Leading indicators of fiscal distress: evidence from extreme bounds analysis

Early warning systems (EWSs) are widely used to assess a country’s vulnerability to fiscal distress. A fiscal distress episode is identified as a period when government experiences extreme funding difficulties. Most EWSs employ a specific set of only fiscal leading indicators predetermined by the researchers, which casts doubt on their robustness. We revisit this issue using extreme bounds analysis, which allows identifying robust leading indicators of fiscal distress from a large set. A robust leading indicator’s effect does not strongly depend on the model specification. Consistent with the theoretical predictions of latest generation crisis models, we find that both fiscal and non-fiscal leading indicators are robust. In addition, we find that a fiscal vulnerability indicator based on fiscal and non-fiscal leading indicators offers a 29% gain in predictive power compared to a traditional one based only on fiscal leading indicators. This suggests that both fiscal and non-fiscal leading indicators should be taken into account when assessing country’s vulnerability to fiscal distress