This presentation by George Kopits was made at the 35th Meeting of Senior Budget Officials held in Berlin on 12-13 June 2014. Find more information at http://www.oecd.org/gov/budgeting/35thannualmeetingofoecdseniorbudgetofficialssboberlingermany12-13june2014.htm

1. Fiscal Risks:
New Approaches to Identification,
Management and Mitigation
George Kopits
35th Annual OECD Senior Budget Officials Meeting
Berlin, June 12-13, 2014

2. G. Kopits, Woodrow Wilson Center
Questions
• Why assess fiscal risks?
• What are fiscal risks?
• How to measure fiscal risks?
• How to manage fiscal risks?
• How to mitigate fiscal risks?

3. G. Kopits, Woodrow Wilson Center
Why assess fiscal risks?
Basic rationale
• Uncertainty of fiscal policies and outlook
• Case for transparency in public finances
Recent developments
• Financial liberalization, integration, crisis
• Fiscal risks partly self-inflicted by governments
• Volatility in sovereign risk; shifts in investor sentiment
 Therefore, need to identify risks and explore drivers;
manage risks; and mitigate risks

4. Why assess fiscal risks?

5. Why assess fiscal risks?

6. G. Kopits, Woodrow Wilson Center
What are fiscal risks?
Definition
• Probable deviation of actual from expected outturn
• At extreme: probability of sovereign default
Types
• Economic, technical, political
• Exogenous vs. endogenous
• Specific, general, systemic

7. G. Kopits, Woodrow Wilson Center
What are fiscal risks?
Specific risks
• Tax measures, including tax expenditures
• Expenditure programs
• Decentralized agencies, subnational gov’ts, SOEs
• Contingent liabilities (explicit, implicit)
Efforts to gain fiscal space induce specific risks
e.g. off-budget operations
guarantees, PPPs
unrecorded SOE losses
nationalization of private pension funds

8. What are fiscal risks?
Pension funds
PPPs and other risk sharing
Financial sector
Legal claims
Other liabilities and guarantees
Natural disasters, health-care risks
Relevance of Specific Risks
(In percent of each category)
High Medium Low None

9. G. Kopits, Woodrow Wilson Center
What are fiscal risks?
General risks (rooted in optimistic bias)
• Fiscal forecasts
• Macroeconomic forecasts
• Structural budget forecasts
• Procyclical expansionary stance
Efforts to gain fiscal space induce optimistic bias
e.g. optimistic macro assumptions, elasticity estimates
no provision for macro shocks
manipulation of output gap estimates

10. What are fiscal risks?*
Optimistic bias: one-year ahead budget forecast errors
(Frankel & Schreger, 2013)

11. What are fiscal risks?*
Optimistic bias: two-years ahead budget forecast errors
(Frankel and Schreger, 2013)

12. What are fiscal risks?

13. G. Kopits, Woodrow Wilson Center
How to measure fiscal risks?
Direct estimates of specific risks
• Identification of risks associated with fiscal measures
• Estimates of probable added cost of fiscal measures
• Estimates of nominal value of contingent liabilities
• Estimates of present value of contingent liabilities,
adjusted for probability of realization

14. G. Kopits, Woodrow Wilson Center
How to measure fiscal risks?
Sensitivity analysis
• Estimate of deviation from baseline projections of
budget balance or public debt, given:
– marginal change in underlying macro variable
– hypothetical policy change
• Stress test for budget balance or public debt, given a
macro shock (output, prices, devaluation, etc.)
• Illustration: fan chart for public debt/GDP ratio

15. G. Kopits, Woodrow Wilson Center
How to measure fiscal risks?
Stochastic approach
• Fair spread model, contingent credit analysis (CCA)
• Value-at-Risk analysis (V-a-R)
• Macroeconomic models (structural, DSGE)
• Vector autoregressive model (VAR)
• Fiscal stress index

16. How to measure fiscal risks?*
Stochastic approach: V-a-R baseline simulation
(probability density function for public sector net worth)
-80 -60 -40 -20 0 20 40 60 80 100
Baseline A
Mean
5% Risk

