Debt Sustainability Analysis March 2010 IMF and World Bank Nicholas StainesAntonio Nucifora IMF, African DepartmentWorld Bank, Africa Region

Outline The Government has expressed interest in foreign borrowing on non-concessional terms to finance investment. This presentation shows the results of a preliminary Debt Sustainability Analysis (DSA) for Mozambique. A baseline scenario based on the current macroeconomic and external borrowing projections. A scenario with a sustained scaling-up of borrowing, illustrating the key issues and risks of non-concessional borrowing (NCB). A scenario with a temporary scaling-up. Highlights that debt sustainability depends on the selection of good investment projects and the borrowing terms. 2

What is a DSA? The DSA is a tool to assess whether a country’s borrowing plans are viable. It compares debt trajectories to ‘sustainable ceilings’ in debt indicators (based on the capacity to make repayments). The analysis is based on data and assumptions about: macroeconomic outlook; existing debt stocks and projections for new borrowing; assumptions about debt relief, new borrowing terms, and investment-growth relationship; The following scenarios are purely illustrative and to be viewed cautiously—they are not projections. 3

Ceilings and Indicators in

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Macroeconomic Framework No new NCB beyond the Portuguese Credit Line (PTL). Projections assume real GDP growth around 6.5%. Inflation remains steady between 5% and 6%. The real exchange rate remains stable. Current account balance improves relative to GDP, as trade and income balances strengthen. Net aid resources decline as a share of GDP and its composition shifts towards borrowing. Projections assume an increased fiscal reliance on domestic resources relative to GDP: (i) rising domestic revenue effort, stabilizing around 21% of GDP (ii) gradual decline in primary domestic deficit by about 2% of GDP (iii) modest use of domestic financing rising to about 1% each year 6

Baseline Key Results External public debt: Mozambique continues to face a low risk of external debt distress. The NPV and debt service ratios on external public debt are all well below their respective thresholds. Portuguese credit lines (PTL) : The PTL deteriorates the NPV and debt service ratios through the medium term. Central government domestic debt: Central government domestic debt indicators also projected to remain low. 7

External Debt Indicators 8

Fiscal Indicators 9

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Assumptions Assumes sustained external NCB of 2.5% of GDP per year above baseline. Assumption of the growth impact of investments: increasing grant- financed investment by one percent of GDP raises growth by 1/3 percentage points. All borrowing through the budget. Compare borrowing on concessional (CB) and on non-concessional terms (NCB). Borrowing terms: CB: Highly concessional borrowing IDA terms (10 years grace, 40 years maturity, at 0.75% interest). NCB: highly non-concessional commercial terms (NCB, 1 year grace, 10 years maturity, 9% interest). CB terms ‘cheap’ relative to growth impact, NCB terms ‘expensive’ relative to growth impact. 11

Impact on Welfare High-return investments seem valuable as the sum (NPV) of the output gains exceeds the borrowing costs. Additional GDP more than covers debt service (but less so for NCB). The problem is: who receives the benefits and pays the debt service costs? 12

Impact on Budget Financing The investment affects the budget financing needs: it generates additional revenues (user charges or general taxes) but also additional debt service costs. Concessional Borrowing requires less financing. Allows less borrowing or a larger primary domestic deficit (reduce revenues/raise spending). It generates fiscal space. This boosts private sector activity and growth. Non-Concessional Borrowing requires more financing. Requires more borrowing or a smaller primary domestic deficit (raise revenues/reduce spending). This reduces private sector activity and growth. Focusing on NCB, how can this higher financing need be met? 13

(a) By Higher Domestic Borrowing 14 Meeting additional financing requirements of NCB with domestic borrowing: Negative impact on growth. Raises NPV of external debt close to the GDP threshold. External debt sustainability vulnerable to shocks (exceed ceilings). Results in large increase in domestic debt and interest costs. Danger of a domestic debt spiral

(b) By More External Borrowing 15 Meeting additional financing requirements of NCB with more external borrowing: Raises NPV of external debt above the GDP threshold. And requires a large contraction in the non-interest current account balance. This would need a large FX depreciation. Would threaten external stability.

(c) By Reducing Primary Domestic Deficit 16 Meeting additional financing requirements of NCB by reducing the primary domestic deficit: Negative impact on growth (as either revenues are raised or other spending reduced). Raises NPV of external debt close to GDP threshold. External debt sustainability vulnerable to shocks. Requires a large reduction in the primary domestic deficit of about 1.7% of GDP. Unlikely to be feasible.

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Less Severe Borrowing Terms Moderate borrowing terms, say NCB with 4% (instead of 9%) interest: Significantly improves the external debt indicators and room for borrowing. Allows a smaller contraction of the primary domestic balance. Highlights key importance of accessing better borrowing terms. 18

Higher Growth Impact Simulate higher growth impact of investments at 0.8 percentage points (instead of 0.35): Improves external debt indicators Allows large expansion of the primary domestic deficit Highlights key role of: Quality of public investment and its selection process. Good business environment to enhance crowding-in effect of public investment. The opposite also holds: the unproductive use of resources will have a large adverse impact. 19

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A Cautious Approach A sustained scaling-up of investment financed by non- concessional borrowing poses large risks. In view of these risks, a more cautious approach may be warranted: Assumes a temporary scaling-up of borrowing on NCB terms by 2.5% of GDP (approx. $300m) each year during This would deteriorate the debt indicators, but leave scope for adjustment. 21

External Debt Indicators 22

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High Risks Though the scenarios are only illustrative, some key points emerge: A sustained scaling-up of infrastructure investment financed by foreign borrowing on commercial terms poses many risks. Costly foreign borrowing can generate a vicious domestic debt cycle, external instability, or require a large fiscal adjustment. A sustained increase in borrowing will make Mozambique’s debt sustainability vulnerable to shocks. Investments should preferably be financed by reducing the primary domestic deficit (raising revenues or reducing non-priority spending). 24

Key Issues and Way Forward The impact of high sustained NCB will depend on: The borrowing terms. The productive use of investments to raise growth. The promptness of fiscal adjustment to maintain domestic and external debt sustainability. The presumption should be for caution in case the resources are not used productively. A cautious approach would be to scale up investment temporarily for priority projects with high growth impact. If investments are highly productive and increase the growth rate, then more borrowing will become possible. 25

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