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The Ongoing Financial Crisis: Implications for Debt Sustainability in Developing Countries and the Future of the DSF. Carlos A. Primo Braga Director, PRMED April 25, 2009. Presentation outline. The ongoing financial crisis in a nutshell Debt sustainability: a summary
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The Ongoing Financial Crisis: Implications for Debt Sustainability in Developing Countries and the Future of the DSF Carlos A. Primo Braga Director, PRMED April 25, 2009
Presentation outline • The ongoing financial crisis in a nutshell • Debt sustainability: a summary • Debt sustainability and the crisis • Debt management and the crisis • The ongoing crisis: a protracted one? • Room for improving the DSF?
The crisis in a nutshell • Antecedents of the crisis: • Boom-bust credit boom, fueled by lax monetary policy in developed countries • Underestimation (poor assessment) of risks • Poor corporate governance • Macroeconomic imbalances (low savings in some developed countries,...) • An asset price bubble and excess investment in real estate
Additional considerations Financial innovation and increased opaqueness -- Reckless use of colaterized debt obligations relying on mortgages as collateral -- Growing reliance on the originate-to-distribute business model/poorer risk assignment Financial integration -- Much larger capital flows /cross-border positions Major regulatory and supervision changes --The repeal of Glass Steagall (1999) to allow US conglomerates to leverage their balance sheets like EU universal banks; transition to Basel II; SEC ruling on net capital (2004)…
Residential mortgage backed securities versus other securitized assets (% GDP USA) Source: Blundell-Wignall and Atkinson (2008), Federal Reserve, Datasteam, OECD.
The crisis in a nutshell Three Contagion Channels • Liquidity squeeze and lower risk appetite higher financial costs • Lower commodity prices and trade volumes lower export proceeds and government revenues • Reduction in capital flows and remittances tightened financial sources
The crisis in a nutshell • Countries reactions to the crisis: • Loose monetary policy • Recapitalization of financial systems • Bail out of household and corporate sectors • Fiscal stimulus packages • Financial systems regulatory overhaul • And IFIs are intermediating more funds than ever
The crisis in a nutshell Impacts and responses • Higher financial costs, although benchmark interest rates will remain low for a while; • New intermediation channels, although financing gaps remain significant; • Renewed focus on fiscal stimulus: fiscal space considerations. Bottom line • Full impact depends on countries’ initial conditions (fundamentals) and exposure to shocks; • Final outcome depends on the depth and length of the crisis.
Presentation outline • The ongoing financial crisis in a nutshell • Debt sustainability: a summary • Debt sustainability and the crisis • Debt management and the crisis • The ongoing crisis: a protracted one? • Room for improving the DSF?
List of Heavily Indebted Poor Countries (as of end March 2009) 5
HIPC: Debt burdens have been reduced markedly…. In billions of U.S. dollars, in end-2008 NPV terms
Debt Relief and Debt Sustainability Progress to date (April 2009) • 35 out of 40 eligible countries have passed the decision point and qualified for HIPC Initiative debt relief • HIPC Initiative debt relief committed to the 35 post-decision-point HIPCs is US$57.3 bln • Of the 40 HIPCs, 24 countries have reached the completion point and qualified for irrevocable debt relief under the HIPC Initiative and the MDRI, estimated at a total of US$61.6 bln • Debt relief is expected to reduce external debt stock in post-CP HIPCs by about 80 percent in end-2008 NPV terms Post-CP HIPCs are in a better debt situation than other HIPCs. As of 2008
Debt sustainability: a summary • Debt is sustainable as long as it can be serviced without resorting to exceptional financing and/or major corrections in the balance of income and expenditures. • Analyses focuses on indicators such as: • PV of Debt in percent of: (i) Exports, (ii) GDP, and (iii) Government Revenues; • Debt Service in percent of (i) Exports, (ii) Government revenues.
Risk of Debt Distress IDA-only countries HIPCs In the case of IDA, the graph reflects only countries for which a DSA is available. The graph for HIPCs includes: Bolivia and Honduras (both Blend countries) and Somalia (for which a DSA is not available)
Debt sustainability: a summary • Debt sustainability indicators will deteriorate due to the fall in exports and government revenues, and the increase in debt service. • For some countries rollover and accelerated repayment may be an issue. • Debt sustainability indicators may deteriorate even further as governments implement fiscal stimulus packages.
Debt sustainability: a summary • A critical issue is how long the crisis will last. • A short lived crisis will have a small effect on debt sustainability as relevant indicators are of a long term nature (forward looking, 20 yrs). • In contrast, a protracted crisis will have a more lasting effect on debt sustainability.
Presentation outline • The ongoing financial crisis in a nutshell • Debt sustainability: a summary • Debt sustainability and the crisis • Debt management and the crisis • The ongoing crisis: a protracted one? • Room for improving the DSF?
Debt sustainability and the crisis Two scenarios/shocks with different financing conditions
Presentation outline • The ongoing financial crisis in a nutshell • Debt sustainability: a summary • Debt sustainability and the crisis • Debt management and the crisis • The ongoing crisis: a protracted one? • Room for improving the DSF?
