## ch2

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### Introduction and context
- Fiscal support during the coronavirus disease 2019 (COVID-19) pandemic has saved lives and reduced economic scarring, but together with the fall in revenues it has yielded high deficits and a jump in debt.
- By the end of 2021, debt as a share of GDP is projected to be:
  - 18 percentage points higher than prepandemic levels for advanced economies;
  - 10 percentage points higher for emerging markets; and
  - 6 percentage points higher for low-income developing countries.
- Interest burden of debt has virtually been unchanged between 2019 and 2021, although since 2014 interest payments as a share of revenues have been rising in low-income developing countries and, to a lesser extent, in emerging markets.
- Higher deficits have boosted gross financing needs, increasing vulnerability to abrupt changes in market sentiment and reducing available fiscal buffers.

### Fiscal credibility and fiscal frameworks
- Fiscal credibility: the public’s confidence in the government’s fiscal plans and ability to achieve commitments (meeting debt obligations, carrying out announced tax and spending plans).
- Fiscal frameworks comprise:
  - long-term fiscal targets (anchors);
  - fiscal rules imposing numerical limits on aggregates (expenditure, deficits, debt);
  - fiscal institutions (for instance fiscal councils);
  - procedures for budget preparation, approval, and execution.
- Strengthening fiscal frameworks can buttress market confidence and improve governments’ access to finance.

### Rebuilding fiscal space — illustrative exercise and quantitative findings
- Exercise design:
  - Uses baseline primary balance, growth, and real interest rate projections for 2021–23 from April 2021 World Economic Outlook.
  - Computes average primary balance needed in 2024–45 to bring debt-to-GDP back to 2019 levels by 2045.
  - Assumes long-term growth rates constant and equal to IMF staff projections for 2024–26.
  - Assumes effective real interest rates after 2023 are 1 percent for advanced economies and 2.5 percent for emerging markets and low-income developing countries.
- Baseline results (average primary surplus required to bring debt to pre–COVID-19 levels):
  - typical advanced economy: higher than in 2010–19 by 0.5 percent of GDP;
  - typical emerging market: higher by 1.0 percent of GDP;
  - typical low-income developing country: higher by 0.3 percent of GDP.
- Sensitivity to higher interest-rate assumptions (effective real interest rates set at 2 percent for advanced economies and 3.5 percent for emerging markets and low-income developing countries):
  - advanced economies: 1.2 percent of GDP;
  - emerging markets: 1.6 percent of GDP;
  - low-income developing countries: 1.0 percent of GDP.
- Shortening the horizon to 2035 (return to 2019 debt-to-GDP by 2035) raises required primary surpluses by:
  - advanced economies: 0.9 percent of GDP higher than in the past;
  - emerging markets: 1.4 percent higher;
  - low-income developing countries: 0.5 percent higher.
- Complementary strategies to reduce debt burden include accommodative monetary policy, asset purchases, liabilities restructuring, and financial repression — each carries risks to output, investment, credit, trade finance, and financial-sector stability.

### Timing and pace of deficit reduction — trade-offs and determinants
- Key country-specific factors for timing and pace:
  - Pandemic phase:
    - Continue protecting lives/livelihoods where virus containment is incomplete, including stronger safety nets.
    - Prolonging fiscal support may be warranted where recovery is slow and fiscal space exists.
    - Countries without fiscal space may need external financial support, an IMF-supported program, or debt restructuring.
    - Accommodative monetary policy can ease the transition to tighter fiscal policy.
  - Balance sheets and risk premiums:
    - Higher initial debt increases risk of spikes in sovereign debt spreads.
    - Lower-debt countries benefit from lower and less sensitive risk premiums.
  - Multiplier:
    - Lower fiscal multipliers strengthen the case for reducing deficits because they worsen sovereign spread spikes.
    - Value of delaying deficit reduction depends on how deficits are used; efficient public investment is especially valuable.
  - Scarring (hysteresis):
    - Substantial risks of long-term scarring where vaccination lagged and fiscal support was limited; countercyclical support can have long-term benefits and, where feasible, could pay for itself through higher growth.
  - Debt composition and investor base:
    - High shares of short-maturity debt raise risk of self-fulfilling debt crises.
    - Larger shares of debt in domestic currency, longer maturities, and more stable investor bases reduce exposure to sharp changes in borrowing conditions.

### Optimal fiscal policy after a recession (model-based illustrations)
- Model context: based on Bianchi, Ottonello, and Presno (2021); results shown as deviations from a counterfactual not affected by the recession.
- Baseline emerging market example:
  - Government external debt in baseline: 23 percent of GDP.
  - Optimal government response increases the primary balance by 0.8 percent of GDP to mitigate higher spreads.
  - Even with the optimal response, sovereign spreads increase by 0.7 percent on impact.
- Timing choices (expenditure-based consolidations; deviations in the first year in percentage points):
  - 1 — Consolidation now: tightening primary balance by 0.5 percent of GDP in the recession year; additional employment loss of 0.2 percent in that first year.
  - 2 — Support now + consolidation next year: loosen deficit by 0.1 percent of GDP now and tighten by 0.5 percent of GDP next year.
  - 3 — Support now + conditional consolidation: loosen by 0.1 percent now and tighten by 0.7 percent next year only if recovery occurs.
- Policy insight:
  - Credible commitments to reduce future deficits lower risk premiums and allow more countercyclical support in the recession year, improving employment outcomes.
  - Conditional consolidation on recovery further improves macroeconomic outcomes.
- Commitment mechanisms: prelegislated tax/spending changes, unemployment-contingent sunset clauses, structural reforms legislated promptly but implemented gradually, or entering IMF-/EU-supported programs.

### Has debt-carrying capacity increased?
- Empirical observations:
  - Interest rates have become less sensitive to debt levels in recent years.
  - Example: a 1-percentage-point increase in debt-to-GDP would have raised emerging market foreign-currency spreads by 2 percent in the early 2000s but by less than 1.5 percent in 2020.
  - Similar declines found for local-currency borrowing interest rates in advanced economies and emerging markets.
- After controlling for global factors:
  - Sensitivity of emerging market foreign-currency spreads to debt, relative to the global average, has remained constant since 2013.
  - Sensitivity to a country’s relative debt level exceeds sensitivity to the global average.
- Interpretation and risks:
  - Lower risk premiums may reflect expectations of low-for-long interest rates, a weakened relationship between spreads and fundamentals, and exceptional central bank interventions.
  - If the weakening nexus is temporary, funding-cost declines and weaker linkages could reverse; synchronized reversals in global savings and rising price of risk could propagate market turmoil.

