1. Debt Management, Fiscal Vulnerability and Fiscal Solvency: The Recent Mexican Experience XXII Meeting of the Latin American Network of Central Banks and Finance Ministries October 2005 Marco Oviedo Alejandro Werner

2. Introduction The Mexican 1994-1995 crisis introduced the discussion about debt management against self fulfilling crises. This work is an attempt to provide an analytical study on debt management under debt sustainability criteria. We start by including risk in the definition of debt sustainability and analyze debt management from a solvency point of view. The approach is particularly useful since we can measure the effect of debt management policies, such as debt composition and maturity in probabilities of insolvency. The question is if the existing levels of public debt and its current conditions could lead to unsustainable paths, and what elements of debt management could break potential unbalances. Thus, by introducing debt management with solvency criteria we can evaluate the effectiveness of debt policy under the Mexican experience.

3. Debt Sustainability with external debt Debt accumulation equation with external debt: Decomposition of GDP in its tradable and its non-tradable components: (1)

4. Debt Sustainability with external debt Equation (1) can be written in terms of GDP ratios (2) Define: and Policy question: how much foreign borrowing the government should issue each period, given the observed values of foreign and domestic interest rates and the depreciation of the real exchange rate?

5. Debt Sustainability with external debt If there is a mismatch, the elasticity of the GDP ratio to a change of the real exchange rate is not zero. The equation that defines the sustainable level of debt is (4) Equation (2) can be rewritten as: (3)

6. Recent Mexican debt policy Public sector net debt has been reduced since the 1980s. The currency composition includes lower proportion of external debt since the 1994-1995 crisis.

7. Recent Mexican debt policy Additionally, both duration and maturity has been considerably increased in the last years.

8. The Rigobon and Garcia methodology is applied. The external debt component, η, is incorporated. This will let us obtain every period the level of external debt as a function of the rest variables and measure the impact of this variable in sustainability. In equation (2) the rate of growth of GDP (  ), the real exchange depreciation (  ), the external interest rate (r*), the domestic interest rate (r) and the primary surplus (s) and its different components are stochastic and are multi-normally distributed, then Methodology And using the observed components of the primary surplus we can estimate which is the probability of public debt of reaching a threshold given the values of the relevant variables.

9. Probability of debt to GDP ratio of reaching more than threshold in the following 5 years Results The probability of reaching a threshold of public debt to GDP ratio of 83 is in average 0.66 in the 1980s. This probability has decreased to 0.21, on average, in the 1990s and 2000s. In particular, during the 2000s the debt to GDP ratio was around the twenties, and the probability of attaining a threshold of 45 percent of GDP in the next five years is less than 0.35.

10. Initial debt composition and the probability of reaching debt 83 percent of GDP There is a positive relationship between the probability of reaching a threshold of 83 percent of GDP and the level of debt at the initial condition. The effect of the composition of debt in the probability of hitting the threshold in the next 5 years is about 0.3, which means that when the initial composition of external debt increases 1 percentage point, the probability increases 0.003. Results

11. Probability of reaching a threshold of 60 percent of GDP in the following 5 years with a constant decrease in the proportion of external debt Effects of a currency composition debt policy We introduce an explicit debt composition policy that decreases the proportion of external debt each period. Increasing the rate of reduction of the proportion of  from zero to 2 percent, reduces the probability of a crisis in 0.02 and from zero to four percent, it reduces the probability in 0.025. Finally, the increase of the rate of reduction from zero to six percent reduces, on average, this probability in 0.032.

12. Debt term structure and the probability of a crisis We include a maturity index in our model and an explicit policy for that parameter by incorporating an explicit constant increase of the maturity index. In the data, this index is increased in 3.9 percent per quarter. In our exercise we incorporate zero, two, four and six percent increment. If the average maturity of the domestic debt increases from zero to two percent every quarter, on average the probability of reaching the specified threshold is 0.02. Similarly, increasing the rate of the term structure of debt from zero to four percent reduces the probability in 0.037, increasing it at 6 percent per quarter decreases the probability in 0.054. To have an idea of this impact, if the average maturity of domestic debt increases from 1000 days to 1060, and then to 1123 so on, the probability of attaining an unsustainable path will be reduced in 0.054 every quarter, thus reducing it in 0.2 in a year.

13. Debt term structure and the probability of a crisis The effect of an increment in maturity in the probability of reaching a threshold of 60 percent of GDP in the following 5 years

14. Sustainability is redefined when debt management is considered. According to the Mexican experience, both currency composition and maturity affect the probability of a crisis. On average, higher proportions of external debt increases the probability of a debt crisis. Similarly, increasing the average maturity of domestic debt has a considerable effect in the reduction of the probability of insolvency. These estimated impacts supports the beliefs of the potential benefits of increasing the maturity on public debt. More analysis should be done in terms of potential costs to provide more light on this matter to policy makers. Conclusions