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8/4/2019 UN Compendium on Debt Sustainability and Development 2011 - Agenda 21
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UnitedNationsConferenceonTradeandDevelopment
COMPENDIUMON
DEBTSUSTAINABILITY
ANDDEVELOPMENT
UnitedNations
New
York
and
Geneva,
2009
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CompendiumonDebt Sustainability and Development
ii
Note
Symbolsof UnitedNationsdocumentsarecomposedof
capitalletterscombinedwithfigures.Mentionof sucha
symbol indicates a reference to a United Nations
document.
Thedesignationsemployedandthepresentationof thematerial inthispublicationdonot implytheexpression
of anyopinionwhatsoeveronthepartof theSecretariat
of theUnitedNationsconcerningthelegalstatusof any
country, territory, cityor area, orof its authorities, or
concerning the delimitation of its frontiers or
boundaries.
Material in this publication may be freely quoted;
acknowledgement, however, is requested (including
reference to the document number). It would be
appreciated if a copyof thepublication containing the
quotation were sent to the Publications Assistant,
Division on Globalization and Development Strategies,
UNCTAD,PalaisdesNations,CH1211Geneva10.
UNITEDNATIONSPUBLICATION
Copyright©UnitedNations,2009
Allrightsreserved
UNCTAD/GDS/DDF/2008/1
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CompendiumonDebt Sustainability and Development
iii
CONTENTS
COMPENDIUMONDEBTSUSTAINABILITYANDDEVELOPMENT .....................................................i
CONTENTS ................................................................................................................................. iii
CHAPTERI.OVERVIEW:DEBTSUSTAINABILITYINTHEORYANDPRACTICE.....................................1A. Introduction ................................................................................................................................... 1
B. DefinitionandDimensionsof DebtSustainability ......................................................................... 3
C. CountryStudies.............................................................................................................................. 5
D. InstitutionalFrameworkforDebtManagement............................................................................ 7
E. CreditRatingAgencies ................................................................................................................... 8
F. GlobalRulesforInternationalFinanceandTrade ......................................................................... 9
G. ConclusionsandFutureTasks ...................................................................................................... 11
CHAPTERII.DEBTSUSTAINABILITYASSESSMENT:THEIMFAPPROACHANDALTERNATIVES......... 17A. Introduction ................................................................................................................................. 17
B. WhatisDebtSustainability? ........................................................................................................ 18
C. ApproachestoAssessingDebtSustainability:ACriticalReview ................................................. 23
D. ReviewandConclusions............................................................................................................... 36
CHAPTERIII.THEMECHANICSOFDEBTSUSTAINABILITYANALYSIS.............................................. 45A. Introduction ................................................................................................................................. 45
B. DebtIndicatorsandEarlyWarningof Crisis................................................................................. 46
C. ThePresentValueof FutureIncome ........................................................................................... 48
D. TheFinancingGap........................................................................................................................ 50
E. DevelopmentPolicyBasedApproachtoDebtSustainability ...................................................... 58
CHAPTERIV.ANANALYTICALFRAMEWORKFORDEBTSUSTAINABILITYANDDEVELOPMENT ......63A. Introduction ................................................................................................................................. 63
B. Debtandthe“FinanceGap”Model............................................................................................. 66
C. SustainableDebtLevels ............................................................................................................... 71
D. FiscalConsequencesof ExternalDebt ......................................................................................... 77
E. DebtVulnerabilityandExternalShocks ....................................................................................... 78
F. Conclusions:PrinciplesforDebtManagementinDevelopmentStrategies................................ 81
CHAPTERV.THEDEBTEXPERIENCESOFUGANDA,KENYAANDBOLIVIA...................................... 89A. Introduction ................................................................................................................................. 89
B. Uganda ......................................................................................................................................... 90
C. Kenya’sDebtExperience.............................................................................................................. 96
D. Bolivia’sDebtExperience........................................................................................................... 101
E. DebtExperiencesCompared...................................................................................................... 108
F. ConcludingRemarks................................................................................................................... 110
CHAPTERVI.CASESTUDIES:ARGENTINAANDTHEREPUBLICOFKOREA.................................... 115A. Introduction ............................................................................................................................... 115
B. LessonsfromtheArgentineCrisisandDefault.......................................................................... 116
C. ExternalDebtManagementof theRepublicof KoreaduringtheCrisesof19791980 and19971998 ........................................................................................................................... 123
D. ConcludingRemarks................................................................................................................... 130
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CompendiumonDebt Sustainability and Development
iv
CHAPTERVII.APPROPRIATEINSTITUTIONALSETTINGSFORPUBLICDEBTMANAGEMENT.......... 143A. Introduction ............................................................................................................................... 143
B. TheContextof PublicDebtManagement.................................................................................. 144C. TheRoleandOrganizationof aDMO ........................................................................................ 148
CHAPTERVIII.CREDITRATINGAGENCIESANDTHEIRPOTENTIALIMPACTON
DEVELOPINGCOUNTRIES ........................................................................................................ 165A. Introduction ............................................................................................................................... 165
B. CreditRatingAgenciesintheInternationalFinancialSystem ................................................... 166
C. CRAs’ProceduresandMethods................................................................................................. 168
D. Impactof Ratings ....................................................................................................................... 172
E. PublicPolicyConcerns ............................................................................................................... 176
F. Conclusions ................................................................................................................................ 180
CHAPTERIX.PURSUINGSUSTAINABLEDEVELOPMENTSTRATEGIES:
THECASEOFTHEBALANCEOFPAYMENTRULESINWTO.......................................................... 191A. Introduction ............................................................................................................................... 191
B. ExchangeControlsandConvertibility ........................................................................................ 194
C. TradeRestrictionsforBalanceof PaymentsPurposes............................................................. 199
D. TradeFinancingandEquity........................................................................................................ 202
E. TheGeneralAgreementonTradeandServices(GATS),Balanceof Payments,andDebt
Sustainability.............................................................................................................................. 204
F. Conclusions ................................................................................................................................ 209
CHAPTER X.RISKASSOCIATEDWITHTRENDSINTHETREATMENTOFSOVEREIGNDEBT
IN
BILATERAL
TRADE
AND
INVESTMENT
TREATIES.................................................................... 211A. Introduction ............................................................................................................................... 211
B. SovereignDebtinBilateralTradeandInvestmentTreaties ...................................................... 211
C. ImplicationsforSovereignDebtProblemsof IncludingNationalTreatmentandMFN
TreatmentinFTAs ...................................................................................................................... 213
D. InvestorStateLawsuitsandSovereignDebt ............................................................................. 216
E. ConcludingRemarks................................................................................................................... 217
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CompendiumonDebt Sustainability and Development
1
CHAPTERI
OVERVIEW:DEBTSUSTAINABILITY
INTHEORYANDPRACTICE
AndrewCornford
(FinancialMarketsCenter)
A. Introduction
Debt sustainability, which concerns the feasibility for a country of meeting its debtrelated financial
obligations during a period beginning with the present, has proved an elusive concept. This is not
surprisinginviewof itsdependenceonanintrinsicallyuncertainfuture.Interestintheconditionsfordebt
sustainabilitybuildsonanearliertraditionof workondebtmanagementwherethefocuswasoncountry
riskandonthelikelihoodandconsequencesof debtdefault.
Theshiftinfocusfromcountryrisktodebtsustainabilityreflectsthesearchof nationalandinternational
policymakers for rules forexternaldebtmanagementwhichhaveagood theoretical justificationanda
reasonable track recordof application.Theproblemsof debtmanagementhave traditionallyalsobeencloselyrelatedtoconsiderationof severalotherissuesinvolvingexternaldebt.Therecentshiftinfocusis
much less evident in the way in which these issues are approached. This is true, for example, of
considerationof externaldebtpolicyasanimportantelementof globalregimesforinternationalfinance
andtrade. Inspiteof the lackof adirect link todebtsustainabilitysome featuresof these regimesare
takenupinthepapersinthiscollectionowingtotheirimportancetotheframeworkof internationalrules
withinwhichexternaldebtmanagementiscarriedout.
Traditionalcountryriskanalysishadtwodimensions,politicalriskandtransferrisk.1Thefirstreferstothe
determinantsof thepoliticalwillandthesecondtotheeconomiccapacitytomeetobligationsondebts
incurredthroughsovereignborrowingaswellasthroughthecrossborderliabilitiesof privateinstitutions
operatingwithinthecountry’sfrontiers.Thetwodimensionsarenotcompletelydistinctsinceeconomic
capacitydependspartlyon a country’swillingness to take thepolicymeasures required tomeetdebt
1Goodoverviewsof thetraditionalanalysisof countryriskareFriedman(1983)andKrayenbuehl(1988)
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Overview:Debt Sustainability inTheory and Practice
2
obligations,and thiswillingness in turn reflectsabalancingof politicalcostsandbenefits.Nevertheless
analysisunderthetwoheadingscoverslargelydifferentsubjects.
Thesubjects takenupunderpoliticalriskcompriseacountry’sconstitutionalandpoliticalenvironment,
thequalityof Governmentandthelevelof corruption,inequalitiesof incomesandwealth,literacyrates,demographic structures, and ethnic and religious differences. Transfer risk concerns subjects not
necessarily lesscomplexbutmostlymoreeasilyquantifiable.Someof these factorscanbeclassifiedas
having a substantially domestic origin such as fiscal and monetary policy, the exchangerate regime,
access tonatural resources, theuseof fundsacquired through foreignborrowing, the tax system,and
exchange controls for current and capital transactions.Other factors areexternal. These include trade
barriers to a country’s exports, commodity prices, interest rates and other conditions in international
financialmarkets,shippingcosts,theavailabilityof concessionalfinancing,andnaturaldisasters.
Transfer risk varieswith theavailabilityand termsof external financingandwith changes in theother
determinantsof accessto foreignexchange. Intheassessmentof transferriskamajorrole isplayedby
quantitativeindicatorssuchasthefollowing:
The debt service ratio: interest and principal with a maturity of at least one year divided by
receiptsof foreignrevenueduringaperiodT;
Thedebt/GNPratio:externalpublicandprivatedebt(normallyexcludingthatwithamaturityof
lessthanoneyear)dividedbyGNP;
Theinterestserviceratio:interestpayments(normallyexcludingthoseondebtwithamaturityof
lessthanoneyear)dividedbyexportsof goodsandservicesduringaperiodT,which,if subtracted
from thedebt service ratio, indicates thepercentageof foreign exchange receipts required to
serviceprincipal;
Thereserves/importsratio:officiallypublishedreservesdividedbyimportsduringaperiodT;
Theliquiditygapratio:anumeratorconsistingof debtwithamaturityof uptooneyearminusthe
balanceoncurrentaccountdividedby the sumof export receiptsandunilateral transfers.The
ratioindicatestheliquiditygapwhichneedstobecoveredbyshorttermborrowing;
Currentaccountbalance/GNP;
The compressibility ratio: nonessential imports as a percentage of total imports, an indicator
which inprincipaldependsonclassifyingpartof importsasbasicneeds (energy, food,essential
inputs and investment goods) on the basis of knowledge of the economy’s requirements but
whichinpracticeisoftenbasedonaruleof thumbsuchas25percentof imports.
Until the late 1970s analysts tended to focus primarily on mediumterm indicators of transfer risk.However, owing to countries’ greater use of international financial markets to meet their external
financingneedsandexperienceof thedebtcrisisof the1980s,theyincreasinglydevotedgreaterattention
toindicatorsbearingonliquidity(forexample,thereserves/importsratio,theliquiditygapratio,andthe
compressibilityratio).
However, actual experience of countries’ debt problems has indicated limits to the usefulness of the
commonly used indicators. These limits are partly due to lack of information concerning aspects of
countries’positionswithanimportantbearingontheircapacitytomeettheirexternalobligations.During
theAsiancrisisof 19971998,forexample,statistics forofficialreservesdidnot include theauthorities’
commitments in the forwardexchangemarketsor toprivate sector financial institutionswhich inboth
cases reduced the foreignexchange available tomeetexternaldebt service.Moreover, the traditionalindicatorsof countryriskaredesignedfortheassessmentof riskandaremuchlesswellsuitedtobetools
fordebtmanagement.
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CompendiumonDebt Sustainability and Development
3
To meet the needs of the latter attempts began to be made to give a more precise meaning to the
conceptof debtsustainability.Theseweredesignedtoprovideaconceptcapableof contributingtopolicy
undereachof thethreemajorheadingsof debtmanagement,namelyavoidanceof financialcrises,debt
management once a debt crisis appears imminent or is under way, and postdefault policy and
rescheduling.Atthesametime,partlyinresponsetothegrowingcomplexityof manycountries’external
commitmentsandtothegreateravailabilityof instrumentsformanagingthem,attentionhasincreasingly
beendevotedtocountries’overallexternalbalancesheets,andtotheproblemsandopportunitieswhich
theypresentforpolicymakers.
Work on sustainability accompanied parallel attempts to investigate the theoretical underpinnings of
conditionsfortheenforcementof crossborderdebtcontracts,andhaslikewisebeenmarkedbyinterest
indevelopingamorerigorousconceptualframeworktoreplace itsmoreadhocpredecessor.2
However,
thepapersinthiscollectionpointtotheprobablyinsolubledifficultiesconfrontingtheattempttodevelop
aconceptof debtsustainabilitycapableof servingasaphilosopher’sstoneforpolicymakers.
B. DefinitionandDimensionsof DebtSustainability
InChapterII,Wyploszprovidesanextensivereviewof thekeyconceptsinvolvedindifferentdefinitionsof
debtsustainability.Theseareasfollows:
Thresholdlevelof debt/GDPratio;
Solvency, i.e. the condition that future surpluses on current account are sufficient to cover
interestobligationsandrepaymentsof principal;
Debt serviceability, i.e. solvency plus the additional condition of no illiquidity, which denotes
inabilitytoservicedebtsatparticularmomentsintime;
Solvencyplusavoidanceof theneed for amajor correction in the formof large cuts inpublic
expenditureorlargeincreasesintaxationrequiredfordebtservice;
Networth,i.e.theconditionthatthepresentvalueof currentaccountsurpluseslesscurrentdebt
isnotdecreasingovertime;
Debtstationarity,i.e.theconditionthatthedebt/GDPratiodoesnotincreasewithoutbounds.
Wyploszpointsoutthatowingtothedependenceof eachof theseconceptsonan inherentlyuncertain
future theycannotbeused to constructuniversallyapplicable rules fordebt sustainability,anattempt
which he characterizes as “mission impossible”. Thus rules using the concepts as a base for policy
prescriptions will necessarily be arbitrary and imprecise. Wyplosz elaborates the implications of thisimpossibilitythroughanexaminationof proceduresforDebtSustainabilityAssessment(DSA)designedby
the IMF and theWorldBank’s InternationalDevelopmentAssociation (IDA) to formalize thenotionof
prudentdebtstrategiesreceptiveoacountry’sdevelopmentneeds.
The startingpoint for the IMF’s DSA is a baseline fiveyear forecast combined with stress testing for
adverse shocks. To allow for the dependence of the probability of debt distress on countryspecific
economic and political conditions this technical exercise is combined with a Country Policy and
InstitutionalAssessment(CPIA)developedbytheWorldBank.TheCPIAgeneratesanindexof governance
qualitybasedon20 component indicators, and countries are classified into three groups according to
theirCPIAindex,thosewithindexesof higherqualitybeingpermittedhigherdebt/GDPthresholds.
2For a concise account of the development of the new conceptual framework for the analysis of crossborder debt see
SturzeneggerandZettelmeyer(2006:chapter2).
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Overview:Debt Sustainability inTheory and Practice
4
AsWyplosznotes,thisprocedureincludesanumberof arbitrarychoicesregardingscenariosanddoesnot
allowformutuallyreinforcingeffectsduetocorrelationsamongshocksorforalternativepolicyresponses
to shocks. Moreover, it is not designed to take account of the potential of borrowing for actually
accelerating economic growth, except indirectly to the extent that a good CPIA index is likely to be
associatedwithanincreaseinthispotential.Thus,perhapsunsurprisingly,theIMF’sDSAhasbeenatthe
centreof discussionsondebtpolicybetweentheFundandnationalGovernments.
In view of the intractable nature of DSA, Wyplosz proposes limiting the exercise to less ambitious
objectives.Forthispurposeheprefersafocusontheevolutionof debtlevelsandontherequirementsof
avoiding debt distress (concernswhichwere at the centre of the traditional approach to country risk
described insectionI,thoughthis isnotmentionedbyWyplosz).Inthecaseof countrieswithaccessto
international financialmarkets important indicators forDSAaretheriskpremiums in thetermsof their
borrowing.MoreoverWyploszstresses thatanyprocedure forDSAbeopen,and that it should include
experts other than those of the multilateral financial institutions themselves. DSA should also
accommodatethe factthatdebtaccumulationcanbea legitimatepartof developmentpolicy.Wyplosz
acknowledges that his proposal can only lead to avoidance of debt distress under plausible, normalconditions.Thepossibilityof debtdistressinresponsetoexceptionaleventsissimplytobeacceptedasa
factof life,andonewhoseconsequencesaretobedealtwithasandwhenitoccurs.
Wyploszisnotsuggestingthattheelementsof theIMFapproachtoDSAhavenovalue.Buttheyshould
bepartof theframework forpolicydiscussionandnotamechanicalguidetopolicyconclusions,asthe
IMFitself increasinglyrecognizes.
Theanalyticsof theIMFapproachandof otherschematicapproachestodebtsustainabilityaremorefully
developed in Chapter III and IV by TranNguyen and Tola (henceforth TranNguyen) and Fitzgerald
(Fitzgerald). TranNguyen’s results include “templates” for debt sustainability based on alternative
national accounting identities as points of departure as well as conclusions concerning the longrunstability –and thus feasibility –of timepaths fordebt.Thepaperalsodevelopssimple frameworks for
analyzing the relationbetweendebt and growth. In a similar spirit Fitzgerald also explores theuseof
nationalaccountingidentitiestoderivesimple“golden”rulesfordebtsustainabilityaswellasconstraints
onfiscalpolicywhichtakeaccountof accesstoexternalfinancing.
Fitzgerald provides a critical review of “financing gap” models which were long widely used as an
analytical framework fordiscussionof debt sustainability.Thesemodelsplaceeconomicgrowthat the
centre of the exercise. The objective of the planning authority is tomaximizeGDP growth subject to
constraints imposed by domestic savings, import capacity, and the fiscal ceiling determined by tax
revenueandaccesstosovereignborrowing.
Theshortcomingsof thesemodelsaretheirdependenceonstableandexogenouslygivenrelationships.An alternative approach explored by Fitzgerald, which draws on assumptions now common in
macroeconomics,involvestakinginvestmenttobedeterminedbyintertemporalmaximizationsubjectto
relationshipsbetweenGDP,thecapitalstockdividedbetweenthatwhichisdomesticallyandthatwhichis
externallyfinanced,depreciation,thecostof newinvestment,national incomedefinedasthedifference
betweenoutputand interestcosts,andexternalconstraintsaccordingtowhich importsaredetermined
bynational incomeandexportsbytheproductivityof theexportsector.Thisapproachcangeneratean
expression for the optimal debt level as a function of the allocation of financing to different major
categoriesof investment.
TranNguyen reviews recent literature on earlywarning indicators of currency and debt crises. This
literatureisanaturaldevelopmentof theearlierapproachtocountryriskdiscussedabove.However,toagreaterextentthanearlierwork,themorerecentliteraturemakesuseof econometricanalysis.Moreover
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CompendiumonDebt Sustainability and Development
5
italsoincludesnewindicatorssuggestedbyrecentexperienceof financialcrisessuchasindicatorsof the
fragilityof thefinancialsector.
Amajorconclusionof TranNguyenisthattheapproachessurveyedsufferfromtheshortcomingthatthe
concept of debt sustainability is not integrated into a framework which also includes a country’sdevelopmentstrategyandtheimpliedgrowthtrajectory.AlthoughTranNguyen’ssuggestionsastosuch
integrationare limitedtosimpledebtandgrowthanalytics, thesubjectwouldbenaturalcandidate for
inclusion in themoreopen, less ruleboundprocedures to analysisof debt sustainability proposedby
Wyplosz.
C. CountryStudies
Of thefivecasestudiesincludedinthiscollectionof papersthree,Uganda,KenyaandBolivia,wereof low
incomecountrieswhoseexternaldebtwaslargelytheresultof publicbilateralandmultilateralfinancing,
whiletheremainingtwo,ArgentinaandtheRepublicof Korea,werecountrieswhosedebtcrisesreflected
abreakdownintheiraccesstointernationalfinancialmarkets.
1. LowIncomeCountries
The experiences of Uganda, Kenya and Bolivia share key common features in the form of failure to
generatesustainablegrowthandpovertyreductionandcontinuingvulnerabilitytothe impactof higher
interest rates and of lower prices on their commodity exports. All three countries undertook reform
programsconsistingof tightermacroeconomicpolicyandprice liberalization.But theprogramsdidnot
addressmajorweaknesses.Forexample,theydidnotincludeabroadeningof thetaxbase,andthetariff
reductions adopted actuallyharmedprogress towards thisobjective.TheGovernmentsof Uganda and
Kenya are still heavily dependent on foreign aid for the financing of their expenditures. Moreover
substantialproportionsof economicactivityandexports inallthreecountriesremainconcentrated ina
limitednumberof unprocessedprimarycommodities.
Therewerealsoimportantdifferencesbetweenthethreecountries’experiences.
UgandaandBolivia,which(unlikeKenya)arebothHIPCcountries, illustratebothgeneralweaknessesof
thisinitiativeandflawsmorespecificallyapplicabletothesituationsof thetwocountries.Thefirstsetof
weaknesses included inadequate analytical bases, which reflected dependence on unrealistic country
scenariosand failure to takeproperaccountof vulnerability toexogenousshocks.Thesecond included
toonarrowadefinitionof debtsustainability,failuretoallowfortheway inwhichpostHIPCborrowing
couldspeedilyreversegainsinacountry’sdebtposition,andtheinappropriatenessof loansasopposedtograntsforthefinancingof programsof povertyalleviation.
DuringtheperiodcoveredbythecasestudiesUgandaandBoliviaachievedanadequatetechnicalcapacity
fordebtmanagement.Kenyaontheotherhandstilllacksanadequatesystemforthispurpose.
2. LowIncomeCountries
Themain focus of the studiesof the Republicof Korea andArgentina are their recent currencycum
bankingcrises, for the former in19971998and for the latter in20002001.For theRepublicof Korea,
thereisalsoareviewof anearlierdebtcrisisin19791980whichtheGovernmentsucceededinridingout
withoutrecoursetothedeflationarymeasuresusuallycharacteristicof policyresponsesinsuchcases.
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Overview:Debt Sustainability inTheory and Practice
6
Therecentcrisesforbothcountriesweredominatedbydevelopmentsaffectingthecapitalaccountafter
periods in which the liberalization of capital transactions led to greater integration into international
financialmarkets.Inbothcasestherewerelargefluctuationsof capitalflows –largeinflowspriortothe
crises followedby largeoutflows. Inbothcases the IMF’spolicyprescriptionswere illsuited todealing
withthecrises.
Theoriginof theRepublicof Koreacrisiswasanunfavorableshiftinitsexportmarketsbeginningin1995.
This ledto inventoryaccumulationand lossesamongstthecountry’s large industrialgroupsthat inturn
provokedareassessmentof thesegroups’prospectsamongsttheforeigninvestorsandlendersonwhich
thegroupswere increasinglycomingtodepend.Asaresultof bankruptciesaccompaniedbyrevelations
concerningpoorcorporategovernanceandcorruption,during1997foreigners’flightfromthecountry’s
stockmarketacceleratedand itsbanks faced increasingdifficulties in rollingover shortterm interbank
loans.TheinitialfinancingpackageagreedlateintheyearbetweentheGovernmentandtheIMF,which
includedawiderangeof conditionsincludingmacroeconomicstringencyandliberalizationof financialand
labormarkets,failedtostemthecrisisasinterestratesreached40percentandthecurrencycontinuedto
depreciate.
A secondpackagewas accompanied by an agreementwith creditorbanks to loan extension and to a
lengthening of maturities in return for government guarantees on private debt. This sufficed to turn
aroundmarketsentiment,andasharprecoveryineconomicgrowthfollowedin1999.Thisexperienceof
theRepublicof Koreahas ledcommentatorstoquerytheappropriatenessof thedeflationaryfiscaland
monetary conditionsof the firstpackageasa response towhatwasprincipallya capitalaccount crisis
ratheronecharacterizedbymacroeconomicimbalances.
ThepaperonArgentina locates the sourceof its crisis in theexchangerate regimeand the impacton
externaldebt dynamics of interest rates required to manage the country’s capital account. This
interpretation isatvariancewith theviewof thecountry’sGovernmentsduring thepredefaultperiodwhereby problemswere seen to bedue to fiscalmismanagement,which called for a policy response
consistingof aseriesof packagesof fiscaltightening.
AsArgentina’scrisisgotunderway,thereweremarkeddisagreementsbetweenthenewGovernmentand
the IMFastoappropriatepolicymeasures.The IMF’srecommendations includedallowingtheexchange
ratetofloatfreelyandanapproachtothebankingcrisiswhichwouldhaveentailedbankliquidations.The
Government’spolicies,whichaccompaniedthebeginningof aneconomicrecoveryfromthefirsthalf of
2002,includedexchangecontrolsandrestrictionsoncapitaloutflowsaspartof apolicyof managingthe
exchange rate, export taxes designed to capture for the Government some of the profits due to
devaluation, anda flexiblemonetarypolicyaimed atassisting the recoveryof thebanking sector.The
Governmentalso resistedpressure from foreignGovernmentsand the IMF to improve the termsof its
offerondebtrestructuringtoitsexternalcreditors.
Owingtothe lackof therequireddata it isnotpossible toconductacontrolledexperimenttotestthe
validityof thenow increasinglywidelyheldbelief asto inappropriatenessof standardfeaturesof policy
programsassociatedwithIMFpolicypackages.However,theRepublicof Korea’sdebtcrisisof 19791980
doesprovideacasestudyof thesuccessfulapplicationof adifferentpolicyapproach.
Thecrisisbeganin1979afteryearsof rapidgrowthpoweredbyaninvestmentboom.Majorfeaturesof
thecrisiswereasharpincreaseinthecurrentaccountdeficit,asevererecession,andariseininflationof
consumerpricestoanannualrateof almost30percent.InsuchcircumstancesthestandardIMFpolicy
prescription would probably have involved macroeconomic stabilization through fiscal and monetary
tightening and allowing the exchange rate to float. The view of the Republic of Korea Government,however,wasthatacceleratinginflationwasthesourceof deterioratingincomedistribution,laborunrest,
anddecliningexportcompetitiveness.Thepoliciesadoptedincludedaoneoff devaluationfollowedbya
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CompendiumonDebt Sustainability and Development
7
managed float under which the Won was tied to a basket of major international currencies,
macroeconomicpoliciesgivingpriority to stopping theeconomicdownturn,and continued recourse to
externalfinancingof adecliningcurrentaccountdeficitdespiteanalreadyhighlevelof externaldebt.
Theeconomic recoverywhich followed is likely tohave reflected theeffectsof an improvement in theexternaleconomicenvironmentaswell thepoliciespursued.Commentatorsalsoattributea significant
role to capital controls which prevented capital flight. Conditions associated with different countries’
currencycumdebtcrisesareof courseneverthesame.Nonetheless,theRepublicof Koreaexperienceof
the early 1980s deserves a place in the template of the menu of policy measures for debt crisis
management.
D. InstitutionalFrameworkforDebtManagement
Whatever the approach adopted by a developing country to debt sustainability, properly developed
institutionsfordebtmanagementarerequired.Thetasksof theseinstitutionsassetoutinChapterVIIby
JaimeDelgadilloCortez(Delgadillo)includethefollowing:
Theproductionof reliabledebtdata;
Developmentof thedomesticfinancialmarket;
Ensuringadequatefinancingfordevelopmentalandsocialneeds;
Ensuringcompliancewithdebtserviceobligations;
Controllingcontingentliabilities;
Meetingtherequirementsof negotiationswithcreditors;
Performingcost/riskanalysis;
Designingstrategiesfordebtsustainability.
For this purpose design of the institutional framework for debt management has to focus on the
following:
Governance;
Clarityof therolesof thedifferentinstitutionsdealingwithdebtmanagement;
Specificationof theobjectives;
Coordinationof publicdebtmanagementwithotherpublicpolicies;
Theorganizational structureof theprincipalbody responsible fordebtmanagement, theDebt
ManagementOffice(DMO);
Transparencyandaccountability.
Delgadillo discusses and exemplifies different options under these two headings for this institutional
framework.
Thenetworkof relationsdescribedbyDelgadilloof whichtheDMO isthecentre includetheministryof
finance, the central bank, the national/planning or development office, creditors, international
organizations (whichmay themselvesbeamongthecountry’screditors), thepublicandprivateentities
whichareasourceof guaranteesandinsurancefortradefinance,etc.,andmajorparticipantsindomestic
financialmarkets.
Theinstitutionalframeworkfordebtmanagementcanbeexpectedtoevolveinresponsetothechanging
profileof acountry’sexternalliabilitiesanditslevelof financialdevelopmentaswellastotheincreasingly
comprehensive approach to management of a country’s external assets and liabilities which is now
receiving greater attention (see below). Inter alia, this approach may entail closer working relations
between the DMO as described by Delgadillo and those responsible for the regulation of financial
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institutionsand thus foroversightof thecurrencyandmaturityrisksassociatedwith these institutions’
balancesheets.
E. CreditRatingAgencies
The ratings industry has its origins in firms which were established in midnineteenthcentury United
States to provide merchants with information on the creditworthiness of their customers. Ratings
originallyreferredtothecapacityof anobligortomeetpaymentsdueonaparticularfinancialobligation
after taking into consideration the creditworthiness of guarantors, insurers, and other forms of credit
enhancement.Butratingsmaynowrefertoissuers,includingcountries,aswellasissues.
Assessmentof developingcountries’creditworthiness long reliedon financial institutions’own systems
for this purpose, guidance from their regulators, services providing information on country risks, and
rankingsof countrycreditriskprovidedbypublicationssuchasinstitutionalInvestorandEuromoney.The
growthintheimportanceof creditratingagenciesinrecentyearsreflectstherequirementsof thegrowth
of international capital markets which has led to increasingly widespread need for creditworthiness
assessments: borrowers are seeking ready recognition from investors; investors require an accessible
vehicle forassessing thequalityof securities;andbanks find ratingsausefulmarketing tool for selling
papertocustomers(Fight,2004:46).
Sincethemid1990stheperformanceof theagencieshasbeencriticizedonseveralgrounds,asdiscussed
inChapterVIIIbyElkhoury:theirslownesstoreacttochangesincreditworthinessandthentheirtendency
onoccasiontooverreact;theiruseof untransparentratingmethods;theirprivilegedregulatoryposition;
theirlackof accountability;andthevulnerabilityof theiroperationstoconflictsof interest.
Criticsviewedtheagencies’responsetotheAsianfinancialcrisisof 19971998ascharacteristicof theirtendencytoslownesstoreactfollowedbyoverreaction.
Althoughtheagenciesmakeknownthefactorstakenintoaccountasinputstotheirratings,their
assignmentof weightstothesefactorsisopaque.
Theagencies’privilegedregulatoryposition isdueto institutional investors’needforaratingof
investmentgradebyanofficiallyrecognizedagencyforthesecuritiesinwhichtheyarepermitted
to invest aswell as toother regulatoryexemptions accorded to such securities. In theUnited
States such recognition is reserved for Nationally Recognized Statistical Rating Organizations
(NRSROs), a designation conferred on only a limited number of agencies including the major
three,Moody’s,Standard&Poor’sandFitch.
Theagenciesarenotaccountablefortheirmistakesortheirabuseof power.
Conflicts of interest may arise owing to the agencies’ involvement in the structuring of
instrumentstheyrate,theirprovisionof consultancyservicestoissuers,thepotentialforpressure
to purchase agencies’ consultancy services in return for an improved rating, and the use of
aggressivesalestacticsto inducean issuerto“solicit”andthuspayforaratingwhich ithadnot
initiallyrequested(an“unsolicited”rating).
Elkhoury reviews some recentofficial initiatives todealwith these criticisms.These include theCredit
RatingAgencyReformActpassedbytheUnitedStatesCongress inSeptember2006,whichtightensthe
procedural requirements forNRSRO registrationand certification,and strengthens theauthorityof the
SecuritiesExchangeCommissionoverNRSROs;andaCodeof Conduct issued inDecember2004by the
International Organization of Securities Commissions (IOSCO), whose objectives include ensuring the
integrityof theratingprocessandachievinggreatertransparencyregardingratingsmethodology.
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However, these steps areunlikely to satisfy the creditagencies’growingbandof critics.The agencies’
operationshavereturnedtothespotlight inconnectionwithratingsaccordedtotranchesof securitized
assetsduringthecreditcrisiswhichbegan inthesummerof 2007.Againspecialattention isfocusedon
theopacityof themethodsunderlying their ratings, their lackof accountability, and thepotential for
conflictsof interestarisingfromtheirroleasprovidersof “ex anteopinions”and“structuringadvice”as
wellasratingsinthecaseof structuredfinancing.3
The consequences may be more stringent rules for agency certification, minimum standards for the
trainingandqualificationsof agencies’analysts,andincreasedtransparencyregardingtheiroperations.If
one looks further into the future,a large increaseand thenumberof credit ratingagenciesworldwide
seemsquite likely. Interalia,suchan increasewouldbeanaturalconsequenceof the roleaccorded to
credit rating agencies in determining weights for credit risk in the determination of banks’ minimum
regulatorycapitalunderBasel2,whichmorethan100countriesarenowplanningtointroduce.
F. GlobalRulesforInternationalFinanceandTrade
Discussion of global rules in connection with external debt typically focuses mainly on arrangements
capable of making debt cries less likely and of facilitating theirmanagement and resolution. Subjects
include bankruptcy mechanisms for sovereign, and sometimes also private, crossborder debt,
improvements intermsandfundingfor IMFcrisis lending,andprecrisis intervention inthemarkets for
internationaldebt.4Buttheframeworkwithinwhichcountriesmanagetheirexternaldebtisalsoaffected
bydevelopmentselsewhereaffecting rules for tradeand trade finance,balanceof paymentsmeasures
andforeigninvestment.
The importanceof the latter setof ruleswas recognized in theDeclarationon theContributionof the
WorldTradeOrganizationtoAchievingGreaterCoherence inGlobalEconomicPolicyMakingadoptedatthetimeof theestablishmentof theWTO.ThisDeclarationacknowledged the linksbetweeneconomic
policies as follows: “Successful cooperation ineach areaof economicpolicy contributes toprogress in
other areas. Greater exchange rate stability…should contribute towards the expansion of trade,
sustainablegrowthanddevelopment,andthecorrectionof externalimbalances.Thereisalsoaneedfor
anadequateandtimelyflowof concessionalandnonconcessionalfinancialandrealinvestmentresources
todevelopingcountriesandforfurthereffortstoaddressdebtproblems,tohelpensureeconomicgrowth
anddevelopment.”Suchcoherenceinglobalpolicymakingrequiresthat“the international institutionsin
eachof theseareasfollowconsistentandmutuallysupportivepolicies”.
Twopapersinthiscollectiontakeupsomespecificinternationalrulesaffectingnationalpoliciesinareas
characterized by interfaces between trade, investment and external financing. Chapter IX by Howsediscusses the applicabilityof WTO rules to exchange restrictions and tomeasuresdirected at exports,
importsandthebalanceof paymentsfromthepointof viewof theircompatibilitywithnotionsof fairness
andequity. InChapterX,Caliari examines the risks tonational autonomy regardingdebtpolicywhich
couldresultfromprovisionsconcerninginvestmentinrecenttradeandinvestmenttreaties.
1. TradeandBalanceof PaymentsMeasuresunderWTORules
Howsetakesashisstartingpoint thecommitmentof UnitedNationsMemberStates in theMillennium
Declaration to “anopen, equitable, rulebased,predictable and nondiscriminatorymultilateral trading
and financial system”. Whilst acknowledging that the concept of equity in international trade and in
3Differencesbetweencreditratingagencies’rolewithrespecttostructuredfinance,ontheonehand,andbond issues,onthe
other,aredescribedinCommitteeontheGlobalFinancialSystem(2005).4Forasurveyof suchproposalsseeSturzeneggerandZettelmeyer(2006:chapter12).
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financialrulesandinstitutionslacksagenerallyaccepteddefinition,Howseshowsthatinternationalrules
(includingthoseof theWTOandthe IMFArticlesof Agreement) incorporate fairness,aconceptclosely
relatedtoequity.Moreoverone important ingredientof equity in international instrumentsconcerning
trade,financeanddevelopmentisthenotionthatrulesshouldbeadjustedtothedevelopmentneedsof
countries’differentsituations.Anotheringredientisthatof people’srightto“voiceandparticipation”,i.e.
their rightnot tohave avisionof development forcedon themordecidedbyothers.TheMillennium
Declarationalsocontainsadistributionalcomponentsincetheconceptof globalsolidarityrequiresthat
“globalchallengesmustbemanagedinawaythatdistributesthecostsandburdensfairlyinaccordance
withbasicprinciplesof equityandsocial justice”.
Concerningexchange restrictionsHowsenotes thegenerallyacceptedviewof the intentof GATT/WTO
provisionsforgoodstradethat,regardlessof theeffectof therestrictionsontradetransactions,theydo
notimposedisciplinesgoingbeyondthoseof theIMF.However,suchrulingsarepermissibleforexchange
restrictionsnotendorsedbytheIMF,ascopewhichHowsebelieveshasbeenusedbytheGATTandthe
WTOasthebasisforexcessivelynarrowinterpretationof countries’rightof recoursetotrademeasures.
More generally Howse questions the apparent presumption of GATT/WTO case law that exchangerestrictionsnotendorsedbytheIMFentailviolationof GATT/WTOrules.
TheGATT/WTOprovisions forgoods trade leavenoscope for rulingsonexchangecontrolsapplying to
capital as opposed to current transactions. However, the corresponding provisions for balanceof
payments restrictions in the caseof services trade under theGeneralAgreement on Trade in Service
(GATS) could lead to challenges to capital controls on the ground that they are inconsistent with a
country’s specific commitments interpreted in combination with general GATS obligations. Howse
believesthatguidelinesshouldbedrawnupforsuchcasesbyinstitutionswithamandatetotakeaccount
of equityinthetradeandfinancialsystems.
HowsealsodiscussestwootherrecentWTOrulingssuggestingashifttomorerestrictiveinterpretationof provisions with a bearing on the compatibility of WTO rules with the principles of equity, voice and
participation.
The first ruling involved a case in which the United States challenged India’s continuing use of trade
restrictionsforbalanceof paymentsreasonsinpursuitof developmentpoliciesunderGATTArticleXVIII.
HeretheWTOAppellateBodyruledthatremovalby Indiaof itsbalanceof paymentsrestrictionswould
not requireachange in itsdevelopmentpoliciessince theobjectivesof thesepoliciescouldequallybe
achievedbymacroeconomicmeasures.Howsetakestheviewthatthisrulingisnotinaccordwiththeself
declaratorycharacterof GATTArticleXVIII.
InthesecondrulingtheAppellateBodydecidedagainstBrazil’suseof officialsupportforthefinancingof
aircraftexportson thebasisof argumentswhich includeduseof thebenchmarksof theOECDExportCredit Arrangement. As Howse points out, this Arrangement is an agreement reached through
negotiations involving the organization’s restricted membership which takes no account of structural
differencesbetweenthefinancialmarketsof developinganddevelopedcountries.
2. DebtandBilateralTradeandInvestmentTreaties
Caliaridrawsattentiontotherisksforpolicytowardsexternaldebtwhichareinvolvedintheextensionof
thedefinition of investment to includedebt instruments observed in some recentbilateral trade and
investmentagreements(suchastheUnitedStatesChileFreeTradeAgreementandtheCentralAmerica
FreeTradeAgreement).These risks result from theassociationof investment in such treatieswith the
obligationsof NationalandMostFavouredNation(MFN)Treatment.NationalTreatmentguaranteesnon
discriminatory treatment of domestic and foreign firms. Under MFN Treatment each party to the
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agreementbinds itself toextend to theallothers thesameconcessionsas thoseaccorded tothemost
favoredparty.
Extended to sovereign debt, National and MFN Treatment could restrict a Government’s flexibility
regardingpostcrisismeasures suchas those involving thedistributionof lossesbetweendomesticandforeigncreditorsandsupporttodomesticasopposedtoforeignbanksaspartof therestructuringof the
financial sector.They couldalso reduce the leverageof thedebtor countryduringnegotiationson the
restructuring of its external debt. In extreme cases theymight even make it difficult to prioritize the
servicingof domesticdebt incurredtomeettheGovernment’swages,salariesandpensionsobligations.
Moreoverapplicationof MFNTreatmenttoexternaldebtmighthavetheanomalousandalmostcertainly
unacceptable effect of according seniority in meeting debt obligations to the parties covered by the
agreementascomparedthosetopartiesnotsocovered.
The risks described cover in the first instance only countries covered by treaties whose definition of
investmentincludesdebt.However,precedentsbasedonbilateraltradeandinvestmenttreatiesarealso
often included among demands submitted by participants and as part of proposed frameworksagreementsduringmuchbroadernegotiationsontradeandfinance.
G. ConclusionsandFutureTasks
Theprincipalfocusof thepapersinthiscompendiumistheneedforaconceptof debtsustainabilitymore
systematic than thepiecemeal indicatorsof country riskpreviouslyused forexternaldebtassessment.
Problemsrelatedtodebtsustainabilityareexaminedthroughtheprismof aseriesof countrystudies.The
papersalsodiscuss the institutional frameworkatnational level fordebtassessmentandmanagement
andtheroleof creditratingagenciesaswellasimportantfeaturesof globalrulesbearingondeveloping
countries’autonomyregardingpoliciesfortheexternalsector.Theconcludingremarkswhichfollowarelimitedtoselectedfeaturesof theconceptualframeworkforassessingdebtsustainabilityandof policies
designed to contribute to theachievementof such sustainability.They include suggestionsas to some
possibledirectionsforfuturework.
1. MacroeconomicPolicy
Likeothercasestudiesof externaldebtmanagement,thoseinthiscollectionhighlighttheimportanceof
appropriate macroeconomic policy to successful debt management. The contents of such policy
necessarilyvaryamong countriesowing todifferences inbotheconomic conditionsandGovernments’
objectives. Thus theexperiencesof Argentina and theRepublicof Korea reviewed in the case studies
illustratethatsuccessfulmacroeconomicpoliciesinacontextof debtcrisisdonotfollowageneralmodel
but rather consistof measuresgeared to countryspecific circumstancesandbasedon countryspecific
balancingof thebenefitsandcostsof alternativeoptions.
The case studies also draw attention to the special vulnerability of lowincome countries to external
shocks.Thisisduetotheirlessdiversifiedstructuresof production,inparticulartheconcentrationof their
exports ina limitednumberof primarycommodities.Theproblemscausedbysuchconcentrationarea
staple featureof the literatureof developmenteconomics.Thestudies in thiscollectionemphasize the
threatposedbythisvulnerabilitytotheachievementof debtsustainability.
Onelessondrawnistheneedforthepoliciestowardsexternaldebtwhichaccommodatetheinvestment
requiredfordiversifyingacountry’sproductivebase.Thislessonconcernsnotonlythedebtmanagementof borrowingcountriesbutalsothetermsandconditionsof financingagreedwithofficialcreditors.Future
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workon policies in this areamight also includedifferent techniques available forhedging commodity
exportreceiptsandareexaminationof pricestabilizationatthenationallevelthroughmarketingboards.
Inthiscontextitmayalsobeworthrevisitingissuesclassifiedbyanearlierliteratureundertheheadingof
centralbankingprinciplesforanexporteconomy.This literature,towhichamajorcontributorwasRaulPrebisch,firstSecretaryGeneralof UNCTAD,onthebasisof hisexperienceasmanagerof theArgentine
Central Bank from 1935 to 1943, concerned the implications for appropriate monetary, and more
generallymacroeconomic,policyof frequentlyobserveddifferencesbetween theexternaland internal
balanceof commoditydependentcountries,ontheonehand,andof industrialcountries,ontheother.5
Intheformergroupof countriesamacroeconomicupswingtendedtobeassociatedwithamorepositive
balanceof tradeandexternalpayments,andthusariseinreservesof foreignexchange;andconversely
recessionordepression tended toaccompanyanegativeexternalbalanceandacontractionof foreign
reserves.Bycontrasttheexternalbalanceof industrialcountriestendedtodeteriorateduringeconomic
upswingsandto improveduringdownswings.Themonetarypolicyproposed forcommoditydependent
countries in response to their circumstances involved restriction during the upswing with the aim of accumulatingreserves,whichwouldpermitamoreexpansionarypolicyandthefinancingof contracyclical
measuressuchaspublicworksduringthedownswing.Theunderlying ideasof this literaturecouldwell
have continuing relevance for the macroeconomic framework for policy towards external debt in
commoditydependentcountries.
2. TowardsaMoreInclusiveApproachtoDebtSustainability
Thiscollectionof papershasachievedgreaterconceptualclarityconcerningdebtsustainabilitybutcannot
providedefinitive,comprehensiveguidelines forassessmentandpolicymaking.Thepaperspoint to the
need for more flexible approaches to the subject which also take account of essential connections
betweenthemanagementof externaldebtanddevelopmentstrategy.Conclusionswhichcanbedrawnfromthecollectionincludethefollowing.
Assessment of debt sustainability will continue to require quantitative indicators as well as
analysisof qualitativefactorstraditionallyincludedintheassessmentof countryrisk.
Amore inclusiveviewof debtsustainabilitywillsuggestnew indicatorsof countryriskanddebt
sustainabilityinadditiontothetraditionalonessurveyed.
Assessmentandpolicymaking should includediscussionbetween thedifferentparties –debtor
countries, creditors and internationalorganizations to resolve legitimatedifferencesbetween
viewsastowhatconstitutesustainabledebtlevelsforacountry.
Adevelopmentalperspectiveshouldbeanintegralpartof theapproachtodebtsustainability.Thisimpliesthatconsiderationof debtsustainabilityshouldnotbeabstractedfromtherequirementsof development
strategy. Such an approach to debt sustainability requires the involvement not only of those with
responsibility for external financing and debt management but also of other policymakers who are
responsiblefordecisionsregardingdevelopmentstrategy.
These conclusions as to an appropriate framework for assessment of debt sustainability would be
consistent with treatment of the subject as part of a comprehensive approach to monitoring and
managementof acountry’sexternalassetsandliabilitiesoutlinedbelow.
5TheargumentisexplainedinmoredetailinWallich(1950:chapterXV).
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3. NationalBalanceSheetsandExternalDebt
Atthecentreof theconceptualapproachestodebtsustainabilityreviewedinthiscollectionof papersare
currentand future receiptsandoutflowswhichdetermine the fundsavailable fordebt service.Sucha
focuson“earningpower”(touseterminologycommonamongaccountantsandfinancialanalysts)could
beusefullysupplementedbyinformationcontainedinthebalancesheetsof acountry’sGovernmentand
firms,especiallytheirexternalliabilities.Aprofileof nationalexternalliabilitiesservesastheanalogueat
thisleveltoacorporation’scapitalstructurewhichprovidesnotonlyaguidetothe institution’sfunding
butalsoenablesittoindexandcontroldifferentfinancialrisks.6
A focus on external liabilities and assets would be a natural extension to debt sustainability of
recommendationsintheReportof theWorkingGrouponCapitalFlowsof theFinancialStabilityForumof
April2000 (Financial Stability Forum,2000). These recommendations responded to termsof reference
which included evaluation of prudentialpolicies, regulations and riskmanagement thatmight help to
reducesystemicrisksassociatedwiththebuildupof externalindebtedness.
TheReportwasoneof manyinternationalinitiativesundertakenintheaftermathof thefinancialcrisesof
the 1990s which involved mainly emergingmarket (i.e. middleincome) developing and transition
economies.Nevertheless,manyof therecommendationsconcerningdatacollectionandanalysisandthe
managementof riskscouldapplyequallyto lowincomedevelopingcountries.Therecommendationsof
theReportaredirectedatthepublicsector,thebankingsector,andthenonbankfinancialandcorporate
sectors. For lowincome countries the recommendations of greatest immediate interest are those
directed at the public sector (though theother recommendations canbe expected to assume greater
importancewith thedevelopmentof their institutional infrastructure).This ispartlydue to thegreater
relative importanceof sovereignborrowing insuchcountries’external liabilities.But italso reflects the
likelihoodof lessdevelopedaccessinlowincomecountriestoinformationconcerningassetsandliabilities
of entitiesintheprivatesector.
TheReport argues thatdetailedprofiles of external balance sheets canmake amajor contribution to
monitoringandmanagingacountry’sexposuretodifferentfinancialrisks.Sectoraldataarenotonlypart
of thisprofile(thoughapart,as justexplained,whoseimportancevariesfordifferentsectorsaccordingto
a country’s level of development) but help to identify linkages capable of facilitating transfers of risk
exposurebetweendifferentsectors.
Forthepublicsectortherecommendationsaredesignedtotranscendthenarrowerfocusof publicdebt
management still found inmany countries.Theaimof theprofileof assetsand liabilities shouldbe to
enablethe formulationof astrategybalancingexpectedcostsandriskscontained in thepublicsector’s
external assets and liabilities. This process can benefit from the development of new vulnerability
indicators(forwhich,thoughtheReportdoesnotdiscussthis,accounting indicatorsusedaspartof the
analysisof thefinancialstatementsof firmscanoftenprovideusefulmodels).
Theimportanceof extendingtheprofilesof externalassetsandliabilitiestothebankingsectorreflectsits
strategiceconomicroleandthedangerthat intheeventof afinancialcrisis itsproblemsarecapableof
inflictingeconomywidedamage.Thedevelopmentof profilesforthissectorwilloftenbenefitfromthe
factthateven indevelopingcountriesfinancialreportingbybankstoregulatorsandshareholdersisof a
relatively high quality, though progress may still be required regarding the information necessary for
assessmentof liquidityand foreigncurrency risk –tworiskswhichassumespecialsignificance incrises.
Extension of the profiles of external assets and liabilities to the nonbank financial sector results in
coverageof institutionsoftenmore loosely supervised thanbanksornot supervisedatallwhichwere
nonethelessamajorsourceof vulnerabilityinsomecountriesintheAsianfinancialcrisis.
6Foranilluminatingdiscussionof therolecapitalstructureforbothcountriesandcorporationsseePettis(2001:chapter6).
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Nomore than theother techniquesdiscussed in this collectionof papers cannationalbalance sheets
provide all the information required for the analysis of debt sustainability and the prevention and
containment of debt crises. They can, however, provide a framework for the further development of
conceptsclarifyingdebtsustainabilityaswellasforthemanagementof therisksassociatedwithexternal
debt.
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References
CommitteeontheGlobalFinancialSystem (2005).The
Role
of
Ratings
in
Structured
Finance:
Issues
and
Implications.Basel,BankforInternationalSettlements,January.
FightA(2004).UnderstandingInternational Bank Risk .Chichester,JohnWiley.
FinancialStabilityForum(2000).Report of theWorkingGrouponCapital Flows,April.
Friedman IS (1983). The World Debt Dilemma: Measuring Country Risk . Washington, DC, Council for
InternationalBankingStudies,andPhiladelphia,RobertMorrisAssociates.
Krayenbuehl TE (1988). Country Risk Assessment and Monitoring, 2nd edition.Cambridge,Woodhead
Faulkner.
PettisM(2001).TheVolatility MachineEmergingEconomiesand theThreat of Financial Collapse.Oxford,
OxfordUniversityPress.SturzeneggerFandZettelmeyerJ(2006).Debt Defaultsand Lessons fromaDecadeof Crises.Cambridge,
MassachusettsandLondon,TheMITPress.
Wallich HC (1950). Monetary Problems of an Export Economy the Cuban Experience 19141947 .
Cambridge,Massachusetts,HarvardUniversityPress.
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CHAPTERII
DEBTSUSTAINABILITYASSESSMENT:
THEIMFAPPROACHANDALTERNATIVES
CharlesWyplosz
(GraduateInstituteof InternationalandDevelopmentStudiesandCEPR)7
A. Introduction
Debtsustainability isavexing issue. Its importance is immediatelyobviousbuttheconceptescapesany
easydefinition. This situation is not unheardof in economics;price stability and full employment are
examplesof other crucially importantpolicyobjectives that cannotbe simplydefined.Yet,whileprice
stability or full employment can both be measured with a reasonable degree of precision, debt
sustainabilitycannotevenbemeasureddirectly.
Every country, therefore, must grapple as best it can with the issue of debt sustainability. Private
borrowersareinthesamesituationasGovernments –forpublicdebts –andstates –forexternaldebts –
withonebigdifference:aprivatedefaultispromptlysanctionedaccordingtopreciselegislationunderthecontrolof courts,whilepublicandexternaldebtdefaultsarefollowedbylitigationandnegotiationswithin
fuzzy legal rulesanduncertainenforcementmechanisms.Uncertaintyabout theconsequenceof public
andexternaldebtdefaults is a sourceof perverse incentives todefault (formally calledmoralhazard)
reflectingunwillingnessasopposedtoinabilitytopay.8
Officiallenderscannotavoiddealingwiththedebtsustainabilityissue.Themultilateralorganizationsand
theParisClubhavelongdealtwiththeissueonacasebycasebasis.Theirstatedruleof procedurewasto
encourageborrowingcountriestoadoptprudentstrategies,whilebeingreceptivetotheirdevelopment
needs. “Prudent” and “receptive” are subjective attributes, however, which inevitably lead to
7I am indebted to AnhNga TranNguyen for suggesting the topic and providing me with much knowledge about debt
sustainability analysis. Many useful comments were provided at the UNCTAD Expert Meeting Debt Sustainability and
DevelopmentStrategiesonOctober2628,2005.Alltheviewsexpressedherearemine,asaretheerrors.8ThisdistinctionisintroducedinBulowandRogoff (1989).
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Debt Sustainability Assessment:theIMF Approachand Alternatives
18
controversies. It isnatural to try andescape such controversiesbydesigning systematicand therefore
universallyapplicableprocedures.Indeed,theWorldBank’sInternationalDevelopmentAssociation(IDA)
andtheIMFhaverecentlystartedtoformalizetheirdebtsustainabilityassessment(DSA)procedures.IDA
lending isnow informedby abatteryof criteriadevelopedwithin theCountry Policy and Institutional
Assessment (CPIA)approach,while the IMFand theWorldBankhaveput inplacea standardizedDSA
proceduredesignedtoberoutinelyusedaspartof itssurveillanceandlendingoperations.
Thispaperexamines theDSAprocedure.Thenextsectionexplainswhy it ismission impossible.Noting
thatsustainabilityisaforwardlookingconcept,itarguesthatanypracticaldefinitionisarbitrary,andthat
any sustainability indicator will be both arbitrary and too imprecise to serve as a tool for policy
prescription. Section C then examines the IMF’s procedure, intended to deal with this impossibility
principle by being both simple and transparent. Because of the “mission impossible” nature of the
exercise,however,theprocedureseemstobeevolvingtowardsmorecomplexity.Indeedsimplicitymay
comeattheexpenseof precision,whichcallsforincreasingcomplexity.Inaddition,giventheIMF’sown
definitionof sustainability, theprocedure requiresadopting, formallyor informally, theCPIAapproach
developedbythe IDA,asourceof opacity.ThesectionalsoreviewsotherDSAapproaches,somewhichemphasizesimplicityatthecostof precision,whileothersgofurtherinthedirectionof complexityatthe
costof transparency.Arguingthatsimplicityandtransparencyindeedareessentialtomaketheprocedure
acceptable, Section D develops a series of principles that lead to a simpler, less ambitious and less
systematicprocedurethatseekstoreplacearbitrary judgmentswithaframeworkfordialoguebetween
theofficiallendersandtherecipientcountries.
B. WhatisDebtSustainability?
1. Definitions
Debt sustainability is accepted that aims at answering a deceptively simple question: when does a
country’sdebtbecomesobigthatitwillnotbefullyserviced?Thequestioncanbeappliedtotheexternal
debtortothepublicdebt.Theanalyticsare identicalonce it isnotedthattheexternaldebt islinkedto
theevolutionof theprimarycurrentaccountbalanceinthesamewayasthepublicdebtislinkedtothe
primarybudgetbalance.Thisdistinctionwillbeblurredinthepresentsectionbyreferringto“debt”and
“primarybalance”,withoutspecifyingwhetheritappliestopublicorexternaldebtsandbalances.
The IMF’sowndefinitionof sustainability is:adebt“is sustainable if it satisfies the solvency condition
withoutamajorcorrection[…]giventhecostsof financing”(IMF,2002,p.5).Solvency,inturn,needsto
bedefined.Debtsolvency isachievedwhen futureprimarysurplusesare largeenough topayback the
debt,principaland interest.More technically, solvency requires that thecurrentdebtplus thepresentdiscountedvalueof allexpendituresdoesnotexceed thepresentdiscountedvalueof all revenues (or,
equivalently, that the currentdebtnotexceed thepresentdiscountedvalueof future revenuesnetof
noninterestexpenditures).
The solvency definition is clear cut and has long been formalized, but raises many implementation
difficulties.Thesustainabilitydefinition,asstated,isvague.
Solvency Issues
Solvency,andsustainabilityasaconceptthatbuildsuponsolvency,isentirelyforwardlooking.Itisfuture
balancesthatmatter,notthepastandnot justthecurrentdebtlevel.Hugedebtscanbepaidback,and
smalldebtsmaynotbesustainable.Theoutcomedependsonwhattheprimarybalancewill look like in
the future, includingtheverydistant future. In fact,mostGovernmentsare indebted foreverandmany
externaldebtsremainhighfordecades.Forinstance,FigureII.1.showstheevolutionof theBritishpublic
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debt,measuredinpercentof GDP.Duringthelast300years,itneverdroppedbelow20percent,reaching
270percentontwooccasionsandaveraging117percent.Thisdebtwasalwayssustained inthesense
thattheBritishGovernmentneverdefaulted.Wereturntothisexamplebelow.Fornowwe justnotethat
dealingwith the issueof debt solvency – and therefore sustainability – requirespassing judgment on
eventsthathavenothappenedyet,thatmaycoveravery longhorizon,measured indecades,andthat
arelargelyunpredictable.
FigureII.1.TheBritishPublicDebt –17002004
(Per cent of GDP)
British public debt
0
50
100
150
200
250
300
1700 1738 1776 1814 1852 1890 1928 1966 2004
Source:BurdaandWyplosz(2005).
Thenextdifficultyisthatthedebtmustbescaledsomehowtocountrysize.Themostpopularapproachis
torelatethedebttotheGDP,as inFigureII.1.,butthechoice isnotstraightforward.Itdependswhat is
the sourceof revenues.Publicdebtsare servicedoutof government revenues, sowhatmatters is the
taxingabilityof theGovernment,nowandinthefuture.
If thedebtisexternalorpublicbutpartlyowedtotherestof theworldand/orinforeigncurrency,itwill
beservicedbytheamountof revenuesinforeigncurrencythattheGovernmentcancollect.Thereislittle
relationshipbetweenGDPandtheadequacyof collectiblerevenues.Soanotherscalingfactorisrequired
and it iscustomarytouseexports.But thisassumesthataconstant fractionof exportscanbeused to
service thedebt.The scaling factor –GDP,exportsoranyothermeasure –mustbe forecastover the
relevanthorizonsothat it isnot justthedebt itself thatmustbeguessed.Therecanbenopretenseof precision.
Afurtherdifficultyisthatdebtsarerolledover.Evenlongtermbondsarenotlongtermenoughtocover
quasipermanent debts.9As the debt is refinanced, borrowing costs change and must therefore be
guessedaswell.Thisrequiresmakingassumptionsonthefuturecourseof domesticinterestratesforthe
partof thedebt that is issued indomestic currency,andassumptions regarding future foreign interest
ratesandcountryriskpremiaforthatpartissuedinforeigncurrency.Interestratescanchangebecauseof
externalconditions –includingsometimescontagionfromfarawayevents –whichaffectinunpredictable
waysthesolvencycondition.
9Thisisnotentirelycorrecthistorically.TheBritishgovernmenthasissuedperpetuitiescalledconsols,bondslackingamaturity.
Oncealargeproportionof thepublicdebt,consolsarenowanoddityunlikelytobefeasiblefordevelopingcountries.
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Inextreme,butnotrare,situations,itmayprovetemporarilyimpossibletorefinancethematuringdebt,
muchlesstoissuenewdebt.Thisdoesnotnecessarilymeanthatthedebtisunsustainable;itisacaseof
illiquidity. Illiquidity may none the less force a debt default, even though the debt is sustainable, as
previouslydefined.
Definitionof Sustainability
Twoqualificationsof theIMFdefinition implythatsustainability isamoredemandingrequirementthan
solvency.The firstqualification istoruleouta“majorcorrection” intheprimarybalance.Thisprobably
referstosevereexpenditurecutsorlargerevenueincreasesachievedthroughtaxationorpricingof goods
andservicessuppliedbythepublicsector.Thedefinitionthereforecoversliquidityconstraints –adrying
upof financing,eitherdomesticorexternal –thatrequiredrasticadjustments.Thesecondqualification
refers to the “cost of financing”. Financing costs are bound to change over time and are therefore
unpredictable. In particular, they may increase as the debt rises, creating a vicious circle of the type
discussedfurtherbelow.Asaconsequence,adebtmaybesustainabletodayandunsustainabletomorrow,
or conversely.Thus thedefinition canbeunstable. Finally,note that “major” is amatterof judgment,whichmeansthattheIMFdefinitionisuncomfortablyvague.
TheIMF’sdefinitionisatvariancewiththesustainabilityconceptproposedbyArrowetal.(2004)inavery
different context (theenvironment).Applied to thedebt issue, theirdefinition couldbe interpretedas
suggestingthatsustainabilityrequiresthatthenetworthof anentity (theGovernmentorthecountry),
definedas thepresentdiscountedvalueof net revenues lessthecurrentdebt,beonanondecreasing
trend.Thisdefinitiondiffers from the IMF’s in two importantways.First, itdoesnot require solvency.
Solvency isachievedonly if networth isnonnegative.Thealternativesustainabilitydefinitiondoesnot
ruleoutthat,initially,networthbenegativeaslongasitisrisingandeventuallybecomesnonnegative,
thusmeeting the solvencycondition.10Second,and importantly forwhat follows, itdoesnot implyany
specificthresholdforthedebt.
Makingdefinitionsoperational
Thus there are many competing definitions of external or public debt sustainability. The Box below
summarizesandinterpretsthesevariousconcepts.Onetheoreticallypureconceptissolvency.Theother
theoreticallyclearconcept,proposedbyArrowetal.(2004),isthatthenetworth(of thecountryforthe
externaldebtortheGovernmentforpublicdebt)beincreasing,oratanyratenondecreasing.Thesecond
concept is lessstrictthanthefirstonesincesolvencyrequiresthatnetworthbealwayspositive.These
conceptscannotbeimplementedassuchbecausetheyrequireknowledgeof thefutureevolutionof the
debt.
IMF (2002) adds to solvency the requirement that solvency be always maintained without any majoradjustment. Bothbecause it relieson solvency andbecause it restson anunspecified limit to “major
adjustment”,thisdefinitioncannotbe implementedassuch.Asexplainedbelow,thedefinition ismade
operationalbyrequiringthatthedebtdoesnotexceedathreshold,tobefurtherdiscussed.Itshouldbe
noted that, if the threshold is conservatively set, the resultingdefinition ismoredemanding than the
previousone(if thethresholdisnotbinding,thedefinitionisempty).
TheArrowetal.(2004)conceptcanbemadeoperationalby ignoringtheunobservablepresentvalueof
primarybalancesandrequiringthatthedebttoGDPratiobestationary.Sincestationarity isdifficultto
assess inpractice,thedefinitioncanbe implementedby requiringthatthedebtratiobeonadeclining
trend,whichdoesnotruleoutoccasionalbuttemporaryincreases.
10ThispointisformallystatedintheAppendix.
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2. AnImpossibilityPrincipleandItsImplications
Because debt sustainability is a forwardlooking concept, it cannot be assessedwith certainty. In this
rigoroussensedebtsustainabilityassessment (DSA) is impossible.Atbest, followingproceduressuchas
thosepresentedinSection3below,educatedguessesmaybepossiblebutitisimportanttorecognizeat
theoutsetthattheseare justguesses,nomatterhowsophisticatedtheymaybe.Theimplicationsof this
impossibilityprinciplearefarreaching.
Giventhelargenumberof guessesthatarerequiredtoreachanyconclusion,thebestthatcanbehoped
for are statementsof the type: “there is a probability of x per cent that the debt is sustainable at a
particularhorizon”.Twoaspectsof thisstatementneedtobehighlightedatthisstage.First,DSAcanonly
provideprobabilities.Insomeextremecases,thesemaybe0or100percent,11butgenerallytheywillbe
somewherebetween thesevaluesbutnoteasilydefined.Putdifferently,DSA is rarelyblackandwhite
andthereforeanimpreciseguidetopolicy.
Second, theprobability thatadebt is sustainable in the IMF sense isbound to changeover time.For
example,ahighlyindebtedGovernmentthatrunsasizeableprimarysurpluswillseeitsprobabilityof debtsustainability rise over time. This is in accord with definition of Arrow et al (2004). Conversely a
Governmentthatstartswithalowdebtbutsystematicallyrunslargeprimarydeficitswillhaveadeclining
probabilityof debtsustainability.
These twopossibilities imply thatany statementon sustainability isvalidonly foraparticularhorizon.
What should thathorizonbe? In theory, it should be infinitebut, in practice, it isdeterminedby the
availabilityof reliableforecasts:if forecastsof primarybalances,interestrates,GDP,etc.areextendedto
10years, theDSAwillprovideananswerat the10yearhorizon, i.e.amuch shorterhorizon than the
11Thecollapseof theLTCMhedgefundisausefullesson.InSectionC,wewillpointoutthesimilaritybetweenDSAandportfolio
assessment,andwillindeeddiscussvalueatrisk,asophisticatedtechniquedirectlyborrowedfromfundmanagement.Resorting
tothemostadvancedtechniquesavailable,LTCMmanagers –whichincludedNobelPrizewinnerRobertMerton –hadconcluded
thattheirinvestmentwasnear100percentsure.Asitturnedout,anextremelyrareconjunctionof eventsoccurredandLTCM,
arguablythemostprestigiousfund,wentbankrupt.
BoxII.1.TheoreticalandOperationalDefinitionsof DebtSustainability
LetbtbethedebttoGDPratioattimet.Simplifyingsomewhat,thevariousdefinitionsinthetextcanbe
summarizedasfollows.
DSAdefinition:bbt
,whereb isathresholddiscussedinsection3.1below.
Solvency:thepresentvalueof btbecomesnegligibleforlonghorizons(limbt/(1+r)t=0ast),
whereristherealinterestrate.Anequivalentdefinitionisthatthepresentvalueof primary
balancesbt.(Seetheappendixforaformalization.)
Debtserviceability:solvencyplusnoilliquidity.Illiquidityariseswhenthedebtcannotbeservicedat
aparticularpointintime.
IMF(2002)definition:solvencyplusnoneedformajorcorrection.
Arrowetal.(2004):networth,i.e.thepresentvalueof primarybalanceslesscurrentdebt,isnot
decreasingovertime.
Debtstationarity:btdoesnotgrowwithoutbounds.Analternativeisthatbtbe(weakly)
declining.
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infiniteonelogicallyrequired.However,sinceeven10yearforecastsaretotallyunreliable,thehorizonis
boundinpracticetobemuchshorter.Butthisunderminestheconceptualbasisof thisapproach.
