External Debt Management: Policy Issues for Sustainability with Reference to the Kyrgyz Republic:

1. External Debt Management: Policy Issues for Sustainability with Reference to the Kyrgyz Republic: Dr HK Pradhan Professor of Finance and Economics XLRI Jamshedpur India 831 001

2. External Finance and Development External borrowing serves as an important source for financing development Enables countries to achieve higher economic growth through higher investments and imports as well as consumption smoothing External capital can be channeled towards achieving the Millennium Development Goals (MDGs) Current preoccupations of Donors are on fulfilling the MDGs and a proactive strategy of obtaining aid and their effective utilization will only enhance such inflows

3. External borrowing can also act like a double-edged sword Excessive contraction of debt as well their irrational deployments can also become obstacles to growth High debt servicing weakens the government�s ability to implement its own policies, particularly as aid flows are often earmarked for servicing Falling aid flows also halts social and developmental progress, accentuating poverty Debt rescheduling erodes the sanctity of credit contracts (discourage donor governments and private investors from engaging in longer-term commitments to the country) High debt levels creates adverse incentives associated with future distortionary taxes

4. In recent years many developing countries have been subject to frequent debt crises in form or another Third World Debt Crisis of 1982, Mexico (1994), East Asia (1997), Brazil (1998), Russia (1998), Turkey (2001) and Argentina (2001) Had severe consequences for their new capital inflows, long-term growth and poverty Resolution of the debt overhang as well as an orderly functioning of the International Financial Architecture are important issues figuring in several multilateral forums today Several Episodes of Debt Crises

5. Recent Debt and Financial Crises 1982 Debt Crisis: oil price hikes during 1973-74 and 1979-80, global recession during 1981-82, rising US interest rates and sharp appreciation of the US dollar during 1980-85 led to Sovereign defaults by many countries from Latin American and few from Asia 1997 East Asian crisis: massive capital outflows, speculative attack on the currencies (with sharp fall); loss of international reserves while the central banks defending the peg; corporate default and banking crisis, compelling the government to extend massive financial assistance with heavy fiscal impact, and, their contagious effects on other countries in the East Asia

6. Recent Debt and Financial Crises 1994 Mexico & 2001 Argentina : excessive external borrowings, capital account liberalizations facilitating private sector borrowings, lack of prudent macroeconomic policies, and week governance and transparency in policy environment in which borrowings are conducted, all led to capital flight and inability of government to service debt 1998 Russia: Inter-related economic and political problems with high fiscal deficit and internal debt, capital flight and falling oil prices leading to internal debt default, partial default of external debt, collapse of the Ruble, and a sharp fall in the value of financial assets.

7. Crises affecting a diverse group of countries Crises have emerged in healthy as well as week economies Occurred due to an interactions of several domestic as well as exogenous shocks Affected countries (Indonesia, Argentina, Brazil, Turkey) that have a good track record of private capital market access, deeper domestic financial markets, access to non-concessionary financing, and relatively higher savings rates Situations in several countries from the South and South-West Asia, the Central Asian republics, and the Pacific Islanders are different: very low savings rates lacking access to private capital markets underdeveloped domestic capital markets depends mostly on the concessional financing

9. Debt Resolution Framework Debt rescheduling under Paris Club and London Club have been the earliest, implying consolidation of debt into new long-term obligations, with new terms and conditions Market based debt reduction/restructuring mechanisms undertaken in the form of debt buybacks, debt-for-equity swaps, secondary market sale of debts, and exchange of debts for collateralized securities. Brady initiatives involved a variety of debt conversion instruments such as debt buyback at a discount, exchanges for discount bonds at market rates, and par bonds at below-market interest rates. The International Development Association (IDA) created a Debt Reduction Facility in 1989 to help low-income countries to buy back their commercial debt. Since its inception, the facility completed 22 operations for 21 countries.

10. HIPIC (Heavily Indebted Poor Countries) Launched in 1996 by the World Bank and the IMF, the HIPC initiative was the first comprehensive approach to the debt reduction, particularly providing relief of multilateral debt Decision Point, a potentially eligible country first goes through traditional debt relief mechanisms (such as application of Naples terms under the Paris Club agreement), establish record of good macroeconomic management by putting in place the IMF/World Bank structural adjustment and stabilization program, and prepares a poverty reduction strategy paper (PRSP). Completion Point, Once the conditions laid down at the decision point are reached the country is said to be reaching the Completion Point, thereby qualifying for the commitment of the relief.� 42 countries qualified as potentially eligible for HIPC debt relief as of September 2004, 14 had reached their completion points and another 27 had reached their decision points. The debt reduction packages approved as of September 2004 for the 27 countries, of which 23 are from Africa, estimated to have been provided the debt service relief of $32 billion in NPV terms.

