In this third station, you will be guided through the tools used to assess the realism of medium- to long-term macroeconomic projections discussed in Station 2. These projections constitute the baseline scenario and are critical inputs to the DSF.
DSAs are only useful if the assumptions underlying them are realistic, rather than optimistic or pessimistic. To promote this realism, the 2017 review of the LIC DSF includes four realism tools.
These realism tools scrutinize the past and future drivers of debt dynamics, the planned fiscal adjustment, the potential impact of fiscal adjustment on growth, and the public investment-growth nexus.
Why do we need realism tools?
The realism tools are designed to examine the baseline assumptions and are not meant to be prescriptive. Rather, they encourage a deeper analysis of inputs by:
- Helping you assess the key macroeconomic and debt projections, which are the main inputs into the LIC DSF;
- Providing a point of comparison for forecasts, whether drawing on a country’s own history, cross-country experience, or on relationships drawn from economic theory;
- Informing you of situations in which important drivers of the macroeconomic baseline debt projections deviate from experience with either an optimistic or a pessimistic bias; and
- Highlighting the realism of your key assumptions to focus the DSA write-up on discrepancies within the macroeconomic framework.
Summary of the LIC DSF Realism Tools
The LIC DSF includes four realism tools, with each examining a different aspect of the macroeconomic framework.
- Drivers of Debt Dynamics: What has contributed to unexpected debt increases in the past, and what is assumed going forward?
- Planned Fiscal Adjustments: What is the assumed fiscal adjustment? Is it realistic relative to cross-country historical experience?
- Growth and Fiscal Adjustment: What is the assumed relationship between fiscal adjustment and growth?
- Growth-Accounting and Public Investment: What is the assumed relationship between public investment and growth?
Tool 1: Debt Dynamics
The three charts below help you to identify and scrutinize historical and projected drivers of debt dynamics. Each illustrates the evolution of projections of external and public debt-to-GDP ratios over DSA vintages (from one year and five years ago).
The growth and fiscal adjustment tool identifies when assumed growth rates in countries undertaking fiscal adjustments suggest further examination of the growth trajectory.
Recall: Fiscal Multiplier
The fiscal multiplier is a summary statistic of the impact that fiscal tightening has on GDP.
A multiplier of 0.4 (the estimated average in LICs) implies that, with all other factors constant, a fiscal adjustment that results in a 1 percentage point improvement in the primary balance would reduce GDP growth by 0.4 percentage points in the year of the adjustment.
Growth-Accounting and Public Investment
Projected growth rates are decomposed into two contributing components:
- Changes in the government capital stock due to public investment, and
- All other sources.
These two components of growth can then be compared with historical data and all previous projections.
- This tool can help assess the consistency of growth projections in countries with a scaling-up or scaling-down of public investment.
- The chart below shows that public investment projections will scale-up in the current 2013 DSA at a much higher rate than in the past, and than in what had been projected in the previous 2012 DSA.
- This tool will also alert you to any increase or decrease in public investment not associated with higher/lower growth rates. This may in turn motivate a deeper discussion regarding such results.
- The chart below shows that, based on the 2008-2012 average, public investment contributed less than 2 percentage points of real GDP growth (left-most bar).
In the example below, the contribution of government capital to overall growth is much larger than the history and the previous DSA vintage reflecting an increase in public investment. Other things equal, one would expect an increase in overall growth which is projected to be very similar to the previous vintage. Are there crowding out effects in the private sector?
- Is there reason to believe that the improvement in efficiency of public investment is higher/lower than the LIC average, leading to a higher/lower growth response?
- Is there a reason to project an improvement in the efficiency of investment that would lead to a higher contribution to growth? For instance, because of institutional strengthening?
- Is there any reason to believe that the impact of investment on outputs will be higher/lower than the LIC average, leading to a higher/lower growth response?
- Is there any reason to project an improvement in the impact of investment on output leading to a higher contribution to growth? For instance, better prioritization of projects with strong multiplier effects?
Takeaways for Station 3
- DSAs are only useful if the assumptions underlying them are realistic (rather than optimistic). This is why the 2017 review of the LIC DSF added the four realism tools.
- The four realism tools help examine the realism of the medium-term macroeconomic projections under the baseline scenario. They include checking the realism of the (i) drivers of debt dynamics, (ii) planned fiscal adjustment, (iii) growth and fiscal adjustment, and (iv) public investment and growth relationship.
- These realism tools are not meant to be prescriptive: every time they flag that the baseline diverges from cross-country or historical experience, a written explanation is expected to clearly discuss the underlying reasons for such divergence.
- Based on the outcomes of the realism tools' scrutiny, the baseline macroeconomic projections can and should be revisited to make them stronger and more consistent.