As discussed below, a common way of circumventing the horizon problem is to assume “everything
constant”andextendpasttrendstoaninfinitehorizon.Thisisconvenientbuthasunlikelyconsequences,i.e.theprobabilityof theassumedpathiscloseto0percent.Suchexercisesdescribepathsthatcannotbe
takenatfacevalue,inparticularforthepurposesof policieswithseriousconsequencesforthelivelihoods
of manypeople.
Another aspect of the impossibility principle is that sustainability as defined by the IMF requires a
judgmentof whendebt istoo large.Figure II.1remindsusthatdebtcanbeverybigandyetsustained.
Recent work has pointed out that “big” is a relative concept.12It is generally considered that the
developingcountriescannotsustainlargedebts.FigureII.2.showsthat,indeed,thepeakinthemid1990s
foremergingmarketswasfollowedbyawaveof crises.Willtherecentriseforthesecountries,nowabove
the previous peak, usher a new wave of crises? No one knows. Yet, framing the debt sustainability
definitionastheIMFdoesmakesunavoidabletheadditionof anewconcept,namelyadebtceiling.Thereisnoprecisewayof definingthisceiling.Itmustbebasedonthemaximumamountof resourcesrequired
toservicethedebt,andthusonassumptionsabouteconomiccostsandpoliticalacceptability.Thiswayof
puttingthequestionleadstoanotherimpossibility,thatof assessingadebtceiling.
Finally,rising interestratesincreasethedebtburdenandreducetheprobabilityof debtsustainability.A
disturbing aspectof this linkage is that interest ratesonpublicdebts,whether indomesticor foreign
currency,includeariskpremium.Theriskitself isrelatedtotheprobabilityof default,i.e.tosustainability.
Theresultisthepossibilityof aviciouscirclethatgoesfromthefearof debtnonsustainabilitytohigher
interestratesandthustoahigherprobabilityof nonsustainability.13Inotherwordsthemerefearof non
sustainabilitymakesitmorelikely.Debtdistresscanthusbeself fulfilling.Thismaymeanthatimproperor
incorrectlyinterpretedDSAcanhaveadeleteriouseffectondebtsustainability.
FigureII.2.PublicDebtsinIndustrialandEmergingMarketCountries –19922002
Source:IMF(2003a).
12Forarecentassessment,includingmanyreferences,seeCordellaetal.(2005).
13ThisprocessisstudiedinBlanchard(2005).
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3. DebtsandInflation
Inflation isa furthercomplication that isoften ignored inDSA.Even forexternaldebt, inflationmatters
because interestandexchangeratesdonotalwaysreflectactual inflation.Forexample, if theexchange
ratedepreciatesfasterthanprices,foreigncurrencydebtbecomesmoreexpensiveindomesticcurrency.
Thesamehappenswhentheinterestrateondomesticcurrencydebtincreasesbymorethantheinflation
rate.Debt service becomes heavier. Conversely,when interest and exchange rates fail to fully reflect
expected inflationandthedebt isnot indexedand isdenominated indomesticcurrency,rising inflation
temporarilyreducesthecostof borrowing.14
DSA should recognize thesevariouspossibilitiesbutdoesnot incorporate standardprocedures for this
purpose.Onereasonistechnicaldifficulties.Notonlywoulditbenecessarytoforecastinflationbutalso
expected inflationandnonneutralities, i.e.theextenttowhichtheexchangerateandthe interestrate
failtoreflectexpectedinflation.Whileitispossibletoforecastinflationoverarelativelyshorthorizon,say
twotothreeyears, forecastsbeyond thathorizondependonpolicyactions thatareyettobe taken. It
may also be that international institutions, that typically do not condone inflation, are unwilling tospeculateonwhatitcouldbeandhowitcouldbeusedtoalleviatethedebtburden.
15
4. LinkwithEarlyWarningIndicators
A large literaturehasbeendevoted toearlywarning indicatorswhich try to identify irregularities that
eventuallyresultinafinancialand/orcurrencycrisis.LikeDSA,earlywarning indicatorsmustbeforward
looking.Crises,and thereforeearlywarning indicators,arebeyondthescopeof thepresentpaper.The
onlydirectlyrelatedquestioniswhetherahighdebt level isacauseof financialcrises,amongthemany
potentialones.AccordingtotheextensivesurveyinHemmingetal.(2003),theanswerismaybe.Formal
statistical analyses provide conflicting results on this point. A problem is that they use current fiscal
indicators, thebudgetbalanceor thedebt level, aspotentialpointersof impending crisis. So far,DSAindicatorshavenotbeenused,tothebestof myknowledge,inearlywarningindicatorestimates.Todoso
wouldprovideagoodgaugeof theirempiricalrelevance.
C. ApproachestoAssessingDebtSustainability:ACriticalReview
TheimpossibilityprincipledevelopedinSectionB.2representsaformidablehurdle.AllapproachestoDSA
havetorelyonassumptionsaboutthefutureevolutionof budgetbalances,GDP,interestrates,etc.The
usefulnessof theconclusions isdirectlyrelatedtothevalidityof theseassumptions,whichbydefinition
areneithersafenortestable.Thissectionstartswithacriticaldescriptionof theapproachchosenbythe
IMF.Itthenpresentsandevaluatessomealternativeapproaches.
1. TheIMFStandardizedApproach
The IMFhasdecided to systematically attach a standardizedDSA toprogramdesign and toArticle IV
consultations.TheseDSAsexamineboththepublicandexternaldebts.Thestatedintentionistoprovidea
simple, fully transparentandstandardized tool thatcanbe readilyapplied toallcountries.16TheWorld
14Buiter(1985)hasshownthatthegreatreductionof theBritishpublicdebtover19461970hasmostlybeenachievedthrough
the inflation tax.A full account of this process includes regulated interest rates, i.e. some degree of financial repression. In
countrieswithfullcapitalmobility,thiswillnotbepossible.Awiderdiscussionof theroleof financialrepressionisbeyondthe
scopeof thispaper.Awellknowndefenseof somedegreeof financialrepressionisRodrik(1998).15AbiadandOstry(2005)provideevidencethatinflationraisestheprimarybudgetsurplus.
16Infacttherearetwodifferentbutrelatedprocedures,onedesignedforcountrieswithmarketaccessandanotheronedesigned
forlowincomecountrieswhichrelymostlyonpublicfinancing.Themaindifferencesarethefollowing.1)Inthecaseof countries
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Bankhasadoptedasimilarprocedure.Unfortunately,the impossibilityprinciple is incontradictionwith
these intentions. Simplicity is achieved at the cost of improbable assumptions; these assumptions are
transparent,buttheyarelessinnocuousthantheyaremadetoappearbecausetheunderlyingcomplexity
isconcealed.
Focusinghereon theexternaldebtpartof theexercise, the IMFapproach includes the following four
steps:17
(i) Afiveyearcentralforecast,orbaseline,of thevariablesthataffecttheevolutionof theexternal
debt:theprimarycurrentaccount,GDP,interestandexchangerates,andinflation.
(ii) Theresultingevolutionof thedebt,asashareof GDP,overthenextfiveyears.Thisevolutionis
uncontroversialasitfollowsfromthefollowingaccountingidentity:
t t t t balance primaryb g r bb 11 )(
WherebisthedebttoGDPratio,ristherealinterestrateandgistheGDPgrowthrate.
(iii) Several stress tests that look at the effect on debt of adverse shocks affecting the variablesforecasted instep((i).Theshocksareasfollows:first,eachof threevariables(the interestrate,
realGDPgrowthandtheprimarycurrentaccount)ischangedonebyonehalf standarddeviation
overthesamefiveyearhorizon;thenallthevariablesaresimultaneouslyshockedbyonequarter
standarddeviationeachover fiveyears; finallytheexchangerate isassumedtobedepreciated
onceby30percentatthebeginningof thesimulationperiod.
(iv) TheDSAconcludeswitha judgmentonwhetherthedebtlevelsimpliedbyanyorallof thestress
testsaretoohighforthedebttobeconsideredsustainable.
The result is a figure like Figure II.3., which is based on the November 2005 review of the standby
agreementwithColombia,seeIMF(2005b).18Thefiguredisplaysvarioussimulatedpathsof theexternal
debtoverthefiveyearperiod200610:thebaselineobtainedinstep((ii))andtheeffectsof threeof the
shocksdescribedinstep((iii)).Theseshocksare:aonehalf standarddeviationcurrentaccountshockand
the combined shock,both assumed to last thewhole simulationperiod20062010; and a30percent
exchangedepreciationoccurringin2006.
withmarketaccess,theanalysisconcernsboththeexternaldebtandthepublicdebtand,inthecaseof theexternaldebt,itdeals
with its levelwhile, in thecaseof lowincomecountries, itconcernsonly theexternaldebt,which ismeasured innetpresent
discountedvalueterms.2)Forlowincomecountries,theDSAusesanexplicitproceduretoestablishdebtthresholds,whilethe
threshold is leftopentodiscussion inthecaseof themarketaccesscountries. IMF(2003b)proposestousethesamestandard
proceduretobothgroupsof countries.Thepresentanalysisignoresthesedifferences.17ThisdescriptionfollowstherecentchangesasdescribedinIMF(2005a).
18Thisseemstobethefirst,andsofaronly,countryreviewthatappliesthechangesasdescribedinIMF(2005a).
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FigureII.3.Exampleof DSA:SimulatedPathsof theDebttoGDPRatio
25
30
35
40
45
2004 2005 2006 2007 2008 2009 2010
Baseline Current account shock
Combined shock 30% depreciation
Source:IMF(2005b).
Whatcanthisinformationbeusedfor?Obviously,thebaselineisnocauseforconcern.Thestresstests,
ontheotherhand,are lessbenign.TheonetimedepreciationraisesthedebttoGDPratiobyabout30
percent,presumablybecausetheexternaldebtisinforeigncurrency.Thisisnotathreattosustainability,
however,becausethedebtstartsdeclininginthethirdyear,mostlikelybecausedomesticpricescatchup
withtherateof depreciation.Moreworrisomearetheeffectsof aworseningof thecurrentaccountand
of thecombinedshocksinceinbothcasesthedebtkeepsonrising.
The unavoidable question is whether these simulations are sufficient to warrant a policy reaction.
Undoubtedly,werethedebtratiotokeepongrowing,thedebtmusteventuallybecomeunsustainable,
butwhen? Inaddition,sincetheshocksareexpectedto last for fiveyears,thedebtshouldpresumably
declinebeyondthehorizon.Inordertobeabletodrawanyconclusionfromthisexercise,therefore,one
must be able to conclude that the debt level reached at some point in Figure II.3. is too high to be
sustainable.This, in turn, requiresestablishingadebt threshold levelbeyondwhichdanger is looming.
Danger means debt distress, i.e. financing difficulties or, worse, partial or total default. In view of
empirical results that show that the riskof debtdistress riseswith the sizeof debt, itseems logical to
establishadebtthresholdbeyondwhichtheriskscanbedeemedunacceptable.This istherationaleof
step((iv)).
Should there be a single threshold for all countries? Here again, empirical research shows that the
probabilityof debt distressdepends not just on thedebt level itself,but alsoon a varietyof factors,
includingtheprevailingmacroeconomicsituationand, importantly,thequalityof economicandpolitical
institutions. A unique common threshold, therefore, is bound either to be too restrictive or too lax,
dependinguponthecountrycharacteristics.ThisiswhytheIMFhasbeguntouseaspartof step((iv))an
additionalprocedurecalledCountryPolicyand InstitutionalAssessment(CPIA).DevelopedbytheWorld
Bank,CPIAproducesanindexof governancequalityforeachcountryproducedbytheWorldBank.19
This index,which ranges from 1 (lowestquality) to6 (highestquality), isbasedon 20 indicators. It is
updatedannually, followinga formalandelaborateprocessthat involves theBank’scountryteamsand
centraldepartments.Foundtoperformwellinstatisticaltests,theindexisusedtoclassifycountriesinto19Thisproceduresofaronlyappliestothelowincomecountries,presumablybecauseitisinuseatIDA.TheFundisconsidering
applyingittocountrieswithmarketaccess.
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Debt Sustainability Assessment:theIMF Approachand Alternatives
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threegroups:countrieswithalowCPIAindexareascribedadebtthresholdof 30percentof GDP,raised
to45percentfortheintermediategroupof countries,andto60percentforthecountriesinthehighest
CPIA indexgroup.These thresholdsarechosen such that theprobabilityof debtdistress is25per cent
whentheyarereached.Followinganexpertreview,theWorldBankreducedthenumberof criteriafrom
20to16andhavemadeindividualratingspubliclyavailableforIDAcountriesin2005.
2. Discussionof theIMFApproach
Steps ((i))and ((ii))aremechanical implicationsof the IMF’s forecasts. If the forecastsareaccurate,the
implieddebt levelisareasonablysafeprevision.TheFundreportsonitsownstudiesthatshowthatthe
forecaststendtoerrontheoptimisticside,withequallyoptimisticdebtpredictions(IMF,2005c).
Probability of Worst CaseScenarios
Thispossibilityof forecastingerrorexplainswhy,“inorderto imposediscipline”onthediscussion,step
((iii))looksatsomeworstcasescenarios.Since“worst”canbevirtuallyanything,theprocedureattemptstobereasonableandtransparent.Tothateffect,theshocksarepreciselycalibrated.Buthowlikelyare0.5
standarddeviationshocks?TheIMFarguesthattheprobabilityof thedebtexceedingtheworstcaseon
thefifthyearisbetween15and30percent,“whichseemsareasonablebalancebetweencapturingthe
mediumtermriskstodebtdynamicswithoutbeingsoextremeastobeirrelevantforpolicydiscussions”
(IMF,2005a;p.3).Theemphasisisrightlyputonpolicyimplicationsbuttheargumentraisesthegeneral
questionof whatcanbelearntfromstresstests.
Thereisnothingwrongwithstresstesting.Indeed,itisacommonapproachtoportfoliomanagementand
widelyused inthe financial industry,asexplained inSectionC.3.Yet,the implicationsprofoundlydiffer
betweeneconomicpolicyandportfoliomanagement. Inthefinance industry,whenstresstestsreporta
dangerzone,evenahighlyunlikelyone,portfoliomanagersmaydecidetochangetheassetcompositionof theirportfolios.Theadjustmentdoesnotcomeforfreesinceitimplieslowerexpectedreturns,butthis
istheusualpricetobepaidfor lowerrisk. Itsacceptabilitydependson investorpreference: if investors
areunhappywiththeirportfoliomanagers,theycanchangethem.
Inthecaseof DSA,whenstresstestssignalariskysituation, therequiredadjustment isto improvethe
primary current account. Inevitably, this calls for contractionary macroeconomic policies designed to
compressdemand.The costs take the formof falling incomesand risingunemployment.Thecostsare
bornebythepopulation.AdmittedlycitizenscanvotetheirGovernmentsoutof office –whentheregime
is democratic – but only ex post. A Government’s decision to react to events that may occur with a
probabilityof 1530percentisconsiderablymoresensitivethanthatof portfoliomanagers.
Characterizationof theWorst CaseScenarios
Thestresstestsinvolvechangesinonevariableatatimeexceptinthecasewhereallof themarevaried
togetherina“bad”directionforfiveyears.Howlikelyaresuchchanges?Itisunclearhowthe1530per
centestimate is constructed.Whydoes it assume that each shock is expected tobemaintainedover
consecutive5years?Does it take intoaccount the fact that someof these shocksmaybe correlated?
Lettingtheshocks lastthewholefiveyearsassumesa100percentautocorrelation.Theoneatatime
shockassumesazerocorrelation,whilethethreevariableshockassumesacorrelationof 100percent.
Theinformationprovided inIMF(2005a)doesnotshedlightonthisimportantquestion,suggestingthat
correlationsareignored.
What canbedone about these problems?Here, aswith the thresholdquestion, the proper technicalresponse isto jackupthe levelof complexity,atthecostof reducingthe intendedtransparency.Faced
with thecriticism thatchanges in justoneof thevariables thatdrive thedebtprocesshavehistorically
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typicallyaffectedtheothersaswell, thenormal tendency is toacknowledge thepointandtakeup the
challenge.Thismeansusingeconometric techniquestoestimatehow, inthepast, thesevariableshave
beenrespondingtoeachother’sshocks.20
Theprocedureiswellestablishedbuthasmanydrawbacks.Tostartwith,theestimateswouldhavetobeconducted country by country, an enormous task that would face serious data availability and
comparability problems. Next, the quality of the estimates is likely to be poor in many cases,21thus
injectingafurtherdoseof uncertaintyregardingthemeaningof thedebtthresholdandthusundermining
itsusefulness. Inaddition, theprocedurewould turna simpleand transparentprocedure intoahighly
technicalandcompletelyopaqueexercise,withlittleassurancethatthetestsareplausible.
The challenge is formidable,possibly insurmountable.22Itwouldbeamistake togo in thedirectionof
addedcomplexity,usingtheabundantparaphernaliaof econometricinstruments.Resortingtosimplebut
less extreme stress tests (shockswith reasonableoverallprobability)wouldbe an alternative,but the
resultscouldwellbetoomundanetobeworthconsidering.Thelackof asatisfactorysolutionisnothing
morethananimplicationof theimpossibilityprinciplepresentedinSectionII.C.
Borrowingand Growth
MissingfromtheDSAframeworkisthepossiblegrowthenhancingeffectof externalborrowing.Intheory,
acountrywithlowlevelsof humanandphysicalcapitalstandstobenefitfromexternalborrowing.If the
borrowingiswiselyinvested,thereturnsshouldmorethancoverthecosts.Thebenefitscomeintermsof
acceleratedgrowthandcatchingup.23
Thislinkageisexplicitlyignoredinthestresstests.Thismaylooksurprisinggiventhatmultilaterallending
isultimately justifiedby itsgrowthenhancingeffect.Onepossibleexplanation isthatthehorizon istoo
short for the growth effects to materialize. The proper response to this argument is to lengthen the
horizon,not to ignore the link. If debtdistressoccursalong theway, theexpectedgrowthbonus fromexternalborrowingwouldbedissipatedbutthisdoesnot justifyignoringthelink.
Anotherpossibleexplanationisthatborrowedresourcesdonotsystematicallydeliveranygrowthbonus.
There ismuchevidence that thequalityof policies andof political governancematter crucially in this
respect (Cordellaetal.(2005).Thisaspect ispartlytaken intoaccountbyCPIAasthequalityof policies
andinstitutionsareusedtodeterminedebtthresholds.
Giventheoverwhelming importanceof growthamorecomprehensiveframework isneeded.By limiting
theroleof policyandinstitutionqualitytothedeterminationdebtthresholds,DSAputsalltheemphasis
ontherisksof overborrowing.Ignoringtheconditionsunderwhichexternalborrowingcanharmorboost
growthamountstoposingthequestioninadequately.If externalborrowingisgrowthenhancing,theriskof over borrowing is small, possibly nonexistent. If, instead, external borrowing does not exert any
favorable growth effect and possibly stunts growth, the relevance of DSA is moot. Countries in this
20Somepapershave started toexplore this issue, seeGarciaandRigobon (2004),Abiad andOstry (2005)andCelasunetal.
(2005).21The degreeof precisionof such estimates is generallyquite limited but inmostdeveloping countriesdata availability and
qualityproblemsarelikelytobemoreserious.22IMF(2003b)suggestsusingthetechniquetoderivefancharts,i.e.chartsthatdepicttheevolutionof thedebtfollowingashock
byindicatingthemostlikelypathalongwitharangeof possibilities.FanchartshavebeenpopularizedbytheBankof Englandas
partof itsinflationtargetingstrategy.ThisishowtheBankpresentsitsinflationforecasts.Importantly,however,thefancharts
aredesignedbytheBankof England’sMonetaryPolicyCommittee.Theyarenottheresultof acomplexeconometricprocedure
but a snapshot representation of what policymakers believe. Fan charts are a great communication tool, which reflect the
considerationsthatgointopolicydecisionsbutnotoutsideexperts’estimationsof whatislikelytohappen.23Intermsof theformulapresentedinFootnote29,thegapbetweentheinterestcostandthegrowthratedeclines,andthedebt
accumulationbecomeslessdestabilizing,orthegapbecomesnegativeandthedebtisspontaneouslyonadecliningtrend.
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situation shouldonlyborrow indistress situations andpromptlypayback thedebtbefore theburden
becomescrippling.
Policy Responses
ThestresstestsalsoassumethattheGovernmentdoesnotreacttotheshocks.This is incontradiction
with much evidence that shows that the primary budget reacts to a rising public debt, which should
presumablyalsohaveadampeningimpactontheexternaldebt.24Thustheworstcasescenariosmustbe
seenasapredictionthatassumesthatGovernmentsdonotdowhatinfacttheyusuallydo.Thisfurther
reducestheplausibilityof thetests.
Country Policy and Institutional Assessment (CPIA)
TheinclusioninIMFdefinitionof debtsustainabilitytheconditionthatdebtlevelsnotbe“toolarge”leads
totheneedtoestablishthresholds.Theobservationthatreasonablethresholdsarelikelytovaryfromone
country toanother then requiresanexplanationof why some countriesaremore likely to suffer from
debt distress than others. This explanation involves a large number of economic and political
considerationsandrequiresvalue judgments,averyuncomfortableundertaking.
TheIMFIDAsolutionhasbeentolookforstatisticallinksbetweenvariouscausesof debtdistressandthe
debtlevel.ThetwoacknowledgedbackgroundstudiesareKraayandNehru(2003)attheWorldBankand
anunpublishedIMFpaper.Inlinewiththeliteratureontheroleof governance,25theresultingCPIAindex,
whichisreasonablypreciselyestimated,isfoundtoexertasignificanteffectontheprobabilityof external
debtdistress.OnthisbasisitwouldbepossibletoassertthatanimprovementintheCPIAindexreduces
the probability of distress and even to compute by how much. This is not how CPIA is used in DSA,
however.
Theprocedure insteadusestheestimationtoansweradifferentquestion:whatdebt level impliesa25percentprobabilityof debtdistress?Theanswercannotbebasedonthepartialeffectof theCPIAindex
only but also involves estimates of the effect of other economic variables. If the resulting overall
estimationdoesagood jobof explainingdebtdistressepisodes,itwouldbeagoodcandidatetoestablish
athresholdforeachcountry.Unfortunately,whiletheeffectof eachof thethreevariablesselecteddebt,
CPIA indexandrealGDPgrowthispreciselyestimated,togethertheyexplainonly23.4percentof the
probabilityof debtdistress. Ina study that seeks toexplain163episodesof debtdistressallover the
world,thisisagoodperformanceamongthebest inthe literatureandunlikelytobemuch improved
upon.Yet,thefactthattheanalysisexplainssolittleof thephenomenonof debtdistressimpliesthatthe
answerishighlyimprecise.SubsequenttestsprovidedbyKraayandNehru(2003)candidlyconfirmthis.
A furtherproblem is that theCPIA index isnot applied countryby country. Instead, the countries areclassifiedinthreegroupsdependingontheirownCPIAindex.Theeffectof governanceisappliedgroupby
group,whichimpliesthattheeffectiseitherexaggeratedorunderestimatedforthecountrieswhoseCPIA
indicesdonotlieinthemiddleof therange.Thisdistortionriseswiththedistancefromgroupmeans.
This procedure is surprising. On the basis of the estimation, it is possible to compute individual debt
thresholds.Why is itnotdone?One reason issimplicity.Three thresholdsareeasier todealwith than
countryspecificthresholds.Butthisisaweak justificationforintroducingseriousdistortionswhichimply
thatthethresholdcannotbetakenseriously.Anotherreasonisthepoliticalsensitivityof theCPIAindex
forindividualcountries.Thisisunderstandable,buttheresultisthattheDSAthresholdsaretoocoarseto
leadtofirmpolicyconclusions.
24AgoodsurveycanbefoundChapter3of IMF(2003a).
25AgoodreferenceisManasseetal.(2003).
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Sustainability Measure
It canbeargued that thedebt level, suitably scaled, is arguably the correctmeasure for sustainability
analysis.26Whentrackingitsevolutionovertime,however,aproblemarises.Whenevertheinterestrate
exceeds the economy’s growth rate, the debt accumulation process is intrinsically unstable. This ispreciselywhysustainabilityisanimportantissue.
27Twodifficultiesfollow.First,relativelysmallchangesin
therealinterestrateandintrendgrowthcantiltthedebtpathfromstabilitytoinstability.Second,when
thereal interestandgrowthratesareclose,smallshockscanhavedramaticallypowerfuleffectsonthe
debtpath.
Thestrengthof thiseffectcanbeseeninFigureII.4.ThefiguredisplaysthebaselinedebttoGDPratioand
theeffectof theDSAstandardcombinedstresstest,bothalreadyshowninFigureII.3.Thethirdcaseadds
tothecombinedtesttheeffectof anexternalinterestrateset3percenthigherthanassumedbytheIMF.
Thus increasingthe interestrateproducesasizeableeffect.Comparingthecombinedshockeffectswith
the lowerandhigherinterestrates,weseethatnotonly isthedebtrisingfasterbut,moreimportantly,
thatthedebtratioisnotstabilized,possiblysuggestingnonsustainabilityunderanydefinition.
Thisexampleillustratesthepointthatdebtaccumulationeffectscanbeeyecatchingand,inthisinstance,
mayraiseconsiderablealarmsincethedebtaccumulationprocessisunstable.Inreality,primarybalances
willbeadjustedastheresultof policymovesandof equilibratingreactionswithintheeconomywiththe
resultthatdebtinstabilityisusuallytakencareof.Of coursetherehavebeenepisodesof explodingdebts,
largely because small slippages can have dramatic effects as the result of the unstable nature of the
process.Thisiswhyputativedebtpathsof thesortproducedbytheIMFaspartof itsDSAprocedurecan
besomisleading.28
26Asnotedinfootnote16,forlowincomecountriesthisprocedureusesthenetpresentvalueof thedebt.While,inprinciple,this
isasuperiormeasure,itscomputationraisesanumberof delicatequestions,whicharenotconsideredhere.Whenwereferto
debtlevels,wedonotdistinguishbetweenthedebtanditsnetpresentvalue.27Whentheinterestrateislowerthanthegrowthrate,thedebttoGDPratioisstableandsustainabilityisassured.Inthelong
run,thisisanunrealisticcasebecausegrowthinexcessof therealinterestrateisacatchupphenomenon(acountrythatdisplays
asteadystaterealinterestratelowerthanthegrowthrateisonthe‘wrong’sideof thegoldenruleinthesensethatitsavesand
invests ‘toomuch’,suboptimallyrepressingconsumption).But intheshortrunthisconditionallowscountriestorundownthe
debttoGDPratio.Theinterestratemaybelowerthanthegrowthrateduringaperiodof fastgrowth(asinChinaorIrelandover
thelastdecade)orduringaperiodof acceleratinginflation(asduringsomeperiodsfortheUKshowninFigureII.1).28ArelatedconcernappliestotheDSAforlowincomecountries.Thechosenmeasure,thenetpresentvalue(NPV)of thedebt,is
very sensitive to interest changes.Thismeasure is compared to theNPVof thedebt ceiling. Should the ceiling itself alsobe
adjusted?TheIMFdoesnotdothis,arguingthatthereareoffsettingeffectsintermsof expectedproductivityadjustments.Thisis
likelytobetrue,eventhoughthetimingandsignof theseeffectsisnotknown.Butitisalsotruethatthesameeffectswillaffect
thepathof thedebtinthesameway.Itisinconsistenttoadjustonemeasureandnottheother.
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FigureII.4.EffectontheDebttoGDPRatioof aHigherInterestRateontheCombinedShock
25
30
35
40
2004 2005 2006 2007 2008 2009 2010
Baseline
Combined Shock
Combined Shock with higher interest rate
Source:Author’scalculationbasedonIMF(2005b).
Implementation
TheIMFhasexaminedtheshortexperiencewiththeimplementationof DSA.ItemergesthattheDSAhas
notbeenassuccessfulasitspromotersintended:“withsomeexceptions,sustainabilityassessmentshave
generallynotbeenatthecenterof policydiscussionsbetweenstaff andnationalauthorities.Thismaybe
becausethesensitivitytestsareconsideredtooextremetoberealisticor,evenif realistic,tooextremeto
warrantapolicy response.Conversely, there remainconcerns that theassumedshocksare toobenign.
Finally, fromapresentational standpoint,debt sustainabilityassessmentswouldhavegreater impact if
theywereintegratedinthebodyof thestaff reportinsteadof beingrelegatedtoanannex.”(p.15)
ThissituationreflectsreservationsaboutDSAascurrentlypracticed,whichleadstoreluctancetoraisethe
topicwithnational authorities. The intended transparencyof the shocksused for the stress testing is
marredbytheir lowprobabilityof occurrence.Another factor isthe“blackbox”natureof theexercise,
especiallytheassumptionsabouttheeconomy’sresponsetotheshocks.(Infact,itisassumedthatthere
isnoresponse,whichisunrealisticasnotedabove.)Moreimportantly,Staff maybeembarrassedbythe
question: “so what?”. This question immediately brings to the fore the need to decide whether a
temporarybulge inthedebt isthreatening.Theanswer ismeanttobeprovidedbytheCPIA.TheCPIA,
however, is another “black box” with a large degree of uncertainty. This uncertainty reduces theusefulnessof theCPIA thresholdsasa reliableguide forpolicy.Beingunabletoanswer the“sowhat?”
question,IMFStaff downplaytheDSAexercise.
3. OtherApproaches
Until recently, due to the impossibility principle, there have been few other attempts to design
implementableapproachestoDebtSustainability.Theearlyonesacknowledgedtheconcept’ssensitivity
tounavoidableassumptionsbystressingsimplicityandtransparency.Simplicityis justifiedbytheneedto
make heroic assumptions which imply that the conclusions will always be fragile. Transparency is
necessary to allow users to understand what lies behind the result. More recently, DSA has moved
towardsmoreelaborateprocedures,drivenby thehope thatempirical regularities can generatemore
reasonableassumptionsandfacilitateassessmentof theirplausibility.Acommentaryonotherapproaches
totheproblemsraisedabovefollows.
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TheDebt StabilizingPrimary Balance
The classic approach to sustainability asks what is the primary balance required to stabilize the debt
(Blanchardetal.,1991;Buiter,1985).Theobjectivecanbetostabilizethedebteitheratitscurrentlevel
or at any other level deemed more desirable. This approach is simple, transparent and easilyimplementablebecause itrequiresfewassumptions. In itssimplestform, it looksatthecurrentdebtto
GDP ratio and computes the primarybalancewhichwouldpermanently keep this ratiounchanged. It
requirestwoassumptions:whatwillbetheevolutionof thereal interestrateandwhat isthepotential
growthrate?Typically,pasttrendsareassumedtoremainstableovertheindefinitefuturebutshockscan
befactoredin, justasintheIMF’sDSA.
UltimatelyIMFdebtpathprojectionsandthecomputationof debtstabilizingprimaryaccountsarebased
on the same reasoning and assumptions. Both rest on the debt accumulation identity
t t t t balance primaryb g r bb 11 )(.Yet, there is an important difference. Debtpath projections
either indicatethat thedebt isstableordeclining, inwhichcase thereshouldnotbeanysustainability
issue, or that it is rising, indicating eventual unsustainability. The debtstabilizing primary accountapproach stops there. The IMF’sDSA goesone step furtherby exploring adverse shocks.When these
shocksimplyarisingdebt,newquestionsarise.Sincetheshocksare,byconstruction,temporary,arising
debtpathdoesnotmeanunsustainabilityunlessthedebtbecomestoo large.Thisthenraisesahostof
new issues,whichhavealreadybeendiscussed inSectionB.1.Thevirtueof thedebtstabilizingprimary
accountapproachistoavoidtheseissuesor,moreprecisely,topreventthemfrombecomingprominent.
Of course,thequestionof whatisanappropriatedebtlevelcannotbealtogetheravoided.Lookingatthe
primary account that stabilizes the current debt assumes that the current debt is appropriate. But
alternativetargets forthedebt levelcaneasilybe lookedat.Thequestion isvexingbecausethetheory
doesnotprovideananswer.TheWorldBank’sCPIA isoneattempttoprovideapracticalanswerbut is
subjecttotheproblemsdescribedinsectionC.2.
Howcouldthealternativeconceptof thedebtstabilizingprimaryaccountbeappliedtotheexampleof a
majorshockliketheexchangeratedepreciationpresentedinFigureII.3.?Inthebaselinecaseunderthe
IMFDSAthedebt/GDPratioisassumedtodecline.Thusadebtstabilizingprimarybalancewouldconsist
of adeficit.29Thiswouldprovideananswer to thequestionof what is thebalanceoncurrentaccount
needed to keep the debt level unchanged as a percentage of GDP, ignoring capital inflows? The
alternativeapproachcouldalsobeusedtoanswerthequestionof whatwouldbethebalanceoncurrent
account required to bring the debt level down to a particular level by, say 2010, if the debt level is
perceivedtobetoohigh?Thiswouldbeastraightforwardcalculation.
Asnoted, the conceptof thedebtstabilizingprimaryaccount is formally identical to the IMFDSA,but
interpretationisdifferent,asillustratedinFigureII.5.Herethedebtisassumedinthebaselinescenarioto
decline,and the figuresshow theeffectsof thecombinedshock.Thecorrespondingpaths forexternal
debtandtheprimaryaccountaredenotedas“original”.Theprimaryaccountremains insmalldeficitas
the debtmust be reduced. If it is assumed that the authorities can control the primary account, the
questionishowtheywouldpursuethepolicygoalof stabilizingthedebt.
Onepossibilitywouldbetofixthedebtatitspreshocklevelof 2005.Thisrequiresalargeprimarysurplus,
onethatcompletelyoffsetstheeffectof theshock.Thissurplusisshownas“Stabilized1”intheleftpanel
of FigureII.5.Therightpanelshowsthatthispolicyrequiresahugeimprovementintheprimaryaccount
in response to the sudden increase in the domestic currency value of the external debt due to the
depreciation.Thepolicyresponse isrelaxedwhentheprice increasescatchupwiththedepreciationso
thatthedebtisstabilizedindomesticaswellasforeigncurrency.
29Theformula,itwillberecalled,isprimarybalance=(interestrate –growthrate)xdebt.
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Fourth,theissueof accesstotemporaryexternalfinancingdrawsattentiontotheallimportantcredibility
issue.Thedownsideof the“Stabilized2”responseisthatthedebtincreasewillbetemporaryonlyif the
authoritiescancommittoasustainedprimaryaccountsurplus.Absentcredibility,theadjustmentmustbe
frontloaded,asinthe“Stabilized1”case.
Credibilityisalsopartof theIMFDSAsinceitliesattheheartof theprocedureof thresholddetermination
carriedoutunderCPIA.Yet,FigureII.5pointstoashortcomingof thisapproachwhichfailstodistinguish
betweencaseswhereanincreaseinthedebtlevelismerelythetemporaryconsequenceof atemporary
shock,on theonehand,and thosewhere it results fromendemicpolicy indiscipline.31This iswhy it is
essentialthatIMFlendingbeaccompaniedbycredibilityenhancingconditionality.
Thisexampleillustratesthepointmadeabove:theIMFDSAprocedureimaginesshockswhichmayresult
insizeabledebtbuildupsbecausetheauthoritiesareassumednottoreact.Weseethat, if giventime,
relativelymoderateprimaryaccount improvementscan stabilize thedebt (this is“Stabilized2”).There
shouldbenoimplicationthattheshockmustbedealtwithimmediatelyaswith“Stabilized1”.
Valueat risk stresstests
Financial institutions havedevelopedprocedures to explore the risks associatedwithportfolios in the
formof thevalueatrisk(VAR)approach.Forfinancialfirms,theobjectiveistheavoidanceof insolvency.
Attheheartof thisapproacharetwomainideas:thathistoryallowstheevaluationof theprobabilityof
variouseventsorcombinationsof events,andthatreactionsshouldtake intoaccountboththepossible
severityof eacheventanditslikelihood.
The techniques used to measure the plausibility of various risks can also be applied to the debt
sustainabilityquestion.The IMF’sapproach takesapartial step in thisdirectionwhen it sets levels for
somevariables instress testingon thebasisof theirpreviousbehavior.But,asnotedabove, it ignores
howthesevariablesreacttoeachother.Inprinciple,onecouldgomuchfurtherinthisdirectionbutonlyatthecostof addingconsiderablecomplexityandopacity.
TheissuehasbeenstudiedbyGarciaandRigobon(2005)andCelasunatal.(2005),sothatitispossibleto
giveasenseof whatshouldandcanbedone.Ratherthanspecifyingshocksonthebasisof thehistorical
evolutionof individualvariables,properlyconstructedstresstestsshouldtakeintoaccountthehistorical
interdependenceamongthesevariables.Forexample,inthecasesdisplayedinFigureII.3.thecombined
shockinvolvesasimultaneousdeteriorationinthecurrentaccount,theinterestrateandGDPgrowth.This
combination may be more or less likely than each of its components. For instance, if GDP growth
systematically worsens when the interest rate increases, the combination is as likely as each of its
components.Allowingforsuchcorrelationsenablesbetterappraisalof theprobabilityof theshocksthat
areconsidered.
This is the first step of the VAR approach which assumes that historical correlations are likely to be
relevantinthefuture –areasonablebutnotnecessarilycorrectassumption.Thenextstepthenistotake
intoaccountallthepossiblecombinationsof shocksbasedonestimatedcorrelations.Theprocedurecan
beautomatedtorandomlygenerateaverylargenumberof shocksbothsmallandbig,inisolationandin
combination.Eachshockisassociatedwithaprobabilityof occurrence.32Thelaststepistoassociatewith
eachshockthecorrespondingevolutionof thedebt,muchasintheIMF’sDSA,exceptthateachdebtpath
nowcomeswithaspecifiedprobabilityof occurrence.
31Thesamefailuremayhelptoexplainwhytheestimatesof KraayandNehru(2003)explainonlyasmallpartof episodesof debt
distress.32Technically,thisiscalledMonteCarlosimulations.
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Debt Sustainability Assessment:theIMF Approachand Alternatives
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Onecanthenaskthefollowingquestion:at,forexample,thethreeyearhorizonwhat istheprobability
thatthedebtbebetweenahighandalowlevel?Thedifferentcombinationsof highandlowlevels,with
associatedprobabilitiescanthenbepresented ina“fanchart” like theoneshown inFigure II.6. Inthis
figuredifferentlyshadedranges identifyalternativeprobabilitiesforpublicdebtof SouthAfricaoverthe
20052009horizon.33Thedarkestrangecorrespondstoanestimatedprobabilityof 80percent,witheach
lighterrangereducingthe likelihoodby20percent.Thefigureshowsthat,thefurtheroutwe look,the
greatertheuncertainty.
This presentation resembles the debt paths shown in Figure II.3. but with important differences. In
contrast to Figure II.3., the shocks are not identified. This is a step forward since the shocks under
considerationinFigureII.3.arearbitraryandthereforeunlikelytobewellsuitedtoanyparticularcountry.
The largenumberof randomly generated shocksunderlying theVARexerciseof Figure II.6. avoid this
criticism.Standardizationof theIMFDSAistheconsequenceof simplicity,butitscostisarbitrarinessand
therefore limited credibility.Moreover theVAR approach enablesone to judge at a glancehow likely
someof thedramaticscenariosare.
FigureII.6.ValueatRiskAnalysis:TheFanChartforSouthAfrica’sPublicDebt
(Externaldebtasaproportionof GDP)
Source:IMF(2005d).
HowevertherearecostsassociatedwiththeVARprocedure.Tostartwith,itiscomplex.Fewdeveloping
countries are equipped to carry out such estimations and it would stretch even the staff of anymultinationalinstitutiontodealwithalargenumberof countries.Inordertoprovidereasonablyreliable
estimates, the procedure requires good data, possibly going farback in the past, and few developing
countrieshavesuchdata.
Complexfanchartexercisesmayalsoprovidean illusory impressionthatuncertainty iswellunderstood.
Whilefanchartsdoprovideuseful information,theirprecision isunknown. Itdependsonthequalityof
thedata,ontheperformanceof theunderlyingeconometricanalysis,andontherelevanceof historyfor
the future. Importantly,perhaps, its“blackbox”naturegoesagainst thegoalof transparencyandmay
deterpolicyaction.Thustheunavoidablecomplexityandopaquenessmaynotbeworththeeffort.34
33Thechartdisplaysthepublic,nottheexternaldebt.34Itmaybe ironic that themostadvancedcountries,whichcanandoftencarryoutsimilarexercises,pay limitedattention to
thematdecisionmakingtime,whileIMF(2003b)andIMFandIDA(2004)callforprioritizingDSAimplicationsinthecaseof the
lessadvancedcountries.
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ReactionFunctions
AkeymessagefromFigureII.5.isthatpoliciesdomatter.Adequatepolicyreactionscandealwithshocks,
andthesereactionsneednotbedrastic,giventimeandcommitment.Thisobservationleadstotheidea
thatdebtsustainabilitycanbeachievedthroughtheadequacyof policyreactionstoshocks.
Viewed thisway,debt sustainabilitycanbeassessedbyobservinghowa country’sauthoritiesbehave.
Thisleadstotheestimationof policyreactionfunctions.Intheareaof monetarypolicy,suchfunctionsare
knownasTaylorreactionfunctionsandhavebecomeroutine.Theapproachhasstartedtobeappliedto
publicdebt,butapparentlynotyettoexternaldebt.
Thekeyquestionhereiswhethertheprimarysurplusissystematicallyraisedwhenthedebtlevelrises.It
ispossibletoestimatethestrengthof thisreactionandtodetermineathresholdbeyondwhichthedebt
accumulationprocess is stable, andwhich thusprovidesanalternativedefinitionof sustainability. IMF
(2003a)presentsanoverviewof theemergingresultsonpublicdebtreactionfunctions.Whilethisworkis
stillpreliminary,itseemsthatmanycountriesdopassthesustainabilitytest.Thisisgenerallythecasefor
theadvancedeconomies.Fortheemergingmarketcountriesthereactionisadequateatmoderatedebt
levelsbutprobablynotforhighlyindebtedcountries.35
Theadvantageof thisapproachisthatitdoesnotrequireassumptionsaboutlikelyshocksandestimation
of theirrespectiveprobabilities.Nordoesitrequirepassing judgmentonwhatisanacceptabledebtlevel,
thusavoidingthecontentiousCPIAprocess.Thelimitof theapproachis,onceagain,aconsequenceof the
impossibility principle. Debt sustainability is a forwardlooking concept: future Governments are not
boundbypastgovernmentbehavior.Evidenceof pastsustainability,orthelackthereof,isnotguarantee
thatfutureGovernmentswillcontinuetoreactinthesameway.Allthatcanbeconcludediswhetherpast
practicesaredeliveringdebtsustainabilityornot.
Itmightbearguedthatsimplylookingattheexistingdebtlevel,orthehistoryof pastdefaults,providesthesameanswer inamuchsimplerway.Butthis isnotcorrect.Thedebtmaybehighcurrentlyeither
becauseof undisciplinedpastpoliciesorbecauseof adverseshocks.Inordertoassesswhetherhighdebt
is the resultof bad luckorof badpoliciesweneedtodisentangle these twoassumptions.This iswhat
reactionfunctionsaredesignedtodo.Forinstance,if thereactionfunctionindicatesthattheauthorities
havesystematicallyreactedinastabilizingwaytodebtbuildups,wecanconcludethatahighdebtisdue
tobadluck.Inasmuchasbadluckdoesnotstrikeagainandagain,insuchinstancesadebtcanbeassessed
ashighandyetsustainable.ThisisthekeylessonfromFigureII.1.,confirmedbyFigureII.5.
Onebenefitof thisapproach is that it focusesattentionon the issueof policymaking institutions.The
best guarantee that the authorities will always react to shocks in a debtstabilizing way is that their
decisions are embedded in a framework that constrains them to do so. Put differently, sustainabilityrequiresthatthedebtlevelbesystematicallytreatedasapolicyobjective.Thiscanbedoneinmanyways.
Onesolutionistheadoptionof rules.Thishasbeenthecaseintheareaof monetarypolicywithrulesfor
moneygrowthorwiththeadoptionof exchangerateanchors.Fiscalruleshavebeenproposedtoensure
publicdebtsustainability;theStabilityandGrowthPactof theEconomicandMonetaryUnioninEuropeis
oneexample.Ahugeandinconclusiveliteraturehasexploredthetradeoff betweenrulesanddiscretion.
More recently there has been attention to intermediate solutions in the form of institutions that are
boundbystrictobjectivesbutarealsogivensomeleewaytoexercisediscretion.Muchprogresshasbeen
achieved in the area of monetary policy with the adoption of inflation targeting and independent
monetarypolicycommittees.Similarconsiderationscouldbeappliedtofiscalpolicy(Wyplosz(2005b)).
35SeealsoWyplosz(2005a)foracomparisonof BrazilandtheOECDcountries.
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D. ReviewandConclusions
Alongwithpricestability, lowunemploymentandbalancedgrowth,sustainabilityof externalandpublic
debt is an essential attribute of goodmacroeconomic policies.36
Alongwith these other attributes, itsprecise definition is elusive and its assessment challenging. This section takes stock of the previous
analysis,developsanumberof principles,andadvancessomesuggestions.
1. Assessment
Theoverviewof theIMF’sDSAandalternativeapproachesyieldsanumberof conclusions.
Thevariousapproachestodebtsustainabilitydiffer fromoneanother intwomainrespects:the
definitionof sustainabilityandthewaytheyattempttodealwiththeimpossibilityprinciple.
Strict definitions of sustainability start from the solvency condition. These are, sometimes
strengthened,forexample,wheretheIMFaddsanomajoradjustmentcondition,andsometimesrelaxed, for example, in the approach of Arrow et al. (2004) to the eventual achievement of
solvency.Weakerdefinitionsfocusonthestationarityof thedebtlevel,usuallyscaledbyGDPor
exports.
Implementationof thesedefinitions requiresmakingguessesabout the futureevolutionof key
variables.Thisgivesrisetothe impossibilityprinciple:becausethe future isunknown,anydebt
sustainabilityassessmentisonlyvalidwithintheboundsof theunderlyingguesses.
There isnowaytoescape impossibilityprinciple.Anyapproach isbasedeitheronananalysisof
thepast,whose relevance isunknown,oronsimulationsof what the futuremightbe,which is
unknownbydefinition.Someapproaches –e.g.VARstresstests –combinebothprocedures.
TheIMFapproachcombinessimpleandtransparentprocedures(computingdebtpathsbasedon
scenarios) with more elaborate procedures (CPIA) for determining country debt ceilings. The
formerarenecessarilyarbitrary.Thelatterattempttoextractinformationfromthepastthrough
“blackbox”procedures.
The impossibility principle does not necessarily provide support for the view that added
complexityallowsformorepreciseassessmentsof sustainability.VARstresstesting,forinstance,
isstateof theartbut,asfaraspolicymakingisconcerned,thebenefitsareillusory.37
Debt sustainability is intimately related to credibility.Credible authoritiesmay adopt aweaker
definitionof debt sustainability,eschewing the seriouseconomicandpoliticalcosts inherent in
strictdefinitions.Credibility, in turn,emphasizes the role indebtsustainabilityof policymaking
institutions.
PolicyconclusionsdrawnfromDSAexercisesmustbeconsideredwithcare.Sacrificinggrowth –in
theshortandeveninthelongrun –toimpreciselyknownrisksconcerningdebtsustainabilitycan
be very costly. Trading off growth and debt sustainability will always remain more art than
science.
2. Principles
Likeanyguidetopolicymaking,DSAmustbebothsimpleandtransparent.Simplicityisneededtomakeit
possible foreverycountry –especially the lessdevelopedcountrieswheregrowthcruciallydependson
36Debtsustainabilitymaybeseenasapreconditionforalltheotherattributes.Itiscertainlynotasufficientcondition.Whether
itisanecessaryconditionremainsopentodebate.37ThispointismadebyGoldfajninhisexcellentdiscussionof GarciaandRigobon(2005).
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externalborrowing –tobeabletoproduceitsownanalysis.Transparencyisimportantbecausetherange
of possiblecausesof debtdistressis infinite.Vagueand lowprobabilitythreatsshouldnot informpolicy
choices.
ThispaperarguesthatDSAoughttorelyonanumberof principles.
Accept theImpossibility Principle
Except forobviousbutextremecases, itwillneverbepossibletoassert thatadebt isunsustainableas
definedbytheIMF.Itsowndefinitionrequirescheckingforsolvency,whichisimpossible.Italsorequires
passing judgmentof what isamajoradjustment,which involvesassessing thewillingnessandpolitical
abilityof theGovernmenttocarryoutunpopularpolicies.Thisturncallsforanevaluationof theimpactof
thesepoliciesandof the likely reactionof various segmentsof society,whichdependson thepolitical
regimeand,indemocraticcountries,ontheelectoralcalendar.Finally,exceptforconcessionalloans,DSA
isdirectly influencedbymarket sentiment,which canbe a sourceof unpredictable viciousorvirtuous
cycles.
ThereisNoTradeOff betweenImpossibility and Simplicity
Theimpossibilityprinciplerestsontheuncertaintyinherentinpredictingthefuture.Whileeliminatingthis
uncertainty is plainly not an option, a natural temptation is to reduce uncertainty by adopting
sophisticatedtechniquesof assessment.Mostusersareunlikelytograsphowthesetechniquesfunction.
Complexitymeansopacity. It isan illusion to think that somedegreeof opacity isworthwhilebecause
eventhemostsophisticated instrumentsdonotavoidthe impossibilityprinciple.Moreoveropacitymay
also result in themistakenuse of the instruments.By contrast simplicity,which laysbareour lackof
knowledgeof thefuture,isavirtueinitself.
Adopt aWorkableDefinitionof Debt Sustainability
Thedifferentdefinitionsandapproachesrevealthatdebtsustainabilityisandwillremainavagueconcept.
Inadditionthereisahugegapbetweentheoryandimplementation.Fromanoperationalviewpoint,two
mainapproachesarepossible:thefirstonerestsondebtthresholdsandthesecondontheevolutionof
debtlevels.Giventheimpossibilityprinciple,if DSAistoestablishuncontroversialdebtthresholds,atleast
for the time being it should rest on a variant of the second approach which specifies that debt is
sustainableif itisonanonincreasingtrend.
EvenBetter,ReplaceDebt Sustainability withDebt Distress Avoidance
However,thatadebt levelbetrenddecreasingisneithernecessarynorsufficienttoavoiddebtdistress.
Numerousdebtcriseshaveoccurredwhile thedebtGDP ratiowasdeclining.On theotherhandmanycountrieswith long risingdebt levelshavenot run into trouble. Intheend, themain reason forpaying
attention to the evolution of debts is concern with the possibility of debt distress which, unlike
sustainability,isaclearconcept.
Recognizethat Debts AreNot Necessarily Bad
Many countriesand virtually allGovernments arequasipermanently indebted, forboth good andbad
reasons.Theviewthatdebtsshouldalwaysbereducedassumesthatalldebtsarebad,whichcannotbe
generally true.Separatinggood frombaddebts isahopelessundertaking,but it is important tomove
awayfromthepresumptionthatdebtaccumulationistobeavoidedunderallcircumstances.38
38It ispuzzling that the IFIs,which routinelyemphasizedebt reduction,existmainly togrant loansandareactually themain
creditorstomanydevelopingcountries.
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OpenUptheProcessof DeterminingWhether Debts AreExcessive
Howshouldoneassesswhetheradebtisexcessive?Whenthedebtistraded,theriskpremiumprovidesa
reasonableguide.ItalsoprovidestherightincentiveforGovernmentstolowertheirdebtlevels.Butwhen
thecountrydoesnothavemarketaccess,thereisnosuchgauge.Yet,thelendersarenaturallyentitledtohaveaview.Given thatanyassessment isbound tobe controversial,as the shortcomingsof theCPIA
exercisewell illustrate,themultilateralfinancialinstitutionsshouldhaveaproceduretoassessexcessive
indebtednessthatisopenandinvolvesexpertsotherthantheirownstaffs.39
Timeisof theEssence
Whencurrentdebtlevelsareconsideredexcessive,avoidanceof debtdistresscallsforadecliningtrend.
Howsteepshouldtherateof declinebe?Obviously,bringingthedebtdowntoasafe levelbeforedebt
distressoccursishighlydesirable,butitmaybecostlyintermsof growthandemployment.Thereisthusa
tradeoff betweenafastdebtrollbackandtheassociatedcosts.Thistradeoff mustbecarefullyassessed,
takingdueaccountof eachcountry’sspecificities.
Accept Risk
Unlesscurrentdebt levelsareconsideredexcessive,keepingthemstable is likely toavoiddebtdistress
undermostplausible conditions.Tobe sure, therewillalwaysbeexceptionalevents thatwill result in
debtdistress.Likealldisastrousevents,thisriskmustbeacceptedasafactof life.Acompleteguarantee
thatdebtdistresswillneveroccurisillusory,andahighlevelof protectionisboundtobeverycostly.
3. Suggestions
Useboth Approaches
DSA rests on the debt accumulation process, which is nothing more than an accounting identity:
t t t t balance primaryb g r bb 11 )(. At the operational level, one approach is to make
assumptions about theevolutionof theprimarybalance, interest rate randgrowth rateg inorder to
projectthedebtpath.ThisistheIMF’sDSAapproach.Theotherapproachistoaskwhatshouldhappento
the primary balance to achieve a desirable debt path, given assumptions about the evolution of the
interestraterandgrowthrateg.Thisisthedebtstabilizingprimaryaccountapproach.Whichapproachis
moreappropriate?
WhiletheIMFalsocomputesdebtstabilizingprimaryaccounts,itspolicyanalysisandgraphicalapparatus
emphasizesdebtpathprojections.Thepresentpaperhasarguedthatthepolicy interpretationof debt
path projections, already subject to the impossibility principle, inevitably leads to a search for debtthresholds,anothermission impossible.Thissuggeststhat it ispreferabletorelyonthedebtstabilizing
primaryaccountapproach.
Butinfactthereisnoreasontochooseoneovertheother.BothcanbeusedasFigureII.5.shows.Allthat
isneededistheclassicdistinctionbetweentargetsandinstruments.Thedebtpathisatarget.Theprimary
account is the instrument (assuming that the authorities can control it). The policy implications then
follownaturally:DSAbecomesaprocedurethatexplorestheeffectonthedebtpathof varioussettingsof
the primaryaccount instrument. What should this combined approach include and what assumptions
shouldbemade?
39Thisisinlinewiththerecommendationsof theexternalpanelthatreviewedtheWorldBank’sCPIA,seeWorldBank(2004).
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Parameter Settings
Abaselineprojection,suchascarriedoutbythe IMF,showshowthedebtaccumulationunfoldsonthe
basisof thecurrentlyforeseenprimarybalance,exchange,interestandgrowthrates.Inassociationwith
thisprojection it isstraightforwardtocomputetheprimarybalancethatwouldstabilizethedebtundercurrent conditions, aswell as the primary balance required to lower the debttoGDP ratiowhen the
currentlevelisperceivedexcessive.
The baseline is not a forecast, only a statement of where current conditions lead. Currently the IMF
provides twobaselines:one that isbasedonStaff forecastsandone that isbasedonhistorical trends.
Neither isadequate. Staff forecasts introduce adegreeof arbitrariness. Indeed, IMF (2003b) reportsa
tendency forthese forecaststoerronthesideof optimism.Producingabaselineonthebasisof these
forecastshas themeritof consistency,but this comes at the costof a self inflicted lackof realism. In
addition, the baseline should extend over a horizon which goes beyond the ability to make credible
forecasts.
Historicaltrendshavetheadvantageovercurrentvaluesof providingsomestability,butthisstability is
illusory.TrendprojectionisadequateforGDPgrowth,whichtendstofluctuatearoundareasonablystable
level,withgoodyearsmakingupforbadyears.Butthis istheonlyhistoricaltrendthatshouldbeused.
Theothervariables,theexchangeandinterestratesandtheprimarybalancearepotentiallyvolatileand,
partlyatleast,controlledbytheauthorities.Exploringthedebtimplicationsof thecurrentsettingsismore
informativethanrelyingonhistoricalaveragesthatareoftenoutdated.
Thehorizonshouldbelong,saytenyears.AsarguedinSectionC.3,debtcorrectionsarebestcarriedout
slowly,with small changes in theprimaryaccountmaintainedovera longperiod.Debtcorrectionsare
inherentlycostly –andmorecostly,thesharpertheyare.Thesamecorrectioncanbeachievedatamuch
lowercostif itistheresultof changessustainedovermanyyears.
Policy Implications
Projected over a longhorizon, the chartsdisplayed in Figure II.5.provide an adequate framework for
policy discussions. The impossibility principle means that DSA should not lead to automatic policy
conclusions, a fact well recognized in IMF (2003b). For this reason, the more transparent are the
parametersettings,thesmalleristheriskof theirbeinggivenanoverlyprominentrole.
Thebaselinedebtprojectionimmediatelyindicateswherethedebtisheading.Theprimaryaccountwhich
isdebtstabilizing –ordebtreducingwhenthedebtisdeemedexcessiveandalowerlongruntargetcan
beagreedupon –providesareasonableevaluationof whatisrequiredtoachievedebtsustainability.
Itisthenpossible,indeeddesirable,toask“whatif?”questions.Inpolicydiscussions,manyquestionscanbeaskedandeasilyanswered. It isstraightforwardtoproducechartssimilar toFigure II.5.showingthe
mechanicaleffectsondebtand the stabilizingprimaryaccountof changes in interestor growth rates,
whethertheyarepermanentortemporary.But it is importanttokeep inmindthatsuchanexercise is
purelymechanical,becauseitignoresthelinkagesamongthevariablesthatdrivedebtaccumulation.For
example,changesintheprimarycurrentaccountmayrequireactingontheexchangerate,whichinturn
willnotonlyaffectthedebtGDPratio intermsof localcurrencybutmayalso leadtodifferent interest
ratelevels.
ThishassomeresemblancetotheIMFapproachtoDSAbutdiffersfromitintwoimportantways:1)there
isnopretenseof providingforecastsandof assessingtheir likelihood;and2)theresultsareanswersto
questions asked by policymakers and not simply readymade suggestions that thedebtmight be in adangerzone.
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40
InstitutionsMatter
Credibility is an essential component of DSA, yet it is largely hidden. Credibility affects exchange and
interest rates, and can trigger virtuous or vicious circles. The CPIA is one way of recognizing the
importanceof credibilitybutsuffers from itsassumption that institutionsaregiven.Policymaking isnot justaboutsettingmacroeconomicvariables.Itshouldalsogiveaprominentroletoshapingpolicymaking
institutions.
Anumberof countrieshavetakenstepsto improvetheirpolicymaking institutions intheareaof fiscal
policy,withmuchsuccess.BrazilandChile,forinstance,haveadoptedformalproceduresthatbindpolicy
actionswithinaframeworkthatputsdebtsustainabilityattheforefront.MostEastAsiancountrieshave
informallydonethesame,relyingonnormsinsteadof legalarrangements.MechanicalDSAimplicitly(and,
as just noted, CPIA explicitly) takes institutions as given. It would seem important to downplay the
mechanical part of DSA and, in contrast, to emphasize forcefully the contributions that adequate
institutionscanmaketoavoidingdebtdistress.
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CompendiumonDebt Sustainability and Development
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Annex: An AlternativeDebt Sustainability Condition
SectionB.1. suggestsanalternativedefinitionof debt sustainability.Thisappendixbriefly characterizesthelinkof thisdefinitionwiththesolvencycondition.
LetBtbethedebtoutstandingatbeginningof periodt,Rt,t+ithediscountfactorbetweenperiodstand
t+i,andSttheprimarybudgetbalance.Thedebtaccumulationprocessimplies:
n
i
it it t t nt nt t S R B B R0
,,
Solvencyisdefinedbytheusualtransversalitycondition:
0lim ,
nt nt t n B R
whichcanberewrittenas:
0
,
i
it it t t S R B
Thenetworthof theentity(Government,country)is:
t
i
it it t t BS RV
0
,
andthereforesolvencysimplyrequiresVt0.
Thealternativesustainabilitycondition(basedonArrowetal.(2004))isthatVtbetrendincreasing,i.e.:
Vt+n –Vt0formostn.
Thus, itmaybethat initiallyVt0butthesustainabilitycondition impliesthatthereexistsahorizonN
suchthat,foralln>N,Vt+n0.
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CHAPTERIII
THEMECHANICSOF
DEBTSUSTAINABILITYANALYSIS
AnhNgaTranNguyenandAlbiTola
(UNCTAD)
A. Introduction
Debtsustainabilityhasbecomeakeyissueinthediscussionondebtindifferentfora.Theconceptof debt
sustainabilityisdifficulttodefineinpracticeanddependsonanswerstoanumberof questions.Whenisa
certain levelof debttoohighandunsustainable?How importantisdebtsustainabilityfordevelopment?
Shoulditbeamajorobjectiveandshouldeconomicpoliciesbeadjustedaccordingly?Alternativelyshould
developmentbeanobjectivewhichcanoverridedebtsustainability?If so,whatdoesthismeaninterms
of policies? Or on the contrary should there be acknowledgement that debt sustainability and
developmentaretoointerconnectedforsuchaseparationof objectivestobefeasible?
Answers to thesequestionsarenot straightforward.The literatureondebt sustainabilityoffersawide
rangeof analysesof theissuefromdifferentperspectives.Thebasicelementsof thedifferentapproachesare highlighted in this paper, with particular reference to their practicality and relevance. Four main
approachesarecovered:
Presentvalueanalysis;
Financinggapsanalysis;
Theindicatorsof debtcrisis;and
Adevelopmentpolicybasedframework.
Theanalyticalunderpinningsof theseapproachesare linked,but the focusonparticularaspectsof the
debt problems is typically different. The last approach attempts to address various concernswithin a
comprehensivemacroeconomicandpolicybasedmodel.
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B. DebtIndicatorsandEarlyWarningof Crisis
In the aftermathof recentdebt criseseconomistshaveattempted to identifyearlywarning indicators
whichwouldsignalinadvancetheprobabilitythatacurrencyordebtcrisiswilloccur.Suchindicatorsare
intendedtofacilitatecorrectivemeasures.Onesuchindicatorisanunsustainablecurrent account deficit
associatedwithlowGDPgrowth.Thattypicallycharacterizeddebtcrisesinthe1980s.
Accordingtothemodelsof debtdynamicsdiscussedbelow,acountry’sdebtaccumulationissustainable
as long as the growthof GDP is greater than the real interest rate.However, access to credit canbe
abruptlystoppedif creditorsbecomeworriedaboutincreasingdebt.Inaddition,highgrowthratesof GDP
accompaniedbycapital inflows,cancausetherealexchangeratetoappreciate.Thiscan leadto lossof
competitivenessandfurtherdeteriorationof thecurrentaccount.
Anotherimportantindicatorof debtsustainabilityisthesizeof exports,whichenhancethedebtor’sability
togenerate the foreigncurrency revenuesneeded to servicedebt.However,a largeexport sectorcan
makeacountryvulnerabletotermsof tradeandforeigndemandshocks.Forexample,as itisshownbyCorsettietal. (1998),theexportsof SouthEastAsiancountriesweresubjecttonegativetermsof trade
shocks in1996priortothefinancialcrisisof 1997followingthefall inthepricesof semiconductorsand
other exports, the increasing competitionof cheaper goods fromChina, anddecreasingdemand from
Japanduetolongstagnationof itseconomy.
Radelet and Sachs (1998) point out that so long as investments financed by external borrowing are
channeled to productive activities, they can contribute to growth. However, over reliance on external
financingcanbethesourceof macroeconomicinstabilityif itinducesanappreciationof therealexchange
rate.PriortotheAsianfinancialcrisisasignificantpartof capitalinflowswasdirectedtosectorsproducing
nontradedgoodsandtorealestate,neitherof whichgenerateforeignexchangerevenue.
RadeletandSachs(1998)alsoidentifytheincreasing fragility of financial sector asasignof anupcoming
debtcrisis.AscredittotheprivatesectorgrewrapidlypriortotheAsianfinancialcrisis,banks increased
theirrecoursetoshorttermforeignborrowing.Bankswerethusexposed intwoways: (1)toexchange
rate risk since theywereborrowing in foreigncurrency foronlending indomesticcurrency;and (2) to
maturitymismatchessincetheyborrowedshortandlentlong.
Traditional indicatorssuchasaslowingof export growth,adeterioratingcurrent account deficit and an
overvalued exchangeratearenotnecessarilyareliablesourceof warnings.Somerecentresearchonearly
warningsystems(EWS),describedinBergetal(2004),hasbeenmodelbased.Theaimof thisresearch,of
which examples are Kaminsky, Lizondo and Rienhart (KLR) (1998) and work of the IMF Developing
CountriesStudiesDivision(DCSD),hasbeentodevelop“theexchangemarketpressureindex”.If thevalue
of thisindexexceedsitsmeanbymorethanthreestandarddeviations,thenthecurrencyisexposedtoa
serious riskof devaluation.Although themodelsdeveloped for thispurposeusedifferenteconometric
techniques,theyaredesignedtoestimatetheprobabilityof an“event”onthebasisof variousindicators.
The indicators of theDCSDmodel include realexchangedevaluation, changes in foreign reserves, the
ratioof shorttermdebttoforeignexchangereserves.TheKLRmodelusesalsoincludesindicatorssuchas
thedomesticcreditgrowth,changeinmoneymultiplier,andtheratioof foreignexchangereservestoM2.
TheIMFalsoexaminedtheratioof theshort termdebt toreservesasawarningindicatorbutfoundthatit
performedbetterasanindicatorof liquiditythanof externalsolvencyproblems.Forexample,priortoits
debt crisis of January 2002 Argentina had a better indicator for this ratio than Turkey in 19992000.
However, its ratio of debtservice to current receipts was twice as large as that of Turkey and more
successfullyanticipateditssubsequentsolvencyproblems.
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TheIMFhasdrawnattentiontothepossibilityof includingmodelsof countryriskmodelsandsovereign
risk indices in the EWS, pointing to an econometric model of Eichengreen and Moody (2000) in this
context. This model is used to estimate the determinants of emergingmarket debt spreads and to
forecast currencyproblemson thisbasis. Inter alia the authors found that thedebtservicetoexports
ratiowashighlycorrelatedwiththelevelof spreads.
Otherstudiesof EWSmodels(reviewed inBergetal.,2004)pointtoamixedperformance inpredicting
crises.While they tend toperformbetter thannonmodelbased indicators suchas sovereign spreads,
sovereign ratings ormarket surveys, they haveoften signaled false alarms.On the otherhand, these
modelshavecoveredalargenumberof macroeconomicandfinancialvariablesformanycountriesandfor
longperiods.Theyhavehighlighted invaluable information about the relative vulnerabilityof different
countries(BergandPatillo,2000).
Aliquidity problemarisesbecauseof abunchingataparticulartimeof debtobligationswhichcannotbe
fullyservicedonthebasisof existingrevenues.However,thedebtcanberepaid if recoursetoexternal
fundingisavailableonatemporarybasisorif thedebtisrestructuredsothatdebtobligationsarebettermatchedtothedebtor’srevenues. Insolvency ,ontheotherhand,denotesthe inabilityof thedebtorto
pay in fullhisdebtobligationsowing tomore structuralproblemswhichcannotbe solved simplybya
rearrangementof paymentsdue.