### Assessing and managing fiscal risks — empirical decomposition of unexpected debt increases
- Method: compare past medium-term projections with realized outcomes and decompose unexpected changes in debt into contributions from:
  - real interest rates;
  - real growth rates (including automatic stabilizers);
  - cyclically adjusted primary balances;
  - valuation effects from real exchange rate movements;
  - other stock-flow adjustments.
- Five-year window findings (1995–2019):
  - Median unexpected jump in debt ratio over five years: 13.6 percent of GDP overall.
    - Median low-income developing country: 16.5 percent of GDP.
    - Median emerging market: 13.4 percent of GDP.
    - Median advanced economy: 12.3 percent of GDP.
  - Main drivers: disappointing growth outcomes and larger-than-anticipated stock-flow adjustments.
  - Median quantified contributions (five-year horizon):
    - Growth forecast errors: 6.5 percent of GDP.
    - Surprises in stock-flow adjustments: 4.3 percent of GDP.
  - Stock-flow adjustments (excluding exchange rate effects) at the 75th percentile:
    - advanced economies: 10 percent of GDP;
    - emerging markets: 12 percent of GDP;
    - low-income developing countries: 20 percent of GDP.
  - Cyclically adjusted primary balance surprises (median, cumulative at five years):
    - 2 to 3 percent of GDP for advanced economies and emerging markets;
    - 0.5 percent of GDP for low-income developing countries.
    - 75th percentile: 9.8 percent of GDP (advanced economies), 12.5 percent (emerging markets), 8.3 percent (low-income developing countries).
  - Real interest rate surprises (median contributions, five-year horizon):
    - less than 0.5 percent of GDP in advanced economies and low-income developing countries;
    - 1 percent of GDP in emerging markets.
- Correlations:
  - High correlation (0.6 to 0.8) between surprises in primary balances and stock-flow adjustments, and between surprises in real interest rates and real exchange rates — risks tend to materialize together.

### Mitigating and managing fiscal risks — practices and design features
- Recommended design features for credible fiscal frameworks:
  - Risk analysis to inform fiscal targets and embed flexibility for countercyclical responses.
  - Budgets accounting for expected costs of loan guarantees.
  - Coverage of at least the general government, complemented by whole-public-sector fiscal data.
- Practices to identify and measure risks:
  - Routine sensitivity analyses of fiscal aggregates to plausible macro changes.
  - Stress tests and fiscal risk statements to inform fiscal strategy and framework flexibility.
- Budgeting contingent liabilities:
  - Budget expected costs of contingent liabilities in medium-term plans, either on an annual cash-flow basis or on a net-present-value basis in the year of support.
  - Complementary approaches: fair-value measurement to capture default risk, recovery rates, and price of risk.
- Risk mitigation examples:
  - Place limits on loan sizes and maturities.
  - Restrict eligibility under credit support schemes (example: Ukraine’s COVID-19 portfolio guarantees).
  - Provide partial guarantees to limit moral hazard (example: Spain’s COVID-19 guarantees limited coverage to 60–80 percent of a loan).
  - Attach conditions to support (restructure SOEs or private companies, improve governance, adopt efficiency measures).
- Policy trade-off: during crises, assuming fiscal risks may bring net benefits, but guarantees and exposures should not outlive their initial motivation once recovery is underway.

### Fiscal rules, sustainability, and empirical evidence on prudence
- Fiscal frameworks aim to:
  1. Ensure sustainability of public finances;
  2. Stabilize the economy through countercyclical policy where appropriate;
  3. Maintain simplicity for communication and accountability.
- Trade-offs and the “trilemma”: satisfying sustainability, stabilization, and simplicity simultaneously is difficult.
- Empirical findings:
  - Fiscal rules have contributed to lower deficits.
  - Debrun and others (2008): fiscal rules associated with higher primary and structural primary balances (1990–2005).
  - Caselli, Stoehlker, and Wingender (2020): fiscal rules improved primary balances for countries that otherwise would have had large deficits.
  - David, Gonçalves, and Perrelli (panel of 55 countries, 1970–2018):
    - Governments tighten the primary balance in response to increases in debt and the interest bill.
    - Countries with debt rules respond with even stronger tightening.
    - Countries following a debt rule typically reverse a 15 percent of GDP jump in debt in about 10 years (in absence of new shocks).
    - Budget balance rules induce stronger primary-surplus responses to increases in the interest bill.

### Ensuring flexibility in fiscal rules and escape clauses
- Rigid rules can be procyclical, especially for public investment; rules with flexibility are not associated with more procyclicality.
- Approaches to improve flexibility:
  - Cyclically adjusted or structural balance rules (more complexity, monitoring challenges).
  - Expenditure rules (easier to monitor, can permit countercyclical policy; may need recalibration for permanent public-sector size changes).
  - More sophisticated expenditure rules allowing spending above limits if matched by discretionary revenue increases (more complex).
  - Automatic suspension proposals when the monetary policy rate hits the effective lower bound (rationale: fiscal policy potency rises when monetary policy constrained; caveat: many advanced-economy rates have long been close to the lower bound).
- Escape clauses:
  - Should be well specified and activated only for events beyond government control (severe recessions, natural disasters, pandemics).
  - Many countries activated escape clauses in 2020; some suspended rules due to high uncertainty.
  - Determining how and when to return to the rule after activation is difficult; some rules require offsetting accumulated deviations, which may be infeasible.

### Returning to or recalibrating fiscal rules
- Options when rules are suspended:
  - Recalibrate or redesign rules to accommodate higher post-crisis debt and provide flexibility.
  - Introduce fiscal responsibility laws or pacts to build consensus on revenue mobilization or adjustment paths.
  - Use a transition regime with a less ambitious interim target consistent with eventual convergence.
- Trade-offs:
  - Revising rules can improve credibility if returning to old rules would require excessive consolidation.
  - Revising targets may signal weaker commitment to sustainability; credibility is low if achieving a target makes future compliance harder.
  - Recalibration benefits are higher when reconvergence would require excessive consolidation.
- Communication:
  - Well-communicated revisions can preserve credibility (examples cited in source: Israel; Mongolia).
  - Media reaction to suspending rules was more positive in countries with high fiscal transparency.

### Strengthening underlying fiscal institutions
- Institutional measures to improve credibility and predictability:
  - Independent review of macroeconomic assumptions (some advanced economies delegate macro forecasting to independent institutions).
  - Well-designed fiscal councils associated with stronger performance and more accurate forecasts.
  - Comprehensive medium-term budgets reflecting all planned fiscal activities to reduce hidden deficits.
  - Effective financial controls and tax administration improve implementation capacity; revenue predictability correlates with tax administration effectiveness and governance quality.
  - Transparency and disclosure aligned with international standards (for example, IMF Fiscal Transparency Code) underpin market confidence.
  - For low-income and fragile states: develop core public financial management systems (annual budget processes, medium-term forecasts, financial controls, reporting).

