Over-optimism in the debt assessments of low-income countries
Debt sustainability analyses are a central tool to guide fiscal and macroeconomic policy, by providing an assessment of fiscal space. For low-income countries, the framework is evolving: a recent guidance note proposed to integrate climate risks and climate policies. A broader review of the framework started formally in April last year and will substantially advance in the next few months.
As part of the secretariat of the Expert Review on Debt, Climate and Nature, FDL, along with others, contributed to the reflection on the integration of climate and nature dimensions of the DSF.
This contribution is a bit different: it seeks to provide more transparency on the way economic and fiscal projections are done in DSAs. First, it unveils a new database of all published LIC-DSAs since 2013, helping researchers who wish to dig into assumptions, projections and outcomes of DSAs. This will help future research in several disciplines, from economics to polical science, where understanding how key technical tools affect policy decisions is central.
It also publishes a working paper aimed at contributing to the IMF and World Bank's reflections by documenting the size and causes of "over-optimism"—a well-known issue where debt projections often underestimate reality.
The paper develops a new framework to analyze projection errors over a five-year period horizon.
This project was made possible through the support of the Rockefeller Foundation.
Project Overview
- We have developed a comprehensive database containing 605 DSAs conducted from 2013 to 2024, which includes detailed information from all publicly available analyses for LICs. This database features : macroeconomic and fiscal data (Table 1), external debt dynamics (Table 2) and shock scenarios. The database will be regularly updated to reflect the latest analyses, allowing for continuous access to this vital information.
- Our Working Paper "How Do Debt Forecasts Get Wrong?" examines forecast errors related to public and external debt, along with key macroeconomic elements. It emphasizes findings of significant optimistic biases, indicating an average underestimation of the debt-to-GDP ratio trajectory by 10 percentage points after five years.
Key Findings
- Biases and Country Size: Larger countries tend to exhibit more significant positive biases compared to Small Island Developing States (SIDS), which are often forecasted more accurately.
- Fiscal Factors: The primary driver behind forecast errors is the underestimation of primary deficits, influenced by overly optimistic projections of fiscal revenues.
- Reform Impacts Post-2017: While the 2017 reforms aimed to enhance realism in forecasts, optimism bias has persisted, indicating a need for more transparent disclosure of assumptions.
- Program Context: DSAs linked to programs show better public debt predictions but often inaccurately estimate deficits, suggesting a misjudgment of political feasibility.
- Country-Specific Influences: Institutional, structural, and cyclical factors significantly impact these biases, with countries dependent on commodity exports displaying notable forecast inaccuracies.
- Recession Conditions: Analyses conducted during recessions tend to project overly optimistic public debt and GDP growth, indicating a misinterpretation of macroeconomic dynamics during different business cycle phases.