sustainability would still need to be country-specific.<sup>12</sup> Van Wijnbergen (2007) suggests that backward looking indicators (such as current levels of debt) need to be complemented by a forward looking fiscal sustainability assessment that takes into account the risks the country faces, including the risk of sudden interruptions in financing flows.

**Stylized simulations of pension reform indicate that for most countries the optimal financing strategy is probably a mixed one.  It may involve an element of debt finance in the early stages of the transition but should evolve progressively towards more tax finance during implementation.**<sup>13</sup> Debt-financed transitions have at best a neutral impact on national savings, and may have a negative impact if the interest rate on explicit debt is higher than the implicit interest rate on the implicit pension debt.  This may be the case when the debt ratio is already high and the government is already paying a risk premium.<sup>14</sup> Excessive debt finance will also hinder the development of the capital market and affect the capacity of pension funds to diversify portfolios.

Some reforming countries have failed to maintain fiscal discipline during the period of implementation and have relied excessively on debt finance. In these countries savings ratios have declined, pension portfolios have remained undiversified, and the impact of the reform on capital market development has been modest **.** For example, in Colombia, Hungary, and Poland, fiscal deficits increased above and beyond the revenue losses to the second pillar. In all these countries savings ratios declined and pension portfolio have remained undiversified, consisting largely of government bonds. Although the fiscal situation has recently improved the transition has still been primarily debt-financed.<sup>15</sup> By contrast, in Chile, the fiscal adjustment implemented at the start of the reform contributed to the increase in national savings, and enabled pension funds to diversify portfolios and finance the private sector already in the early stages of the transition. The factors probably contributed to Chile’s impressive growth performance in this period.<sup>16</sup> On the other extreme, some reforming countries with large fiscal surpluses and national savings, driven by massive foreign exchange inflows, have experienced very poor returns on second pillar assets. There are reforming countries such as Kazakhstan that are commodity exporters and have experienced a prolonged boom in 12 Reinhart, Rogoff and Savastano (2003), Oviedo (2006), and Mendoza and Oviedo (2003) examine the role of macroeconomic fundamentals in debt sustainability. Note that the assessment of sustainability can be complicated further by the possibility of multiple equilibria related to different market perceptions (see Calvo (1988), Sachs, Tornell and Velasco (1996) and Palley (2004).

> 13 Kotlikoff  (1995 and 1996) shows that a mixed financing strategy increases savings and growth in the transition to the new steady-state, while also contributing to an improved intergenerational burden sharing. Corbo and Schmidt-Hebbel (2003) show that Chile’s high growth rates after the reform were due in part to a tax-financed transition.  Kotlikoff (1996) shows that capital accumulation may reduce interest rates and reduce the cost of debt service, but this would be difficult to achieve in a pure debt-financed transition. 14 The risk premium could increase further if the market does not treat implicit and explicit debt equivalently.  The impact of the swap of implicit for explicit debt on the risk premium has not been tested. 15 Rudolph et al (2006), Impavido and Rocha (2006), and Rudolph and Rocha (2007).

> 16 Corbo and Schmidt-Hebbel (2003), Chile Pensions Commission (2006).

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