### Improving predictability and credibility of fiscal plans — empirical evidence
- Credibility concept: credible government budgets align private expectations with official projections and reduce forecaster disagreement.
- Empirical findings:
  - Governments typically project significantly lower fiscal deficits than private-sector forecasts for current and next fiscal year.
  - Strong frameworks and fiscal rules increase credibility: private forecasts are closer to official projections in countries with debt/deficit rules and fiscal councils.
  - Budget balance rules tend to anchor private expectations (EU adoption led to deficits converging to the –3 percent of GDP limit).
  - Past forecast errors reduce private-sector confidence; downward revisions to official projections widen the gap with private forecasts.
  - Private forecasters on average give credit for only one-fourth of planned adjustments for the next year.
  - Credibility affects borrowing costs:
    - When private forecasts are more pessimistic than official projections by 2 percent of GDP, 10-year sovereign yields increase by 6 basis points.
    - Budget announcements lower interest rates in high-credibility countries but show no visible effect in low-credibility countries; the announcement-month difference can be as much as 40 basis points.
  - Credibility is slow to build and fast to lose.
- Empirical sample notes:
  - Regressions for credibility comparisons use 423 observations covering 23 advanced economies and 9 emerging markets over 1997–2019.
  - Bin scatter plots relating credibility gaps to yields use 3,071 observations covering 34 countries from 2001 to 2019.
  - Credibility thresholds: high credibility above 75th percentile; low credibility below 25th percentile.

### Media perception and communication around escape-clause activation (Box 2.1)
- Sample: 36 countries; 1,364 articles per country in official language referring to escape clause in two weeks before and after activation; average 38 articles per country.
- Media findings:
  - Exceptional circumstances and government response emphasized; keywords included “pandemic”, “COVID”, “crisis”, “fiscal”, “deficit”, “health”, “support”, “measure”, “budget”.
  - More than half of news articles acknowledged the effect on debt; share reached 73 percent among advanced economies.
  - “Corona bonds” discussed in 7 percent of articles in European advanced economies; “bonds” in 23 percent of emerging-market articles; “investors” in 11 percent of emerging-market articles.
  - Credit-rating-agency names were 7 to 10 times more likely to appear in articles for low-income developing countries and emerging markets than for advanced economies.
  - Lower-income groups paid more attention to credibility, the medium term, and debt sustainability.
- Sentiment and transparency:
  - Tone scale ranges –1 (most negative) to +1 (most positive); average and median scores across countries about 0.
  - Perception more positive in countries with stronger standards of transparency.
- Communication best practices when activating escape clauses:
  - Publish a credible medium-term fiscal framework.
  - Provide government reports on relevant programs.
  - Include analysis by independent agencies.
  - These practices support credibility and align with literature linking fiscal transparency to stronger credit ratings and easier market access.

### Assessment of Debt Sustainability Scenario Analysis
- Coverage: 36 advanced economies, 88 emerging markets, and 58 low-income developing countries; complemented by review of selected national fiscal institutions’ fiscal risk analyses.
- Scenario performance findings:
  - Growth shocks:
    - In about 80 percent of IMF debt sustainability analyses for market-access countries, growth scenarios envisioned short-term debt increases larger than actual projection errors from growth shocks.
    - In low-income developing countries, temporary growth scenarios anticipated short-term debt increases in only one-third of episodes.
    - Ability to anticipate adverse debt dynamics weaker over the medium term (3–5 years) than the short term (1–2 years).
  - Exchange rate depreciation, primary balance slippages, and contingent liabilities were better captured at short-term horizons than medium-term horizons.
  - Real interest rate surprises were hardest to flag; higher-than-expected real interest rates during the period were driven by inflation undershooting expectations across diverse countries.
  - National fiscal institutions’ fiscal risk analyses often did not include the risk of inflation undershooting expectations.
- Note on methodology:
  - Real interest rate scenario effectiveness analysis based on 197 (short term) and 139 (medium term) IMF debt sustainability analyses for market-access countries and 56 (short term) and 37 (medium term) European Commission DSAs.

### Conclusion and prioritized policy recommendations
- Context: COVID-19 fiscal support remains indispensable in most places, but buffers have dwindled.
- General policy principles:
  - Where fiscal space remains, prolong support to fight the health crisis and bolster recovery.
  - Where fiscal space is limited, balance additional support with preserving capacity for future emergencies.
  - Strengthening credibility reduces the cost of the trade-off between support and fiscal sustainability.
- Design considerations for fiscal frameworks:
  - Appropriate long-term fiscal targets are country specific and may change with circumstances.
  - Decline in global interest rates may have increased debt-carrying capacity, but an increase in interest rates cannot be ruled out.
  - Embed more flexibility (for example, expenditure rules instead of budget balance rules) to support exit from the crisis.
  - Consider objectives beyond debt-to-GDP (for example, public-sector net worth or an interest-bill anchor) where rollover risks are limited and transparency is high.
  - Countries that suspended fiscal rules may need to redesign or recalibrate pre–COVID-19 rules, balancing constraint and credibility costs.
- Strategies to signal commitment to future deficit reduction:
  - Strengthen fiscal frameworks to improve compliance with fiscal rules.
  - Undertake structural fiscal reforms.
  - Enter into an IMF-supported program.
  - Legislate future tax or spending changes in advance.
- Communication and transparency:
  - Clear communication of priorities, fiscal transparency, and commitment-strengthening strategies facilitate transition to new objectives.
  - Activating escape clauses was less controversial in countries with high fiscal transparency.

*Source: Chapter 2, "Strengthening the Credibility of Public Finances," Fiscal Monitor, International Monetary Fund | October 2021.*

### Introduction

### ch2 - Introduction

### Overview and context
- Fiscal support during the coronavirus disease 2019 (COVID-19) pandemic has saved lives and reduced economic scarring, but together with the fall in revenues it has yielded high deficits and a jump in debt (Chapter 1).
- By the end of 2021, debt as a share of GDP is projected to be 18 percentage points higher than prepandemic levels for advanced economies, 10 percentage points higher for emerging markets, and 6 percentage points higher for low-income developing countries.
- Despite higher deficits and debt, the interest burden of debt has virtually been unchanged between 2019 and 2021 (Figure 2.1, panels 1 and 2), although since 2014 interest payments as a share of revenues have been rising in low-income developing countries and, to a lesser extent, in emerging markets (Chapter 1).
- Higher deficits have boosted gross financing needs (Figure 2.1, panel 3), making countries more vulnerable to abrupt changes in market sentiment and reducing available fiscal buffers for future crises.