11. Private Sector Initiatives Collective Action Clauses (CACs) in the bond indentures is being worked out as the legal basis for the collective action by the bond holders. The CACs would permit a specified super-majority of holders of a particular bond issue to agree to a restructuring that would be binding on all holders of that issue. By preventing holdouts in individual bond issues, such clauses would thereby facilitate any needed restructuring. Sovereign Debt Restructuring Mechanism (SDRM) proposed by the IMF, in the aftermath of the Argentine crisis in 2001, for debt work-outs providing the necessary forum for dispute resolution, somewhat similar to the bankruptcy statutes for the corporate. Under the proposed system the national government would request the convening of an international panel, which in turn would negotiate with the private creditors and arrive at a debt restructuring agreement, with the approval by a majority of the creditors. The proposal has not been favored by the private creditors

12. External Debt of the Kyrgyz Global Development Finance 2004(World Bank) classifies Kyrgyz Rep as severely indebted low income country Rapid accumulation of external debt from a debt-free start in 1991 to reach $2.0 billion by 2003. Had a Paris Club rescheduling on March 7 2002 of US$ 99 million contracted before August 31, 2001(cut-off-date), the amount falling due during December 6, 2001- December 5, 2004

13. External Debt of the Kyrgyz

14. Kyrgyz Rep has by far the heaviest debt burden within the group of CIS-7(Figures are for 2002)

17. End-2000 Kyrgyz Rep was identified as eligible for the Enhanced HIPC Initiative (after fully taking into account the Paris Club Rescheduling based on Naples Terms) The Country preferred to introduce a comprehensive debt management to restore debt sustainability: (i) fiscal adjustment, (ii) increasing the minimum grant element in all new financing to 45%,(iii) repaying non-concessional debt ahead of schedule in 2002-05, and (iv) preparing for the rescheduling from Paris Club under Naples terms Source: IMF and World Bank, Poverty reduction, Growth and Debt Sustainability in Low Income CIS Countries, February 4, 2002

18. HIPIC (Heavily Indebted Poor Countries) Launched in 1996 by the World Bank and the IMF, the HIPC initiative was the first comprehensive approach to the debt reduction, particularly providing relief of multilateral debt Decision Point, a potentially eligible country first goes through traditional debt relief mechanisms (such as application of Naples terms under the Paris Club agreement), established record of good macroeconomic management by putting in place the IMF/World Bank structural adjustment and stabilization programme, and prepare a poverty reduction strategy paper (PRSP). Completion Point, Once the conditions laid down at the decision point are reached the country is said to be reaching the Completion Points, thereby qualifying for the commitment of the relief.� Of the 42 countries qualified as potentially eligible for HIPC debt relief in September 2004, 14 had reached their completion points and another 27 had reached their decision points. The debt reduction packages approved as of September 2004 for the 27 countries, of which 23 are from Africa, estimated to have been provided the debt service relief of $32 billion in NPV terms.

19. Why did the Kyrgyz Rep face debt difficulties since 2000? Was there excessive borrowings (over lending)? Did multilateral lenders (WB, IMF) overestimated the prospects for growth, exports, revenue and investment capacity, leading to cash-flow problems since 2000? Was this just a coincidence, that the transition economies faced in general, during the period of their transition? Did the domestic macroeconomic reforms proceeded as planned, facilitating an improved investment climate for sustained growth? Or, was there a bad advice?

