1. Macroeconomic Assessment and Risk Management Framework
Macro - I
Macroeconomic Assessment and Risk Management Framework

2. Outline of the lecture - Introduction / Overview
- Identification of macroeconomic risks
- Filling up the RMF

3. Macroeconomic framework Public financial management
Overview
Budget support is an aid modality. It involves the transfer of financial resources to the national Treasury of a partner country.
The process that leads to BS involves 4 assessments by the Commission of (the relevance and credibility of):
Public policies
Macroeconomic framework
Public financial management
Transparency and oversight of the budget process.

4. Public Financial Management risks Corruption and fraud
Overview
The risk assessment framework helps anticipate, monitor and react to political or economic development in the economy. 5 risk categories are considered
Political risks
Macroeconomic risks
Development risks
Public Financial Management risks
Corruption and fraud
The materialization of any of these risks is likely to significantly reduce the effectiveness of budget support unless adequate mitigating measures are taken by the partner country

5. Outline of the lecture - Introduction / Overview
- What is macroeconomic stability?
- Detecting macroeconomic risks
- Filling up the RMF

6. Macroeconomic Stability
Key elements of macroeconomic stability:
Sustainable balance of Payments (external balance)
Low and stable inflation and low unemployment (internal balance)
Public debt sustainability (internal balance)
Sound financial system
Sustainable private (corporate and household) debt

7. Macroeconomic Stability
Growth is hard to achieve without a sustainable balance of payments
External crisis usually brings disruptions to imports and capital flows that can trigger a fall in GDP
Country
Year
% Change in Real GDP
Mexico: 1995
1995
-6.2
Indonesia: 1998
1998
-13.1
Turkey: 2001
2001
-7.5
Argentina: 2002
2002
-10.9
Source: IMF. World Economic Outlook, September 2006, October 2007.

8. Macroeconomic Stability
Growth is hard to achieve without price stability
High inflation discourages saving and foreign investment, distorts relative prices, promotes wasteful financial activities, and encourages speculation, dollarization, and capital flight
Deflation (negative inflation) discourages consumption, investment (if real interest rates are positive) and delays relative price adjustments (because of nominal rigidities)

9. Macroeconomic Stability
Unsustainable public debt can threaten macroeconomic stability and economic growth
A high public debt
May reduce the ability of the government to implement contra-cyclical fiscal policies as needed
Can panic investors and thus result in a self-fulfilling public debt crisis (high interest rates and inability to roll-over short term debt)

10. Macroeconomic Stability
In addition, high fiscal deficit can lead to
High inflation (notably in case of fiscal dominance that forces the CB to “print money” to finance the budget deficit)
A reduction in private investment when government borrowing crowds out the private sector
Increased external vulnerability in case of foreign borrowing

11. Macroeconomic Stability
The global financial crisis showed that the health of a country’s financial sector has far-reaching implications for its economy as well as for other economies
Financial soundness is crucial to shock absorption.
A fragile banking system is likely
(i) to reduce the effectiveness of monetary policy because of weak transmission channels to the real sector

12. Macroeconomic Stability
(ii) to propagate and amplify shocks, rather than facilitate their absorption by the economy
e.g. by impeding recovery because of inability to lend to sectors important for the recovery
e.g. by putting public debt sustainability in case of recapitalization needs.

13. Macroeconomic Stability
(iii) to complicate policy responses to shocks and imbalances
e.g. in case of BoP imbalances, devaluation might be delayed for fear of its impact on the banking sector (short in foreign currency)
e.g. in case of inflation, monetary policy tightening might be delayed for fear of an increase in non performing loans (NPL) that would undermine banks

14. Macroeconomic Stability
Large gross private debt can challenge macroeconomic stability
Large and growing private debt can be a sign of an unsustainable growth model (based on an excessive increase in borrowing by the private sector)

15. Outline of the lecture - Introduction / Overview
- Macroeconomic stability
- Detecting macroeconomic risks
- Filling up the RMF

16. Detecting macroeconomic risks
External Sector
Current Account Balance check list (1/2)
CAB: Deficit or Surplus? Reason for deficit ? (high investment? Low saving?)
Composition of exports (product diversification of exports ; destination of exports)
Level and evolution of the real exchange rate (has the country lost competitiveness ?)

