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Issues of Debt, External Debt and Debt Relief …..and just a little on Capital Flows

Issues of Debt, External Debt and Debt Relief …..and just a little on Capital Flows Handout Number 4 2006-07. Topics. Basic Data on Debt Levels Theoretical Levels of “Sustainable” Debt Notes on Damage Caused by Excessive Debt Some Theory on Debt Relief

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Issues of Debt, External Debt and Debt Relief …..and just a little on Capital Flows

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  1. Issues of Debt, External Debt and Debt Relief …..and just a little on Capital Flows Handout Number 4 2006-07 Macro Topics in Development and Transition Handout No. 4 2007

  2. Topics • Basic Data on Debt Levels • Theoretical Levels of “Sustainable” Debt • Notes on Damage Caused by Excessive Debt • Some Theory on Debt Relief • Notes on HIPC Initiative and Gleneagles (2005) Macro Topics in Development and Transition Handout No. 4 2007

  3. First – a few facts re Capital Flows • Huge in pre-1914 years (but close link with labour migration- the previous golden age of globalisation)) • Private flows largely ended in 1930s with great depression and widespread debt defaults • Post-war assumption was that OFFICIAL flows would be needed to restore significant capital movements • False dawn of new private capital movements (from Western commercial banks) following OPEC price hike in 1973/74 • Collapse in early 1980s followed by resumption of new forms of private flows to a limited sub-set of developing economies (EM economies) • Sustained in 1990s and 200s albeit with significant new questions posed by the various financial crises (Mexico. East Asia, Russia, Argentina, Venezuela) • Now a trichotomy (i) successful EM economies (ii) failed HIPC countries (iii) in-between cases who aspire to be included in (i) Macro Topics in Development and Transition Handout No. 4 2007

  4. Topic 1: Basic Facts • Low Income Countries (LICs) have low ABSOLUTE Levels of External Debt • LICs have a Large Proportion of Debt to (i) Official Bilateral Creditors and (ii) Multilateral Agencies but not much to (iii) Private Creditors • Most remaining LIC Debt is very concessional (low cost) • But in spite of this the debt burdens are excessive in some 41 Countries (HIPCs) • Causes are various: Civil wars, bad Fiscal management, Corruption etc. Macro Topics in Development and Transition Handout No. 4 2007

  5. Source is 1997 IMF paper by A Boote and K Thugge Macro Topics in Development and Transition Handout No. 4 2007

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  8. Update using esds.ac.uk(earlier data are from Boote and Thugge IMF paper-1997) Macro Topics in Development and Transition Handout No. 4 2007

  9. Private Flows By Region ($billion) 84-89 1994199519961997199819992000 2001 Total Net Private Flows 12 142 211 224 115 66 67 36 116 Latin Am & C. 0 40 46 64 68 62 40 48 66 Asia Crisis Cts -3 34 54 67 -16 -28 3 -22 10 Other Asia 13 36 38 53 22 -12 -1 5 13 Middle East 2 17 14 13 22 10 1 -18 1 Transition -2 9 51 19 6 28 13 16 18 Africa 2 8 8 8 12 7 10 9 8 Asia Crisis Countries: Indonesia, Korea, Malaysia, Philippines, Thailand. This refers to the crises of the 1990s starting in 1996 Macro Topics in Development and Transition Handout No. 4 2007

  10. Portfolio Flows by Region ($ billion) 84-891994 1995199619971998 1999 2000 2001 Portfolio Fs. 4 105 41 80 39 0 5 17 33 LAC -1 63 3 38 19 20 9 7 18 Asia Crisis Cts 0 12 19 26 8 -8 13 13 3 Other Asia 2 7 3 4 -1 -7 -9 -8 -1 Middle East 5 3 -1 -5 -6 -17 -10 -7 -4 Transition 0 17 15 15 11 6 -7 8 9 Africa 0 3 3 3 7 7 9 4 5 Note the huge instability of these flows through the crisis period as well as the contagion effects on countries not directly involved in major crises Macro Topics in Development and Transition Handout No. 4 2007

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  13. Source is W. Easterly in World Development, 2002 Macro Topics in Development and Transition Handout No. 4 2007