20. Reasons for the rapid accumulation of debt Let us recognize that the debt problems are due to the way the current account deficit is being financed, the nature of capital flows (such as debt vs non-debt creating flows), the way external capital being used for (such as financing investment as opposed to consumption or non-tradable), the enabling environment supporting an investment climate for growth and exports. In the case of Kyrgyz Republic, it was the less than anticipated growth of GDP and exports (as forecasted by the donors), increasing current account deficits, external borrowing for the Public Investment (lacking domestic savings and resources), Russian financial crisis in 1998 and its impact on exports and local currency, and devaluation of the Som and its impact on debt burden

21. External Debt and National Accounts Y = E Y = C + S + T E= C+ I + G + X- M C + S + T = C + I + G + X � M (S- I) + (T-G) = (X- M) = � D

22. Debt Sustainability is the Key�. Can a country go on accelerating its growth rate simply by increasing its borrowing from abroad? As the size of the borrowings increase, a sizeable part of export earnings and fresh borrowings get utilized in meeting debt obligations As the country cannot get enough net external capital, growth gets affected Debt servicing impinges on the government budget, affecting social spending and poverty programs Vicious circle begins Sustainable debt sets the stage for a virtuous cycle: Debt-investment-growth/productivity-exports-repayments

23. Types of capital flows determines to a large extent the sustainability of external debt Debt creating flows Multilateral and bilateral flows Commercial bank loans, bonds Non-debt creating flows Foreign direct investments Hybrid Flows Portfolio investment flows Vulnerable Flows Short term debt Debt with floating interest rates Short term deposits with the banking system

25. External Debt of the Kyrgyz Republic

27. Debt Sustainability Analysis (DSA) Solvency: If its level of debt has made its servicing (amortization as well as interest payments) incompatible with the net current inflows. Liquidity: Temporary liquidity problems can trigger debt servicing difficult intense, due to fall in export earnings, increase in international interest rates, appreciation of the contracted currency or increase in prices for imports such as oil. Making DSA analysis is important to decide whether a country needs a debt reduction and major correction in balance of payments as in the case of solvency or rescheduling or restructuring may be just sufficient to make the level of debt sustainable.

28. Debt Service Ratio Measures Interest Service Ratio: Interest payments to earning in exports of goods and services indicate the terms of external debt burden. It also indicates how much the current earnings are needed in order that the debtor remains current in servicing debt. Debt-Service Ratio: Debt-service payments to exports of goods and services indicate how much of a country�s export revenue will be used up in servicing its debt In the case of concessional debt, current debt-service ratio may understate the burden of debt as the repayment profiles are typically back-loaded Projections of debt-service ratios are subject to several assumptions associated with making forecasts over long periods, as long as 35-40 years in case of concesional loans.

29. Debt Stocks Based Measures External Debt to GDP: Provides some indication of the potential to service external debt by switching resources from production of domestic goods to the production of exports. External Debt to Exports: Provides an indication of solvency, since an increasing debt to exports ratio indicates that the country may have problems meeting its debt obligations in future External Debt to Central Government Revenue: Measuring the government�s ability to generate fiscal resources, as not all export earnings are in the hands of the public sector. NPV of External Debt to GDP, Exports or CGR: Present value, as against the face value, is expected to capture the extent of concessionality of outstanding debt Has the limitations when the maturity is very long, relating the present value to existing GDP or Exports or Revenues NPVs are sensitive to the level of the discount rate, which change with market conditions

30. Indicators of Solvency for the Kyrgyz Republic

31. Liquidity Specific Indicators Reserves/Imports: An important indicator of reserve adequacy Reserves/Short Term Debt: Can be used to assess the vulnerability to liquidity crisis in the event of capital flight on account of short term debt. Interest Payments/Reserves: Measures the interest payments of all debt which could be covered by usable reserves. Short Term Debt/Total Debt: Measures the relative importance of short term debt (all debt with residual maturity of less than a year) in total external financing, measures the extent of vulnerability in the event of liquidity crisis

32. Indicators of liquidity for the Kyrgyz Republic

33. Foreign Exchange Reserves Holding of adequate level of reserves is an important element of debt management potential debt servicing essential imports at times of shortages foreign exchange market interventions other short term liquidity management

34. Solvency vs Liquidity There is of course no thumb rule that would determine the thresholds for solvency and liquidity Every insolvent borrower faces liquidity problems Need to measure and assess simultaneously several indicators in a forward looking framework Other indicators may include external debt over total debt (domestic plus external), corporate debt/total debt, share of concessional debt, average terms such as interest and maturity Sustainability analysis has to be country specific, considering the debt history, sovereign ratings, the development of capital markets. Well functioning capital market would enable governments to borrow domestically thus avoiding external debt. Country-specific external debt-burden thresholds also depend on the quality of the country�s policies and institutions