17. How to measure fiscal risks?*
Stochastic approach: V-a-R alternative simulations
(probability density function for public sector net worth)
-80 -60 -40 -20 0 20 40 60 80 100
Baseline A
Simulation 1A
Simulation 2A
Simulation 3A

18. How to measure fiscal risks?*
Stochastic approach: fan chart simulation
(probability density function for government debt ratio)

19. G. Kopits, Woodrow Wilson Center
How to measure fiscal risks?
Stochastic approach: main characteristics
• Overall: experimental, limited application
• Macro models: theoretically consistent, too specialized
• Other methods: useful as broad indicators of risk,
but need country-specific calibration
• V-a-R: consistent and versatile (can capture specific,
general, systemic risks), but data intensive
• All exposed to Lucas critique

20. G. Kopits, Woodrow Wilson Center
How to manage fiscal risks?
Scope
• Specific risk: statement of risks
• General risk: sensitivity analyses, stress tests, fan charts
• Specific, general, systemic risks: stochastic approaches
 Practices range widely, yet concentrated mostly on
specific risks; some countries focus on general risks, but
no attention to systemic risks

21. G. Kopits, Woodrow Wilson Center
How to manage fiscal risks?
Role of government
• Identification and estimation of specific risks to
commence in line ministries, decentralized
agencies, subnational entities, SOEs
• Finance ministry has overall responsibility for estimates
of specific risks (except in relation to implicit
liabilities) and estimates of general risks
• Disclosure of estimates of risks in budget bill and
specialized bills
 Practices vary, but typically finance ministry exercises
full responsibility (if at all)

22. G. Kopits, Woodrow Wilson Center
How to manage fiscal risks?
Role of legislature
• Budget committee responsible for commencing and
preparing debate on fiscal risks, on the basis of
timely information from own staff plus IFI
• Monitoring, debate, and approval of fiscal risks
 Practices mixed, but focus on risks and ensuing debate
tend to be selective, relatively few countries
concluded with explicit approval of risks

23. G. Kopits, Woodrow Wilson Center
How to manage fiscal risks?
Role of IFI
• Oversight and evaluation of government’s assessment
of risks (if available)
• Identification / preparation of own estimates of specific
and general risks (as part of impact analysis and
macro-fiscal projections), including of risks
stemming from implicit contingent liabilities
• Estimation of systemic risks, including in close
cooperation with macroprudential supervisory
authority
 Experience is mixed: older IFIs engaged in specific and
general risk assessment; some younger IFIs too;
none involved in systemic risk assessment

24. G. Kopits, Woodrow Wilson Center
How to mitigate fiscal risks?
Mitigating exogenous risks
• Coordinated and commensurate fiscal / monetary policy
stance (if space) to cope with external shocks
• General or earmarked reserves, and hedging instruments
to cope with natural disasters and other shocks
• Disclosure of estimates of risks on budget bill and
specialized bills
 Many governments rely on such tools in anticipation of
external shocks, though sometimes with limited fiscal
space or insufficient resources

25. G. Kopits, Woodrow Wilson Center
How to mitigate fiscal risks?
Mitigating endogenous risks
• Elimination of creative accounting and forecasting
• Strict limits on off-budget and PPP schemes
• Mandatory insurance, risk-based pricing, and effective
regulation of activities prone to moral hazard
• Clarity on, and strict enforcement of, no-bailout clauses
for subnational gov’ts, banks, and SOEs
• Well-designed rules-based fiscal framework
• Structural reforms in key areas (taxation, pensions, etc.)
 Increasing number of governments rely in different
degrees on such practices

26. How to manage/mitigate fiscal risks?
Statement of risks
Long-term sustainability report
Parliamentary approval of risks
Assessment by independent institution
Countercyclical fiscal stance
Targeting prudent debt level
Fiscal rules
Structural reforms
Pricing guarantees, mandatory insurance
Risk sharing
Credible no-bailout provision
Use and Effectiveness of Risk Management and Mitigation
(In percent of each category)
High Medium Low None

27. Beware of the swan...