### Fiscal credibility and fiscal frameworks
- Fiscal credibility is defined as the public’s confidence in the government’s fiscal plans and ability to achieve its commitments, such as meeting debt obligations and carrying out announced tax and spending plans.
- Building credibility helps secure financing and reduces volatility faced by the private sector.
- Fiscal frameworks are the set of rules, procedures, and institutions that guide fiscal policy, comprising:
  - long-term fiscal targets (anchors), e.g., a debt ceiling;
  - fiscal rules that impose numerical limits on aggregates such as expenditure, deficits, or debt;
  - fiscal institutions, for instance fiscal councils; and
  - procedures governing budget preparation, approval, and execution.
- Strengthening fiscal frameworks can buttress market confidence and improve governments’ access to finance.

### What should guide the strategy for public debt?
- The pandemic highlighted the benefits of preserving access to finance: advanced economies could provide stronger support than many emerging markets and low-income developing countries.
- Costs of high debt include constraints on fiscal policy, especially when debt is denominated in foreign currency or is short duration, and higher vulnerability to financing conditions and policymakers’ concerns.
- Calibrating debt objectives should aim to preserve achievements in reducing fiscal procyclicality, building buffers, and improving institutions.

### Rebuilding fiscal space — illustrative exercise and findings
- A simple exercise quantifies the multiyear increase in the primary balance needed to bring debt back to 2019 levels by 2045. The exercise:
  - takes as given primary balance, growth, and real interest rate in baseline projections for 2021–23 from the April 2021 World Economic Outlook;
  - computes the average primary balance needed in 2024–45 to bring the debt-to-GDP ratio back to 2019 levels by 2045;
  - assumes long-term growth rates constant and equal to IMF staff projections for 2024–26; and
  - assumes effective real interest rates after 2023 are 1 percent for advanced economies and 2.5 percent for emerging markets and low-income developing countries.
- Results of the baseline exercise (average primary surplus required to bring debt to pre–COVID-19 levels):
  - typical advanced economy: higher than in 2010–19 by 0.5 percent of GDP;
  - typical emerging market: higher by 1.0 percent of GDP;
  - typical low-income developing country: higher by 0.3 percent of GDP.
- Sensitivity to interest-rate assumptions:
  - If effective real interest rates are set at 2 percent for advanced economies and 3.5 percent for emerging markets and low-income developing countries, the needed increase in the primary surplus would be:
    - advanced economies: 1.2 percent of GDP;
    - emerging markets: 1.6 percent of GDP;
    - low-income developing countries: 1.0 percent of GDP.
- Shortening the horizon to return to 2019 debt-to-GDP ratios to 2035 raises required primary surpluses by:
  - advanced economies: 0.9 percent of GDP higher than in the past;
  - emerging markets: 1.4 percent higher;
  - low-income developing countries: 0.5 percent higher.
- Complementary strategies to reduce debt burden include accommodative monetary policy, asset purchases, liabilities restructuring, and financial repression, each with associated risks (e.g., effects on output, investment, credit, trade finance, and financial-sector stability).

### The trade-off with supporting the recovery — factors determining timing and pace of deficit reduction
- Timing and pace of reducing deficits should be country-specific. Relevant factors identified:
  - Pandemic phase:
    - Countries still struggling to contain the virus need to continue protecting lives and livelihoods, including with stronger safety nets.
    - Even where the virus is under control, prolonging fiscal support could be correct if recovery is slow and fiscal space remains.
    - For countries without fiscal space and amid the pandemic, external financial support, an IMF-supported program, or debt restructuring may be needed.
    - Accommodative monetary policy can ease the transition to tighter fiscal policy when fiscal space is limited.
  - Balance sheets and risk premiums:
    - The initial level of debt is key when determining policy stance; higher debt increases the risk of spikes in sovereign debt spreads.
    - Countries with lower debt benefit from lower and less sensitive risk premiums, increasing crisis-response capacity.
  - Multiplier:
    - A lower fiscal multiplier strengthens the case for reducing deficits because it worsens the spike in sovereign spreads.
    - The value of delaying deficit reduction depends critically on how deficits are used; well chosen and efficient public investment is especially valuable.
  - Scarring (hysteresis):
    - Risks of economic scarring from the pandemic are substantial, particularly where vaccination has lagged and fiscal support was limited.
    - Countercyclical fiscal support can have long-term benefits and, where feasible, could pay for itself through higher economic growth.
  - Debt composition and investor base:
    - High shares of short-maturity debt raise the risk of self-fulfilling debt crises.
    - Larger shares of debt in domestic currency, longer maturities, and more stable investor bases reduce exposure to sharp changes in borrowing conditions.

*This chapter was prepared by staff from the Fiscal Affairs Department. The authors of this chapter are Raphael Espinoza (Lead), Hassan Adan, Cristian Alonso, Bryn Battersby, Carlos Goncalves, Gee Hee Hong, Andresa Lagerborg, Roberto Perrelli, and Amanda Sayegh, with support from Andrew Womer, and under the guidance of Paolo Mauro (Deputy Director) and Paulo Medas (Division Chief ).*

### 1. Optimal Change in Primary Balance2. Sovereign Spreads

### 1. Optimal Change in Primary Balance2. Sovereign Spreads

### Optimal fiscal policy after a recession
- Baseline assumptions and model source:
  - Based on the model in Bianchi, Ottonello, and Presno (2021).
  - Data shown as deviations from a counterfactual economy not affected by the recession.
  - In the baseline, government external debt is 23 percent of GDP.
  - A lower initial level of debt corresponds to an economy whose government external debt in the initial period is 75 percent lower than the baseline.
  - The lower multiplier is 7 percent smaller on impact than the baseline.
- Optimal policy response (baseline emerging market example):
  - Government optimally increases the primary balance by 0.8 percent of GDP (panel 1) to mitigate higher spreads.
  - Even with this optimal response, sovereign spreads increase by 0.7 percent on impact (panel 2).

### Timing of consolidation and effects on spreads and employment
- Illustration of three policy timing choices (all consolidations are expenditure based; deviations in the first year in percentage points):
  - 1 — Consolidation in the present: corresponds to tightening of the deficit by 0.5 percent of GDP in the current year.
    - Tightening the primary balance by 0.5 percent during the year of recession would see an additional loss of employment of 0.2 percent in that first year.
  - 2 — Support in the present + consolidation in the future: corresponds to a loosening of the deficit by 0.1 percent of GDP in the current year and tightening by 0.5 percent of GDP the following year.
  - 3 — Support in the present + consolidation in the future, conditional on recovery: implies a loosening of the deficit by 0.1 percent of GDP in the current year and a tightening by 0.7 percent of GDP in the following year only if the economy has emerged from the recession.
- Key policy insight:
  - Credible commitments to reduce future deficits lower risk premiums and allow more countercyclical support in the recession year, improving employment outcomes relative to immediate consolidation.
  - Making consolidation conditional on recovery further improves macroeconomic outcomes.
- Examples of commitment mechanisms:
  - Prelegislated tax/spending changes (example cited: a corporate tax rate change announced to take effect in future).
  - Sunset clauses contingent on economic indicators (example cited: unemployment-contingent sunset of extended unemployment benefits).
  - Structural reforms legislated promptly but implemented gradually (pension reforms, subsidy reforms, public employment and wage reforms).
  - Entering IMF- or EU-supported programs to improve credit ratings and lower sovereign spreads by providing financing and transparent independent monitoring.

