An early-warning indicator for debt sustainability

Casper van Ewijk, Jasper Lukkezen, Hugo Rojas-Romagosa, 28 November 2013



Insight into the sustainability of public finances is critical to European policymakers and financial markets alike. It informs decisions concerning the need for reform and the determination of the appropriate risk premium on government debt. Furthermore, unsustainable public finances may cause significant spillovers, highlighting the need for international fiscal surveillance. Recent experiences in Europe underscore how hard it is to foresee sovereign debt crises, with regard to both occurrence and depth; assessment of public finances is no easy task.

Therefore there is a need for a dynamic, forward-looking framework to assess the stability of public finances in the medium term. Our approach entails a simple and practical stochastic simulation that incorporates the budgetary reaction of the governments to economic setbacks. The framework is stylised and focuses on the three key variables that determine debt dynamics: the interest rate, the growth rate of gross domestic product (GDP), and the stance of fiscal policy. Higher interest rates spur the growth of debt, whereas higher growth rates and a stronger responsiveness of the budgetary policy to debt help to keep debt under control.

Are governments in control of their debt?

The responsiveness of budgetary policy is measured by the reduction in the government deficit (or the increase in the surplus) for any euro increase in debt. We will henceforth call this the fiscal response. A positive fiscal response means that we expect governments to take actions to reduce the deficit (or increase the surplus) when the debt ratio rises. A zero or negative value indicates that governments fail to respond effectively, or even exhibit the perverse reaction of increasing the deficit when debt increases (labelled ‘fiscal fatigue’ by Ghosh et al. 2013). The responsiveness of fiscal policy – which reflects the quality of the fiscal institutions and 'budgetary culture' of each separate country – tends to be persistent over time.

Combining the fiscal response function with a stochastic model of interest rates and growth rates for each country we can simulate the evolution of public finances over a medium term horizon (see also Celasun et al. 2006 and Budina and Van Wijnbergen 2008 for a similar approach). Using multiple simulations yields a distribution of possible time paths for future public debt-to-GDP ratios. Figure 1 shows the simulated evolution of the UK vis-à-vis the Icelandic debt level (from Van Ewijk et al, 2013). The striking difference between these two graphs is the spread in the outcome. The expected growth of debt is more or less similar, but Iceland features a far larger risk of a sharp increase in debt. The higher macroeconomic volatility in Iceland translates into a significantly wider band of plausible future debt levels. This indicates a large risk exposure for Iceland relative to the UK.

Figure 1. Large risk exposure of Iceland in comparison to the UK.

Notes: Debt levels in % of GDP. The black line is the median debt path, the light orange area contains 90% of the debt paths, the light and the dark orange area contain 95% of the debt paths, and the blue reference lines are at 60 and 90% of GDP respectively.

Figure 2 illustrates how important the policy response is in reducing the risk exposure of a country. For Spain we find no significant fiscal response based on history over the past decades. The lack of a policy response leads to a wide spread in outcomes. If we alternatively assume that Spain would have an average fiscal response of 7% – with a 100% higher debt to GDP ratio leading to a 7% higher primary surplus to GDP – the confidence bands are substantially smaller.

Figure 2. Fiscal response reduces uncertainty

Notes: see Figure 1.

An indicator for debt sustainability

These simulations indicate that the uncertainty in outcomes is more important for the risk of a debt crisis than the expected evolution of debt on average. This idea is captured in a comprehensive ‘at risk’ indicator for assessment of fiscal policy. The indicator measures the degree to which governments are in control of their public finances by estimating the risk of a significant debt increase in the near future. Specifically we take the distance between the 97.5th percentile and the median after ten years as an indicator for the upward risk in the debt ratio. Thus, the 'at risk' indicator measures the possible increase in debt that might happen with a probability of 2.5% within a time horizon of ten years.

Table 1. 'At risk' indicators for debt sustainability, 2011–2021

2011 Initial debt 102 82 65 99 80 120 68 107 99
2021 'At risk' indicator 6 9 8 6 11 33 59 167 54

Notes: Debt levels and indicator values in % of GDP.

