure could give an incomplete picture. In particular, both countries
have roughly the same debt ratio in 2011 but fare differently across the two indicators on
short and medium-term gross funding needs. Germany, due to its low projected deficit, has
much smaller gross funding needs than the United Kingdom in 2011-12. But, the United
Kingdom has the longest average debt maturity among advanced economies and thus needs
to annually roll over a much smaller portion over the medium term than does Germany (the
United Kingdom’s ratio of debt to maturity is about half of that for Germany). These
indicators show that even for countries with strong fiscal fundamentals there are trade-offs
that need to be carefully considered as part of the debt management strategy.
Markets’ perceptions of default risks is highest for ‘peripheral’ euro area economies but with
strong country differentiations. CDS and RAS spreads for Greece, depicted in the third panel
in Figure 2, have surged while they have stabilized in Portugal and come down sharply in
Ireland (not shown in the figure) since July 2011. While this in part reflected markets’
increased differentiation of the economies’ growth, reform, and fiscal outlooks, in other
episodes sovereign spreads have moved closely together reflecting global and financial
developments as well as policy uncertainties. RAS spreads have, until early September 2011,
continued to be negative for several advanced economies, such as Germany, the United
Kingdom, and the United States. This can be attributed in part to the downward trend in
sovereign yields and somewhat less for the fixed interest rate arm of interest rate swap
contracts. It indicates that for these countries (e.g., Germany) markets assessed government
paper to be less risky than flows of funds exchanged between big commercial banks. The
divergence of RAS and CDS spreads for some of countries tends to reflect the relative
illiquidity of derivatives markets as well as, for some countries, flight-to-quality effects, both
of which distort the no-arbitrage relationship across the cash and derivatives markets.

Using sovereign CDS spreads to assess spillover risks indicates that countries representing
the “largest source of contagion” in the sample are Greece, Portugal and Ireland (based on
CDS data as of end-August 2011 (Figure 2, second panel). The spillover coefficient for these
countries has almost doubled since March 2011. Germany, Japan, and the United States, on
the other hand, together with several other advanced economies, appear to be the most
resilient to sovereign risk contagion, according to the spillover coefficient.
B. Medium- and Long-Run Pressures and Susceptibility to Shocks
Most advanced economies need to sustain substantial fiscal efforts over the medium term in
order to reverse current debt trajectories. Greece, Japan, and the United States would need to
reach and maintain a cyclically-adjusted primary surplus of more than 7 percent of GDP to
achieve a debt-to-GDP ratio of 60 percent of GDP by 2030 (Figure 3, panel 1, indicator I1).
Even for Germany and the United Kingdom, efforts will be sizeable in light of the debt
legacy that the crisis has left and the additional medium-term pressure from age-related costs.
Sources of the medium-term spending pressures differ. For instance, for the United States
and the United Kingdom both the initial debt level and the age-related costs are important
contributing factors, whereas for Japan and Greece the required balance is explained mainly
by the high debt levels. This is also the reason why the United Kingdom needs a higher
primary surplus in the very long run (indicator I2) than Japan. It reflects for the United
Kingdom a projected substantial increase of age-related spending of more than 9½ percent of
GDP over the next four decades compared to a projected increase of about 2 percent of GDP
for Japan.

The susceptibility of medium-term debt dynamics to adverse growth and interest rate shocks
varies strongly with structural country differences.
· The impact on lower-than-expected real GDP growth hinges on trend growth, the size
of the pre-shock stock of public debt, and the size of the automatic stabilizers. As the
second panel in Figure 3 shows, trend growth matters particularly for countries with
projected low average growth rates, such as Japan. The second factor, the initial stock
of debt, also plays a key role for Japan and Greece. The third factor matters more for
many European countries, including Germany and the United Kingdom, where the
size of automatic stabilizers is bigger. Comparing the impact of a one percentage
point reduction in real GDP growth over the next six years, the impact is largest for
Japan and Greece. The impact on the debt path of the United States is mitigated
somewhat by its relatively strong trend growth and smaller automatic stabilizers.
· The impact of a permanent increase in interest rates on average financing costs during
2011-16 (I1) is largest in Japan, Greece, and the United States (Figure 3, third panel),
ranging between 1 and ¾ percent of GDP for these three countries. This reflects their
high gross financing needs. Looking at the second interest rate shock indicator, which
measures the new total average interest rate bill corresponding to the higher interest