### Has debt-carrying capacity increased in recent years?
- Observed changes in sensitivity of spreads to debt:
  - Empirical analysis suggests interest rates have become less sensitive to debt levels in recent years (Figure 2.5, panel 1).
  - Example quantification: a 1-percentage-point increase in the debt-to-GDP ratio would have raised emerging market spreads in foreign currency by 2 percent in the early 2000s but by less than 1.5 percent in 2020.
  - Similar decline found for interest rates in local currency borrowing for both advanced economies and emerging markets.
- Role of global vs. country-specific factors:
  - After accounting for global factors, the sensitivity of emerging market foreign currency spreads to debt, relative to the global average, has remained constant since 2013 (Figure 2.5, panel 2).
  - Sensitivity of spreads to the relative level of debt of each country has exceeded the sensitivity to the global average debt level.
- Interpretation and risks:
  - Lower risk premiums may reflect expectations of low-for-long interest rates, weakened relationship between spreads and fiscal fundamentals, and exceptional central bank interventions (quantitative easing).
  - If the weakening of the nexus between interest rates and debt is temporary, the decline in funding costs and weakening relationship could reverse.
  - The synchronized increase in global savings seen in 2020 is likely to be at least partially reversed as advanced economies exit the pandemic sooner than the rest of the world; market turmoil could propagate across similar countries if the price of risk rises globally.

### Assessing and managing fiscal risks
- Need for fiscal frameworks to account for unexpected fiscal costs:
  - Fiscal frameworks must be flexible for crisis response but ensure that large debt increases in crises are offset by progressive debt reduction in good times.
  - Understanding magnitude and source of fiscal risks is essential.
- Sources of fiscal risks highlighted:
  - Pandemic uncertainty and long-term scarring.
  - Exposure to higher global interest rates and risk premiums as debt and gross financing needs increased.
  - Larger risks on public balance sheets and contingent liabilities from implicit guarantees, state-owned enterprises, corporate support programs, net acquisition of underperforming financial assets.
  - Increased propensity for pandemics and climate-related disasters.
- Recommended design features for credible fiscal frameworks:
  - Risk analysis should inform fiscal targets and embedded flexibility for countercyclical responses.
  - Budgets should account for expected costs of loan guarantees.
  - Frameworks should cover at least the general government and be complemented by fiscal data for the whole public sector.

### Explaining unexpected increases in debt (empirical decomposition)
- Methodology summary:
  - Compare expected macro-fiscal paths from past medium-term projections with realized developments.
  - Decompose unexpected changes in debt into contributions from real interest rates, real growth rates (including automatic stabilizers), cyclically adjusted primary balances, valuation effects from real exchange rate movements, and other stock-flow adjustments.
- Key empirical findings (five-year windows, 1995–2019):
  - Considering all unexpected increases in the debt ratio over five-year windows, the median jump was 13.6 percent of GDP:
    - 16.5 percent of GDP for the median low-income developing country.
    - 13.4 percent of GDP for the median emerging market.
    - 12.3 percent of GDP for the median advanced economy.
  - Main drivers of unexpected jumps in debt across country groups:
    - Disappointing growth outcomes and larger-than-anticipated stock-flow adjustments.
  - Quantified median contributions (five-year horizon):
    - Growth forecast errors: 6.5 percent of GDP.
    - Surprises in stock-flow adjustments: 4.3 percent of GDP.
  - Exchange rate depreciations and other stock-flow adjustments are especially important in emerging markets and low-income developing countries due to quasi-fiscal operations, arrears, contingent liabilities from state-owned enterprises, acquisition of financial assets, incomplete statistics, and creative accounting.
    - The 75th percentile of the contribution of stock-flow adjustment (excluding exchange rate effects) reached:
      - 10 percent of GDP in advanced economies.
      - 12 percent of GDP in emerging markets.
      - 20 percent of GDP in low-income developing countries.
  - Cyclically adjusted primary balance surprises (median, cumulatively at five years):
    - 2 to 3 percent of GDP for advanced economies and emerging markets.
    - 0.5 percent of GDP for low-income developing countries.
    - Dispersion: 75th percentile reached 9.8 percent of GDP in advanced economies, 12.5 percent of GDP in emerging markets, and 8.3 percent of GDP in low-income developing countries.
  - Real interest rate surprises at a five-year horizon had little effect on unexpected debt increases (median contributions):
    - Less than 0.5 percent of GDP in advanced economies and low-income developing countries.
    - 1 percent of GDP in emerging markets.
- Correlations and implications:
  - High correlation (0.6 to 0.8) between contributions of surprises in primary balances and stock-flow adjustments, and between surprises in real interest rates and real exchange rates, implying that risks tend to materialize together ("when it rains, it pours").

### Mitigating and managing fiscal risks (policy practices)
- Practices to identify, measure, and mitigate fiscal risks:
  - Routine sensitivity analyses of fiscal aggregates to plausible changes in key macro parameters (growth, commodity prices, exchange rates) are widely used by many advanced economies and several emerging and low-income countries.
  - Stress tests and fiscal risk statements can inform fiscal strategies and framework flexibility.
- Budgeting and provision for contingent liabilities:
  - Budgeting for expected costs of contingent liabilities in medium-term fiscal plans helps ensure resources are available and clarifies trade-offs across policy instruments.
  - Expected costs can be budgeted on an annual cash-flow basis or on a net-present-value basis in the year of fiscal support (examples cited: Colombia, New Zealand, United States).
  - Complementary approaches include fair-value measurement to capture risk of default, recovery rates, and price of risk.