  14. Topic 2: Sustainable Debt Levels (Theory) This applies to both: • Domestic debt (e.g. Government issues of domestic Treasury securities) and • External debt The main difference is of course the Exchange Rate influence on the true burden of (2) the External Debt Macro Topics in Development and Transition Handout No. 4 2007

  15. Basics – see paper by Raghenendra Jhain Addison and Roe, Fiscal Policy for Development, (2006) Using the government’s inter-temporal budget constraint he identifies two cases namely • Case 1: Sustainable Debt. rt-t < t where the first term is the real interest rate on government debt and the second is the rate of growth of real GDP, and Case 2: Unsustainable Debt rt-t > t In this case the debt is unsustainable and the debt stock will become infinite no matter what sequence of primary deficits are chosen unless the (growing) debt stock can be offset by matching it with a sequence of increasing primary surpluses in the future. Jha’s paper presents the formal conditions for this stability to be achieved. See also the note from Angelopoulos as circulated Macro Topics in Development and Transition Handout No. 4 2007

  16. …………..Continued • The sustainability of the public debt is an inter-temporal question. Every short-term deficit can be sustainable so long as it is matched by an adequate future surplus. • Jha also derives a comparable measure of sustainability for a country’s external debt. By analytically connecting the two sets of sustainability conditions (i.e. for internal and external deficits), Jha derives expressions for the case where the fiscal deficit is sustainable but the external deficit is not and then also for the reverse case. • He notes that any external deficit problem must result in a sustained wedge between domestic and international interest rates to attract the necessary capital inflow to finance ongoing deficits. But this acts as a drag on growth and also complicates the task of achieving a sustainable fiscal position. Monetary policy is also compromised in this case by the monetary financing of an enlarged fiscal deficit. Macro Topics in Development and Transition Handout No. 4 2007

  17. Influences on the External Debt ratioSource is S. van Wijnbergen, in World Bank Economic Review, Vol3 No 3, 1989/90 Define the Debt:GDP ratio as “b” and measure it in LOCAL Currency Then Where And D$ = the Debt in Dollar Terms Macro Topics in Development and Transition Handout No. 4 2007

  18. An Equation for the Debt Ratio Source is S. van Wijnbergen, in World Bank Economic Review, Vol3 No 3, 1989/90 Sustainable Debt ratios require an appropriate combination of the right-hand side variables. See also notes from last weeks seminar discussion Macro Topics in Development and Transition Handout No. 4 2007

  19. …………... Continued Note: A real devaluation will increase the burden of debt even if there is no new borrowing (no increase in D$) But a nominal devaluation that is fully matched by a rise in Pd has no effect on the Debt ratio Three other Main Influences on the Debt ratio (“b”) • Non-Interest Current Account Deficit/Surplus (NICA) will Raise/Lower “b” • Interest Rate on Debt (“r”) INCREASES “b” even if Current Account is balanced • Income (GDP) Growth (“n”) LOWERS “b” (via denominator) So key is (r-n) • Real Devaluation RAISES “b” but if it generates a higher “n” will also have effects in the opposing direction. Macro Topics in Development and Transition Handout No. 4 2007

  20. Export Measures of Sustainability Similar Logic can be applied to understand the Dynamics of the Debt/Export ratio. Merely replace “n” by “ne” where “ne” is the growth rate of Exports in Nominal Terms. HIPC Criteria are: • NPV Debt/Exports < 200/250% reduced to 150% in 1999 (HIPC II) • Debt Service/Exports < 20/25% Macro Topics in Development and Transition Handout No. 4 2007

  21. Practice: Adding in the role of Institutions (Source:G. Nankani and M. Allen, IMF 2004 www.worldbank.org/debt) Macro Topics in Development and Transition Handout No. 4 2007

  22. Solvency of Countries This requires an ABILITY to pay taking account of the assets and liabilities of the country. It requires that discounted future income(Y) net of expenditures (C+I+G) exceed the initial debt level. i.e. But the numerator here = NICA, so [5] gives us the proposition that Macro Topics in Development and Transition Handout No. 4 2007

