20 November 2012

DG ECFIN Economic Paper: Sovereign debt sustainability scenarios based on an estimated model for Spain

This paper by Jan in 't Veld, Andrea Pagano, Marco Ratto, Werner Roeger and Istvan P Szekely proposes a framework for sovereign debt sustainability assessment based on an estimated DSGE model.

One advantage of this is that it allows taking into account feedback effects of debt ratios, spreads and fiscal measures on growth and tax bases, and thus captures the impact of changes in the composition of GDP which is pronounced during fiscal consolidation. Unsustainable debt developments may give rise to increasing interest rate spreads which could further reduce growth and tax revenue and worsen debt dynamics, while fiscal austerity measures are likely to reduce growth and lower tax revenues in the short run. Capturing the impact of risk premium on growth and public debt dynamics is crucial to understand current developments and policy trade-offs in euro area periphery countries.

The standard sovereign debt sustainability assessment framework  used by international organisations, like the European Commission, the ECB and the IMF, is based on an analysis of debt and debt service dynamics derived from projections of a number of indicators over a medium- to long-term horizon. This paper shows how an estimated structural model could be used to complement the standard approach to debt sustainability assessments, and applies this  to the case of Spain. The main advantage of this model-based approach is that it allows taking into account feedback effects of debt ratios, spreads and fiscal measures on growth and tax bases. For example, unsustainable debt developments may give rise to increasing interest rate  spreads which could further reduce growth and tax revenue and worsen debt dynamics, while  fiscal austerity measures are likely to reduce growth through reducing domestic demand and thus lower tax revenues in the short run, but can also reduce spreads if the policy is credible and thus can dampen the negative longer-term impact on growth. With estimated shock  variances, a risk assessment can also be given on the basis of probabilities of (un)sustainable  paths.

As an example, the paper takes an estimated model for Spain. While at first sight Spain's public debt might not appear as pressing a problem as its external indebtedness - Spain's  sovereign debt was at 68 per cent of GDP in 2011 still below the euro area average - sovereign debt  sustainability has become a concern for Spain and spreads vis-à-vis German Bunds have risen dramatically. Although this analysis is  limited to a direct extrapolation of the 2011 fiscal  position and thus abstracts from possible interventions to support financial institutions, the authors are  able to show how a model  can be applied to assess alternative scenarios of lower growth  projections, an increase in the sovereign risk premium, and frontloaded fiscal consolidations and discuss their impact on long-term debt developments.

It is shown how lower growth projections can have significant negative impact on debt projections. This underlines the need for structural reforms to raise the growth potential of the economy. Fiscal consolidation measures that reduce debt and deficits faster towards sustainable targets may have short-term costs in terms of lower growth, but can avoid the costs associated with permanently higher risk premia. The speed of fiscal consolidation is a major and rather controversial policy choice in European countries with high public debt and weak structural fiscal position. Model-based analysis as illustrated in this paper can help to choose the least harmful ways of keeping public debt on a sustainable path.

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