35. Policy Dependent Debt Threshold Assessment of Institutional Strength and Quality of Polices Poor Medium Strong NPV of debt/GDP 30 45 60 NPV of debt/exports 100 200 300 NPV of debt/revenue 150 200 250 Debt service/exports 15 25 35 Debt service/revenue 20 30 40

36. Sustainability conditions Debt can be serviced for long periods, as long as creditors make positive net transfers through concessional loans and grants, and therefore depends to a large extent on the on the willingness of official creditors to make positive net transfers Debt sustainability is therefore a difficult concept in countries predominantly depending on the official (bilateral and multilateral, concessional) flows Moreover, countries heavily depending on official flows ignore market signals, such credit asseesment, margins on private credits, secondary market spreads, thereby may make compromise with sustainability conditions Sustainability conditions require that creditors and debtors have full information, and if there is asymmetric information, unrealistic assessment would be the outcome

37. Sustainability conditions Debt dynamics is an outcome between debt sustainability and macro-economic policies. Ukraine refinanced (or rescheduled) $1.8 billion Eurobonds in 2000, when its debt ratios were considered moderate Hungary, with a very high ratio of debt, remained solvent, did not resort to rescheduling, and could manage with pursuing stronger economic growth, tax revenues and exports Sustainability indicators serve as the early warning signals, and solutions would require undertaking suitable macroeconomic policies correcting imbalances.

38. DSA QuadrantsFactors affecting debt stress Domestic real GDP Exports Energy consumption Natural disasters Foreign Real Export growth Terms of trade current account deficit Real Exchange rate Oil price shocks

39. DSA requires.. Making analysis of economic and financial shocks to which the country is potentially exposed Examining the interrelations between variables in the economy such as exchange rate depreciation/ appreciations on debt servicing capacity, inflation, macroeconomic and real shocks

40. Policy Issues in External Debt Management Macroeconomic policies Monitoring domestic debt Monitoring contingent liabilities Debt market development Risk management Institutional framework

41. Macroeconomic stability is the key to external debt management

42. Kyrgyz Rep: Macroeconomic Trends Since the Debt Problems

43. Monitor the level of domestic debt Domestic debt has been limited(8.6% of GDP in 2003) due to the small size of the financial sector, low savings rate, and limited growth of pension and insurance funds Domestic debt issues were considered merely as part of the budgetary exercises

44. Debt management should include external as well as domestic debt Growth of public debt has important implications on the economy. Servicing the domestic debt is basically a fiscal sustainability issue, involves additional domestic resource mobilization( taxation, spending cuts, new domestic borrowings) Servicing external debt involves the same, when limited foreign exchange earnings, implying that raising local currency, converting to foreign exchange and servicing external debt

45. Contingent Liabilities Explicit or implicit government guarantees affect the future increases in government debt obligations Explicit contingent liabilities arise from any contractual arrangement protecting the risk of another party, such as a line of credit, exchange rate and interest rate risk guarantees, sovereign guarantee of corporate external borrowings, and commercial guarantees of projects Implicit contingent liabilities can arise due contractual or legal obligation conditional upon certain events such as ensuring systemic solvency of the banking system, deposit insurance, etc. Implicit contingent liabilities are more difficult to assess than explicit ones, due to the potential moral hazard issues Contingent liabilities are difficult to measure in the presence of poor governance and non-transparent regimes

46. Need to separately monitor the level of private sector debt Private sector debt include corporate debt (domestic and international) as well as liabilities of the financial intermediaries (banks, DFIs, NBFCs) Some of these debt may have government guarantees Claims on the private sector as a whole accounted for about 4.8 per cent of GDP in 2003 Need to gradually also consider the debt positions of the private sector Trends in private sector debt needs to be monitored have the potential of creating moral hazard or disrupting the functioning of financial market conditions in the event of macroeconomic crisis Excessive build up of the private sector debt created severe non-performing loan (NPL) problems in post crisis Asia, needing bank failures and bail outs, with the implications of huge fiscal costs

47. Exchange Rate Policy Policy of managed float with limited intervention Exchange rate has appreciated in nominal terms So far, previously under valuation has been correcting Need to have real exchange rate targets Appreciation, though reduces debt servicing costs, but affects exports Should balance between two goals: avoid falling price competitiveness of exports and prevent a rise in the cost of external debt servicing

