Sovereign Debt in Developing Countries with Market Access: Help or Hindrance ?

1. Sovereign Debt in Developing Countries with Market Access: Help or Hindrance? Indermit Gill and Brian Pinto The World Bank “The Financial Sector Post-Crisis: Challenges and Vulnerabilities” April 26-27, 2005

2. Acknowledgements • We thank Joshua Aizenman, Amar Bhattacharya, Nina Budina, Craig Burnside, Christophe Chamley, Ajay Chhibber, Gautam Datta, Norbert Fiess, Jim Hanson, Olivier Jeanne, Himmat Kalsi, Homi Kharas, Gobind Nankani, Vikram Nehru, Anand Rajaram, Luis Serven, John Williamson, Holger Wolf, and many others for useful comments or contributions. All errors are ours. The opinions expressed in this paper are entirely those of the authors and should not be attributed to the World Bank, its Executive Directors, or the countries the represent.

3. In Principle: • Government borrowing should facilitate growth by permitting investments in infrastructure and social sectors • Debt often superior to taxing money or output • Free capital flows should augment resources in developing countries and accelerate growth and convergence.

4. In Practice: • 1980s: widespread external debt crisis, took a decade to resolve • Early 1990s • Brady Plan -18 countries, restructured $200 billion of bank loans into $154 billion in bonds • Financial liberalization • After mid-1990s: • Another round of crises • Two new generations of crisis models Things haven’t gone too well with sovereign debt and capital account openness.

5. Objective- Answer three questions: • What are the chances of another 1980s-type debt crisis? • Is public debt constraining growth? • What is being done about sovereign debt? Focus: Market Access Countries

6. Table 1. Sovereign Debt -Ten Big MACs and Ten Debt Majors

7. Approach • Survey the literature to develop a conceptual framework • Growth theory • External capital flows • Macroeconomic crises There’s not much theory linking sovereign debt and growth. Empirical studies are few and fraught with measurement and econometric problems. • Answer the three questions. Debt issues are very country-specific, difficult to generalize.

8. Findings from the Literature Survey • MACs do not appear to have used sovereign debt well. • External capital flows are more likely to have enhanced vulnerability than growth

9. Why Such Negative Findings? • Debt intolerance vs. Original Sin • Paucity of suitable instruments • Fiscal Space – IFI macro framework is wrong • Political economy explanations more convincing than pure economic theory, which rules out crises by construction.

10. Table 3. Main Factors Underlying Debt Reduction, 1990-2003 Based on Budina, Fiess and others (2004)

11. Debt Reduction Episodes • All episodes involve GDP growth as one of the main contributing factors. • Two-thirds involve significant primary surpluses; in only one episode, Lebanon 1991-93, were debt ratios reduced while running a primary deficit. • Two-thirds of the episodes involve real exchange rate appreciation.

12. Table 4. Main Factors Underlying Debt Increases, 1990-2003 Based on Budina, Fiess and others (2004)

13. Debt Increase Episodes • All episodes involve real interest or exchange rate changes or both as significant factors • Most episodes involve "other factors" such as financial sector bailouts • In more than half the cases, the countries ran primary surpluses during these debt run-ups; only in three cases did countries run primary deficits. • Economic growth collapses did not play an important part

14. Public Debt and Economic Growth g - GDP growth - Inflation FD - fiscal deficit (1) (2) Output volatility (3) (4) - optimal debt SR - sovereign (or default) risk

15. Sustainability and Solvency • “Sustainability” problem means mix of primary fiscal balances, real interest rates and growth rates is untenable. • Market final arbiter of sustainable debt level for MACs. • “Solvency” problem means discounted sum of future primary fiscal surpluses less than initial debt. • Insolvency implies unsustainability.

16. Let’s Get Real! • No objective measure of sustainability. • Example: primary deficits and r>g but low debt-to-GDP; or temporary. • On the other hand: • government may be unhappy -- too much revenue going for interest, short maturities • market may be signaling high default and devaluation risk. • “Unsustainable debt dynamics” inextricably tied up with market perceptions and political economy.

17. Possible Responses to Unsustainability • Procrastinate (Russia, Argentina) • Inflate away debt (Russia, Argentina) • Default and restructure (Russia, Argentina) • Increase primary surplus, move to flexible exchange rates, reform fiscal and other institutions (E. Asia, Brazil, Turkey).

18. Chances of Another Big Crisis • Never say never. But crisis risks have receded since late 1990s. • Low international interest rates, encouraging movements in market spreads • Moral hazard likely to be lower after Russia Argentina • Significant countries running large primary fiscal surpluses, flex exchange rates, move towards domestic debt.

19. Table 6. Economic Indicators Before and After Crisis in Four Big MACs

20. Growth Being Constrained? • Easy answer: yes, based on debt thresholds established by existing studies • Yes, if debt sustainability problems (Argentina, Brazil, Jamaica, Lebanon, Turkey) • Yes, if debt intolerant and volatile. • Yes, if leads to an adverse spending composition (India)

21. What is Being Done? • Numerous initiatives, little concrete progress • SDRM on hold, CACs appear to be taking off • Chance of new instruments remote • Most significant: what countries themselves are doing.

22. Some Conclusions • MACs need to pay more attention to the government’s inter-temporal budget constraint (different mindset) • If debt sustainability problems, negative impact on growth very likely (don’t assume you’ll grow out of the debt problem) • Fiscal space a valid point, but approach cautiously • Fiscal and institutional reform key • Vexing problem: How can IFIs help MACs?

23. Thank you!