General government debt-to-GDP ratio that will not
be exceeded by 2016 with a 90 percent probability
Probability of stabilizing the general government debtto-
GDP ratio by 2016

rate (I2), countries such as Ireland, Italy, and Portugal indicate greater vulnerability
relative to the first indicator given their already high financing costs in the baseline.
· Most economies that are highly vulnerable to growth shocks are also exposed to
interest rate shocks. One country where the impact of both shocks differs is the
United States. It is vulnerable to an interest rate shock due to its large gross financing
needs but is relatively less exposed to a growth shock given its relatively small size of
automatic stabilizers and more robust trend growth.
Finally, when applying stochastic simulations to analyze risks to medium-term debt
dynamics, they point to trajectories being most unfavorable in Japan, Greece, and the United
States (Figure 3, fourth panel). All three have a less than fifty percent probability to stabilize
their debt ratio by end-2016. For the United States, however, the debt level that it will not
exceed with a 90 percent probability is substantially lower than for the other two countries.
For Germany and the United Kingdom, the simulations predict a greater than 50 percent
probability to stabilize debt ratios over the next five years based on random shocks and past
fiscal behavior.

C. Bringing the Indicators Together

The illustrative application of the indicators and tools highlights the complexity and
interconnectedness of different dimensions of vulnerabilities and related policy options.
While for a few countries fiscal vulnerabilities appear large on all fronts, for most others
vulnerabilities are concentrated in particular areas. Expanding the existing strengths can be
one way of mitigating vulnerabilities in other dimensions. For the countries shown here, this
includes, for example, ensuring strong trend growth in the United States to support debt
dynamics, containing the relatively small age-related spending pressure from entitlements in
Japan to manage this source of medium and long-term pressure, and maintaining a long
average maturity of debt in the United Kingdom to keep funding needs in check. However,
such policies would need to be combined with forceful measures that address fiscal
weaknesses in other areas. The use of a set of indicators and tools, as well as a comparison of
countries against their peers can be a useful way of identifying and communicating key areas
of concern as well as policy requirements and options.16


The crisis has heightened fiscal vulnerabilities and risks in many advanced economies but the
levels, types, and origins differ across countries, as captured by the various indicators
16 To summarize the relative vulnerabilities of countries across the various indicators and tools, one can
consider ranking them or assigning “warning flags”, for example for “low”, “medium”, and “high” risk
depending on their relative position to other countries. This approach is followed in the joint FSB-IMF Early
Warning Exercise which prepares vulnerability ratings for each sector, including the fiscal sector (for more
details, see IMF, 2012).
covered here. This paper presents a range of indicators and analytical tools to monitor fiscal
developments with a view to capturing these differences and identifying the various
dimensions of fiscal challenges. While these tools are far from comprehensive, they cover
pressures that can be exerted in the short run from financing needs and markets as well as
medium and long-term pressures on debt dynamics and potential shocks that can aggravate
the baseline scenario. With data available for a large set of advanced economies with little
time lag, the methods also allow a systematic comparison of countries against their peers
along many fronts. Such positioning can provide a useful backdrop for policymakers. It
allows drawing lessons from “comparators” and is often used by market analysts in their
assessment of fiscal developments.
However, more work needs to be done to systematically capture additional aspects of fiscal
vulnerabilities. This includes, for example, the investor base, the currency denomination of
debt, and the level of contingent liabilities. Judgment is ultimately needed in putting the
different pieces of information together for a vulnerability analysis. An indicator-based
approach alone cannot fully account for vulnerabilities having potentially different relevance
across countries. For example, the rather low maturity of debt in Japan is currently mitigated
by the stable and overwhelmingly domestic investor base. Another warning against a simple
mechanical use of the tools is that some variables react with a lag or tend to overreact. This
applies in particular to market perceptions of default risk that have in the past frequently
responded very late in differentiating countries’ individual fiscal vulnerabilities and
subsequently overshot in responses. Consequently, the tools to assess fiscal vulnerabilities
and risks should be continuously monitored for their usefulness and expanded or adjusted as