In theorya country is solventeven if it runsahuge current accountdeficit as long as it is capableof
producingcurrentaccountsurplusesinthefutureand,asdescribedbelow,GDPincreasesatarateabove
the rateof interest. In practice this conditionhasbeen shown tobeunrealistic.According toRoubini
(2001)themainproblemwithsuchdebtdynamics lieswiththefactthataGovernmentcannotcredibly
committoruntherequiredfiscalandbalanceof paymentssurplusesinthefuture.Thisauthorprefersthe
simpleratioof foreigndebttoGDPratioasanindicatorof bothsolvencyandsustainability.If thisratiois
increasing,thenalargertradesurpluswillberequiredtoachievesolvencyandthismustbeincreasedstillfurtherif therealinterestrateisbiggerthanGDPgrowth.
Otherstudieshaveattempted todetermineempirically thethresholdsbeyondwhicha“debtcrisis” (or
solvency problems) will develop. The debt crisis is defined as an event in which there are arrears of
principal or interest on external obligations, or in which the country reschedules or restructures its
externaldebt.Thesestudies (IMF,2002a)have found thatadebtcrisisoccurs typicallyatdebt toGDP
ratiosbelow5060percent.The“transferproblem” implies thatacountrymustalsogenerate foreign
exchange receipts throughanexport surplus sufficiently large to service itsdebt.This implies that the
exportstoGDP ratio (or another indicator for the same purpose such as the debt servicetoexports
ratio)isrelevant.Thesurveyof IMF(2002a)showedthatfordebtcrisesatexporttoGDPratiosbelow20
percentthreequartersoccurredatdebttoGDPratiosof lessthan60percentof GDP,whileforcrisesat
exportGDPratiosof between20and40percentthecorrespondingdebttoGDPratiowasbetween60
and80percent.
Themain indicatorsusedtomeasure liquidityaretheratioof foreignexchangereservesto imports,the
ratioof foreignexchange reserves to shorttermdebt, the shareof shorttermdebt in totaldebt, and
interestpaymentstoforeignexchangereserves.Althoughacountrycanbesolvent,itrisksadebtdefault
orcrisisif itdoesnothaveenoughliquiditytoserviceitsshorttermdebt,perhapsowingtoabunchingof
loansmaturingataparticulartime.Thismighthappenduringafinancialpanicwhereshorttermcreditors
decide not to renew their loans or ask for a repayment. Thus debtor countries should monitor their
maturity structure to make sure that they have enough shortterm assets to cover their shortterm
liabilities.
Assessingthesolvencyandthe liquidityof acountry isadynamicprocesswhichshouldtakeaccountof
differentshocksthatmightreduceitscapacitytoserviceitsdebt.Theseshockscouldbedropsinexport
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TheMechanicsof Debt Sustainability Analysis
48
earnings,unfavorablemovements inthetermsof trade,or increases inoilprices.Roubini (2001)draws
theattentiontowhathecalls“self fulfillingsolvencytraps”.Thisiswhereahighexternalorpublicdebt –
but not necessarily at a level entailing insolvency will be considered by the markets as a situation
sufficientlyriskyforthespreadsoninterestratestoincrease.Asaresult,thedebtorcountrywillpaymore
interestandwillaccumulatedebtmorerapidly.Thisisanothercasewherealiquiditycrisismayturnintoasolvencycrisis.
Liquidityandsolvencyconceptsareusuallyinterlinkedinpracticesothatitisverydifficulttodistinguish
between the two. It is generally difficult to determine whether incapacity to pay is temporary or
permanent.Moreoverproblemsof illiquiditycanturnintoinsolvencyif theyarenottackledintime.
C. ThePresentValueof FutureIncome
Howshoulddebt sustainabilitybedefined?Sincedebt isgenerally incurred to finance investment,one
approachinvolvesananalogywiththemicrolevelanalysisof investmentprojects.Heredebtsustainabilityisdeterminedbytheconditionthatthepresentvalueof thefuture incomestream(netof expenditure)
derivedfrom investmentprojectsshouldbeat leastequaltothenominalvalueof debtusedtofinance
them.Therearetwowaystoobtainthepresentvalueof futureincomestreams.Thepresentvaluecanbe
computed by discounting the streams of income by the interest rate of the debt. Another way is to
compute theexpected internal rateof return,definedasthe rateof discountapplied to future income
whichwouldmakestheexpectedpresentvalueof incomeequaltothenominalvalueof debt.Inthiscase
debtsustainabilityisassuredif theexpectedinternalrateof returnisatleastequaltotheinterestrateof
thedebt.
Applicationof thepresent value approach todebt sustainability to thedebtof a countrynonetheless
involvesaddressingmanychallengesatonce: Theinvestmentprojectsfinancedbydebtarethesumof privateandpublicprojectswithdifferent
ratesof return.Thelattermayincludeprojectsaddressingsocialratherthaneconomicneeds.
The income generated by investment can be denominated in foreign currency (in the case of
exports)orinlocalcurrency.
Externaldebt sometimes isused to smoothout cyclical changes inconsumption (whichdonot
generateany income),debtbeing incurredduring timesof depressedgrowthandrepaidduring
highgrowthperiods.
Debt can carry concessional or market interest rates and have different maturities and grace
periods,whichmakethechoiceof theappropriatediscountrateacomplicatedissue.
Notwithstanding these difficulties, the present value approach has beenwidely applied to developing
countries’ debt. The IMF implicitly uses this concept of the present value in their approach to debt
sustainability (see IMF, 2002a). It defines debt sustainability as “a situation in which a borrower is
expected tobeabletocontinueservicingitsdebtswithout anunrealistically large futurecorrectiontothe
balanceof incomeand expenditure”.40Underlyingthisdefinitionof sustainabilityareconceptsof solvency
andliquidity,whicharedefinedonthebasisof thepresentvalueapproach.
40Sustainability, according to the IMF, rules out: (1) debt restructuring; (2) Ponzi games where the borrower indefinitely
accumulatesdebt faster than itscapacity to servicedebt isgrowing); (3)moralhazardwhereby theborrower livesbeyond its
meansbyaccumulatingdebtintheknowledgethatamajordebtservicereductionwilleventuallybeneeded.
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CompendiumonDebt Sustainability and Development
49
Solvency issecuredwhenthepresentvalueof adebtor’scurrentandfutureprimaryexpenditure(E)isno
greaterthanthepresentvalueof itscurrentandfuturepathof income(Y),netof anyinitialindebtedness
(D):
))1(
)1(
(
)1(1
0
1
0
1
t t
ii
j
jt
it
ii
j
jt
it Dr
r
Y
r
E
.
A liquidity crisisoccurswhenadebtor’s liquidassetsandavailable financingare insufficient tomeetor
rollover its maturing liabilities, regardless of whether the solvency condition is met. Sustainability is
reachedwhenadebtor’sliabilitypositionsatisfiesthepresentvaluebudgetconstraintwithouttheneed
foramajorcorrectioninthebalanceof incomeandexpenditure,givenitscostsof financing.
Thepracticalityof suchanotionof solvencyisquestionable.First,thetimehorizonisinfinitelylong,which
makes planning or time framing of Government’s budget impossible. Furthermore, the appropriatediscountratemuststillbechosen.Differentchoiceswillresultindifferentestimatesof presentvalue.
Thepresent value approach is also applied to the analysisof the primary balanceof theGovernment
budget or the balance of payments on current account excluding payments. Based on the national
accounting identities, thebalance, Pt, that is the difference between revenue and expenditure or the
currentaccountbalance,inbothcasesexcludinginterestpayments,isequaltothechangeindebtDtplus
interestpayments:
11)1( t t t P Dr D
Assumingaconstantinterestrate,recursiveapplicationof thisformulagives:
1
1
11 )1()1(
i
it i
j j
jt
t r
D
r
P D
Asitendstoinfinity,thetermontherighthandsidetendstozero.Thismeansthatthepresentvalueof
debt in the indefinite future converges to zero and reflects the unwillingness of lenders to allow the
debtor perpetually to pay its interest obligations by borrowing more. Hence, for i sufficiently
large,
01)1( j
j
jt
t r
P D
,which impliesthatalldebtmusteventuallybepaidbackforsustainabilityto
ensue.
Thisobservationleadstotheinterestingconclusionthattheabilitytogenerateasurplusisaprecondition
forlongtermdebtsustainability.Inthecaseof thefiscalbalancethisisaprimarysurplus.Inthecaseof
thebalanceof paymentsoncurrentaccountthedebtorcountrymusteventuallyexportandearnenough
foreignexchangethroughatradesurplustorepaydebt(thesocalledtransferproblem).
Adifferentversionof thepresentvalueapproachistheIMF Net Present Valueof Debt .Inthecaseof low
incomecountriesthatreceive loansonconcessionalterms,creditorsapplytheconceptof “Netpresent
Value”41(NPV)of loanstocalculatethe“realburden”of debt,usingaformulaforwhichthedebtservice
onconcessionalloansisdiscountedatthemarketrateof interestinordertoreflectthe“trueopportunity
41Theterm«NetPresentValue»(NPV)isusedhereinawaythatdivergesfromstandardcorporatefinance jargonforwhichNPV
isthedifferencebetweenthepresentvaluesof theincomeandcostof aninvestmentproject.Infact,amorecorrecttermhere
wouldbethe“presentvalue”(PV).
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TheMechanicsof Debt Sustainability Analysis
50
cost” of the loans. This NPV concept was first applied in the context of Paris Club rescheduling on
concessionaltermsandtheninthecontextof theInitiativefortheHeavilyIndebtedPoorCountries(HIPC).
The IMFapplies it tothe lowincomecountries in itsdebtsustainabilityanalysis framework (IMF,2003,
May).
Therationalebehindtheuseof thisversionof NPV isthatdiscountingthestreamof futuredebtservice
paymentsbyanappropriatemarket interest rateprovidesanaggregatemeasureof theeffectivedebt
serviceburdenimpliedbyagivendebtstock.However,asseenatthebeginningof thissection,inorderto
gaugewhetherthedebtorcanserviceitsdebt,thedebtor’s futurestreamof incomehastobediscounted
either at the rate of interest on the loanwhich has been contracted or at the rate of return on the
investmentproject.
ThisNPVapproachdoesnot,therefore,reflectthedebtor’scapacitytopay.If atall,thiscapacityistaken
intoaccountwhenconcessionaltermsaregrantedtolowincomecountries.Theversionof NPVisrathera
conceptof interesttocreditors,usedtomeasurethegrantelementof aid.Itcanalsobeusefulasameans
to determine comparable opportunity costs for donors for burden sharing purposes in debtrelief operations.
D. TheFinancingGap
Thefinancinggapanalyticalapproachesarebasedonthethreenationalaccountidentitiesrelatedtothe
balanceof payments,domesticinvestmentandsavings,andgovernmentbudget,whichlinkexternaldebt
withdifferentfinancinggaps:thecurrentaccountdeficit,ortheshortageof domesticsavingscompared
todomesticinvestments,orthegovernmentbudgetdeficit(partof whichcannotbefinancedbydomestic
publicdebt).
Assuch,thefinancinggapsare justaccountingidentities.Economistshaveexpandedtheseidentitiesand
added behavioral equations in order to project financing gaps or to analyse the dynamic stability
conditionsof externaldebt.Theuseof gapmodels toproject financinggapsandaid requirementshas
been widely accepted by international financial institutions. However this approach has been much
criticized,notablybecauseof expost inaccuraciesof theseprojectionsandbecauseof the instabilityof
the key variable, the incremental capitaloutput ratio (ICOR),42used to determine the growth path of
income.
Despite these shortcomings, financing gaps as determined by accounting identities remain useful
indicators forpolicymakers in the short run for the analysisof theoriginsof externaldebt andof the
burdenof debtservicingongovernmentbudget.
1. DebtandNationalAccountingIdentities
Threenationalaccountingidentitiesrelatedtothebalanceof payments,domesticinvestmentandsavings,
andthegovernmentbudgetshowthelinksof externaldebttodifferentfinancinggaps.
(1)Thebalanceof paymentsidentity isstatedasfollows:
)()( 11
**
1 t t t
E
t t t t t t t
E
t
E
t t R R FDI Di E X P M P E D D E
42SeeEasterly(1997).
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CompendiumonDebt Sustainability and Development
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where E
t Distheexternaldebtstock indomesticcurrency, t E
thenominalexchangerate(domesticper
unitof foreign currency),*
t P foreignprices, t M
importvolume, t P domesticprices, t X
export volume,*
t i theforeigninterestrate, t FDI thenetflowof foreigndirectinvestment(includinglongtermportfolio
equityinvestment),and t Rthestockof foreignexchangereserves.
This identity shows that new debtcreating capital inflows fill that partof the current account deficit
( E
t t t t t t t Di E X P M P E 1
**
)notfinancedbyFDIandthechangeinreserves.
(2)Theinvestment savingsidentity isderivedfromthenationalincomeidentity:
)(*
t t t t t t t t t t M P E X P I C S C Y
Where t C isconsumption, t S issavings,and t I isinvestment.
sothat t t t t t t t M P E X P I S *
Combiningthebalanceof paymentsandinvestmentsavingsidentitiesgivesanotherequationforexternal
debt:
t t
E
t t t t t
E
t
E
t t R FDI Di E S I D D E 1
*
1 )()(
Thisidentityshowsthatnewdebtcreatingcapitalinflowsfillthegapbetweendomesticinvestmentplus
InterestspaymentsanddomesticsavingswhichnotfinancedbyFDIandthechangeinreserves.
(3)TheGovernment budget identity isstatedas:
where D
t DisGovernment’sdomesticdebt, 1t G is government consumptionexpenditureand t P is the
primarysurplus.
)( t t t t t t DT IGG ET T P
Where t T isgovernmentrevenue, t ET
externaltransferstoGovernment, t Ggovernmentconsumption,
t IG governmentcapitalformation,and t DT domestictransfersandsubsidies.
This identity above shows thatnewdebtcreating capital inflows fill thegapbetween the totalbudget
deficitandtheamountof thedeficitthatcanbefinancedbyissuingdomesticdebt.
2. TheStabilityof ExternalDebtDynamics
Theroleof foreigncapitalinthedevelopmentprocesshasfirstbeenanalysedinthecontextof thetwo
gapmodels,wherebydebtorcapital inflowhelps in filling the resourcegap resulting fromof shortage
foreignexchangeearnings(derivedfrom identity(1))orof savings(derivedfrom identity(2)).Asdebt is
assumedtocontributetogrowth,overtimetheresourcegapisgraduallynarrowedandtowardstheendof thecycle,thedebtorcountrywillhaveenoughsurplusesinresourcestorepayitsdebt.
t
E
t t t
D
t t
E
t t
D
t t P DGi E Di DG E D DG 1
*
1
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TheMechanicsof Debt Sustainability Analysis
52
This virtuous cycle of debt is characterized by a stable dynamic path of debt accumulation, which
decreases over time. Assuming unchanged exchange rate and expressing the variables in the same
currency(withE=1),thedynamicinteractionsbetweendebtononehandandincomegrowthandexport
growthontheotherhand,woulddeterminetheconditionsunderwhichthedebtaccumulationprocess
canbecontrolled.Thebasicmodelshownbelowillustratessuchdebtdynamics.43
Thefirstequationdescribesdebtaccumulation(D)tofinancetheresourcegap,whichisdefinedhereas
thedifferencebetweenimportsandexports(MX)andtheinterestpaymentsonearlierdebt(iD).
(1)iD X M
dt
dD
Theincreaseinoutputissimplytheproductof investment(I)andtheinverseof theincrementalcapital
outputratio(1/k):
(2) I
k dt dY 1
Thesavingsgap(thedifferencebetween investmentIanddomesticsavingsS)andtheforeignexchange
gap(thedifferencebetweenimportsMandexportsX)areequalexpost:
(3)iD
dt
dD X M S I
Other specifications canbeadded to thisbasicmodel.Forexample, imports canbebrokendown into
importsof capitalgoodsandimportsof consumptiongoods.Exportscanbespecifiedtogrowexogenously
ortodependontheinvestmentrate.
Considerthesavingsgapfirst.
Thesavingsfunctionsimplystatesthatsavingsaretheproductof themarginalpropensitytosave(s)and
domesticproduct:
(4) S=sY
Usingthesavingsgap(IS)andrearrangingtheterms,debtaccumulation(expressedasaratioof debtto
output)canbesetinfunctionof theoutputgrowthrate(g),investment(gk)andsavings(s)rates:
(5))()(
)/( s gk g i
Y
D
dt
Y Dd
Equation5statesthatthechangeintheratioof debttodomesticproductdependsonthecurrentlevelof
this ratio,aswellas thedifferencebetween the interest rateand thegrowth rate,and thedifference
betweentheinvestmentrateandsavingsrate.Thesolutiontothisdifferentialequationwilldeterminethe
conditionof stabilityof thedebtaccumulationprocess:
(6)
t g iei g
s gk
Y
D
i g
s gk
Y
D )(
0
0
whereD0/Y0isthevalueof D/Yattimet=0.
43Notethatthemodelisinrealterms,i.eallvariablesaredividedbytheGDPdeflator.
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CompendiumonDebt Sustainability and Development
53
Fromequation6 itcanbeseenthatthedynamicpathwillbestableandconvergetoequilibriumonly if
the rateof GDP growth ishigher than the interest rate. If the interest rate ishigher than the rateof
growth,debtwillgrowataneverincreasingrateandwillreachanexplodinglevel.
Withg>i,theasymptoticvalueof thedebtincomeratiois:
LimD/Y[(gk –s)/(g –i)]
t
Themaximumamountof D/Y (or themaximum levelof sustainabledebttoGDP) isdeterminedby the
differencebetweenthemarginalinvestmentrate(gk)andsavingsrate(s).
Alternatively,using the trade gap (M X)and rearranging the terms,debtaccumulation canbe set in
functionof theinterestrate(i)andtherateof growthof exports(x).
(7) X
X M xi
X
D
dt
X Dd )(
)/(
whereD/Xisthedebttoexportratio.
Equation7statesthatthechangeintheratioof debttoexportisthesumof thecurrentlevelof thisratio
multipliedbythedifferencebetweentheinterestrateandtherateof growthof exports,andthecurrent
trade gap divided by the current level of exports. The solution to this differential equation gives the
followingtimepathof thedebtexportratio:
(8)
t xie X
X M
i x X
D
X
X M
i x X
D )(
0
0 11
whereD0/X0=debtexportratioattimet=o.
Here,thestabilityconditionisthattheinterestrateshouldbelowerthantherateof growthof exports(i<
x).Thetrajectoryof D/Xcanbeexponentiallyascendingordescending,dependingonwhetherxisgreater
orsmallerthani.
Withi<x,D/Xwillconvergetoanequilibriumwiththefollowinglimit:
LimD/X[1/(xi)][(M –X)/X]
t
Asthesizeof thedebttoexportratiodependsonthetradegap,this limittosustainabilitycanbevery
highif thetradegapisverylarge.
Finally, taking into consideration the fiscal gap, asderived from theGovernmentbudget identity (and
assumingthattheGovernmentincursonlyexternaldebtanddoesnothavedomesticallycontracteddebt),
applyingthesameprocedureasaboveyieldsthefollowingequation:
(9) Y
PB
g iY
D
dt
Y Dd
)(
)/(
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TheMechanicsof Debt Sustainability Analysis
54
PBistheprimarydeficitof theGovernmentbudgetandgistherateof growthof theeconomy.Thistime
thestabilityconditionisthatgexceedsi.
The debt dynamics depicted above imply that as long as GDP grows faster than real interest rate, a
countryissolventevenif theratioof foreigndebttoGDPkeepsgrowing.Thesameappliesforfiscaldebt.Likewise,as longasexportgrows fasterthan real interest rate,acountry issolventeven if the ratioof
foreigndebttoexportsisincreasing.
Inpractice, theseconceptshave shown tobenotvery realistic. Inparticular,even though the stability
conditionscanbesatisfied,theasymptoticvaluesof debt,aswellasthetradegapandfiscaldeficitwhich
determinethesevalues,canbeveryhigh.Nothing inthemodelsignalsthecapacityof debtorstorepay
thefullamountof thisdebt.Unlesslendersarewillingtolendoveraprolongedperiodwhileknowingthat
debtisnotgoingtoberepaid,debtorsneedtorunfiscalsurplusortradesurplusinordertoreducetheir
debt.
3. TheIMFandWorldBankDSAFramework
Thethreefinancinggapidentitiesarealsousedasthebasisof theframeworkemployedbytheIMFand
theWorldBankfordebtsustainabilityassessment(DSA).Theframeworkconsistsof twotemplates,one
relatedtotheexternaldebtsustainabilityandtheothertothefiscalsustainabilityof thepublicsector.
The external debt sustainability template analyses the debt incurred externally by domestic residents
(boththepublicandtheprivatesector).Usingthebalanceof paymentsidentityasthepointof departure
and rearranging the terms derived from the algebraic transformations of this identity, the following
equationcanbeusedtodecomposechangesinexternaldebt:
11 ))1()1(()1(
1 t t t t tbd r g g r g g d d
where d isthedebttoGDPratio, istheshareof domesticcurrencydebt intotalexternaldebt, is
the change in the exchange rate expressed in US$ per local currency unit, tb is the currentaccount
balanceexcluding interestpayments inpercentof GDP, is thechange in thedomesticGDPdeflator
expressedinUS$, g istherealGDPgrowthrate,and r istheinterestrate.
Thisequationallowsthefollowingdecompositionof theseparatechannelsaffectingtheevolutionof the
debtGDPratio:
thenoninterestcurrentaccountdeficit,tb;
therealinterestrate,t d
g g
r
1( ;
therealgrowthrate,t d
g g
g
)1(
;
priceandexchangeratechanges,t d
g g
r g
)1(
)1()1(
.
Thethreelasteffectscanbecharacterizedasthecontributionsof endogenousdebtdynamics.
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CompendiumonDebt Sustainability and Development
55
The fiscal sustainability template analyses the behavior of the debttoGDP ratio with all variables
expressed indomestic currency.Using theGovernmentbudget identity as thepointof departure and
rearrangingthetermsderivedfromalgebraictransformationsof thisidentity,thefollowingequationcan
beusedtodecomposechangesinpublicdebt:
1 1
1ˆ ˆ( (1 ) (1 ))
(1 )t t t t d d r g g r d pb
g g
whered is thedebttoGDP ratio,pb is theprimarybalance, r̂ isaweightedaverageof domesticand
foreign interest rates, the shareof foreigncurrency denominated public debt, the change in the
domesticGDPdeflator,andgtherealGDPgrowthrate.Changesintheexchangerate(localcurrencyper
U.S.dollar)aredenotedby ,with 0 indicatingadepreciationof thelocalcurrency.
Thisequationallowsthefollowingdecompositionof thechannelsaffectingtheevolutionof thedebtGDP
ratio:
theprimarydeficit pb ,
therealinterestrate,t d
g g
g r
)1(
)1(
;
therealgrowthrate,t d
g g
g
)1(
;
exchangeratedepreciation,t d
g g
r
1(
)1(
.
Again,thethreelasteffectscanbecharacterizedasthecontributionsof endogenousdebtdynamics.
By identifyingdifferentfactorscontributingtothegrowthof thedebtratios,thetemplates indicatethe
channelsthroughwhichdebtcanbereduced,if thelevelistoohigh.Notethatinthetemplatesthereal
GDP growth rate and export growth rate are exogenously given so that there is only a oneway
relationshipfromGDPandexportgrowthtodebtaccumulation.Theshortcoming,therefore,isthelackof
areverserelationshipfromGDPanddebtgrowthtogrowthof exports,whichlimitsuseof thetemplates
forexaminingcertainscenariosfordebt,GDPandexportgrowth.
Furthermore,theIMFandWorldBankDSAframeworkleavesopenthequestionof theappropriatelevel
of debt aroundwhichdebt shouldbe stabilized.Anexampleof adhoc characterof the applicationof IMF/WorldBankDSAframeworkindeterminingasustainablelevelof debtisthesettingof theindicative
thresholdsfortheratiosof NPVof debttoGDP,toexportsandtogovernmentrevenueatdifferentlevels
forlowincomecountriesaccordingtothepolicyperformanceof borrowingcountriesasmeasuredbythe
CountryPolicyandInstitutionalAssessment(CPIA)Index.Thefollowingtableillustratesthesethresholds.
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TheMechanicsof Debt Sustainability Analysis
56
TableIII.1.IndicativeExternalDebtBurdenIndicators1/
Qualityof PoliciesandInstitutions2/
Poor Medium Strong
NPV of debt in per cent of:
Exports 100 150 200
GDP 30 40 50
Revenue3/ 200 250 300
Debt servicein per cent of:
Exports 15 20 25
Revenue3/ 25 30 35
1/SeeIDAandIMF“OperationalFrameworkforDebtSustainabilityAssessmentsinLowIncomeCountriesFurther
Considerations”,2005.
2/Country’swithaCPIAbeloworequalto3.25aredefinedtohaveapoorqualityof policiesandinstitutions,while
aCPIAabove3.75indicatesagoodquality.
3/Revenueisdefinedexclusiveof grants.
There are severalproblemswithusing theCPIA as the sole criterion fordetermining debt thresholds.
Historicalseries for theCPIA indexarenotpubliclydisclosed (onlydata for IDAcountriesstarting from
2005aredisclosed).Asaconsequence,allanalyses that linkdebt sustainability to theCPIAhavebeen
conductedbyWorldBank/IMFstaff andnoexternalresearcherhasbeenallowedtotesttherobustnessof
thelinksbetweenthesetwovariables.Itisalsoquestionablewhetherthequantitativeimpactof theCPIA
ontheprobabilityof debtdistress is largeenoughtoformulatedebtthresholdsonlybasedontheCPIA.
Moreover,itisnotclearwhethertheCPIAisindeedameasureof policiesor justaleadingindicatorof a
debtcrisis.
4. Debt,TradeandGrowth
Interlinkagesbetweentrade,growthanddebtcanbeshownmoredirectlybyrearrangingthebalanceof
payments identity of section B.1 in accordance with the algebraic transformations in section I of the
Appendix.Thesegivethefollowingequation:
111 )()( t t f f t t d g ctot d pi xmd d
wheredistheratioof externaldebttoGDP,mtheratioof importstoGDP,xtheratioof exportstoGDP,
if theforeigninterestrate,pf therateof changeof foreignpriceindex,phthedomesticpriceindex,ctot(=
e+pf –ph) therateof changeof thetermsof trade (ebeing the rateof changeof theexchangerateexpressedasdomesticperunitof foreigncurrency),variablesbeingexpressedindomesticcurrency.
Ignoringtheeffectof realforeigninterestrateandincludingatermrepresentingtheeffectof FDI(fdi,the
ratioof netflowsof FDItoGDP),thisequationhasbeentestedempiricallythroughapanelregressionof
data for seven countries (Argentina, Bangladesh, Bolivia, Kenya, the Republic of Korea, Malaysia, and
Uganda)overtheperiod19812004.Theresultsareasfollows(tstatisticsinparentheses):
dt –dt1=0.270.36(xt –mt)0.37fdi0.14g0.18ctot
(6.07)(5.54)(2.30)(1.68)(0.66)
R2=0.1858
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CompendiumonDebt Sustainability and Development
57
Thevariablesontherighthandsideof theequationexplain1819percentof thevariationsindebtratios.
Thecoefficientsaresignificantatthe5or10percentlevelexceptforthatof thetermsof tradechange.
Allthecoefficientshavetheexpectedsigns.Understandably,thetradebalanceplaysahighlysignificant
role indebtaccumulation:atradedeficitaddstodebt,whileatradesurplusreduces it.FDIandgrowth
reducedebtaccumulation.
5. Contributionof DebttoGDPGrowth
Theprecedingsuggeststhatgrowthreducestheexpansionof thedebtratio.Butwhatisthecontribution
of debt togrowth? Inorder toassess this relationship, thebalanceof payments identity is rearranged
again to show the relationshipbetween growth as adependent variableandother variables including
debtflows(seeappendixforthealgebraictransformations).Thisrelationshipisreflectedinthefollowing
equation(derivedinsectionIIof theAppendix).44
wwee
Y dY D Dd P dP E dE P dP Y dY /)/)()(1()///)(1(
**
where istheinitialratioof exportstoimports,thepriceelasticityof imports,theincomeelasticity
of imports, thepriceelasticityof exports, theincomeelasticityof exports,Dethenetexternaldebt
flows, P the export price index, P* the importprice index, E the exchange rate (domesticperunitof
foreigncurrency),andYwworldincome.
Panelregression,coveringthesamecountriesandthesameperiodasintheanalysisabove,wasusedto
estimatealternativerelationships((i)and(ii))basedonthisequation.
(i)g=0.040.109d+0.049ctot+0.054x(10.75)(5.25)(2.00)(1.91)
R2=0.25
whereg is realGDPgrowth,d thechange in the ratioof externaldebt stock toGDP,ctot the rateof
changeof thetermsof trade(UNCTADindexof termsof trade),andxthegrowthrateof constantUS$
exports
Allcoefficientsaresignificant.Thesignof thecoefficientof debtisnegative,signifyingthatanincreasein
thedebttoGDPratioreducesgrowth.
(ii)g=0.338+0.127f +0.094ctot+0.045x
(8.05)(2.22)(3.23)(1.46)
R2=0.11
inwhichthedebtstockisreplacedbyavariable(f)measuringtheratioof netexternalresourceflowto
GDP:f = ft ft1and f =nd+ fdi+oda,ndbeingtheratioof nettransfersondebt (debt flowsnetof
amortizationminusinterestpayments)toGDP,fditheratioof netflowsof FDItoGDP,andodatheratio
of grantstoGDP.
44Thirwall and Hussain (1986) derived a similar equation, expressing growth in terms of the volume effect of relative price
changes,thetermsof trade,andthegrowthof theworldeconomyandcapitalflows.
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TheMechanicsof Debt Sustainability Analysis
58
The variables on the righthand side of (ii) explain only 11 per cent of GDP growth However, the
coefficients except that of export growth are statistically significant. This time external debt is not
specified intheequationassuchbut is includedasoneof thecomponentsof thevariablerepresenting
netexternalresourceflowswhichhaveastatisticallysignificantpositiveimpactongrowth.
E. DevelopmentPolicyBasedApproachtoDebtSustainability
Theabovediscussionshowsthatthereisadiversityof approachestoDSA.Eachapproachhasaparticular
focusandservesadifferentpurpose,whether itbedebtmanagement,crisisprevention,ordebtrelief.
Technical indicators should be supplemented by policy considerations and other kinds of analysis if
countriesaretomanagetheirexternaldebtinasustainableway.
Bearing in mind all external and domestic factors contributing to debt sustainability, under a
developmentpolicy approach, debt sustainability is not viewed only from the narrow perspective of
reducinganunsustainable levelof debtbut isalso integrated intotheoveralldevelopmentstrategyof acountry.Underthisapproach,debtshouldbemanaged insuchawayastomaximize itscontributionto
sustainabledevelopment.
Suchanapproachincorporatestheviewthatexternalindebtednesscannotbesustainableinthelongrun
if thedevelopmentstrategyadopteddoesnot leadtoan increase inforeignexchangeearningstorepay
thedebtonlyaftertheotherdomesticresourcerequirementsof thedevelopmentstrategyhavebeenmet.
Thusthepointof departureof asustainabledebtstrategyisaclearvisionof thecountry’sdevelopment
trajectory.Debt shouldbe integrated into thisdevelopment trajectoryby encouraging efficientuseof
externaldebtwhichbalancesitscostsandbenefitsinthecontextof thetrajectory.
Thepanoplyof policies integratingdebt intoacountry’sdevelopmentstrategywouldaimataddressingdifferentsituations:
policiestoenhanceanefficientuseof debtinlinewithdevelopmentobjectives;
policiestoadjusttoshocksinordertoavoiddebtcrises;
policiestodealwithdebtcrisesandtorestoregrowth.
Integrationof debtanddevelopmentstrategydoesnotexcludepoliciestoreduceexcessivelevelsof debt
but emphasizes the context of a growthoriented approach to debt sustainability. Furthermore such
integration isbasedon acknowledgement that in an interdependentworldpreventionof adebt crisis
often also requires actions at the international level, based on international cooperation to ensure
adequatetransferof resourcesfordevelopmentaswellastradingopportunitiesfordebtorcountries.
Theestablishmentof aneffective institutional frameworkup fordebtmanagement isessential for the
implementationof asustainabledebtstrategy.Within this frameworkspecific rolesandresponsibilities
shouldbeassignedtotheministryof finance,thecentralbankandthedebtmanagementagency,i.e.the
differentgovernmententities,andtheframeworkitself shouldbeadaptedtotheadministrativecapacity
of eachdebtorcountry.
Development isnot a smoothprocess, andno country canbe sheltered from the threatof adebtor
financialcrisis.Countriescanmoreeffectivelyadjusttodebtandcurrencycrisesif theymanagetoforesee
theeventslikelytotriggerthem.Takingearlyadjustmentmeasures,wherepossible,couldinsomecases
help tomitigate thegravityof thecrisisandshorten itsduration.The indicatorsreviewed in thispaper
should help in this respect. They should also help countries to assess the costs and benefits of debtrenegotiations.
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CompendiumonDebt Sustainability and Development
59
References
BergAandPattilloC(2000).TheChallengesof PredictionEconomicCrises.IMF
Economic
Issues.22,July.BergA,BorenszteinEandPattilloC(2004).AssessingEarlyWarningSystems:HowHaveTheyWorkedin
Practice?IMFWorkingPaper(WP/04/52),March.
CorsettiG,PesentiPandRoubiniN (1998).WhatCaused theAsianCurrencyandFinancialCrisis.NBER
WorkingPapers,6833,December.
EichengreenBandModyA(2000).WouldCollectiveActionClausesRaiseBorrowingCosts?NBERWorking
Papers,7458,January.
IMF(2002a).AssessingSustainability.PreparedbythePolicyDevelopmentandReviewDepartment,May.
IMF(2002b).EarlyWarningSystemModels:TheNextStepForward.In:Global Financial Stability Report.
Washington,DC,InternationalMonetaryFund,March.IMF(2003).DebtSustainability inLowIncomeCountries:TowardsaForwardLookingStrategy.Prepared
bythePolicyDevelopmentandReviewDepartment,May.
InternationalDevelopmentAssociationandInternationalMonetaryFund(2005).OperationalFramework
forDebtSustainabilityAssessmentsinLowIncomeCountries:FurtherConsideration(IDA/R2005
0056).
KaminskyG,LizondoSandRienhartC(1998).Leadingindicatorsof CurrencyCrises.IMFStaff Papers,47,
0:62–98.
RadeletSandSachsJ(1998).TheOnsetof theEastAsianFinancialCrisis.Mimeo,February.
RoubiniN (2001).Debt Sustainability:How toAssessWhether aCountry is Insolvent.NewYork, SternSchoolof Business,NewYorkUniversity,20December.
ThirwallAPandNureldinHussainM(1982).Thebalanceof paymentsconstraint,capitalflowsandgrowth
ratedifferencesbetweendevelopingcountries.OxfordEconomicPapers,November.
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TheMechanicsof Debt Sustainability Analysis
60
ANNEX
1. Debt,TradeandGrowth
FromtheBalanceof Paymentsidentity:
1)0 EF EDiM EP X P f f h
X arerealexports(orvolumeof exports)
M arerealimports(orvolumeof imports)
h P isdomesticpriceindex
f P isforeignpriceindex
D isexternaldebtexpressedinforeigncurrency
F areexternalflows,includingnewdebtandnetFDI,expressedinforeigncurrency
E isnominalexchangerate(domesticcurrencyperunitof foreigncurrency)
f iistheforeigninterestrate
Weassumethattherearenochangesininternationalreserves.
DividingallvariablesbynominalGDP,Y P h ,weget:
2)
0Y P
EF
Y P
EDim xhh
f
where x = PhXPhY ,Y
M
P
EP m
h
f *
and for simplicity it is assumed that all external flows are debt
relatedsothat dt
dD F
DefineY P
EDd
h
and
Y P
EF f
h
Differentiatetheexpressionford :
2)(
)()(
Y P
dY P Y dP EDY P DdE EdD
dt
dd
h
hhh
2)(
)(
Y P
dY P Y dP ED
Y P
DdE EdD
h
hh
h
Y P Y
EDdY
Y P P
EDdP
Y P
DdE EdD
hhh
h
h
11
Y P
EDg
Y P
EDp
Y P
DdE EdD
hh
h
h
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CompendiumonDebt Sustainability and Development
61
Y P
g p E dE DdD ED
h
h
//
Wecanrewritetheaboveexpressionas:
D
F
Y P
ED g ped
dt
dd
h
h )(
=f g ped h )(
e rateof changeof exchangerate
h prateof changeof domesticprices
grealGDPgrowthrate(dY/Y)
Finally,wereplace f withtheaboveexpressioninequation2:
0)( dt
dd d g ped im x h f
or
3)
d g pei xmdt
dd h f )(
Further,wecanrewriteequation3as:
d p g p ped i xm
dt
dd f h f f )(
where f prepresentstherateof changeof foreignprices
or
d g ctot d pi xmdt
dd f f )()(
where ctot (=ph pf e) is therateof changeof
thetermsof trade.
2. Contributionof DebtandCapitalFlowstoGrowth
First,thebalanceof paymentsidentity:
4))()( 11
**
1 t t t
e
t t t t t t
e
t
e
t R R FDI Di X P M P E D D
Deisexpressedindomesticcurrency.
Forsimplicity,wewillassumethatallcapitalinflowsaredebtrelatedandsoincludedintoe
t D,thatthese
inflowsareestimatedonanetbasis(i.e.afterallowingfori*Dt1),andthattheforeignexchangereserves
areunchanged( 0
t R ).Then:
t t t t t
e
t M P E X P D *** *
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TheMechanicsof Debt Sustainability Analysis
62
Takinglogsonbothsides:
)**ln()*ln( *
t t t t t
e
t M E P X P D
Differentiating:
M
dM
E
dE
P
dP
X P D
X P Dd e
t
e
t
*
**
)*(
Since dX P X dP X P d **)*( and t t t t t
e
t M P E X P D *** *wecanrewritethisexpressionas:
{P*X/P**E*M}{dP/P+dX/X}+{Det/P**E*M}{d(Det)/Det}=dP*/P*+dE/E+dM/M
Replacing M E P X P **
**by and M E P
D
e
t
***
by 1 weget.
5)M
dM
P
dP
E
dE
X
dX
P
dP
D
Dd e
e
*
*)()1(
where representstheinitialratioof exportstoimports.
Substitutingtheexpressionforrealimports,
R R Y dY P dP E dE P dP M dM /)///(/ **
andrealexports,ww Y dY P dP E dE P dP X dX /)///(/ **
,
whereisthepriceelasticityof exports,thepriceelasticityof imports,theelasticityof demandfor
imports,theelasticityof demandforexports,YrtheGDPof thedebtorcountry,andYwforeignincome,
andsolvingfordYr/Yr,weget:
6)dYr/Yr=
wwee Y dY D Dd P dP E dE P dP /)/)()(1()///)(1( **
OntheRHSof thisexpression,weseethatthebalanceof paymentconstrainedgrowthrateof realGDP
dependson:
therateof changeof termsof trade )///( ** P dP E dE P dP ;
thecombinedeffectof priceelasticityof importsandexportand relativepricechanges/changes in the
termsof trade )///)(( ** P dP E dE P dP ;
thecombinedeffectof rateof changeof debtrelated foreigncapital inflowsand the tradedeficitasa
proportionof imports,(1)ee D Dd /)( ;
thecombinedeffectof growthrateof theratioof exportstoimports,theelasticityof demandforexports,
andforeignincome,Yw.
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CompendiumonDebt Sustainability and Development
63
CHAPTERIV
ANANALYTICALFRAMEWORKFORDEBT
SUSTAINABILITYANDDEVELOPMENT
ValpyFitzGerald
(Universityof Oxford)
A. Introduction
1. ExternalDebtandDevelopment
This paper is intended to contribute to the further development of debt sustainability analysis for
developing countries,withina framework thatdoesnot take thenarrowviewof debt sustainabilityas
beingreachedsolelybyreducingexcessivecurrentlevelsof debt.Ratheritviewsdebtsustainability,asan
integralpartof asuccessfuldevelopmentstrategy,closelylinkedtoexportgrowth.
There are at least three good reasons for developing countryGovernments to borrow abroad: (i) the
economicreturnonpublicinvestmentindevelopingcountriesissuperiortothecostof borrowedcapitalso that growth can be accelerated by prudent use of debt without excessively reducing current
consumption levels;(ii)domesticfirms(particularlysmallandmediumenterprises)cannoteasilyborrow
abroadandtermsarebetterforsovereignborrowerssothatitisefficientfortheGovernmenttousedebt
foronlendingtoproductivesectors,particularlyexports;and(iii)theexternalitiesfrompublicinvestment
ininfrastructure,health,education,etc.arelargeandpositivebutcannotgenerallybecapturedinreturns
toforeigndirectinvestors.
Foreignprivateinvestorscanbenefitfrominvestingindevelopingcountrysovereigndebtastheratesof
return are higher than those obtainable on OECD government bonds, while the risk due to possible
defaultcanbemitigatedbyappropriatediversificationof portfolios.However,financefromthissourceis
available only for “emerging markets” – that is middleincome countries and a few large lowincome
countries.Most lowincomecountries,ontheotherhand,donothaveaccesstoexternalprivatecapital
except for foreign direct investment in natural resource sectors owing to problems associated with
contractenforcement, informationasymmetry,andeconomicexternalities. Inconsequencebilateralaid
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An Analytical Framework for Debt Sustainability and Development
64
donorsandmultilateraldevelopmentbanksactas financial intermediaries toprovide loanson suitable
termsonthebasisof theirownabilitytoraisefundsinglobalcapitalmarkets.
Externaldebthas tobe repaid in foreignexchange, so that tradeplaysa critical role.The relationship
between external borrowing and trade is the key to a successful external debt strategy, as externalindebtedness cannot be sustainable in the long run if the development strategy does not lead to an
increaseinforeignexchangeearningsaboveimportrequirementssufficienttorepaythedebt.Thepoint
of departureof asustainabledebtstrategyis,therefore,aclearvisionbytheGovernmentof thecountry’s
developmenttrajectoryanditsrelationtoitstradepotential.
2. TheCurrentEmpiricalContextforExternalDebtAnalysis
It isessential to take into account the situationof different typesof debtor countries (middleincome
countries, lowincomecountries,HIPCs,etc.)bothbecause lendersarediverse (withdistinctobjectives
andleverages)andbecausecountries’economicstructuresandvulnerabilitytoexogenousshocksdiffer.
Inthissubsectionwetakeabrief lookataggregatedataorganizedbyregionalgroups,incomelevels,and
debtdifficulties.Thisdisguisesmanyproblemsat thecountry levelbutgivesagood ideaof theoverall
issues.
AsTableIV.1.indicates,thedebtburdeninrelationtoexportsisthreetimeshigherinlowincomethanin
middleincomecountries.Howevermiddleincomecountriesowethreequartersof alldevelopingcountry
debt.Thusthe“debtproblem” isan issueof integration intotheworldeconomy if consideredfromthe
point of viewof amiddleincome country,but an issue of economicdevelopment if viewed from the
perspectiveof alowincomecountry.
TableIV.1.ExternalDebtandExportsbyIncomeLevel,2003
Exports
(US$bn)
ExternalDebt
(US$bn)
Debt/Exports
(Per cent)
Lowincomecountries 176 523 297
Middleincomecountries 1813 1815 100
Totaldevelopingcountries 1999 2339 117
Source:WorldBank(2005b).
Thetotalvalueof externaldebtanddebtservicevarieswidelybyregionandbydebtorstatus,atTableIV.2. indicates.By2003netexternalborrowingwasquite lowcomparedtooutstandingdebt inallthree
regionsidentifiedhere,45butonlyinDevelopingAsiaarereservessufficientlylarge(particularlysincethe
mid1990sfinancialcrises)tocoverexternaldebt liabilities. InLatinAmerica(andbyextension in“UDC”
countries with recent debt difficulties) reserves barely cover debt service, leading to serious liquidity
difficulties. InAfrica(andbyextensiontheHIPCgroup)reservesareat leastfourtimesdebtservicebut
thishasnopracticalsignificancebecause thedebt isnot traded. It isworthnoting that if theoverseas
assets of the private sector were recorded and entered here, the net asset position of developing
countrieswouldbepositive –and inthissensethere isno“developingcountry debt issue” assuchbut
ratheraserioussovereigndebtproblem.
45TheCISandEasternEuropewereinfactthemainnetborrowersin2003.
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CompendiumonDebt Sustainability and Development
65
TableIV.2.ExternalDebtof DevelopingCountriesbyRegionandDebtorStatus,2003(US$bn)
Totalof
which
Developing
Asia
Latin
America
and
Caribbean
Africa UDC HIPC
Externaldebt 2724.3 695.7 759.0 278.0 804.2 145.8
OfficialReserves 1412.6 670.1 196.2 90.9 168.7 19.7
Debtservice 437.8 105.5 174.3 25.2 112.3 3.6
Netexternalborrowing 91.5 18.7 0.6 3.8 3.8 2.0
Exceptionalfinancing 32.4 6.2 14.4 6.7 13.0 5.1
Source:IMF(May2005).Notes:“UDC”areUnsustainableDebtCountries(author’sdefinition)witharrearsand/orreschedulingduring19972001;
HIPCare“highlyindebtedpoorcountries”underconsiderationbytheWorldBankandIMFfordebtcancellation;
“debt service” is actual payments of interest on total debt plus amortization payments on longterm debt,
incorporating exceptional financing; “exceptional financing” is arrears on debt service, rescheduling of debt
serviceanddebtforgiveness.
Theexternaldebtstructurevariesintwodimensions –maturityandcreditor.AstableIV.3.shows,most
debtis“longterm”(thatiswithamaturityof oneyearormore)andhasanaveragematurityof theorder
of tenyears.AfricaandtheHIPCcountriesrelymostlyonofficialcreditors,whileAsiaandLatinAmerica
relymoreonprivate lenders.Within this lattercategorybondspredominateoverbankcredit,although
thedifferenceisnotgreatinpracticefromthepointof viewof theborrower.
TableIV.3.Structureof ExternalDebt,byMaturityandCreditor,2003(US$bn)
Total
of
which
Developing
Asia
LatinAmerica
andCaribbean
Africa UDC HIPC
Shortterm 377.9 106.3 89.7 19.4 34.8 3.3
Longterm 2344.9 589.4 669.3 258.6 769.4 142.5
Totaldebt 2724.3 695.7 759.0 278.0 804.2 145.8
Officialcreditors 1021.9 292.6 204.5 213.1 491.3 132.0
Privatecreditors:
bankcredit
722.1
161.9
185.8
42.5
183.2 10.8
bonds 960.0 241.3 368.7 22.4 129.7 3.0
Source:IMF(May2005).
Notes:ForUDCseenotestotableIV.2.
In relation to exports it is clear from Table IV.4. that the major “debt overhang” difficulties are
encounteredinLatinAmericaandAfrica,wheremostof theUDCandHIPCaretobefound.Inrelationto
debtserviceLatinAmerica(andbyextensiontheUDCs)hasthemostseriousproblem.Africancountries
(andthustheHIPC)benefit fromsofter,aidrelateddebtterms –and, indeed,donot fullyservice theirdebt.Thedifferencesininterestratespaidreflectthedifferencesbetweenmiddleincomecountrieswith
accesstoprivate lendingand lowincomecountrieswhichrelyonofficial lenders,ontheonehand,and
thehigherdefaultriskinLatinAmericacomparedtoAsia,ontheother.
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An Analytical Framework for Debt Sustainability and Development
66
TableIV.4.Indicatorsof DebtinRelationtoTrade,2003
Totalof
which:
Developing
Asia
Latin
America
and
Caribbean
Africa UDC HIPC
Per cent of exports
ExternalDebt 111.3 73.2 199.3 144.6 208.9 321.1
InterestPayments 4.3 2.6 10.8 4.1 6.8 3.6
Amortization 13.6 8.5 34.9 9.0 22.3 6.6
Per cent of debt
Interest 3.9 3.6 5.4 2.8 3.3 1.1
Amortization 12.2 11.6 17.5 6.2 10.7 2.1
Source:IMF (May 2005).
3. Coverageof thePaper
This paper focuses on external debt. It does not examine domestic debt, even though with currency
convertibilitypublicdebtdenominatedindomesticcurrencycanrepresentacontingentclaimonforeign
exchangereserves –albeitatanundefinedexchangerate.Nordoesthispaperaddressdebtcrisesassuch
and thesubsequent renegotiationsand restructurings.None the less,manyof theanalytical results for
prudentdebtmanagementdiscussedbelowarerelevanttodebtsustainabilityatthedomesticaswellas
theexternallevelbecauselattersustainabilitycannotbesensiblyplannedforeitherexceptinthecontext
of asustainabledebttrajectory.
The structure of the paper is as follows. Section B provides the appropriate national accounting
framework fordebtanalysis,and then setsout the traditional “gapmodels” (savings, tradeand fiscal)
along with a summary of the modern critique of this approach. Section C outlines the modern
intertemporalapproachtodebtanalysis,derivestheoptimaldebtlevelinrelationtooutputandexports
foranopendevelopingeconomy,andproposestwo“goldenrules”forexternaldebtmanagement.The
macroeconomic consequences of external debt are addressed in SectionD,which startswith the key
impact on real exchange rates and follows thiswith the framework for analysing the effectson fiscal
balancesandincomedistribution.SectionEexplainshowcreditrationinginglobalcapitalmarketsmeans
thatdebtlevelsarenotdeterminedbyborrowers,andgoesontoanalysetheimpactof interestrateand
trade shocksunder thesecircumstances.Finally,SectionFderivespolicyconclusions forbothdomesticGovernmentsandtheinternationalcommunity.
B. Debtandthe“FinanceGap”Model
1. NationalAccountingsandDebt
Debtaccountingisquitecomplexbecausedebtflows –inflowsof freshdebtcapitalandoutflowsof debt
service –enterintotheprocessof savingsandinvestment,thebalanceof payments(onbothcurrentand
capital account) and the fiscal framework. In the savings and investment balance, net debt flows
constitute“externalsaving”.Inthecurrentaccountof thebalanceof paymentsinterestpaymentsondebtareanoutflowof factorincome.Inthecapitalaccountnetdebtflowscreatechangesinthenetexternal
assetposition.Inthefiscalaccountsgrossdebt inflowsareanexternalresource,whileamortizationand
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CompendiumonDebt Sustainability and Development
67
interest payments are major expenditure items. Furthermore net debt flows in a particular year, in
combinationwithinheriteddebt,determinedebtfornextyear,thusintroducingadynamicelementinto
debtaccounting.
Theseaccountingidentitiestellusnothingaboutthebehaviorof thevariouscomponents:inotherwordstheyarenotamodel.However,theydoclarifythecomplexrelationshipbetweendebtandthedomestic
economy,andalsounderlinethefactthatthecomponentsmustbereconciledinotherwords,“addup”.
Weusethefollowingnomenclature:
Yaggregateoutput(i.e.GDP)
Caggregateconsumption
Xexportsof goodsandservices
M importsof goodsandservices
Sdomesticsaving
I investment(grossfixedcapitalformation)i interestrateonexternaldebt
amortizationrateonexternaldebt
Dexternaldebt
Ggovernmentexpenditure
Tgovernmentrevenue
Rofficialforeignexchangereserves
Westartwiththeaggregatedemandsupplybalance
X I C M Y [B.1]
which,whenthesavingsinvestmentidentityisinserted,yieldsthe“accumulationbalance”
[B.2]
Thebalanceof paymentsoncurrentaccountincludesnotonlyexportsandimportsof goodsandservices,
but also factor income (income from capital andworkers’ remittances). To simplify the expositionwe
includehereonly the interestpaymentson (public)externaldebtat this stage.Note that, if theseare
includedin[B.2],thenthedefinitionof savings(S)isnationalsavingsandthatof output(Y)isGNP.
Thecurrentaccount(CAB)andthecapitalaccount(KAB)areoppositeandequal.Thus
iDM X CAB [B.3]
andthecapitalaccountis
R D KAB [B.4]
sothat
0
KABCAB [B.5]
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An Analytical Framework for Debt Sustainability and Development
68
Note that private capital flows (and the corresponding factor payments) can be inserted into this
accounting framework very simply. Foreign private assets (A) include portfolio holdings overseas
(sometimesmisleadinglycalled“capital flight”)andFDIabroadbydomesticcompanies.Foreignprivate
liabilities(L)includebothforeignborrowingbydomesticfirmsandinwardFDI.Thefullcapitalaccountcan
thusbewritten46
}{ A R L D KAB [B.4a]
However,intherestof thispaperweshallassumethattheGovernmentistheonlyexternaldebtor –not
leastbecausethe“externaldebt”statisticsreflectpublicsectorandpubliclyguaranteedexternaldebt.
Inthisframeworkweassumethatthefiscalbalanceisclosedonlybyforeignborrowing –thusexcluding
monetaryissue(“seignorage”)anddomesticborrowingfromconsideration:
iDG DT [B.6]
Last,butfarfromleast,wehavethelawof motionfortheexternaldebtitself (D)intermsof itsprevious
periodvalue(D1),andnewborrowing(D)andthedepreciationrate()inthefollowingtwoalternative
forms:
11
11
D D D D
D D D D
[B.7]
2. “FinancingGap”Modelsof DebtandGrowth
In the contextof work ondevelopment strategies from the 1960s through the 1980s “financing gap”
modelsprovidedthebasicanalyticalframeworkforbothlendersandborrowers.47Inthesemodels,
48the
objectiveof theplanneristomaximizetherateof outputgrowth(y)subjecttotheconstraintsimposedby
domestic savings (i.e. the capacity to invest), the external sector (i.e. the capacity to import)or fiscal
balances(i.e.thecapacitytospend).
The savings constraint exists because available funds are determined by the domestic economy’s
propensitytosave(s)andtheinflowof externalfinance(F),whichinturndeterminesthemaximumlevel
of investment(I)thatcanbeundertakenandthustherateof growth(y).
The external constraint exists because the level of imports (M) cannot exceed the foreign exchangeavailable fromexports (X)and capital inflows (F).Exportsareassumed fixed in the short term,due to
capacityconstraintsand/orlimitedexternalmarkets.Theavailabilityof importsdeterminesthemaximum
levelof output(Y)foragivenimportpropensity(m).
The fiscalconstraintexistsbecausegrowthdependsonpublic investment (eitherbecause itconstitutes
the bulk of investment, as in poor countries, or because it is essential in order to promote private
investment,asinmiddleincomecountries).Publicinvestmentisassumedtobeaconstantproportion(p)
of totalinvestment.Publicinvestment,andthusgrowth,isconstrainedbybudgetarybalance(Z).
46Acompletecurrentaccountidentitywouldincludeprivateinflowsandoutflowsof factorincome
47Avramovicandothers(1964)isagoodsurveyof thetraditionalmethodologyforanalysingtherelationshipbetweendebtand
growth.48There isa large literatureonthesemodels,whichoriginateswiththeHarrodDomargrowthmodelof thesavingsconstraint,
andcontinueswithChenery&Strout(1955),whomodeledtheexternalconstraint.Thismodelwasthenextendedtoincludealso
thefiscalconstraint.Goodformalexpositionsof allthree‘gapmodels’aregivenbyBacha(1990)andTaylor(1994).
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Inconsequenceof theseassumptionsexternalfinance(F)actsasasourceof “externalsaving”,tofillthe
gapbetweendomesticsavingsandtotalinvestment,actingasaformof “importsupport”andasasource
of fiscalrevenue.ThroughthesechannelsFaffectsboththelevelof investmentandtherateof growthof
GDP.Thismodelstillinformsmostof theempiricalpolicydebateaboutaid,debtandforeigninvestment.
Theplanningproblemisthustomaximizeywhere
t t t
t t t t
t 2t 1t
t t t
t 1-t t
t t
pI Y t g Z
Di D D F
I m+Y m=M
Y g t Y s=S
I + K = K
K k =Y
)(
)(
)(
11
[B.8]
subjecttothethreeconstraints
t t
t t t
t t t
F Z
F + X M
F +S I
[B.9]
(wheretistaxrevenueandggovernmentexpenditureasaproportionGDP).
Theoutcomedependsonwhichof thethreeconstraintsactuallybindsatanyonepointintime,whichis
anempiricalissue.
Thesavingsconstrainedmaximumgrowthrate(*
s y)canbederivedas:
Y
F g t sk y s )(*
[B.10]
The main concern of aidrelated policy modeling in most developing countries is the externally
constrainedmaximumrateof growth(*
e y),whichcanbederivedas:
1* mY
F X
m
k = y
2
e
[B.11]
Finally,thefiscallyconstrainedrateof growth(*
f y)canbederivedas
)(* g t
Y
F
p
k = y f
[B.12]
Allthreegrowthratesareof course increase inresponsetonetdebtinflows(i.e. 0/ F y ),butwith
differentderivatives.Whichbindsdependsonthecharacterof theeconomy.Generallyitisreasonabletoassumethatinthepooresteconomiesthesavingsconstraintisbinding,andthatexternalandfinallyfiscal
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An Analytical Framework for Debt Sustainability and Development
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become binding as economic development advances. The effect of net debt flows is likely to be
progressivelygreaterineachof thesethreestagesbecausegenerally
F
y
F
y
F
y
m p
se f
***
2 1
[B.13]
3. TheLimitationsof “FinancingGap”Models
The “financing gap” model continues to form the basis for the trade, aid and growth linkages in the
mediumtermmacroeconomicprogrammingmodelusedbytheWorldBank:theRevisedMacroeconomic
StandardModel(RMSM).49Italsoinformstheshorttermmonetaryprogrammingframeworkusedbythe
IMF.50Thesetwomodelsstillformtheessentialanalyticalunderpinningforthemissionreportsof thetwo
BrettonWoodsinstitutionsonstabilizationandadjustmentprograms.51TheUNDPmakesestimatesof the
externalfinancingrequirementsof poorcountriesonasimilarbasiswhenpreparingformeetingsof donor
consortia.
However,thelastdecadehaswitnessedgrowingawarenessof thelimitationsof thesemodels,whichno
longercorrespondeithertomodernmacroeconomictheoryortomacroeconomicpolicypracticeinopen
economies. Indeed fromaneoclassicalviewpointthisanalyticaltradition isregardedas invalidatingthe
proposals from the Bank and the Fund on additional lending and debt forgiveness.52However, their
persistenceisdoubtlessdueinlargeparttotheiranalyticalsimplicityandthefactthattheparameterscan
beestimatedeasilyandquicklyfromavailablemacroeconomicdataindevelopingcountries.
Withoutgoingsofarastoreject“financinggap”models,itispossibletoidentifyfourareasof weaknesswhichneedtoberemediedinordertoproduceasounderconceptualframeworkandanalyticalmodelfor
quantifyingdebtsustainability.Theseare:
First,thecoefficientsinthebehavioralequations(particularlytheconstraints)areassumedtobe
stable andexogenous, rather thanendogenouslydetermined. In the caseof savings,empirical
evidence and Keynesian theory suggest that domestic saving (and thus consumption) in fact
adjuststothe levelof fixed investmentandforeign inflowsof capital.53Again,thefiscalbalance
canalwaysbeadjustedbyvaryinggovernmentexpenditure.
Second,intheexternalbalanceof trade,exportsareassumedtobegivenandimportstodepend
onlyonthe levelof economicactivity.This ignorestheeffectof therealexchangerateonboth
importandexportvolumes,and thus thepossibilityof adjusting to foreignexchangeshortageswithouthaving to reducegrowth.54Italsounderplays the roleof exchangerates indetermining
thefiscalbalance.
Third,“financinggap”modelsassumethatextraexternalfinancealwayscontributestogrowth,by
simply and directly adding to savings, import capacity or fiscal resources and thus allowing
investment –andthusgrowth –torise.However,itisestablishedthatexternalresourcesoftenin
49SeetheAddison(1989)andhttp://www.worldbank.org/data/rmsm/index.htmforanupdatedversionof thispaperplusother
RMSMdocuments.50See IMF (1987),which in turnderives fromPolack (1957).SeealsoBaquirandothers (2003) for thegrowth linkages in IMF
models.51SeeAghenorandMontiel (2003) fora recentsurvey,andKhanandothers (1990) fora formalstatementof therelationship
betweenthetwomodels.52SeeEasterly(1999).
53SeeFitzGerald(2003a).
54SeeDornbusch&Helmers(1988).
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CompendiumonDebt Sustainability and Development
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practice leadto increasedconsumption.55Moreoverthe investmentundertakenmaynot leadto
increasedexportsandthusdebtrepaymentcapacity.
Fourth,andmostseriouslyfromananalyticalviewpoint,the“financinggap”modeldoesnotallow
for intertemporaloptimizationbyeconomicagents: that is, the fact thathouseholds, firmsandGovernmentstakeinvestment,savingandborrowingdecisionslookingforwardovermanyyears.
Theassumptionof intertemporaloptimizationisthebasisof modernmacroeconomicsingeneral
and for small open economies in particular; and allows resource allocation behavior to be
endogenized.56
C. SustainableDebtLevels
1. TheOptimalDebtLevel,ExportCapacityandIntertemporalMaximization
The contemporary approach to debt sustainability starts from the same foundation as the modernmacroeconomictheoryof openeconomies,whereapparentbalanceof paymentsdisequilibriaintheshort
run canbe seenaspartof an intertemporalequilibriumbaseduponexpectationsbyeconomicactors
about the future. The small open economy is composed of overlapping generations of households
optimizingconsumptionandsavingovertimeandof firmsmaking investmentdecisionsbasedonprofit
maximization.57Currentaccountsurpluses(ordeficits)generatenetasset(or liability)positionswiththe
restof theworld,whichinturnaffectthefuturebehaviorof firmsandhouseholds.
If there isfreeaccessto international financialmarketsatagiven interestrate(i)andno issuessuchas
debtdefault,thenthecountryobeystheFisherianmaximandseparatesthedecisionto investfromthe
decisiontoconsume.58Focusinghereonthedecisiontoinvest,firmschoosetheirinvestmentstrategyso
as to maximize the wealth of their shareholders when measured at world interest rates. Theintertemporalequilibriumstrategy
59amountstoselectinganinvestmentrate(k*)thatisasolutionto
t t
t t t
t t
t t k
Q I k
K I K
K QQ
dt J Qit
/
)(
))(exp(max0
[C.1]
whereQ isthelevelof netoutput,Jthecostof installingnewcapital,Kthecapitalstockandtherateof depreciation.
Inorderto findatractablesolution tothisgeneralproblem,wehavetospecifytherelevant functional
forms.Westartoff bydefiningnationalincome(W)asoutputminusdebtinterestcosts,wheredebtalso
playsaroleincapitalformation,suchthat
55AtleastsinceGriffin(1970).
56SeeObstfeld&Rogoff (1995)andSen(1994).
57Thisisnowastandardformulation:seeforinstanceObstfeld&Rogoff (1995).58Thesavingsratedependsonthesocialratediscountfactorandtheintertemporalelasticityof substitutionof consumption,on
theonehand,andthe(world)interestrate,ontheother.SeeSen(1994).59SeeCohen(1994)forthederivation.
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An Analytical Framework for Debt Sustainability and Development
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0)(''
0)('
DW
DW
iDY W
[C.2]
inorderthatamaximumshouldexist.60Thisformulation isalsoconvenientbecausethetwoconstraints
reflectdecliningabsorptioncapacityanddebtoverhangeffectsrespectively.Undertheseconditions,the
optimaldebtlevelwillbedefinedbytheconditionformaximizingWwithrespecttoD:
0)(
D
i Di
D
Y
D
W
[C.3]
Inotherwords,debtshouldbecontracteduptothepointwherethemarginaladditiontooutputequals
themarginaladditiontointerestcosts.Ceteris paribus,thehighertheinterestrate,thelowertheresultingoptimaldebtlevel;andthelargerthepositiveimpactof thatdebtonoutput,thehighertheoptimaldebt
level.
Tofindtheoptimaldebtlevel,westartwithastandard61endogenousgrowthproductionfunctionof the
form
aK Y [C.4]
Leavingasidethelasttermin[C.3]andthusassumingthattheinterestrateisunaffectedbythedebtlevel,
wehavethefollowingmaximizationcondition:
a
i
D
K
i D
K
K
Y i
D
Y
D
W
0
[C.5]
Thekeyissueisthusshowntobetheeffectof debtoninvestment.Weshallexaminetheparticularcase
where the domestically funded capital (K1) is already installed, there is no previous debt, and the
authoritiescontemplatemoving inoneperiodtotheoptimaldebt level,byprovidingextracapitalstock
(K2)fundedbyexternaldebt
21 K K K [C.6]
Externaldebt(D)isthencontracted.Afixedproportion()of thisisusedtofundtheinstallationof new
productivecapital(directlyasinruralinfrastructure,orindirectlyasloanstoexporters),whiletherestis
allocatedtootheractivitiessuchassocial investments(healthetc),coverageof currentaccountdeficits,
ornoneconomicinfrastructure.Thecostof thisproductivepublicinvestment(J)isaquadraticfunctionof
theinvestmentrate:62
60Otherwisetheoptimaldebtlevelwouldbeinfinite,of course.61SeeRebelo(1991)forthebasisof the‘AK’modelusedhere,andAghion&Howitt(1999)foracomprehensivesurveyof modern
endogenousgrowththeory.62SeeHeijdraandvanderPloeg(2002:40)andalsoCohen(1994:490).
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1
2
2 21 K
K
K J
J D
[C.7]
With>I
Sowecannowspecifytheobjectivefunction[C.2]as
1
2221
21)(
K
K K
i K K aW
[C.8]
anddifferentiatingwithrespecttoK2yieldstheoptimalsolution intermsof theratio()betweendebt
fundedcapitaland“domesticallyfunded”capital:
11ˆ
01
1
2
1
2
2
i
a
K
K
K
K ia
K
W
[C.9]
Notethattheoptimalcapitalstructurecoefficient()canbenegative –whichwouldimplyaccumulation
of foreignassetsinsteadof borrowingabroad.
Wefindtheoptimaldebttooutputratio(),bysubstituting[C.9]into[C.7]and[C.4]:
)1(
)1(
ˆ
ˆ
)1()ˆ(ˆ
1ˆ
1ˆ
ˆ
121
1
1
22
aY
D
aK K K aY
K K
K K D
[C.10]
Clearly isincreasingin,andthusby[C.9]theoptimaldebtoutputratiowillbeloweredbyanincrease
intheinterestrate(i)(asweshouldexpect),butwillbeloweredbyanincreaseintheproportionof debtfundsallocatedtoproductiveinvestment()orintheoverallproductivityof capital(a).Thisresultcanbe
generalizedtoasteadystategrowthsituationbecauseinsuchasituationY/Kisconstant(andthusboth
componentsof capitalgrowat theoutputgrowth rate),and thusD/Ymustbeconstant. If theoptimal
debtlevel()ishigher,thendebtcanbesafelyraised.
Overall capitalproductivity requires some further comment in the contextof this study.Weassume a
simplifiedformof theexternallyconstrainedeconomydiscussedintheprevioussectionsuchthat:
K X
X M
mY M
[C.11]
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An Analytical Framework for Debt Sustainability and Development
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whereexportsareafunctionof theproportion()of thecapitalstock located intheexportsectorwith
knownproductivity().If itisassumedthatthesecondconstraintof [C.11],i.e.thatM=X,substitutionof
thefirstexpressionof [C.11]into[C.4]andtheresultintothethirdexpressionof [C.11]gives
11ˆ
1
2
im K
K
ma
[C.9a]
Inotherwords,theoptimaldebtlevelriseswiththeproportionof debtfundedcapitalstockallocatedto
theexportsector.However,itfallswithanincreaseininterestratesortheimportcoefficient.Toputthis
anotherway:longrundebt solvency – and thustheavoidanceof debt crisesarising fromtradeor capital
market shocks– requirestheallocationof ahigher proportionof the fundsraised not only to productive
investment but alsotoinvestment intheexport sector.