48. Creating Domestic Bond Markets Gradual introduction of local currency debt instruments by deepening domestic capital markets Creating domestic markets for local currency bond issuance is difficult due to: Small size of the financial system (with bank assets 7 per cent of GDP and non-bank assets another 2.5 per cent of GDP) Capital markets, insurance, and pension sectors are all equally small

49. Necessary preconditions for domestic bond market initiation Create benchmark bonds Establishment of yield curve Establish realistic interest rates Strengthening institutions and intermediaries Create investor confidence Stable inflation, sustainable fiscal parameters Improve trading and settlement infrastructure Improve financial information for the private sector borrowers Adequate investor protection Rationalization of regulatory framework

50. Currency Risk Management Cross currency risk due to the appreciation of Japanese yen against US dollar in recent times Cross currency risk due to mismatch between earnings in exports and debt repayments

51. Currency Risk: An Example Effect of exchange rate movements between $/� on a borrower�s net income, when � appreciates from $1.03/� to $1.12/� during the year

52. Risk Management Instruments Financial derivative contracts such as currency forwards, swaps and futures help managing currency and interest rate risks of external borrowings Since there is virtually no market for financial derivatives, authorities could, on a case-by-case basis after very careful a scrutiny, allow domestic entities to access such instruments from the overseas markets, and to this end, necessary regulations and control mechanisms need to be put in place. Development of derivative markets domestically will take very long time, depending on the strength of the banking system

53. A comprehensive framework of debt management should include.. Assess the vulnerabilities of the public sector as a whole Consider a comprehensive measure of liabilities such as external debt, domestic debt, private sector debt, contingent liabilities, liabilities of the banking sector Work towards enhancing the foreign currency earning capacity of the economy: improvement in exports, increase in FDI, private capital inflows into capacity generating sectors Being under the IMF programs and with Paris Club rescheduling, a dampening of private as well as FDI inflows is a possibility in near term Requires an acceleration of structural reforms and promoting investment climate, to enhance the long-term productive capacity of the economy.

54. Debt management framework� Continue with present macroeconomic policies keeping key targets (key prices are inflation, interest rate, and exchange rates) Accelerate promoting investment climate by strengthening banking sectors, gradually building domestic debt markets, stock markets and listing of stocks, strengthen legal and institutional environment) Maintain adequate reserve levels and manage reserves appropriately Risk and liquidity management practices in other sectors of the economy, particularly the financial sector needs assessment

55. Debt management framework� Debt maturities should be decided avoiding bunching of repayment obligations, avoiding potentially unmanageable concentrations of refinancing risk assessing exposure to the risk of not being able to refinance maturing liabilities, or of being able to do so only at higher interest rates To the extent, borrowings can be matched with the cash flow structure of projects (structuring grants, grace periods, costs (IRR), and maturity project cash flows

56. Debt management framework� Use the world�s best practices such as debt conversion schemes (debt-for-equity swaps, debt-for-environment), debt repayment against export deliveries, debt-for-investment scheme (in specific projects) An arrangement on converting $50 million of Russian debt into environmental protection projects was achieved in July 2001 with Finland, for example Eventually preparing grounds for eventual new borrowings on global capital markets, for private sector investments

57. Integrated Approach to Asset-Liability Management Currency risk management could be an important element of debt management Working towards avoiding mismatch between existing assets (which include commodity exports and capital inflows, including borrowings) and liabilities (which include commodity imports and debt servicing) Use financial derivatives (such as swaps and forwards) with extreme caution

58. Institutional Capacity in Debt Management Strengthen institutional capacity in debt management Legal framework defining the boundary of operations Efficient debt recording and data analysis Use analytical techniques such as debt sustainability indicators, sensitivity/scenario analysis, stress test, currency risk analysis, cash flows forecasting, etc

59. Successful debt management depends on good policy Effective debt management depends to a large extent on the country�s own policy and economy Would depend on the judgment of policy makers and planners Debt Sustainability is a dynamic concept Relates to the debtor�s ability to generate future debt servings and assessing the evolving economy in an era of globalization Technical advice and models cannot substitute for good policy making Howsoever full proof and consistent the models are?

60. Debts are like any other trap, getting in is easy, but getting out is pretty hard George Bernard Shaw Thank You