The first row of Table 1 reports the debt level at the end of 2011. The second row reports the 'at risk' indicator measuring the upward risk of a debt increase at the end of 2021. The ‘at risk’ indicator distinguishes countries with few to no debt sustainability concerns (US, UK, Netherlands, Belgium and Germany) from countries with serious debt-sustainability issues (Italy, Spain, Portugal, Iceland).

An interesting question is how this indicator would have performed when it was calculated before the current debt crisis, for example in 2007. Figure 3 reports the ‘at risk’ indicator in 2007 and plots it against the market perceptions of default risk per country during the period 2009-2012, as measured by the five-year Credit Default Swap (CDS) rate. This graph indicates that the ‘at risk’ indicator is able to distinguish between countries with and without debt sustainability concerns in line with actual risk as perceived by the market during the crisis. The US, UK, the Netherlands and Belgium pose negligible risk, with Germany and Iceland posing small risk and Italy and Spain face debt sustainability concerns, while Portugal faces the highest risk in our sample. However, in 2007 the market perceptions did not distinguish between these countries: the CDS spreads were virtually zero then.

Figure 3. The 2007 ‘at risk’ indicator vs default risk 2009-2012

Note: Indicators in % of GDP; rates in basis points for 5 year CDS, observation window January 2009 until November 2012.

How should we use these indicators?

Static indicators such as the size of public debt or the deficit are often used to assess government finances. While these parameters are straightforward and unambiguous, they provide little information on the uncertainties facing public finances in the years to come. Also, these indicators neglect the role of the policymaker in controlling public debt. For the long term, the European Commission employs long-range projections to assess the sustainability of public finances against the background of ageing populations. These projections are essentially static as well, since they take the economic policy arrangements and the economic environment as given. There is ample evidence that the responsiveness of fiscal policy to economic setbacks and the quality of fiscal institutions are essential to debt sustainability.

The ‘at risk’ indicator fills this gap, although some caveats apply. First, the indicator focuses on the medium term and does not provide information on short term events –whether Spain will be able to roll over its debt in the coming months, for example. Second, the fiscal response measures how – over medium and long time periods – the government of a particular country has dealt with medium-sized changes in debt levels. Therefore it does not take full account of recent institutional reforms that are introduced to strengthen budgetary discipline. Finally, the underlying economic process is modelled very simply. A more structural approach could provide insight into what policies may be best to avoid sustainability problems. Our ‘at risk’ indicator is not meant to replace current indicators, but rather to complement indicators monitoring the actual state of public finances. The main contribution of our indicator is that it points out how important uncertainty is to public finances, and how important proper fiscal institutions are in dealing with this uncertainty. This may provide guidance on whether or not it is reasonable for a country to join a monetary union. In such a union, it is harder to control public debt by monetary and exchange-rate instruments, and more weight is put on the quality of fiscal institutions to keep public finances under control.


Bohn, H (1998), “The Behavior of US Public Debt and Deficits”, Quarterly Journal of Economics 113(3): 949–963.

Budina, N and S van Wijnbergen (2008), “Quantitative Approaches to Fiscal Sustainability Analysis: A Case Study of Turkey since the Crisis of 2001”, World Bank Economic Review, 23(1): 119–140.

Celasun O, X Debrun and J Ostry (2006), “Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A ‘Fan-Chart’ Approach", IMF Working Papers 06/67.

Van Ewijk, C, J Lukkezen and H Rojas-Romagosa (2013), An early-warning indicator for debt sustainability, CPB Policy Brief 2013/8.

Ghosh, A, Kim, J, E Mendoza, J Ostry, and M Qureshi (2013), “Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies”, The Economic Journal 123(566): F4–F30.

Topics: EU institutions, Global crisis
Tags: eurozone, sovereign debt crisis

Economist at the Macroeconomic Analysis Department, CPB Netherlands Bureau of Economic Policy Analysis

Research Economist, CPB Netherlands Bureau of Economic Policy Analysis

Professor of Economics, University of Amsterdam and Director, Netspar

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