Finally,wecanalsodefinetheoptimaldebtserviceratio()fromthisresult,where
X
Di
ˆ
ˆ)(
[C.12]
bysubstituting[C.10]and[C.11]into[C.12]toyield:
ai
X
Y
Y
Di )(
ˆ
ˆ
ˆ
ˆ)(
[C.13]
The optimal debt service ratio () will decrease with a higher interest rate (i) because its negative
influenceontheoptimaldebtoutputratio()outweighsthatof theexplicititermin[C.13].
2. The“GoldenRules”forDebtSustainability
The “lawof motion” for externaldebt from theprevious section (equation [B.7]) canbe expressed in
termsof theprimary63currentaccountbalance(P)ontheassumptionthatthisdebt istheonlyformof
externalfinance:
11)1( t t t P Di D [C.14]
whichthroughrepeatedsubstitutionyields
1
0 )1()1(
t
t t
t
t
t
i
P
i
D
+D0 [C.15].
Whenngoestoinfinity,thepresentvalueof debt(i.e.thelefthandsideof theequation)goestozeroand
weretrievetheintertemporalbalanceof paymentsconstraint
63Thatis,excludinginterestpayments.
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0
0)1(t
t
t
i
P D
[C.16]
Inotherwords,alldebtmusteventually bepaidback.
However, in practice, developing country financial authorities and debt managers have to work on a
shortertimescaleandwithouttheluxuryof searchingforoptimalsolutions.Theceilingon“prudent”debt
is conventionally expressed as a share of output or as a ratio of debt service to exports, the former
reflectinglongertermsolvencyconsiderationsandthelattershortertermliquidityones.
Oncetheprudentialceiling(d)onthedebtoutputratiohasbeenreached,debtmanagementstrategyis
logicallynottoexceedit.Thusthe“goldenrule”isthat
d
Y
D
Y
D
t
t
t
t
1
1
[C.17]
Foragivenrateof outputgrowth(y)andexpressingtheprimarydeficitasaratio(p)of outputwehave
pd y
id
Y
P
Y y
Di
Y y
P Di
Y
Dd
t
t
t
t
t
t t
t
t
1
1
)1(
)1(
)1(
)1(
1
1
1
1
[C.18]
sothatthe“goldenrule”forthedebtoutputratiois
d yi y
id p )(1
1
1
[C.19]
Inotherwords,aprimarydeficit (p<0)canonlybesafely incurred if thegrowthrate ishigherthan the
interestrate(y>i).
If weexpresstheruleintermsof thecurrentaccountbalanceproper,asaproportion(c)of outputthen
thegoldenrulebecomes
yd cid pc
[C.20]
In other words, themaximum current account deficit as a proportion of GDP is the rate of growth
multiplied by the prudent debt GDPratio.
We can now turn to the second “golden rule” related to the ratio of debt service to exports. The
derivationisverysimilartothatforthefirstrule,butexpressedintermsof thesecondceiling():
Oncetheprudentialceiling(d)ondebtinrelationtooutputratiohasbeenreached,thenextrequirement
of debtmanagementstrategy is thatservicepaymentsontheresultingDt in relation toexportsshould
notexceed.Thusthe“goldenrule”isthat
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An Analytical Framework for Debt Sustainability and Development
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1
1)()(
t
t
t
t
X
Di
X
Di
[C.21]
Foragivenrateof exportgrowth(x)andexpressingtheprimarydeficitasaratio(p’)of exportswehave
pi x
i
X
P i
X
Di
x
i
X x
P Dii
X
Di
t
t
t
t
t
t t
t
t
)(1
1
)()(
1
1
)1(
})1){(()(
1
1
1
1
[C.22]
sothatthe“goldenrule”forthedebtserviceratiois
i
xi
x
i
i p 1
1
1
[C.23]
Inotherwords,andmoregenerallythataprimarydeficit(p’<0)canonlybesafely incurred if theexport
growthrate ishigherthanthe interestrate (x>i). If weexpressthesecondrule intermsof thecurrent
accountbalanceproper,asaproportion(c’)of exports
i
xc
i pc
[C.24]
3. ConvergenceandExpectations
Policymakerswithresponsibilityfordebtattempttoadoptatleastamediumtermview,andwhentheir
debtlevelsareabovetheprudentlimits,thena“convergence”strategymustbeadoptedinordertoreach
theselimitswithinareasonablenumberof years.Supposethatwewishtoreachtotheprudentiallimit(d)
of the debtGDP level over a number of years from the present level (d’) by reducing the debt by a
proportionueachyearovernyears,then
n
d d d u
/1
[C.25].
Thefirstgoldenruleisthenreexpressedas:
d yuc
d yui p
)(~)(~
[C.26]
Whethernewdebtissustainabledepends,therefore,onexpectationsaboutthefuturegrowthof output
andof thedeterminantsof thebalanceof tradeandof thecurrentaccount,namelyexportgrowthand
future interest ratesand termsof trade.Aswehaveseen, thedebt level itself willaffectgrowth inanoptimalsolutionsothattheusetowhichthedebtistobeput,andthusfutureproductivity,arealsopart
of the solution. Debtors and creditors should have agreed on these forecasts before signing a debt
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CompendiumonDebt Sustainability and Development
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contract.Forinstance,if weexpecttherateof changeof thetermsof trade(h)tohaveaprojectedvalue
inthefuture,thenthisisdistinguishedfromexportvolumegrowth( x )sothat[C.24]isrewrittenas
i
xhc
[C.24a]
Foradebt contract tobeagreeduponbydebtorand creditor,bothmustagreeonprojectionsof key
parameters;or if theydisagree,at least theoveralloutcomemustbeanticipatedasprofitable toboth
sides..Butasexemplifiedbythedebtcrisesof theearly1980sandof themiddle1990sandbythepresent
plightof theHIPCs,eventsdonotalwaysturnoutasexpected.Expectationsonbothsidesarethuscrucial
tothelending/borrowingdecision –therecanbeno“over borrowing” without “over lending”.
D. FiscalConsequencesof ExternalDebt
Analytical frameworks suchas thosedeveloped in sectionsBandC canbeusedexplore theeffectsof
policy towardsexternaldebt.One important issueunderthisheading isthe relationbetweendebtand
fiscalpolicy.Heretheanalysisstartsfromanadjustedversionof equation(B.6)inwhichtaxrevenueand
foreignfinancingconstrainfeasiblelevelsof governmentexpenditureandservicespayments(interestand
amortization)onexternaldebtasfollows:
F T DiG )( [D.9]
Thusanincreasedgrossdebtflow(F)allowsafiscalexpansion(i.e.Gtorise).However,accumulateddebt
itself generateslargebudgetaryitemswhichinsomecasesbecomethelargestsingleitemof government
expenditure,crowdingoutotherexpenditurecategories.64
Thisconstraintcanbeelaboratedandsimplifiedtotakeaccountof additionalassumptions:
Sinceexternaldebtisdenominatedinforeigncurrencyandtherestof theGovernment’sbudget
indomesticcurrency,thedebttermismultipliedbytherealexchangerate(e=(Epf/)/pd);
Debtamortizationflowsarenettedout:,
A strict budgetary rule is observed that only allows a maximum fiscal deficit (q) in domestic
currencytobefinancedfromseignorageand/ordomesticborrowing;
Theprudentdebtoutputratio(d)ismaintained;
Taxrevenueisagivenshare(t)of nationalincome
(D.9)isthenrewrittenas:
Y deY qt ieDG )( [D.10]
Diving through by Y and rearranging, we then obtain the constraint on the share (g) of government
expenditureinnationalincomeintermsof thefamiliardebtparameters(d,i)andtherateof growth(y)of
output:
d i yeq g )()( [D.11]
Absenta serious tax reform ()oramore relaxedmonetarystance (q), thegovernmentexpenditure
share (g) in national income is highly dependent on the debt parameters, on the one hand, and the64Foralldevelopingcountriesin2003,theaverageratioof externaldebtservicetoGDPwas6percent.Theaverageratioof tax
revenuetoGDP(t )was15percentandof publichealthexpendituretoGDPwas3percent(WorldBank,2005a).
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An Analytical Framework for Debt Sustainability and Development
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growth rate (y)and the realexchange rate (e),on theother, bothof whichvariablesare themselves
stronglyaffectedbythedebtstrategy.Inparticular,anincreaseineconsequentupondevaluationwhen
therateof outputgrowthislow(i.e.y<i) –acommonoccurrenceduringdebtcriseswillhaveastrongly
negativeimpactonthefiscalconstraintandthusongovernmentexpenditure.
This subordination of government expenditure as illustrated by the fiscal constraint [D.11] to debt
managementhasatleastthreemajorconsequences:
(a) It isdifficult togivepriority to increasingsocialprovision ingeneral (andpoverty reduction in
particular)byexpandingrealhealthandeducationexpenditurefasterthanpopulationgrowth;
(b) Itisnotpossibletoengageinanactivecountercyclicalfiscalpolicyinordertoreducetheimpact
of exogenous shocks on investment and growth, for example, by expanding infrastructure
expendituretomaintaincapacityutilization;
(c) Longtermplanningof publicexpenditureisrenderedmeaningless,withnegativeeffectsforthe
efficiencyof publicservices, infrastructureprovisionandtheutilizationof scarceadministrative
skills.
E. DebtVulnerabilityandExternalShocks
1. Determinantsof DebtFlows
Sofarwehavebeenworkingontheassumptionthatdevelopingcountriescanchoosethelevel(D)of debt
thattheycontractatagiveninterestrate(i).Thisistheconventionalassumptionineconomicanalysisas
well as in policy debates when reference is made to “overborrowing”. In fact, however, lenders
determinethevolumeof changesindebtandthe interestrate isnotgiven.Internationaldebtflowsaresubjecttoaformof creditrationing.
Official lending (that is by bilateral donors or multilateral organizations) is always determined by the
lenderon itsowncriteria,althoughtheseshould inprinciplesupportsustainabledevelopmentandthus
coincidewiththoseof theborrower.However,theborrowerdoesnotdecidethedebt level.Ratherthe
overallvolumeof officiallendingisdeterminedbytheinstitutionalstrategyof thelender.Withinthetotal
regionalandcountryallocations lendingdependsuponboth the technicalappreciationof development
prospectsandthusthesustainabilityof debt;ontheonehand,andthegeopoliticalpressuresof donor
Governments,ontheother.
Givenaceilingof officiallendingfromdonorsinanyoneperiod,developingcountryGovernmentstendto
contractdebtuptothislimit.Itisinthissensethat“creditrationing”existsforthiscategoryof lending.It
is extremely rare fordeveloping countries –particularly small lowincome countrieswithout access to
privatecapitalmarkets –toturndownofficiallendingproposals.Theinterestrateandmaturityof official
debtisalsosetbythelender,usuallyonasubsidizedbasis.Eligibilityisdecidedbythedonor.
Ininternationaldebtmarketsforbothbondsandbankloanstothegreatmajorityof developingcountry
Governments (“sovereigns”) another form of credit rationing obtains. This reflects the influence of
uncertainty in the loanmarketcreateswhichcausesadverse selection,as the two sideshavedifferent
perceptionsof riskand lenderscannotdistinguishbetweenborrowersastotheirabilitytorepay inthe
future.Italsoreflectsthelowertoleranceof riskonthepartof OECDinvestorsinforeignthanintheirown
markets,asituationwhichleadstoaninefficientallocationof theirportfoliosknownas“homebias”.65
65SeeFitzGerald&Babilis(2005).
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Consider the initially upwardsloping supply schedule of bank loans or bond purchases in Figure IV.1.
below.Thisshowsthereturnspread,r(theexcessof theriskyovertherisklessrate,thelatterbeingthe
rateof interestongovernmentbonds,alongtheordinateandthevolumeof lendingalongtheabscissa.
The competitive international banking market is made up of many noncollusive bank lenders and
borrowers. Banks are pricetakers in deposit markets but set lending rates (i.e. spreads) to maximize
expectedreturns.Higher lendingrateshaveanadverseselectioneffectsonborrowersby increasingthe
perceivedrisksof lending.Theseinturnthusincreaseactualdefaultriskowingtotheincreasedburdenof
interestpaymentsandtheenhancedincentivetodefaultduetoriseswithdebtandinterestrates.Beyond
acertainpoint thedebtsupplyschedulewillbebackwardsloping.Banks’unwillingness todifferentiate
betweendifferentriskreflectstheir imperfect informationonfundamentals(e.g.defaultrisk)aswellas
theirfearof covariantriskbetweenborrowers(contagion).
Thedemandschedule(Dd)infigureIV.1.fordebtisthebackwardslopingcurveforthesupplyof capital.
Competitive lendersmaximizetheirdebtholdingsatthepoint(Dd,r*):atthisprice(i.e.returnspread)
thepotentialsupplyof capitalordemand fordebtassets fromdevelopingcountries (Ds) is inexcessof
demand forcapitalor thesupplyof assets (Dd)– inotherwords,thewillingnesstoborrowexceedsthewillingnesstolend.
*)(*)( r Dr D D sd [E.1]
Themarket interest rate in foreign currency (if) to emergingmarket borrowers is determinedby two
elements, the risklessworld rate (iw)and the riskpremium (r).The riskpremium is theproductof the
perceived66probability of default () and an appropriate of investors’ degree of risk aversion (A).67
PerceiveddefaultriskdependsuponindicatorsdiscussedinsectionC.BsuchasthedebtGDPratio(d)and
thedebtserviceratio().68
66Theperceptionisthatof lenderstypicallyinfluencedbycreditratingsagencies.
67Thus the riskpremium isonlyequal to theunderlyingdefault risk if the financialmarket is strictly riskneutraland there is
perfectinformation;sothatyieldspreadsshouldnot generallybeinterpretedasmeasuresof ‘countryrisk’ –seeCunninghamand
others(2001).68Aswellascruderliquiditymeasuressuchasthe‘quickratio’mentionedinSectionF.1.
FigureIV.1.CreditRationinginGlobalDebtMarkets
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An Analytical Framework for Debt Sustainability and Development
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Thuswehave:
),(
d Ar
r ii w f
[E.2]
Clearly an increase in d or default risk (which is why the loan supply curve eventually
becomesbackwardsloping)andthusnotonlyraisesinterestcostsbutalsoreducesloanavailability.Note
that theriskpremium (r)dependson forecastsof debtdefaultprobability,andthusonexpectationsof
exportandoutputgrowth,ontheonehand,andontherisktoleranceof investors,ontheother.
2. CapitalMarketShocks
Oneshockisanincreaseinratesof interestinacountrywithamajorfinancialmarket.Thisshockaffectsinterestratespaidbydevelopingcountrysovereignborrowers(if)intwowaysasEquation[V.2]indicates:
firstly,bysimplyraising)theriskfreerate(iw),and,secondly,byraisingtheriskpremium(r)owingtothe
increaseinthedebtserviceratio().
However, another more commonly observed market shock results from shifts in the demand for
emergingmarketdebtduetochangeswithindevelopedcountrymarkets –suchaschangesinregulations,
fluctuations inriskaversionamongst lendersandinvestors,orcontagionfromotherdebtors.These lead
to“horizontal”downwardshiftsintheassetdemandcurveinFigureIV.1.
The macroeconomic and distributional consequences for emerging markets can be disproportionately
large.69This results froma fundamentalasymmetry in internationalcapitalmarkets:whilecapital flows
arerelativelysmall inrelationtothehomeeconomiesof lendersand investors,theyaremuch larger in
relation to host markets. The effect of the shocks is exacerbated by hysteresis:70owing to the
irreversibilityof investmentandwagepricestickiness,adownswingdoesnot leadtheeconomybackto
whereitwasbeforetheupswing.Fluctuationsintherealexchangerateassociatedwithshorttermcapital
flowsalsoleadfirmstomisallocateinvestmentbetweenthetradedandnontradedsectors,withnegative
consequencesforgrowth.71
Another potentially serious negative effect of debt shocks on growth is not felt directly through the
balanceof paymentsbutratherthroughtheeffecton investoruncertaintyaboutfuturemacroeconomic
conditions72andpolicychanges
73whenthedebt levelexceedstheprudential limit,apositioncommonly
knownas“debtoverhang”.Butthisriskcanbereducedbygovernmentaction.Even if theGovernment
cannotcrediblyprecommittorepaydebt,investingingrowthbeforeborrowingcanmakeforeignlendersaswellasdomesticinvestorsmoreoptimisticaboutgrowthprospects.
3. GlobalTradeShocks
Globaltradeshockscantakevariousformswhichinclude:
69SeeFitzGerald (2001). Interestingly, thiswas theposition takenby the IMF in the1998World EconomicOutlook (‘Financial
Crises:Characteristicsand Indicatorsof Vulnerability’).However,by2005theWorld EconomicOutlook hadbecomemuchmore
sanguine,attributingmostof emergingmarketvolatilitytodomesticfundamentals.70Amodelof thisprocess is setout inChapter6of FitzGerald (2003).On themacroeconomic theoryof hysterisis andpath
dependencyseeHeijdra&vanderPloeg(2002),Chapter2.2andAppendixA.6.4.71SeeFitzGerald&Perosino(1999).
72SeeFitzGerald,Jansen&Vos(1994).
73SeeRodrick(1991).
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CompendiumonDebt Sustainability and Development
81
Suddenmovements inexportprices,particularlyforprimarycommodities,duetodemandshifts
indevelopedcountriesorsupplychangesbyotherproducers;
Unexpectedshiftsinimportprices,particularlythoseforessentialcommoditiessuchasoil;and
Thelossof accessforexporterstoparticulardevelopedcountrymarketsduetochangesintrade
barriersordomestic(e.g.health)regulations.
Theseshocksobviouslyhaveaneffectonthedebtserviceexportratiobychangingthedenominator:for
example,asuddenfallinprimarycommoditypriceswillraisethisratio,eventhoughdebtserviceitself has
notchanged,andcan renderapreviouslysustainabledebtunsustainable.Secondordereffectsdepend
uponwhatpolicyresponsetheauthoritiestake.Insummarytheyhavefouroptions:
Incurringmoredebt inorder tosustain import levelsand maintainthe level of economicactivity.
Thisislikelytoappreciatetherealexchangerate(oratleastpreventitfromdepreciating)andto
preventanincreaseinexports.Theresultisafurtherriseinthedebtserviceratiothroughlower
exportsinadditiontothehigherdebt.
Maintainingthedebt level and allowingthecurrency todepreciateinorder toimprovethecurrent
account balanceand stimulateexports.Inthiscaseexportsdonotfallandthedebtserviceratio
does not increase. However, owing to the increased burden of servicing the external debt in
domesticcurrencythefiscalbalanceisworsenedwithconsequentcutsinsocialexpenditurecuts.
Moreovertheincomedistributionworsenswithdecliningrealwagesandinflation.
Maintaining thedebt level and stabilizing the real exchange rate.This is likely tobeassociated
with cutting the level of economic activity in order to depress imports, prevent inflation and
balancethecurrentaccount.
Any oneof theabove policiescombined witha reallocationof debt funds toexportswithgood
marketssoastomaintainexportgrowthandthusreducethedebtserviceratio.
Which policy option is adopted determines the impact of a trade shock on debt sustainability. The
domestic policy choice between exchange rate shifts and demand management depends on local
economic structures and political processes, as well as pressures from creditors or international
institutions.The “golden rule” in this context iswell known: “treatnegative shocks aspermanent and
positiveshocksastemporary”.Itisclearlybettertoreducedebtinresponsetoimprovedtradeconditions
thantoincreaseitwhentheydeteriorate.Nonetheless,developingcountryGovernmentsfrequentlydo
theexactopposite: increasingdebtduringdownswingsandnotreducing itagain inupswings.Moreover
the tendency to apply public external debt to nontraded sectors (which is often encouraged by the
internationalinstitutions)reducestheabilitytocopewithtradeshocks.
F. Conclusions:PrinciplesforDebtManagementinDevelopmentStrategies
1. TheParametersof DebtPolicy
Themain indicatorsunderlyingprudentdebtmanagementareshown inTableIV.5.It isclearthatthose
economies with unsustainable debt (i.e. the UDCs which were in arrears and/or undertook debt
reschedulingduringthe19972001period)stillhaveveryhighdebtGDPratiosclosetotheconventional
upperboundof 60percent.Thisceilingisderivedfromexperienceof countrieswhichgetintomajordebt
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An Analytical Framework for Debt Sustainability and Development
82
difficultiesandisinfactconsiderablylowerthanthatsetbytheWorldBank74inthecontextof theHIPC
initiative.
ThoseUDCswhichdependonprivatecreditorsaremainlyinLatinAmerica:theirdebtserviceratiosand
interestpayments as aproportionof debt arehigherand the averagematurity shorter than forothercountriesintheregion.TheLatinAmericanUDCsaretypicallysufferingfromaliquidityproblem,reflected
in the fact that the ratioof reserves to shorttermobligations (or “quick ratio”as it isknownbydebt
traders) is lessthanunity,makingthemsusceptibletospeculativeattack.TheAfricanHIPCs incontrast,
appear tobe insolvent rather than illiquid: their inability to repayprinciple results invery long implicit
maturities(i.e.yearsrequiredtopayoff debtatpresentratesof amortization). Inmarkedcontrast,Asia
appearstobebothsolventandliquid.
TableIV.5.Indicatorsof DebtVulnerability,2003
Total
of
which:
Developing
Asia
LatinAmerica
andCaribbeanAfrica UDC HIPC
ExternalDebt(per cent of GDP) 38.1 25.4 43.9 49.9 63.2 86.9
DebtService(per cent of exports) 17.9 11.1 45.8 13.1 29.2 10.2
InterestPayments(per cent
of debt)
3.9 3.6 5.4 2.8 3.3 1.1
Implicitmaturity(years) 8.2 8.6 5.7 16.1 9.4 48.7
LiquidityRatio 1.73 3.16 0.74 2.04 1.14 2.86
Source:Author’scalculationsbasedonIMF(May2005).
Notes: “UDC” are Unsustainable Debt Countries’ with arrears and/or rescheduling during 19972001; HIPC are “highly
indebtedpoorcountries”underconsiderationbytheWorldBankandIMFfordebtcancellation;interestpayments
divided by debt outstanding should be comparedwith longterm average interest rates in advanced economies
averaging 5 percent in this period; “implicit maturity” is outstanding debt divided by amortization payments;
“liquidity ratio” is the ratio of reserves to payments in the form of interest and principle on short term debt
principleplusservicepaymentsonlongtermdebt.
Nonetheless,asTable IV.6.shows,sustainabilityasmeasuredbyall indicatorsand foralldebtorclasses
clearlyimprovedbetween1996and2003.Thisappearstobeduetoexportgrowthandcontrolof imports
(whichallowedcurrentaccountbalancestomove intosurplus inmanycountries,especially inAsiaand
LatinAmerica)ratherthantosignificantreductionsindebtlevels.Indeed,allregionsappeartoberunningcurrentaccountdeficits thatare lessor surpluseswhichare larger than indicatedby theprudent rules
showninthetable.
Theseindicatorspointtotheeffectsof creditrationingonthepartof creditorsandstabilizationeffortson
thepartof debtors.Theysuggestthatthereisroomtoinitiateanewcycleof increaseddebtlevelssolong
asitisaccompaniedbyprudentmacroeconomicpolicy.
74See World Bank (2004). ‘Moderately indebted’ countries are those with a ratio of the present value of contracted debt
payments (PV)toGNPof over132percentandof PVtoexportsof goodsandservices (XGS)of over48percent,while ‘highly
indebted’countrieshavePV/GNPof over220percentandPV/XGSof over80percent.Noexplanationisgivenforhowtheseexact
figuresarederived.These ratiosarealsodifficult tocomparewith the IMFdataused in thispaperbecause the ratioof PV to
nominaldebtdependsonthetermsof thedebtitself.
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TableIV.6.ChangesinDebtSustainability19962003
Totalof
which:
Developing
Asia
Latin
America
and
Caribbean
Africa UDC HIPC
ExternalDebt(per cent of GDP)
1996 37.8 31.2 35.0 69.0 51.0 126.9
2003 38.1 25.4 43.9 49.9 63.2 86.9
GDPgrowth(per cent)
19962003
5.1 6.6 2.6 3.9 3.5 4.8
Currentaccount balance (per
cent of GCESR(2005para.117).DP)
1996 1.9 2.2 1.1 2003 3.1 0.3 0.1
“prudentvalue”( ) 1.9 1.9 1.0 2.3 2.0 5.1
DebtService(per cent of exports)
1996 21.5 13.9 46.7 20.3 29.2 22.6
2003 17.9 11.1 45.8 13.1 29.2 10.2
Exportgrowth
19962005
10.8
12.0
7.0
8.1
8.1
7.1
Currentaccount balance (per
cent of exports)
1996 7.3 14.7 3.6
2003 8.9 1.4 0.29
“prudentvalue”( ) 2.1 1.5 3.2 1.4 2.4 1.24
Source:author’scalculationsfromIMF(May2005).
Note:fordefinitions,seeSectionIIIabove..Thedebt/GDPanddebtservice/exportlevelsusedinthecalculationof prudential
CABand“goldenrule”arethesimpleaveragesof 1996and2003.
2. PolicyImplicationsforDevelopingCountries
Debt levels must clearly be kept within prudent limits and Governments should make credible
commitments to keepwithin these constraints, employing appropriate legislation if necessary. Such apolicyisessentialtoreduceuncertaintyfordomesticfirmswhicharethemainvehiclesfortheinvestment
onwhich growthdepends.Adebtoverhangand theprospectof deflationary stabilizationpoliciesand
debtrestructuring(orevenmoratoria)implyfuturelossesof sales,profitsandassetvalues.
Debt should be contracted on the longest terms possible. The cost of servicing should be kept at a
minimum subject to appropriate controlover the vulnerability to future capitalmarketorworldtrade
shocks.Suchcontrolmayimplythathigherinterestratesareareasonablepricetopayforloansof longer
maturityif vulnerabilitycanbereducedthereby.75
The use of funds generated by external debt should be geared to ensuring repayment capacity. This
meansthatasubstantialproportionof thesefundsshouldbeallocatedtothesupportof exportgrowth.
ThisdoesnotimplythattheGovernmentshouldbedirectlyengagedinexportproductionbutratherthat
75Missale(1999)demonstrateshowthisprinciplehasbeenappliedinOECDcountries.
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fundsshouldbeused tosupportappropriate infrastructureprovision, thesupplyof longtermcredit to
exporters,andtrainingfortheworkforce.
The support of export growth also involves maintaining a competitive real exchange rate, which has
implicationsboth fornominalexchangeratemanagementand forwagebargainingpolicy.Thepoliticaleconomy constraints on excessive reduction of real wages are best countered by appropriate
commitments to output and employment growth. Low real interest rates and an expansionary credit
policyareneededtosupporttheinvestmentratelikelytoberequiredforthetargetrateof growth.Thisin
turnmeans that the domestic financial system should to some extent be shielded from international
capitalmarkets.
The recent popularity of inflation targeting as the core of stabilization policy in emergingmarket
economiesdoesnothelpreducedebtvulnerabilitybecauseithastheeffectof increasingvulnerabilityto
cyclicalcapitalflows.Openingof thecapitalaccountandafloatingexchangeratehasbeenaccompanied
byrelianceonasinglemonetarypolicy instrument (the interestrate)andrigid fiscalrules inemerging
marketeconomiesinpursuitof pricestability.Thisprecludesnotonlycountercyclicalmonetaryandfiscalpolicybutalsotheuseof theexchangeratetomaintainexportcompetitivenesswhichisakeyelementof
prudentdebtmanagement. There is a strong argument foremergingmarketGovernments to adopt a
countercyclicalmonetarystance inresponse tocapital flows.Thiswouldneedtobesupportedbyreal
exchangeratetargeting,bankcreditregulationandamoreactivefiscalstance.76
If suchapolicy istobesuccessfulinmiddleincomecountrieswithsubstantialshorttermprivatecapital
flows, there is thus a strong case for intervention through various controls to reduce the volatility of
capital flows.77Thesecontrolsnowusually take the formof taxes, regulatorymeasures (suchassetting
specialreserveordeposit levelsfor inflows),andtargetedmoneymarketoperations,whilequantitative
controlshavebecomelesscommon.
3. PolicyImplicationsfortheInternationalCommunity
Thereareanumberof otherpolicyareasthatcanonlybeaddressedbytheinternationalcommunity.
Substantialdebt reductionhasnotyetbeen forthcoming,even forHIPCcountries,due todifficulties in
budgetaryallocationsforthecorrespondingassetwritedowns.This isan internalaccountingmatterfor
OECDcountriesandrequiresurgentsolution.Furtherdebtrestructuringcanreducetheliquidityproblem
of debtservicepressureonthecurrentaccount.However,itdoesnotreducetheinvestmentdisincentives
fromdebtoverhangandmayevenmakethemworsebyincreasinguncertainty.78
Giventhatexportgrowthisakeycomponentof prudentdebtmanagement,accesstoOECDmarketsfor
developing country exporters is crucial to their ability to contract debt prudently, while accelerating
economicgrowthandpovertyreduction.Thesameistrueof measurestoreducespeculativefluctuations
inprimarycommodityprices.Ideally,thesewouldbecombinedwithlinkageof debtrepaymentstoexport
levels –atleastinthecaseof paymentstoofficialcreditors.79
Since capital shocks to developing countries usually originate within OECD financial markets, policy
towardsthemshouldbebasedonrecognitionof theirexternalcharacter.Onesteptoreducetheimpact
of theseexogenous shockswouldbe for the IMF toprovide temporary financeona larger scale,more
quicklyandwithlessconditionalityinordertofacilitatesmoothdebtmanagement.Inthelongerrun,itis
76SeeFitzGerald(2005b).
77SeeFitzGerald(2005a).78Thiseffectfaroutweighsanypotentialmoralhazardimplicitin‘frontloading’debtforgiveness.
79Inpracticemarketsare veryunlikely toaccept sovereignbondswith yields linked to commodity exports.However, certain
primarycommoditiescanbeusedascollateralforborrowing.
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85
essentialtodeepenthemarketfordevelopingcountrydebtinOECDcountriesby:lengtheningthetenor
of instruments, taking measures to increase their liquidity, and encouraging their inclusion in the
investmentsof pensionandinsurancefunds.80
80Suchmeasureswouldalsoreducetheriskinessof sovereigndebt.
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CHAPTERV
THEDEBTEXPERIENCESOF
UGANDA,KENYAANDBOLIVIA
DamoniKitabire,PeterMichaelOumo,FrancisM.Mwegaand
PaulBeckerman
81
A. Introduction
Thischapter reviews thedebtexperiencesof threeof theworld’spooresteconomies,namelyUganda,
KenyaandBolivia.Thechapterhighlightstheconditionsanddebtproblemsthatunderpinnedthefailure
of successivedebtinitiativestorendertheirdebtpositionsustainable.
Amajorcontributoryfactortothisfailure isthatthethreecountries’exportsremainconcentratedona
handfulof commodities,allof which suffered significantdeteriorations in the termsof trade since the
1980s.Moreover, the threecountriesalsoexperienced severeclimatic shocks, suchasseveredroughts
(Kenya)andEl Nino(Bolivia).Tothesefactorsmustbeaddedpoliticalturmoil,instabilityandwars.
Uganda and Bolivia have records of having been exemplary pupils of Washington Consensus policies.
Kenya followed similarly orthodox approaches to macroeconomic management, albeit against a
background of turbulent relations with creditors. All three countries went through a succession of
programs. The reform efforts revived growth at the outset but sustained per capita gains failed to
materialize.
ThecountryreviewsinsectionsII,III,andIVhighlighttheroleof factorsaffectingsustainabilitythatshould
havebeenincorporatedinpastdebtrelief analyseswithspecialemphasisonexportdiversification,fiscal
81Section B is based on a paper by Damoni Kitabire and Peter Michael Oumo (Ministry of Finance, Planning and Economic
Development of Uganda) (Kitabire and Oumo (2005)), Section C is based on a paper by Francis M. Mwega (Department of
Economics,Universityof Nairobi) (Mwega (2005)),SectionD isbasedonapaperbyPaulBeckerman (IndependentConsultant)
(Beckerman(2006)).
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TheDebt Experiencesof Uganda,Kenyaand Bolivia
90
positions, and new financing. The three experiences are then compared and contrasted in Section E.
SectionFsummarizestheprincipalfindings.
B. Uganda
1. Introduction
Despite threedecadesof attempts to reduce the external debtburden,debt sustainability stilleludes
Uganda.Thecountry’sprincipaldebtproblemhasbeenitsheavydebtserviceburden.Despiteremarkable
GDPgrowthsincethe1990sand improvements inexportearnings,theeconomyremainsdependenton
rainfedagricultureandvulnerabletoshocksdeliveredbyworldcommoditymarkets.Thecountryisalso
stillheavilydependentondonoraidwhichcurrentlyfinancesabout40percentof thebudget.
Since the 1991 debt crisis, Uganda has developed a fairly coherent debt strategy. However, its debt
burden remained high until the HIPC Initiative put Uganda on a sustainable debt path momentarily.
UnfortunatelytheHIPC Initiativedidnot leadtoapermanentexitfromdebtproblems.Thecountryhas
borrowedheavilypostHIPCtoachievetheMDGsanditsdebtindicatorsareunsustainableagain.
2. EconomicPerformanceandPolicies
Ugandaentered the1980swithadegreeof political stability thatallowedGDPgrowth to recover toa
positive1.7per cent in19801983.Thereafter, industrialproductiondeclineddue to foreignexchange
shortageandthepoorstateof infrastructure,whileagriculturalproductionalsolagged.In1983/84fiscal
there was fiscal slippage on an IMF stabilization program which was cancelled in late 1984. Political
instabilityandaprotractedguerrillawarledtoanewGovernmenttakingpowerinJanuary1986.
InMay1987,thenewGovernmentembarkedonanEconomicRecoveryProgrammewiththesupportof
IMF,WorldBankandothers.Thiswasfollowedin1989byaStructuralAdjustmentProgramme(SAP).Its
focus was on limiting the involvement of the state in economic activities, the liberalization of trade,
financialsectorandmarketingactivities,theprivatizationanddivestitureof publicenterprises,andmore
generally the promotion of privatesector participation in production. The program resulted in an
acceleration of GDP growth to an average rate of 6.9 per cent per annum between 1991/92 and
1999/2000(seeFigureV.1.).
By 2000, the structure of the Ugandan economy had changed dramatically. In 1982/83, agriculture
accountedfor53.6percentof GDP,butitssharedeclinedto36.3percentin2004/05.Atthesametime,
thesharesof industryandservicessteadilyincreased,thatof servicesrisingfrom35.2percent1982/83to36.6percent in1990/91andbecomingthe largest in2001/02.However,Ugandaremainsvulnerableto
weatherchangesasthecountry’sagriculturalsystemreliesheavilyonrainfedsmallholderagriculture.
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FigureV.1.Uganda’sGDPGrowth1982/83 –2004/05
(Per cent)
-10%
-5%
0%
5%
10%
15%
20%
25%
1 9 8 2
/ 8 3
1 9 8 4
/ 8 5
1 9 8 6
/ 8 7
1 9 8 8
/ 8 9
1 9 9 0
/ 9 1
1 9 9 2
/ 9 3
1 9 9 4
/ 9 5
1 9 9 6
/ 9 7
1 9 9 8
/ 9 9
2 0 0 0
/ 0 1
2 0 0 2
/ 0 3
2 0 0 4
/ 0 5
Agriculture Industry Services GDP at Market Prices
Source:Ugandabureauof Statistics.
Largelydependentonprimarycommodities,Uganda’sexportgrowthhasbeenerratic.Followingreform
efforts,growthrebounded intheearly1990s.Thiswasreinforcedbythecoffeepriceboomof 1993/94
1996/97. Following efforts todiversify away from coffee, the shareof coffee inUganda’s exports has
declined from70percent inthe1990stoabout20percentsince2000/01.FishhasbecomeUganda’s
leadingexport,followedbycotton,tea,tobacco,andflowers.
As shown in FigureV.2.,Uganda’s terms of trade (TOT)have been erratic butwith anoverall secular
decliningtrend,largelydeterminedbytheinternationalpriceof coffee.TheTOThaverecentlyimproved
andchangeshavebeenpositivesince2002/03.Deterioratingtermsof tradehaveadirectimpactondebt
sustainability.Coffeeexportpricesin2003/04were49percentlowerthanenvisagedatthetimeof HIPC
IIcompletion.64percentof thedeterioration intheratioof theNPVof debttoexportsbetween2002
and2004wasduetofallingcoffeeexportprices.
FigureV.2.ChangesinUganda’sTermsof Trade1989/90 –2004/05
(Per cent)
-40%
-20%
0%
20%
40%
60%
80%
100%
1 9 8 9
/ 9 0
1 9 9 0
/ 9 1
1 9 9 1
/ 9 2
1 9 9 2
/ 9 3
1 9 9 3
/ 9 4
1 9 9 4
/ 9 5
1 9 9 5
/ 9 6
1 9 9 6
/ 9 7
1 9 9
7 / 9 8
1 9 9 8
/ 9 9
1 9 9
9 / 0 0
2 0 0
0 / 0 1
2 0 0
1 / 0 2
2 0 0 2 / 0 3
2 0 0 3
/ 0 4
2 0 0 4
/ 0 5
Source:Bankof Uganda.
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Under the Economic Recovery program initiated in 1987, reforms in trade policy gradually eased
quantitative restrictions and were geared towards export promotion. Trade licensing schemes were
abandonedandcoffeemarketingwasliberalizedinthelate1980s.In1992,thetaxoncoffeeexportswas
abolished.Itwasbrieflyreintroducedin1994tolimittheappreciationof theexchangerateasaresultof
thecoffeeboom,andabolishedagainin1996.Importdutieswererationalizedin1992toarangeof 1060
percent,andwerefurtherreducedtoarangeof 1050percentin1994.
Initially, theexchangeratepolicy involved repeateddevaluationsand rationingof theavailable foreign
exchange under various schemes. A foreigncurrency retention scheme was introduced in 1988 and
extended in 1989. In 1990, the exchange market was liberalized with the legalization of the parallel
(kibanda)market. In1992,anexchangerateauctionmarketwascreated.The foreignexchangemarket
was fully liberalized and the exchange rate was floated in 1993. In 1997, the capital account was
liberalized.
Topromoteforeigninvestment,UgandaenactedanInvestmentCodein1991.Thisreversedlongstanding
antipathy towards foreign investment and introduced standard provisions regarding investmentincentives, profit repatriation and protection against expropriation. FDI rose from US$43.2 million in
1992/93toUS$670millionasof end2004/05.
Successive reforms have enabled Uganda to manage its fiscal balances more prudently but have not
reduced the country’s dependency on donor aid for financing its budget. In the 1990s, over half of
Uganda’sbudgetwasfundedbydonoraidandthisratiowasstill40percentin2005/06.Upto1996over
half of theaid receivedwas in the formof loans, thoughgrantsbecamemore important subsequently
(AtingiEgo2005).
DealingwiththeDutchDiseaseeffectsof theseflowshasbeenthesourceof asignificantriseindomestic
debtservicing.DutchDiseaseeffectsputappreciationpressuresontheexchangerate,withinterestrate
risesowing to the attempt to contain the inflationaryeffectsof the inflowson liquidity.According to
AtingiEgo (2005), since1998DutchDiseaseeffects inUgandahaveadverselyaffected investmentand
imports.
3. ExternalDebt
Uganda’s debt problems date back to the 1980s. Debt continued to accumulate (despite the
Government’s increasing inability to service it)due to continuing foreignexchange shortages.By1986,
Uganda’sdebt stockhadgrown toUS$1.4billion,up fromUS$680million in1980.Between1986and
1990,becauseof thereconstructionandrecoveryprogramandof alackof aneffectivedebtmanagement
strategy, both the debt stock and debt service went out of control. Large sums were borrowed onunfavorabletermsandarrearsaccumulated,theburdenbeingexacerbatedbydelinquentprivatesector
loansguaranteedbytheGovernment.
By the late 1980s,Uganda faced a debt crisis. In 1990, theGovernment ran out of foreign exchange
followingasharpdecline in termsof tradedue largely toadecline in thepriceof coffee.Debtservice
obligationsamounted toover60percentof exportearnings.Drasticactionwas thereforenecessary to
reversethecollapseinthebalanceof payments,promptingthedevelopmentof Uganda’sfirstintegrated
debtmanagementstrategyin1991.
AsshownintableV.1.,mostof Uganda’sdebt(63percentin1991to88percentasof 2004)isowedto
multilateral institutions and is therefore longterm. Owedmainly to IDA and ADF the debt is also on
concessionalterms,i.e.has10yearsof grace,andarepaymentperiodof 30yearsforIDAandof 40yearsforADF.ThedebttoGDPratiohasdeclineddrasticallyfromapeakof 98percentin1992andhasrecently
stabilized ina rangeof 60 70percent.The ratioof debt service toexportshasalsoundergone sharp
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fluctuationsbutsincetheendof the1990shasstabilizedataround20percentlargelyduetoHIPCdebt
relief initiativeandthepromotionof nontraditionalexports.
TableV.1.Uganda’sDebtStructureandIndicators1980 –2004
US$ Million 1980 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
T otal Deb t S to ck 6 89 .0 1 ,4 22 .0 1 ,9 45 .0 1 ,9 23 .0 2, 17 7. 0 2 ,5 83 .0 2 ,5 91 .6 2 ,6 47 .4 2 ,6 37 .1 2 ,9 99 .4 3 ,3 86 .9 3 ,5 15 .8 3 ,6 60 .2 3 ,6 31 .6 3 ,4 99 .6 3 ,5 79 .9 3 ,3 97 .5 3 ,8 25 .2 4 ,2 96 .3 4 ,3 10 .0
o/w arrears 101.0 92.0 99.0 136.0 190.0 298.0 370.9 583.1 301.8 251.0 233.4 250.3 316.6 275.5 241.5 232.0 286.8 301.7 318.7 342.9
Mul ti la te ra l n .a n .a n .a n .a n .a n .a 1 ,643 .6 1, 755. 9 1 ,815 .9 2, 156. 1 2 ,487 .9 2, 655. 1 2 ,763 .0 2, 826. 8 2 ,782 .6 2, 936. 3 2 ,893 .3 3, 318. 1 3 ,720 .4 3, 782. 8
Bi lateral n.a n.a n. a n.a n .a n.a 8 11.8 6 51.4 6 97. 3 730.4 7 87 .9 7 55.1 7 96 .0 7 48.6 6 49.9 5 93.2 4 76.1 4 88.5 5 55 .5 5 10 .3
o/w Paris Club n.a n.a n.a n.a n.a n.a 285.5 273.2 281.7 332.0 380.1 350.6 339.1 325.0 288.2 260.6 131.5 111.4 122.8 66.1
Non Paris Club n.a n.a n.a n.a n.a n.a 526.3 378.2 415.6 398.4 407.9 404.5 456.9 423.6 361.7 332.6 344.7 370.1 432.7 444.2
Other n.a n.a n.a n.a n.a n.a 136.2 240.1 123.9 112.9 111.1 105.6 101.2 56.2 67.1 50.5 28.1 18.5 20.4 16.9
Mulitilateral (% Debt Stock) n.a n.a n.a n.a n.a n.a 63.4% 66.3% 68.9% 71.9% 73.5% 75.5% 75.5% 77.8% 79.5% 82.0% 85.2% 86.7% 86.6% 87.8%
Bilateral (% Debt Stock) n.a n.a n.a n.a n.a n.a 31.3% 24.6% 26.4% 24.4% 23.3% 21.5% 21.7% 20.6% 18.6% 16.6% 14.0% 12.8% 12.9% 11.8%
Other (% Debt Stock) n.a n.a n.a n.a n.a n.a 5.3% 9.1% 4.7% 3.8% 3.3% 3.0% 2.8% 1.5% 1.9% 1.4% 0.8% 0.5% 0.5% 0.4%
Debt Service 57.0 172.0 160.0 202.0 186.0 147.0 148.0 131.0 140.6 167.8 150.7 142.2 155.9 154.6 162.9 133.4 146.1 133.6 172.0 179.7
Debt/GDP 54.6% 32.7% 66.4% 54.2% 59.5% 86.0% 83.4% 98.2% 87.4% 81.3% 64.3% 64.0% 64.0% 59.5% 62.0% 65.9% 65.0% 71.3% 74.4% 68.8%
Debt Service/Exports 17.2% 43.2% 43.8% 62.3% 61.2% 59.8% 66.1% 65.2% 83.2% 66.1% 22.6% 19.7% 18.9% 24.4% 22.4% 20.1% 21.6% 19.1% 22.2% 19.4%
D ebt / Ex port s R at io 208 .2% 357 .3% 532 .9% 593 .5% 716 .1% 1050. 0% 1157. 0% 1317. 1% 1560. 4% 1180. 9% 507 .8% 486 .3% 443 .8% 573 .1% 481 .8% 540 .0% 501 .9% 545 .7% 555 .1% 464 .4%
Source:Ministryof Finance,Planning&EconomicDevelopmentandBankof Uganda.
Firstattemptsatdevelopingadebtmanagementsystemcamein1983withtheformationof theExternal
DebtManagementOffice (EDMO)withintheBankof Uganda (BoU). In1986,twootheroffices;theAid
CoordinationUnit(ACU)intheMinistryof FinancePlanningandEconomicDevelopment(MFPED),andthe
TreasuryOfficeof Accounts (TOA)weremandatedtomanageanddisburseexternaldebttogetherwith
the EDMO. The ACU, now called Aid Liaison Department (ALD), was responsible for seeking and
negotiatingnewloansinlinewithGovernment’sfinancingrequirements.
The key featuresof Uganda’sdebt adopted in the1995 strategy include seeking grant fundingbefore
contracting any loan and ensuring that all loans are strictly on IDAcomparable terms. Loansmust be
approvedby thebeneficiarysectorand thedevelopmentcommitteebeforebeingcontracted,and they
mustbeinlinewithsectoralandpovertyreductiontargets.LoansarethenscrutinizedbytheMinistryin
chargeandcheckedagainstbudgetarytargets,afterwhichcabinetandparliamentaryapprovalaresought.
TechnicalcapacityfordebtmanagementinUgandaiswelldeveloped.Particularlysince1995,Ugandahas
madesustained,tangibleprogressincapacitybuildinginallaspectsof debtmanagement.Moreover,BoU
hasnowagooddebt recordingcapacityandacompleteuptodatecomputerizeddatabasewhichuses
UNCTAD’sDebtMonitoringandFinancialAnalysisSystem(DMFAS).
4. DomesticPublicDebt
InUganda the issuanceof Governmentdebthasnotonlyhad thenormal functionof meeting revenue
shortfalls, but also that of financing the sterilization of foreign aid inflows. As sterilization efforts
intensifiedattheendof the1990s,Treasurybillsalesrosefrom23percentto32percentof commercial
bankholdingsbetween1998and2004despitethefactthatdomesticdebtwastypicallyintherangeof 1
2percentof GDP(seeTableV.2.).Interestpaymentsondomesticdebt,however,doubledin19952000
owingtothepolicyof highinterestratesassociatedwiththeattempttomanagetheconsequencesof high
aidinflows.ByaddingtopressuresonthefiscalbalancetheseinterestpaymentscontributedtopostHIPC
difficulties.
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TableV.2.DomesticDebtinUgandaandKenya,19802000
(Per cent)
5. TheDebtStrategyfrom1991to1995
Inearly1991, theGovernmentof Ugandaembarkedonacomprehensivedebtstrategy, includinga full
debt audit. The 1991 Debt Strategy focused on overcoming the immediate debt payment crisis and
developing mechanisms to ensure that it did not reoccur. The first objective of this strategy was to
provideasolutiontothecashflowproblemthroughdebtrestructuring.Thisnecessitatedclearingarrears
andreducingdebtserviceto levelsconsistentwithUganda’sabilitytopay.Thesecondobjectivewasto
improve debt management structures. This resulted in the strengthening of debt management by
requiringministriestoworkwiththeAidCoordinationUnit(ACU) intheMinistryof Finance.Inaddition,
strictlimitsonborrowingwereputinplace,witharequirementtoexhaustallsourcesof grantfinancing
beforeconsideringnewloans,whichhadtocomefromhighlyconcessionalsources.
By1991,Ugandahadalreadyundertakenfourrestructuringoperationswithintheframeworkof theParis
Clubin1981,1982,1987,and1989.Unfortunately,theserestructuringoperationswerenotsufficientto
easethedebtoverhangfortworeasons.First, intheParisClubs1to3,negotiationscoveredonlydebtfallingdueduringashortconsolidationperiod(1218months).Second,untilParis8,onlyprecutoff debt
(accountingfor4percentof thetotaldebtstock)waseligiblefordebtrelief.Moreover,thedeminimis
clauseexcludedloansof lessthanSDR500,000fromrescheduling.
The1991strategyalsoaddressedthecountry’scommercialdebt.Although thisdebtaccounted for just
over9percentof totaldebtstockin1992,mostof itwasinarrears.Ugandaembarkeduponadebtbuy
backstrategy,financedbytheWorldBank.Theofferpricewasfixedat12centsperdollar inDecember
1992,andtheclosingdatewasinFebruary1993.Overall,thebuybackwasverysuccessful.
The1991debtstrategywassuccessfulinmanyways.Itestablishedclearproceduresfornegotiatingnew
loansand strengtheneddebtmanagement. Ithelped to increase theproportionof paymentsmadeontime.Itledtolargereductionsincommercialdebtanddebtservice.Consequently,thedebttoGDPratio
fellfrom83percentin1991to64percentin1995.Thestockof arrearsfellfrom15percentin1991to7
percentin1993,whilemultilateraldebtincreasedfrom61percentto75percentof totalexternaldebt
Kenya Uganda Average HIPCDecisionPoint2/
NonHIPC3/
Domesticdebt 198089 21 2 11 9 10 14(in percent of GDP) 199094 23 1 12 6 7 18
199500 22 2 15 8 8 23Total debt 198089 81 2 62 69 73 53(in percent of GDP) 199094 100 74 102 138 143 59
199500 74 59 118 169 164 59Domestic/Total debt 198089 25 100 25 22 25 30
199094 23 1 19 6 7 35
199500 29 4 22 6 7 40199094 71.7 14.4 49.7 42.3 43.6 60.8199500 74.5 29.4 51.9 42.5 43.2 65.3
Source: Christensen(2004)Notes:
1/BothdomesticdebtsincludeTreasuryBillsandGovernmentStocks,withKenyaalsoissuingbonds
2/IncludesUganda
3/IncludesKenya
Domesticinterest payments/ total debt
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CompendiumonDebt Sustainability and Development
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overthesameperiod.However,thisputthecountryinadifficultpositionbecausemultilateraldebtcould
notberestructured.
Therewerethreemainweaknessesinthe1991debtstrategy.Firstwastheinsufficientreductioninlong
termmultilateraldebt. Secondly, the country continued to require large amountsof new financing tosupportthereformprogramwiththedangerof increaseddebtservicingobligationsif thenewfinancing
wasnotconcessionalenough.Thirdly,therewerestillsomeproblemswithdebtmanagementstructures.
A comprehensive review of the debt strategy was carried out in 1995 with help from the Swedish
Government.Thenewstrategywhichemergedfocusedonfourobjectives:
(a) Reductionof themultilateraldebtserviceburdenthroughbilateralgrants;
(b) Increasingtheconcessionalityof newborrowingandthequalityof loanfinancedinvestment;
(c) Improvingdebtandreservemanagement;
(d) Improvingcoordinationwithdonors,and lobbyingfor longtermmultilateraldebtreduction. In
fact, in November 1995, a MultilateralDebt Fund (MDF) was established, with contributions
usedtoservicedebt.Thestrategyalsointroducedtherequirementof parliamentaryapprovalof
newloans.
6. TheHIPCDebtRelief Initiative
InApril1998,UgandabecamethefirstcountrytobenefitfromHIPCDebtRelief Initiative.PriortoHIPC
debtrelief,thenominalvalueof Uganda’sexternaldebtstockwasUS$3.5billion,andtheNPVof debtto
exportsratiowas294percent.UnderHIPCI,Ugandareceiveddebtrelief of US$347millioninNPVterms.
Of thisamount,79percentwasduetomultilateralcreditorssothatforthefirsttime,debtrelief hada
largemultilateralcomponent.Uganda’sNPVof debttoexportsratiowassupposedtofall196percent,i.e.
belowthethresholdratioof 202percent.
However, Uganda’s debt swiftly returned to unsustainable levels, mainly on account of the El Nino
weatherphenomenon,whichseverelyaffectedexportperformancein1999.Hence,inMay2000,Uganda
received further relief underEnhancedHIPC.Prior to this, in June 1999,Uganda’sexternaldebt stock
reachedUS$3.6billion.Totalrelief underHIPCIIwasexpectedtoamounttoanadditionalUS$656million,
withmultilateralcreditorscontributing83percent.Thetotalrelief undertheHIPCasawholewasUS$1
billioninNPVterms,orunderonethirdof thepreHIPCnominaldebtstock.
7. PostHIPCDevelopments
SinceHIPC IIcompletion,Uganda’sexternaldebt sustainabilityasmeasuredbyNPVof debt toexports
ratiohasdeteriorated.Uganda’sNPVof debt toexportsratiohad reached280percentaccording toa
June2004analysis.
Anumberof factorshavecontributedtothedeteriorationindebtindicators.
First,istheimpactof fallingcoffeepricesonexportearnings,whichwere57percentand36per
centlowerin2002/03and2004/05thaninitiallyenvisaged.
Secondly,risinginterestratesreducedtheconcessionalityof thecountry’sdebt.
Thirdly,attheEnhancedHIPCdecisionpoint,estimatesfornewfinancing inthemacroeconomic
framework and balance of payments projections were not fully incorporated in the Debt
SustainabilityAnalysis. Fourth,theinitiativewasweakenedbytherefusalof somecreditorstoparticipate.
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Fifth, and most importantly, Uganda has borrowed more than US$1.6 billion since HIPC II
completion, 85 per cent of which is owed to IDA and ADF, primarily to finance the Poverty
EradicationActionPlan(PEAP),Uganda’soverarchingpolicyframeworktoeradicatepoverty.This
heavyrelianceonborrowedfundsreflectslimitedimprovementsindomesticrevenues,whichhas
leftthecountryhighlydependantonexternalassistance.
Inthe2004budgetspeech itwasannouncedthatceilingswouldbeputonannualtoachieveagradual
declineintheNPVof debttoexportsratiotosustainablelevels.
Its tumultuoushistory aside,Uganda’sexperience serves tounderscore thatwithout a comprehensive
debtstrategyitisimpossibletousedebtfordevelopment.Inaddition,thefailuretodiversifytheexport
basehasleftthecountryatthemercyof primarycommodityprices
Ugandaneedstoconsolidatethegainsof thedebtstrategy ithaspursuedsince1991.The institutional
arrangementsforexternalborrowingshouldclearlyoutlinetheroles,responsibilities,andobligationsof
all stakeholders. Uganda is currently attempting to ensure that borrowing is strictly for enhancingproductivityand competitiveness.Moreover thequalityof infrastructurebuiltwithpastborrowinghas
fallen into a dilapidated state even before the loans are repaid so that there is a serious risk of
accumulatingfurtherdebtforitsrepair.
C. Kenya’sDebtExperience
1. Introduction
Kenyadidnotexperienceonebigdefault.Rather, ithashadseriousrecurrentdebtservicingproblems,
withadebtcrisispeakingin1991.Theseproblemsoccurredagainstabackgroundof negativeexogenousfinancialand trade shocksarising from the vulnerabilityof theKenyaneconomyand thepricesof key
primarycommoditiestoweatherconditions.
2. TheEconomicEnvironment
(a)Overall Economic PerformanceThe 198084 period was characterized by various adverse external and internal shocks (including two
severedroughts),globalrecessionandreducedcapital inflowsfollowingthe1982debtcrisis.Itwasalso
characterizedby inability to satisfy the IMF credit ceilings andGovernmentborrowing conditionalities,
leadingtothecancellationof anumberof programs. In198590,economicgrowthwasrelativelyrapid,
partlydue to an increase in coffee and teaprices andadecline inpetroleumprices.TheGovernment
adoptedaprocyclicalpolicyand increasedpublicexpenditure (bothcapitalandcurrent)morethanthe
increaseinrevenue.
Inthefirsthalf of 1990s,theeconomyreceivedmoreshocks:adroughtin1991/1992,oilpriceincreases
due to the Gulf War, an aid embargo in 199193, and ethnic clashes in 1992. These shocks were
accompaniedbyanincreaseinthebudgetdeficit,risinginflation,andlargeexchangeratedepreciations,
astheforeignexchangemarketwasliberalized.Inthesecondhalf of the1990s,economicgrowthdeclined
furthertoanaverageof 1.9percent,assimilarinstabilitiescontinued.
Asshown in tableV.3., theperformanceof Kenya’sexportsectorhasbeen lacklustreandexportshavegrown lessthanGDPsince independence.Theshareof exports inGDPdecreased from21.8percent in
1980 to 12.5 per cent in 2004. Tea, horticulture and coffee are by far the most important exports,
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accounting for 54 per cent in 20002004. Kenya’s terms of trade have also declined substantially.
Dependenceonprimarycommodityhasalsomeantthatthetermsof tradeareveryvolatile.
TableV.3.Kenya:of Exports,Termsof Trade(TOT)andForeignDirectInvestment(FDI)
Year
Exports
(K£ million)
GDP
(K£ million)
Exports
(in per cent of
GDP)
Exports
(US$million)
Growthof
exports
(per cent)
TOT
1982=100
FDI/GNI
(per cent)
1980 487.64 2235.37 21.8 1318.0 123 1.1
1981 513.86 2597.23 19.8 1388.8 5.37 108 0.2
1982 545.74 2944.62 18.5 992.2 28.56 100 0.2
1983 633.08 3316.63 19.1 994.8 4.78 94 0.4
1984 754.81 3851.78 19.6 1041.2 10.20 110 0.2
1985 785.10 4374.62 17.9 957.4 8.05 92 0.5
1986 957.97 5083.98 18.8 1182.6 23.52 103 0.5
1987 753.41 5648.23 13.3 913.2 22.78 85 0.51988 917.74 6480.62 14.2 986.8 8.06 88 0.0
1989 999.83 7451.34 13.4 925.8 6.18 79 0.8
1990 1232.38 8377.78 14.7 1022.8 10.47 69 0.7
1991 1533.83 9540.33 16.1 1091.6 6.73 82 0.2
1992 1708.08 11402.53 15.0 943.6 13.55 79 0.1
1993 3625.21 14185.41 25.6 1063.2 12.67 90 0.0
1994 4170.72 16903.24 24.7 1162.0 75.13 101 0.1
1995 4656.18 19205.79 24.2 1674.8 10.05 95 0.4
1996 5696.30 21865.55 26.1 2071.2 23.67 93 0.1
1997 5722.95 31161.76 18.4 1944.9 6.10 102 0.4
1998 5722.25 34701.44 16.5 1738.3 10.63 100 0.4
1999 5770.3 37173.95 15.5 1528.9 12.05 86 0.42000 5988.2 39817.15 15.0 1529.2 0.02 84 1.3
2001 6071.7 48391.90 12.5 1560.1 2.02 79 0.5
2002 6569.7 51938.20 12.6 1715.2 9.94 78 0.4
2003 6835.45 57089.00 12.0 1781.4 3.86 81
2004 7953.05 63685.80 12.5 2056.5 15.44 77.4
Average 0.10
Source:EconomicSurvey,VariousIssues.
CollierandGunning (1999)attributemuchof Kenya’sweakgrowthperformancetogeographyandrisk.
Muchof thecountryisalsosemiaridsothatagriculturalproductionintrinsicallyrisky.Kenya’sgeography
alsomeans that transport costsarehigh,quite aside fromdeficiencies in infrastructure.But they alsoargue that trade shockscausedaneconomicdeclinebecauseof overregulationand theGovernment’s
lossof controloverpublicexpenditure.Azam(1997)showsthat insufficientprivate investmentandthe
failure to increasehuman capitalaccumulation contributed to the slowingof growth in the1980sand
1990s.
(b)LiberalizationStrategiesInthe1980s,Kenyahada“managedfloat”exchangerateregime.Theperiodwitnessedacuteshortages
of imported inputs due to nonavailability of foreign exchange. This resulted not only in frequent
interruptions inproductionbutalsoinchronicunderutilizationof installedcapacity.Kenyatookaseries
of measures that gradually removed foreign exchange controls and liberalized the exchange rate,
includinga largedevaluationof theshilling. In19921993 theofficialexchange rateand the interbank
foreignexchangerateweremerged,controlsoncurrentandcapitalaccounttransactionswereremoved.
Furtherliberalizationfollowedin1995.
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TheDebt Experiencesof Uganda,Kenyaand Bolivia
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Similarly in the 1980s and 1990s Kenya implemented trade reforms,which eliminatedmostnontariff
barriersand lowered tariffs, substantiallyopening theeconomy.Themaximum tariff ratewas reduced
from 170 per cent to 70 per cent over 19871993. Recently, under obligations of the East African
Communitycustomsunion,tariff bandswerereducedtothreewithamaximumexternaltariff of 25per
centsinceJanuary2005.
Kenyaliberalizeditscapitalaccountoverthesameperiod.Reformsalsoincludedtheeasingof restrainton
foreignownershipand theestablishment in1990of theCapitalMarketsAuthority (CMA).TheNairobi
StockExchangemarketopenedtoforeigninvestorsinJanuary1995.Toinsureagainstthepotentialriskof
liquidity crises delivered by exogenous shocks or speculative activities, Kenya has followed other
developingcountriesinaccumulatingforeignreserves.
Kenyaalsoembarkedon financial sector reforms.Positive real interest rates, the targetof themarket
reforms,aimedatenhancingefficiency.InstitutionalreformsfocusedonstrengtheningtheCentralBank,
particularly in itssupervisoryandregulatoryroles. Inmonetarypolicytherewasashifttomore indirect
instrumentslikeopenmarketoperations.Therewasafinancialcrisisin1998whichledtotheliquidationof severalbanks.Muchof thefinancialdeepeningwhichhasresultedisduetotheconversionof deposits
of nonbankingfinancialinstitutionstocommercialbanksdeposits.
The Central Bank has maintained a high interestrate regime to stabilize the exchange rate and has
pursuedagenerallytightmonetarypolicyinthefaceof inflationarypressures.Oneof theconsequences
hasbeenwidespreaddistressedborrowingsothatbanks’portfolioshaveincludedmanynonperforming
loans.Thedeclineincredithasbeenassociatedwithdeclininginvestment.
Kenya’sfiscalpolicyislinkedtoitsexternalindebtedness.Kenyaisheavilydependentonaidinflowsforits
governmentfinances,withaidaccountingfor45percentof thebudgetatthepeakin1991(O’Brienand
Ryan,1999).Throughoutthe1990s,foreignaidaveragedabout9percentof GDP,accountingforabout
20per centof the annual governmentbudget and financing slightlyover80per centof development
expenditures(Njeru2004).
3. ExternalDebt
Kenya isasamoderately indebtedcountry.Thecountry’sexternaldebt increasedfromUS$4.2billion in
themid1980stoapeakof US$7.5billionin1991,decliningtoUS$6billionin2002.Asaproportionof GNI
itincreasedfrom70.8percentof GNIin1985toapeakof 156percentin1993butthendeclinedto49.2
percent in2002.(SeeTableV.4.)Externaldebtservice increasedtoapeakof 39percentof exports in
1988butthendeclinedto13percentin2002.
Almost all of Kenya’s external debt is either public or publicly guaranteed and owed primarily to
Governments and multilateral organizations. For the period 19852002, private nonguaranteed debt
generallyaccountedforlessthat15percentof thetotal.Shorttermdebtaccountedforbetween54and
69percentof outstandingstocks.Theaveragegraceperiodisabout6.9years,theaveragegrantelement
about50.9percent,andtheaveragematurityperiodabout26.5years.Bilateralaidhasbeenmainly in
theformof grants(72percentof thetotal),whereasmultilateralaidhasmainlybeenintheformof loans
(86percent),mostlyfromtheWorldBankgroup.
While Kenya’s externaldebt toGNI ratios are currently less unfavorable than at thebeginning of the
1990sandareevensustainableaccordingtoHIPCcriteria(IMF2003),thestockof externaldebtand its
servicing nevertheless poses a major problem for two reasons. First, debt servicing is still a large
proportion of export earnings and government expenditures. Second, a large external debt createsuncertaintiesforinvestmentsandunderminesthecredibilityof domesticpolicies(Elbadawietal.,1997).
Pattilloetal.(2002),usingapaneldatasetof 93developingcountriesover196998,findthattheaverage
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CompendiumonDebt Sustainability and Development
99
impactof externaldebtongrowthbecomesnegativeforadebttoGDPratioof 3540percent.Kenya’s
externaldebtsignificantlyexceedsthisthreshold.
TableV.4.DebtIndicatorsof Kenya
Year
Totaldebt
stocks
(US$million)
External
debt
(as per cent
of GNIa )
ExternalDebt
service
(as per cent of
Exportsof
goodsand
services)
Principal
arrears
(US$
million)
Interest
arrears
(US$
million)
Budget
deficit
((as per
cent of GDP
b )
Domestic
Debt
(as per cent
of GDPb )
Foreign
financing
(as per cent
of budget
deficit b )
1985 4180.6 70.8 38.7 4.1 10.9 12
1986 4602.8 65.9 35.6 6.2 17.3 3.7 16 42.7
1987 5782.9 75.4 39.8 12.6 28.3 4.8 27.8 40.6
1988 5808.9 71.2 39.0 25.5 40.3 7.5 27.1 21.9
1989 5889.6 73.7 36.6 49.4 64.6 3.7 26 17.91990 7057.6 87.2 35.4 71.8 94.7 3.8 24.6 21.3
1991 7457.8 98.3 32.6 155 140.9 4.3 26.9 54.3
1992 6902.6 90.7 31.1 263.3 188.8 5.0 25.9 40.4
1993 7115.4 156.0 27.1 409.8 241.7 1.3 33.5 44
1994 7128.9 105.5 32.9 9.2 81.2 4.5 27.2 42.6
1995 7313.4 84.2 30.4 6.1 31.4 5.8 24.9 6.2
1996 6811.4 75.4 27.8 14.8 9.9 1.3 21.5 175.1
1997 6455.6 62.2 22.1 56.6 27.5 1.2 22.4 12.7
1998 6808.1 60.9 23.2 105.7 58.2 2.2 21.1 48.8
1999 6450.2 64.5 25.7 177.9 68.8 0.8 20 135.8
2000 6159.2 61.1 18.7 133.6 42.1 0.7 19.7 168.5
2001 5561.6 49.9 15.8 149.9 34.4 0.9 18.1 268.72002 6031.2 49.2 13.6 236.5 56.8 1.6 84.9
aSource:WorldBank,GlobalDevelopmentFinance,2004.
bSource:KenyaEconomicSurvey,VariousIssues.
Kenya has yet to develop a coherent strategy for managing aid flows. Aid design, process and
implementationhavebeenad hoc through issuesof circulars from theMinistryof Finance (MOF).The
defaultpolicyistoaccommodateasmuchforeignaidasismadeavailable.TheexternalLoansandCredits
Actspecifies limitsonborrowing toaprincipalamountoutstanding tonomore than650millionKenya
poundsattheprevailingexchangerate,or“suchhighersumastheNationalAssemblymaybyresolution
approve”.Thelatterisaloopholeroutinelyusedbyministersinparliament.Themanagementof foreign
aid and external debt are the responsibility of several government ministries and agencies. Themaingovernmentsdepartmentsdealingwithdonorsandloans(theExternalResourcesDepartment(ERD)and
Loans Division and the External Debt Management (DMD)) are highly constrained in human resource
capacityintermsof numbersandskills.Thecountryalsolacksdebtmanagementobjectives.
