UNCTAD, World Bank and IMF Workshop Geneva, February 06-10 2017 Baseline Projections and Risks in Key Policy Areas: Fiscal, Monetary and Externals Sectors UNCTAD, World Bank and IMF Workshop Geneva, February 06-10 2017

Outline What are the links between macroeconomic policy and the formulation of debt management strategy? How do these links operate in practice? Baseline projections Risks Structural factors Feedback from MTDS and macroeconomic policy Risk mitigation DM Strategy can improve the functioning of the financial system

1. Broad linkages between mtds and the macro policy framework

Why looking at links between MTDS and Macro Framework Mexico 1994/5 Sudden devaluation of the peso led to capital flight and a run on reserves of the Central Bank and government debt crisis exacerbated by a large stock of short-term debt and high level of dollar denominated debt =>IMF bailout to resolve liquidity Argentina 2001/2: External current account deficit (5% of GDP) high in terms of exports (100%) and currency peg meant overvaluation of the peso and costly gov. FX debt=>200% depreciation/debt restructuring. Greece 2010: Mainly primary deficit problem but non transparent fiscal/debt accounting and significant reliance on short- term and variable rate funding aggravated situation

EM Crisis tend to emulate supply side shock Often characterized by twin deficit: Fiscal expansion (G↑) leading to increasing fiscal deficit and current account deficit as imports increase (M↑). If exchange rate is flexible, local currency depreciates and exports increases (X↑) and restores balance of payments. If exchange rate is fixed, central bank intervenes to defend the currency, and reserves are depleted unless there is additional FDI and portfolio inflows. Need domestic devaluation (P↓) or fiscal tightening to restore balance of payments. As local currency depreciates, domestic prices tend to rise due to pass through effect. This leads to monetary tightening and high domestic interest rates. Risk premium demanded by investors will also rise. when economy is doing badly, inflation and interest rates tend to go up, and local currency tend to depreciate. optimal debt structures would minimize exposure to inflation, interest rate and exchange rate shocks

Why balance sheet structures of other parts of the economy matter Asian financial crisis 1998/1999 Ireland and Iceland 2008 Even if central government debt is low, implicit contingent liability can materialize

2. MTDS: How do these linkages operate in practice? Baseline projections Risks Long-term structural factors

Concrete links to Macroeconomic Framework Use MTEF for baseline projections of macroeconomic variables. Projections need to be part of a consistent macroeconomic framework. Source: macro unit, budget department, central bank Baseline market variables should be consistent with macroeconomic framework Nominal exchange rate projection should be consistent with outlook for real exchange rate projections based on competitiveness of the economy Nominal interest rate should be consistent with inflation outlook

Baseline Projections: 4 Sectors- Key Macro & Market Variables Real sector Fiscal policy External sector Monetary policy GDP: denominator in cost /risk indicators and affects financing needs (revenue may fall and expenditure increase with decrease in GDP); Primary balance = Revenues – Non-interest expenditures Exchange rate Balance of Payments and external financing needs Reserves accumulation and ability to roll-over debt Interest rates Inflation outlook and variability Real interest rate

National Accounts (local currency, flows) REAL SECTOR GENERAL GOVERNMENT National Accounts (local currency, flows) Private consumption General government consumption (Wages + Purchases of goods and services) Private investment General government investment Exports of goods and nonfactor services Imports of goods and nonfactor services Fiscal Accounts (local currency, flows) Revenues Grants Expenditures Current Capital Overall balance Financing Domestic financing (net) Banking system Nonbanking sector External financing (net) EXTERNAL SECTOR MONETARY SECTOR Balance of Payments (US dollars, flows) CURRENT ACCOUNT Exports of goods and nonfactor services Imports of goods and nonfactor services Factor services (net) Transfers (net) Official Private CAPITAL & FINANCIAL ACCOUNT Direct investment Medium/long-term capital (net) Private sector Government Short-term capital (net) Private sector Overall balance Reserves (Change in net foreign assets) Monetary Auth (local curr., stocks) Net foreign assets Net domestic assets: Net credit to government sector Credit to banks Other items (net) Reserve money Currency Banks’ reserves DMBs (local currency, stocks) Net foreign assets Banks' reserves Net domestic assets: Net credit to government sector Credit to nongovernment sector Other items (net) Liabilities to monetary authorities Private sector deposits

Fiscal MTDS DSA BOP Monetary Schematic diagram* 1 3 1 4 2 5 Primary balance Interest payments 2 3 Total debt service, new financing source & its terms External debt service 4 Government debt holdings by financial system 5 * Abstracts from other linkages.

MTDS → Fiscal 2016 2017 2018 2019 Gross financing requirement Primary Balance Interest Payments existing debt new debt Principal Repayment Financing sources Multilateral Bilateral Commercial Domestic Financing gap MTDS → Fiscal

MTDS → BOP 2016 2017 2018 2019 Overall balance Current Account Balance Trade balance Service and income (net) o/w interest payment new debt Capital account balance Financial account balance FDI Portfolio investment (Eurobond & nonresidents) Other investment (Loans) Financing sources Gross official reserves Multilateral credit Bilateral credit Financing gap MTDS → BOP

MTDS → monetary 2016 2017 2018 2019 Central Bank Net foreign assets Net domestic assets Credit to the public sector (net) Capital and other asset (net) Base money Commercial Banks Credit to the private sector (net) Other assets

