External Debt Management , Classification of External Debt Crises. and Indicators

1. External Debt Management ,Classification of External Debt Crises. and Indicators -first presentation- Aug 30, 2005 Dr. Sayuri SHIRAI http://www.paw.hi-ho.ne.jp/~sshirai

2. Two Main External Debt Issues 1. Economic Crises in Low-income developing countries IMF and World Bank as a provider of concessionary loans (PRGF, IDA) Main issue: macroeconomic problems together with the quality of governance and institutions Millennium Development Goals, HIPCs, Debt relief 2. Economic Crises in Emerging Market Economies (East Asia of 1997-99, Russia in 1998, Brazil in 1999, Argentina in 2001) IMF and World Bank provide non-concessionary loans Regional initiatives in Asia (AMF, New Miyazawa Initiative) Main issue: severity of crises, contagion of crises

3. Various External Debt Crises Since the 1990s Current Account Crisis (developing countries) Capital Account Crisis (emerging market economies) Commonality: Fixed Exchange Rate Regime Large Current Account Deficit Substantial External Debt

4. Recent Crises in Emerging Market and Developing Countries �Mexican Crisis of 1994-1995 �East Asian Crisis of 1997-1998 �Russian Crisis of August 1998 �Brazilian Crisis of January 1999 �Argentina Crisis of December 2001

5. Classification of External Debt Crises is Important Different policy prescriptions are necessary Understanding IMF criticism and better international financial architecture to prevent crises => massive, immediate financial support and banking sector soundness (SRF, CCL, CACs, SDRM) => better poverty-oriented development strategies (PRSP, donor coordination over ODA increase and external debt relief, MDGs) Different external debt management skills are necessary (private debt versus sovereign debt)

6. Types of External Debt Crises

7. New Environment Related to the East Asian Crises of 1997-98 (1) Liberalization of domestic financial market (e.g., interest rate deregulation, entry deregulation) + Liberalization of international capital flows + Technology development + New Financial Assets => Market-determined interest rates (2) Borrowers: Public (fiscal deficit, small domestic savings) => Private => Contingent liability (3) Creditors: Public => Private (syndicate) => Private (investors) (4) New risk: (a) Shortened debt maturity (private) => volatile and speculative capital flows => frequent speculative currency attacks; (b) Enlarging asset price volatility + excessive risk-taking => balance sheets of banks and firms

8. Capital Account Crisis New type of crises driven by capital flows Good macroeconomic performance Massive capital Inflows => accumulation of foreign reserves (BOP surplus) Investors� sentiment matters

9. Current Account Crisis Inappropriate Macroeconomic Policies Fiscal Deficit => Monetization + External Debt => Inflation + Current Account Deficit (S-I)g + (S-I)p = Current Account < 0 or (Income � Absorption) = Current Account < 0 => Foreign Reserves Shortage + Real Appreciation => IMF rescue with conditionality

10. For a Country Prone to the Current Account Crisis, (Domestic and foreign) public debt management is very important because: (1) Government debt portfolio tends to be the largest (2) Public sector default often leads to a sharp curtailment of capital flows, while that of the private sector does not necessarily indicate an external crisis (3) Public debt problems often generate substantial risk not only to the government�s balance sheet, but also to the country�s financial stability

11. Purpose of Public Debt Management Public debt management = the process of establishing and executing a strategy for managing the government�s (external and domestic) debt to (1) raise the required amount of funding, (2) achieve its risk and cost objectives, and possibly, (3) develop an efficient market for government securities In a macroeconomic context, the level and rate of growth in public debt should be sustainable and can be serviced under various circumstances, while meeting cost and risk objectives. A country should adopt and maintain a credible debt strategy to reduce excessive levels of debt and be aware of the impact of government financing requirements and debt levels on borrowing costs Public debt covers both marketable debt and non-market debt (concessional financing); domestic and foreign currency borrowings; and off-balance sheet claims, including contingent liabilities In many developing countries, external debt management is more important than domestic one

12. Public Debt Management and Macroeconomic Policy Sound public debt management cannot be a substitute for sound macroeconomic policies Sound public debt management is not enough to ensure that a country is well insulated from economic and financial shocks Macroeconomic policy framework covers appropriate exchange rate regime, a monetary policy framework, a sound external position, a well-supervised financial system Sound macroeconomic policy is essential to foster confidence among financial market participants so that they are willing to invest in government securities with a minimum of uncertainty However, having sound public debt management is closely associated with her ability to absorb various shocks Risky debt management practices increase the vulnerability of the economy to economic and financial shocks