Debt management and the crisis • While a debt sustainability analysis focuses on the long-term sustainability of debt, which is influenced by both its level and composition, a debt management framework focuses on how the composition of debt is managed. • The crisis creates particular challenges for debt managers: • How to close an increasing financing gap and finance a country’s development needs at low cost with a prudent degree of risk, especially at a time when conditions in financial markets are severely constrained? • Given limited external financing options, how can potential benefits from developing domestic markets be exploited at a low cost and prudent degree of risk? • Given the efforts by many governments to strengthen their balance sheets over the past decade, how can these sounder public debt structures be protected? • Since the crisis implies substantial macroeconomic adjustments, how should debt management strategy reflect the new reality?
The Debt Management Facility as part of the solution, leveraging existing TA providers • Systematic application of the Debt Management Performance Assessment (DeMPA); • Country-led design of medium-term debt management strategies (MTDS) jointly with the IMF; • Design of reform programs; • Training events; • Research and development of knowledge products; • Peer learning initiatives, such as a the Debt Management Practitioners’ Program and the Debt Managers Network.
Presentation outline • The ongoing financial crisis in a nutshell • Debt sustainability: a summary • Debt sustainability and the crisis • Debt management and the crisis • The ongoing crisis: a protracted one? • Room for improving the DSF?
The financial crisis will cause a sharp decline in global growth: the largest since the 1930s Growth of Real GDP, Percent Low-income Middle-income World High Income Source: DEC Prospects Group.
Economic shocks and the world trading system Trade credit spreads (bp) • Contraction in trade finance was also fostered by loss of critical market participants • Secondary market drying up, reducing ability of banks to sell trade finance positions • Concerns about protectionist measures rising • World trade volume (goods and services) is likely to contract by 6% to 10% in 2009 • The food and fuel price surges led to disorderly and sometimes harmful trade policy responses • Financial crisis has led to a trade credit crunch and sharp increases in credit spreads Source: Data collected by WB staff from private sources.
All types of private capital flows to emerging economies plunging Source: Institute for International Finance: “Capital Flows to Emerging Market Economies.” 01/27/09.
Potential declines inremittances and ODA (USD, % Change) (% of GDP) Remittance Flows to Developing Countries Official Development Assistance Source: World Bank data and staff estimates.
Bottom line: outlook for LICs in 2009 has deteriorated sharply
A protracted crisis? • Short-term responses/effects • Fiscal stimulus packages substitute for the fall in aggregate demand • Government’s and IFI’s lending replace banks and other financial intermediaries • Recapitalization/lending to banks allow them to stay in business
G20 countries – discretionary fiscal stimulus in 2009 (% of GDP) Source: IMF Staff Note to G20 Deputies Jan. 31, 2009
A protracted crisis? • Long-term issues: • Global imbalance: large deficits and accumulation of debt in some countries (and reserve accumulation in others) needs to be reversed, a costly and difficult adjustment. • Further balance sheet effects may result from this adjustment as some currencies appreciate/depreciate. • Allocation of losses among stake holders: a complex economic and political process.
Presentation outline • The ongoing financial crisis in a nutshell • Debt sustainability: a summary • Debt sustainability and the crisis • Debt management and the crisis • The ongoing crisis: a protracted one? • Room for improving the DSF?
Room for improving the DSF? • Broadly speaking the DSF comprises two aspects: • Country assessments: CPIA, DSA (“medical check up”) • Policy on borrowing, including non concessional (“treatment”) • Currently the treatment allows for flexibility (the IMF is revising its own policy to make it more flexible and the Bank does a case by case analysis)
Room for improving the DSF? • Bottom line: • Developing countries need growth and trade to resume quickly (the sooner the better) • Need cheap financing to muddle through (the more and cheaper the better) • What relaxing the DSF and related policies would accomplish? • It would allow countries greater access to borrowing, but that is not necessarily the remedy under the current conditions (non-concessional borrowing implications).
Room for improving DSF? • Is there room for improving the tests run on the “patient”? YES, ongoing efforts • Is there room for more flexible treatments? YES, but this needs to be integrated with broader reviews of concessionality policies • Analysis of the “tests” and the “treatments” should not be confused • LICs should be particularly careful about the implications of non-concessional borrowing…
Concluding Remarks • Financial crisis: scale of policy responses is country specific, but, given the procyclicality of the financial system, it is important to coordinate financial sector reform and to synchronize macroeconomic responses; • The deepening of the downturn suggests the need for an increase in high-impact fiscal expenditures. But embedding stimulus packages in a credible medium-term strategy, that safeguards fiscal sustainability, is key; • Debt sustainability implications for LICs: a function of the crisis duration. Implications of non-concessional borrowing need to be carefully evaluated; • Debt management: the crisis underscores the importance of debt management practices and makes the Debt Management Facility even more relevant; • WBG response: increase in IBRD lending (mix of Development Policy Loans (budget financing/fast disbursing: financial sector restructuring; contingent source of liquidity...) and Investment Loans (preserving infrastructure spending; support for clean technology; social safety nets...)); fast-tracking IDA funds; Vulnerability Financing Facility; INFRA (support for infrastructure); expansion of guarantees (MIGA); new IFC facilities (support for trade; recapitalization of banks; refinancing of microcredit institutions).