IV Fiscal Sustainability : A Value - at - Risk Approach

ecurring debt problems and high public debt have brought the issue of fiscal sustainability to the foreground in several Central American countries. Although public debt-to-GDP ratios have started to come down in recent years, they still exceed 50 percent in most of the region's countries, making the debt a source of vulnerability that deserves close attention. Over the past three decades, the region experienced a number of debt write-downs, and high debt levels have constrained implementation of effective policy responses in the case of adverse shocks (see Offerdal, 2004). There has been no regional study on public debt sustainability in Central America. So far, sustainability assessments have been country specific, aimed at ensuring attainment of fiscal viability for the country in question. As a consequence, the results of existing sustainability assessments are less suited for comparisons across the region. Although substantial progress has been made in recent years, the methodology of debt and fiscal sustainability assessments are still at an early stage of development. 1 Projections of debt dynamics, which are intrinsically uncertain and highly variable, are typically stable and deterministic with only a limited number of possible outcomes being explored. As stated by the International Monetary Fund (2002, p. 6), ". .. assessments of sustainability are proba-bilistic, since one can normally envisage some states of the world under which a country's debt would be sustainable and others on which it would not. Standard frameworks currently used do not supply these probabilities explicitly; rather, they trace the implications of alternative scenarios and leave the user to determine the respective probabilities. " To assess the degree of vulnerability posed by current debt levels in Central America, this study summarizes recent sustainability assessments and proposes a complementary probabilistic framework to evaluate sustainability. The traditional debt sustainability framework is taken one step further by estimating explicitly the probabilities of alternative scenarios using a common set of assumptions. 2 A Value-at-Risk (VaR) approach is utilized to calculate the probability distribution of the debt-to-GDP ratios of several Central American countries, the latter used as proxy for the degree of fiscal vulnerability. This VaR approach is in line with the stochastic simulation method suggested in IMF (2003). The approach is not, however, without drawbacks since the VaR approach is based entirely on historical data. This caveat applies, in particular, in the case of a regime change, like the one in El Sal-vador, which officially dollarized in …