Assessing Fiscal Sustainability with Alternative Methodologies

This paper applies and analyzes three alternative methodologies to assess fiscal sustainability of the central government’s debt, using as illustrative examples the cases of Colombia and Costa Rica: The IMF’s (2003 a); the Mendoza & Oviedo’s (2003); and a new methodology that incorporates the effects of the structural and cyclical components of output, government expenditures, and revenues, on the evolution of debt, with a particular indicator of debt sustainability based on the structural components, as long as the cyclical component of debt balances out along the full cycle. In addition, a methodology to estimate the probability of default of debt and to treat the interest rate as a function of that probability is developed and applied. The common characteristic of the three approaches is the explicit incorporation of uncertainty about the behavior of the variables determining the evolution of the government’s debt, and the formulation of specific indicators that capture the effect of volatility in the economy, as well as their incidence on fiscal and financial variables. In addition, the three methodologies applied use specific procedures to estimate the expected value of the relevant variables. The results, particularly those expressed in terms of the probabilities of default, constitute useful analytical tools for policy makers to foresee the wideness of the period available to undertake corrective fiscal policies, which are explicitly characterized along the paper.