4. PublicDomesticDebt
Tofinanceitsbudgetdeficits,Kenyahasborrowedondomesticmarketsaswellasabroad.AsTableV.4.
shows, Kenya’s domestic debt accounted for 25 per cent of GDP formuch of the 1990s, and foreign
financinginsomeyearscoveredahighproportionof thebudgetdeficit.Attheirpeakin1993/94interest
paymentsondomesticdebtamounted to47.6per centof government revenuesand24.8per centof
governmentexpenditurerespectively.Thesepercentagesexceedwidelyusedbenchmarksforsustainableratesof interestondomesticdebt.Sterilizationof the inflows associatedwith the foreign financingof
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TheDebt Experiencesof Uganda,Kenyaand Bolivia
100
budget deficits contributed to tight credit markets and recession, thereby undermining growth and
contributingtodebtproblems.
5. TheEvolutionof Kenya’sExternalDebt
Kenya’s first debt problems followed the drought and trade shocks of the early 1980s, with external
debt/GNIratioexceeding70percentby1985.Afterabrief improvement,followingmoreexternaltrade
shocksand theethnicclashesof 1992,debt levels roseagain,andKenyaaccumulatedarrearsonboth
interestandprinciple.Arrearspeakedinmid1993afterthecuttingof aidandof relationswithdonors.By
1994KenyahadrescheduleddebtsworthUS$500millionitowedtotheParisClub(WorldBank2003).In
1998itbegannegotiationstorescheduledebtowedtoprivatelendersattheLondonClub.82
Debt indicators improvedasa resultof the1994debt rescheduling.WhenHIPCwas launched in1996,
Kenyawasdeclaredcapableof achievingsustainabilitywithanNPVof debttoexportsof lessthan150per
cent(148percent).However,furthertrade,climateandpoliticalshocks(surroundingthe1997elections
andanother suspensionof foreignaid)worsened thesituationagain in the late1990s (seeTableV.4.).
Following the approval of an IMF program in 2000, Kenya rescheduled with the Paris Club under
“Houston”termswithanagreementcoveringUS$300millionof arrears.However,arrearscontinuedto
accumulateand, followinga third IMFprogram in2003,anewParisClubdealwas secured in January
2004 covering US$353 million of arrears. External debt stocks were not significantly reduced by the
agreementsof 2000and2004.Indeed,thestockincreasedfromUS$5.5billionin1999toUS$5.7in2004.
Inrecentyears,therehasbeensome improvementineconomicperformance.Afiscalstrategyhasbeen
establishedtocontrolexpenditureoverthemediumtermandtherehasbeenareversalof thedeclining
trendindomesticrevenuesaswellasasmallrepaymentof publicdebtin2004/05.However,Kenyahas
beendemandingmoredebtrelief followingtheMDRI initiative,particularlysince itsserviceburdenhas
beenexceedingMDGspendingforyears.
As with Uganda, Kenya’s debt accumulation has been closely related to its fiscal needs. Kenya’s case
shows that in theabsenceof adebtstrategy,externaldebt isunlikely toserveadevelopmentagenda.
Kenya’s development and public investment expenditure suffered from both fluctuations in external
financingandtheburdenof debtservice
Kenya’s debt woes are also related to its continued dependency on agriculture and on primary
commodities.Severeclimaticandtermsof tradeshockshaveunderminedgrowthanddeepenedpoverty.
Despite diversification in theproduction and exportbase the economy remains vulnerable to adverse
exogenousshocks.
Kenyahas failed todevelopsignificantdebtmanagementcapacityorclearaidstrategies.Arrearshave
tended toaccumulateevenwhenexternaldebtstockswerenotgrowing.Owing topoor relationswith
donorsthecountryhasalsomissedoutonmajordebtreductioninitiatives.Mostdebtrestructuringshave
concentratedonliquidityproblems,i.e.arrears.Weaknessindebtmanagementandaidstrategyarelikely
toresultinacontinuationof thecountry’shistoricalpatternof debtproblems.
82Theformeragreementledtothecancellationof US$21millionof arrearsandmaturities,whilethelatterdealeventuallyledto
thereschedulingUS$45millionof debt.
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CompendiumonDebt Sustainability and Development
101
D. Bolivia’sDebtExperience
1. Introduction
Bolivia is topologically ruggedcountrywitharidagriculturalconditionsand lowpopulationdensity.The
natural resourcesbasedeconomyhasgeneratedonly limitedemployment,andexportsearningshave
contributedlittletorelievingpoverty.Boliviawasoneof thefirstbeneficiariesof HIPCInitiativesbecause
itstrackrecordasaliberalizingreformer.However,sincethelate1990sBolivia’spercapitarealGDPhas
stoppedgrowing.Politicaloppositiontoreformhasintensified.ThedebtstockreturnedtopreHIPClevels.
Bolivia’sexperienceraisesquestionsconcerningcurrentdebtrelief arrangements.
2. OverallEconomicPerformance
In the early 1980s, like many other Latin American economies, Bolivia’s economy slid into recession
associatedwithsurgingworldinterestratesandthe1982debtcrisis(seeFigureV.3.).Between1981and1988percapitarealGDPdeclinedby15percent.Overthesubsequent10yearspercapitarealGDPgrew
atanannualaveragerateof 2percent.In19982003itstagnated.
In the 1990s economic growth was revived by rising investment associated with the “capitalization”
process (seebelow)andwith theexportof naturalgas.FDI inflowsbecamemore important thandebt
from themid1990s, and remittanceswere also an important source of external financing. Inflows of
financing from private foreign creditors have been adversely affected by past experience of losses.
However,recentlymultilaterallendersliketheAndeanDevelopmentCorporation(CAF)andtheIDAhave
beenasignificantsourceof credit.
As an exporter of naturalresource products Bolivia has been vulnerable to adverse price shocks andtermsof trade movements. The prices of its key exports collapsed spectacularly in the early 1980s.
Commodity pricesdidnot recover significantly in the1990s. FigureV.4. shows thedecline inBolivia’s
termsof tradesince1991.Exportpriceslostaquarterof theirvaluebetween1991and2000,whileimport
pricesdriftedupwardswithworldinflation.Decliningtermsof tradeunderminedebtexportratios.
Additionally Bolivia was affected by a series of shocks as of 1997: El Niño; the East Asian crisis in
September1997;theRussiancrisisof August1998;andtheBrazilianandArgentinecrisesof 19992001.
Moregenerallycountryspecific factorshavehinderedgrowththough toanextentdifficult tomeasure.
Thesefactorsincludeharshtopographyandclimate,ethnicandlinguisticdiversity,regionaldivisions,and
ahistoryof politicalinstability.
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TheDebt Experiencesof Uganda,Kenyaand Bolivia
102
FigureV.3.Bolivia:PercapitarealGDP,PrivateConsumption,andPublicExternalDebt,
19702004
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
1970 1975 1980 1985 1990 1995 2000
Per-capita real GDP
Per-capita real non-government consumption
Per-capita real public external debt (incl. debt to IMF and interest arrears)
Source:InternationalFinancialStatistics(InternationalMonetaryFund).
FigureV.4.Bolivia:Termsof Trade,19912004
(June;1991=100)
0.0
20.0
40.0
60.0
80.0
100.0
120.0
140.0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Terms of trade (1991 = 100) Export prices (1991 = 100) Import prices (1991 = 100)
Export prices -->
Im ort rices -->
Terms of trade -->
Source:CentralBankof Bolivia(website).
3. Bolivia’sLiberalizationandStructuralReformPolicies
Since1985 successiveBolivianGovernmentshave carriedout someof LatinAmerica’smostambitious
liberalizationandreformprograms.Thereformprocessbeganwiththe1985stabilizationprogram,which
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CompendiumonDebt Sustainability and Development
103
vanquished hyperinflation. The Bolivian Government introduced a “New Economic Policy” of: fiscal
discipline;priceandinterestrateliberalization;liftingof controlsoncrossborderfinancialflows;aunified
marketbasedexchange rate;and trade liberalization.Price liberalization,whichhadended the control
and subsidies of prices,was none the less replacedby price capping in 2000 after export prices rose
sharply.
Exchangerate management has been at the centre of Bolivia’s stabilization efforts since 1985. The
authoritiesallowedthepesotofloatandendedmultipleexchangeratepractices.InJanuary1987,anew
currency, the “boliviano”, was introduced, at a rate of one peso per million. In early 1988 the new
currencystabilizedatabout2.3bolivianosperdollar.TheCentralBankhasmanagedtheexchangerateas
acrawlingpeg,movingitinlinewiththedifferencebetweenBolivia’sandworldinflationrates.Thispolicy
hasledtothemaintenanceof relativelyhighforeignexchangereserves(seeFigureV.5.).
Persisting dollarization has complicated exchangerate policy.Despite compulsory conversion of dollar
bank deposits into Bolivian pesos in the early 1980s, there has remained a large amount of informal
dollarization, which has contributed to inflationary pressure. Since 1985 dollardenominated accountshaveaccountedfor8590percentof depositsandloans.Bolivia’scocatradehasalsocontinuedtobringa
largeinflowof dollars,contributingtodollarization.
Tightmonetarycontrolhasbeen fundamental to themaintenanceof priceandexchangerate stability.
Between1987and2004,theaverageannualrateof increaseinconsumerpriceswasonly8.7percent;and
theaverageannual rateof increase in thepriceof theU.S.dollar inbolivanoswas8.2percent.On the
whole,Bolivia’sexchangeratepolicyhascontinuedtosupportstabilizationsince1985.
FigureV.5.Bolivia:YearendForeignExchangeReserves,19802003
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
1980 1985 1990 1995 2000
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
Months of imports of goods and non-factor services Per cent of GDP
Months Per cent of GDP
Source:CentralBankof Bolivia
The mid1990s witnessed a “second generation” of reforms, which centered on three elements:
restructuring and capitalization of key sectors; pensions’ reform; and significant decentralization. The
“capitalization” program of 19951996 was an alternative to politically unfeasible privatization. The
Governmentauctionedtherightto50percenttemporaryownershipstakeandmanagementcontrol inselected enterprises accompanied by a commitment to carry out specified capital expenditures. The
program was successful in the sense that the enterprises which were capitalized exceeded agreed
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TheDebt Experiencesof Uganda,Kenyaand Bolivia
104
investment targets, and services improved (IMF2005). A closely associated reform was the 1996
HydrocarbonsLawdesignedtoenhanceforeigninvestment,particularlyinthedevelopmentof newfields.
The reformdid succeed in attracting substantial investments, and led todiscovery andexploitationof
large gas reserves. However, government revenue from the sector was disappointing, and deepening
foreignparticipationhasbeensourceof popularresentment.
In 1997 theGovernment undertook reformof the troubledpensions system along the linesof Chile’s
pension reform, i.e. shifted to a contribution system.As fordecentralization, representative governing
bodiesweresetupfordepartmentsandprovinces.These institutionsweregivensignificantfiscalroles,
including sharesof government revenue.However, the transferof revenue and responsibilitiesproved
politicallycontentious,andcontributedtoBolivia’sfiscaldifficulties.
Throughoutthesechanges,theGovernmentlackedfirmpoliticalsupport.Ambitiousasthereformswere,
theydidlittleforordinaryBolivians.Inresponse,manyBolivianstriedtoescapepovertyby“rentseeking”
strategies involving publicsector employment, smuggling activities, or participation in the illicit coca
derivatives trade. Thus the political process became closely linked to persistent pressures for publicemploymentandsubsidization;smugglingbecameubiquitous;andsuppressionof thecocatradehasbeen
impossible.Since securingpublicpositionshasbecome abasic functionof politicalparties, it ishardly
surprisingthattheadministrationhasbeenpronetoinefficiency,overstaffingandcorruption.
Thereformsof the1990shavebeguntounderminefiscalbalancesdespitetheexistenceof policyrules
such as forbidding theprintingof money andmechanisms to control government expenditure and to
ensureagoodflowof foreigntraderevenues.Taxrevenuehasstabilizedsince1998atabout1213per
cent of GDPwith customs revenues steady at about 1per cent of GDP.Hydrocarbons reformhad an
unexpectedly large upfront fiscal cost, especially when royalties were cut in 1997. Earnings from
hydrocarbonshadbeenaround10percentof GDPbutby2004theyhadslidto6.4percent.Receiptsfrom
fuel excises initially rose after 1997 but stagnated in 2000 when fuel prices were frozen. On theexpendituresidepersonnelcostsare10percentof GDP.Thecostsof decentralizationandof thepension
reformturnedoutwellabovewhatwasanticipated.Lastly,domesticinterestpaymentshavebeenrising
inlinewithdomesticborrowing.
4. Bolivia’sExternalDebt:StructureandMainFeatures
Externaldebtgrewindollartermsfromthe1970suntilHIPCdebtrelief in2001.Inthe1970sthebulkof
thedebtwasbilateraldebtowedtocommercialsourcesandborrowedmostlyfordevelopmentpurposes,
notablyinfrastructure(communications,roads,airports).Between1980and1987thegrowthof Bolivia’s
totalexternaldebtaccelerated,increasingfromUS$2.7billiontoUS$5.8billionfrom justunder60to just
over 140per cent of GDP. The prime reason for this surge was increases in world interest rates. Inaddition, international recessiondrovedownBolivianexportprices.Asa resultBoliviacouldno longer
meetitsdebtserviceobligationstocommercialbanks,andwentintoarrearsanddefault.
Between1989and1992,Bolivia’soverallexternaldebt stock stabilized at aboutUS$4billion, rising to
US$5billionafter1996.Meanwhile,highereconomicgrowthduringthemid1990sreducedthedebtGDP
ratio somewhat. In1998and2001Bolivia receivedaboutUS$1billion inHIPCdebt relief, reducing the
debtGDPratio.However,thisreductionprovedtransitoryandwithintwoyearsslowgrowthandheavy
borrowing frommultilateral sources raised thedebtGDP ratio towhere ithadbeenbeforeHIPCdebt
reduction.
Since the second half of the 1980s Bolivia has cut its dependence on commercial bank finance.
Multilateralagencies increasedtheir lending inthe late1980stoassiststabilization,and inthe1990sto
support liberalizationand structural reform.Thus,of theend2004 totalexternaldebtof US$4.6billion
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CompendiumonDebt Sustainability and Development
105
US$4.3billionwasowedtomultilateralentitieswiththeIDAaccountingforUS$1.7billion(seeFiguresV.6.
andV.7.).
FigureV.6.Bolivia:YearEndPublicandPubliclyGuaranteedExternalDebt,19702004
(US$billion)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Multilateral Bilateral Private sources:
Source:GlobalDevelopmentFinance(WorldBank).
Debtserviceremainedwithinarangeof 4to5percentuntiltheendof the1990s.Itthensurgedbrieflyin2000and2001duetorelativelyhighrepaymentflows.Bolivia’sexternaldebtservicetoexportsratiowas
generallybeenabove20percentuntilitfellbelow20percentafterHIPCdebtreduction.Bolivia’sinterest
burdenwaskeptdownbytheconcessionalnatureof muchof itsdebtsincethesecondhalf of the1980s.
FigureV.7.Bolivia:YearEndPublicandPubliclyGuaranteedExternalDebt,19702004
(Per cent of GDP)
0.0
20.0
40.0
60.0
80.0
100.0
120.0
140.0
160.0
180.0
200.0
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Multilateral Bilateral Private sources:
Source:GlobalDevelopmentFinance(WorldBank).
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TheDebt Experiencesof Uganda,Kenyaand Bolivia
106
Boliviadebtmanagementhas improved significantlysince theearly1980s.At that time,Boliviahadno
administrative system of debt management and governance as such, though theGovernment formed
committeestodealwithcommercialbanks.In1985debtwasconsolidatedinthenationalTreasury,anda
ministeriallevelcommitteewasformedtoworkoutastrategy.In1987commercialbanksdecidedtooffer
relief throughdebtbuybacksbuttheoperationswerecarriedoutadhocbyexpertswithoutthehelpof
sophisticateddebtmanagementsystems.
Under the basic institutional arrangement eventually adopted the Government assigned the bulk of
managing and monitoring of external debt to the Central Bank because of its institutional depth and
analyticalcapacities.Sincethe1980sBolivia’stechnicaldebtmanagementcapacityhasimprovedsteadily
andBolivia’sdebtpoliciesarenowhighlytransparent.TheConstitutionrequiresparliamenttoapproveall
newborrowing.
5. DomesticPublicDebt
Alongside of its external borrowing to finance government expenditures Bolivia has also borrowed
domesticallyparticularlyafter the1985 reforms.Thusdomesticpublicdebt rose steadily from1991 to
overUS$1bnin2000,thendoublingto justunderUS$2billionby2004,i.e.from13to21percentof GDP.
The issuanceof domesticobligationscanhelpGovernmentstodeepentheir financialsectorandwiden
theirrevenuebase.ButaswithotherHIPCs,Boliviahadtopayhigh interestrateson itsdomesticdebt,
which isnotcontractedonconcessionalterms. Interestpaymentson internaldebtrodefrom0.4to1.8
per cent of GDP between 1998 and 2004,while interest payments on external debt remained stable
aroundonepercentof GDP.Domesticdebtreached21percentof GDPin2004,andtotalpublicdebt95
per cent of GDP. Initial fiscal sustainability targets under HIPC programs overlooked this source of
indebtednessandtheresultingpressureonfiscalbalances.
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CompendiumonDebt Sustainability and Development
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TableV.5.Bolivia:DomesticPublicDebt19912004
Year
DomesticDebt
(US$million)
TotalPublicdebt
(US$million)
Domesticdebt
(as per cent of
GDP)
TotalPublic
debt(as per cent
of GDP)
1991 385.6 4258.4 7.2 86.9
1992 396.2 4429.8 7.0 85.5
1993 296.8 4300.1 5.2 80.2
1994 97.5 4576.5 1.6 78.3
1995 217.0 4999.6 3.2 77.8
1996 438.8 5080.8 6.0 74.8
1997 508.4 5040.0 6.4 70.1
1998 827.9 5487.3 9.8 74.5
1999 983.6 5557.4 11.9 79.3
2000 1100.1 5560.1 13.2 79.7
2001 1508.6 5920.6 18.7 92.22002 1504.3 5804.7 18.3 89.1
2003 1724.4 6768.7 20.1 98.8
2004 1992.9 6944.0 21.3 95.5
Source:Cowanetal2006.
6. PastandPresentExternalDebtPracticesandStrategy
Sincetheearly1980sthreebroadphasesof Bolivia’sdebtstrategycanbedistinguished.Thefirstbegan
withtheonsetof thedebtcrisis in1982.AtthattimeBoliviareliedheavilyonexternaldebttocover its
fiscaldeficit,andwhendebtflowswerecutoff,theGovernmentshiftedtomonetaryfinancing,generating
hyperinflation.In1984Boliviadeclaredamoratoriumondebtservice.Themarketvalueof Bolivia’sdebtto commercialbanksplunged to1015per centof its face valueby themid1980s.The secondphase
lasted from the August1985 stabilization program until 2000 and consisted largely of reducing debt
throughvariousinitiativesandincreasingrecoursetoconcessionalflows.Since2001newmultilateraldebt
inflowshaveoffsetHIPCdebtreduction,politicalturmoilhasintensified,andGDPgrowthhasstagnated.
OncethestabilizationprogrambeganinAugust1985,theauthoritiesrestoredrelationswiththeIMFand
other creditors. The 1986 IMF program opened the way to new financing. Bolivia took a pioneering
approachtoitscommercialbankdebt(aboutUS$650millionin1986).Usingfundsprovidedbydonors,it
retired thebulkof itsdebtbypurchasing itatdeeplydiscountedvalues.83Bolivia’sdebt tocommercial
bankswasmostlyeliminatedbytheearly1990s.
Thereafter, Bolivia sought relief on its bilateral debt through the Paris Club. It went through six
reschedulingsbetween1986and1995.Between1986and2003,BoliviahadthreeIMFprogramsinvolving
SDR515million, including one of the first Poverty Reduction and Growth (PRG) Facilitiesin 1998. In
April2003,Bolivia securedan IMFagreement forSDR129millionamidsteconomicandpolitical crises.
Fearing that the collapseof the agreementwould aggravateBolivia’sproblems, the IMFwaived some
conditions,andBoliviadrewSDR102millionbyMarch2005(IMF2005).
In September1998, multilateral and bilateral creditors provided Bolivia debt relief amounting to
US$449million innetpresentvalue (NPV) terms,at the“completionpoint”of itsHIPCprocess.Of this
total,bilateralcreditorsandtheIADBeachaccountedforabout35percent,theWorldBankforabout12
per cent, CAF for 9 per cent, and the IMF for about 6percent. The conditions Bolivia satisfied for
83TheBolivianbuybackoperationof 1987,whereUS$253millionwererepurchasedatabout11centsperdollar,wasoneof the
firstlargescalebuybackcarriedoutwiththespecificpurposeof reducingacountry’sexternaldebtsincethe1930s.
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CompendiumonDebt Sustainability and Development
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privateenterprisesandthefiscalcostsof domesticborrowing(orboth).Exchangeratedevaluationfailed
to make primary commodity exports more competitive, and trade liberalization undermined the
government revenue base. Cuts in government spending undermined public investment, thereby
weakeningprivateinvestmentandhumancapitalformation.
Inallthreecasesthereformsadoptedwerenotsufficienttoovercomemanydeeprootedproblemsand
structuralweaknesses.Fiscaldisciplinehasbeenbeneficial,butitdoesnotexpandataxandrevenuebase
curtailedbymeasuressuchastariff removals.Hence,4050percentof governmentactivities inUganda
and Kenya continue to be financedby foreign aid. Likewise,orthodox reformshavenot reducedhigh
productionandtransportationcostsinherenttothethreecountries’difficultgeographyandtopography.
Neither the reformsnor thedebt initiativeshave adequately recognized orproduced solutions to the
extremevulnerabilityof the threecountries tostrongexternalshocks.All threecountrieshaveaheavy
concentrationof economicactivityandexports ina fewprimaryandunprocessedcommodities,whose
prices have been highly volatile and subject to sharp declines. The effects of this concentration are
exacerbatedbythedependenceof largepartsof thepopulationonrainfedagriculture.
Itisagainstthiscontextthatthethreedebtorshavehadtomanagetheirexternaldebtburdens.Whilethe
countries were catapulted into debt traps at different times and with different intensities, debt
sustainabilitycontinuestoeludeallthree.Although inheriteddebtstockshavebeenreducedandthere
have been shifts to concessional financing and grants, the three debtors continue to experience the
pressuresof highdebtburdens.
Recentdebt crises inall three caseshaveoriginated in the government sector, i.e. the inabilityof the
Government to service foreign loans. However, the defaults and arrears were caused less by the
ballooningof debtstocksthanbysuddenandunexpectedsharpshortfallsinrevenuesduetoexogenous
shocks,namelyrisinginterestratesorcollapsingexportearningswhichleddebtratiostosoar.
AllthreeGovernmentshave increasinglyresortedtodomesticborrowing,albeittodifferentdegrees,to
financegovernmentbudgets.Domesticdebtsanddebtburdenshaveonlyrecentlybeenincludedindebt
sustainability analyses (World Economic and Social Survey 2005). Domestic debt tends to be more
expensive thanexternal finance, so that its costsworsen fiscaldifficultiesorwiden fiscaldeficits. This
underminesthebeneficialeffectsof operationsreducingexternaldebt,andisoneof thereasonsforthe
failureof HIPCinitiatives.InUgandaandKenyadomesticdebthasalsobeenissuedtosterilizeofficialaid
inflows.InUgandasuchsterilizationhashadtheconsequencethattherewouldbenoimprovementinits
debtserviceafterHIPCIIafterallowanceforthecostof theTreasuryBillsissuetosterilizeaidflows.
Atthetimeof theirfirstcrisesnoneof thethreecountrieshadinplaceameaningfuldebtstrategyoreven
goodmanagement systems to monitor or analyse debt. This has changed substantially in the case of UgandaandBolivia,whichbothnowhaveadequatetechnicalcapacitytomanagetheirdebt.OnlyKenya
stilllacksanadequatedebtmanagementsystem.
Since the1990s,debt strategieshavebeendeterminedbyofficial creditors.Rescue fromdefaults and
fresh finance depended on the IMF and multilaterals, which initiated the countries’ adjustment and
reformprogramsaspreconditionsfordebtrestructuringswiththeLondonandParisClubs.Thedetailsof
theagreementsreachedexplainwhytherewasaneedforcontinuousandrepeatedreschedulingefforts.
These resulted fromearly cutoff points, theexclusionof toomany typesof debtsand creditors,debt
relief inadequatetoeaserepaymentdifficulties.
Thelaunchof theHIPCinitiativewasarecognitionof thefollowing: Debtproblemsparticularlyforpoorercountriesreflectinsolvencyratherthanilliquidity;
Partialandprotractedreschedulinghasnotprovidedapermanentexitfromrestructuring;and
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TheDebt Experiencesof Uganda,Kenyaand Bolivia
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Reachingsustainabledebtpathsrequiresdebtreduction.
The fact thatHIPChad tobe enhanced almost as soon as itwasbornhighlighted its similarity to the
reluctantandpartialapproach todebtproblems thatcharacterizedprevious initiatives. Italsoreflected
weak analytical bases,which, for example, overlooked fiscal criteria for sustainability. More seriously,
debt sustainability analyses were not based on realistic and comprehensive scenarios, and
underestimatedthevulnerabilitytoand theextentof exogenousshocks (see forexampleNissankeand
Ferranini (2006). Even the most compliant countries included in the initiative had been consistently
thrownoff coursebysuchshocks,includingduringandafterHIPC.
ThepostHIPCproblemsof UgandaandBoliviarevealotherflaws:
Thelimitsof anarrowfocuswhichdefinestheattainmentof debtsustainabilityintermsof debt
ratiosbelowthresholdsatonepointintime;
Failuretotake intoaccountthattheriseinpostHIPCborrowingcouldquicklyreversegains(the
resultinUganda’scaseof afailuretoplacealimitonthestockof newborrowing); Theproblemof usingloansinsteadof grantstofinancepovertyalleviationprograms;
Themoregeneraldifficultyforpoorereconomiesof achievingthereformsof fiscalpolicywhich
makepossibleobservanceof domesticdebtthresholds.
In 2007 Bolivia had unsustainable debt based on fiscal criteria and Uganda’s debt sustainability has
deteriorated since HIPC II completion. Kenya’s debt indicators remain unsatisfactory and its second
PovertyandGrowthFacilityisunderreview.
F. ConcludingRemarks
All three countries coveredby this studyhave extensively liberalized their trade and foreignexchange
regimes and their financial sectors. Part of this liberalization was undertaken at the countries’ own
initiative.Butwithrespecttomanyof themeasuresthecountrieshad littlechoice,sincereceivingdebt
relief andaid frommultilateralsdependedon implementationof conditions inagreedprograms.These
conditionslimitedthespaceof policymakersandfailedtodelivereitherbroadbasedorsustainedgrowth.
These experiences show that the programs on which debt relief was conditional were based on an
inadequateapproach.Byfailingtodelivergrowthortostabilizerevenuesandexportearnings,theyalso
failed toprovidea sufficient improvement in theability to repayor servicedebt.Debt initiativeswere
blinkeredandpartialintheircoverage,draggingeachcountryintoanunendingseriesof negotiationsand
reschedulings.
Onelessonof theseexperiencesistheneedforamuchdeeperandmorecomprehensiveunderstanding
of debt sustainability and of solvency which goes beyond thresholds and liquidity ratios, however
rigorously derived. Another lesson is that it is impossible to use debt to spur economic growth and
development without a coherent debt management strategy. A third lesson is that new external
borrowingbypoorer countrieswill contribute to growthonly if directed atexpenditures thatenhance
productivityandcompetitiveness.
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CompendiumonDebt Sustainability and Development
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CHAPTERVI
CASESTUDIES:ARGENTINAAND
THEREPUBLICOFKOREA
MarioDamill,RobertoFrenkel,MartínRapettiandYungChulPark84
A. Introduction
Thispaperexaminesrecentcrises thatshook theeconomiesof ArgentinaandtheRepublicof Koreaas
well as the international financial system. Both were capitalaccount crises in apparently successful
middleincomedevelopingeconomies.Whilebothcountrieshadexperienceddebtcrisesbeginninginthe
late 1970s, Argentina’s default of 20002001 and the Republic of Korea meltdown of 1998 were
exceptional in their severity. International rescue packages led by the IMF were organized in both
instancesandwereasourceof politicalcontroversy.
TheArgentinecrisisanddefault,thelargestinrecentyears,isstillsubjecttodisagreementastoitscauses.
SectionIIascribescentralimportancetoawrongdiagnosisof thecrisisbytheIMF,whichconcentratedon
addressinga fiscaldisequilibriumduringa liquiditycrunch.Thecountry’spolitical leadershipsharedthe
IMF’s belief, as is evident from the various fiscal adjustment programs undertaken. Several factors
externalaswellasinternaldidpushpublicdebttowardsunsustainablelevels,particularlyinthecontext
of a recession.However, structural featuresof theeconomy such as the convertibility regime and the
dollarizationof thebanking systemwereof critical importance to thedefault,which led toahistorical
fallingoutbetweenArgentinaandtheIMFandanacrimoniousdebtrestructuring.
84Section B is based on a paper byMarioDamill, Roberto Frenkel andMartín Rapetti (Researchers at CEDES, BuenosAires)
(Damill, Frenkel and Rapetti (2005)), Section C is based on the paper by Yung Chul Park (Graduated School of International
Studies,SeoulNationalUniversity)(Park(2005)).
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CaseStudies: Argentinaand theRepublicof Korea
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Theexperienceof theRepublicof KoreadescribedinSectionIIIalsosuggeststhatIMFpolicyprescriptions
worsened the crisisbyhelping topush theeconomy intodefault.Section IIIalsohighlights the roleof
banking crises,collapsing financialmarkets,and irresponsible foreignborrowingby chaebols.Yet,as in
Argentina,theimmediatetriggersof thecrisiswereadverseexternalshocks,namelytheweakeningof the
Yenandregionalcontagion.SectionIVcomparesmajorfeaturesof thetwocrises.
B. LessonsfromtheArgentineCrisisandDefault
1. Introduction
This section challenges the leading explanations of the latest Argentinean debt crisis, whereby
uncontrolledpublicspendingisperceivedasthemaincauseof debtaccumulation,crisisanddefault.
Firstly, it is shown that the effectsof rises in interest rates riseswere themaindriverof publicdebt
dynamicsattheendof the1990s.Even if allowance ismadefortheeffectof uncertaintiesaboutpublic
debt sustainability on investors’ assessment of the country’s position, the main source of the
deteriorationwasnotfiscalpolicybutfinancialfragilityandcontagion.
Secondly, the role of macroeconomic policies – particularly exchange rate policy in generating an
unsustainabledebtpathisemphasized.InthisregardtheArgentinecaseisanextremeexampleof badly
managed financial integration leading tohigh interest rates, low growth, and vulnerability to financial
contagionandvolatilityof capitalflows(Frenkel,2003b).
Thirdly,thepaperchallengesacommonlyheldopinionthatthedefaultdecisionwasmainlyresponsible
for the deep crisis in Argentina. It shows on the contrary that the abrupt contraction in activity and
employmentoccurredbefore thedefault as theGovernment tried to keep debt serviceon track. Thedefaultprovedtobeoneof triggersthatsubsequentlyallowedrecovery.
Fourthly, the section examines how debt restructuring took place in the context of a confrontational
relationshipbetweentheIMFandArgentina.Themostunusual –indeedunprecedented featureof this
processwasthattheIMFdidnotparticipateinthedesignof therestructuring.
2. MacroeconomicPerformanceinthe1990s
Between 1977 and 1982 Argentina went through a phase of financial opening and accelerated
indebtednessthatendedinmassivecapitalflight,exchangeratecrisis,anddefault.Thiswasfollowedbya
longperiodof internationalcreditrationingbetween1982and1990.The19912001periodalsoendedincrisisanddefault.Adistinguishingfeatureof thesetwoperiodsistheroleplayedbytheprivatesectorin
thegenerationof externalfinancialobligations.Despitethestrongriseintotalexternaldebtinthe1990s
theshareof publicexternalintotaldebtdeclinedbyover20percentagepointswhichsuggeststhatfiscal
disequilibriumwasnotthemaincauseof thecrises.85
Argentinaenteredbothphasesof acceleratedindebtednessinthecontextof stabilizationprogramsbased
ona fixednominalexchange rate.Theseprogramsset inmotionprocyclicalmacroeconomicprocesses
which left the economy vulnerable tonegative external financial shocks. (Frenkel, 1983; Taylor, 1998;
Frenkel,2003a).
In1981thestabilizationpolicybasedontheexchangerateanchorwasabandoned.Anewphasefollowed,
characterized by massive devaluations of the peso. These devaluations were accompanied by higher
85SelectedindicatorsforArgentina’seconomyduring19772006aregivenintable1.
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internationalinterestratesandaneventualpeakof theratioof foreigndebttoGDPof nearly60percent
in 1982. The public sector’s share in external debt also rose in this period because the Government
assumed a considerableproportionof theprivate foreigndebt.During the secondphaseof the1990s
totalexternaldebtincreasedbutmostof thatrisewasgeneratedbytheprivatesector.
Thefiscalbalancewentthroughthreeperiodsinthe1990s.(seetableVI.2.)During199194theaverage
deficit,which inthe1980swasabout7percentof GDP,decreasedto lessthan1percentof GDP.This
wasmainlyduetoanimprovementintheoverallpublicsectorbalance.Nonetheless,publicdebtrosein
theearly1990sbecausetheGovernmentassumeddebtsthatwerenotregistered in the fiscalbalance,
especiallydebtsof publicsectorpurveyorsandof thesocialsecuritysystem.
In1994newnegativepressuresemergedonpublicfinancesduetothreefactors.Firstly,asocialsecurity
reform that created the Private Pension Funds led to a significant fall in contributions. Secondly, the
regionalboomwasfollowedbytheconsequencesof theTequilaeffectin1995,whichwasmanifestedina
sharp rise in the countryrisk premium of Argentina’s interest rates (see table VI.3.). Thirdly, the
Governmentattemptedtocountertheseconsequencesbyloweringthetaxburdenontradables.Between1995and1997thepublicdebt/GDPratioroseslightlybeforestabilizing.
TheRussianandBraziliancrises in1998 resulted inanew jump in the countryriskpremium.Thiswas
accompanied by a recession and increased financial vulnerability of debtors. A sharp rise in interest
payments had already begun in 1996. By 2000 these payments amounted to nearly 19 per cent of
governmentrevenues.Recessionandhigherinterestrateslargelyexplaintheexplosivepathstakenbythe
publicdebtanddeficit,whichhadtheconsequencethatthepublicdebt/GDPratioincreasedbyalmost20
percentagepointsbetween1997and2001.
3. MacroeconomicPerformanceBeforeandAftertheDefault
Themacroeconomicstoryof thelate1990scanbedescribedasaswingfromeuphoriatodepression.The
negative turnaround in the external environment experienced in 19971998 left the economy with a
significantandgrowingcurrentaccountdeficit,anappreciatedrealexchangerate,andavisible lackof
policyinstrumentstodealwiththeproblem.Hence,restrictivefiscalpolicieshadtobearthemainburden
of attemptsatadjustment.Theexpectationwas that fiscaldisciplinewould triggergreater confidence,
leading toa recovery indomesticexpenditurewhichwouldpush theeconomyoutof recession.De la
Rua’sadministrationacceptedthisargument,andtheIMFgaveitssealof approval.
However, the result was failure. Fiscal policy alone was impotent to counter large macroeconomic
imbalances,whichweremostlyrootedintheexternalsectorof theeconomy.Theeconomysufferedthe
longestrecessionsincetheFirstWorldWar.
Capital inflows contracted sharply in response to the contagion caused by the Mexican crisis at the
beginningof 1995(seetableVI.4.).Foreignexchangereservesalsofell.However,therecessionwasshort
livedthankstotheeffectsof theIMFledpackageof financialsupport.Afterabrief recoverythecountry
risk premium began to increase again after the devaluation in Thailand in 1997. As noted above, a
sustainedcontractionstartedaftertheRussiandefaultin1998.
Duringtheearly1990stherewerelargeprivatecapitalinflows,followedbyacontractionin1995.Capital
inflowstothepublicsectorweremorestable,beingsustained intherecessionof 1995andduringthat
whichbegan in1998.Privatecapital inflowsrecovered in1996butwereaccompaniedbyoutflowsof a
similarmagnitude.From1998onwardsthenetinflowturnedintoalargenetoutflow.
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The increase intheforeignpublicdebtof theentireperiodfrom1991onwardsexceededUS$35billion.
Thisamount isquiteclosetotheincrease intheforeignfinancialobligationsof thenonfinancialprivate
sectorwhich,however,weremorethanoffsetbytheriseof thesector’sexternalassets.
InDecember1999,anewGovernment tookoffice.Aspreviouslymentioned, thisGovernmentbelievedthatthemaincauseof theeconomicdepressionwasfiscalmismanagement.Successivepackagesof tight
fiscalmeasureswereapplied.Effortstopreventdefault includedaFiscalResponsibilityLaw in1999that
setamandatorydecliningtrendforthepublicdeficitdesignedtobringittozeroinafewyears.Bymid
2001themeasuresbecamedesperateand includedanunprecedented13percentacrosstheboardcut
in public wages and pension benefits. Coming after years of severe recession, these cuts did not
contributetosocialpeace.
Theexpected“confidenceshock”nevermaterialized.Indeed,theroundsof contractionaryfiscalpolicies
onlyreinforcedthedeflationarytrend.During2000and2001theGovernmentattemptedtocomplement
fiscal measures with some financial initiatives. It also implemented important debt swaps aiming at
convincingthepublicthattherewasnoriskof default.Bytheendof 2000,apackageof localandexternalsupport of about US$40 billion was announced (the “blindaje” or financial shield). The IMF led the
operationwithaUS$13.7billionextensionof thestandbycreditinforcesinceMarch2000.However,two
monthslater,acrisisinTurkeyledtoasharpriseinthecountryriskpremium.
Asareactionavoluntarydebtswap(the“megacanje”)of bondsof US$30billionwas launched in June.
However,because thenewly issuedbondscarried interest ratesof about15percent, they fuelled the
perception that debt had become unsustainable. Another voluntary swap directed at domestic
bondholdersinvolvingUS$42billionof publicbonds,waslaunchedinNovember2001.Allthesemeasured
failed to halt the withdrawal of bank deposits and the fall of international reserves which began in
October2000.
From the beginning of December 2001 the Government established tough restrictions on capital
movements andon cashwithdrawals from banks. Itwas hoped thesemeasureswould hold back the
demandforforeigncurrency,preservethestockof reserves,andmakeitpossibletoavoiddevaluation.In
fact,theyushered intheendof theregime.TheDecembermeasuresthrewthecountry intosocialand
politicalunrest.Inthefirstdaysof 2002,thecurrencyboardregimewasofficiallyabandoned,andwithit
theonetooneparityof thepesototheUS$.
Afterthreeyearsof recessioneconomicactivitysufferedaparticularlyabruptfallasof mid2001.Social
indicators such us the unemployment rates and poverty indexes, which had worsened in the 1990s,
deteriorated further, adding to social tensions and to thepolitical crisis (Damill, Frenkel andMaurizio,
2003).
Thecatastrophicfall inoutputandemploymentcontinuedforawhileaftertheendof theconvertibility
regime.However,contrary tomainstreambeliefsandquiteextraordinarily,arecoverystartedonlyone
quarterafterthedevaluationanddefault.Itwastriggeredbythesuddenchangeinrelativepricesinfavor
of sectorsproducingtradables.
The turnaround was associated with a set of policies aimed at recovering basic macroeconomic
equilibrium.Thepoliciesincludedthefollowing:
(a) The impositionof restrictionson capitaloutflows and exchange controls, includingunder the
lattertherequirementthatexporterssellapartof foreigncurrencyearnings;
(b) Theestablishmentof taxesonexports,whichallowed theauthorities to capture someof thebenefitsof thedevaluationforexporters’incomes;
(c) Aflexiblemonetarypolicyaimedtoassisttherecoveryof banks;
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(d) Anexchangeratepolicyaimedatavoidingtheappreciationof thepeso.
The IMFhad insistedon the immediate free flotationof thepeso.Fora shortperiod theGovernment
adoptedthisregime.Oncetheexchangeratewasfreetofloat,theexchangeratemovedabruptlytolevels
of close to4pesosperUS$.The reintroductionof exchange controlswasdesigned to contain further
movement. Soon afterwards thedemand forpesos started to recoverwithUS$ inexcess supply. This
resultingstabilizationhelpedtohalttheriseindomesticprices,asdidthefreezingof publicutilityrates.
GDP recoveryof the firsthalf of 2002hada short firstphase inwhichaggregatedemandbarely rose.
Whatstoppedtherecessionwasarecoveryindomesticproductionwhichwasnowmeetinganincreased
proportionof domesticdemand as imports contracted sharply. Investment rosebynearly40per cent
between2002and2004,beingfollowedcloselybyprivateconsumption.
Economicrecoverytookplaceinacontextof severecreditrationing.Investmentwasfinancedbyretained
profits.A“wealtheffect”fromtheexternalassetsholdingsof theprivatesector,alsohelped.Theseassets
–now estimated atoverUS$100billion rose in value as resultof exchange ratedepreciation, and inrelationtothepricesof domesticassetssuchasrealestate.
Improvement inthecurrentaccountstarted in1998.Theabruptcontractionof importsaftertheendof
convertibilityhelpedtotransformadeficitof almostUS$3billionin1998intoasurplusof US$17billionin
2002.
On the fiscal front between 2001 and 2004 there was an improvement in the overall balance of the
ConsolidatedPublicSectorfromadeficitof 5.6percentof GDPin2001toasurplusof 3.5percentin2004
(see table VI.5.). This reflected improvements in the three major components, the primary balance,
interestpayments,andtheaggregatebalanceof theprovinces.
The most important factor in the improvement of the primary balance was an improvement in tax
revenues due mainly to those on exports and income. In table VI.7. interest payments are shown as
decliningby2.5percentof GDP.However,thisdoesnotindicatetheeffectof thesuspensionof payments
onexternalpublicdebt,whichatthe2004exchangeratewouldhaveamountedtoabout10percentof
GDP:
4. DefaultonExternalDebtandtheRestructuringProposals
Thesuspensionof servicepaymentsonpartof publicdebtwasdeclaredon24December2001.Outof a
totalof US$144.5billionUS$61.8billion inpublicbondsandsomeUS$8billion inother liabilitieswere
affected.Thedevaluationof thepesohadamajorimpactontheeconomy’scontractualobligations,given
thepervasivedollarizationof contracts.Afewdaysafterthedevaluation,aspartof policiestoattenuate
theshock,theauthoritiesissuednewdebt.
Themainsourceof thenew indebtednesscamefrom interventions inthefinancialsystem,and ledtoa
US$14.4billionriseinpublicdebt.InFebruary2002theGovernmentdecidedtoundertakeacompulsory
conversion of foreigncurrency bank deposits at a rate of 1.4 pesos per dollar.86The withdrawal of
depositswasrestrictedto1,500pesosperpersonperweek.Bankcreditsinforeigncurrencyweresubject
to conversionata rateof onepesoperdollar.This “asymmetricpesoification”of creditsanddeposits
causedasignificantlossinbanks’networththatwascompensatedbytheGovernment.Newdebtissued
forthispurposeamountedUS$5.9billion.
86Whenthemeasurewassanctioned,thedollarwasataround2.15pesos.Fourmonthslater,thedollarexchangeratereached4
pesos,decliningsmoothlythereafter.FromMarch2003,theparitystabilizedatbetween2.83pesosperdollar.
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acceptance.92Later,itwasmadeclearthattheswapwouldcomprisebothcapitalandinterestarrearsand
theamountof thenewbondswas increasedtoamaximumof US$38.541.8billion.Thethreedifferent
bondsweremaintainedinthenewproposal.
TheBuenosAiresproposalimpliedahigherfuturefiscaleffort.TheGovernmentwasineffectcommittedtoaprimarysurplustargetof 2.7percentof GDPduringthefirstfiveyears,thistargeteasingtoaround
2.3percentof GDPasof 2014.Undertheassumptionof 3.3percentannualaveragegrowth,projections
indicatedthatthe fiscaleffortwould financemost interestpayments.However,even if themultilateral
organizationsagreedtorefinancedebtduetothem, theGovernmentwouldstillhavetoobtainannual
fundingof about2percentof GDPfortenyearsaftertheswap.
EvidencethatArgentinawouldfaceaheavydebtburdenaftertheswapdidnoteasecreditors’demands.
ImmediatelyaftertheannouncementinJunebondholders’organizationsrejectedtheproposal.Financial
analysesshowedthatasubstantialhaircutof about7380percentwas implied.Thesizeof thehaircut
depended crucially on the discount rate used in the calculation. That usedwas the yield of assets of
emergingmarketcountriesratedasof similarrisk,i.e.1214percent.
By late 2004 developments on international capital markets unexpectedly started to play in favor of
Argentina.Greaterworldliquiditystimulatedtheappetiteforriskandforemergingmarketsdebt,andled
to a reduction of developing countries’ risk premium.93In this new context estimates of the haircut
impliedbyArgentina’sproposalwerereducedandtheswaplookedmoreattractive.Thepresentvalueof
offeredbondscalculatedatthenewdiscountratewas3035centsonthedollar.Thiswassimilartothe
marketpriceof thedefaultedbonds.
The improvement in the financialenvironmentpavedtheway fortheGovernment finally to launchthe
swapwithoutintroducinganychangetotheJune2004proposal.94TheswapstartedonJanuary14,2005.
OnMay3,2005, theGovernmentannounced thatacceptancehad reached76.15percent.Thismeant
thatUS$62.3billionof theoldbondswouldbeexchangedforaboutUS$35.3billionof new instruments
andGDP growthlinked coupons. Theoperation reducedpublic externaldebtbyUS$67.3billion,95and
attenuatedthepublicfinances’exposureto foreignexchangerisk,sincearound44percentof thenew
bondsweredenominatedinlocalcurrency.
5. Argentina,theIMFandtheInternationalFinancialSystem
At first glance it may seem striking that the crisis and the massive default took place in a country
considered an example of the success of Washington Consensus policies. From the IMF’s perspective
Argentina’s currencyboardhadbeen aprime exampleof a feasible corner solution for exchangerate
policy inanemergingmarket(Fischer,2001).Yetatthesametime itwaswidelybelievedthatthedebtandtheconvertibilityregimewerenotsustainable,astheprogramdidnotinvolveanysubstantialchanges
tomacroeconomicpolicy.
Argentina’s program aimed at reestablishing confidence through commitments to fiscal austerity.
However, the recessionand the liquiditycrunchmeant that itwas implausible that the issuingof fiscal
92In the loweracceptance scenario the recognitionof interestarrearswould include theperioduntilDecember31,2003 for
aboutUS$18.1billion,whereasinthehigheracceptancescenarioitwouldincludeinterestsarrearstillJune30,2004,forUS$1.4
billion.93The JPMorganEMBI+ indexdecreased toanaverageof 375basispoints in the lastquarterof 2004,whereas theBrazilian
countryriskpremiumfellto417basispoints.94Torelieve itself fromcreditors’pressures,thegovernmentgaveuptherighttochangetheguidelinesbysendingabilltothe
Congresspreventingtheadministrationfromdoingso.Congressquicklyapproved.95AccordingtoministerLavagna,at theendof 2004, thehaircutwould reducedebtstocks fromUS$191.2billiontoUS$123.9
billion.Thepublicdebt/GDPratiowouldhavefallenfrom113to72percent.
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CaseStudies: Argentinaand theRepublicof Korea
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signalswouldbesufficienttostopthecrisis.Bythetimeof thereductionsingovernmentexpenditurein
mid2001,thereweregood reasonstothink thatmultilateralresourceswouldendup financingprivate
capitalflightwithoutpreventingadefault.
After the changes at the head of the IMF in 2001, the Fund’s relationship with Argentina becameincreasinglystrained.IMFrecommendationsplayedanegativeroleinstabilizationandrecovery.Aprime
examplewasexchangeratepolicy.InFebruary2002theIMFdemandedthe immediateflotationof the
exchange rate, threatening not to reestablish negotiations in its absence. The implementation of this
measure predictably led to an abrupt rise in the price of the dollar and an acceleration of inflation.
Similarly, there was a clash over the management of the crisis in the banking sector. The Lavagna
Governmentwanted gradualaction and voluntaryoptions,while the IMFpromotedheroic “solutions”
suchasbankliquidations.
TheseexamplesshowthattheFundoperatedonthebasisof thediagnosisthat(1)theexchangemarket
couldnotbestabilized,(2)ahyperinflationaryprocesswasunavoidable,and(3)reestablishmentof some
degreeof financialintermediationindomesticcurrencysoonwouldbeimpossible.Theimplementationof themeasurespromotedbythe IMFwouldhavetransformed itsdiagnosis intoaself fulfillingprophecy.
The IMFmaintained itspolicy lineuntilMay2003when theDeputyManagerDirector recognized the
deficiencyof theFund’sdiagnosis.
The 2002 and 2003 agreements were signed in the context of a highly confrontational relationship
betweenArgentinaand the IMF. InSeptember2003,a threeyearagreement torefinancedebts to the
IMFwasagreed.Thetermsof conditionalitywereonlyestablishedforthefirstyear,astheGovernment
refusedtocommittohighertargetsforsubsequentones.Targetsincludednewregulationsof privatized
publicutilities,measures to strengthen financial system,andanew lawabout thedistributionof fiscal
revenues between the national and provincialGovernments. The conditionality also included a clause
underwhichthecountrywastodisplay“goodfaith”inthetreatmentof externalcreditors.Theambiguityof thetermlefttotheIMFagreatmarginof discretioninitsevaluation.
AyearlaterArgentinahadcomfortablyfulfilledthequantitativetargetsbutnotthequalitativeones.The
most significant one under the latter heading was probably the finalization of the renegotiation of
contractsandtheestablishmentof anewregulatory frameworkforprivatizedpublicutilities.Whilethe
IMF was conducting its evaluation, Argentina was presenting the debt restructuring proposal and
organizing the swap. The relationship betweenArgentina and the Fund reached an impasse. The IMF
couldhaveterminatedtheagreementonthebasisof thefailuretofulfillqualitativetargets.Thatwould
havesignifiedaseriousnegativeshock foracountry in themiddleof thedebt restructuringprocess. It
couldalsohaveledtofinancialdifficultiesfortheIMFsinceArgentinawasalargeborrower.
Theimpassewasovercomebythesuspensionof theprogramuntilthebeginningof 2005atArgentina’srequest.Thereafter,ArgentinarepaidtotheIMFallprincipalandinterestthatcouldnotbepostponed.In
theperiod20022004itmadenetprincipalpaymentsof morethanUS$2.1billion,andinterestpayments
of US$1.9 billion. As these figures compared with net receipts of US$23 billion in 19942001, the
ArgentineanMinisterof theEconomydescribedtheIMFasmovingfrombeinga“lastresortlender”toa
“privilegeddebtpaymentscollector”.
A crucial element in the process was the Government’s view that international financial crises and
defaults are the result of excessivedebts attributable to the irresponsible behaviorof borrowers and
lenders.This irresponsiblebehavior isencouragedby the implicit guarantee givenby the IMF’s rescue
packages. Hence, there should be less intervention by the IMF both under normal conditions and in
defaultsituations.Argentina’sGovernment requestednoninterventionof the IMF,arguing further thatthe restructuringproposaldidnot involveadditionalmultilateral funding.Thehighhaircutwas seenas
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proportionaltotheirresponsibilityshownbythemarket.Indeed,Argentina’sstrategyillustratedboththe
flawsof theinternationalfinancialsystemandtheviabilityof alternativewaystosolveproblems.
By2006ArgentinahadrestartednegotiationswiththeIMFfromapositionstrengthenedbythehighlevel
of acceptanceof theswap.Thenegotiationsgavegreater legitimacytotheoperation.Toorigidpositionby the IMF risked being politically uncomfortable for some G7 Governments, and would have
contradictedtheacceptanceof thehaircutbyprivatecreditors.
Moreover,with the high acceptance of the swap, the IMF faced a fait accompli in that the outcome
indicatedanassumptionbythemarketthatArgentina’smultilateraldebtwouldberefinanced.Stillmore
uncomfortably for the IMF the Fund had not participated in the design of the proposal. This clearly
clashedwithIMF’sinstitutional logic inthattherefinancingof acountry’sdebtwassupposedtorequire
itsapprovalof newloans.Therefore,byacceptingArgentina’sdemandstheIMFappearedtobeaccepting
achangeinitsrole.
Thesetensionswereexacerbatedbythespecialcircumstancesthattheinstitutionwasgoingthrough.TheIMFhadactivelyparticipated in the restructuringsof sovereigndebtswith theprivate sector since the
1980s.TherecentSDRMinitiativewasintendedtobeanextensionof thattradition,andwasanattempt
todefine,formalizeandstrengthentheIMF’sroleincasesof sovereigndebtdefault.AfterWallStreetand
theUnitedStatesrejectedtheSDRMinitiative,thisroleof theIMFremainsilldefined.Thisisnotthefirst
time that theGovernmentsof developedcountries –particularly theUnitedStateshave redefined the
functionsof theIMFduringtheprocessof dealingwithimmediateandspecificproblems.Forexample,the
1995 Mexican crisis led to IMF rescue packages for capital as opposed to currentaccount crises.
Argentina’s case may eventually contribute to a redefinition of the functions of the IMF in the
internationalfinancialsystem.
C. ExternalDebtManagementof theRepublicof KoreaduringtheCrisesof 1979
1980and19971998
1. Introduction
During thepast fourdecades, theRepublicof Koreahasexperienced anumberof periodsof financial
stress.Themostseriouswasthe199798crisisthatbroughtthecountrytothebrinkof default.Theother
periodsof stress,includingthecrisisof 197980,werelessdamaging(Park,1986;Cooperet al.,1994).In
many respects the causeswere similar: they included investmentbooms in theperiods leading to the
crises,largeandgrowingcurrentaccountdeficits,andappreciationsof therealexchangerate.However,
the 199798 financial meltdown was a capitalaccount crisis, of which the Republic of Korea had nopreviousexperience.96
TheRepublicof Koreaengineeredaquickrecoveryfrombothcrises.Intermsof economicfundamentals
therewasno reason tobelieve theRepublicof Koreawas anymore vulnerable to a crisisduring the
secondhalf of the1990s than ithadbeen twodecadesearlier.Nevertheless, thecostof resolving the
secondcrisiswasfargreater,andthetwocrisesfolloweddifferentadjustmenttrajectories.
SectionBdiscussesthebuildupandresolutionof the197980debtcrisis.This isfollowed inSectionsC
andDbyanexaminationof macroeconomicdevelopmentspriortoand intheaftermathof thesecond
crisis.SectionEexploresthelessonsandSectionFcontainsasummaryof themainpoints.
96SelectedeconomicindicatorsforRepublicof Koreafor19751985and19952004aregivenintables6and7.
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2. The19791980DebtCrisis
TheRepublicof Koreaeconomy slowed in1979 after three yearsof strong growth,while the current
accountslidintodeeperimbalance,risingtoadeficitof 6.6percentof GDPin1979andof 8.3percentin
1980fromoneof 2percent in1978. In1980outputcontractedby1.5percentandtheconsumerprice
index (CPI) soared to29percent.Theeconomywas thusexperiencing stagflationwitha large current
accountimbalance.Atthesametimetotalexternaldebtasaproportionof GDPswelledto42.6percent.
In these circumstances a traditional IMFsupportedprescriptionwouldhave included a strongdoseof
stabilizationmeasurestogetherwithacurrencydevaluation.ButRepublicof Koreapolicymakersoptedfor
adifferentgrowthfirstpolicy.Tothesurpriseof theIMFandthe internationalfinancialcommunity,the
economyreboundedin1981,growing6.2percent.
At the centreof Republicof Korea economicpolicy in themid1970swas theplan for theheavy and
chemicalindustries.Thispolicyentailedtaxincentives,lowcostbankcredit,andothersubsidiesmostlyto
large firms belonging to the Republic of Korea’s industrial groups or chaebols. The result was aninvestmentboomleadingtoariseintheratioof grossinvestmenttoGDPfrom28.7percentin1977to36
percentin1979.Atthesametimetheeconomyoverheated,withannualincreasesinrealwagesin1976
78averagingover18percent.Asteephikeinagriculturalpricescausedbyapoorharvestin1978further
aggravatedinflationarypressures.
Despite this, theRepublicof KoreaGovernmentwasdetermined tomaintainadollarpeggedexchange
rate.Thisledtoanappreciationof therealexchangerate,whichinturnunderminedexportearnings.At
thesametime,theRepublicof Koreasufferedadverseexternalshocks.Itwashitbythesecondoilcrisisin
1979,sufferinga15percentdeteriorationinitstermsof tradein19791980.
Furthermore, theRepublicof Koreawas thrown intopolitical turmoilby theassassinationof President
Park in 1979. The new military Government of May 1980 was hardly in a position to adopt a strong
stabilization program. Political uncertainties worsened Republic of Korea economic prospects. Not
surprisingly,businessesadjustedbycutting investment, fixed investment fallingby11percent in1980.
Theeconomysankintoadeeprecessionin1980,whichwasaggravatedbyacrisisintheinformalcredit
market.However, surprisingly thecurrentaccountdeficitdidnot shrinkasexpected.Thiswasbecause
consumption remained strong:consumersconsidered the fall inoutput transitoryandcut theirsavings
rather than their consumption. As a result the share of saving in GDP dropped more than that of
investment.
Lackingsupportforastabilizationprogram,thecaretakerGovernmentfocuseditspolicyresponsetothe
deteriorating current account on the exchange rate. The won was devalued visàvis the US$ by 27
percentin1980,andthereaftertheRepublicof Koreamovedtoamanagedfloattiedtoabasketof majorinternational currencies. On the macroeconomic front the Government gave priority to stopping the
economicdownturn.
Hereitscommitmentwastobroadlyconceivedstabilizationtogetherwithfinancialreformandcorporate
restructuring. In its view inflationwas at the rootof thedeterioration in incomedistribution,of labor
unrest, and of the weakening of the country’s export competitiveness. A growthfirst strategy would
succeedonlyif thedeficitonthecurrentaccountwasbroughtundercontrolandfinancedexternally.The
prospectforsuchapolicywasuncertainastheRepublicof Koreahadoneof largestexternaldebtsamong
developingcountries.Nevertheless,debtservice levelsremainedwithinasustainablerange.Thegamble
paid off. The Government maintained an expansionary policy until 1983 when it began restraining
domesticdemand.By1981 inflationwasalreadysubsidingandtheeconomyrecoveredfullyonlyayearaftertherecessionof 1980.
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CompendiumonDebt Sustainability and Development
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Whatwere the factors responsible for thedramatic turnaround?HaggardandCollins (1994) singleout
threedevelopments:
An improvement in theexternalenvironmentdue to (1) fallingpricesof oil and rawmaterials
leading toabetter termsof tradeand lower inflation, (2)declining international interest rates,and(3)anappreciationof theyenagainsttheUS$;
Decliningrealwagesinboth1980and1981,partlyduetomoreflexiblelabormarkets;
The depreciation of the real exchange rate, which improved the Republic of Korea’s export
competitiveness.
However,otherimportantfactorsalsohelpedpulltheRepublicof Koreaeconomyoutof crisis.Onewas
theclosedcapitalaccount.Thisallowedflexibilityaswellaseffectivenessformonetarypolicy inafixed
exchange rate regime.Despite theeconomic crisis andpolitical turmoil, theRepublicof Koreadidnot
experienceanycapitalflightoranywithdrawalof foreignloans.TheothercrucialfactorwastheRepublic
of Korea’sabilitytofinanceitscurrentaccountdeficitexternally.Thecountrywasneverdeniedaccesstointernationalfinancialmarkets,althoughitsborrowingcostswentup.
By1983, stability returnedalongsideof the resurgence ingrowth.Bynowbothdomesticdemandand
exportearningswerestrong.Inthesecircumstancesacontinuationof loosemonetaryandfiscalpolicies
couldhaverekindledinflation.Furthermore,totalexternaldebtremainedatover47percentof GDP.To
reduce thedebtburden thecurrentaccounthad tomove in thedirectionof surplus.Thisexplains the
Government’sshifttoastabilizationpolicywhichwassustaineduntil1988.
3. The19971998Crisis
(a)Investment BoomFueled by ForeignBorrowingTheRepublicof Koreaeconomyreboundedstronglyfromaslowdownin1992and1993.Thisgrowthwas
ledbyexportsand investment(39percentof GDP in1996). Inthatyear,thedeficitoncurrentaccount
wasa littleover4per centof GDPandapparentlymanageableyetamajor financial crisis followed in
19971998.
Expansion of investment on this scale in an economy with still small financial markets led to higher
externalborrowing.Twomajordevelopments canhelp toexplain thisdebtfinanced investment surge.
Thefirstwasthestrengtheningof theyenfromthesecondhalf of 1992tothefirsthalf to1995.Thisrise
ended inthespringof 1995whentheyenhitthe levelof 79.5yentothedollar.Theyen’sappreciation
broughtaboutasharpincreaseinRepublicof Koreaexportearningsbecausemanyof itsindustrieswere
indirectcompetitionwiththoseof Japan.
Theseconddevelopmentwas increased financialopenness,which increased theavailabilityof lowcost
foreigncredit. In theperiod19961998externaldebt rose from28 to47percentof GDP.Muchof the
inflowsduring 19951997 consistedof shorttermborrowingsbydomestic financial institutions,which
usedtheproceedstofinance investmentsbychaebols.Theconsequences includedseriouscurrencyand
maturitymismatchesinthebalancesheetsof financialinstitutions(Park,1998,andParkandSong,2002).
Atthesametime,Republicof Koreaindustrialgroupswereincreasingtheirinvestmentsabroad.Muchof
this investmentwas financedwith foreign credits. This helps to explain a rise in the foreigndebts of
domestic firms fromUS$35.6billion in1996toUS$43.2billionayear later.The liabilitiesof theforeign
subsidiariesandbranchesof Republicof Korea firmswereestimatedtohaveexceededUS$51billionattheendof June1997.
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Reflectingthe ineffectivenessof theGovernment,exchangeratepolicy inthe lastthreemonthsbefore
the crisis drifted into inconsistency and unpredictability. Thewon had been under strong pressure of
depreciation since early 1997. Throughout the year, the Government stated that itwould defend the
exchangerate.Whenthewon/US$exchangerateapproachedthepsychologicallyimportantlevelof 1000,
theGovernmentintervenedheavilyinthemarket,onlysuddenlytowithdrawafewdayslater.
Between June and November 1997, the Bank of Korea’s reserve holdings fell by US$10 billion. The
Government furtherstrained investors’credulityby failing todivulge thetrue levelof foreignexchange
reserves.ItassertedthattheBankof KoreastillheldaboutUS$30billioninreserves,whentheactuallevel
of usablereserveshadalreadydroppedbelowUS$22billioninMarch.Bytheendof Novemberthefigure
hadfallentoUS$7billiondollars.
The dire financial situation was further compounded by changes in sovereign credit ratings. Between
JanuaryandNovember1997,Moody’sadjustedtheratingdownwardtwice,andS&Pthreetimes.Bythe
sametokenthepremiumonRepublicof Koreasecuritiesrose.Foreignbanksbegantorefusetorollover
shortterm loanstotheRepublicof Korea.Theactionsof thecreditratingsagenciesgeneratedaviciouscycleof decliningratingsandmarketsentiment.
4. Managementof andRecoveryfromthe199798Crisis
Bytheendof October1997thefinancialsituationwasoutof control.Foreigninvestorsmovedoutof the
stockmarketindroves,andRepublicof Koreabankswereincreasinglyunabletorollovertheirshortterm
foreignloans.Toavoiddefault,theywereforcedtoturntotheBankof Koreaforliquidityortoresortto
foreignovernightloans.
No action was taken until the announcement on 19 November of a reform package, which included
measures for the disposal of nonperforming loans and a widening of the band for exchangeratemovements. In theprevailingpanic, themarkethardlynoticed.Threedays later,unable tocontrol the
situation,theGovernmentpubliclyapproachedtheIMFforassistance.NegotiationsbetweentheRepublic
of KoreaGovernmentandtheIMFwerecompletedinarecordtimeof 10days.TheIMFagreedtoprovide
atotalof US$21billiontobedisbursedoverathreeyearperiod. Italsosecuredfinancialcommitments
totalingUS$36billionfromtheWorldBank,theAsianDevelopmentBank,theUnitedStates,Japan,and
othersasasecondlineof defense.
IMF conditionality required tight monetary policy, a fiscal surplus, sweeping financialsector reform
includingfurther liberalization,greater flexibility inthe labormarket,andrestructuringthechaebols.By
theendof December,a25percent interest rateceilingandmostcapitalcontrolswereabolished.The
limitonaggregate stockownershipby foreignerswas raised to55percent,and the shorttermmoneymarketwas also tobederegulated.However, the swift conclusionof negotiationsdid little to change
marketsentimentwhichwasalsoaffectedby thepoliticaluncertaintiesconcerning theoutcomeof the
presidential elections due in December 18. The won/dollar exchange rate continued to depreciate;
interestratessoared;andstockpriceswentintoanosedive.
The squeeze on the money supply together with banks’ efforts to meet the 8 percent Basel capital
adequacyratiobyApril1998reducedtheavailabilityof bankcredit.InDecemberthepercentagerateof
loan defaults jumped to 1.49 from 0.14 a year earlier,while business failureswere five times higher.
External lenderssawthatthe IMF financingwhichhadbeenagreedwasshortof theamountof foreign
debt repayment due. Therewere also concerns that tightmonetary and fiscal policieswould depress
economicactivitysomuchthattheRepublicof Korea’sabilitytoservice itsdebtwouldbeundermined.
Interestratesshotuptothedizzyingheightof 40percent,andthewon/depreciatedtoalevelof 1,995per
dollar.
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CaseStudies: Argentinaand theRepublicof Korea
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Thefinancialsituationwasclearlyunsustainable,andrumorsbegantocirculatethattheRepublicof Korea
mighthavetodeclareadebtmoratorium.OnChristmasEve,theIMFandtheG7countriescameupwith
anotheremergencyfinancingprogramof US$10billion,drawingonthesecondlineof defense.Thenew
package succeeded in turning around market sentiment as itdemonstrated the resolve to rescue the
Republicof Koreafromfinancialcollapse.Foreignlenderswantedtobeassuredof paymentsof principle
and interest.They asked for and received government guaranteesonprivatedebton thebasisof the
argument that this would facilitate debt restructuring and new credit extension. By January 1998,
internationalcreditorbanksagreed toconvertmostof theshorttermdebtof Republicof Koreabanks
(US$24billion) into longterm loans,withgovernmentguarantees thatmatureoverone tothreeyears,
andinterestratesof 2.252.75pointsaboveLibor.
In1998thegrowthrateof GDPplungedto6.9percentfrom+4.7percentayearbefore.Pricesleaped
by7.5percent,thewondepreciatedby27percentvisàvisthedollar,andtheunemploymentreached8
per cent, thehighest since the1960s.Surprisingly, the crisiswas short lived.The reboundwasno less
drastic thanpreceding fall.TheRepublicof Koreaeconomygrewby9.5percent in1999,andrecovery
continuedthereafter.
The initialGDPcontraction in1998was largelycausedbythecollapseof investment.Theconsumption
GDPratioremainedfairlystable,whiletheinvestmentGDPratiodroppedsharplyto25percent.In1998,
therewasahugecurrentaccountsurplusof almost12percentof GDP.Thiswasbecauseimportdemand
declinedby22percent in1998,whileexportsfellbyunder3percent,movementswhichreflectedthe
influenceof boththerecessionandthedepreciationof thewon.