*Source: Chapter 2, "Strengthening the Credibility of Public Finances," Fiscal Monitor, International Monetary Fund | October 2021.*

### CHAPTER 2 STRENGTHENING THE CREDIBILITY OF PUBLIC FINANCES

### CHAPTER 2 STRENGTHENING THE CREDIBILITY OF PUBLIC FINANCES

### Risk Mitigation, Buffers, and Crisis Support
- The potential for additional, unexpected costs calls for building buffers when setting targets, for instance, for deficits or debt (IMF 2016; Eyraud and others 2018).
- A probabilistic approach that considers the historical realization of fiscal risks can be used to estimate debt ceilings (IMF 2016).
- Well-designed risk mitigation strategies can reduce risks—or limit fiscal costs if they materialize—and thereby support the credibility of fiscal frameworks.
- Examples of limiting exposure:
  - Placing limits on loan sizes and maturities.
  - Restricting eligibility under credit support schemes (example: Ukraine’s COVID-19 portfolio guarantees were restricted to enterprises above a certain risk class).
  - Providing partial guarantees to limit moral hazard (example: Spain’s COVID-19 guarantees limited guarantee coverage to 60–80 percent of a loan, depending on firm size and loan purpose).
- Conditions attached to support: state-owned enterprises or private companies receiving support may be asked to restructure, adopt more efficient production methods, or strengthen governance.
- Policy trade-off: decisions to mitigate or assume risks depend on the government’s fiscal position, institutional strength, and the state of the economy; during crises, assuming fiscal risks may bring net benefits, but guarantees and other exposures should not outlive their initial motivation once the recovery is under way.

### Fiscal Frameworks, Sustainability, and Credibility of Fiscal Plans
- Fiscal frameworks comprise long-term fiscal targets, fiscal rules, fiscal institutions, and budget procedures; they guide political deliberations toward convergence on fiscal objectives, including acceptable debt levels.
- Procedural rules (for example, medium-term expenditure ceilings) can control deficits and debt by providing space for judgment while incentivizing fiscal responsibility; effective where fiscal transparency and a constituency for fiscal sustainability exist (example: Australia and New Zealand fiscal responsibility legislation requiring a medium-term fiscal strategy and regular reporting).
- Design goals for fiscal frameworks:
  1. Sustainability of public finances.
  2. Stabilization of the economy through countercyclical fiscal policy, when appropriate.
  3. Simplicity for communication and accountability (Kopits and Symansky 1998).
- Desirable additional features: resilience, ease of monitoring, operational guidance, and enforcement.
- Trade-offs and a possible “trilemma” (Debrun and Jonung 2018): satisfying sustainability, stabilization, and simplicity simultaneously is difficult; examples:
  - Debt-to-GDP anchors are simple and predictive but may understate cost when interest rates trend downward.
  - Structural balance rules reduce procyclicality but are harder to monitor.
  - Commodity price or simple expenditure rules may leave room to increase debt.
  - Simple numerical rules can be rigid (Blanchard, Leandro, and Zettelmeyer 2021); procedural rules give flexibility but are harder to communicate and monitor without sound institutions (Martin, Pisani-Ferry, and Ragot 2021).
- Pandemic context:
  - The unprecedented fiscal response to COVID-19 led many countries to deviate from precrisis numerical objectives.
  - Nearly 50 countries have activated escape clauses in their fiscal rules or suspended their fiscal rule since the onset of the pandemic.
  - More than half of these are European Union or West African Economic and Monetary Union members covered by activation of escape clauses at the supranational level.
  - At the national level, most countries activated escape clauses; some opted to suspend their fiscal rules because of high uncertainty (examples: Colombia, Ghana, and Peru).
  - Countries are considering converging back toward old targets or resetting them within redesigned fiscal frameworks.

### Specifying and Pursuing the Long-Term Fiscal Target
- Common anchors: debt or the budget balance; new proposals include the interest bill and public sector net worth.
- Trade-offs:
  - Debt-to-GDP ratio: simple, easy to monitor, and has predictive power for crises (Moreno Badia and others 2020), but may not capture cost of debt if interest rates trend downward.
  - When combined with a deficit limit (example: European Union’s Stability and Growth Pact), a lower long-term economic growth rate implies a higher long-term stable debt ratio consistent with a given deficit limit (Buti and Gaspar 2021).
- Interest bill as an anchor:
  - Argued to be attractive while interest rates remain low (Furman and Summers 2020).
  - Assessments have used indicators involving the interest bill—as a share of GDP and as a share of fiscal revenues (IMF 2003).
  - Advantages in a few countries with very low rollover risk (example: the United States).
  - For the majority that need to manage rollover risks, the interest bill can increase quickly during debt crises; the stock of debt is more informative if a single indicator is needed (but information on interest bill, debt maturity, gross financing needs is valuable).
  - The interest-bill-to-GDP ratio is more cyclical than the debt-to-GDP ratio in countries where interest rates tend to rise when GDP falls—as in many emerging markets (Figure 2.7). A binding interest bill ceiling would force even more fiscal adjustment in a recession.
- Public sector balance sheet measures:
  - Consider assets governments and public corporations hold (financial assets, public buildings and infrastructure, land, natural resources).
  - Example: New Zealand’s fiscal framework includes a long-term objective for net worth alongside a traditional net debt anchor to help protect public investment.
  - Measuring net worth requires sound valuation of public assets and high-quality, transparent, and credible fiscal accounting.
  - Ringfencing spending (as in a golden rule excluding public investment) creates incentives to misclassify current spending as protected investment expenditure.

### Fiscal Rules and Fiscal Prudence — Empirical Findings
- Empirical evidence suggests existing fiscal rules have contributed to lower deficits (Bergman, Hutchison, and Hougaard Jensen 2016).
- Debrun and others (2008): in 1990–2005, fiscal rules were associated with higher primary balances and structural primary balances, controlling for endogeneity.
- Caselli, Stoehlker, and Wingender (2020): for countries that would have had large deficits absent a fiscal rule, having adopted a fiscal rule improved the primary balance.
- David, Gonçalves, and Perrelli (forthcoming) panel analysis (55 countries over 1970–2018) finds:
  - On average, governments react to increases in debt and in the interest bill (fiscal reaction function) by tightening the primary balance (Figure 2.8), implying debt ratios can be expected to decline and stabilize after a shock to debt or to debt service.
  - In countries with debt rules, jumps in debt lead to an even stronger tightening of primary balances.
  - Countries that have followed a debt rule have typically managed to reverse a jump in debt amounting to 15 per cent of GDP in about 10 years—in the absence of new shocks—significantly faster than other countries (Figure 2.9).
  - Governments that follow budget balance rules raise the primary surplus more forcefully in response to increases in the interest bill.

