Debt Sustainability and Debt Composition UNCTAD Paper by Heiner Flassbeck and Ugo Panizza

Introduction Problems with DSA exercises Often mix the concept of external sustainability with that of fiscal sustainability Trend to focus on the level of debt without considering its composition

Outline Disentangling Concepts of Sustainability External Sustainability and Fiscal Sustainability Interactions/Linkages Debt Decomposition analysis Debt composition Proposed composite debt indicator Determinants of debt crises

Different concepts of sustainability tied to different types of debt External sustainability focuses upon the Transfer Problem: ability to generate foreign exchange Fiscal sustainability focuses upon the Budgetary Problem: ability to increase or broaden the tax base to generate revenue

External Debt Indicators Standard external debt sustainability indicators: Debt to GDP ratio Debt to revenues ratio Debt to export ratio Weaknesses of these indicators These indicators are problematic if import growth outpaces export growth. Unless the external debt is issued in domestic currency, the foreign exchange needed will only result from a current account surplus. Not all types of debt carry the same risk features

Fiscal Sustainability & Budgetary Problem Public debt has an external and domestic component. Fiscal sustainability analyses focus on adjustments to the level and composition of tax revenue or primary expenditures Both public debt (domestic vs. external) and fiscal sustainability lack clear definitions Formal fiscal sustainability tests are problematic and are demanding in terms of data. The tests do not establish any necessary conditions for long-run sustainability

Fiscal Sustainability Indicators Common Rule of Thumb: Δd = (r – g) d – ps, where d is the debt to GDP ratio r is the steady state real interest rate g is the long run growth rate of real GDP ps is the primary surplus to GDP Problems: No well specified definition of sustainability or of the necessary conditions for LR sustainability Requires many assumptions on growth, interest rates, government expenditures and revenues These variables tend to be endogenous and correlated with one another

Considerations for Developing Countries Fiscal sustainability indicator does not account for the fact that developing countries often: Have a limited capacity to raise taxes Have a volatile revenue base Are subject to large external shocks (real and financial) that increase the volatility of GDP growth Have high levels of liability dollarization

Tradeoffs between External and Fiscal Sustainability Consider a real devaluation: Positively impacts external sustainability through increased export competitiveness and FOREX earnings Negatively impacts fiscal sustainability if a large share of public debt is denominated in foreign currency, results in a jump in the debt-to-GDP ratio.

These interactions highlight the need for domestic debt to be included in DSA exercises. Broad shift towards a greater proportion of domestic debt in developing countries Domestic debt has been excluded from DSA exercises thus far because Domestic debt has different risk characteristics Not appropriate to sum debt of different risk characteristics together Data are scarce

Important Considerations Any attempt of measuring debt sustainability requires a thorough analysis of the causes of indebtedness Analysis purely based on debt levels and on the forecast of some macroeconomic variables will lead to nowhere.

In a perfect world Construct a composite debt indicator Decompose external and public debt by: Maturity and currency characteristics Type of lender Type of borrower Authors propose categorization of external debt across 12 different levels of risk. Assigning different weights to different risk categories to calculate a composite risk measure

Back to reality… empirical study Empirical study examines how debt level and composition affect the probability of a debt crisis Estimate a probit model on an unbalanced panel of 78 developing countries for the period Explanatory variables: GDP growth; international reserves to GDP, trade openness; undervaluation of the exchange rate; growth rate of private credit; fiscal and CA balance; inflation; corruption

Total external debt is decomposed into four components: Total short term external debt Long-term private external debt Long-term public external debt to private creditors Long-term public debt to official creditors (bilateral and multilateral)

Empirical findings Examining separate components of total external debt, authors find evidence that debt composition matters Find significant evidence that crises are positively correlated with long term public debt owed to private creditors Find evidence suggesting that the relationship between default risk and debt with private creditors is more sensitive to external shocks than between default risk and debt with official creditors. Find evidence that there is less risk associated with borrowing abroad in their own currency.

Conclusions Different types of debt may be ranked by risk: 1. External public debt with private creditors in a foreign currency (highest risk) 2. Domestic public debt 3. External public debt with official creditors (lowest risk) 4. The evidence wrt private debt does not yield consistent evidence

Remaining Obstacles Data availability International agreement to provide better and comparable data on debt statistics

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