17 December 2024

ECON study: Debt Sustainability Analysis: Assessing its Use in the EU’s New Fiscal Rules

A large share of euro area member states is highly indebted.. their debt ratios have experienced a strong and continued upward trend that needs to be reversed. The debt sustainability analysis..provides great flexibility . but exhibits weaknesses in transparency, robustness and credibility.

 Stress testing needs to be enhanced and applied to the adjustment period. This document was provided/prepared by the Economic Governance and EMU Scrutiny Unit at the request of the ECON Committee. 

In a monetary union of fiscally largely sovereign member states, it is essential that member states act to maintain fiscal sustainability in light of adverse incentives. Yet, the euro area experienced a strong trend towards greater indebtedness that is particularly pronounced in a significant share of member states. In response, the fiscal rules have been revised to provide greater flexibility to national fiscal policy. It is hoped this would improve compliance and motivate highly indebted states to set policies that reduce debt-to-GDP ratios and bring them on course towards 60%. The debt sustainability analysis is key in providing member states with flexibility while ensuring debt sustainability. Yet, it is based on many unobservable inputs, seemingly complex and thus potentially subject to manipulation and bias.
In principle, the debt-sustainability analysis of the Commission is state-of-the-art, but key features and design choices in the context of the rules significantly weaken its potential to help guide member states on a path towards lower debt ratios or to help maintain debt below 60% of GDP. This study proposes the following modifications and procedures to remedy this situation.
• The Commission’s prior guidance is presented in a transparent and replicable manner, but this does not extend to the national plans endorsed by the Commission. An appropriate calculation sheet with all the assumptions and forecasts from the endorsed analysis should be provided for a deeper public review and discussion that improves credibility.
• A regular assessment of the realism of key assumptions and resulting debt dynamics should be conducted by national independent fiscal institutions and funded accordingly.
• Scrutiny by the European Parliament can improve the credibility of the Commission's methodology and application. It should make use of independent expertise and a regular annual assessment.
• The debt sustainability analysis should be augmented with proper stress testing of the developments during the adjustment period. This is missing at this point. Stress testing after the adjustment period contradicts the timing assumptions underlying standard medium-term risk assessments.
• The European Parliament should request procedures for stress testing during the adjustment period with implications for the design of policy during the adjustment period. Proposals from independent sources can be requested to design a robust risk assessment.
• The timing of the stress testing after the adjustment creates incentives to choose an extension of the adjustment period, hence this should be accompanied by stress testing including an assessment of realism problems.
• The risk of reverting to the historical structural budget balance should be included in the stress testing and the stochastic debt sustainability analysis should also incorporate a variant based on a bootstrapping approach.

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