### Ensuring Flexibility in Fiscal Rules
- Rigid fiscal rules can make policy procyclical, especially for public investment (Fatás and Mihov 2007; Guerguil, Mandon, and Tapsoba 2017).
- Evidence: fiscal rules without flexibility are associated with more procyclicality; when flexibility is allowed, fiscal rules are not associated with more procyclicality (Bova, Carcenac, and Guerguil 2014; Gootjes and de Haan 2020).
- Approaches to improve flexibility:
  - Cyclically adjusted fiscal balance or structural fiscal balance rules (Fedelino, Ivanova, and Horton 2009; Bornhorst and others 2011) — but they increase complexity and challenge monitoring and enforcement; real-time assessment of the cyclical position is difficult (Orphanides and van Norden 2002).
  - Expenditure rules are easier to monitor and permit countercyclical fiscal policy by constraining spending during booms (Ayuso-i-Casal 2012; Belu Manescu and Bova 2020); they also help protect important spending during downturns. Basic expenditure rules do not accommodate permanent changes in the size of the public sector unless recalibrated.
  - More sophisticated expenditure rules can allow spending to grow above the limit if matched by increases in discretionary revenues, at the cost of greater complexity.
  - Proposal to automatically suspend the fiscal rule when the monetary policy rate reaches its effective lower bound (Portes and Wren-Lewis 2015) — rationale: fiscal policy is especially potent when monetary policy is constrained; caveat: for many advanced economies the policy rate has long been close to the lower bound, making the termination condition unclear.
- Escape clauses:
  - Allow deviations from the rule in times of need; should be well specified and activated only for events beyond government control (severe recessions, natural disasters, pandemics) (Eyraud and others 2018).
  - Many countries activated escape clauses in 2020 to accommodate revenue drops and increased health and social spending.
  - Determining how and when to return to the rule after activation is difficult; some rules require offsetting accumulated deviations, which may not be economically or politically feasible.

### Returning to the Rule or Recalibrating It
- Many countries that suspended rules during the pandemic are considering recalibrating them to accommodate higher debt levels and provide more post-crisis flexibility.
- Trade-off:
  - Revising rules can improve credibility if returning to an old rule would require excessive fiscal consolidation on macroeconomic or distributional grounds.
  - Revising targets may signal weaker commitment to fiscal sustainability; credibility of a target is low if the effort to achieve it makes future compliance harder (Drazen and Masson 1994).
  - Fiscal consolidation that damages growth potential complicates the trade-off.
- Policy principle: whether to return to an old rule or redesign/recalibrate depends on country-specific circumstances; benefits of recalibration are higher when reconvergence would require excessive consolidation.

*International Monetary Fund | October 2021*

### CHAPTER 2 STRENGTHENING THE CREDIBILITY OF PUBLIC FINANCES

### CHAPTER 2 STRENGTHENING THE CREDIBILITY OF PUBLIC FINANCES

### Recalibrating and Redesigning Fiscal Rules
- Revising fiscal rules may be warranted when pre–COVID-19 rules are outdated or economically counterproductive; however, frequent changes weaken credibility.
- Options when rules are suspended or impractical:
  - Introduce fiscal responsibility laws or fiscal pacts to build consensus on revenue mobilization or adjustment paths before recalibrating or adopting new rules.
  - Use a transition regime with a less ambitious interim target that remains consistent with eventual convergence to the old rule.
  - Redesign or recalibrate rules in the post–COVID-19 period where appropriate, but avoid revamping frameworks that were implemented or reformed too recently.
  - Ensure redesigned frameworks include realistic goals agreed upon by a broad coalition (government, political parties, civil society).
- Communication matters:
  - Well-communicated revisions can preserve credibility (example: Israel’s 2013/14 deficit ceiling revision and Fitch reaffirmation at “A”; Mongolia’s 2015–17 revisions raised concerns but IMF program negotiations in 2017 afforded some credibility).
  - Media reaction to suspending rules in 2020 was more positive in countries with high fiscal transparency and established market access.
  - An active and comprehensive communication strategy can help explain reforms and protections for the vulnerable (Stankova 2019).

### Strengthening Underlying Fiscal Institutions
- Independent review of macroeconomic assumptions can enhance credibility; some advanced economies delegate macro forecasting to independent institutions (for example, Austria and the United Kingdom).
- Well-designed fiscal councils are associated with stronger fiscal performance and more accurate and less biased forecasts (Debrun and Kinda 2014).
- Comprehensive medium-term budgets that reflect all planned fiscal activities reduce risks of hidden deficits and help ensure plans are consistent with objectives.
- Effective financial controls and tax administration improve implementation capacity:
  - The predictability of revenues is positively correlated with a tax administration’s effectiveness and the quality of governance (Figure 2.10).
  - Implementing tax and spending reforms during or immediately after a crisis while minimizing adverse private-sector effects is challenging.
- Transparency and disclosure:
  - Transparent reporting of macroeconomic and fiscal projections, underlying assumptions, and deviations, in line with international standards such as the IMF Fiscal Transparency Code (IMF 2019), underpins market confidence.
  - Disclosing risks (for example, in fiscal risk statements) and regular monitoring encourages better risk management.
- For low-income developing countries and fragile states: develop core public financial management systems (annual budget processes, medium-term forecasts, financial controls, reporting mechanisms).
- For advanced economies and emerging markets: improve medium-term frameworks, budgets, and risk analysis and management to support predictability and credibility.

### Improving the Predictability and Credibility of Fiscal Plans
- Credibility concept: If a government budget announcement is credible, private expectations about the budget balance should be centered around government projections with minimal disagreement among forecasters.
- Empirical findings:
  - On average, governments project significantly lower fiscal deficits than the private sector for both the current calendar year and the next fiscal year.
  - Strong fiscal frameworks and fiscal rules increase the credibility of official projections (Figure 2.11).
    - Private forecasts are closer to official projections in countries with debt rules or deficit rules, and where frameworks include a fiscal council or an independent monitoring agency.
  - Budget balance rules tend to anchor private sector expectations toward the rule’s deficit ceiling:
    - Adoption of EU fiscal rules led to deficits converging to the 3 percent of GDP limit embedded in the Stability and Growth Pact (Caselli and Wingender 2021).
    - In the European Union, uncertainty on the budget deficit widens when budgets deviate from the –3 percent of GDP limit.
  - Past achievement matters:
    - The private sector is more pessimistic after official projections that have made large forecast errors.
    - Downward revisions to official fiscal balance projections increase the gap between official and private forecasts.
  - Announced fiscal adjustments are discounted by the private sector:
    - On average, private forecasters give credit for only one-fourth of the adjustment planned for the next year (Figure 2.12).
- Credibility affects borrowing costs:
  - When private forecasts are more pessimistic than official projections by 2 percent of GDP, 10-year sovereign yields increase by 6 basis points (Figure 2.13).
  - Budget announcements lead to a fall in interest rates around announcement time in high-credibility countries, but show no visible effect in low-credibility countries (Figure 2.14).
    - The difference can be as much as 40 basis points in the month of announcement, though the gap closes subsequently.
  - Credibility is slow to build and fast to lose; preserving credibility helps avoid adverse market conditions.