AnempiricalexaminationbyParkandLee (2002)of worldwidepatternsof adjustment in160currency
crisis episodes from 1970 to 1995 shows a widespread tendency for countries to undergo a Vtype
recoveryof realGDPgrowth similar to thatexperiencedby theRepublicof Koreaafter the19971998
crisis.Thestudyalsoshowsthatalargerealdepreciation,expansionarymonetaryandfiscalpolicy,andanimprovement in theglobaleconomicenvironmentareusually responsible for theupturns.Allof these
developmentswerepresentduringthesecondRepublicof Koreacrisis.WhatdistinguishestheRepublicof
Koreaexperiencefromothersarethedegreeof theinitialcontractionandsubsequentrecovery.Thiswas
duetothefollowingfactors:
ExchangeRateDepreciationandOpenness:inviewof theRepublicof Korea’srelativelyhighlevel
of opennessandrelativelylargetradesector,adepreciationof therealexchangeratewasgoing
tohaveanespeciallylargeimpact.
Favorable External Environment: the Republic of Korea economy was the beneficiary of an
improvement in the external trading environment. The global economy was strong in 1999.
Moreover,theRepublicof Koreaexportsalsobenefitedfromhigherpricesof semiconductors,andfromanappreciationof theyenwhichimproveditsindustries’competitiveness.
MacroeconomicPolicyAdjustments:realizingthedepthof theslowdown,theIMFagreedtorelax
monetary and fiscal policies as early as April 1998. The ensuing expansion of money supply
preventedafurthercontractionof domesticdemand.
The positive role of expansionary macroeconomic policies in the postcrisis recovery has raised the
questionof whetherthe initialtighteningwastooharsh,maintainedfortoo long,andasaconsequence
deepened the crisis. In order to deal with the crisis, the IMF chose a traditional policy prescription
designedformanagingacurrentaccountcrisis,whichcomprisedtightmonetarypolicyandfiscalausterity.
However, the Republic of Korea crisis involved principally the capital account. In these circumstances
increased interestratesresulted inwidespreadbankruptcieswhichdid littletorestorefinancialstability
andtheconfidenceof foreignlendersandinvestors.
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TheIMFandsupportersof thecontractionarymonetarypolicyarguethatintheabsenceof suchapolicy
capitaloutflowsandthebankrunwouldhavecontinued.ThosewhodisputetheIMFviewsuchasRadelet
andSachs(1998)andFeldstein(1998),ontheotherhand,maintainthattheRepublicof Koreaproblem
wasoneof liquidity.Therefore,thetraditionalIMFstrategywaslikelytohavedonemoreharmthangood
asitdrovemanyhighlyleveragedbutviablefirmsoutof business,therebydeepeningeconomicrecession.
5. Lessonsof theTwoCrises
Bothdebtcriseswereinpartprecipitatedbyinvestmentboomsfinancedbyforeignborrowing.Theratios
of externaldebttoGDPweresimilar,andtheRepublicof Koreaexaggeratedthecrisesbyadheringfortoo
longtorigidexchangerateregimes.Inbothcases,TheRepublicof Koreaeconomyreboundedswiftlyin
bothcases,butthescarsof the199798crisisweremoreextensiveanddeeper.
Themostsignificantdifferencebetweenthetwocrisesinvolvedthepolicyresponses.Inthe197980crisis
theRepublicof Koreapolicymakers took advantageof the country’s continuing access to international
financialmarketstofinancethedeficitoncurrentaccountinthebelief thateconomicfundamentalswere
strongandthattheeconomywasafflictedbyatransitoryimbalance.InthesecondcrisistheGovernment
hadtoseekIMFfinancingthatsubjectedtheeconomytoawiderangingarrayof policychanges.Itpaida
highpriceintermsof lostoutputandof thecostof resolvingbankruptfinancialinstitutionsandbailingout
insolventcorporations,whichamounted16percentof GDP in1998. Ithadnochanceof replicatingthe
strategyof relianceonexternalborrowing followedafterthe19791980owingto its increasedfinancial
opennessandthemorelimitedpossibilityof recoursetocapitalcontrols.
Greaterfinancialopennesswastheresultof thepolicyof economicliberalizationpursuedsincethemid
1980s,whichhadalsoresulted inamoreopentraderegime.TheGovernmenthadopenedthefinancial
sectorandderegulatedcapitalaccounttransactionaheadof thebidto jointheOECDintheearly1990s.
By the time of the 199798 crisis broke out the Government had been reforming institutions andrestructuringitsfinancial,corporate,andpublicsectorsformorethanadecade.
A financially open economywith a relatively inflexible exchange rate lacks an effective buffer against
external financial shocks. Moreover orderly financial opening requires an efficient financial regulatory
systemtomonitor risks.The reformof the regulatorysystem lagged intheRepublicof Koreaata time
whenfinancialinstitutionsweretakingonnewrisks,especiallyintheiroperationsabroad.
AccordingtoEichengreen,WyploszandRose(1996)therearethreetypesof distortionthatcangiverise
toafinancialcrisis.Thefirstisasymmetricinformationwhereborrowersorissuersof debtorequitytake
advantageof superiorinformationascomparedwiththatof lendersandinvestorsabouttherisksof their
business.Asymmetric information, isassociatedwiththedangerof herdbehavioronthepartof foreigninvestorsand financial institutions.Second ismoralhazard inbothdomesticand international financial
markets. This denotes the danger that thosewho expect protection against loss through bailouts by
publicauthoritieswilltakegreaterrisksthantheywouldotherwise.Thethirdisanydistortionthatcould
leadtotheinstabilityintheexchangerateassociatedwithmultipleequilibriainforeignexchangemarkets.
Allof thesedistortionswerepresentintheRepublicof Koreaintherunuptothe199798crisis.
Beforeandduring theearlyyearsof market liberalization foreign lendersand investorsdidnotcare to
learnaboutthestructuralweaknessesof Republicof Koreabanksandcorporategovernancebecauseof
governmentguarantees.Onlywiththegrowingexposureof theKoreaneconomytointernationalfinancial
marketsdidtheirawarenessincreaseof balancesheetmismatchesatbanksandchaebols.Bythetimethe
Thai crisis spread to other parts of East Asia in September 1997, the Republic of Korea began losing
reserves. Lacking confidence concerning the adequacy of Republic of Korea reserves, lenders and
investorsbegantoreducetheirexposuretothecountry,refusingeventorenewshortterm loans.Both
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CaseStudies: Argentinaand theRepublicof Korea
130
borrowersand lendersweretoblameforbringingonthecrisis borrowersowingtotheirdisregardfor
prudenceandriskmanagementandlendersowingtotheirshorttermismandherdmentality.
InternationalfinancialmarketsandRepublicof Koreapolicymakersshareresponsibilityforfailingtocarry
outreformswhichwouldhavereducedmoralhazard.Commercialandmerchantbankhadlongoperatedwith implicitgovernmentguarantees.Togetherwith inadequate supervision theseguaranteesprovided
incentivestobankstoborrowlargeramountsof fundsabroad,andtoinvestinriskierprojectsthanthey
wouldotherwise.
Moralhazardalsoappearstohaveaffectedthe lendingbehaviorof foreign financial institutions.These
expected to receive national treatment. Assuming that they too would benefit from government
guarantees, foreign banks did not conduct careful credit analyses of Republic of Korea borrowers.
Moreover, when the crisis broke out, few foreign banks attempted to reschedule loans to troubled
Republic of Korea banks in sharp contrast to their behavior towards delinquent borrowers in their
domesticmarkets.
Finally, creditorsbelieved that, as a group, they couldpressurize theRepublicof KoreaGovernment if
there was a crisis. In the event this assumptionwas to prove justified since their pressure played an
importantroleinthedecisionof theRepublicof KoreaGovernmenttoseekIMFfinancing.Thebankswere
aware that a debt moratorium was not a realistic option owing to the large number of lenders and
borrowers involved.Banks’ recourse to thispressurealso reflected theirknowledge that IMFprograms
favorcreditorsoverdebtors(Soros1998).
Thecrisisof 199798wasacapitalaccountcrisis inwhichthe initialcurrentaccount imbalancedidnot
playaprimaryrole.Massivecapitaloutflowsprovokedaliquidityandcreditcrisis.Intheseconditionsthe
traditional IMFstabilizationprogramdidnotwork,andan infusionof freshcapitalwasrequiredtostop
thebleedingof theeconomy.
It is natural to askwhether theGovernment could have followed the samepolicy as thatpursued in
response to the crisis of 19791980, i.e. combining a growthoriented macroeconomic policy with
continuedrelianceonexternalborrowing.Itishardtobelievethatfinancialmarketstodaywouldsupport
anythingbutamacroeconomicstabilizationprogram,even if thereweregoodgroundsforthinkingthat
thecrisiswouldbetransitory.Insuchanenvironmenttheaccumulationof largereservesthroughcurrent
account surpluses by major emergingmarket countries as insurance against the imposition of
inappropriatestabilizationprogramsbecomesfullyunderstandable.
D. ConcludingRemarks
Thesecondcrisesof boththeRepublicof KoreaandArgentinawerecapitalaccountcrisesthattookplace
ineconomies thathad liberalized capital transactions and thatwere thus integrated into international
financialmarkets.CapitalinflowswhichfuelledthegrowthprecedingthecrisesandwhichintheRepublic
of Koreacasebecameaninvestmentboomweretransformedintooutflowswhichledtomeltdowns.In
bothcasesIMFpolicyprescriptionsworsenedthecrises.
During much of the 1990s Argentina experienced strong growth. However, as early as 1995 adverse
developmentsintheexternalenvironmentbegantotriggereconomicdifficultiesandthecountrysuffered
aminicrisistogetherwithasharpdeteriorationinitsfiscalbalancefollowingtheMexicancrisisof 1995.
Afterarecoveryin19961997Argentina’sriskpremiumbegantoriseagainandforeignborrowingbecame
more costly. Externaldebtwas increasing,while the ability topaywasbeingundermined.A seriesof rescue packages failed to restore confidence, and were unable to stop eventual bank runs and the
bleedingof foreignexchangereserves.Thedollarizationof bankcreditsandof thecontractualstructureof
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CompendiumonDebt Sustainability and Development
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theeconomymadethecollapsemoresevere.Publicsectordebtroseafterthedefaultowingtomeasures
takenbytheGovernmentaspartof itsinterventioninthefinancialsystem.
The Republic of Korea crisis also came after a period of high growth, and was triggered by the
depreciationof theyenandadverseshocksto itsexports.Thesechangestriggeredgreaterattentiononthepartof foreign lenders to thescaleof foreignborrowingbychaebolsand todeteriorations in their
balance sheets. The rises inbankruptcies andnonperforming loans that followedheralded a financial
market crisiswith foreign borrowers refusing to rollovermajor bank loans.Given the context of the
earliercrisisinThailandthewoncameundermassiveattackasbankrunsandcapitaloutflowscontinued.
Thesedevelopmentsunderlinedtheimportanceof betterfinancialregulationandcorporategovernance
andnot justgoodmacroeconomicmanagementasessentialelementsof successfuldebtmanagement.
In both countries the meltdowns led to sharp falls in GDP growth. Resolution of the debt problems
followeddifferentcourses. In theRepublicof Koreacase,bank lending toprivateborrowerswasmore
importantand resolution involved theconversionof shorttermbank loans into longerterm loanswith
government guarantees. InArgentina debt securitiesweremore important and restructuring involvedtheirconversionintoalternativesecuritieswithlowercouponsorvaluesandlongermaturities.
InbothcasestheIMFprogramsincludedillconceivedpolicymeasuresduetomistakesindiagnosis,which
worsenedtheimpactof thecrises.InArgentina,theausteritymeasuresdeepenedtherecession,thereby
underminingpayment capacityand acceleratingdefault. In theRepublicof Korea,earlier relaxationof
monetaryandfiscalpolicycouldhavemeantthatbankruptciesand lostoutputwouldhavereached less
than16percentof GDP.
Inbothcases, the recoverywasaidedby favorableexternaldevelopmentssuchas the improvement in
appetiteamongstlendersandinvestorsfordevelopingcountryrisk,easingof interestratesandimproved
export markets. In Argentina default also provided a respite to the fiscal balance and the domestic
economy.
Inbothcases,devaluationcompressedimportsaswellashelpingexports(whoseincreasewasparticularly
notable for theRepublicof Korea). The turnaroundswere surprisinglyquick: theworstof the crisis in
Argentinawas inDecember2001,andsignsof recoverywereevident in the firsthalf of 2002;and the
Republicof Koreacrisiscollapseof 1998was followedbya spectacular recoveryasearlyas1999.This
followsapattern identifiedbyLevyYeyatiandPanizza(2006)accordingtowhich,bythetimeadefault
occurs,thelossesintermsof outputandgrowthhavealreadytakenplacesothatitsoccurrencecoincides
withthebeginningof economicrecovery.Animplicationof thispatternisthat,oncefirmexpectationsof
defaulttakeholdandthemeltdownstarts,measurestopostponethedefaultmaywellbemorecostly
thanthedefaultitself.
Beyondacertainpoint,neithercountrycouldhavedoneanythingtostopexternaldebtfromfollowingan
exploding path. Herd behavior delivered the final blows, As Park (2005) notes, international financial
markets are not a good source of shortterm liquidity for emerging economies, when they are
experiencing financial instability. The lesson drawnby several emergingmarket countries has been to
accumulate reserves as a form of insurance. If these economies felt assured of adequate liquidity
assistance from international financial institutionsor regional financial cooperative arrangements, they
wouldbelessinclinedtofollowthispolicy.
IMFpolicyfailuresandtheperceptionthatitsidedwithcreditorsinthesetwocriseshavecontributedto
underminingof itsauthorityamongstdevelopingcountries.Argentina’sdebtrestructuringproposalsand
independent recovery program have set a precedent for crisis resolution not mediated by the IMF.However, the faithof theUnitedStatesandprivate creditors in individualdebtworkoutsunder rules
subjecttoonlyminormodificationsincomparisonwiththepresentregimeisunlikelytoconstituteafully
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fledged, unquestioned alternative. Moreover impetus from these quarters in favor of further capital
accountliberalizationhasnowbeenlost.
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C a s e S t u d i e s : A r g e n t i n a a n d t h e R e p u b l i c o f K o r e a
136
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1 4 5 1 5 . 4
1 8 3 2 4 . 1
P u b l i c p u
b l i c l y g u a r a n t e e d d e b t ( a s p e r c e n t a g e o f
G D P )
4 5 . 2
3 7 . 5
6 7 . 6
3 3 . 2
2 5 . 1
2 0 . 8
1 9 . 4
1 9 . 5
2 1 . 3
2 2 . 9
P r i v a t e n
o n g u a r a n t e e d d e b t ( a s p e r c e n t a g e o f G D P )
1 . 7
1 . 4
2 . 3
1 . 3
0 . 9
1 . 0
2 . 7
5 . 1
6 . 2
7 . 0
P u
b l i c f i n
a n c e s
( P e r c e n t o f G D P )
C e n t r a l G
o v e r n m e n t , t o t a l r e v e n u e a n d g r a n t s
1 5 . 6
1 3 . 5
1 4 . 1
1 4 . 3
1 6 . 7
1 7 . 1
1 8 . 9
1 8 . 9
1 8 . 6
1 7 . 6
C e n t r a l G
o v e r n m e n t , t o t a l e x p e n d i t u r e a n d n e t l e n d i n g
1 9 . 6
1 8 . 0
2 6 . 2
1 6 . 0
1 8 . 0
1 7 . 4
1 8 . 0
1 9 . 4
1 9 . 6
2 0 . 1
C e n t r a l G
o v e r n m e n t b a l a n c e
4 . 1
4 . 4
1 2 . 1
1 . 7
1 . 2
0 . 2
0 . 9
0 . 5
0 . 9
2 . 5
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C o m p e n d i u m
o n D e b t S u
s t a i n a b i l i t y a n d D e v e l o p m e n t
137
T a b l e V I . 1
. ( c o n t i n u e d )
O u t p u t a
n d t r a d e
1 9 9
7
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
2 0 0 5
2 0 0 6
( P e r c e n t u n l e s s o t h e r w i s e s t a t e d )
R e a l G D P a
n n u a l g r o w t h
8
. 1
3 . 9
3 . 4
0 . 8
4 . 4
1 0 . 9
8 . 8
9 . 0
9 . 2
8 . 0
I n f l a t i o n C P I c h a n g e
0
. 5
0 . 9
1 . 2
0 . 9
1 . 1
2 5 . 9
1 3 . 4
4 . 4
9 . 6
1 0 . 9
N o m i n a l e x c h a n g e r a t e ( P e s o p e r U S $ )
0
. 0
0 . 0
0 . 0
0 . 0
0 . 0
2 0 6 . 5
5 . 3
0 . 8
0 . 7
5 . 2
T e r m s o f T
r a d e ( g o o d s )
2
. 0
6 . 0
6 . 1
1 0 . 1
0 . 5
0 . 4
9 . 8
0 . 4
3 . 0
6 . 5
T e r m s o f T
r a d e ( g o o d s a n d s e r v i c e s )
0
. 0
4 . 8
4 . 4
9 . 9
0 . 7
0 . 6
8 . 6
1 . 8
2 . 1
5 . 7
( i n U S $ m i l
l i o n s u n l e s s o t h e r w i s e s t a t e d )
T o t a l e x p o
r t s , f o b
2 6 4 3 0
. 8
2 6 4 3 3 . 7
2 3 3 0 8 . 6
2 6 3 4 1
2 6 5 4 2 . 7
2 5 6 5 0 . 6
2 9 9 3 8 . 8
3 4 5 7 5 . 7
4 0 3 8 6 . 8
4 6 4 5 6 . 4
T o t a l i m p o
r t s , f o b
2 8 5 5 3
. 5
2 9 5 3 0 . 9
2 4 1 0 3 . 2
2
3 8 8 9 . 1
1 9 1 5 7 . 8
8 4 7 3 . 1
1 3 1 3 4 . 2
2 1 3 1 1 . 1
2 7 3 0 0 . 1
3 2 5 8 4 . 8
C u r r e n t A c
c o u n t B a l a n c e
1 2 1 3 8
. 1
1 4 4 8 2
1 1 9 4 2 . 8
8
9 8 0 . 6 2
3 7 8 0 . 4 2
8 7 1 9 . 6 9
8 0 9 2 . 6
3 2 1 8 . 9 8
5 6 9 0 . 5 2
7 9 9 8 . 2 2
C u r r e n t a c c o u n t ( i n p e r c e n t o f G D P )
4
. 1
4 . 8
4 . 2
3 . 2
1 . 4
8 . 5
6 . 2
2 . 1
3 . 1
3 . 7
G r o s s R e s e
r v e s
2 2 3 3 6
. 8
2 4 7 6 9 . 9
2 6 2 6 8 . 3
2
5 1 4 7 . 7
1 4 5 5 3 . 4
1 0 4 8 9 . 8
1 4 1 5 3 . 9
1 8 9 8 0 . 6
2 7 2 6 6 . 9
3 0 9 9 6 . 2
P u b l i c p u b
l i c l y g u a r a n t e e d d e b t ( a s
p e r c e n t a g e o f G D P )
2 2
. 8
2 5 . 8
2 8 . 6
2 9 . 8
3 2 . 0
8 8 . 3
7 4 . 5
6 5 . 6
3 3 . 1
2 9 . 9
P r i v a t e n o n g u a r a n t e e d d e b t ( a s
p e r c e n t a g e o f G D P )
8
. 0
9 . 3
9 . 6
9 . 1
1 1 . 8
2 7 . 9
2 1 . 9
1 5 . 5
1 4 . 4
1 0 . 4
P u
b l i c f i n a
n c e s
( P e r c e n t o f
G D P )
C e n t r a l G o
v e r n m e n t , t o t a l r e v e n u e a n d
g r a n t s
1 8
. 5
1 9 . 0
1 9 . 4
1 9 . 5
1 8 . 8
1 8 . 2
2 0 . 7
2 3 . 4
2 3 . 7
2 4 . 2
C e n t r a l G o
v e r n m e n t , t o t a l e x p e n d i t u r e
a n d n e t l e n
d i n g
2 0
. 1
2 0 . 3
2 1 . 9
2 2 . 0
2 2 . 6
3 3 . 4
2 5 . 8
2 7 . 8
2 6 . 2
2 5 . 9
C e n t r a l G o
v e r n m e n t b a l a n c e
1
. 6
1 . 3
2 . 5
2 . 4
3 . 7
1 5 . 2
5 . 2
4 . 3
2 . 5
1 . 7
S o u r c e : U
N N a t i o n a l A c c o u n t S t a t i s t i c s ; I M F B a l a n c e o f P a y m e n t s S t a t i s t i c s , I n t e r n a t i o n a l F i n a n c i a l S t a t i s t i c s a n d W o r l d E c o n o m i c O u
t l o o k d a t a b a s e s ; W o r l d B a n k G l o b a l D e v
e l o p m e n t F i n a n c e
d a t a b a s e .
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CaseStudies: Argentinaand theRepublicof Korea
138
TableVI.2.Consolidatedfiscalbalance(NationalAdministrationandProvinces)
(asa percentageof GDP,annual average)
Source:Authors´calculationsbasedonMinistryof Economy,CetrángoloandJiménez(2003)andGaggero(2003).
(1)Primarybalanceexcludingreceiptsandexpendituresof nationalsecuritysystem.
(3)=(2)+ProvincesandBuenosAiresCitybalances.
TableVI.3.Totalpublicinterestpayments,TaxcollectionGDPratioandsovereignrisk
premium
(inpercent)
Source:Authors´calculationsbasedonMinistryof Economy.
(1)IncludesSecuritySystemreceipts.
(2)Calculatedasaratiobetweeninterestpaymentinperiodtanddebtattheendof t1.
(3)Taxreceiptsincludethosefromsocialsecuritysystem.
Primary Surplus
without Social
Security
(1)
Primary
Surplus
Interest
payments
Total
Balance
(2 )
Average 1981-90 nd -4.4 1.9 -6.2 -7.0
Average 1991-94 2.1 1.3 1.2 0.1 -0.6
Average 1995-97 1.7 -0.3 1.7 -2.0 -2.6 Average 1998-01 3.1 0.5 3.1 -2.7 -4.1
Average 1991-01 2.3 0.6 2.0 -1.5 -2.4
Consolidated
Public Sector
Balance
(3 )
Period
National Adm inistration
Year
Tax
collection as
percentageof GDP
(1)
Average
interest rate
on publicdebt
(2)
Interest
payments /
tax collectionratio
(3)
Sovereing
risk premium
(annual
average)
1991 18.8 s.d 5.5 9.6
1992 20.8 6.6 8.3 6.9
1993 21.3 5.0 6.0 4.9
1994 21.1 5.5 6.9 5.9
1995 20.9 6.1 9.2 12.4
1996 19.6 5.8 9.7 6.5
1997 21.0 6.7 10.9 3.3
1998 21.4 7.6 12.2 5.8
1999 21.4 8.3 15.9 7.2
2000 21.9 8.9 18.5 11.5
2001 21.0 9.4 23.4 14.8
2002 19.2 5.2 13.3 -.-
2003 23.1 1.9 9.6 -.-
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CompendiumonDebt Sustainability and Development
139
TableVI.4.Changeinforeigndebtandforeignassetsbysectorandperiod
(US$million)
Source:Authors ́estimationsonthebasisof datafromtheMinistryof Economy.
(1)IncludingtheCentralBank.
TableVI.5.Fiscaladjustment:Resultsof theConsolidatedPublicSector(CPS)
(as per cent of GDP)
Source:Authors ́calculationsbasedonMinistryof Economy.
(*)Taxonbankdebitsandcredits.
(**)Includestaxessharedwithprovinces,whichareincludedas.
expendituresinPrimaryexpendituresastransferstoprovinces.
(***)IncludingtheCityof BuenosAires.
Public
Sector (1)
Financial
Sector
Private
Sector (2)Total
Financial
Sector
Private Sector
(3)
8,529 5,726 10,321 24,575 1,728 566 9,755
5,924 2,952 4,361 13,238 821 11,174 -6,813
9,222 11,579 15,607 36,407 15,307 15,050 557
8,523 -555 3,139 11,107 -4,274 11,876 -8,737
2,975 -8,053 -688 -5,766 -10,665 12,865 -13,553
35,173 11,649 32,740 79,561 2,917 51,531 -18,791
1995:4 to 1998:2
1998:2 to 2000:4
Period
External debt of
Changes in
Net external
debt of private
sector (2)-(3)
1991:4 to 1994:4
1994:4 to 1995:4
External assets of
2000:4 to 2001:4
Total
Tax receipts 13.8 18.7 4.9Taxes on exports 0.0 2.3 2.3
Financial tax (*) 1.1 1.5 0.4VAT 3.1 3.4 0.4Income tax 2.5 3.4 0.9
Other taxes (**) 7.2 8.1 0.9Other receipts 4.9 4.8 -0.1Total receipts 18.8 23.5 4.7
Total expenditures 22.0 20.9 -1.1Primary expenditures 18.2 19.6 1.4
Interest services 3.8 1.3 -2.5Primary result 0.5 3.9 3.3Total result of the NPS -3.2 2.6 5.9
Provinces (***) -2.4 0.9 3.3
Total result of the CPS -5.6 3.5 9.2
Variation(2004-2001)
Concept
N a t i o n a l P u b l i c
S e c t o r
2001 2004
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C a s e S t u d i e s : A r g e n t i n a a n d t h e R e p u b l i c o f K o r e a
140
T a b l e V I . 6
. R e p u
b l i c o f K o r e a : S e l e c t e d E c o n o m i c I n d i c a t o r s , 1
9 7 5
1 9 8 5
M a c r o e c o n o m i c I n d i c a t o r s
1 9 7 5
1 9 7 6
1 9 7 7
1 9 7 8
1 9 7 9
1 9 8 0
1 9 8 1
1 9 8 2
1 9 8 3
1 9 8 4
1 9 8 5
( P e r c e n t )
R e a l G D P a n n u a l g r o w t h
5 . 9
1 0 . 6
1 0
9 . 3
6 . 8
1 . 5
6 . 2
7 . 3
1 0 . 8
8 . 1
6 . 8
I n v e s t m e n t
8 . 9
2 0 . 7
3 0 . 2
3 4 . 4
1 0 . 0
1 0 . 7
3 . 1
1 1 . 1
1 7 . 4
1 0 . 9
5 . 3
S a v i n g a s p e r c e n t a g e o f G D P
1 9 . 8
2 5 . 0
2 8 . 4
3 0 . 3
3 0 . 0
2 5 . 0
2 5 . 4
2 6 . 3
2 9 . 5
3 1 . 8
3 2 . 2
I n v e s t m e n t a s p e r c e n t a g e o f G D P
2 8 . 7
2 6 . 7
2 8 . 7
3 3 . 1
3 6 . 1
3 1 . 8
2 9 . 6
2 8 . 7
2 9 . 0
3 0 . 3
3 0 . 0
I n f l a t i o n C P I c h a n g e
2 5 . 3
1 5 . 3
1 0 . 2
1 4 . 7
1 8 . 3
2 8 . 7
2 1 . 4
7 . 2
3 . 5
2 . 2
2 . 4
R e a l w a g e s a n n u a l g r o w t h
1 7 . 6
1 9 . 8
1 8 . 2
8 . 5
4 . 0
0 . 5
7 . 9
7 . 2
6 . 4
6 . 6
E x t e r n a l S e c t o r I n d i c a t o r s
1 9 7 5
1 9 7 6
1 9 7 7
1 9 7 8
1 9 7 9
1 9 8 0
1 9 8 1
1 9 8 2
1 9 8 3
1 9 8 4
1 9 8 5
( p e r c e n t u n l e s s o t h e r w i s e s t a t e d )
C u r r e n t A c c o u n t a s p e r c e n t a g e o f G D P
8 . 8
1 . 1
0 . 0
2 . 0
6 . 6
8 . 3
6 . 4
3 . 3
1 . 8
1 . 4
0 . 8
R e a l e x p o r t g r o w t h
1 3 . 9
5 1 . 8
3 0 . 2
2 6 . 5
1 8 . 4
1 6 . 3
2 1 . 4
2 . 8
1 1 . 9
1 9 . 6
3 . 6
T e r m s o f T r a d e ( 1 9 8 5 = 1 0 0 )
8 7 . 0
9 9 . 3
1 0 6 . 2
1 1 1 . 3
1 0 8 . 9
9 4 . 4
9 2 . 5
9 6 . 5
9 7 . 4
9 9 . 5
1 0 0 . 0
N o m i n a l E x c h a n g e R a t e ( W o n / U S D )
4 0 4 . 5
4 8 4
4 8 4
4 8 4
4 8 4
4 8 4
6 0 7 . 4
6 8 1
7 3 1
7 7 6
8 0 6
R e a l e f f e c t i v e e x c h a n g e r a t e ( 1 9 9 3 = 1 0 0 )
9 3 . 4
1 0 8 . 6
1 1 3 . 1
1 0 7 . 6
1 2 0 . 1
1 0 7 . 6
1 0 8 . 4
1 0 6 . 3
1 0 1 . 9
9 9 . 3
9 3 . 4
T o t a l e x t e r n a l d e b t a s p e r c e n t a g e o f
G D P
3 9 . 5
3 5 . 5
3 3 . 2
2 8 . 1
3 2 . 1
4 2 . 6
4 5 . 4
4 8 . 7
4 7 . 8
4 6 . 2
4 8 . 4
S h o r t t e r m D e b t a s p e r c e n t a g e o f e x
t e r n a l d e b t
2 8 . 2
2 8 . 6
2 9 . 4
2 6 . 2
2 7 . 1
3 4 . 6
3 1 . 5
3 3 . 4
3 0 . 0
3 6 . 5
2 2 . 9
D e b t S e r v i c e R a t i o ( l o n g t e r m d e b t o
n l y )
1 2 . 7
1 0 . 4
1 1 . 3
1 3 . 7
1 4 . 0
1 4 . 7
1 6 . 1
1 6 . 3
1 6 . 3
2 1 . 3
F o r e i g n E x c h a n g e R e s e r v e s ( U S $ b i l l i o n )
1 . 6
3 . 0
4 . 3
4 . 9
5 . 7
6 . 6
6 . 9
7 . 0
6 . 9
7 . 6
7 . 7
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C o m p e n d i u m
o n D e b t
S u s t a i n a b i l i t y a n d D e v e l o p m e n t
141
T a b l e V I . 7
. R e p u
b l i c o f K o r e a : S e l e c t e d E c o n o m i c I n d i c a t o r s , 1
9 9 5
2 0 0 4
M a c r o e c o n o m i c I n d i c a t o r s
1 9 9 5
1 9 9 6
1 9 9 7
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
( P e r c e n t )
R e a l G D P a n n u a l g r o w t h
9 . 2
7 . 0
4 . 7
6 . 9
9 . 5
8 . 5
3 . 8
3 . 1
4 . 6
I n v e s t m e n t
1 3 . 1
8 . 4
2 . 3
2 2 . 9
8 . 3
1 2 . 2
0 . 2
6 . 6
4 . 0
1 . 9
S a v i n g a s p e r c e n t a g e o f G D P
3 6 . 5
3 5 . 7
3 5 . 8
3 7 . 9
3 5 . 8
3 3 . 9
3 1 . 9
3 1 . 4
3 3 . 0
3 5 . 0
I n v e s t m e n t a s p e r c e n t a g e o f G D P
3 7 . 7
3 8 . 9
3 6 . 0
2 5 . 0
2 9 . 1
3 1 . 0
2 9 . 3
2 9 . 1
3 0 . 0
3 0 . 2
I n f l a t i o n
4 . 4
5 . 0
4 . 4
7 . 5
0 . 8
2 . 2
4 . 1
2 . 7
3 . 6
3 . 6
R e a l w a g e s a n n u a l g r o w t h
6 . 4
6 . 7
2 . 5
9 . 3
1 1 . 2
5 . 6
1 . 5
8 . 6
5 . 7
2 . 8
E x t e r n a l S e c t o r I n d i c a t o r s
1 9 9 5
1 9 9 6
1 9 9 7
1 9 9 8
1 9 9 9
2
0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
( p e r c e n t u n l e s s o t h e r w i s e s t a t e d )
C u r r e n t A c c o u n t a s p e r c e n t a g e o
f G D P
1 . 7
4
. 1
1 . 6
1 1 . 7
5 . 5
2 . 4
1 . 7
1 . 0
2 . 0
4 . 1
R e a l e x p o r t g r o w t h
3 0 . 3
3
. 7
5 . 0
2 . 8
8 . 6
1 9 . 9
1 2 . 7
8 . 0
1 9 . 3
3 1 . 0
T e r m s o f T r a d e ( 2 0 0 0 = 1 0 0 )
1 3 8 . 5
1 2 5
. 4
1 2 2 . 2
1 1 6 . 7
1 1 4 . 1
1 0 0 . 0
9 5 . 5
9 5 . 0
8 9 . 0
8 5 . 3
N o m i n a l E x c h a n g e R a t e
7 7 1
8 0 4
9 5 0
1 , 4 0 1
1 , 1 8 9
1 , 1 3 0
1 , 2 9 1
1 , 2 5 2
1 , 1 9 2
1 , 1 4 6
R e a l e f f e c t i v e e x c h a n g e r a t e ( 1 9 9
3 = 1 0 0 )
1 0 5 . 0
1 0 8
. 1
1 0 0 . 5
7 3 . 7
8 4 . 3
9 0 . 7
8 5 . 1
8 9 . 7
9 2 . 1
9 4 . 6
T o t a l e x t e r n a l d e b t a s p e r c e n t a g e o f G D P
2 3 . 2
2 8
. 2
3 3 . 7
4 7 . 3
3 4 . 4
2 9
2 7 . 1
2 6 . 1
2 6 . 6
2 6 . 1
S h o r t t e r m D e b t a s p e r c e n t a g e o
f e x t e r n a l d e b t
4 5 . 8
4 8
. 2
3 6 . 6
2 4 . 2
2 8 . 2
3 3 . 7
3 2 . 2
3 4 . 8
3 3 . 9
3 3 . 8
D e b t S e r v i c e R a t i o ( l o n g t e r m d e b t o n l y )
F o r e i g n E x c h a n g e R e s e r v e s ( U S $
b i l l i o n )
3 2 . 7
3 3
. 2
2 0 . 4
5 2 . 0
7 4 . 1
9 6 . 2
1 0 2 . 8
1 2 1 . 4
1 5 5 . 4
1 9 9 . 1
S o u r c e : B a n k o f K o r e a .
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CompendiumonDebt Sustainability and Development
143
CHAPTERVII
APPROPRIATEINSTITUTIONALSETTINGS
FORPUBLICDEBTMANAGEMENT
JaimeDelgadilloCortez
(WorldBank97)
A. Introduction
Weak institutionsdealingwithpublicdebtmanagement in transitionandemergingeconomiesas
well as external shocks can be major sources of debt distress. While shocks cannot be totally
controlled,theinstitutionalsettingfordebtmanagementcanbestrengthened.Thusvulnerabilityto
debtproblemscanbereducedorbettermanagedwhensolidinstitutionsareinplace.
Publicdebtmanagementcanbedefinedastheprocessof establishingandexecutingastrategyfor
managingtheGovernment’sdebtportfolio inordertomeetgovernmentfundingrequirements,to
achieveobjectiveswithregardtocostsandrisks,andtomeetotherobjectivesrelatedtodebtsuch
aspromoting investment for economic growth anddeveloping thedomestic financialmarket forgovernmentsecurities.Effectivedebtmanagementcanalsohelptoensurethatboththe leveland
growthof debtarefiscallysustainable.98
In emerging and transition economies the main emphasis in debt management is put on the
following:
Theproductionof reliabledebtdata;
Marketdevelopment;
Ensuringadequatefinancingfordevelopmentalandsocialneeds;
Ensuringcompliancewithdebtserviceobligations;
97TheauthorwasaSeniorEconomicAffairsOfficerof UNCTADwhenhewrotethischapter.
98SeeWorldBankandIMF(2002),andDMFAS,EffectiveDebtManagementaRevision,forthcoming.
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AppropriateInstitutional Settings for PublicDebt Management
144
Controllingcontingentliabilities;
Negotiatingagreementswithcreditors;
Performingcost/riskanalysis;
Designingstrategiestoattainasustainabledebtposition.
An appropriate institutional framework for debt management can contribute to achieving the
objectivesof effectivedebtmanagement.Institutionalarrangementsshouldfocusonthefollowing:
Governance;
Clarityof therolesof theinstitutionsdealingwithdebtmanagement;
Specificationof theobjectivesforpublicdebtmanagement;
Coordinationof publicdebtmanagementwithotherpublicpolicies;
Theorganizationalstructureof DMOs;
Transparencyandaccountability.
Thispaper isdivided in twoparts. Section II provides anoverviewof the contextof publicdebtmanagementanddescribesthechallengeswhichDMOsandotherareasof publicdebtmanagement
mustmeet as part of the broad framework of macroeconomic policies. Section III examines the
different issues related to the institutional frameworkof debtmanagement includinggovernance,
mandates, accountability and transparency, the separation of executive and operational debt
management,andtheneedforanexecutivedebtmanagementcommittee.Theprincipalfocusisthe
role,organizationandfunctionsof DMOsinlowandmiddleincomecountriesfromtheperspective
of developmentneeds.
B. TheContextof PublicDebtManagement
1. TheChallengesandConstraintsFacingInstitutionsDealingwithDebtManagement
Proactive debt management is essential in today’s market conditions. DMOs must face the
challengeof morecomplexportfoliosof publicandprivatedebt,theglobalizationof capitalmarkets,
andthevolatilityof capitalflows.Furthermore,manyemergingmarketeconomiesobtainsubstantial
financingintheformof equityflows.
External factorssuchasvolatility in thepriceof exportproductsandexchangeand interestrate
fluctuations, and contagion effects are beyond the DMO’s control. However, in normal
circumstances,DMOscanplayacrucialroleincrisispreventionandresolution.
Inadequate legal arrangements,uncleardefinitionof functions and responsibilities, inappropriate
organizational structures, inadequate staff and insufficient training, and the failure to define
strategicobjectivesandresponsibilitiesarealltoocommonfeaturesof DMOs.Theseweaknessesare
manifest in theabsenceof strongmiddleofficeswhich shouldbeequipped to conductanalytical
workrequired fordefiningadebtstrategy.Uncleardebtmanagementobjectivesandbenchmarks
andtheinabilitytoconductDebtSustainabilityAnalysis(DSA)arealsofrequentproblemsof DMOs.
Other deficiencies involve the implementation of strategies and the lack of coordination with
monetaryandfiscalpolicies.
Factorswhicharenotunderthecontrolof DMOsbutwhichnonethelesscanimpedetheirefficient
performance include structuraldeficiencies inmoneymarkets and in theprimary and secondarymarkets for financial instruments as well as inadequate management of quasifiscal deficits and
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CompendiumonDebt Sustainability and Development
145
internationalreserves.MoreoversomeDMOs lacktheresourcesormandate(orboth)totransmit
clearmessagestootherlevelsof theGovernment.
Thisdocumentdoesnotaddressallof theseissues.Itfocusesonwaysinwhichtheconstraintsand
challenges facingDMOs canbe addressedby strengthening the abilityof DMOs tomanage theirdebt portfolios and by strengthening other institutional and legal arrangements for debt
management.
FigureVII.1. illustrates thecoreactivitiestypicallyperformedbyDMOs in lowandmiddleincome
countries. In the former, debt management is concerned principally with captive markets for
domestic debt and concessional financing or grants. Government financing depends heavily on
shortterm instrumentswithhigh interestrates.DMOsthusattempttodiversifythedebtportfolio
bydevelopingprimary and secondary financialmarkets andby eventually accessing international
capitalmarkets.
In the case of middleincome countries, debt management has a wider role in involving themanagementof thecostsandrisksof amorediversifiedportfolioincludingrecoursetotransactions
inderivatives,providingarangeof financialservicestotheGovernment,andeventuallyparticipating
inaintegratedfinancialriskmanagementwithotherpartsof theGovernment.99
FigureVII.1.
99See,forexample,TheChangingRoleof thePublicDebtManager,presentationmadebyPhillipAnderson,WorldBank,in
UNCTAD(2005).
LowIncome
Countries
Debt
Management
ExpandedRole
MiddleIncome
Countries
Debt
Management
BasicRole
IntegratedCost/RiskManagement
of Liabilities;
Supplyof Financial
ServicestoGovernment;
Managementof FinancialAssets;
TransactionsinDerivativeMarkets;
OperationalRiskManagement.
AccessInternationalCapital
MarketstoDiversifyDebt
Portfolio;
DevelopDomesticPrimary&
SecondaryMarkets;
IssueShortTermGovernment
Securities;TapCaptiveSourcesof
DomesticDebt;
ManageODAandIDAGrants.
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AppropriateInstitutional Settings for PublicDebt Management
146
2. PublicDebtManagementasanIntegralPartof theFrameworkof Macroeconomic
Policies
Figure VII.2. below indicates the relationship between public debt, external debt and the real
domesticsectorsof theeconomy.Publicinvestmentprogramsarefinancedwithinternalorexternal
resourcesintheformof loansorgrants.
Debt flows are recorded in theBalanceof Payments.DSA relatespublicdebt information to the
balanceof paymentsdataandmacroeconomicvariables includinggrowthobjectivesandeconomic
and social programs. Information regarding debt stocks and flows (including debt service and
disbursements), interest rates, exchange rates, capitalaccount movements, etc. is combined to
determinethesizeof thefinancinggap.Thisneedstobefilledwithacombinationof externaland
domesticfinancingand,if necessary,withdebtrestructuringordebtrelief.
Given the importance of domestic debt and the necessity of incorporating it into the overall
managementof governmentliabilities,theconceptof TotalPublicDebtisusedinthispaper,whichthusincludesbothexternalanddomesticdebt.
FigureVII.2.
EXTERNAL SECTOR
R E A L S E C T O R
PUBLIC FINANCIAL SECTOR
PUBLIC DEBTEXTERNAL
Flow chart for public debt management in developing economieswithin macroeconomic framework
D i s b u
r s e m e
n tr e c
e i p t s
D e b t
s e r v i
c ep a y m
e n t s
P r i n c
i p a l &
i n t e r e
s t
F i n a n c i n g p r o j e c t s
Imports - Exports
L o c a l c u r r e n
c y
Internal Financing
Requirements
Tax and revenues
L o c al c o un t er p ar t f un d s
P u b l i c i nv e s t m en t pr o gr am s
G.D.P. B.O.P.
BUDGET
DOMESTIC DEBT
External Financing requirements
Loans and grants
G r o w
t h O b j e c t i v e s
Sincepublic debt is often the largest liability in the national balance sheets of low and middle
income countries, its management cannot be seen as isolated from the overall macroeconomicmanagementof acountry.Publicdebthasmajorlinkageswithmacroeconomicandfinancialstability.
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CompendiumonDebt Sustainability and Development
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Theobjectivesof fiscal,monetaryandpublicdebtpolicies shouldbe coordinated to achieve and
maintaindebtsustainabilityandfiscaldiscipline.
Moreover, an effective system of overall financial management is essential not only for
macroeconomicmanagementbutalso forprovidingreliable financial informationtoprevent fraudandwaste.
Publicdebtmanagementaspartof suchasystemcansignificantlycontributetotheattainmentof
itsobjectives.Relevant informationondebtmanagement strategies,DSA,andpublicdebt stocks
andflowsareessentialingredientsof soundpublicfinances.Thisisparticularlytrueinthecontextof
budgetingandexpendituremanagement.Inthisarea,Governmentswantto improveplanningand
budgetformulation;setrealisticandachievablespendingceilings; improvespendingprioritization;
monitorcommitmentsanddisbursements;andensureaccurateandtimelyinformationflowsamong
governmentinstitutions.
As isnoted in theWorld Bank’sPublic ExpenditureManagementHandbook, theory andpracticeshowthatreformof acountry’s institutionsof financialmanagementbothformaland informal –
can have a decisive influence on budgetary outcomes at three levels. At the first level, the
introductionof institutional reforms inpublic financialmanagement can improveaggregate fiscal
discipline andplanning aswell as the traditional control functionsof public expenditure through
budgetparameters.Atthesecondlevel,thesereformscanimprovetheplanningfunctionof public
expendituremanagementthroughimprovementsinthecapacitytoallocateresourcesinaccordance
withstrategicprioritiesandbaselinedataonpriorexpendituresandrevenuepatterns.Atthethird
level, the reforms contribute to political decisionmaking concerning the allocation of scarce
resourcestoselectedpriorities.
Figure VII.3. illustrates the flows of information between a consolidated DMO and its main
stakeholders: the Ministry of Finance, the Central Bank, the National Planning Agency, and its
externalcreditors including InternationalOrganizations. Incomingandoutgoing informationtoand
from the DMO contribute to a close and coordinated relationship regarding debt management
amongkeyinstitutions.Thisfacilitatestheimplementationof debtmanagementoperationssuchas
debtservicepayments,andenablestheDMOtoassisttheGovernmentinconductingaDSA.
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CompendiumonDebt Sustainability and Development
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transactionandborrowing costs.Consolidationof theauthority fordebtmanagement ina single
wellstructuredDMOcanenormouslycontributetotransparencyandaccountability.
Legislation on fiscal responsibility can bring the debt management objectives in line with fiscal
targets. This is particularly important when local Governments have a certain degree of independencetoincurdebts,bothforeignanddomestic,especiallyinfederalcountries.
Delegationimpliesaccountability.Therefore,itishighlydesirablethattheActof Parliamentspecifies
thattheMinisterof FinancepreparesanannualorsemiannualreportwithParliamentonactivities
related topublicdebtmanagement,andonplans regardingpublicdebtmanagement in thenext
fiscalyear.Thishelpspromotetransparencyandaccountability,andencouragesadomesticdebate
on these issues. Investors and international financial institutionswould alsobe able to acquire a
better knowledge of the Government’s future funding plans and of its developmental priorities.
(Majorfeaturesof thelegalframeworkforDMOsandof itsresponsibilitiesaresummarizedinBoxes
1and2.)
BOXVII.1.DMOs’MainFunctionsandResponsibilities
Toimplementthedebtstrategy,debtmanagementpolicies,procedures,benchmarksandguidelines
prescribedintheregulationsdesignedattheappropriatelevelof Government;
Toissuedebtortocontractdebtonbehalf of theMinisterof Finance,toparticipateinDSAtogether
withotherareasof theGovernment,toalerttheauthoritiesconcerningsituationsof unsustainable
debt,andtorecommendtimelyadjustmentswhenneeded;
Tomaintainatimelyandreliabledatabaseonpublicdebtandtoconductregulardatavalidation;
Tominimizecostsandrisksassociatedwithpublicborrowingandpubliclyissuedguarantees;
To order debt service payments to the financial agent of the central Government through the
Treasuryand/ortheBudgetDepartment,fortheloansandbondissuesof thecentralGovernment.
Togenerateandprovidereliableandtimelyinformationonpublicdebtpoliciesanddatatoavariety
of usersandtothepubliconaperiodicbasis;
Toprovidegovernmentguaranteesafterriskevaluation.TheCongressonannualbasisthroughthe
budget law normally authorizes guarantee coverage. The DMO should monitor all forms of
contingentliabilities;
Tomonitortheloansandbondsissuesof publicentitiesandenterprises;
Tomonitordebt incurred at the subnational level, including the loans andbonds issuesof local
Governmentsandentitiescontrolledbythem;
Tomonitorgrants,privateexternaldebtandonlendingtobothpublicandprivateentities;
Toensure that theprovisionsof internationalagreementswithcreditors (ParisClub,LondonClub,
otherbilateralcreditors,multilateralcreditors,etc.)arecompliedwith.
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AppropriateInstitutional Settings for PublicDebt Management
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Sound practice under the heading of accountability requires regular auditing of the financial
transactionsundertakenbythedebtmanagerstoassesstheircompliancewithgenerallyaccepted
accountingpracticesandwiththeGovernment’sportfoliomanagementpolicies.Thisauditingwould
reviewtherisksintheportfolioandcompliancewiththeriskmanagementframework.Itcouldalso
facilitate the establishment of multiyear targets for debt. The results of the audits would be
disclosedinthereportstotheMinisterof FinanceandParliament.
2. Policies,ProceduresandOperations
Risks of losses from inadequate operational controls should be managed according to soundbusinesspractices, includingwellarticulatedresponsibilities forstaff,clearmonitoringandcontrol
policies,andadequatereportingarrangements.
Debt management activities should be supported by an accurate and comprehensive
managementinformationsystemwithpropersafeguards.
Staff involved indebtmanagementshouldbesubjecttoacodeof conductandconflictof
interestguidelinesregardingthemanagementof theirpersonalfinancialaffairs.
A framework shouldbedeveloped to enabledebtmanagers to identify andmanage the
tradeoffsbetweenexpectedcostsand risks in theGovernment’sdebtportfolio.Portfolio
benchmarksshouldreflectthelevelof riskthatisacceptabletotheDMO.
Aspartof riskassessment,debtmanagersshouldregularlyconductstresstestsof thedebtportfolioonthebasisof economicandfinancialshockstowhichtheGovernment –andthe
countrymoregenerally –arepotentiallyexposed.
In order to help/guide decisions and reduce Government’s risk, debt managers should
considerthefinancialandotherriskcharacteristicsof theGovernment’scashflows.
Theresponsibilityforidentifyinganddevelopingplanstomanageoperationalrisksalso lies
with theDMOwhich shouldhaveaplan tominimizedamages causedby such risks. (For
moredetailonoperationalrisksseeAnnex1.)
BOXVII.2.LegalandRegulatoryProcessesforDebtIssuancebyaDMO
A DMO needs to be able to operate in accordance with rules which ensure that debt issuance is
consistent with specified borrowing limits, and which do nothing to undermine the confidence of
lendersandinvestorsconcerningtheobligationtoserviceandrepaygovernmentdebt.Thedelegation
of authorityshouldbeclear,asshouldbeaccountabilityandreportingobligations.ManyGovernments
have in place legislation of this kind. Usually the legislation authorizes the Minister of Finance toconductallborrowingandrelatedfinancialtransactionsonbehalf of theGovernmentandestablishesa
maximum amount of new funding and guarantees that can be extended over a specified period
(generallyone year). This avoids theneed for specific authorizations from Parliament for individual
transactions,whichmight increase the roleof political factors in thedecisionmakinganddelay the
executionof transactions.
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DMOs can implement a “Code of Conduct for Staff andManagement” that rests on a tripod of
professionalismandintegrity;honesty,faithfulness,efficiency,staff courtesyinofficialconduct;and
dignifiedconductinprivatelife.
Professionalism and integrity requires staff to openly demonstrate professionalism and
integrityinexecutingthepoliciesandprogramsof theDMO;
Honesty, faithfulness,efficiency,and courtesy inofficial conduct requiresstaff tokeepfaith
to their official responsibilities by not allowing personal considerations or activities to
interferewithofficialduties,maintainingconstancyandsincerityof purpose,being result
oriented,andrespectingthepeopleitdealswith;
Dignified conduct in privateliferequiresstaff toexerciserestraintintheirprivatelivesandin
theconductof privateactivitiesthatcouldhavebearingsontheirofficialengagements.
Annualworkplansshouldbetightlyintegratedwithdebtstrategywork.Thereisastrategyhierarchy
extendingfromoverallstrategicdebtmanagementobjectivestoannualdebtmanagementreviews
andplansconsistentwiththeoverallobjectivesandtooperationalplansforindividualworkareasto
giveeffecttotheannualstrategy.
BOXVII.3.Typesof RiskMarketRisk.Theriskassociatedwithchangesinmarketindicators,suchasinterestrates,exchangerates,commodity
prices.Forbothdomesticandforeigncurrencydebtchangesininterestratesaffectdebtservicingcostsonnewissues
and on floating rate debt at the ratereset dates. The market risk of debt denominated in or indexed to foreign
currencies is due to the vulnerability of debtservicing costs as measured in domestic currency to exchange rate
movements.Bondswithembeddedputoptions (i.e.rightsfor investorstosellthebondstothe issuerataspecified
priceduringacertainperiod)canexacerbatemarketandrolloverrisks.
RolloverRisk.Theriskthatdebtwillhavetoberolledoveratahighcostor,inextremecases,cannotberolledoverat
all.Totheextentthatrolloverriskislimitedtotheriskthatdebtmighthavetoberolledoverathigherinterestratesit
maybeclassifiedasatypeof marketrisk.However,becauserolloverriskcanleadto,orexacerbate,adebtcrisis,itis
oftentreatedseparately.Managingthisriskisparticularlyimportantforemergingmarketcountries.
LiquidityRisk.Therearetwotypesof liquidityrisk.Oneconcernstherisksof situationsinwhichaborrowerdoesnot
haveaccess to liquidassetswhentheyareneeded.Theotherreferstotheriskof penaltyratesof interestorother
costswhenaborrowerwantstoexitapositionthroughthesaleof assetsforwhichthemarket isilliquid.Thisrisk isparticularlyrelevanttothemanagementof liquidassetsandliabilitiesandtotheuseof derivativescontracts.
CreditRisk.Theriskof nonperformancebyaborrowersorbyoneof thecounterpartiestootherfinancialcontracts.
Thisriskarisesinvariouscontextssuchastheacceptanceof bids inauctionsof securitiesissuedbytheGovernment
andinrelationtocontingentliabilitiesandderivativecontracts.
SettlementRisk.Thepotentiallossthatacounterpartycouldsufferasaresultof thepossibilitythatitdoesnotreceive
funds or other assets, for reasons other than default, from another counterparty in accordance with an agreed
timetable.
OperationalRisk.This includesarangeof differenttypesof risksdueto involvement invariouskindsof business. It
includesrisksduetotransactionerrorsinthevariousstagesof executingandrecordingtransactions,toinadequacies
orfailuresininternalcontrols,systemsandservices,andtotheeffectsof naturaldisasters.Itmaybedefinedtoinclude
reputationalriskandlegalrisk.
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AppropriateInstitutional Settings for PublicDebt Management
152
3. TheSeparationof ExecutiveandOperationalDebtManagement
TheExecutiveDebtManagementfunctions(thatisthepolicy,regulatoryandresourcingfunctions100)
are the responsibilityof theMinisterof Financeandotherhighgovernmentofficials, suchas the
Headsof theDMO,NationalPlanning, andBudget andTreasuryOffices. These functionsmaybe
subjecttooveralldirectionandcoordinationthroughahighlevelbodywhichcouldbedenominated
astheExecutiveDebtManagementCommittee(EDMC).
Theroleof theEDMC istoapprovedebtmanagementguidelinesandtheprinciplesto implement
them. It meets at intervals to analyse the DMO’s performance and evaluate compliance with
establishedregulationsandtargets.TheGovernorof theCentralBankcanbepartof thisCommittee
tohelptoensurecoordinationbetweenmonetarypolicy,debtmanagementandfiscalpolicy.Day
todayoperationsaredelegatedby theEDMC to theDMOand then reported toandcoordinated
withtheMinisterof Finance.
Anorganizationalstructure foreffectivedebtmanagement is shownschematically in figureVII.5.,andtheproposedcompositionof theEDMCinfigureVII.6.ItsdifferentfunctionsarespecifiedinBox
VII.4.
FigureVII.5.EffectivePublicDebtManagement
TheDMOmusthaveaclearmediumtermstrategy,performance indicators,andstrictmonitoringandcontrolfunctions.Thesefunctionsshouldnotberelatedonlytodebtissuanceanddebtservice.
Theyshouldalsoencompasseffectivemanagementof therisksassociatedwiththedebtstructure
andensuringcompatibilitywiththefiscaltargets,whilereducinggovernmentfinance’svulnerability
toshocks.
BasedonpreviousworkoneffectivedebtmanagementdevelopedbyDMFAS/UNCTADandother
international organizations such as the World Bank and the IMF and best practices in debt
management implemented in several countries, the recommended Executive Debt Management
(EDM)functionscanbesummarizedasfollows:
100SeeDMFAS/UNCTAD(1993).
ExecutiveDebtManagementCommittee
(HeadedbyMinisterof Finance)
DebtManagementOffice
MiddleOfficeFront Office BackOffice
ExecutiveDebtManagement
Operational
DebtManagement
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CompendiumonDebt Sustainability and Development
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(a) EDMfunctionsforexternaldebtincludetheestablishmentof debtsustainabilitystandards;
determinationof borrowingneedsand limits,anddesired termsandborrowing sources;
formulation of guidelines for debt operations such as debt conversions, buybacks, on
lending,etc;apolicyframeworkforgovernmentguaranteesandcontingentliabilities;and
arrangementsandregulationsforborrowing,disbursements,anddebtservice.
(b) EDMfunctionsfordomesticdebtconcerntheformulationof debtmanagementobjectives
and strategy; establishing borrowing ceilings according to budgetary and fiscal goals;
developmentof abenchmarkdebt structure;determinationof thevolume and typesof
instrumentstobeusedandtheirmaturity,timing,frequency,andsellingtechniques;and
developmentof communicationlinkageswithstakeholders.
(c) Operational Debt Management is the responsibility of the DMO itself. Basic functions
underthisheading includerecording,operating,monitoring,controlling,coordinatingand
negotiating public debt. These functions are best performedwithin the frameworkof a
Back,Middle,andFrontOfficetypeof organization.Separationof functionsinthiscontext
helps promote the independence of those designing strategies and monitoring them
(MiddleOffice) from those registeringdebtandperformingoperations (BackOffice)and
fromthosecarryingoutnegotiationsanddebttransactions(FrontOffice).
FigureVII.6.PossibleCompositionof theExecutiveDebtManagementCommittee
Head of Treasury
Head of Budget
Economic Adviser to the President
Head of PlanningOffice
Governor of Central Bank
Head of DMOSecretary
Minister of Finance
Chairman
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AppropriateInstitutional Settings for PublicDebt Management
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Consolidationof thedebtmanagementfunctionsinasingleofficecanleadtoefficiencygains.Thisis
crucially important to avoid fragmentation of the debt strategy. When conducting DSA and risk
analysisitisimportanttohaveanintegratedviewof thetotaldebtportfolio.
The termsof referenceof theDMO should incorporateall functions related to the contractingof domesticandexternaldebt.Therefore,theorganizationalstructuremusthaveunitsresponsiblefor
theregistrationandmanagementof bothtypesof liabilities.(FordetailsseeBoxVII.1).
Theorganizationalstructureof theDMOshouldbebasedonaFunctionsManualthatdeterminesits
role, responsibilities and functions together with a staff table detailing job descriptions and
responsibilities.Thefunctionsof eachelementof theDMOstructureshouldbeclearlyspecifiedhere.
There shouldbeeffective coordination and information sharingwithin theDMO embodied in an
internalcommunicationsstrategy.
TheDMOshouldhavethepersonnelrequiredforefficientresponsetoitsmandates,andapolicyof
adequateremunerationtoattractandretainqualifiedstaff.
BOXVII.4.Functionsof theExecutiveDebtManagementCommittee
Approvethedebtmanagementstrategyoverthemediumterm;
Decideonsectorsthatwillhaveaccesstoexternalordomesticfinancingandonwhatterms;
Definethelevelandcharacteristicsof domesticdebtissuesforfiscalpurposes;
Establishborrowingceilingsbydebtorandcreditorcategories;
Establishguidelinesforextendinggovernmentguarantees; Definetherequiredmixof externalanddomesticindebtednessandthedesiredamortizationprofiles;
DecideondebtrestructuringsproposedbytheDMOtoconformwiththedebtstrategy;
Providelaws,guidelinesandregulationsforeffectivedebtmanagement;
Define institutional framework for the DMO and other institutions involved in debt management
operations,includingpropercoordinationof activities;
Put inplace theorganizational framework for theDMO, including information flows, functions, and
schedulesof duties;
Through the Budget Law, for each fiscal year, establish the debtservice targets and ceilings on
indebtednessforforeignanddomesticdebt;
Establishbenchmarksforcertaindebtindicators,suchasdebtservicetoexports,stockof publicdebttoGDP,debtservicetogovernmentrevenues,etc.;
Definepolicies,includingthosecoveringsalaries,careerperspectivesandallowances,forattractingand
retainingDMOstaff withrelevantqualifications;
PutinplacetrainingprogramsforDMOstaff;
Supportimprovements,maintenanceandextensionsof thedebtdatabase.
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4. TheFront,Middle,andBackOfficesof aDMO
(a)Back OfficeThe Back Office centralizes all aspects of the registration, monitoring and control of
disbursements/subscriptions,of theexecutionandmanagementof publicdebtserviceoperations,
andof theproductionof statisticalinformation.Thefunctionscomprisetheadministrationof thefull
cycleof thelifeof acontract/instrumentfromthesignature/issuetoitsfullpayment.
TheOfficeisresponsibleforthemanagementof therecordsof debtholdersandfortheregistration
of governmentdebt instruments.Forecastsof forthcomingdebtservicepayments fordomesticas
wellasexternaldebtneed tobeproducedandsentto the financialagentof theGovernment for
compliancewiththedebtserviceobligations.
TheOfficeperformsthebasic functionswhichpermitallotheroperational functions tobecarried
out.Thedistributionof taskstocomplywiththesefunctionscouldbedividedintothefollowing:(1)the Areaof Registrationconcerningtheregistryof debtinformationinthedatabase;(2)the Areaof
AccountingOperations,whichismainlyconcernedwiththeissueof thePayment Orders;and(3)the
Areaof theDatabase Administrator inchargeof thesystemandnetworkmaintenanceincludingthe
requiredinformationtechnology.ThesefunctionsshouldberegulatedbyaProceduresManualthat
setsnormsfortheflowof informationintheoperativecycleandthatlinkstheoperationalactivities
withthestructureandfunctionsof theDMO.
Under Areaof Registrationgrants,onlending,guaranteeddebtandcontingentliabilitiesshouldbe
registeredandmonitoredclosely,asshouldprivatenonguaranteeddebtanddebt incurredatthe
subnationallevel.
TheBackOfficenormallyhastodealwith largescalerequirementsfor informationonpublicdebt.
Internationalorganizations,differentareasof theexecutiveand legislativebranches, researchers,
and the media require reliable and continuously updated debt information. Transparency and
efficiencyingeneratinginformationisthusakeytaskof the“Areaof Registration”.101
Animportantactivityof thispartof theBackOfficeistoconductdatavalidationatregularintervals
inordertoensurethereliabilityof thedatabase.Normally,thisalsorequiresregularreconciliations
of data with creditors. The dissemination of information on public debt should be closely
coordinatedwiththeFrontandMiddleOffices.
The preparation of payment orders to service public debt can be performed by the Area of
AccountingOperations,withpaymentschedulesgeneratedbythefunctionalgroupsof the Areaof Registration,althoughtheactualaccountingfordebtservicepaymentsisnotnecessarilydoneinside
theDMO.With a reliable debt database and a debt system, the preparation of paymentorders
shouldberapidandefficient.Thepaymentorderscanbegeneratedandprinteddirectlyfromthe
databasesystem,basedonthedebtsystem’sinformation.Theprocessof debtservicepaymentsto
creditorsisperformedafterthereconciliationof thecreditors’requestswiththeamountsscheduled
inthedebtsystem’sdatabase.Thiscentralizationof publicdebtregistrationandmonitoringandthe
operative process for the issue of the payment orders represent important savings through the
reductionof processingtimeandtheeliminationof penaltiesforlatepayments.
101FormoredetailsonthistopicseeInformationandTransparencyinDebtManagement,presentationbyUdaibirS.Das,
IMF,inUNCTAD(2005).
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AppropriateInstitutional Settings for PublicDebt Management
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The Areaof AccountingOperationsof theBackOfficeshouldalsoensurethatbudgetaryprovisions
exist for (external and domestic) public debt service, including contingent liabilities, and that
sufficientsumsareallocatedtoreserves.
AwellorganizedBackOfficewillhave a structure for ensuring the efficient flowof information,adequate business processes, and the quality of information produced. Therefore, the structure
shouldbeorganizedwithadistributionof functionsthatclearlydefinesandestablishesthesources
of financingandthecoordinationof thedifferententitiesinvolved.
Under the Area of the Database Administrator the monitoring and control of publicdebt
information should be based on a methodical centralization of public credit operations in the
databaseof theDMO.Thedebtdatabase shouldcontainuptodate informationon thedomestic
andexternaldebtregistered in thesystem.The registrationof operationsof domesticorexternal
financinginthedatabasesystemisinitiatedwiththeopeningof loanfilesclassifiedbythetypeand
use of the financing, creditor, debtor, and executing agency. This registration will facilitate an
adequatecontrolof themanagementof disbursementsandpaymentsmadeduringthefiscalyearaswellastheprojectionof futuredebtservice.Thecontrolandmonitoringof theregistrationof new
loansinthedatabaseshouldbecarriedoutbytheheadof eachfunctionalgroup.Thestatusof the
database and its evolution should be evaluated in regular meetings among the heads of the
functionalgroupswhohavetheresponsibilityof executingtheworkprogram.
The inputof loan information to thedatabaseshouldbemonitoredandcontrolledperiodicallyby
the head of unit of the Back Office of the DMO. The technicians of the units should have the
responsibilitytorunlistsof loanstoverifytheconsistencyof theinformationandtocorrectthemif
necessary. The Database Administrator should perform the validation of the consolidated debt
information periodically. Errors and inconsistencies in the information can be detected through
consolidatedreports,andtheheadof eachgroupshouldbenotifiedforcorrections.Thestatusof thedatabaseand itsconsistencyshouldbeanalysed inperiodicmeetingswith theheadsof units
whohavetheresponsibilityof executingtheagreedworkprogram.
Confidence in thedebt informationprocessedand reportedby theDMOhasadirect relationship
withthequalityof datathatisenteredinthesystem.Inordertoensuretimelinessandhighquality,
theprocessingandreportingof debtinformationshouldberegulatedbyaresolutionorlegalnorm
thatinstructsalltheentitiesof thepublicsectortorespondtodatarequirementsof theDMO.
Thecontrolandsupervisionfunctionsof aDMOrequirethatdebtinformationbecollectedwithout
obstacles.Thiswillguaranteethattheauthoritieshaveaccesstouptodatedetailedandaggregated
information.Therefore it is important that theDMOestablishesdirectcontactwith theexecuting
agenciesorusersof resourcesandcreditors.InformationfromthesesourceswillbereconciledwiththatreceivedfromothersourcesincludingtheCentralBank.
It is also important that the institution in charge of monitoring the public investment program
providesallitsinformationtotheDMO.Thisinformationwillguaranteethattheprojectionsof debt
servicearecompatiblewithestimatesof disbursementsfor investmentprojects.Thiswillenhance
thequalityof theestimatesprovidedbytheDMOforthepreparationof theGovernment’sbudget.
(b)TheMiddleOfficeThe main function of the Middle Office is to conduct the analytical work required for assisting
executivemanagementlevelsindesigningadebtstrategyandaframeworkforriskmonitoringand
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control.Regulardebtportfolioreviewshouldbepartof theactivitiesof thisoffice incoordination
withothergovernmentoffices.
Otherimportantrolesof thisofficearethegenerationof managerialreportsonpublicdebtforusers
insidetheDMOandtheGovernment,andthepublicationandotherdisseminationof statisticsandother information related to policies concerning external and domestic debt. The preparationof
debt information and reports should be in accordance with standard requirements and specific
requests. The Procedures Manual should specify the reports that are required by various
governmententitiesandbyexternaluserssuchastheWorldBank,theIMF,regionaldevelopment
banks,ParisClubcreditors,civilsocietyandotherprivateparties.