13. Solvency and Liquidity An entity is solvent if the present discounted value (PDV) of its current and future primary expenditure (E) is no greater than the PDV of its current and future path of income (Y), net of any initial indebtedness. An entity is illiquid if (regardless of whether it satisfies the solvency condition) its liquid assets and available financing are insufficient to meet or roll-over its maturing liabilities The distinction between solvency and liquidity is ambiguous because illiquidity may be manifested in rising interest rates which eventually calls into question the entity�s solvency.

14. Sustainability and Vulnerability It is useful to define sustainability and vulnerability instead of solvency and liquidity An entity�s liability is sustainable if it satisfies the present value budget constraint without a major correction of income and expenditure given the costs of financing Debt sustainability rules out any of the following: A debt restructuring is already needed (or expected to be needed); A borrower keeps on indefinitely accumulating debt faster than its capacity to service these debts is growing; A borrower lives beyond its means by accumulating debt in the knowledge that a major retrenchment will be needed to service these debts The interest rate is a factor influencing debt accumulation and sustainability Sustainability incorporates the concepts of solvency and of liquidity, without making a sharp demarcation between them Vulnerability refers to the risk that the liquidity or solvency conditions are violated and the borrower enters a crisis

15. Fiscal Sustainability Assessment of a variety of measures of the fiscal deficit and public sector debt, as well as ratios such as public debt-to-GDP ratios e.g. overall deficit excluding net interest payments (called the primary fiscal balance) /GDP, revenue/GDP, and expenditure/GDP, (primary balance-unrequited grants-privatization receipts)/GDP Debt dynamics equation: => The debt (D) at t+1 period is defined as the difference between debt at t period plus interest minus net debt creating component of fiscal deficit (TB). => When this equation is rewritten in terms of GDP, it would be expressed by Rearranging the equation yields the next equation for the change in the net debt ratio.

16. Medium-term projections are also important in the assessment of fiscal sustainability Realistic set of assumptions e.g., revenue elasticities, revenus from natural resources e.g., primary expenditure projections Projected changes in revenue/expenditure should be based on revenue/expenditure measures or tangible changes in the environment, not on efficiency gains in tax administration or expenditure or revenue windfalls Financing amounts from each source should be projected with associated risks Financing plans should be consistent with medium-term monetary and external sector projections Domestic banking financing should be consistent with movements of money demand, deposit growth, and financing needs of private sector The impact of real exchange rate changes on public debt should be a part of the sensitivity test

17. Financial Sector Stability The financial sector is associated with public and external debt The government acts as the ultimate guarantor of the financial sector => potentially large contingent liabilities An unsustainable stock of government debt could cause broader financial instability because government securities often constitute a large share of the assets of banks The importance of financial sector stability Lowering double mismatches Improving the soundness of the banking sector e.g., reducing directed credits to government-targeted industries, overly generous bailing-out of insolvent banks, connected lending to associated family firms e.g., strengthening prudential and supervisory regulations in terms of CAMEL (Capital adequacy, Asset quality, Management competence, Earnings, and Liquidity)

18. Risks Related to Debt Management Market Risk: Risks associated with changes in market prices (such as interest rates, exchange rates, commodity prices) on the cost of the government�s debt servicing Rollover Risk: Risks that debt has to be rolled over at an unusually high cost or, in extreme cases, cannot be rolled over Liquidity Risk: Two types of liquidity risk One refers to the cost investors face in trying to exit a position because of the lack of depth of a particular market Second refers the risk for a borrower when the volume of liquid assets diminish quickly in the face of unanticipated cash flow obligations or a difficulty in raising cash through borrowing Credit Risk: Risks of non-performance by borrowers on loans

19. Settlement Risk: Potential loss that the government suffer as a result of failure to settle by another counterparty Operational Risk: Including transaction errors in the various stages of executing and recording transactions; inadequacies or failures in internal controls, or in systems and services; reputation risk; legal risk; security breaches; or natural disasters that affect business activity => Developed countries generally focus primarily on market risk => Emerging market economies tend to give higher priority to rollover risk. => Developing countries with little access to foreign capital markets and limited domestic debt market tend to raise funds mainly from governments in advanced countries or international developing financial organizations => thus, their concerns are placed not so much on the afore-mentioned risks, but on the continuation and regularity of flows of concessionary loans and grants.

