Parameter Estimate Uncertainty in Probabilistic Debt Sustainability Analysis

Abstract

This paper extends the probabilistic debt sustainability analysis (DSA) developed by Celasun, Debrun, and Ostry (2006) to account explicitly for parameter estimation errors in the debt projection algorithm. This extension highlights public debt projection uncertainty resulting from both the intrinsic volatility of debt determinants and the inaccuracy of the parameter estimates of econometric models employed in the projections. The revised algorithm is applied to conduct a debt sustainability analysis of Uruguay. As part of this exercise, a restricted vector autoregression and a country-specific fiscal reaction function are employed. The resulting increase in the variance of the debt projections that account for the uncertainty of parameter estimates in the forecast is smaller than may have been anticipated, as the improved specification of the underlying econometric model reduces the variance of debt projections. Hence, more precise estimates of economic fundamentals and fiscal policy reaction allow for a feasible debt forecast with a more accurate depiction of its inherent forecast uncertainty.

Identifying Fiscal Policy Transmission in Stochastic Debt Forecasts

“…In addition, the proposed framework builds on prior work that both reduces and more accurately depicts the uncertainty surrounding debt forecasts. As in Litterman (1983) and Hajdenberg and Romeu (2010), forecast uncertainty in this study reflects the uncertainty stemming from parameter estimates. Hence, at each step of the forecasting algorithm, macroeconomic aggregates and the primary balance are projected from a draw of the distribution of the estimated parameters, rather than the estimates themselves.…”

“…While for the country studied here (Brazil) a long quarterly historical time series is not available, for comparison with prior studies, the existing quarterly data is used. Nevertheless, as in Issler and Lima (1998) and Hajdenberg and Romeu (2010), a long-term (45 year) data set is constructed for the system estimation.…”

Fiscal Sustainability of Local Governments in the Visegrad Group Countries

“…An important disadvantage of the sustainability indicators is that they are used in an environment without uncertainty (Chalk & Hemming, 2000, p. 9). Uncertainty should be incorporated into fiscal sustainability analyses to make the study more comprehensive (Bohn, 1995;Hajdenberg & Romeu, 2010;Tanner & Samake, 2008;Barnhill Jr. & Kopits, 2004).…”

Evaluation of Sustainability of the General Government Debt in a Small Open Economy

“…Lately, however, it is increasingly recognized that in applied economic and financial models, the accuracy of the results is strongly influenced by the use of stochastic variables (Consiglio & Staino, 2012;Date et al, 2011;Hajdenberg & Romeu, 2010;Frank & Ley, 2009;Ciegis et al, 2009;Ferrarini, 2009;Budina & van Wijnbergen, 2009;Ferrarini, 2008;Tanner & Samake, 2008;Genberg & Sulstarova, 2008) and complex analysis of debt indicators (Knedlik & Von Schweinitz, 2012;Sopek, 2009). These methods are increasingly being used as an effective tool to assess and predict the debt-related risk.…”

“…Various government debt sustainability assessment methodologies are considered by Faraglia et al (2013), Teica (2012), Choi et al (2010), Hajdenberg and Romeu (2010), Frank and Ley (2009), Neck and Sturm (2009), Sopek (2009), Genberg and Sulstarova (2008, Wyplosz (2007), Telatar et al (2004), Uctum ir Wickens (2000). In general, in scientific literature there is no consensus, what are the government's debt sustainability criteria and assumptions for sustainable debt.…”