Theworkprogramof theMiddleOffice should include thepreparationof monthlyandquarterly
managerial reports for the Ministry of Finance. The reports would comprise the stock of debt
outstandingandtransactionsthattookplaceduringspecificperiods.Thisworkprogramshouldalso
besupportedbythepreparationanddistributionof aStatisticalBulletinof PublicDebt.
The work program should also include estimates mainly used for analytical purposes such as
projectionsof disbursementsandpublicdebtservicewithvariousassumptionsconcerning interest
andexchangerates.Theusefulnessof suchestimateswillbeenhancedbythedevelopmentof the
capacitytoincorporatedebtdataintotheframeworkof balanceof paymentsandmacroeconomic
dataanalysis.Suchanexpanded frameworkwill facilitate thedesignand implementationof debt
strategies.
Forthisworkitmaybeusefultoestablishan Analytical Functionand aRisk AnalysisFunction.
The Analytical Functionwillperformportfolioanalysisinamacroeconomicframeworkandanalysis
of longtermdebt sustainabilityon a regularbasis.DSAneeds to include fiscal sustainability and
should also include scenario analysis of ways of meeting medium and longterm social and
economicneeds.ThiscanbeaccomplishedbyusingdifferentDSAanalyticaltools,suchastheWorld
Bank/IMFdebtdynamicstemplates,DebtProorDSM+.102
Performanceof sensitivity analysiswithdifferent assumptions about exchange rates and interest
rates allows theMiddleOffice toprovide information about the impactof differentdebt service
scenariosonfiscalandmonetaryvariables.Proposeddebtmanagementtargetsregardingcurrency
composition and amortization profiles are also part of the Middle Office’s responsibilities. This
functionwill provide a basis for theMinisteror the EDMC to evaluate themacroeconomicdebt
strategy and amend it, if necessary. The Analytical Functionwould also allow theDMO to adopt
strategieswithinthemandategiventoitandtoproposestrategychangestotheMinisterof Finance.
TheRisk AnalysisFunctionwillberesponsiblefortheevaluationandestablishmentof costandrisk
limits for the debt portfolio. This can be accomplished by scenario analysis involving different
assumptionsconcerningnotonlyexchangeandinterestratesbutalsoothermajormacroeconomic
variablessuchasglobaleconomicgrowthaswellasgrowthandpricesinthecountry’smajorexport
markets.
102Information on these analytical tools can be obtained through the websites of Debt Relief International or the
DMFAS/UNCTADProgramme.
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(c)TheFront OfficeThefunctionsof theFrontOfficearemostlyrelatedtothegatheringof financialresourcestocover
resourceutilizationandneedsrelatedtothepublicdebtordebt.Theythusincludealltheprocesses
involvingthenegotiationandcontractof newborrowing.
Thefrontofficeperformsthefunctionsthatcouldbedescribedasthoseof anEDMCSecretariat,i.e.
toensurethatthelaw,therulesandregulations,andtheguidelinesissuedbytheEDMCareapplied
andfollowed.ForthispurposetheFrontOfficerequiresproperlegaladvice.
Twomajor functionsof theFrontOfficeare the Implementation/Monitoring/NegotiatingFunction
andtheGovernment SecuritiesMarket Function.
The Implementation/Monitoring/Negotiating Function is responsible for the following up and
implementationof thedecisionstakenattheexecutive levelandforensuringthatimplementation
bytheGovernmentisestablishedinaccordance.Inlowerincomecountriesthisfunctionisalsolikely
tocoverattractingOfficialDevelopmentAssistance(ODA)andgrants.
The Government Securities Market Function comprises numerous responsibilities regarding the
developmentof markets for governmentdebt, and carryingout issuance, redemption, andother
tasksrelatedtomanagementof theGovernment’sdebt.
Theseincludethefollowing:
The development of securities market regulation to support the issuance and trading of
governmentsecurities;
The development of market infrastructure to help increase market liquidity and reduce
systemicrisk;
Strengtheningthedemandforgovernmentsecuritiesbybuildingthepotentialinvestorbase;
Improving the quality government securities in primary and secondary markets through
extendingmaturitiesandconsolidatingthenumberof issues;
MatchingtheGovernment’sfinancingneedswiththetermstructureof itsdebt;and
Creatingefficientchannelsforthemarketinganddistributionof governmentsecurities.
In itsGovernment SecuritiesMarket FunctiontheFrontOfficeshouldaimas faraspossibleat the
separationof instrumentsusedfordebtmanagement,ontheonehand,andformonetarypolicy,on
the other. When the market for government securities is limited to shortterm instruments, it
conflictsbetweenthepursuitof theobjectivesof monetaryanddebtpoliciesaredifficulttoavoid.
InmoresophisticatedDMOstheFrontOfficehasrolesinvolvingderivativestransactions,integrated
riskmanagement,accessingthe internationalcapitalmarkets,andprovidingvariousotherfinancial
servicestotheGovernment.
5. InstitutionalLocationof theDMO
AunifiedDMOwithconsolidatedfunctionsregardingoperationaldebtmanagementappearstobe
themostappropriatesettingforeffectivedebtmanagement.103Theexistenceof asingleinstitution
in charge of implementing debt policies permits a greater attention and concentration to debt
management issues and helps to ensure a clear separation between fiscal, monetary and debt
managementpolicies.103SeealsoCurrie,Dethier,andTogo(2003).
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Regardingthelocationof theDMOwiththeGovernmentpresentpracticesvary.
SeparateDMOs aremore frequent indeveloped economieswith sophisticated financialmarkets.
UnderthisarrangementDMOsimplementthedebtstrategiesdeterminedbytheMinisterof Finance
as an agency of the Government.104To ensure Government monitoring and control of debtmanagement, for example, through an EDMC, clear governance, legal and institutional
arrangements are put in place and strategic objectives and benchmarks for debt management
established.
Themainadvantagesof separateDMOscanbesummarizedasfollows:
(a) Greaterefficiencyinmanagingdebt;
(b) Moreindependencefrompoliticalinfluence;
(c) Thepossibilityof attractingqualifiedstaff atbettersalaries;and
(d) Latitude for the application of privatesector management practices and debt
techniques.
Anexampleof theorganizationalstructureof aseparateDMOisprovidedinBoxVII.5.
DMOsinsidetheMinistryof Finance(MOF)aremorecommoninlessdevelopedeconomies,where
morecoordination isneededbetweendebtmanagementandotherpoliciesowingtothevitaland
strategicroleof theformer.
Advantagesof thisarrangementarethefollowing:
(a) Greater coordination of debt management with the core activities of the MOF,
suchasfiscalandbudgetarypolicies;
(b) Moreflexibilityinmanagingcontingentliabilitiesandonlending;and
(c) Facilitationof handlingissuesrelatedtothefiscalsustainabilityof debt.
Fiscaldiscipline,socialandeconomicgrowth,anddebtsustainabilityareinextricablyintertwinedin
lessdevelopedeconomies.105
IneithercasetheMOFisultimatelyaccountableforincurringdebtonbehalf of theGovernmentand
delegatessomeof itsauthoritytotheDMOforthispurpose.Whenthedebtmanagementactivities
are consolidated in a single office with an appropriate organizational structure and governance
arrangements, there arenogreatdissimilaritiesbetween a separateDMO and aDMO inside the
MOF.
104RecentExperiencesintheOrganizationof DebtManagementOffices,presentationbyFredJenseninUNCTAD(2005).
105SeeBorresenandCosioPascal(2002).
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160
BoxVII.5.TheSeparateDMOof Nigeria
ThereareafewdevelopingcountriessuchasNigeriawithseparateDMOs.Thefigurebelowshows
thearrangementsof theNigerianDMO.
Supervisory Board
(Executive Debt Management)
DirectorGeneral (OPERATIONAL
(Operational Debt Management)
Public debt committee headed by
Minister of Finance
(Executive Debt Management)
Internal Audit
Front Office
Corporate
Affairs
Department
Back OfficeMiddle Office
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TechnicalPaperNº1(UNCTAD/GDS/DMFAS/2).NewYorkandGeneva,UnitedNations.
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ContaduriaGeneralde laNacion (2005). The Integrated Systemof Financial Information.Buenos
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IMF(2004).SovereignDebt Structure for CrisisPrevention.Washington,DC,July.
MagnussonT(2001).TheInstitutional and Legal Base for EffectiveDebt Management.UNCTADThird
InterRegionalDebtManagementConference,Geneva.
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UNCTAD (2004).EconomicDevelopment in Africa– Debt Sustainability:Oasisor Mirage,NewYork
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Abbreviations
ALM AssetandLiabilityManagement
BIS BankforInternationalSettlements
BOP Balanceof Payments
CB Centralbank
ComSec CommonwealthSecretariat
DMFAS DebtManagementandFinancialAnalysisSystem
DMOs DebtmanagementOffices
DSA DebtSustainabilityAnalysis
DSM+ DebtSustainabilityModelPlus
EDM ExecutiveDebtManagement
EDMC ExecutiveDebtmanagementCommitteeGDP GrossDomesticProduct
G8 Groupof Eight
G77 Groupof 77
IDA InternationalDevelopmentAgency
IFMS IntegratedFinancialManagementSystems
INTOSAI InternationalOrganizationof SupremeAuditInstitutions
IT/IS InformationTechnology/InformationSystems
IMF InternationalMonetaryFund
MDGs MillenniumDevelopmentGoals
MEFMI Macroeconomic&FinancialManagementInstituteof EasternandSouthernAfrica
MOF Ministryof FinanceODA OfficialDevelopmentAssistance
OECD OrganizationforEconomicCooperationandDevelopment
SAI SupremeAuditInstitutions
UN UnitedNations
UNCTAD UnitedNationsConferenceonTradeandDevelopment
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Annex
Source:INTOSAIGuidanceforPlanningandConductinganAuditof PublicDebt.
ManagingOperationalRisks
Operations risks arise in the areas that provide support services to the management of public debt.
Auditorswouldrecognizethefollowingoperationalriskswhentheyexaminetheorganizationalstructure
of publicdebtmanagement.
(a) Lack of separation of duties or functions. Public debt transactions must be independently
processed,confirmed,valued,andreviewed,andmonitoredbyanindependentadministrative
office.
(b) Inadequatestaff expertise.Supervisorsmusthave theproperexpertise toavoidbecominga
“rubberstamp”tothoseresponsiblefordebttransactions.Supportstaff isusuallythefirstline
of defensetouncovererrorsandirregularitiesthatmayoccurinprocessingdebttransactions.(c) Productrisk.Newdebtinstrumentscanbetoocomplexorpoorlyunderstood.Thiscanleadto
theinabilityof supportstaff toprocess,value,andcontrolnewdebtinstruments.
(d) System and technology risks. These risks exist when staff fails to stay up to date in its
understanding of technological developments associated with new information systems or
adopts computerized information systemswithout“reengineering” theirdebtmanagement
practices.
(e) Proceduresrisks.Theserisksexistwhenthedebtmanagementfunctionsdonothavewritten
proceduresand thework flow isnot structured inapredictableandwelldesignedmanner
withproperaudittrails.Thesewrittenproceduresbecomemoreimportant,themorecomplex
debtinstrumentsare.
(f) Disaster recovery risks. These risks exist when the debt organization has not planned for
alternativesites,computerresources,communications,resources,tradingfacilities,andothersupportservices inthecaseof adisaster.Thoseresponsiblefordebttransactionsmusthave
alternativeremotetradingandtechnologysites.
(g) Documentation risks. These risks exist when debt transactions do not have welldesigned
agreements that are legally authorized, properly executed and supported by appropriate
confirmation inatimelymanner.Legaldepartmentsandsupportstaff mustmaintainmaster
agreementsandsupportingconfirmations.
(h) Valuationrisks.Theserisksexistwhenthesupportstaff cannotperform,atleastonaregular
basis,anindependentvaluationof alldebtinstrumentsorif thevaluationof thesupportstaff
differs from the valuation of the Supreme Audit Institutions (SAI) or an independent third
party.
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CHAPTERVIII
CREDITRATINGAGENCIESANDTHEIRPOTENTIAL
IMPACTONDEVELOPINGCOUNTRIES
MarwanElkhoury
(IndependentConsultant)
A. Introduction
Credit rating agencies (subsequently denoted CRAs) specialize in analysing and evaluating the
creditworthiness of corporate and sovereign issuers of debt securities. In the new financial
architectureCRAsareexpectedtobecomemore important in themanagementof bothcorporate
and sovereign credit risk.Their rolehas recently received aboost from the revisionby theBasel
CommitteeonBankingSupervision(BCBS)of capitalstandardsforbanksculminatinginBaselII.
The logicunderlyingtheexistenceof CRAs istosolvetheproblemof the informationalasymmetrybetween lenders and borrowers regarding the creditworthiness of the latter. Issuers with lower
credit ratingspayhigher interest ratesembodying larger riskpremiums thanhigherrated issuers.
Moreover,ratingsdeterminetheeligibilityof debtandotherfinancialinstrumentsfortheportfolios
of certain institutional investorsduetonationalregulationsthatrestrict investment inspeculative
gradebonds.
The rating agencies fall into two categories, recognized and nonrecognized. The former are
recognizedby supervisors ineach country for regulatorypurposes. In theUnitedStatesonly five
CRAs(of whichthebestknownareMoody’sandStandard&Poor’s)arerecognizedbytheSEC.The
majority of CRAs such as the Economist Intelligence Unit (EIU), Institutional Investor (II), and
Euromoneyare“nonrecognized”.
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ThereisawidedisparityamongCRAs.Theymaydifferinsizeandscope(geographicalandsectoral)
of coverage.Therearealsowidedifferences in theirmethodologiesanddefinitionsof thedefault
risk,whichrenderscomparisonbetweenthemdifficult.
Regardingtheirrolevisàvisdevelopingcountries,thesovereignratingisparticularlyimportant.AsdefinedbyNagy (1984),“Country risk is theexposuretoa loss incrossborder lending,causedby
events in a particular country which are at least to some extent under the control of the
Governmentbutdefinitelynotunder thecontrolof aprivateenterpriseor individual”.Under this
definitionall formsof crossborder lending inacountry,whether totheGovernment,abank,a
privateenterpriseoran individualareincluded.Countryrisk isthereforeabroaderconceptthan
sovereignrisk.Thelatterisrestrictedtotheriskof lendingtotheGovernmentof asovereignnation.
However, sovereign and country risk arehighly correlated as theGovernment is themajor actor
affectingboth.Moreover,thereonlyrareexceptionstotheprincipleof thesovereignceiling;i.e.the
debtratingof acompanyorbankbasedinacountrycannotexceedthecountry’ssovereignrating.
Thefailureof bigCRAstopredictthe19971998Asiancrisisandtherecentbankruptciesof Enron,WorldComandParmalathaveraisedquestionsconcerningtheratingprocessandtheaccountability
of CRAsandhaspromptedlegislatorstoscrutinizeratingagencies.Thisreportgivesanoverviewof
thesovereigncreditratingindustry,analysesitsimpactondevelopingcountriesandassessessome
of theCRAs’shortcomingsinthecontextof concernsthathaverecentlybeenraised.
B. CreditRatingAgenciesintheInternationalFinancialSystem
1. Asymmetryof InformationandCRAsas“Opinion”Makers
A credit rating compresses a large variety of information that needs to be known about thecreditworthiness of the issuer of bonds and certain other financial instruments. The CRAs thus
contribute to solving principalagent problems by helping lenders “pierce the fog of asymmetric
information that surrounds lending relationships and help borrowers emerge from that same
fog”(White(2001)).
CRAs stress that their ratings constituteopinions.Theyarenota recommendation tobuy, sellor
holdasecurityanddonotaddressthesuitabilityof aninvestmentforaninvestor.Ratingshavean
impacton issuersviavariousregulatoryschemesandbydeterminingtheconditionsandthecosts
under which they access debt markets. Regulators have outsourced to CRAs much of the
responsibility forassessingdebt risk.For investors ratingsareascreening tool that influences the
compositionof theirportfoliosaswellastheirinvestmentdecisions.
2. CreditRatingsandBaselII
Regulatory changes inbanks’ capital requirementsunderBasel IIhave resulted inanew role for
creditratingagencies.Ratingscanbeusedtoassigntheriskweightsdeterminingminimumcapital
chargesfordifferentcategoriesof borrower.UndertheStandardizedApproachtocreditriskBaselII
establishes credit risk weights for each supervisory category which rely on “external credit
assessments”(seeBoxVIII.1.).Moreover,creditratingsarealsousedforassessingrisks insomeof
theotherrulesof BaselII.
Theimportanceof ratingsbasedregulationsisparticularlyvisibleintheUnitedStates,whereitcanbetracedbacktothe1930s.Theseregulationsnotonlyaffectbanksbutalsoinsurers,pensionfunds,
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mutual funds and brokerdealers by restricting or prohibiting the purchase of bonds with “low”
ratings, i.e. noninvestment grade or speculativegrade ratings.106While ratingsbased regulations
arelesscommoninEurope,theyarepartof thenewCapitalRequirementsDirectivethattheEUwill
implementthroughBaselII.
Various writers such as Reisen (2002) have expressed the view that the Basel II Accord may
destabilizeprivatecapitalflowstodevelopingcountries.Thiswouldbetrueif thecloserlinksunder
Basel II between the levels of banks’ regulatory capital and their assessment of credit risks
accentuated procyclical fluctuations in their lending.Moreover the same linkmay also result inhigher interest rates than under the 1988 Accord for less creditworthy developingcountry
borrowers. The ratings of CRAs may contribute to unfavorable effects under both headings. As
discussedbelow, changes in these ratings sometimes follow closely cyclical changes ineconomic
conditions.Moreoverowingtotheirlowcreditratingscertaindevelopingcountriesmaybeassigned
higherweights forcreditriskthanunder1988CapitalAccordandthusbechargedhigher ratesof
interestontheirborrowing.
106ThemajorCRAshave theirown ratingsschemeswhichdiffer fordifferentcategoriesof debt – longand shortterm,
bankandnonbank and in thecaseof Fitch’s ratings forbanks include the likelihoodof external support, should this
becomenecessarytoenablethemtocontinuemeetingtheirfinancialobligationsonatimelybasis.Thebestknownratings
arethoseof StandardandPoor’sandMoody’sforlongtermdebt,whichvarybetweenAAAandBBBforinvestmentgradeforStandardandPoor’s(AaaBaa3 forMoody’s)andbetweenBB+andCC forspeculativegradeforStandardandPoor’s
(Ba1CforMoody’s).Formoredetailsseetable1of Annex2.
BOXVIII.1.BaselII
Themajorobjectiveof Basel II istorevisetherulesof the1988BaselCapitalAccord insuchawayasto
alignbanks’regulatorycapitalmorecloselywiththeirrisks,takingaccountof progressinthemeasurement
andmanagementof theserisksandtheopportunitieswhichtheseprovideforstrengthenedsupervision.
UnderPillar1of Basel2 regulatorycapital requirements for credit riskare calculatedaccording to two
alternative approaches, the Standardized and the Internal RatingsBased. Under the Standardized
Approach(SA)themeasurementof creditriskisbasedonexternalcreditassessmentsprovidedbyexternal
creditassessment institutions (ECAIs)suchascreditratingagenciesorexportcreditagencies.Underthe
internal ratingsbasedapproach (IRBA), subject to supervisoryapprovalas to the satisfactionof certain
conditions,banksusetheirownratingsystemstomeasuresomeorallof thedeterminantsof creditrisk.
Underthefoundationversion(FIRBA)bankscalculatetheprobabilityof default(PD)onthebasisof their
ownratingsbutrelyontheirsupervisorsformeasuresof theotherdeterminantsof creditrisk.Underthe
advancedversion (AIRBA)banksalsoestimate theirownmeasuresof allthedeterminantsof creditrisk,
includinglossgivendefault(LGD)andexposureatdefault(EAD).
Under the regulatory capital requirements foroperational risk thereare threeoptionsof progressively
greater sophistication. Under the Basic Indicator Approach (BIA) the capital charge is a percentage of
banks’gross income.UndertheStandardizedApproach(SAOR)thecapitalcharge isthesumof specified
percentagesof banks’gross income fromeightbusiness lines (oralternatively for twoof thesebusiness
lines,retailandcommercialbanking,of differentpercentagesof loansandadvances).UndertheAdvanced
MeasurementApproach (AMA), subject to the satisfactionof more stringent supervisory criteria,banksestimatetherequiredcapitalwiththeirowninternalsystemsformeasuringoperationalrisk.
Pillars 2 and 3 of Basel 2 are concerned with the supervisory review of capital adequacy and the
achievementof marketdisciplinethroughdisclosure.
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C. CRAs’ProceduresandMethods
1. QuantitativeandQualitativeMethods
TheprocessesandmethodsusedtoestablishcreditratingsvarywidelyamongCRAs.Traditionally
CRAshave reliedon aprocessbasedon aquantitative andqualitative assessment reviewed and
finalizedbya rating committee.More recently therehasbeen increased relianceonquantitative
statisticalmodelsbasedonpublicly availabledatawith the result that the assessmentprocess is
more mechanical and involves less reliance on confidential information. No single model
outperformsalltheothers.Performanceisheavilyinfluencedbycircumstances.
A sovereign rating is aimed at “measuring the risk that a Government may default on its own
obligationsineitherlocalorforeigncurrency.Ittakesintoaccountboththeabilityandwillingnessof
aGovernment to repay itsdebt ina timelymanner” (Moody’s,SpecialComment (2006)).Thekey
measure increditriskmodels isthemeasureof theprobabilityof default,PD,butexposure isalsodetermined by the expected timing of default and by the recovery rate, RE, after default has
occurred.
(a) S&P ratings seek to capture only the forwardlooking probability of the occurrence of
default.Theyprovidenoassessmentof theexpectedtimeof defaultorof modeof default
resolutionandrecoveryvalues.
(b) BycontrastMoody’sratingsfocusontheExpectedLoss,EL,whichisafunctionof bothPD
andtheexpectedrecoveryrate,RE.ThusEL=PD.(1RE).
(c) Fitch’s ratings also focusonbothPD andRE (Bhatia,2002).Theyhaveamoreexplicitly
hybridcharacterinthatanalystsarealsoremindedtobeforwardlookingandtobealertto
possiblediscontinuitiesbetweenpasttrackrecordsandfuturetrends.
The credit ratings of S&P andMoody’s are assigned by rating committees and not by individual
analysts. There is a large dose of judgment in the committees’ final ratings CRAs provide little
guidanceastohowtheyassignrelativeweightstoeachfactor,thoughtheydoprovideinformation
on what variables they consider in determining sovereign ratings. Identifying the relationship
betweentheCRAs’criteriaandactualratings isdifficult, inpartbecausesomeof thecriteriaused
areneitherquantitativenorquantifiablebutqualitative.Theanalyticalvariablesareinterrelatedand
the weights are not fixed either across sovereigns or over time. Even for quantifiable factors,
determiningrelativeweightsisdifficultbecausetheagenciesrelyonalargenumberof criteriaand
thereisnoformulaforcombiningthescorestodetermineratings.
InassessingsovereignriskCRAshighlightseveralriskparametersof varyingimportance:economic,
political, fiscal and monetary flexibility and the debt burden (see Box VIII.2.). Economic risk
addresses the ability to repay its obligations on time and is a function of both quantitative and
qualitative factors.Politicalriskaddressesthesovereign’swillingnesstorepaydebt.Willingnessto
pay is a qualitative issue that distinguishes sovereigns from most other types of issuers. Partly
becausecreditorshaveonly limitedlegalredress,aGovernmentcan(andsometimesdoes)default
selectively on its obligations, even when it possesses the financial capacity for debt service. In
practice,politicalriskandeconomicriskarerelated.AGovernmentthatisunwillingtorepaydebtis
usuallypursuingeconomicpolicies thatweaken itsability todo so.Willingness topay, therefore,
encompasses the rangeof economic andpolitical factors influencing governmentpolicy (seeBox
VIII.2.).
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Broadly speaking, the economic variables aim at measuring three types of performance: (1)
measuresof domesticeconomicperformance,(2)measuresof acountry’sexternalpositionandits
ability to service its external obligations and (3) the influence of external developments. Bhatia
(2002) notes that CRAs’ analysis prior to the Asian financial crisis focused on traditional
macroeconomic indicatorswith limitedemphasisoncontingent liabilityand international liquidity
considerations.Moreoverprivatesectorweaknesseswerenotincludedintheanalysisof sovereign
rating.
Inpractice,asmallnumberof variablesGDPpercapita,realGDPgrowthpercapita,theconsumer
priceindex(CPI),theratioof governmentfiscalbalancetoGDP,andgovernmentdebttoGDPhave
a large impacton credit ratings.(The relationshipbetween these indicators and S&P’s ratings are
illustrated in figures15of Annex1.).Byand large,higherGDPpercapita lead tohigher ratings;
higherCPI to lower ratings, the lower the rating, the lower thegovernmentbalanceasa ratio to
GDP;higherfiscaldeficitsandgovernmentdebtinrelationtoGDPalsolowerratings.
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Source:S&P,“SovereignCreditRatings:APrimer”,October2006.
Notes:NFPEs:Nonfinancialpublicsectorenterprises.
BoxVIII.2.S&PSovereignRatingsMethodologyProfile
Politicalrisk
Stabilityandlegitimacyof politicalinstitutions
Popularparticipationinpoliticalprocesses
Orderlinessof leadershipsuccessions
Transparencyineconomicpolicydecisionsandobjectives
Publicsecurity
Geopoliticalrisk
Incomeandeconomicstructure
Prosperity,diversityanddegreetowhicheconomyismarketoriented
Incomedisparities
Effectivenessof financialsectorinintermediatingfunsavailabilityof credit
Competitivenessandprofitabilityof nonfinancialprivatesector
Efficiencyof publicsector
Protectionismandothernonmarketinfluences Laborflexibility
Economicgrowthprospects
Sizeandcompositionof savingsandinvestment
Rateandpatternof economicgrowth
Fiscalflexibility
Generalgovernmentrevenue,expenditure,andsurplus/deficittrends
Revenueraisingflexibilityandefficiency
Expenditureeffectivenessandpressures
Timeliness,coverageandtransparencyinreporting
Pensionobligations
Generalgovernmentburden
Generalgovernmentgrossandnet(of assets)debtasapercentof GDP
Shareof revenuedevotedtointerest
Currencycompositionandmaturityprofile
Depthandbreadthof localcapitalmarkets
Offshoreandcontingentliabilities
Sizeandhealthof NFPEs
Robustnessof financialsector
Monetaryflexibility
Pricebehaviorineconomiccycles
Moneyandcreditexpansion
Compatibilityof exchangerateregimeandmonetarygoals
Institutionalfactorssuchascentralbankindependence
Rangeandefficiencyof monetarygoals
Externalliquidity
Impactof fiscalandmonetarypoliciesonexternalaccounts
Structureof thecurrentaccount
Compositionof capitalflows
Reserveadequacy
Externaldebtburden
Grossandnetexternaldebt,includingdepositsandstructureddebt
Maturityprofile,currencycomposition,andsensitivitytointerestratechanges
Accesstoconcessionallending
Debtserviceburden
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2. EmpiricalAssessmentsof CreditRatingDeterminants
Anumberof economistshaveestimatedeconometricallythedeterminantsof creditratingsforboth
matureandemergingmarkets(CantorandPacker(1995,1996),Haqueetal.,(1996,1997),Reisen
andvonMaltzan(1999),JuttnerandMcCarthy(2000),andBhatia,(2002)).Inthesestudiesasmall
numberof variablesexplain90percentof thevariationintheratings:
GDPpercapita;
GDPgrowth;
Inflation;
Theratioof nongoldforeignexchangereservestoimports;
Theratioof thecurrentaccountbalancetoGDP;
Defaulthistoryandthelevelof economicdevelopment.
Indeed, a single variable, GDP per capita, explains about 80 percent of the variation in ratings
(Borenszstein and Panizza (2006)). It is worth noting that the fiscal position, measured by theaverageannualcentralgovernmentbudgetdeficit/surplus ratio toGDP, in the threeyearsbefore
the rating year and the external position measured by the average annual current account
deficit/surplus in relation to GDP, in the three years before the rating year, were found to be
statisticallyinsignificant.
Whileincludingpoliticaleventscanimprovetheexplanatorypowerof theregressions,theexclusion
of politicalvariablesdoesnotbiastheparameterestimates(Haqueetal.,1996;CantorandPacker,
1996). In addition, for developingcountry ratings, two other variables adversely affected ratings
independentlyof domesticeconomicfundamentals(Haqueetal.,1996,1997):
Increasesininternationalinterestrates;
Thestructureof itsexportsanditsconcentration.
JüttnerandMcCarthy(2000)foundastructuralbreak inratingsassessmentin1997 inthewakeof
theSouthEastAsiancrisis.“[…]Econometricestimatesmayconveywrongormeaninglesssignalsto
investorsduringaratingcrisis…thereisnosetmodelorframeworkfor judgmentwhicharecapable
of explaining the variations in assignment of sovereign ratingsover time” (Jüttner andMcCarthy
(2000)).Theauthorsaddinafootnotethatthismeansthatinaglobalfinancialcrisisratingsmodels
might become completely obsolete since a stable relationship between rating and their
determinantsmightbeimpossibletoidentify.
In theiranalysisof thedeterminantof ratingsduring theAsiancrisis, JüttnerandMcCarthy found
thatthefollowingvariables:
TheCPI;
Theratioof externaldebttoexports;
Adummydefaulthistory,and;
Theinterestratedifferential;
Therealexchangerate.
Neither the interest rate differential nor the real exchange rate were found to be significant
determinantspriortotheAsiancrisisthusindicatingthatthesevariablesmayhavebeenoverlooked
by the agencies before the crisis. Variables denoting financial strength were not found to be
significantdeterminantsof sovereign ratingsevenoneyearafter theAsian crisis.However, these
variables were subsequently included in ratings assessments by the major CRAS following their
unsatisfactoryperformanceduringAsiancrisis.
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3. RatingDifferences,Notching,SolicitedandUnsolicitedRatings
Although CRAs have different concepts and measurements of the probability of default, various
studieswhichhavecomparedMoody’sandS&P’ratings,havefoundagreatsimilarityforinvestment
graderatings(CantorandPacker,1996;AmmerandPacker,2000).Inthecaseof speculativegrade
issues,Moody’sandS&Passigndivergentratingsmuchmorefrequentlytosovereignbondsthanto
corporate bonds. The literature also finds clear evidence of differences in rating scales oncewe
movebeyondthetwolargestagencies.Forexample,ratingsforthesameissuertendtobelowerfor
thetwolargestagenciesthanforotheragenciessuchasFitchorDuff andPhelps.
Someof thesedifferences canbeexplainedby sample selectionbias.The analysisof Cantorand
Packer(1996)pointstoonlylimitedevidenceof significantselectionbiasandsignificantevidencefor
differences in rating scalesbetween larger and smallCRAs.Regardlessof ratingsdifferences, the
market appears to reward issuers with a lower interest costs when a third rating is assigned,
especiallywhentheratingishigher(BCBS(2000)).
Fitch and the EganJones Ratings Company have accused the two big CRAs of practicing the
“notching”, a practice whereby S&P and Moody’s would initiate an automatic downward of
structuredsecurities,if thetwoagencieswerenothiredtoratethem(EganJonesRatingsCompany,
2002).Moody’s response toFitch’saccusations is thatunsolicited ratingsusually result ina lower
rating for debt securities because of either a lack of information or the use of different
methodologiestodeterminetheprobabilityof default.
Unsolicitedratingsraisepotentialconflictsof interest.BothMoody’sandS&Pstatethattheyreserve
therighttorateandmakepublicratingsforUnitedStatesSECregisteredcorporatebonds,whether
ornot requestedbyan issuer. If the issuerdoesnot request the rating, the ratingwill simplybe
based on publicly available information. If the issuer requests the rating, then it providesinformationtotheratingagencyandpaysthefees.Manynewentrantsinthecreditratingindustry
issueunsolicitedratingstogaincredibility inthemarket.Some issuershaveaccusedCRAsof using
unsolicitedratingsandthethreatof lowerratingsinduceissuerstocooperateintheratingprocess
andpaythefeesof solicitedratings.107
Since2001,Moody’sclaimsthatithasnotdoneanyunsolicitedratinginEurope.S&Palsoclaimsnot
todo anyunsolicited ratingoutside theUnitedStates.Asunsolicited ratings arebasedonpublic
information and thus lack issuer input, the issue of unsolicited ratings could be addressed by
requiring CRAs to disclose whether it has been solicited or not. Both Moody’s and S&P already
specify in their ratingswhether the ratinghasbeen solicited and give issuers theopportunity to
participateatanystageof theprocessif theywish.
D. Impactof Ratings
1. CostsandBenefitsof ObtainingaRating
Asmentioned earlier, the primary purpose of obtaining a rating is to enhance access to private
capitalmarkets and lowerdebtissuance and interest costs. Theoreticalwork (Ramakrishnan and
Thakor, 1984; Millon and Thakor, 1985) suggests that credit rating agencies, in their role as
informationgatherersandprocessors,can reducea firm’scapitalcostsbycertifying itsvalue ina
107SEC,‘Concept’Release.RatingAgenciesandtheUseof CreditRatingsundertheFederalSecuritiesLaws,Securitiesand
ExchangeCommission.ReleaseNos.338236;3447972;IC26066.
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market,thussolvingorreducingtheinformationalasymmetriesbetweenpurchasersandissuers.For
sovereign borrowers, there is evidence of a clear correlation between bond spreads and rating
grades,asshowninFigureVIII.1.,(BIS(2006)):thelowertherating,thehigherthespread.
FigureVIII.1.BondSpreadsbyRatings
Source:BISQuarterlyReview,March2006fromJPMorgan
ChaseEMBIGlobalDiversified(EMBIGD).
There areother indirectbenefits from ratings for low income countries,namely to fosterFDI, to
promote more vibrant local capital markets, and increase publicsector financial transparency(StandardsandPoor’s(2004)).Asaresult,evensomesovereignsthatdonot intendto issuecross
borderdebtintheimmediatefutureseekcreditratingsfromCRAs.
Foremergingmarkets,thereisanimportantexternalityof obtainingarating,thatof the“sovereign
ceiling”effect.Borenzsteinetal.(2006)findthat,althoughithasbeenrelaxedsince1997,theeffect
of thesovereignceilingremainsstatisticallyhighlysignificant,especiallyforbankcorporations,being
more importantforbanksthatreside incountrieswithahigh levelsof sovereigndebtandsmaller
forbankswithstrongforeignparents.
2. BoomsandBusts:FinancialCrisesinEmergingMarketsandtheProcyclicalityof
Ratings
The19971998Asian crisishighlightedCRAs’potential for reinforcingboomsandbustsof capital
flows.As ratingswere lagging insteadof leadingmarketeventsandoverreactedduringboth the
preandpostcrisisperiods,theymayhavehelpedtoamplifythesecycles.
Severalempiricalstudiesshowthatsovereignratingsaresticky,laggingmarketsentimentandover
reactingwithalagtoeconomicconditionsandthebusinesscycle.Larrain,ReisenandvonMaltzan
(1997)havefoundthatratingsarecorrelatedwithsovereignbondyieldspreads.Intheaftermathof
the19941995Mexicancrisis,theauthorsfindatwowaycausalitybetweensovereignratingsand
marketspreads.Notonlydo internationalcapitalmarkets react tochanges inthe ratings,but the
ratingssystematicallyreact,withalag,tomarketconditionsasreflectedinthesovereignbondyield
spreads.Thisstudyalsoindicatesahighlysignificantannouncementeffectwhenemergingmarkets
sovereignbondsareputon reviewwithnegativeoutlook.Moreover, the study findsa significant
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negative effect of rating announcements: following a rating downgrade investors readjust their
portfolios.Positiveratingannouncements,bycontrast,donotseemtohaveasignificanteffecton
bondspreads.
Moody’s more recent (2003) report on procyclicality claims that the relative stability of creditratings compared to marketbased indicators suggests that ratings were more likely to dampen
ratherthantoamplifythecreditcycle,andthatmostratingchangesreflectedlonglastingchanges
in fundamentalcredit riskratherthan temporarycyclicaldevelopments.The relationshipbetween
creditratingsandcyclicality –andthustheimpactof changes intheCRAs’practicesinresponseto
shortcomingsrevealedbythecrisesof the1990sthusremainsanopenempiricalquestion.
3. AccuracyandPerformanceof Ratings
CRAs’failuretopredicttheMexicanandAsianfinancialcriseswasdue,amongotherthings,tothe
fact that contingent liability and international liquidity considerations had not been taken into
accountbyCRAs..
ConcerningtheAsiancrisis,Moody’sacknowledgedthat ithadbeenconfrontedwithanewsetof
circumstancesrequiringaparadigmshiftinthefollowingareas:
Greater analytic emphasis on the risks of shortterm debt for otherwise creditworthy
countries;
Greateremphasisontheidentityandcreditworthinessof acountry’sshorttermborrowers;
Greaterappreciationof therisksposedbyaweakbankingsystem;and
Greaterattentiontotheidentityandlikelybehaviorof foreignshorttermcreditors;
Increasedsensitivity to the risk thata financialcrisis inonecountrycan lead tocontagion
effectsforothercountries.
Abalancehastobefoundinthetradeoff betweenaccuracyandstability.Ratingagenciesareaverse
toreversingratingswithinashortperiodof time.BothMoody’sandS&Pintendtheirratingstobe
stablemeasuresof relativecredit risk.Moody’sclaims that thiscorresponds to issuers’aswellas
institutionalinvestors’wishesandthatits“desire for stableratingsreflectstheview that morestable
ratingsare“better” ratings.
Bhatia (2002)hasmeasured“failures”basedon ratingsstability.Withexceptions for someof the
lowestratingshedefinesa“failedrating”asonethatisloweredorraisedby“threeormorenotches
within12months.Thechoiceof threenotches isrelatedtothesmallprobabilityof athreenotch
ratingchangeamongCRAs.ApplyingtheBhatiadefinitionof ratingfailuretothe longtermforeign
currency sovereign ratingsof S&PandMoody’s in19972002, shows thatS&PandMoody’sboth
experienced failures during the Asian crisis; S&P also failed during the Russian and Argentinean
crisis; and Moody’s failed during the Russian but not the Argentinean crisis (see table VIII.1.).
Bhatia’sfailuredefinitionsuggeststhatratingfailureswerelessprevalentin19992002thanin1997
1998.
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TableVIII.1.SovereignRatingsFailureStatistics,199720021/
Source:Bhatia,2002,Box5.
In response to criticism concerning such failures, Moody’s has introduced “Watchlist” and S&P’s
launched “Outlook” reports in order to alleviate the tension between accuracy and stability by
providingtimelywarningsof likelyratingchanges.
Ratings performance can also be compared with market indicators. IMF (1999) conducted an
analysisof yieldspreadsinrelationtotheAsiancrisisandfoundthatoneyearaheadof thecrisisin
Thailand, Indonesiaand theRepublicof Korea,sovereignspreadswerequite low of theorderof
100150basispoints.InRussiaandBraziltheywerehigherabout300basispoints.Thus,inrelative
terms the markets were in broad agreement with the CRAs with respect to these countries,
indicating a higher risk of default for Russia and Brazil than for the Asian countries. Moreover,
spreads did not widen much initially in response to the onset of the Asian crisis, a patternconformingtothatof theratings.Thustheperformanceof financialmarketsbroadlyparalleledthat
of themajorCRAs.
4. Impactof RatingsonPoliciesPursuedbyBorrowingCountries
Forborrowingcountriesaratingdowngradehasnegativeeffectsontheiraccesstocreditandthe
costof theirborrowing(CantorandPacker,(1996)).Althoughpreciseinformationisnotavailableon
the way in which macroeconomic policies are taken into consideration by CRAs in establishing
sovereign ratings, it is reasonable to assume thatorthodoxpolicies focusingon the reductionof
inflation and governmentbudgetdeficits are favored. There is a risk, therefore, that in order to
avoidratingdowngradesborrowingcountriesadoptpoliciesthataddresstheshorttermconcernsof
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portfolioinvestorsevenwhentheyareinconflictwithlongtermdevelopmentneeds.However,this
isanissuewhichhasnotbeenthesubjectof systematicresearch.
E. PublicPolicyConcerns
1. RecentRegulatoryInitiatives
Inviewof thecriticalroleplayedbyCRAs inthemodernfinancialarchitecture,policymakershave
recentlyfocusedonsomeshortcomingsarisingfromthefollowingconcerns:
Barrierstoentryandlackof competition;
Conflictsof interest;
Transparency;
Accountability.
These concerns have been raised by the International Organization of Securities Commission,
(IOSCO), theUnitedStatesSecuritiesandExchangeCommission, (SEC), theEuropeanCommission
Committee of European Securities Regulations, (CESR), and by the United States Congress and
Senate.
Onthebasisof Section702of theSarbanesOxleyActof 2002theUnitedStatesCongressmandated
theSECtoissueaReportontheRoleandFunctionof CreditRatingAgenciesintheoperationof the
SecuritiesMarkets.Thiswastoaddressseveralissuespertainingtothecurrentroleandfunctioning
of CRAs including the information flow in the creditrating process, barriers to entry artificially
createdby theNationallyRecognizedStatisticallyRatingOrganizations (NRSRO)designation in the
UnitedStates,andconflictsof interestorabusivepractices.
Areviewof theconceptof NRSROwasalreadyunderwayattheSEC.InJune2003,theSECissueda
ConceptRelease seeking commentswith respect towhetherCRAs’ ratings should continue tobe
usedforregulatorypurposes,andif so,whethertheNRSROcertificationprocedurewasappropriate
aswellasmoregenerallywhat shouldbe theadequate levelof regulatoryoversight forCRAs. In
April2005,theSECreleasedaProposedRuleaimingatinsuringahigherlevelof transparencywith
respecttotheNRSROconcept.
The technicalcommitteeof the IOSCO issued three reports inSeptember2003: (i)Reporton the
Activitiesof CreditRatingAgencies; (ii) Statement of Principles Regarding theActivitiesof Credit
Rating Agencies; (iii) and Report on Analyst Conflicts of Interest. These reports highlighted the
important role CRAs play in financial markets, and aimed at ensuring greater reliability for their
ratings.InDecember2004,theIOSCOpublisheditsCodeof ConductFundamentalsforCreditRating
Agencies (the IOSCOCode)which aimed atdeveloping “governance rules” forCRAs to ensure (i)
quality and integrity of the rating process, (ii) independence of the process and avoidance of
conflicts of interest and (iii) greater transparency in the methodology of ratings and adequate
treatment of confidential information. However, the IOSCO Code did not address the issue of
enforcementof theCode,recommendingthatCRAsadopttheserulesvoluntarily.
InresponsetoIOSCO’sCodeof ProfessionalConduct,Moody’sandS&PpublishedtheirownCodeof
Professional conduct in the secondhalf of 2005, thus aligning theirpolicies andprocedureswith
IOSCO’s Code. In the spring of 2006, Moody’s and S&P published their first report on the
implementationof theCodeof conduct.Hereitwasstatedthat,evenbeforetheSECandIOSCOhad
recommended new rules of conduct in 2003, the two agencies had already established internal
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codes of conduct and procedures to prevent and manage potential conflict of interest and to
safeguardtheindependenceandobjectivityof theirratingprocesses.
Considerationof theissuesrelatedtoCRAsbytheUnitedStatesCongresseventuallyculminatedin
the Credit Rating Agency Reform Act which was signed into law in early September 2006. Thisamended theSecuritiesExchangeActof 1934 to redefineanNRSROasanyCRA thathasbeen in
business for at least three consecutive years and is registered under the Act. It also prescribed
procedural requirements for mandatory NRSRO registration and certification. It granted the SEC
exclusiveenforcementauthorityoveranyNRSROandauthorizedtheSEC(i)totakeactionagainstan
NRSRO that issued credit ratings in contravention of procedures, criteria and methodologies
included in its registration application, and (ii) to censure, or limit, suspend or revoke the
registrationof anNRSROforviolationsof theAct.
IntheEU,theEnronandParmalatcollapsesprompteddiscussionsonCRAreliability.Inresponsetoa
call by Commission for advice the CESR released inMarch 2005 “CESR’s TechnicalAdvice to the
EuropeanCommissiononpossibleMeasuresConcerningCreditRatingAgencies”.
2. Issuesof Concern
(a)Barrierstoentry and lack of competitionIntheUnitedStatesthereareonly5CRAsdesignatedbytheSECasNRSROs:A.M.Best.,Dominion
BondRatingService(DBRS),Fitch,Moody’sInvestorsService(Moody’s)andtheStandard&Poor’s
(S&P)divisionof McGrawHill.DBRSisCanadianbasedwitharegionalscopeandtheonlynonU.S.
NRSRO designated agency. A.M.Best is a global agency which rates the debt only of insurance
companies.Thus there are three globalNRSROsprovidinga comprehensive service in theUnited
States,of whichtwoagencies,Moody’sandS&P,controlover80percentof themarket.Themeannumberof CRAsrecognizedamongtheBCBS’membercountriesisaroundsixandtherearebetween
130150creditratingagencies intheworld.However,onlyasmallnumberof CRAsarerecognized
internationallyandthenumberhasnotchangedmuchsincethe1970s(BCBS,2000).
AccordingtotheUnitedStatesDepartmentof Justice,theNRSROdesignationhasactedasabarrier
toentry inacatch22manner108.Anew ratingagencycannotobtainnational recognitionwithout
NRSROstatusand itcannotobtainNRSROstatuswithoutnationalrecognition.Inthewordsof the
RapidRatingstestimonybeforetheCommitteeonFinancialServices(H.R.2990(2005b,p.8)),“the
effect of this catch22 has been to preserve a duopoly that has thwarted competition and
innovation”.
In an effort to increase competition and improve the quality of credit ratings Representative
FitzpatrickintroducedH.R.2990,TheCreditRatingAgencyDuopolyRelief Actof 2005.Hebelieved
thattheSECNRSROdesignationconstitutedan“insurmountableandartificialbarriertoentry…[…]
Lackof competition in the industryhas led to inflatedprices, stifled innovation, lowerqualityof
ratings,anduncheckedconflictsof interestandanticompetitivepractices.”(H.R.2990(2005a),p.4
5)).Thisbillwasthebasisof theCreditRatingAgencyReformActof 2006(H.R.2990(2005b)).
Inits2005reporttotheEUCommissionmentionedabovetheCESRalsostatedthatnewCRAsfacea
numberof barrierstoentryandexistingCRAsfaceanumberof naturalbarrierstoexpansion.Issuers
usuallyonlydesire ratings from thoseCRAs thatare respectedby investorsandwhich tend tobe
only those with a long performance record (CESR (2005), paras. 247248). The CESR report
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concludedthat“theimpactof regulatoryrequirementsoncompetitionisnotclearandthereforeit
cannot conclude that any regulatory requirements would either increase or decrease the entry
barrierstotherating industry.ThusCESRdoesnotrecommendtheuseof regulatoryrequirements
asameasuretoreduceorremoveentrybarrierstothemarketforcreditratings”(CESR(2005),para.
252).TheCESRrecommendeda“waitandsee”attitudeandimplementationof IOSCO’s“Code”.
In a response to such initiatives Moody’s stated that it “has supported eliminating regulatory
barrierstoentry”.But,withregardtocompetitionissues,Moody’sarguesthatthe“costlynatureof
executive time” would not allow issuers to have many different ratings. Because of network
externalities, only a small number of CRAs would be favored by investors, who would desire
“consistencyandcomparabilityincreditopinions”.NewlyestablishedCRAswouldneedtimetogain
credibilityinthemarket.
S&Palsorecommendeditssupportto“amoreopenandtransparentprocesstodesignateNRSROs,
reduce barriers to entry and ensure that the markets remain the ultimate judge of the rating
process”(StandardsandPoor’s(2003)).However,S&PdidnotbelievethatthewholeNRSROprocessshouldbewithdrawn.
(b)Potential conflictsof interest InitsSeptember2003“Reportof AnalystConflictsof Interest”,IOSCOhighlightedpotentialconflicts
of interestfacingtheindustrythatcaninterferewiththeindependenceandobjectivityof itsanalysis.
Conflictsof interestmayarisewhenaratingagencyoffersconsultingorotheradvisoryservicesto
issuersitratessinceissuerscouldbeundulypressuredtopurchaseadvisoryservicesinreturnforan
improved rating.The reportalsodrewattention to the issueof “notching”byCRAs, i.e. lowering
ratings for issues which they had not rated, and that of “solicited” versus “unsolicited” ratings,
whereaggressivetacticsmightbeusedtoinducepaymentsforaratinganissuerdidnotrequest.
TheIOSCOCodeaddressesthefirstof theseissueswiththefollowingrecommendation:“Thecredit
ratingaCRAassignstoan issuerorsecurityshouldnotbeaffectedbytheexistenceof orpotential
forabusinessrelationshipbetweentheCRA(oritsaffiliates)andtheissuer(oritsaffiliates)orany
otherparty,orthenonexistenceof sucharelationship”(IOSCOCode(2004),Section2,para.2.2).
This principle has been integrated into Moody’s and S&P own Codes of Professional Conduct
(StandardsandPoor’s(2003)).”
(c)Transparency Manymarketparticipantshaveexpressedconcernoverthelackof transparencyoverCRAs’ratings
methodologies,procedures,practices andprocesses. In this context the IOSCOCode stresses the
following :“Inorder topromote transparencyand improve theabilityof marketparticipantsand
regulators to judgewhether aCRA has satisfactorily implemented the Code Fundamentals,CRAs
shoulddisclosehoweachprovisionof theCodeFundamentalsisaddressedintheCRA’sowncodeof
conduct. CRAs should explain if and how their own codes of conduct deviate from the Code
Fundamentals and how such deviations nonetheless achieve the objectives laid out in the Code
FundamentalsandtheIOSCOCRAPrinciples.Thiswillpermitmarketparticipantsandregulatorsto
draw theirown conclusionsaboutwhether theCRAhas implemented theCodeFundamentals to
theirsatisfaction,andtoreactaccordingly”(IOSCOCode(2004),p.2).
IOSCOrequirestheCRAs’methodologiestobecomepublictoenhancetransparency inan industry
whichisveryopaqueinnature.CESRgoesfurtherandproposes,asanalternativetoself regulation,“theneedtointroducesomespecificrulesonfairrepresentationwhichwouldestablishaminimum
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levelof disclosureonthoseelementsandassumptionswhichmakeclearformarketoperatorsand
investors to understand how a specific rating was determined by a credit rating agency” (CESR
(2005),para.117).
Thenatureandextentof informationmadeavailabletothepublicstillvariesfromagencytoagency.Sincethepublicationof theIOSCOCodeanditsintegrationintotheCRAs’ownCodeof Conduct,the
CRAshaveincreasedthenumberof lengthyresearchreportsandpublicationsontheirwebsitesand
published some of the criteria used to assess credit risk in their bid to improve transparency.
However, theview is stillwidespread thatCRAs’methodologies, thevariablesandweightswhich
theyemploy,andthecriteriausedinthedeliberationsof ratingscommitteesremainopaquetoboth
investorsandborrowers.TheCESRsummedupthecontinuingproblemwhenitstatedthat:“Credit
ratingagenciesshouldaimfortransparencyasthebestwayforwardtoenableinvestorsandissuers
tounderstandthequalityandobjectivityof thecreditrating.Creditratingagenciesshouldtherefore
implementmeasure2.7of theIOSCOCode”.
(d) Accountability There isnomechanismtoprotect investorsand/orborrowersfrommistakesmadebyCRAsorany
abuseof poweron theirpart.This is trueeven if reputational interests and competitionprovide
incentives for generating quality financial information. In order to promote transparency and
improvetheabilityof marketparticipantsandregulatorsto judgewhetheraCRAhassatisfactorily
implementedwhatitpledgesitisdoing,theIOSCOCoderecommendsonlythatCRAsgivefulleffect
totheCodebypublishingtheirown,adheringtoitand justifyingpubliclyanydeviationbetweenthis
codeandtheiractivities.
There remains the need for more formal regulation to address market failures in the form of
imperfectcompetitionandprincipalagentproblemsinthecreditratingindustry.TheCESRtechnicalreportclearlyputs itsfingeronthe issue involved:“Thereasonforhavingaregulatorymechanism
shouldratherbethatthereexistssomemarketfailurethathastobedealtwith.Inessenceallthe
issuesdiscussedinthepreviouschapterarisebecausetheexistenceof conflictsof interestsbetween
the CRAs and the issuers and/or the users of ratings (the investors). These types of conflicts of
interestsbetweenprofessionalplayersonthe financialmarketsarenaturalandexist innumerous
areasof themarkets.Theybecomeespeciallyapparent intheratingmarketbecauseof the lackof
balanceof powerbetweenthedifferentplayers. IssuersarerelativelyweakcomparedtotheCRAs
becauseof theirdependenceontheratingstheyget. Investorshavenothistorically invested large
resources in improving rating agencies behavior, perhaps because there was insufficient
transparencyonthewayCRAsoperated to facilitatethis.ThismeantthatCRAshistoricallyhavea
verystrongposition.WhattheIOSCOCodeistryingtodoistorebalancetheinterestsbetweenthedifferentplayers”(CESR(2005),para.260).
Rousseau(2005) –not inreferences sumsupconcernsovertheresulting“accountabilitygap”as
follows:“ThisaccountabilitygapisworrisomeforCRAsaswellasmarketparticipants.Fortheformer,
theaccountabilitygapmayaffecttheircredibilityinthemarketplace.Forthelatter,itisof particular
concerngiven therole thatCRAsplay incapitalmarkets...There isaneed fora […]mechanism to
takeoverif reputationfails.”
Forthefirsttimeinthehistoryof ratingsintheUnitedStatestheCreditRatingAgencyReformActof
2006 has clearly designated the SEC to monitor CRAs’ compliance with new securities laws and
regulations. The SEC will be able to act as deemed necessary and to study and report to
congressional committees any problems faced in the future with anything relating to the creditratingindustry.
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180
F. Conclusions
CRAsplayakeyroleinfinancialmarketsbyhelpingtoreducetheinformationalasymmetrybetween
lenders and investors,onone side, and issuerson theother side, about the creditworthinessof companies (corporate risk) or countries (sovereign risk). CRAs’ role has expanded with financial
globalizationandhas receivedanadditionalboost fromBasel IIwhich incorporates the ratingsof
CRAsintotherulesforsettingweightsforcreditrisk.
Inmakingtheirratings,CRAsanalysepublicandnonpublicfinancialandaccountingdataaswellas
information about economic andpolitical factors thatmay affect the ability andwillingnessof a
Governmentorfirmstomeettheirobligationsinatimelymanner.However,CRAslacktransparency
anddonotprovideclearinformationabouttheirmethodologies.
Ratingstendtobesticky, laggingmarkets,andthentooverreactwhentheydochange.Thisover
reactionmayhaveaggravatedfinancialcrisesintherecentpast,contributingtofinancialinstability
andcrosscountrycontagion.Moreovertheactionsof countrieswhichstrivetomaintaintheirrating
gradesthroughtightmacroeconomicpoliciesmaybecounterproductivefor longterm investment
andgrowth.
The recentbankruptciesof Enron,WorldCom,andParmalathaveprompted legislative scrutinyof
theagencies.Criticismhasbeenespeciallydirectedtowardsthehighdegreeof concentrationof the
industry,whichintheUnitedStateshasreflectedaregistrationandcertificationprocessintheform
of NRSROdesignationbiasedagainstnewentrants.Theeffectof suchconcentrationhasbeenthe
absenceof thedisciplineenforcedbycompetitionandalowlevelof innovation.
IntheUnitedStatespolicyactionhasincludedthe2006CreditRatingAgencyReformActwhichhas
overhauled the regulatory framework by prescribing procedural requirements for NRSROregistrationandcertificationandbystrengtheningthepowersof theSEC.
At the international level the main initiative has been the publication by IOSCO of its Code of
Conduct.ThisCodeaimsatdevelopinggovernancerulesforCRAstoensurethequalityandintegrity
of theratingprocess,theindependenceof theprocessandtheavoidanceof conflictsof interest,and
greater transparency. In its 2005 Technical Advice to the European Commission on possible
MeasuresConcerning Credit RatingAgencies the CESR recommended the implementationof the
IOSCOCodeandadoptionof a“waitandsee”attitude.
Definitiveassessmentof these initiativeswouldstillbepremature.The industrywillreceiveafillip
from implementationof Basel II.ThemajorCRAswillundoubtedlyseekasubstantialshareof the
new business which will result. The promotion of competition may require policy action at the
nationalleveltoencouragetheestablishmentof newagenciesandtochannelbusinessgeneratedby
newregulatoryrequirements intheirdirection.Regulatoryactionatthenationallevelmayalsobe
necessary to ensure that the agencies operate in accord with levels of accountability and
transparencymatchingtherecommendationsof theIOSCOCode.
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Annex I.SovereignRatingsMethodology ProfileFigure1.GDPperCapita
Source:S&P,Oct.2006,“SovereignCreditRatings:APrimer”.
Figure2.RealGDPGrowthperCapita
Source:S&P,Oct.2006,“SovereignCreditRatings:APrimer”.
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Credit Rating Agenciesand their Potential Impact onDevelopingCountries
186
Figure3.ConsumerPriceIndex(CPI)
Source:S&P,Oct.2006,“SovereignCreditRatings:APrimer”.
Figure4.GeneralGovernmentBalanceasPercentageof GDP
Source:S&P,Oct.2006,“SovereignCreditRatings:APrimer”.
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Figure5.NetGeneralGovernmentDebtasPercentageof GDP
Source:S&P,Sept.2005,“SovereignCreditRatings:APrimer”.
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Credit Rating Agenciesand their Potential Impact onDevelopingCountries
188
Annex II Table1.RatingSymbols
RATING SYMBOLS FOR LONG-TERM AND SHORT-TERM DEBT
InterpretationLong-Term Short-Term Long-Term Short-Term Long-Term Short-Ter
INVESTMENT-GRADE RATINGS
Highest Credit Quality Aaa AAA AAA
High Credit Quality Aa1 AA+ AA+
Aa2 Prime-1 AA A1+ AA F1
Aa3 AA- AA-
Strong Payment Capacity A1 A+ A+
A2 A A1 A
A3 Prime-2 A- A-
Adequate Payment Capacity Baa1 BBB+ A2 BBB+ F2
Baa2 Prime-3 BBB A3 BBB F3
Last Rating in Investment-Grade Baa3 BBB- BBB-
SPECULATIVE-GRADE RATINGS
Speculative Ba1 BB+ BB+
credit risk developing Ba2 BB B BB B
due to economic changes Ba3 BB- BB-
Higly Speculative, B1 Not Prime B+ B+
credit risk present B2 B B
with limited margin of safety B3 B- B-
High Default Risk, Caa1 CCC+ C CCC+ C
capacity depending on sustained, Caa2 CCC CCC
favorable conditions Caa3 CCC- CCC-CC CC
Default, Ca, C C, D D C, D D
although prospect of partial recovery
Moody's S&P Fitch
Source:BasedonS&P,Moody’sandFitch.
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Table2.RatingAgenciesRecognizedinVariousCountries
Source:BCBS(2000),Table2,p.46.
Note: Table2showstheratingagenciesrecognizedbythebankingsupervisorsinBCBScountriesand
selectednonmembers.The totalnumberof agencies recognized ineachcountry isshown in
therighthandcolumn.Itisevidentthereisconsiderabledisparityinthenumberof recognitions
grantedbysupervisors.ThebigthreeCRAs,S&P,Moody’sandFitch,arerecognizedbyallBCBS
membersandalmostallnonBCBScountriesshown.
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CHAPTERIX
PURSUINGSUSTAINABLEDEVELOPMENT
STRATEGIES:THECASEOFTHEBALANCEOF
PAYMENTRULESINWTO
RobertHowse,AleneSmithandAllanF.Smith
(Universityof Michigan)
A. Introduction
1. Equity
InSection IIIof theMillenniumDeclarationentitled“DevelopmentandPovertyReduction,”United
NationsMemberStatescommittedthemselvesto“tocreateanenvironment atthenationaland
global levels alike which is conducive to development and to the elimination of poverty.” This
dependson“goodgovernancewithineach country”,“goodgovernanceat the international level,
andontransparencyinthefinancial,monetaryandtradingsystems.”Hence,they“arecommittedto
anopen,equitable,rulebased,predictableandnondiscriminatorymultilateraltradingandfinancial
system.”
The concept of equity in international trade and financial rules and institutions has not been
explicitly defined and is the subject of debate and speculation among philosophers and political
theorists. Economists are often skeptical of whether the trade and financial systems should be
understood atall in termsof justice rather than as instrumentsof economicpolicy coordination.
Nevertheless,itwillbeobservedthattheactualrulesoftendodepend,explicitlyorimplicitly,ona
conceptof fairness.For instance,oneof therulesthatwillbediscussed inthispaper,contained in
Article IVof the IMFArticlesof Agreementrequiredthat IMFMembersnot“manipulateexchange
rates or the international monetary system in order to prevent effective balance of payments
adjustmentortogainanunfaircompetitiveadvantageoverothermembers.”
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PursuingSustainableDevelopment Strategies:TheCaseof theBalanceof Payment RulesinWTO
192
The conceptof equity is thus inescapable in the interpretation and applicationof the lawof the
internationaltradeandfinancialsystems.Thequestioniswhethertherearelegalandpolicysources
thatallowustogiveadefinitemeaningtothisconceptasweapplyittoparticularrulesanddisputes
inthetradeandfinancialsystems.
One ingredient of equity that is widely reflected in international instruments concerning trade,
financeanddevelopmentisthenotionthatrulesshouldbeadjustedtothe individualsituationsof
countrieswithrespecttotheirdevelopmentneeds.Thus,thereiswidespreadagreementthatformal
legalequality,treatingeveryonethesameregardlessof theirparticularsituation,isnotequitable.At
thesametime,thereisdisagreementamongstatesonhowmuchdifferentialtreatment is justified
inagivensituation.
Thereisaninterestingparallelismbetweentheconceptionof equityastreating“unlikes”differently
and the recognition in recent economic literature that—contrary to what was implied in the
WashingtonConsensusformula—thereisnotasingleformulaorpathwaytodevelopmentthatwill
workforallcountries.109
Anotherdimensionof equityreflectedininternationalhumanrightsinstrumentsisthatof voiceand
participation.Theseinstrumentssuggestthatpeopleshouldnothaveavisionof developmentforced
onthemordecidedbyothers.TheDeclarationontheRighttoDevelopment,forexample,stipulates
thattheRighttoDevelopmentincludes“freeandmeaningfulparticipationindevelopment.”
Closelyrelatedtothenotionof equityistheconceptof socialandeconomic justiceexpressedinthe
UnitedNationsCovenanton Social andEconomic andCulturalRights.Article11of theCovenant
provides: “1. The States Parties to the present Covenant recognize the right of everyone to an
adequatestandardof livingforhimself andhisfamily,includingadequatefood,clothingandhousing,
and to the continuous improvementof living conditions. The StatesPartieswill take appropriatesteps toensure the realizationof this right, recognizing to thiseffect theessential importanceof
internationalcooperationbasedon freeconsent.”Whilenotall states mostnotably theUnited
StateshaveembracedtherightsintheCovenantastreatyorcustomaryinternationallaw,eventhe
UnitedStateshasparticipated intheDeclarationontheRighttoDevelopment,which incorporates
toalargeextentandaffirmstheserights.Aconcreteimplicationof thisnotionof equityisthatthe
rules of the international trade and financial system should, at aminimum, not undermine, and
ideally should facilitate, theabilityof states todischarge theirobligationsunder theCovenant to
implementsocialandeconomicrights.
Finally, equity has been considered by United Nation Member States to imply a fair global
distribution of burdens andbenefits from theoperationsof the international trade and financial
system.Thisgoesbeyondanotionsimplythatthesystem(s)shouldenablestatestoachievesocial
and economic justice within their borders to a conception of global solidarity. According to the
MillenniumDeclaration,solidarityrequiresthat“globalchallengesmustbemanaged inawaythat
distributes the costs and burdens fairly in accordance with basic principles of equity and social
justice.”110
In itsexaminationof WTO rulesand jurisprudenceas they relate to thebalanceof paymentsand
other international financial issues this paper will draw on the dimensions of equity articulated
above.
109RodrikD (2001). TheGlobal Governance of Trade as if Development Really Mattered .UnitedNationsDevelopment
Programme.110See alsoBeviglia ZampettiA (2005).Progressing Towards a Just Future Through theMDGs:What is theRoleof an
“Equitable”MultilateralTradingSystem?Draft:12.October.
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TheWTOAgreementdefinesthegoalof themultilateraltradingsystemintermsof theprinciplethat
“relations inthefieldof tradeandeconomicendeavorshouldbeconductedwithaviewtoraising
standardsof living,ensuringfullemploymentandalargeandsteadilygrowingvolumeof realincome
and effective demand, and expanding the production of and trade in goods and services, while
allowingfortheoptimaluseof theworld’sresourcesinaccordancewiththeobjectiveof sustainable
development...”Clearly,thegoalsof raisingstandardsof livingandensuringfullemploymentare
closely linked to the conception of social and economic justice in the UN Covenant on Social
EconomicandCulturalRights.
2. Coherence
Arguablycoherenceisalogicalimplicationof therecognitionof equityasafundamentalelementof
the internationaltradeand financialsystems.Coherencerefers, firstly,totherulesandpoliciesof
theinstitutionswhereequityisarticulatedanddefinednormativelyand,secondly,totherulesand
policies of the international trading and financial systems themselves. Inequity may result from
uncoordinated rulesbetweenthetradingandthefinancialsystems.
Forexample,theIMFmayrequireacountrytoimproveitsbalanceof payments.However,therules
of the trading systemmaynotpermit theuseof certain instruments fordoing so.Theremaybe
goodreasonswhytheseinstrumentsareconstrainedbytherulesof theinternationaltradingsystem.
However,intheabsenceof abroadandpalatablerangeof policyoptionsfortrade,thecountrymay
pursue thegoal specifiedby the IMF through recourse topolicy instruments that threaten social
equity,andresultinpovertyandunemployment.
AnearlyexplicitattempttoaddresscoherenceattheWTOistheUruguayRoundDeclarationonthe
Contributionof theWorld TradeOrganizationtoGreater CoherenceinGlobal EconomicPolicymaking.
Paragraph2of theDeclarationreads:
“Trade liberalization forms an increasingly important component in the success of the
adjustment programs that many countries are undertaking, often involving significant
transitionalsocialcosts. In thisconnection,Ministersnote theroleof theWorldBankand the
IMF in supporting adjustment to trade liberalization, including support tonet foodimporting
developingcountriesfacingshorttermcostsarisingfromagriculturaltradereforms.”
Themostimportantpartof theDeclarationisarguablytobefoundinParagraph5:
“The interlinkages between the different aspects of economic policy require that the
international institutions with responsibilities in each of these areas follow consistent andmutually supportive policies. The World Trade Organization should therefore pursue and
developcooperationwiththeinternationalorganizationsresponsibleformonetaryandfinancial
matters, while respecting the mandate, the confidentiality requirements and the necessary
autonomy in decisionmaking procedures of each institution, and avoiding the imposition on
Governments of crossconditionality or additional conditions. Ministers further invite the
DirectorGeneral of the WTO to review with the Managing Director of the International
Monetary Fund and the President of the World Bank, the implications of the WTO’s
responsibilitiesforitscooperationwiththeBrettonWoodsinstitutions,aswellastheformssuch
cooperation might take, with a view to achieving greater coherence in global economic
policymaking.”
