25 November 2024

Assessing the Debt Sustainability Analysis Methodology in the EU’s New Economic Governance Framework

The new EU Economic Governance Framework requires that the projected general government debt-to-GDP ratio of member States, if not already below 60% of GDP, is put or remains on a plausibly downward path over the medium term.

EXECUTIVE SUMMARY
One of the conditions to evaluate whether this requirement is met is that “the risk of the general government debt ratio not decreasing in the five years following the adjustment period of the national medium-term fiscal-structural plan is sufficiently low, the assessment of which shall be based on the Commission’s Debt Sustainability Analysis (DSA). Thus, this methodology plays a critical role in the new economic governance framework.

Against this background, this paper reviews the Commission’s DSA methodology, in terms of its transparency, replicability and differences with respect to the approach followed by other organizations implementing DSA, such as the International Monetary Fund (IMF).

The main conclusions are:
• Most features of the DSA methodology are appropriate and in line with state-of-the art practice. However, the methodology reflects ad hoc procedures that may affect in a critical way the results that are obtained in terms of fiscal adjustment that Member States have to implement.
• This is not a critique of the methodology itself or of the methodological choices made by the Commission. Rather it is an inevitable consequence of having opted for an economic governance framework based on a non-observable and difficult to estimate variable, namely the volatility of the path of the debt-to-GDP ratio following the end of the four-to-seven year adjustment period. This decision was contrary to one of the stated goals of the economic governance reform, namely to reduce the reliance on non-observable variables.
• In these circumstances, as a minimum, it would be useful to work further in assessing the implications of the specific features of the DSA methodology in determining the required reduction of the debt ratio in the post-adjustment period and hence on the required level of the primary surplus to be reached at the end of that period.
• The paper also highlights the radical change of the new governance framework with respect to the past, especially in terms of the relationship between the required reduction of the debt ratio in the post adjustment period and the initial level of the debt ratio.
• Indeed, the pre-reform framework required an annual decline in the debt-to-GDP ratio that was proportional to the initial debt level. Instead, the new framework requires that, under certain reasonable assumptions, the debt ratio falls annually by one tenth of the estimated standard deviation of the debt ratio distribution five years after the end of the adjustment period (a measure of the volatility of the debt ratio). The initial debt level is (almost) irrelevant in determining the magnitude of the required debt decline....

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