  23. Insights from this are fairly obvious • Countries with LOW b to start with are more likely to be solvent • Countries with HIGH growth rates (n) are more likely to remain solvent • Countries with HIGH borrowing costs (r$-P$) will find it less easy to remain solvent Example: b=50%; r$-P$=8%; n=6% Solvency requires NICA > 1% of GDP NOW Experiment with different values of the parameters to see how the demands of solvency increase reduce Macro Topics in Development and Transition Handout No. 4 2007

  24. Examples based on the formula A. Growing out of High Debt e.g.Korea and Turkey in the 1980s versus B. Deflating out of High Debt e.g. Latin America in the 1980s Macro Topics in Development and Transition Handout No. 4 2007

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  28. The Creditworthiness of Countries This is a more demanding condition based on whether countries are PERCEIVED as likely to pay even if they remain solvent – it is really what differentiates the Emerging Market economies from the HIPCs • Lenders (and credit rating agencies such as Standards and Poors) who assess this will typically look at variables as in the solvency ratio (e.g. a high growth rate will increase creditworthiness) • plus FOREX earnings (mainly exports) as a signal of the country’s access to the necessary currency in which to make payment (e.g. fast growth of exports is better than a fast growth of other components of GDP) Macro Topics in Development and Transition Handout No. 4 2007

  29. The FACE and MARKET Value of Debt(the basis for understanding the incentives affecting Debtors and Creditors) Note: • where F>MV, the creditworthiness of the borrower is likely to be in doubt • The gap F-MV creates ADDITIONAL Problems to high debt itself Macro Topics in Development and Transition Handout No. 4 2007

  30. Topic 3: Theory: High Debt and Economic Performance Four Main Mechanisms: • VIA Adverse Expectations – High External Debt supports expectations of Lower Future Levels of Govt. Expenditure; Higher Future Levels of Inflation and Other Taxation; and the need for ER Depreciation. This results in lower post-tax expected returns on Domestic Investment and possibly Capital Flight. (this effect works via F) • Via Costs of Future Outlays. When Govt. is insolvent i.e. the F>MV, then Govt Spending is rationed in terms of any Marginal Unit of spending – the opportunity cost of any additional unit of resource is very high. The Discount rate>Market rate of interest Any debt repayments impose excessive costs on the economy (e.g. tax) (via F – MV) • Via Uncertainty. The Insolvency Situation creates great uncertainty about possible Regime Shifts e.g. changes in policy, how large will be the resources committed to debt service, will new external funding be obtained to help and at what cost? Again the result is less investment (via F-MV) Macro Topics in Development and Transition Handout No. 4 2007

  31. Continued • via Debt Overhang. The Market Value of Debt (V) = the Present Value of Future EXPECTED Debt Service. If V arises from a PARTIAL service of a larger debt (I.e. Face Value>Market value) then the ACTUAL level of Future Debt service is uncertain. IF the Economy does well it is HIGHER than if the economy does badly. This acts as a disincentive for Debtor countries to achieve strong/improved performance. The effect is equivalent to a large TAX on good performance as this pays of creditors more rapidly.(F-MV) • In addition, there is a crowding-out effect in the Current Period. Greater outlays on debt service mean lower outlays on other Govt. goods and services. This is more easily resolved via more concessional lending in the current period. (F) References P-R Agenor and P. Montiel, Development Macroeconomics, Ch.15 D. Rodrik in Journal of Development Economics (JDE)1991 S. Claessens, World Bank Policy Research Paper, No 1147, 1993. Macro Topics in Development and Transition Handout No. 4 2007

  32. The Free Rider Problem D MV Debt Gap C B F X Y O Macro Topics in Development and Transition Handout No. 4 2007

  33. Topic 4: Simple Model of Debt Relief Source: W. Easterly “How Did Highly Indebted Poor Countries Become Highly Indebted?” World Bank 1999, Web Site. Published in World Development, 2002 For a Partial Counter see Tony Addison, paper to 2001 WIDER Conference on Debt. www.wider.unu.edu and Individuals Maximise Utility from Consumption over an Infinite Horizon σ= inter-temporal elasticity of substitution (present for future consumption) Macro Topics in Development and Transition Handout No. 4 2007