Paragraph 2 draws attention to the significant social costs of trade liberalization and economicreform. But the Declaration does not extend the idea of coherence to cooperation with those
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currency),thiswouldbefinancedbyborrowingfromtheInternationalMonetaryFund.Inthecaseof
astructuralorpersistentimbalance,acountrywoulddevalueitscurrencyunderthesupervisionof
theIMF,whichmightrecommenddomesticpolicyadjustmentstoensurethatfurtherdevaluations
werenotrequiredsubsequentlyinordertomaintainthebalanceof payments.
TheBrettonWoodssystembrokedownin1971whentheUnitedStatesunilaterallyoptedoutof the
systemwhenitannouncedthesuspensionof convertibilityof thedollarintogold.Theresultiswell
summarizedina2004UNCTADdocument:
“Unfortunately, after the breakdown of the Bretton Woods system at the beginning of the
1970s, theworldmonetary system slipped back into the kind of “monetary chaos” that had
characterizedtheprewarperiodanditsdismaleconomicandpoliticaloutcomes.Nevertheless,
the liberalizationof the tradingsystem,evenafter theendof theBrettonWoodssystem,was
pushed forward by policymakers as if a consistent approach on the monetary side, i.e. a
coherentmonetaryorder,wouldhaveexisted.Onlyrecently,withtheAsiancrisisaswellaswith
the LatinAmerican currency turmoil,have the shortcomingsof the “monetary chaos”and its
repercussionsonthetradingsystembeenacknowledged,evenbymainstreameconomictheory
andtheWTO.Butinstabilityisonlypartof thestory.....if changesintheinternationalvalueof
moneyareinnowayrelatedtothefundamentalsof countrieswithopenmarketsforgoodsand
capital,traditionaltradetheoriesquicklylosetheirgrasponrealityandtradeliberalizationloses
muchof itsalleged justification.”112
In the caseof developing countriesprogress towards convertibility and the removalof exchange
controlswasamajorfeatureof theeconomicorthodoxyinthe1980sand1990s.Suchreformswere
thought to have the effect of encouraging foreign investment and creating domestic financial
systems as well as access to the global financial networks that would underwrite growth and
development.
TheAsianandLatinAmericanfinancialcrisesof the1990s ledtorethinkingof thisorthodoxy.Well
knowneconomistssuchasJagdishBhagwatiandJosephStiglitzmaintainedthattoorapidfinancial
liberalization contributed to the crises, which led to widespread human misery in a number of
countries,expressedtheirsupportforcapitalcontrolsasaninstrumentforstemmingapanicflight
of shorttermcapital.113114
TheGATTrulesconcerningexchangemeasuresandconvertibilityarecontained inArticleXVof the
GeneralAgreement:
Article XV:4 states that “Contracting parties shall not, by exchange action, frustrate the
intentof theprovisionsof thisAgreement,norbytradeaction,theintentof theprovisions
of theArticlesof Agreementof theInternationalMonetaryFund.” According to the InterpretativeNoteAdArticle XV: “Theword “frustrate” is intended to
indicate, forexample, that infringementsof the letterof anyArticleof thisAgreementby
exchangeactionshallnotberegardedasaviolationof thatArticleif,inpractice,thereisno
appreciabledeparturefromtheintentof theArticle.Thus,acontractingpartywhich,aspart
of its exchange control operated in accordance with the Articles of Agreement of the
InternationalMonetary Fund, requiredpayment tobe received for its exports in itsown
currencyorinthecurrencyof oneormoremembersof theInternationalMonetaryFundwill
112World TradeOrganization (2004). Economic PolicyChallenges in anOpen Economy:Coherence between Trade and
Finance. Communication of UNCTAD to the WTO Working Group on Trade, Debt and Finance (WT/WGTDF/W/27),
November.113BhagwhatiJ(2004).InDefenseof Globalization.Oxford,OxfordUniversityPress,199200.
114StiglitzJ(2002).Globalizationand ItsDiscontents.NewYork,W.W.Norton.
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nottherebybedeemedtocontraveneArticleXIorArticleXIII[of theGATTonquantitative
restrictions].Anotherexamplewouldbe thatof a contractingpartywhich specifiesonan
import licensethecountryfromwhichthegoodsmaybe imported,forthepurposenotof
introducing anyadditionalelementof discrimination in its import licensing systembutof
enforcingpermissibleexchangecontrols.”
ArticleXV:9of theGATTprovides:“NothinginthisAgreementshallpreclude:(a)theusebya
contracting party of exchange controls or exchange restrictions in accordance with the
Articlesof Agreementof the InternationalMonetaryFundorwith thatcontractingparty’s
specialexchangeagreementwiththeCONTRACTINGPARTIES,or(b)theusebyacontracting
partyof restrictionsorcontrolsonimportsorexportsthesoleeffectof which,additionalto
theeffectspermittedunderArticlesXI,XII,XIIIandXIV,istomakeeffectivesuchexchange
controlsorexchangerestrictions.”
AccordingtoArticleXVI:2of theGATT,thereshallbedeferenceto“thedeterminationof the
Fundastowhetheractionbyacontractingpartyinexchangemattersinaccordancewiththe
Articlesof Agreementof theInternationalMonetaryFund,...”
Taken together, theseprovisions suggest that,wheremeasureshavebeen takenwith respect to
exchange controls or restrictions, even if such measures would otherwise be considered trade
restrictionsbecauseof theireffectonimportandexporttransactions,theintent of theGATT isnot
toimposedisciplinesbeyond thoserequired by theIMF.
Itisinaccuratetoviewtheseprovisions,assomecommentatorshave,essentiallyceding jurisdiction
to the IMF. According to this view, when an exchange measure is not consistent with the IMF
Articles, the“safehaven”of ArticleXVdisappearsand themeasuremaywell then fallafoulof a
provisionof theGATTsuchasArticleXI.Thus,whenacountrydisagreeswiththeFundonthebest
course for solving a financial crisis, including one that does not worsen the plight of the leastadvantaged, theGATTpermitscountry tobe“punished”throughbeing found inviolationof GATT
rules.InsuchcasestheGATT/WTOwouldbecomearesidualenforcerfortheIMF.
Arguablythiswasnottheintentof theGATTframers.Firstof all,priortotheWTOtheGATTdispute
settlementsystemcontainedmanydiplomaticsafetyvalves.Secondly,theoriginalIMFArticleswere
premisedonaworldof largelyfixedexchangeratesadjustedthroughIMFsupervision.However,in
today’sworldof speculationdriven currencymarkets and thewidespread liberalizationof capital
controls(generallyendorsedbytheIMF)there isnoagreed internationalstandardagainstwhicha
currencycanbeviewedasoverorundervalued,thustriggeringareasonableobligationtoadjust
economicfundamentalsthroughmeansthatdonotimposeunreasonablecostsonothercountries.
Inthisworldrecoursetoexchangerestrictionsmaybea justifiableoptionforacountryseekingto
avoidacurrencycrisisortoprotect itself fromthecontagioneffectsof acrisiselsewhere.Thiscan
beillustratedwiththecaseof Malaysia.
In September 1998 Malaysia decided to defy the IMF’s advice and to impose selective capital
controlsinordertohelptoresolveitsfinancialcrisisaswellastoenablethemaintenanceof afixed
exchangerate.KaplanandRodrikconcludethat,incomparisonwithothercountriesthatfollowIMF
prescriptions, and taking into account differences in those countries’ situations, “the Malaysian
policywasmoresuccessfulinaccomplishinganimmediatereductionininterestrates,stabilizingthe
currency, and stemming financialpanic.Thiseased, for the short term at least,worries that the
banking systemwouldgounderand that therewouldbeadevaluation spiral.The turnaround in
marketconfidencewascorrespondinglymorerapid. Inaddition, fiscalpolicywasonbalancemore
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askhow far China’s exchangeratemeasures undermine the development policies of otherWTO
Members.
InGATT/WTOpracticeand jurisprudence, the justifiabilityof measuresunderArticleXVhasbeen
consideredonanumberof occasionsinrelationtomanagementof thebalanceof payments.
AccordingtotheGATTAnalyticalIndex,“DuringtheReviewSessionin195455,Italybrought
acomplaint concerningactionbyTurkeyprovidingexportbonuses forcertainagricultural
productsandlevyingspecialimporttaxesoncertaingoodsdeemedlessessentialinorderto
providethenecessaryfundsforthebonuses.Italystatedthattheexportsubsidieshadnot
beennotifiedasrequiredbyArticleXVI:1andthattheimporttaxeswere inconsistentwith
Article II:1(b).Turkeystatedthataspartof areformof itsforeignexchangesystem, ithad
establishedanEqualizationFundwhichwasfinancedbythesaleof importpermits,andthat
thissystemhadbeenapprovedbytheInternationalMonetaryFund.Arepresentativeof the
Fundconfirmed that thepracticesunderquestionweremultiplecurrencypracticesunder
the Fund Articles of Agreement and that in a Decision concerning Turkey the Fund hadstated that itdidnotobject to the temporary continuanceof thesepractices andwould
remaininconsultationwithTurkeyonthesepractices.”118
In1998 in the ArgentinaTextilesand Apparel case,Argentinaargued thata3percentad
valoremtaxthatitcollectedwasforpurposesof fundingthecollectionof accuratestatistical
dataonimportandexporttransactionsaspartof itsoverallunderstandingwiththeIMFon
stabilization and adjustment.119In its ruling the panel held that there was no exception
undertheGATTthatwould,forthesereasons,limitArgentina’sobligationsunderArticleVIII
withregardtocustomsfees.Thepaneldidnotconsiderwhether,giventhatArgentinawas
maintaining the tax in the context of its arrangements with the IMF, the tax could be
deemedtobeanexchangemeasurewithinthemeaningof XV:9of theGATT.Thefactthat
thetaxappliedtoallimportsindicatesthatitwasnotintendedasaprotectionistmeasuretoshelterArgentineindustriesfromcompetitionwhile lendingplausibilitytoitsconnectionto
Argentina’s exchange arrangements. The Appellate Body upheld the panel’s approach.
Argentinahad argued that theDeclarationonCoherence and the subsequentAgreement
betweenthe1996IMFandtheWTO,referredtoabove,were“legislativedevelopments”in
the WTO which had the effect of creating a metanorm of avoidance of “cross
conditionalities,” such that its relationswith the IMFwould require a state to engage in
conductthatwouldviolateWTOlaw.TheAppellateBodyfirstof allobservedthatArgentina
hadnotshowntothepanel’ssatisfactionthatthetaxhadbeenrequestedof itbytheIMFor
therewasaconflictof legalobligation, i.e.thatArgentinahada legallybindingagreement
withtheIMFthatwouldbeviolatedif itdidnotimposethetax.
Thefindingsof theAppellateBodyinthe ArgentinaTextilesand Apparel casesuggestanarrowand
formalistic view of the problem of coherence and conflicting conditionalities. In many cases the
IMF’srequirementsareof ageneralnature,and linked totheachievementof certain results.The
IMF leavesthe instrumentalitiestothecountry’sGovernment.Thatthe IMFhasnotrequested“x”
policydoesnotmeanthat“x”policydoesnotresult fromrequirements imposedby the IMF—the
policyinquestionmaybeoneof theonlyfeasiblewaysof satisfyingtheIMFdemandsatreasonable
social cost. Moreover the notion of legal conflict suggested by the Appellate Body is equally
problematic. It reduces the challenge of coherence to a notion of avoiding conflicting treaty
requirements.However,internationallawisnottheonlyoreventheprimaryleverthattheIMFuses
118
WorldTradeOrganization(1995)GuidetoGATT Law and Practice.Geneva,1:439.119World Trade Organization (1998). ArgentinaMeasures Affecting Imports of Footwear, Textiles, Apparel and Other
Items,Reportof theAppellateBody.(WT/DS56/AB/R),(adopted22April1998),paras.6974.
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to“enforce”conditionality;rather,theIMFwillsimplynotdisbursefurtherfundstoacountrythat
does not meet its conditions, regardless of whether those conditions are formalized as legal
requirementsorexpressedasistypicallythecasein“memoranda”or“lettersof intent”.120121
In its decision the Appellate Body placed considerable emphasis on the notion that neither theDeclarationonCoherencenorthesubsequentCooperationAgreementbetweentheWTOandthe
IMF added to or diminished the rights and obligations contained in the WTO Agreements. The
Appellate Body noted that the effect of crossconditionalities or possible conflicts between
measuresthatmightresultfromIMFprogramsandWTOobligationswasspecifiedas“consultation”
betweentheFundandtheWTO.Yetwhenitconsideredwhetherthepanel’sfailuretoconsultwith
theFundconstitutedaviolationof itsobligationtomakeanobjectiveassessmentof thematter,the
Appellate Body ignored the consultation requirement as set out in the Paragraph 10 of the
Agreementbetween the IMFand theWTO.The thrustof theDeclarationonCoherence and the
subsequent Agreement between the IMF and the WTO is that issues that arise from possible
inconsistenciesbetweenmeasures taken in relation toFundprogramson theonehandandWTO
obligationsontheotherought,atleastinthefirstinstance,tobeaddressedthroughconsultationsandcooperationbetweentheWTOSecretariatandtheFund.
Insummary,as interpreted inthepracticeof WTOdisputesettlement inthecasesdiscussedhere
and in others, the WTO rules on exchange actions are likely to be permissive regarding any
macroeconomicpolicyinterventionthathastheexplicitblessingof,orisspecificallyrequiredbythe
IMF.However,where aWTOMember takes an action that the Fund isnotprepared toendorse
explicitly,or that ithasnotrequired,andsuchanaction fallsgenerallywiththekindof exchange
measurescoveredbyArticleXV,thereissomethingclosetoapresumptionthattheWTOruleshave
beenviolated .Yet,acompletereadingof theagreementestablishingtheWTOandof IMFrulesand
proceduressuggeststhattheydonotnecessarily justifythispresumption.
C. TradeRestrictionsforBalanceof PaymentsPurposes122
ArticlesXIItoXIVof theGATTelaborateacomplexcodedesignedtogovernanddisciplinetheuseof
import restrictions for balanceof payments purposes. Article XII:1 states the basic right of any
Contracting Party to impose quantitative restrictions in derogation from Article XI “in order to
safeguard itsexternal financialpositionand itsbalanceof payments”.ArticleXII:2establishesthat
suchrestrictionsshallbelimitedtowhatis“necessary:(i)toforestallthe imminentthreatof,orto
stop,aseriousdeclineinmonetaryreserves,or(ii)inthecaseof aContractingPartywithverylow
monetaryreservestoachieveareasonablerateof increaseinitsreserves”.Suchrestrictionsmustbe
progressivelyrelaxedasthebalanceof paymentsimproves.
Furthermore, Contracting Parties “undertake, in carrying out their domestic policies, to pay due
regardtotheneedformaintainingorrestoringequilibriumintheirbalanceof paymentsonasound
andlastingbasis”(ArticleXII:3).Atthesametime,noContractingPartyisobligatedtotakedomestic
balanceof paymentsmeasuresthatwouldthreatentheobjectiveof fullemployment).Aprocessof
consultations is envisagedwith the GATT Council concerning any new restrictions or increase in
120SeeEldarO (2005).Reformof IMFConditionality;aProposal forSelf ImposedConditionality. IILJWorking paper,10.
NewYorkUniversityLawSchool,CentreGlobalAdministrativeLawSeries.121Siegel DE (2002). Legal Aspects of the IMF/WTO Relationship: The Fund’s Articles of Agreement and the WTO
Agreements. American Journal of International Law ,96:561581.122The following draws from Michael J, Trebilcock and Howse R (2005). The Regulation of International Trade. Third
Edition,Routledge,LondonandNewYork,ch.5“Trade,ExchangeRatesandtheBalanceof Payments.”
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restrictions,withperiodicreviewof thenecessityof thetrademeasuresandtheirconsistencywith
Articles XII–XIV. In addition, Article XII contains provisions on dispute settlement, including the
authorizationof retaliationwhereaPartypersistsintraderestrictionsthathavebeenfoundbythe
ContractingPartiestoviolatetheGATT.
ArticlesXIIIandXIVcontain,respectively,therequirementthatmeasurestakenpursuanttoArticle
XII:1 be implemented on a nondiscriminatory basis and certain narrow exceptions to this non
discrimination requirement,e.g.wherediscriminatoryexchangecontrolshavebeenauthorizedby
theIMF(seethediscussionof substitutabilitybelow).
In thecaseof developingcountries, there isamuchbroaderexemption fromGATTdisciplines for
traderestrictionsundertakenforbalanceof paymentsreasons.ArticleXVII:2(b)statestheprinciple
that developing countries should have additional flexibility “to apply quantitative restrictions for
balanceof paymentspurposes inamannerwhichtakesfullaccountof thecontinuedhigh levelof
demandforimportslikelytobegeneratedbytheirprogramsof economicdevelopment”.
This suggests that even though a developing country could address its balance of payments
difficultiesthroughexchangerateadjustmentsortightermacroeconomicpolicies, itshouldnotbe
expectedtodosoinviewof theharmtodevelopmentthatmaycomefromtheresultantdeclinein
needed imports. It is recognized that quantitative restrictionswill allow a developing country to
conserveitslimitedforeigncurrencyresourcesforpurchasesof importsnecessaryfordevelopment
–whereasadevaluationof itscurrencywouldresultinallimportsbecomingmoreexpensive.Inthis
connectionitbearsemphasisthatbalanceof paymentsrestrictionsingeneralmaybediscriminatory
withrespect toproductsalthoughnotwith respecttocountries. Indeed, it isexplicitlystated that
“the contracting party may determine (the) incidence (of restrictions) on imports of different
productsorclassesof productsinsuchawayastogiveprioritytotheimportationof thoseproducts
whicharemoreessentialinthelightof itspolicyof economicdevelopment”(ArticleXVIIIB(10)).
In 1979 the Contracting Parties, without formally amending the General Agreement, made the
“Declaration on Trade Measures taken for Balanceof Payments Purposes”, which expanded the
ambitof ArticlesXII–XIVandXVIIIbeyondquantitativerestrictionsto include“all importmeasures
takenforbalanceof paymentspurposes”.
TheUnderstandingontheBalanceof PaymentsProvisionsof theGeneralAgreementonTariffsand
Trade 1994 (BOP Understanding), incorporated in the Uruguay Round Final Act, is aimed at
improvingGATT/WTOdisciplineregardingtrademeasurestakenforbalanceof paymentspurposes.
Memberscommitthemselvestopublish,assoonaspossible,timeschedulesfortheremovalof such
trade measures. Furthermore in perhaps the most important modification of the existing GATT
regimeMemberscommitthemselvestogivepreferencetotrademeasuresof apricebasednature,
suchas tariff surcharges,and toonly resort tonewquantitative restrictionswhere“becauseof a
criticalbalanceof paymentssituation,pricebasedmeasurescannotarrestasharpdeterioration in
theexternalpaymentsposition”(Articles2,3).
PursuanttotheUnderstanding,on31January1995theWTOGeneralCouncilestablishedtheWTO
CommitteeonBalanceof PaymentsRestrictions.From its inception through2003, theCommittee
has conducted consultations with numerous Members concerning the existence and possible
reductionandphaseoutof theirbalanceof paymentsrestrictions.Insomeinstances,withrespect
for example to India and Tunisia, there was controversy within the Committee itself as to how
rapidly thebalanceof payments situationof the country could reasonablypermit the removalof
measures.
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Dissatisfied with the lack of consensus on India’s use of balanceof payments based trade
restrictionstheUnitedStateschallenged India’scontinueduseof traderestrictionsforbalanceof
paymentsreasonsindisputesettlement,claimingviolationsof theGATTandtheBOPUnderstanding.
A key issue here was the relationship between the mandate of the BOP Committee and the
jurisdictionof theWTOdisputesettlementorgans. Indiaarguedthat,giventheexplicitroleof the
Committee inthesurveillanceof thechallengedmeasures, thedisputepanelshoulddefer to that
process.Thepanelbelowfoundthatthecompetenceof theBOPCommitteeandthatof thepanel
werenotmutuallyexclusiveinthesematters.Indiaappealedthisfinding.
The Appellate Body (AB) first observed that, according to Article 1.1 of the Dispute Settlement
Understanding (DSU), the dispute settlement procedures in the DSU apply generally to disputes
broughtunderthedisputesettlementprovisionsof thecoveredagreements(inthiscaseArticleXXIII
of theGATT1994).Moreoveronecouldnot inferany limitationontherightsof accesstodispute
settlementundertheDSU,oronthecompetenceof panelsto interpretandapplythebalanceof
payments provisions of the GATT, from the grant of competence to review Article XVIII:B
justificationsforsuchrestrictionstotheCONTRACTINGPARTIES.
India, however, had argued that GATT practice with respect to Article XXIII precluded access to
disputesettlementregarding trade restrictionsmaintained forbalanceof paymentspurposes.The
BOP Understanding limited the competence of the dispute settlement organs in balanceof
paymentsdisputesinfavorof thatof theMembership,sittingastheBOPCommittee.Thedistinction
thatIndiadrewwasbetweendisputesaboutthe“application”of balanceof paymentsmeasuresand
thosethatconcernedthesubstantive justificationof themeasures.
TherewerealsodifferencesbetweenIndiaandtheABoverthescopeof developmentpolicieswhich
could justifyTraderestrictionsforbalanceof paymentsreasons.
India argued that under Article XVIII balanceof payments restrictions are to be removed as the
conditions towhich theywere addressed improveonly so long as the removalwasnot likely to
provoke the return of those conditions. Moreover under a further proviso of Article XVIII a
developing country shouldnotbe required to removebalanceof payments import restrictions, if
doing so could requirea change in that country’sdevelopmentpolicies.123India’s relianceon this
provisionrequiredtheABtodeterminewhatisadevelopmentpolicyandwhetherremovalbyIndia
of itsbalanceof paymentsrestrictionswouldrequireachangeinthesepolicies.
In its ruling the AB relied on a judgment of the IMF that India did not need to change its
developmentpoliciesbecauseitcouldaddresstheconsequencesof removingitsimportrestrictions
through“macroeconomic”policies.However,thisrulingisquestionableonvariousgrounds.
Had theAB considereddevelopmentpolicy informedbya conceptionof equity that includes the
notion thatdevelopmentpolicy isamatter in the first instance forparticipationof thosewhoare
affected,itwouldhaveanalyzedthelegalissuequitedifferently.
Firstly,theABwouldnothaveacceptedthatoneinstitution,particularlythetechnocratsin
thatinstitution,have“ownership”of themeaningof a“development”policy.
Secondly,theABwouldnothaveembracedthestarkcontrastbetweendevelopmentpolicy
andmacroeconomicpolicy.Thiscontrast impliesthatdevelopmentpolicy isrestrictedtoa
series of techniques that “experts” view as formulae for “development,” rather than
123The followingdrawsonHowseR (2004).Mainstreaming theRight toDevelopment into InternationalTradeLawand
PolicyattheWorldTradeOrganization.(E/CN.4/Sub.2/2004/17),320.UnitedNations,Geneva.
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includingall thosepolicies thatpeople—in thiscase, thoseof India—viewasaffecting the
fulfillmentof theirapproachtodevelopment.Fromtheperspectiveof equity,asinformedby
the social and economic rights recognized in the UN Covenant on Social, Economic and
CulturalRights,macroeconomicpoliciesareclearly“developmentpolicies.”
Thirdly,on thequestion of whether India shouldbe required to change itsdevelopment
policy inordertobeabletoremovethebalanceof paymentsrestrictionswithoutareturn
to crisis conditions, for thepurposesof bothequityandcoherence theABought tohave
solicited theviewsof abroaderrangeof institutionsandsocialactors—ataminimumthe
internationalorganizationswithexpressmandatesregardingdevelopmentsuchasUNCTAD
andtheUNDP.
Finally,theABmighthavetakenaccountof theself declaratorycharacterof ArticleXVII.B,
i.e.that itempowersIndiatochart itsowncourse indevelopmentpolicy.This impliesthat
theprovision isnot intended to invite thedispute settlementorgans toexaminedenovo
India’s judgmentthatremovalof therestrictionswouldrequireachangeinitsdevelopment
policy.
D. TradeFinancingandEquity
Increasing exports is recommended as part of policy packages for addressing indebtedness and
balanceof payments difficulties since, unlike macroeconomic deflation, it actually increases
employmentand reducespoverty.Trade financing is crucial tomanyexport transactions.Yet the
very economic conditions that export receipts are needed to address may make access to such
financingdifficult,particularlyfordevelopingcountriesthathavesufferedfinancialcrises.Thisissue
isbroached inthe2005ReporttotheWTOGeneralCouncilof theWorkingGrouponTrade,Debt
andFinance.124Ina1999WTOstudyFingerandShulnechtexplainthe importanceof government
backed export credit agencies in trade financing as follows: “the commercial andpolitical riskof
international trade transactions is often much larger than for domestic transactions. . . . well
functioningECAs[ExportCreditAgencies]areprobablyevenmoreimportantfordevelopingcountry
exporters [than for industrial country exporters in developed countries]. [Developing country
exporters](andtheirbanks)areoftenrelativelysmalland,therefore,lessabletogeneratetheirown
information on commercial and political risk abroad. They are also often likely to obtain less
favorablefinancingtermsbecauseof mistrustbyimportersfromothercountries.”125
WTOrules,however,arenotconcernedwithfacilitatingdevelopingcountryexportsthroughexport
financing, but rather with disciplining or curbing such financing to the extent it is viewed as an
export subsidy. The relevantprovisions areparagraphs (j) and (k)of Annex I (“Illustrative Listof
Export Subsidies”) to the WTO Agreement on Subsidies and Countervailing Measures (SCM
Agreement). Paragraph (j) states that the following would be examples of prohibited export
subsidies: “The provision by Governments (or special institutions controlled by Governments) of
export credit guarantee or insurance programs, of insurance or guarantee programs against
increasesinthecostof exportedproductsorof exchangeriskprograms,atpremiumrateswhichare
inadequatetocoverthelongtermoperatingcostsandlossesof theprograms.”
124WorldTradeOrganization (2005).Reportof theWorkingGrouponTrade,DebtandFinance to theGeneralCouncil.
(WT/WGTDF/4).10October.125FingerKM and Schulknecht L (1999). Trade, Finance and FinancialCrises.World TradeOrganization Special Studies.
WorldTradeOrganization,Geneva.910.
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Furtherexamplesaretobefoundinparagraph(k)of AnnexI:“ThegrantbyGovernments(orspecial
institutions controlledby and/or actingunder the authorityof Governments)of export credits at
ratesbelowthosewhichtheyactuallyhavetopayforthefundssoemployed(orwouldhavetopay
if theyborrowedoninternationalcapitalmarketsinordertoobtainfundsof thesamematurityand
othercredittermsanddenominatedinthesamecurrencyastheexportcredit),orthepaymentby
themof allorpartof thecostsincurredbyexportersorfinancialinstitutionsinobtainingcredits,in
sofarastheyareusedtosecureamaterialadvantageinthefieldof exportcreditterms”.
This characterization is subject to following important exception in paragraph (k): “Provided,
however, that if aMember isaparty toan internationalundertakingonofficialexport credits to
whichat least twelveoriginalMembers to thisAgreementarepartiesasof 1 January1979 (ora
successor undertaking which has been adopted by those original Members), or if in practice a
Memberappliesthe interestratesprovisionsof therelevantundertaking,anexportcreditpractice
whichisinconformitywiththoseprovisionsshallnotbeconsideredanexportsubsidyprohibitedby
this Agreement.” The international undertaking referred to here is the OECD Export Credit
Arrangement. By incorporating this Arrangement in paragraph (k) the WTO SCM Agreementessentiallydrawsa linebetweenprohibitedandpermissibleformsof exportfinancingbasedonan
Agreementnegotiatedbyandfordevelopedcountriesinadevelopedcountryforum,theOECD.
Thebenchmarks inparagraphs (j)and (k) fordecidingwhetherornota trade financingmeasure
shouldbeclassifiedasanexportsubsidypresupposethematurecapitalmarketsandsophisticated
riskspreadingandallocationvehicles typicalof fullydevelopedeconomies.Whether theyarealso
appropriatefordevelopingcountries,especiallyonesthathavehadaccesstoprivatecapitalseverely
limited due to debt and/or other financial crises is questionable. The Center for International
EnvironmentalLawnotesconcerningtheOECDArrangement:“TheArrangementcanbeunderstood
asacartellike,pricefixingmechanism,wherethe largest lendersof exportcreditsestablish limits
oncompetition…Itisanagreementbytherichestcountriesintheworld,andthereforeitsprovisionsaretailoredfortheirneeds.”126
Implications inpracticeof theSCMAgreementcanbe illustratedbytheBrazil Aircraft case,where
the issuewasthesaleforexportof commuter jetssupportedbyexportcreditsbybothBraziland
Brazil’scompetitorCanada.
IntheBrazil Aircraft caseBrazilarguedthat“duetothehighlevelof riskperceivedbyinternational
markets with respect to Brazilian borrowers, the cost to EMBRAER and to Brazilian financial
institutionsof raisingfundstofinanceexportsof Brazilianregionalaircraftishigherthanthecostto
Bombardier and Canadian financial institutions of raising funds to finance exports of Canadian
regionalaircraft.BecausePROEXpaymentsmerelyoffsetinpartthathighercostof funds,allowing
export credit financing for Brazilian regional aircraft on terms that are closer to, but still less
favorablethan,thoseavailableforcompetingCanadianregionalaircraft,thosepaymentsarenotin
Brazil’sviewusedtosecureamaterialadvantageinthefieldof exportcreditterms.”Inotherwords,
Brazilwasarguingthattheparticularfinancingbarriersfacedindevelopingcountriesshouldbeused
todeterminethebenchmarkagainstwhichanexportcredit isassessedtodecidewhether it isan
unfairexportsubsidy.(Para7.21)
Thepanel curtly and almost scornfully rejectedBrazil’s approach.Mostdisturbingly, it suggested
thatBrazil’sargument that thebaselineof the“marketplace” inparagraph (k)beadjusted to the
circumstancesandneedsof developingcountrieshadtoberejectedbecausetheparagraphwasnot
126Centerof InternationalEnvironmentalLaw(2003).ExportCreditAgenciesandtheWorldTradeOrganization.Draft Issue
Brief.November:45.
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a provision concerning special and differential treatment (for developing countries) (Para. 7.32).
Article 27of the SCMAgreementdoes provide limited relaxationof WTO disciplines applying to
export subsidies fordeveloping countries.Nevertheless, the interpretative approachof thepanel
suggeststhat,evenwherespecialanddifferentialtreatmentexists inaWTOAgreement,theother
provisionsshouldbeinterpretedinamannerthatisblindastotheequitiesasbetweendeveloped
anddevelopingcountrymembers.
Article 27.1 of the SCM Agreement states a general principle much broader than the specific
exceptions and limitations of Article 27.215: “Members recognize that subsidies may play an
importantroleineconomicdevelopmentprogramsof developingcountryMembers.”However,the
panel tendentiously characterizedBrazil’sapproach to themeaningof “used to secureamaterial
advantage” in para. (k) as a “general lowering” of SCM disciplines, which might be harmful to
developingcountriesasawhole.ButonamorereasonableinterpretationBrazil’sargumentwasnot
intendedtoleadtoanacrosstheboardloweringof disciplines,butrathertotakeintoaccountthe
differenceinfinancialmarketconditionsof aparticulardevelopingcountryinrelationtothoseof its
developedcountrycompetitors. It ishardtoseehowsuchanapproachcouldbeharmfultootherdevelopingcountries,manyof which facemuchmoreseriousstructuraldisadvantages in termsof
accesstofinancingthanBrazil.
TheAppellateBody compounded the indifference todevelopingcountry concerns and challenges
shownbythepanel.Althoughparagraph(k)refersonlytotheOECDArrangementasa“safehaven”
in terms of the disciplines of that paragraph, the Appellate Body used the benchmarks of the
Arrangementastheappropriatemethodologyfordetermining inBrazil’scasewhethertheratesof
interestonitsexportcreditsweresuchastoleadtotheconclusionthatthey“areusedtosecurea
materialadvantage”.
Intheaftermathof thisdecision,somedevelopingcountrieshave justifiablyputparagraph(k)of theSCMAgreementontheagendaof thepresentDohaRoundof negotiations.127
E. TheGeneralAgreementonTradeandServices(GATS),Balanceof
Payments,andDebtSustainability
The regulation of banks and other financial institutions is critical to management of debt and
financialcrises,especially fromanequityperspective.Thecollapseof financial intermediariescan
destroythesavingsand jobsof ordinarycitizens.Thus,theWTOhasaspecialsetof rulesthatapply
toliberalizationof financialserviceswithinthegeneralcontextof GATS.
Beforeconsidering thesespecial rules, it is important tounderstand theprovisionsof thegeneral
WTOframeworkforservicesliberalization,theGATS,whichmayapplytothemanagementof debt
and financial crises. The GATS applies to trade in services through four modes: (1) crossborder
delivery; (2)presenceof theconsumer intheterritoryof thevendor (e.g.tourism,education,and
health care); (3) commercialpresenceof thevendor in the consumer state; and (4) crossborder
movementof workersengaged inproviding services.Certainobligations in theGATS apply to all
services trade in these four modes. There are also general exceptions, including in relation to
balanceof payments measures (which are examined below). Many of the most important
obligationsinGATS,suchastherulesapplyingtothegrantingof MarketAccesstoforeignsuppliers
127CIEL,supra.n.20.
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andaccordingthemtheNational(i.e.nondiscriminatory)Treatmentobligationapplyonlywherea
specifiedservicesectorislistedinaWTOMember’sscheduleof specificcommitments.
Article XI:1 of GATS creates a general rule that “a Member shall not apply restrictions on
international transfers and payments” applicable to sectors where a Member has made specificcommitmentsArticleXI:2states:“NothinginthisAgreementshallaffecttherightsandobligationsof
theMembers of the InternationalMonetary Fund under theArticles of Agreementof the Fund,
including the use of exchange actions which are in conformity with the Articles of Agreement,
providedthataMembershallnotimposerestrictionsonanycapitaltransactionsinconsistentlywith
its specificcommitments regarding such transactions,exceptunderArticleXII [of GATS]orat the
requestof theFund.”
Thelanguageof XI:2indicatesanextremelyimportantdifferencebetweenGATTandGATS.However
narrowlyorrestrictivelyinterpreted,therelevantprovisionsof theGATT,aswehaveseen,contain
only disciplines on current account measures. However, under the GATS a Member’s specific
commitmentsmaypreventitfrominstitutingcapitalaccountcontrols.TounderstandtheflexibilityundertheGATSwithregardtocapitalcontrolsitisthereforenecessarytolookcarefullyatArticleXII,
the balanceof payments exception. This exception can only be utilized after satisfying a very
complexandlongseriesof conditions.Thiscanbeillustratedfromthetextof ArticleXIIisasfollows:
Article XII:RestrictionstoSafeguard theBalanceof Payments
1. In theeventof seriousbalanceof paymentsandexternal financialdifficultiesor threat
thereof, a Member may adopt or maintain restrictions on trade in services on which it has
undertakenspecificcommitments,includingonpaymentsortransfersfortransactionsrelatedto
such commitments. It is recognized thatparticularpressureson thebalanceof paymentsof a
Memberintheprocessof economicdevelopmentoreconomictransitionmaynecessitatetheuseof restrictionstoensure,interalia,themaintenanceof alevelof financialreservesadequatefor
theimplementationof itsprogramof economicdevelopmentoreconomictransition.
2. Therestrictionsreferredtoinparagraph1:
(a) shallnotdiscriminateamongMembers;
(b) shall be consistent with the Articles of Agreement of the International
MonetaryFund;
(c) shallavoidunnecessarydamagetothecommercial,economicandfinancial
interestsof anyotherMember;
(d) shallnotexceedthosenecessarytodealwiththecircumstancesdescribedinparagraph1;
(e) shallbetemporaryandbephasedoutprogressivelyasthesituationspecified
inimproves.
3. In determining the incidence of such restrictions, Members may give priority to the
supply of services which are more essential to their economic or development programs.
However,such restrictionsshallnotbeadoptedormaintained for thepurposeof protectinga
particularservicesector.
4. Anyrestrictionsadoptedormaintainedunderparagraph1,oranychangestherein,shall
bepromptlynotifiedtotheGeneralCouncil.
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5. (a) Members applying the provisions of this Article shall consult promptly with the
CommitteeonBalanceof PaymentsRestrictionsonrestrictionsadoptedunderthisArticle.
(b) TheMinisterialConferenceshallestablishprocedures128forperiodicconsultations
withtheobjectiveof enablingsuchrecommendationstobemadetotheMemberconcernedasitmaydeemappropriate.
(c) Such consultations shall assess the balanceof payment situation of the Member
concerned and the restrictions adoptedormaintainedunder thisArticle, taking into account,
interalia,suchfactorsas:
i) the nature and extent of the balanceof payments and the external
financial;
ii) difficulties;
iii) the external economic and trading environment of the consulting
Member;iv) alternativecorrectivemeasureswhichmaybeavailable.
(d) Theconsultationsshalladdressthecomplianceof anyrestrictionswithparagraph2,
inparticulartheprogressivephaseoutof restrictionsinaccordancewithparagraph2(e).
(e) In such consultations, all findings of statistical and other facts presented by the
International Monetary Fund relating to foreign exchange, monetary reserves and balance of
payments,shallbeacceptedandconclusionsshallbebasedontheassessmentbytheFundof the
balanceof paymentsandtheexternalfinancialsituationof theconsultingMember.
6. If aMemberwhichisnotamemberof theInternationalMonetaryFundwishestoapplytheprovisionsof thisArticle,theMinisterialConferenceshallestablishareviewprocedureand
anyotherproceduresnecessary.
Anumberof featuresof ArticleXIIareworthyof specialattention.
Firstof all,XII:1givesdevelopingor transitionaleconomiesaclear right to takemeasures
thatprovidealevelof financialreserves“adequate”fortheMember’sprogramof economic
transition or development. Thus, Article XII:1 affirms that development goals are the
legitimatebasisforaWTOMemberdeterminingthekindsof balanceof paymentsmeasures
itneeds. Whereasthemeasuresmust“notexceedthosenecessary”todealwith“seriousbalanceof
payments and external financial difficultiesor threat thereof,”Article XII:3 affirms that a
Member “may give priority to the supply of services which are more essential to their
economicordevelopmentprograms.”
Moregenerally,theconceptof “necessity”oughttobeinterpretedinthecontextof Article
XIIasawhole,whichgivesconsiderableemphasis toan individualMember’sapproach to
development.ArticleXII canbe readasnot requiringaMember tousealternativepolicy
measures,even if theseare less restrictiveof services trade,wheresuchmeasureswould
underminetheconceptof equityimplicitorexplicitintheMember’sdevelopmentprogram.
128Itisunderstoodthattheproceduresunderparagraph5shallbethesameastheGATT1994procedure.
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Unliketheprovisionsof theGATT,ArticleXIIof theGATSspecifiesthatdeferencetotheIMFextends
only to statistics and facts and conclusions drawn from such statistics and facts. Therefore, a
judgmentabouttheconsistencyof measureswiththe IMFArticlesmaybemade independentlyat
theWTO.
ArticleXIIenvisagesconsultationsonbalanceof paymentsmeasures intheCommitteeonBalance
of PaymentsRestrictions.However,according to the logicof the IndiaBalanceof Payments case
discussedabove,sincetheGATSprovidesnoexceptionfromdisputesettlementforArticlesXIand
XIIof theGATS,theexistenceof theCommitteeonBalanceof Paymentswouldnotleadtoremoval
orrestrictionof panelandAB jurisdiction.
ItisimportanttoappreciatetheextenttowhichGATSspecificcommitmentsmayimplylimitstothe
ability to impose capital account controls. Footnote 8 of Article XVI:1 reads: “If a Member
undertakesamarketaccesscommitmentinrelationtothesupplyof aservicethrough[mode1]and
if the crossbordermovementof capital is anessentialpartof the service itself, thatMember is
thereby committed to allow suchmovementof capital. If aMemberundertakesamarketaccesscommitmentinrelationtothesupplyof aservicethrough[mode3],itistherebycommittedtoallow
relatedtransfersof capitalintoitsterritory.”Situationswhere“movementof capitalisanessential
part of the service itself” would apply most obviously to certain kinds of financial services (for
example,mutualfunds),buttheotherkindof situationmentioned inFootnote8 ismuchbroader,
applyingtoallcaseswheretheserviceisbeingsuppliedthroughacommercialpresenceintheWTO
Member.Nevertheless, in such circumstances, the requirementof liberalization seems limited to
inward movementof capital.
Somekindsof controlsover (outbound)capitalmightbeviewedasconditionsonwhocansupply
services(numberof servicesuppliers)inviolationof XVI:2(a),oras“limitationsonthetotalvalueof
servicetransactionsorassets”inviolationof XVI:2(b)or“totalnumberof serviceoperationsorthetotal quantity of service output” in violation of XVI:2(c). This possibility would follow from an
extremelybroadinterpretationof XVI:2(a)and(c)bytheABintheUSGamblingcase.Essentially,the
ABsuggestedthattoviolateeitherprovision,measuresneednottaketheexplicitformsdescribedin
thoseprovisions,providedthattheyhavecomparableeffectsonrestrictingmarketaccessandare
quantitative innature (Reportof theAppellateBody,paras. 232,247). Since capital controls are
clearly measures that are quantitative in nature, they may well have effects on the number of
servicesuppliersorthetotalvalueof servicestransactionsorassetsunderArticleXVI.
Commitmentswith respect to financial servicesaregovernedby theAnnexonFinancialServices.
TheAnnexcontainsthefollowingprovision:
DomesticRegulation
(a) Notwithstanding any other provisions of the Agreement, a Member shall not be
preventedfromtakingmeasuresforprudentialreasons,includingfortheprotectionof
investors,depositors,policyholdersorpersonstowhomafiduciaryduty isowedbya
financialservicesupplier,ortoensuretheintegrityandstabilityof thefinancialsystem.
Wheresuchmeasuresdonotconformwiththeprovisionsof theAgreement,theyshall
notbeusedasameansof avoidingtheMember’scommitmentsorobligationsunder
theAgreement.
The first sentence of this provision appears to allow any measure “to ensure the integrity and
stabilityof thefinancialsystem”withouttheneedtoshowthatthemeasureisnecessaryortheleastrestrictive of trade in services. The second sentence, however, seems drafted in a manner to
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underminetheregulatoryflexibilitygranted inthe firstsentence, inthat itqualifiestheuseof the
provisionasanexception toGATScommitmentsandobligations.Thus,whereameasure isnot in
conformitywithGATS,it“shallnotbeusedasameansof avoidingtheMember’scommitmentsor
obligationsundertheAgreement.”
Itisdifficulttodiscerntheexactimplicationof thisqualifyingorconditionallanguage.Onepossible
reading would be that it imports an intent requirement into 2(a), namely the notion that the
measuresmustbegenuinelyintendedto“ensuretheintegrityandstabilityof thefinancialsystem”
ratherthantoprotectdomesticfinancialindustries.Suchanintentrequirementmightbedifficultto
apply inthecaseof a financialcrisis,whereensuringthesurvivalof domesticfinancial institutions
maywellbepartandparcelof ensuringthe“integrityandstabilityof thefinancialsystem”itself.
Finally,anycommitmentorobligationunderGATSissubjecttothegeneralexceptionsinArticleXIV
of GATS.Thus,whetherornotaMember’smeasuremeetsthecriteriasetforthinArticleXIIof the
GATSor theAnnexonFinancial services, themeasuremay stillbe justified if “necessary” for the
protectionof human lifeorhealthorof publicmoralorpublicorder.According to footnote5of ArticleXII,Thepublicorderexceptionmaybeinvoked“onlywhereagenuineandsufficientlyserious
threatisposedtooneof thefundamentalinterestsof society.”Inthiscontextitisnoteworthythat
intheUnited StatesGamblingcasetheABupheldthepanelapproachthatsuggestedtheremustbe
somedeferencetoaWTOMember’sowndeterminationof themeaningof publicmoralsandpublic
order(AppellateBodyReport,paras.296297).
Asageneralmatterotherpoliciessuchasexchangeratestabilization,depreciationorappreciation
undertakeninresponsetoafinancialcrisismaybeunsustainableintheabsenceof capitalcontrols.
Experiencewith applicable parts of theGATSwill thus eventually play a role in determining the
rangeof macroeconomicpolicyresponses.
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F. Conclusions
WTO rules on exchange actions and the balanceof payments justifications for trade restrictionsclearlyreflectaconceptionof equitythattakes intoaccounttheparticularneedsandsituationsof
developing countries. In certain, carefully defined matters the WTO rules entail deference to
judgmentsof theIMF.
However,inactualdisputesettlementelementsintherulesthatreflectequitytowardsdeveloping
countrieshavebeenminimizedorignored.Moreover,thedisputesettlementorganshavegonewell
beyondtheexplicitlimitsof deferencetotheIMF,deferringsuchtotheIMFeveninsuchamatteras
the meaning of a country’s “development policy” (the IndiaBalance of Payments case). Since
developing countries have limited representation and voice in the IMF, from the perspective of
equityasparticipationindecisionmakingconcerningdevelopmentthesetendenciesof thedispute
settlementorgansseemdifficultto justify.
More generally, the concept of coherence reflected in relevant WTO instruments and activities
directedtowardsbalanceof paymentsandexchangematters is toonarrowly focusedon relations
between the IMF and the WTO, and does not include cooperation with other international
institutionsconcernedwithequity indevelopment.Theconceptof coherenceshouldberevisedto
accommodate the relationship with equity implied in the Millennium Declaration and related
instruments.
Moreover even within the narrow conception of coherence embraced in the WTO, the agreed
mechanism foravoiding crossconditionalities,namelyobligatory consultationsbetween theWTO
SecretariatandtheIMFpriortoeithertakingdecisionsthatcouldresultincrossconditionalities,has
not been closely followed. A review should be undertaken of the justification for not using thisprocess and of the extent to which avoidance of crossconditionalities has been achieved in
experiencesofar.
Inthecaseof theGeneralAgreementonTrade inServices(GATS),there isarealpossibilitythata
WTOMember’s specific commitments combinedwith the general obligations of theGATS could
meanthataMember’sadoptionof capitalcontrolsconstitutesaGATSviolation,eventhoughsuch
controls may be necessary to address a financial crisis in a manner consistent with social and
economic justice. In viewof theexceptions and limitations in theGATS that couldnone the less
justifysuchmeasuresthereisacaseforthedrawingupof guidelinesinthisareawhichtakeaccount
of equity inthetradeandfinancialsystem inthe interpretationof such limitsandexceptions.This
task should be undertaken by international institutions with a mandate related to equity indevelopment.
As exemplified by the Brazil Aircraft case, the rules on export subsidies in the SCM Agreement
appear to limit the capacity of developing countries to provide support for export transactions
throughexportcredits.This reflects theuseof marketbenchmarksdevised forandbydeveloped
countries in the OECD Arrangement for the assessment of export credit arrangements.
Considerationshouldbegiventoanalternativeapproachwhichwouldtakeintoaccountstructural
differences between the financialmarketsof developed anddeveloping countries aswell as the
specialchallengesregardingaccesstocapitalmarketsforexportfinancingfacingcountriesthathave
facedfinancialordebtcrises.
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CHAPTER X
RISKASSOCIATEDWITHTRENDSINTHE
TREATMENTOFSOVEREIGNDEBTINBILATERAL
TRADEANDINVESTMENTTREATIES
AldoCaliari
(Centerof Concern)
A. Introduction
ThereisagrowingtrendinFreeTradeAgreementsfortheinclusionof provisionsthatsubjectpolicy
towardsthefinancialsectorto legaldisciplinesenshrined intradeand investmentagreementsand
totheassociateddisputesettlementmechanisms.Thistrendplaceslimitsontheusebydeveloping
countries of several tools designed to build and preserve stable and healthy financial sectors
responsive to national development priorities and supportive of trade. The limits are capable of
increasingdevelopingcountries’vulnerabilitytofinancialanddebtcrises.
B. SovereignDebtinBilateralTradeandInvestmentTreaties
In bilateral Free Trade Agreements recently negotiated by the United States Government a
controversialissuehasbeentheinsistenceof theUnitedStatesonpursuinginclusionof clausesthat
wouldapplytosovereigndebtissuedbythepartiesprinciplessuchasNationalTreatmentandMost
FavoredNation(MFN)Treatmentwhicharepartof bilateral investmenttreatiesandof GATT/WTO
rulesfortradeingoodsandservices.
A review of some recent treaties reveals at least two different approaches to the treatment of
sovereigndebt.
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1. SovereignDebtExplicitlyExcludedfromApplicationof thePrinciples
UnderNAFTA, investmentcoversasweepingarrayof typesof ownership interests, including loans
and securities. However, in conformity with Article 1416 in the section on Financial Services,
“investmentmeans “investment”asdefined inArticle1139 (InvestmentDefinitions),except that,
withrespectto“loans”and“debtsecurities”referredtointhatArticle:(a)aloantoordebtsecurity
issuedbyafinancialinstitutionisaninvestmentonlywhereitistreatedasregulatorycapitalbythe
Partyinwhoseterritorythefinancialinstitutionislocated;and(b)aloangrantedbyordebtsecurity
owned by a financial institution, other than a loan to or debt security of a financial institution
referredtoinsubparagraph(a),isnotaninvestment;”
Tothisisaddedthefollowing:“forgreatercertainty:(c)aloanto,or debt security issued by,aParty
or astateenterprisethereof isnot aninvestment” (author’sitalics).
Therefore,underNAFTA,sovereigndebtsareexplicitlyexcludedfromthedefinitionof investment.
2. SovereignDebtExplicitlyIncludedwithintheScopeof Applicationof Investment
Principles
In the2003UnitedStatesChileFreeTradeAgreement (FTA) specificprincipleson investmentare
explicitlyapplicable to sovereigndebt.TheUnitedStatesChileFTA containsabroaddefinitionof
investmentbasedonthefollowingstandardadoptedbytheUnitedStatesinitsmostrecentBilateral
InvestmentTreaty(BIT)Model.129
“Investmentmeanseveryassetthataninvestorownsorcontrols,directlyorindirectly,thathasthe
characteristicsof aninvestment,includingsuchcharacteristicsasthecommitmentof capitalorother
resources,theexpectationof gainorprofit,ortheassumptionof risk.Formsthataninvestmentmaytakeinclude:
Anenterprise;
Shares,stock,andotherformsof equityparticipationinanenterprise;
Bonds,debentures,loans,andotherdebtinstruments;
Futures,options,andotherderivatives;
Rights under contract, including turnkey, construction, management, production,
concession,orrevenuesharingcontracts;
Intellectualpropertyrights;
Rights conferred pursuant todomestic law, such as concessions, licenses, authorizations,
andpermits;and Othertangibleor intangible,movableor immovableproperty,andrelatedpropertyrights,
suchas leases,mortgages, liens,andpledges;but investmentdoesnotmeananorderor
judgmententeredina judicialoradministrativeaction…”
Thisdefinitiongenerallyincludes“bonds,debentures,loansandotherdebtinstruments”.130Inwhat
represents a significant departure from NAFTA, the treaty explicitly makes the agreement’s
129ThisdefinitionhasbecomestandardblueprintfortheUSnegotiatingpositionintreaties.SeeUnitedStates2004Model
BIT,Art.1130
Usuallywithafootnotethatclarifies“Someformsof debt,suchasbonds,debentures,andlongtermnotes,aremorelikely to have the characteristics of an investment, while other forms of debt, such as claims to payment that are
immediatelydueandresultfromthesaleof goodsorservices,areleslikelytohavesuchcharacteristics.”
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provisionsapplicable to sovereigndebts issuedby theChileanGovernment.131The same rulesare
contained in theCentralAmericaFreeTradeAgreement (CAFTA).132Thus, theUnited StatesChile
FTAandCAFTAmakeNationalTreatmentandMFNTreatmentapplicabletosovereigndebtsissued
bytheGovernmentsof thecountriesinvolved.
3. The“Elliptic”Inclusionof DebtintheUnitedStatesUruguayFTA
TheUnitedStatesUruguayFTA(signedin2004)raisesaninterestingquestionbecauseitsprovisions
could lead to reinterpretation of previous treaties. The FTA contains the standard definition of
investmentas including“Bond,debentures,otherdebt instrumentsand loans” Italsocontains, in
AnnexF,aclausewithlanguagesimilartothefirstpartof theNAFTAarticleabove.133
Uptothispointof thetext,althoughthere isnoexplicitexclusionas intheNAFTAsupplementary
clause, the agreement seems to imply that sovereign debt is excluded from the definition of
investment.
However,thisdoesnotappeartobethecase.AnnexGof theUnitedStatesUruguayFTAheaded
“SovereignDebt”,readsasfollows:
“1.Noclaimthatarestructuringof adebt instrument issuedbyUruguaybreaches
an obligation under Articles 5 through 10 may be submitted to, or if already
submitted continue in, arbitration under Section B, if the restructuring is a
negotiated restructuring at the time of submission, or becomes a negotiated
restructuringaftersuchsubmission.”
Thiswouldappeartomeanthatsovereigndebtis,indeed,includedinthescopeof thedefinitionof
investmentforthepurposesof theTreaty. Italsowouldopentheway forthe interpretationthat,absentanexplicitexclusion,sovereigndebt isconsidered to fit into thescopeof thedefinitionof
investment.Thiscouldhavetheconsequenceof leadingtoanexpansionof thescopeof theterm,
“investment”, in treatiesworded similarly to theUnited StatesUruguay FTA, such as theUnited
StatesSingaporeFTA.
C. ImplicationsforSovereignDebtProblemsof IncludingNationalTreatment
andMFNTreatmentinFTAs
Whatarethepossibleimplicationsof applyingNationalTreatmentandMFNTreatmenttosovereign
debt?
131SeeAnnex10B(Annextothechapterof thetreatythatdealswithinvestment):“Thereschedulingof thedebtsof Chile,
orof itsappropriateinstitutionsownedorcontrolledthroughownershipinterestsbyChile,owedtotheUnitedStatesand
thereschedulingof itsdebtsowedtocreditorsingeneralarenotsubjecttoanyprovisionof SectionAotherthanArticles
10.2and10.3”Articles10.2and10.3intheTreatyrefertoNationalTreatmentandMostFavoredNationTreatment.132SeealsoUgarteche(2004,1418and3435).
133Art.4reads:
“(b) Investmentmeans“investment”asdefined inArticle1,exceptthat,withrespectto“loans”and“debt instruments”
referredto inthatArticle: (i)a loantoordebt instrument issuedbya financial institution isan investment inafinancial
institutiononlywhereitistreatedasregulatorycapitalbythePartyinwhoseterritorythefinancialinstitutionislocated;and(ii)aloangrantedbyordebtinstrumentownedbyafinancialinstitution,otherthanaloantoordebtinstrumentof a
financialinstitutionreferredtoinsubparagraph(b)(i),isnotaninvestmentinafinancialinstitution”.
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These principles were originally developed in different historical contexts. National Treatment
featured from the firsthalf of the twentiethcenturyonwards in treatiesof friendship,commerce
andnavigation(FCNtreaties),i.e.bilateraltreatiescoveringmiscellaneoussubjectssuchasaccessto
ports,tariffs,thepowersandresponsibilitiesof consuls,andprotectionagainstappropriation.The
lastof theseheadingstypicallyincludedprovisionsconcerningnationaltreatment,i.e.guaranteesof
nondiscriminatory treatment of foreign firms. MFN clauses were included in reciprocal trade
agreementsnegotiatedbetweentheUnitedStatesandvariouscountriesunderaprogramlegislated
in1934.Under theMFNclauses included in theseagreementseachof thepartiesbound itself to
extendtotheothertariff concessionsatleastasgreatasthoseextendedtothemostfavorednation
withwhich it traded.BothNationalTreatmentandMFNTreatmentwere included in theGATTas
principlesapplyingtotradeingoods.
The extension of National Treatment and MFN Treatment to other subjects is neither
straightforwardnoruncontroversial.134Indeed, theirextension tosovereigndebt raises issues that
could be more harmful to developing countries than those considered under their traditional
applicationtoforeigninvestment.Adiscussionof anumberof theseissuesfollows:
1. DismantlingToolsNeededfortheRecoveryof theLocalEconomyinPostCrisis
Situations
The application of National Treatment to sovereign debtwould restrict the ability of thedebtor
Government to take certain policymeasures aimed at the recoveryof the local economy in the
aftermathof financial crises.NationalTreatment in this contextmeans that foreign creditors are
offeredtreatmentindebtrestructuringsnolessfavorablethanthatofferedtodomesticcreditors.135
However,thereareseveralreasonswhyacountryrestructuring itssovereigndebtafterafinancial
crisismightneedtoresorttoofferingpreferentialconditionstodomesticcreditors.
In a financial crisis, domestic creditors often suffer a double adjustment . First, they are
typically forced toaccepta“haircut”on theirclaims,whichmeans that thevalueof their
loansarereducedbyacertainpercentage.Secondly,theyoftensuffercostsrelatedtothe
internaladjustment,suchashighinterestrates.Infact,theimpactof debtrestructuringon
domesticcapitalmarketsand,inturn,ontheresumptionof growthandrepaymentcapacity
needs tobe taken into account in assessing the consequencesof debt crises (Machinea,
2004:188)..”
Dealing with domestic before foreign debt might also allow the Government to return
rapidlytodomesticcapitalmarketsduringwhatislikelytobeasustainedinterruptioninits
accesstointernationalcapitalmarkets(IMF,2002:13).
The debtor may also need to accord priority to domestic debt in order to protect the
financialsystem.TheIMFhassaidthat“therestructuringof certaintypesof domesticdebt
mayhavemajor implications for economic performance, as a resultof its impacton the
financialsystemandtheoperationof domesticcapitalmarkets”(IMF,2002:13).Sovereign
debtrestructuring typicallyhasadouble impacton the financialsystem.Ontheonehand
134SeeKhor(2002),whostates:“Itiscertainlynotclearthattheprinciplesof theWTO(includingNationalTreatmentand
MostFavoredNationtreatment)thatapplytotradeingoodsshouldapplytoinvestment,northat,if applied,theywould
benefitdevelopingcountries.”SeealsoChangandGreen(2003),ActionAid(2003),OxfamInternational(2003).135
Thisisimportantinthecontextof thedevelopingcountrysignatoriesof CAFTA,since,withtheexceptionof Honduras,an importantshareof publicdebt inallthesecountries isowedtodomesticcreditors. Insomeof them, likeCostaRica,
domesticdebtisactuallyhigherthanexternaldebt.
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financial institutionsareweakenedbythe impactontheircapital levelsof thereduction in
the value of bonds. On the other hand, debt restructuring is associated with a general
increase in uncertainty, which can inflict widespread damage on the creditworthiness of
firms (Machinea,2004: 188189). Thus, in such cases special treatment todomesticdebt
mayenablethedebtortoprotect“acoreof thebankingsystembyensuringtheavailability
of assetsrequiredforbankstomanagecapital,liquidityandexposuretomarketrisks”(IMF,
2002:13).
Asovereigndebtormayalsoneedtoaccordspecialtreatmenttodomesticdebtorsforthe
samereasonsthatcanleadittoaccordspecialtreatmenttonationalsectorsandindustries
aspartof anationaldevelopmentstrategyandtheachievementof developmentgoals.
In the IMF’sview shelteringdomestic investors from the full impactof debt restructuring
maybenecessary inorderto“garnersupportforanambitiousadjustmentprogram”(IMF,
2002:13).
2. PreventingtheStatefromPayingSalariesandPensionsinDebtCrises
Theapplicationof NationalTreatmenttosovereigndebtmeansthattheGovernmentwillbeunable
toprioritizedomesticdebtassociatedwithmeetingwages,salariesandpensionobligations.Inother
words, theGovernment isbound to treat thesedebts in the sameway as foreigndebtsheldby
transnationalbanksandinstitutionalinvestors.If itsresourcesareenoughtocoveronlyaportionof
itsdebts,thestatewillnotbeabletochoosetodirect those fundstomeetingthesepriorities,at
leastnotaslongasitdoesnotdevoteequalamountforpaymentstoforeigncreditors.
Unlikeanindebtedprivatecompany,anindebtedsovereignhashumanrightsobligationsandsocial
responsibilitiestowardsitspeople.Thismeansthat,indealingwithsovereigndebt,thereareissues
that cannotbe addressedby strict analogieswithbankruptcyprinciples applicable to theprivate
sector.Thusproposalsof civilsocietyforarulesbasedframeworkhavetypicallycalledforrecourse
toanalogieswithframeworkswhichaccommodatetheoverallmissionthatthestateisexpectedto
fulfill. Such frameworks include Chapter 9 of United States Bankruptcy Law applicable to
municipalities. Even the IMF’smuchcriticized SovereignDebt RestructuringMechanism proposal
excluded“Wages,salariesandpensions”fromitsapplication(IMF,2003:24).
3. ReducingtheLeverageof DebtorsinaDebtRestructuring
Byfirstgatheringthesupportof domesticcreditorsaGovernmentcanacquiresubstantialcloutfor
thenegotiationsoverdebtrestructuringwithothercreditors.Theofferof preferentialconditionsto
thesedomesticcreditorscanbecriticalinthiscontext.Thusif theprincipleof NationalTreatmentis
applied to sovereign debt, this avenue for the indebted country to strengthen its negotiating
positioniseffectivelyforeclosed.
Theofferof preferentialconditionstodomesticcreditorswascrucialtoenhancingtheGovernment’s
leverageinArgentina’snegotiationswithitscreditorsafteritsDecember2001default.InSeptember
2003theGovernmentreleaseditsinitialproposedconditionsfordebtrestructuring,whichincluded
a75percenthaircut forbondholders.TheGovernment contended that thiswas the sizeof the
reduction that would enable it to recover sustainable economic growth, while ensuring that its
promisesof paymentwerekept.Somegroupsof bondholdersquicklyrejectedthisoffer,claiming
thatitwaswoefullyinsufficientand,inthelightof thecountry’smostrecentgrowthfigures,below
thecapacityof thecountrytorepay.ThecreditorsalsostronglylobbiedtheG7which,directlyand
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through the IMF,putpressureonArgentina to improve itsoffer.136Withpressuremounting from
thesequarters,Argentinaturnedtodomesticpensionfundswithanofferof inflationlinkedbonds
thatrepresentedanimprovementovertheoffermadetotheotherbondholders.Bythusgranting
these institutions preferential conditions, Argentina was able to reach agreement with creditors
holdingmorethan17percentof itstotaldebt.Thiswasacriticalfirststepingarneringthesupport
of amajorityof creditors that eventually totaled76per cent.However, theofferof preferential
treatmenttodomesticpensionfundswouldnothavebeencompatiblewiththeprincipleof National
Treatment.
4. Creationof aPrivilegefortheDebtOwned(orAcquired)byCreditorsfromthe
Party
Applicationof NationalandMFNTreatmentonlytocreditorsof countriesthatarepartiestobilateral
investmenttreaties(whichhaveinrecentyearslargelyreplacedtheFCNtreatiesmentionedearlier)
would have the discriminatory result of granting seniority to creditors from such countries overthosefromothercountries.Thiswouldaffect therightsof bondholders fromnonpartycountries
without their consent since theyare,bydefinition,excluded from intervening in thenegotiations
under the bilateral agreement. For these bondholders such treatment might be equated to an
involuntarydebtswapunderwhichtheyfindthemselvesholdingadowngradedinstrument.
D. InvestorStateLawsuitsandSovereignDebt
Oneeffectof applyingtheprinciplesof investmenttreatiestosovereigndebt isthatGovernments
that violate investor protections can face expensive lawsuits. As under NAFTA and numerous
bilateral investment treaties,CAFTA grantsprivate foreign investors the right tobypassdomesticcourtsandsueGovernmentsininternationaltribunals(Peterson,2004:3).
Such“investorstatelawsuits”arehighlycontroversialforanumberof reasons(Peterson,2004and
2004a). Many arbitration tribunals operate with a lack of transparency, having no obligation to
disclose relevant documents or allow any form of public participation. The system for choosing
arbitratorshas alsodrawn criticism as the arbitrators canbedrawn from the ranksof practicing
investment lawyersand there isnoobligation toappointarbitorswhowillbe independent in the
senseof nothavingastakeinhowthetreatyisinterpreted.
Moreover,arbitraltribunalsdonothavetopayregardtolegalprecedents(Peterson,2004:6).This
feature, which creates a lot of uncertainty in the investment arena, could become particularly
troublesomewhenappliedtosovereigndebtcrises.Indeed,themainrationaleformoresystematic
arrangements for handling sovereign debt defaults has been the need to provide greater
predictability forbothdebtorsandcreditors in themessyprocessof exitingsovereigndebtcrises.
Clearly,theexistingsystemof arbitrationtribunalswoulddoapoor jobataddressingthoseconcerns
andwouldinjectadditionaluncertaintyintoexistingarrangementsforthefollowingreasons:
136InitsIMFagreementtheArgentinegovernmenthadpromisedto“negotiateingoodfaith”andwassingledoutinsome
G7statementsasnotcomplyingwithsuchapledge.Privatecreditorsmaintainedthatnegotiationsingoodfaithrequired
theagreementof 80percentof creditors,whilethegovernmentof Argentinaclaimedthatafigureabove6570percentwouldsuffice. Itwas incongruous thatthe IMFandG7countries,whichwerethemselvesamongst thecreditors,should
haveunilaterallyattemptedtodefinetheconditionsof anacceptabledebtrestructuring.
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CompendiumonDebt Sustainability and Development
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Theapplicationof theprinciplesof NationalTreatmentandMFN tosovereigndebtmight
givethesearbitraltribunalstheauthoritytodefinedifficultquestionsthatarguablybelong
tothedomestic jurisdictionof states.
The application of these principlesmight alsoopen theway for the application of othermore general principles that are becoming common in investment treaties, such as
“minimumstandardof treatment”or“fairtreatment.As illustratedabove inthediscussion
of Argentina’sdebtrenegotiation,there isnorulesbasedframeworktodeterminewhat is
an“acceptable”levelof repaymentor“negotiationingoodfaith”,etc.indebtnegotiations
andrestructurings.Noristhereanycertaintythatprinciplesorrulesoriginallyformulatedin
thecontextof bankruptcylawwillbeappliedbyanarbitrationtribunal.
These generalprinciples are contentiouseven in the contextof investment treaties.That
minimum or fair standards of treatment apply only to investors, while considerations
involving workers and other human rights as well as the environment, which might
counterbalancethem,arenotgivenequalweightisasourceof controversy.
Closelyrelatedtopointsraised insectionC.2 isthepointthatapplicationof thesegeneral
principlestosovereigndebtwouldnottakeaccountof theresponsibilityof theGovernment
of thedebtorcountrytoitspopulation.
E. ConcludingRemarks
The existing regime for dealing with sovereign debt crises lacks a rulesbased, multilateral
framework.Thisleavesdebtorsvulnerabletopowerasymmetriesascomparedwithcreditors.These
asymmetries would be reinforced by extension of the definition of the investment instruments
coveredinbilateralinvestmenttreatiestoincludeallormostdebtinstruments,particularlythoseforsovereigndebt.Therehavealreadybeenmovestowardsamoreinclusivedefinitionof investmentin
somerecenttreaties.Thishastheconsequencethatdebtinstrumentsaresubjecttoprinciplessuch
asNational Treatment andMFN Treatmentwhichwereoriginallydeveloped tohandleproblems
arisingunderbilateral investmenttreatiesandgoodstradeundertheGATT,andnotdebtcrises.A
notableexceptiontotherecenttendencyforextendingsuchprinciplestodebtistheNAFTA,which
explicitly excludes sovereign debt from the definition of investment. In view of the dangers to
developing countries from theextensionof principlesdesigned for foreign investmentand goods
tradetodebtinstruments,theNAFTAapproachfurnishesasuperiormodelforthefuture.
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Risk Associated withTrendsintheTreatment of SovereignDebt inBilateral Tradeand Investment Treaties
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