- Empirical sample and statistical notes:
  - Regressions for Figure 2.11 use 423 observations covering 23 advanced economies and 9 emerging markets over 1997–2019 (Online Annex 2.4).
  - Figure 2.13 bin scatter plots are based on 3,071 observations covering 34 countries from 2001 to 2019.
  - Credibility thresholds: high credibility is defined as above the 75th percentile; low credibility is below the 25th percentile (Figure 2.14). Figures exclude announcements during the global financial crisis and in years of sovereign debt crisis.

### Conclusion and Policy Recommendations
- Context: Fiscal support during COVID-19 remains indispensable in most places, but buffers have dwindled.
- Policy trade-offs:
  - Where fiscal space remains, prolonging support to fight the health crisis and bolster recovery is appropriate.
  - In many countries, governments face a trade-off between additional support and preserving space for future emergencies.
- Strengthening credibility can reduce the cost of this trade-off:
  - Market access is more favorable when the private sector trusts the government’s commitment to fiscal sustainability.
  - Credibility is also important for countries with limited market access to achieve predictability, foster private investment, and maintain macroeconomic stability.
- Design considerations for fiscal frameworks:
  - The appropriate design and calibration of long-term fiscal targets is country specific and may change with circumstances.
  - The persistent decline in global interest rates since the global financial crisis may have increased debt carrying capacity; pre–COVID-19 debt anchors might be too conservative.
  - Easy financing conditions may continue for a few years, but an increase in interest rates cannot be ruled out and could worsen fiscal accounts and raise debt crisis risks.
  - Embedding more flexibility (for example, expenditure rules instead of budget balance rules) can support exit from the crisis.
  - Consider objectives beyond debt-to-GDP (for example, a net worth target for the public sector or an anchor based on the interest rate bill) where rollover risks are limited and transparency standards are high.
  - Countries that suspended fiscal rules may need to redesign or recalibrate pre–COVID-19 rules, balancing constraint and credibility costs.
- Strategies to signal commitment to future deficit reduction:
  - Strengthen fiscal frameworks to improve compliance with fiscal rules.
  - Undertake structural fiscal reforms.
  - Enter into an IMF-supported program.
  - Legislate future tax or spending changes in advance.
- Communication and transparency:
  - Clear communication of priorities, fiscal transparency, and commitment-strengthening strategies facilitate transition to new objectives.
  - Activating escape clauses during the pandemic was less controversial in countries with high fiscal transparency.

### Assessment of Debt Sustainability Scenario Analysis
- Coverage of analysis: 36 advanced economies, 88 emerging markets, and 58 low-income developing countries; complemented by review of selected national fiscal institutions’ fiscal risk analyses.
- Findings on scenario performance (Figure 2.1.1):
  - Growth shocks:
    - In about 80 percent of IMF debt sustainability analyses for market access countries (advanced economies and emerging markets), growth scenarios envisioned short-term debt increases larger than actual projection errors from growth shocks.
    - In low-income developing countries, temporary growth scenarios anticipated short-term debt increases in only one-third of episodes.
    - In all country groups, capacity to anticipate adverse debt dynamics is weaker over the medium term (3–5 years) than the short term (1–2 years).
  - Exchange rate depreciation, primary balance slippages, and contingent liabilities were better captured at the short-term horizon than at the medium-term horizon.
  - Real interest rate surprises were the hardest to flag:
    - Higher-than-expected real interest rates during the period were driven by inflation undershooting expectations.
    - Inflation undershoots occurred across diverse countries (examples cited in the source: Equatorial Guinea in 2015; China and Canada in 2014; Iceland in 2016).
    - National fiscal institutions’ fiscal risk analyses (for example, The Netherlands, New Zealand, the United Kingdom, and the United States) often did not include the risk that inflation could undershoot expectations.
- Note on exercise methodology:
  - The real interest rate scenario effectiveness analysis is based on 197 (short term) and 139 (medium term) IMF debt sustainability analyses for market access countries and 56 (short term) and 37 (medium term) European Commission debt sustainability analyses.

*International Monetary Fund | October 2021*

### Box 2.1. Evaluating How Well Scenarios in Debt Sustainability Analyses Capture Key Fiscal Risks

### Box 2.1. Evaluating How Well Scenarios in Debt Sustainability Analyses Capture Key Fiscal Risks

### Methodology
- Sample: 36 countries, including cases where escape clauses were activated at the supranational level (European Union and West African Economic and Monetary Union).
- Text corpus: 1,364 articles in each country’s official language referring to the escape clause in the two weeks before and after its activation.
- Approach: Text analysis following methods used in research on media perception of economic policies (Fraiberger 2016; Shapiro, Sudhof, and Wilson 2020; Shapiro and Wilson 2021).
- Country group composition and article frequency:
  - 13 advanced economies
  - 15 emerging markets
  - 8 low-income developing countries
  - Average of 38 articles per country

### Media findings on topics and emphases
- Exceptional circumstances and government response were emphasized; relevant keywords included “pandemic”, “COVID”, “crisis”, “fiscal”, “deficit”, “health”, “support”, “measure”, and “budget”.
- Debt and market-access concerns:
  - More than half of the news articles acknowledged the effect on debt.
  - Share acknowledging debt effect reached 73 percent among advanced economies.
  - “Corona bonds” were discussed in 7 percent of the news articles in European advanced economies.
  - “Bonds” were mentioned in 23 percent of the articles of emerging markets.
  - “Investors” were mentioned in 11 percent of the articles of emerging markets.
  - The name of a credit rating agency was between 7 and 10 times more likely to be mentioned for low-income developing countries and emerging markets, respectively, than for advanced economies.
- Lower-income groups paid more attention to issues of credibility, the medium term, and debt sustainability (see Figure 2.2.1, panel 2).

### Media sentiment and transparency links
- Sentiment measurement:
  - Tone scale: –1 (most negative) to +1 (most positive).
  - The average and median score across countries was about 0.
  - Perception was especially positive in Honduras and Peru.
- Transparency association:
  - Perception tended to be more positive in countries with stronger standards of transparency (see Figure 2.2.1, panel 3).
  - This highlights the importance of transparent, timely, and comprehensive reporting of fiscal information, and oversight by audit institutions, parliaments, and civil society for building credibility and public trust.

### Communication and policy implications (best practices)
- Preserving credibility when activating escape clauses requires an effective communication strategy.
- Identified best practices include:
  - Publication of a credible medium-term fiscal framework (examples: Honduras and Panama).
  - Government reports on relevant programs (examples: Chile and Germany).
  - Analysis by independent agencies (examples: Colombia and Peru).
- These practices align with literature linking fiscal transparency to stronger credit ratings and easier market access.

*Source: Box 2.1, Fiscal Monitor: Strengthening the Credibility of Public Finances, International Monetary Fund | October 2021*

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_Source: https://www.imf.org/-/media/files/publications/fiscal-monitor/2021/october/english/ch2.pdf_