MTDS → DSA 2016 2017 2018 2019 Public Debt Stock Domestic debt For LIC DSA - existing and new debt For MAC DSA - existing debt External debt For LIC & MAC DSA – existing debt Debt Service External principal and interest payment Domestic principal and interest repayment For LIC DSA – existing and new debt For MAC DSA – existing debt Consistent new debt assumptions

Macroeconomic Framework: Main Risks? Having established the baseline we need to ask what are the most likely risks (deviations from the realistic baseline) RISK SOURCE IMPACT ON DEBT-RELATED RISK GDP decline Taxes and revenues Weak debt repayment capacity Deterioration fiscal position Primary balance High financing needs Current Account Deficit & FDI reduction Balance of Payments Need for external financing (private / public) Inflation and credit rating DX interest rates High DX debt service Currency depreciation Exchange rate High FX debt service Sudden stops of flows (reversal) Balance of Payments Exchange rate Limits the choice of financing sources High FX debt service Terms of Trade Commodities prices Exchange rate

Relation to Debt Sustainability Analysis (DSA) DSA role is to gauge the level of the debt. Does it lead to future debt servicing difficulties (over indebtedness)? Derive advice on the (max.) primary fiscal balance based on DSA. Inputs on refinancing risks MTDS role is to derive the composition of debt Debt structure, and interest rate structure often crudely modeled in DSA. This is the role of MTDS If MTDS leads to a revision in debt strategy implicit in MEF/DSA this should be fed back into MEF/DSA [when updated]. DSA feeds the macro variables of the MTDS, it does not work the other way

Fiscal Baseline Projections DM should be clear about Expected path of Primary Balance Gross Financing Needs: Government Deficit = Primary Balance + Interest + Debt Repayments For LICs: grants depend on donor policies and economic prospects (a declining source of revenues as countries develop - a structural factor to consider) From DSA whether there is considerable risk in terms of sustainability composition policy should help to reduce risk unsustainable debt cannot be mitigated with a better debt portfolio structure

Monetary Baseline Projections Short-term interest rates driven by monetary policy. Other nominal rates driven by inflation expectations. Unstable monetary regime and inflation will lead to high inflation risk premiums for medium-long-term fixed rate instruments Inflation indexed debt requires trusted index not subject to political “intervention”

Baseline Projections: External Sector Balance of Payment defines the external financing needs (BoP gap) in the short- term (for given exchange rate/reserves target) Current account drives the path of the exchange rate which is a key variable in cost-risk of external vs domestic funding Reserves are key for roll-over risk especially under a fixed exchange rate regime where authorities will defend a predefined level

Exchange rate shock impact

Longer-term Structural Factors Examples of structural factors: structural changes in monetary policy (inflation targeting), in the long term reduce borrowing cost development of domestic debt markets (reforms) changing trends in prices of commodities long term trends in exchange rates due to productivity improvements Long-term structural factors influence the debt strategy through their effects on the baseline macro scenario and on the mix of available instruments

3.feedback from MTDS and macroeconomic policy

The Challenge Public debt management should be an integral part of a country’s comprehensive policy agenda (often not the case), including among others: prudent fiscal policy measures appropriate policy mix, with a consistent monetary policy framework adequately regulated and supervised financial system, in particular the banking sector Public debt management should be an additional policy tool, consistent with the general macroeconomic policy framework.

Mitigating Fiscal Vulnerabilities Choice of strategy can reduce liquidity risk and therefore, reduce the likelihood of crisis Longer debt maturity helps reduce fiscal vulnerabilities: reduces roll-over risk and slows the pass through of increasing spreads / interest rates More domestic funding reduces foreign exchange rate risk exposure Similarly, reducing variable rate debt can reduce budgetary uncertainty and exposure to shifts in market’s assessment of credit risk (credit risk impacts the interest rates) Liquidity risk as opposed to solvency risk which is a fiscal issue

Mitigating difficulties in the implementation of Monetary Policy Longer domestic debt maturities may help reduce the conflict between monetary and debt management objectives CB can more freely set high nominal short-term interest rates to achieve monetary objectives Public debt management can help develop efficient fixed-income markets Facilitates move to indirect instruments of monetary policy (open market operations) Improves size and liquidity of Bonds issues reduces the cost of borrowing.

Mitigating Balance of Payments Vulnerabilities Lengthening external debt maturities reduces roll-over and potential drain on reserves/ pressure on the balance of payments through capital flight. Switching to domestic can reduce pressure on the BoP, but this could crowd out effects to domestic private borrowing. However,crowding out domestic sector can be mitigated by developing savings market. Maximizing concessional borrowing reduces pressure to borrow for BoP support.

Link to Financial System More generally, public debt management can effectively support the development of more robust financial markets, improving the functioning of the financial system Facilitating corporate debt markets Providing a benchmark for the private sector Providing scope for securitization of banks’ assets (i.e. mortgage loans) Facilitate repo market development Improving liquidity of banks’ balance sheets (provide collateral) Facilitate development of derivatives markets Allowing for more effective risk management within the economy

Conclusions The overall aim of public debt management is to minimize costs to the budget, taking account of potential vulnerabilities Composition of debt stock can help mitigate vulnerability of budget to shocks thus enhancing macroeconomic stability Reducing rollover risk is an important mitigating factor to address broad range of vulnerabilities To achieve its intended objectives, public debt management should be performed in close coordination with the rest of the macroeconomic policy Despite public debt management’s policy impact on macroeconomic stability, financial stress and crisis may still occur, but amplitude of such events will not be exacerbated.