A Framework for Assessing Fiscal Sustainability and External Viability, with an Application to India


A Framework for Assessing Fiscal Sustainability
and External Viability, with an Application to India
by Karen Parker and Steffen Kastner

The achievement of balance of payments viability is a central
objective of most Fund-supported adjustment programs. A viable balance of
payments is one in which a country's current account deficit can be
financed, over the long term, by capital inflows on terms that are
compatible with its development and growth prospects. Until recently,
assessments of whether an economy was externally viable were based almost
exclusively on balance of payments and external debt projections. These
were used to profile future debt-service obligations and to estimate
prospective financing gaps. The relationship between fiscal policy and
balance of payments viability received less attention. Yet external
projections alone cannot identify whether a country is on a sustainable
path. The experience of many countries during the 1980s showed that
policies that channel a large share of private savings toward financing
government deficits may raise inflation and interest rates, depressing
growth. A satisfactory assessment of medium-term viability must entail a
careful examination of the public-private resource flows implied by the
external, fiscal, and monetary targets.

Over the past decade, a large literature has developed around the issue
of fiscal sustainability. Intertemporal models have identified the
conditions for government solvency and have highlighted the consequences of
untenable fiscal strategies. However, this literature does not address a
number of practical questions that confront government authorities in
setting fiscal policy: What are the short-run trade-offs between adjustment
and deficit financing? What are the implications of alternative fiscal
strategies for growth and external viability? This paper presents a simple
macroeconomic simulation model that can be used to evaluate alternative
fiscal strategies and their implications for medium-term viability. It is a
step toward bridging the gap between the literature on fiscal sustainability
and the demands of operational work.

The framework, developed in a spreadsheet format, generates estimates
of public spending compatible with identified targets for growth, inflation,
and government borrowing. The difference between the spending path
consistent with these targets and that based on current policies is the
fiscal adjustment required to meet the authorities' macroeconomic
objectives. The framework can also be used to assess the implications for
inflation, interest rates, and public indebtedness of a given spending path.
Finally, one can analyze the impact of financial reform on fiscal and
external performance. The principal products of the analysis are medium-
term fiscal, savings and investment, and balance of payments projections.
These are accompanied by sensitivity analyses to evaluate their robustness
to alternative assumptions about macroeconomic policies, exogenous
variables, and the model's parameters. The model is applied to India in
order to illustrate the types of simulations that may be conducted.