  34. ……… Continued (see also the seminar presentation in Week 3) Maximisation is subject to: The optimum long term consumption is where: Note that the long term growth rate of C is harmed by (i) a high discount rate( ρ) and (ii) a low rate of inter-temporal substitution (1/σ) Macro Topics in Development and Transition Handout No. 4 2007

  35. ……….. Continued Using these previous two equations we can solve for the optimum ratio of the country’s wealth (W) to its consumption (C) Note (important) that the optimum is defined in relation to A-L and NOT in relation to L alone Cf the parallel with our earlier discussion about fiscal deficits Macro Topics in Development and Transition Handout No. 4 2007

  36. DebtRelief Debt Relief will reduce “L” but does not change the parameters that fix the OPTIMAL value of (A-L)/C So for GIVEN values of ρ, σ and r, the country/government responses will be to borrow again to restore the optimal that is temporarily disturbed by a lower stock of debt. This is good in the sense the while the debt is rebuilt, the country can live just a bit better. BUT is does not mean that the country’s tendencies to incur debt will go away. To solve the debt problem more fundamentally it is essential the the terms and conditions of the debt relief somehow force/require a change in (say) ρ Hence the conditions placed on HIPC countries Macro Topics in Development and Transition Handout No. 4 2007

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  40. Topic 5 The HIPC Initiative Macro Topics in Development and Transition Handout No. 4 2007

  41. Example – extent of the problem Macro Topics in Development and Transition Handout No. 4 2007

  42. ………. Continued Macro Topics in Development and Transition Handout No. 4 2007

  43. Profile of Debt Distress (Source: AArt Kraay and Vikram Nehru – When is External Debt Sustainable, Feb 2004, www. Worldbank.org/debt Macro Topics in Development and Transition Handout No. 4 2007

  44. Source is Boote and Thugge 1997 paper for IMF Macro Topics in Development and Transition Handout No. 4 2007

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  46. Principles • Reduce Debt Levels to those that can be SUSTAINABLY Financed – Rule of thumb is Debt(NPV)/XGS<150% • Funds released by Debt Relief committed against clear Poverty Reduction agenda as defined in Poverty Reduction Strategy Paper (PRSP). These are informed by the improvements needed to meet the Millennium Development Goals by 2015. • Monitoring of Macroeconomic Performance determines whether country has achieved conditions for HIPC eligibility (see Chart from Boote and Thugge) • Also at each stage if rule of thumb met using conventional debt reduction methods (e.g. Paris Club) then country does not need additional HIPC relief Macro Topics in Development and Transition Handout No. 4 2007

  47. The Logic of HIPC and Gleneagles Macro Topics in Development and Transition Handout No. 4 2007

  48. THREE Elements in Debt Management post-Gleneagles 1. The HIPC Initiative A country is potentially eligible for the HIPC Initiative if it meets income and indebtedness criteria.  • Its annual per capita income must be below the threshold for eligibility for concessional borrowing from both the World Bank and the IMF and • external public debt must exceed 150 percent of its exports (or in certain cases 250 percent of fiscal revenues). There are 40 such potentially eligible HIPCs. To become eligible, the country must also have had a program with the IMF at some point since the start of the Initiative in 1996. 2. 100 Percent Cancellation: The Multilateral Debt Relief Initiative On March 28, 2006, the Board of IDA approved IDA’s participation in the Multilateral Debt Relief Initiative (MDRI), requiring IDA to cancel all debt outstanding and disbursed owed by HIPCs to IDA as of end-2003 as soon as these countries reached the HIPC completion point.  Macro Topics in Development and Transition Handout No. 4 2007

  49. ………. Continued 3. Avoiding the Need for another Debt Relief Initiative:The Debt Sustainability Framework for Low-Income Countries The new debt sustainability framework is a forward-looking approach to guide borrowing and lending decisions to devote resources toward achieving the MDGs without creating the buildup of unsustainable debt.  By assessing each country’s circumstances, the framework balances the need for funds with current and prospective ability to repay debt. Macro Topics in Development and Transition Handout No. 4 2007

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