17. Detecting macroeconomic risks
External Sector
Current Account Balance check list (2/2)
In case of large inflows of remittances: are these flows at risk?
In case of large inflows of officials grants: are these flows at risk?

18. Detecting macroeconomic risks
External Sector
Capital and financial account check list (1/1)
Size and composition of capital flows (short term / long term)
In case of large short term capital flows:
How volatile are they?
Are they at risk? (for example in case of change in global interest rate)
Did portfolio flows in the last few quarters coincide with large stock market appreciation?
Would banks be able to roll-over their short term debt in foreign currency?

19. Detecting macroeconomic risks
External Sector
External debt sustainability and stock of FX reserves check list (1/1)
Is the external debt sustainable?
In case of large short term capital flows: what is the amount of FX reserves available in case of sudden stop in capital flows?

20. Detecting macroeconomic risks
Public finance
The budget check list (1/1)
Size of budget deficit
Total
Primary (before interest payments)
Before grants
Revenue (as % of GDP) (it is a problem when it is too low – e.g. below 15% in poor countries)
Deficit financing
Central bank financing?
Other domestic financing? (any risk of crowding out private sector borrowing and investment?)
External financing? (at concessional rate?)

21. Detecting macroeconomic risks
Public finance
Public debt check list (1/1)
How high is it?
Is it sustainable?
Is it sustainable under a stress scenario?
Risks to the public debt (contingent liabilities):
Economic outlook for State owned enterprises (any need of recapitalization or large subsidies?)
Any risks of recapitalization need of the banking sector? (see later)

22. Detecting macroeconomic risks
Monetary policy
Monetary policy check list (1/1)
Past inflation, expected future inflation (above 5%?)
Central bank independence and credibility
Level of private credit / GDP and recent evolution of this ratio
Large discrepancy between official and shadow (i.e. black market) nominal exchange rate (against the USD or the euro)
Any sign of “dollarization” (share of deposits in foreign currency above 15-20%)

23. Detecting macroeconomic risks
Financial Sector Satbility
Financial check list (1/1)
General FSAP assessment
Recent evolution of Financial Soundness Indicators
…… more on financial sector in lecture 5

24. Detecting macroeconomic risks
Source of information
Source of information for identifying macroeconomic risks
Macroeconomic policies and financial sector
IMF article IV report (or IMF reviews for countries under IMF programs)
IMF FSAP documents and Financial Soundness Indicators
Debt sustainability
Debt sustainability : IMF - WB Debt sustainability assessment (for both public and external debts)
Vulnerability and Exogenous Shocks
IMF article IV reports (notably the Risk Assessment Matrix)

25. Outline of the lecture - Introduction / Overview
- Macroeconomic stability
- Detecting macroeconomic risks
- Filling up the RMF

26. RMF
The Excel spread sheet (1/3) 2 files: Questionnaire - Risk profile Important note: “Excel spread sheet” doesn’t mean that’s it’s only about numbers (or even mainly numbers). The process of filling up the spread sheet increases the probability that most potential risks are being scrutinized and understood. The process leads to a recommendation regarding EU budget support in the country.

27. The Excel spread sheet (2/3)
RFM
The Excel spread sheet (2/3)
Questionnaire: concentrates on basic risks
44 questions in total, 7 of which for macroeconomic risks
For each of them, one needs to
assess the level of risk (Low – Moderate – Substantial – High)
give a justification for the level chosen and a description of the exact nature of the risk
Most of the answers are not straightforward
For the numerical part, level of risk are averaged by dimensions (14 of them) with some room for ad-hoc adjustment (up or down by one notch) based on judgement.

28. The Excel spread sheet (4/4) Risk profile :
RFM
The Excel spread sheet (4/4)
Risk profile :
Average level of risks for the 5 categories and overall average and trends (automatic)
Overall recommendation: “What should the EU do regarding BS in this country?” (written statement)
Major risks and risk (or benefits) of non EU intervention (written statement)
Key mitigating measures (written statement)

29. RFM
Overall risk

30. Assignment
Using IMF information, please write a short country fiche for either Cambodia or Ghana and fill the RMF excel file.
In order to do so, it is convenient first to use the check-list above, and identify the relevant risks for the country. Then indicate whether the country authorities are aware of the risks and are taking measures to reduce/mitigate them.
Day-3 class will be on Financial Soundness indicators. Your assessment will be adjusted in the afternoon of day 3 to include financial stability.

31. Thank you