20. Two External Vulnerability Indicators Indicators of Foreign Reserve Adequacy: (1) Ratio of Reserves to Short-term External Debt: =>Most important indicator of reserve adequacy in countries with significant but uncertain access to capital markets => Positive relationship between this indicator and crisis index => IMF view: the ratio of foreign reserves to economy-wide short-term debt should be 1 (2) Ratio of Foreign Reserves to Imports: => A useful measure of reserve needs for countries with limited access to capital markets (3) Ratio of Foreign Reserves to Broad Money: Measures the potential impact of a loss of confidence in the domestic currency, leading to capital flight by residents Useful if the banking sector is weak and/or credibility of the exchange rate regime remains to be established

21. External Debt-Related Indicators (1) Ratio of External Debt to Exports: A useful indicator of trend in debt that is closely related to the repayment capacity For the larger emerging market economies, this ratio has positively impact interest spreads on sovereign bonds. (1)� Ratio of External Debt Service to Exports: Another possible indicator of economy-wide debt sustainability Debt service includes principal payments and interest paid on both long- and short-term debt. In practice, this ratio often excludes amortization payments on short-term debt from debt service, as a common practice. Government and guaranteed debt service is a useful indicator of government debt sustainability (2) Ratio of External Debt to GDP This stock-based indicator is a useful supplementary indicator of relating to resource base (reflecting the potential of shifting production to exports or import substitutes so as to enhance repayment capacity). Tax revenue could be also used in exchange of GDP. These indicators are useful when public debt is predominant, since they relate debt to the underlying source of repayment or the country�s tax base.

22. (3) Average Interest Rate on External Debt A useful indicator of borrowing terms The indicators (1) (2) suffer from drawbacks (e.g., a single snapshot in time) Useful to report and analyze the average interest rate on the debt alongside with the above indicators, as an indicator of concessionality of debt and to analyze the impact of changing interest rates on the real debt burden (4) Average Maturity on External Debt: Useful for homogenous categories such as nonconcesssional public sector debt, to track shortening of maturities or efforts to limit future vulnerabilities The maturity structure of debt has a profound impact on liquidity Adequately focused measures, such as average maturity by sector and by debt category, can usefully be compared over time. (5) Share of Foreign Currency External Debt in Total External Debt: Useful indicator of the impact of exchange rate changes on debt The balance sheet effects of a depreciating exchange rate vary with the extent to which the debt is denominated in foreign currency If sharp changes occur in the exchange rates in which debt is denominated, but these are not offset by similar changes on the inflow side (such as exports), significant income effects may result

23. External Debt-Related Indicators for Public, Financial and Corporate Sectors (1) Public Sector: => Public debt management must ensure that external debt is serviced while minimizing costs => Indicators that capture the solvency and liquidity risks associated with external public debt: public sector debt service ratio, public debt/ GDP (and to tax revenue), the average interest rate, various maturity indicators, foreign-currency-denominated or indexed debt , the share of overall short-term and longer-term floating rate external debt (2) Financial Sector: Financial sector vulnerability is a cause for concern as regards external vulnerability Financial sector is vulnerable because highly leveraged, exposed to maturity mismatch, operate in markets with asymmetric information, and subject to moral hazard through explicit or implicit deposit insurance and limited liability Financial sector is vulnerable to the balance sheet effects of changing exchange rates, withdrawal of foreign currency deposits or credit lines by foreign banks The appropriate prudential indicators include the followings Open foreign exchange position Foreign currency maturity mismatches

24. (3) Corporate Sector Individual firm failures should be addressed through bankruptcy and resolution systems However, the organization of the corporate sector and its financial structure can impact external vulnerability. E.g., Overextension of foreign currency financing to the corporate sector can lead to widespread corporate nonpayment Key indicators are the followings: Net foreign currency cash flow as a ratio to overall cash flow Net foreign currency debt over equity Traditional indicators�such as the coverage of interest payments by operational cash flow, leverage, the ratio of short-term to overall debt, returns on assets (ROA before tax and interest), and the ratio of domestic currency versus foreign currency debt