The writer, incoming Professor of Practice at Georgetown University, is a former deputy research director at the IMF
The human suffering wrought by Sri Lanka’s recent debt default is a tragedy. Sri Lankans unable to get access to life-saving medicines, food, water or fuel show the human dimension of financial problems.
But the tragedy is not restricted to one country. There is a serious risk it could prove to be much more widespread, given the proportion (nearly 60 per cent) of the world’s poorest countries that are already classified as being in debt distress or at high risk of it. And debt service burdens in middle-income countries are also worrying — even before one factors in the spillovers from higher US interest rates. These will tighten financial conditions globally, and thereby raise the odds of default in emerging market economies with unhedged balance sheets, lagging economic recoveries and shorter-maturity public debt.
The international community has called for much greater transparency about the extent of the liabilities of over-extended sovereign borrowers, in order to assess and contain the risks of protracted and disorderly defaults. But as important as greater debt transparency is, there is a separate problem that has received much less attention: the need for accurate forecasts of the evolution of public debt over time.
To set interest rates, the US Federal Reserve needs to know not just how high inflation is today, but also how it is likely to develop. Similarly, governments and the international community need to have both an accurate measure of public debt and an unbiased forecast of its future path if they are to be able to plan policy and to develop robust fiscal strategies consistent with debt sustainability. Unfortunately, the reliability of public debt forecasts, particularly for emerging and developing countries, is seriously wanting.
This finding comes from a recent study of the accuracy of public debt forecasts published by the official and private sectors. Such forecasts proved to be biased. That is, projected debt over a five-year horizon was lower on average than the ultimate reality. The forecasts by the official and private sectors were equally biased, and the bias for emerging and developing countries was unrelated to the failure to anticipate recessions, which is a perennial problem in the business of projecting. In other words, the bias was systematic.
Forecasts that are worth paying attention to should be unbiased. Sometimes the reality will be higher than the projection, sometimes lower. But an unbiased projection is one that is not, on average, on one side or the other of the reality.
The bias is more severe in circumstances in which there is a particularly acute need for sobriety; that is, when there has been an increase in public debt and the projection is for the ratio of debt to gross domestic product to decline. Historically, projections of declining public debt are the ones that are particularly suspect, with a bias of about 11 per cent of GDP.
A good compass is essential to know where you’re going. But in the realm of public debt forecasts, we lack such a reliable guide.
Why is this a problem today? As the risk of sovereign defaults spreads, systematically optimistic public debt forecasts for emerging and developing countries are a serious issue. They may breed complacency and lead to inadequate planning, particularly when the historical bias is so large and chronic. Indeed, were the average bias of past years to be seen in today’s environment, many emerging or developing countries would find themselves with debt ratios that, rather than declining as projected over the next five years, would stabilise at, or rise to, levels that have traditionally signalled a crisis.
There is an urgent need, therefore, to repair the compass and remove the bias in public debt forecasts.
Source: Economy - ft.com
