Assumptions for the pessimistic scenario

As presented in section 4.1, it is very important to try to come up with a coherent ‘worst case’ scenario. In this simulation, we will assume that the political transition is not taking place smoothly, which negatively affects the business climate. Investments will decline, both foreign and domestic, and consumption will also decline as savings increase in times of uncertainty. We therefore expect a sharp and extended decline in GDP

WEO 2011 ______

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Optimistic Scenario

% of GDP

+ Interest Rate __ __  __

+ Exchange Rate ‐ ‐ ‐ ‐ ‐ + Budget Deficit  __  . . __ . . __

+ Growth  

...

growth, to reach 1% in 2012 and 2013, and a mild increase to 2% in 2014, reaching 3% in 2015.

One can be tempted to see increasing inflation as another pessimistic indicator in an economy’s outlook. Nevertheless, the GDP deflator is more linked to the demand of producers than consumers, and therefore can be in line with the expected evolution of the real GDP. Given our pessimistic scenario for real GDP growth, we see limited room for inflationary pressure on the GDP deflator. Therefore, we decided to use the same assumptions as in the WEO 2011.

As can be seen in Figure 4.11, the debt-to-GDP ratio reaches 54.8% in 2015, compared to 47.9% in the WEO 2011 baseline scenario and 50.3% and 47.8% in the realistic and optimistic scenarios, respectively.

On the budget side, because GDP is lower than what we would observe in our realistic and baseline scenarios (because of lower real GDP growth), the ratio of the budget deficit-to-GDP will automatically increase, if we keep the revenues and expenditures at their levels forecast by the IMF WEO 2011. In this case, the budget deficit given the pessimistic real GDP growth will reach 6.7% in 2012, 5.7% in 2013, 4.9% in 2014 and 3.9% in 2015.

The first assumption we will implement is that the revenues and expenditures are not at the WEO 2011 levels but at our realistic scenario levels. In this case, the debt ratio increases from 54.8% to 57.4% by 2015 (Figure 4.11).

However, when we forecast the revenue perspectives with a pessimistic view, we might expect a lower growth of revenue receipts in comparison with the realistic scenario for two main reasons: on one hand, the government might fail to implement the necessary reforms for tax collection and might also have a more limited access to foreign grants. On another hand, the economic slowdown usually negatively affects the tax receipts, as companies’ profits are squeezed and personal and VAT taxes usually decline. We decided to use 2% lower growth rates of revenue than those used in the realistic scenario, so the numbers become 11.5% in 2012, 9.8% in 2013 and 9% in 2014 and 2015.

Figure 4.11 Impact on debt of a pessimistic outlook for growth and budget revenues in Tunisia

Source: Authors’ own calculations.

In this case, and while keeping expenditures at their realistic scenario levels, the debt ratio increases again to reach 63.6% of GDP (Figure 4.11).

Expenditures are the main discretionary fiscal policy and the government might be tempted to increase expenditures as a stimulus to a slowing economy, and for the reconstruction of the impact of the revolution, for unemployment benefits, subsidies, employment in the government agencies and government investments in infrastructure projects in several cities that were neglected by the former government before the revolution. It has also been observed that some newly elected governments run larger-than-average fiscal expenditures in order to get re-elected (a phenomenon known as the ‘political budget cycle’), which might also be the case here.

In order to simulate such behaviour, we will implement three different scenarios: a 1% increase in public expenditure growth compared to the growth of expenditures in our realistic scenario, a 2% increase and a 3% increase of the growth of expenditures. The impact on debt, ceteris paribus, compared to our latest assumptions on GDP and revenues, is an increase of the debt ratio reaching respectively 67.2%, 70.8% and 74.5%

(Figure 4.12).

Figure 4.12 Impact on debt of a pessimistic outlook for budget expenditures in Tunisia

Source: Authors’ own calculations.

In the following steps of the pessimistic scenario, we will keep only the assumption of a 2% increase in expenditure growth, which reaches 18%

in 2012 (compared to 16% in the realistic scenario). Between 2013 and 2015, the expenditures will grow by 10% per year, which is the average growth rate before the revolution. The debt level in 2015 is therefore 70.8% as seen above (Figure 4.12).

Interest rates are expected to increase in reaction to a larger budget deficit, which requires both internal and external financing, putting pressure on the interest rates. Should the government decide to finance part of the deficit from domestic banks, it will lead to crowding-out and will increase the interest rates. On the foreign side, an increase in the deficit is often perceived as a worrisome sign that increases the country risk and the premium on the borrowing rates.

In our pessimistic scenario, we decided to increase the interest rates by 100 basis points more than in the realistic scenario, which leads to an increase by 300 basis points in 2012 and 2013, and 200 basis points in 2014 and 2015. In reaction, the debt ratio increases from 70.8% to 76.1% (Figure 4.13).

We also simulated a sharper increase in interest rates, both domestic and foreign, by increasing them by 200 and 300 basis points compared to our realistic scenario, which lead to an increase in debt to 78.4% and 80.8%

respectively (Figure 4.13).

Figure 4.13 Impact of interest rate increase in Tunisia

Source: Authors’ own calculations.

The assumption of an increase in interest rates by 500 basis points compared to those that prevailed before the revolution pushes the Tunisian debt level for the first time above the psychological threshold of 80% of GDP, which is more than double that forecast by the IMF 2010 Article IV consultation of 39.8%. It is worth highlighting that interest rates can easily increase by much more than the levels simulated here, reaching in some cases more than 20% (Greece recently), which might be a serious disaster for the Tunisian economy (Figure 4.14).

Figure 4.14 Sharp increase in interest rates in Tunisia

Source: Authors’ own calculations.

The last determinant of the DSA is the exchange rate. In our baseline scenario (WEO 2011), we assumed an annual depreciation rate of 2.5%, which is the rate used from the beginning of our pessimistic scenario until now. When we apply the 5% depreciation per year that we used in our realistic scenario, the debt level jumps from 76.1% to 79.1% of GDP. If the depreciation increases to 7% annually, the debt level increases to 81.5%

(Figure 4.15).

Figure 4.15 The impact of different levels of depreciation of the Tunisian dinar

Source: Authors’ own calculations.

In our view, the government shouldn’t proceed with a devaluation of 7% annually, as this might trigger speculative attacks. Agents in the economy might be tempted to buy dollars as they are almost sure they will get a 7% annual return due to the depreciation, which might amplify the demand for dollars and lead to an even-larger depreciation. Therefore, we recommend that the government proceeds with a one-time large depreciation and maintains the exchange rate fixed thereafter. This will provide exports with a strong boost that will help generate a higher GDP growth (the J-curve theory), and will prevent any speculative attacks against the currency. We simulated three levels of devaluation – 20%, 25%

and 30% – that takes place only in 2013, and the debt level reaches respectively 79.5%, 80.9% and 82.2% (diagrammed in Figure 4.15). It would be highly advisable to proceed with the devaluation of the Tunisian dinar when the world, and particularly Europe, is witnessing a confirmed recovery in order to maximise the benefits of the devaluation on the Tunisian economy.

One-time 30% depreciation 82.2%

7% annual depreciation 81.5%

One-time 25% depreciation 80.9%

One-time 20% depreciation 79.5%

5% annual depreciation 79.1%

Realistic + 100 basis points 76.1%

WEO 2011 47.9%