The Risks of Sovereign Finance Ugo Panizza Debt and Finance Analysis Unit DGDS UNCTAD

Outline The risks of sovereign finance Debt structure matters Debt Sustainability Analysis

The risks of sovereign finance Two types of risk –Probability of financial or debt crisis –Constraints on the conduct of macroeconomic policies Two types of policies –Domestic –International

Developing countries don’t have high levels of public debt… Public Debt around the World (weighted averages) East Asia Emerging Europe L. AM & CAR Sub-Saharan Africa Advanced M. East & N. Africa South Asia 2001– – –1995 Source : Authors' calculations based on Jaimovich and Panizza (2006).

Developing countries don’t have high levels of public debt… …and yet, they tend to have low credit ratings …and are the object of recurrent debt crises…

Public Debt and Sovereign Rating ( ) Italy Jamaica Japan Israel Belgium Ghana Jordan Saudi Arabia Pakistan Egypt, Arab Rep. Mongolia Senegal Morocco Grenada Argentina Barbados Bolivia Panama Indonesia Bulgaria Portugal Cyprus Hungary Sweden Philippines Papua New Guinea Austria Tunisia Malta Denmark Ecuador India Benin Canada Finland Qatar Netherlands Spain France Uruguay Russian Federation Venezuela, RB United Kingdom Peru Croatia Brazil Poland South Africa Ireland Malaysia Trinidad and Tobago United States Iceland Belize Turkey Costa Rica Ukraine El Salvador Colombia Bahamas New Zealand Paraguay Germany Slovak Republic Mexico Switzerland Lithuania Bahrain Slovenia Norway Oman ChinaThailand Kazakhstan Guatemala Korea, Rep. Czech Republic Chile Australia Latvia Botswana Estonia Luxembourg Public Debt as Percent of GDP Standard & Poor's Sovereign Rating AAA B- BB- BBB- A- AA- Source : Jaimovich and Panizza (2006) and Standard and Poor's Investment grade

Developing countries don’t have high levels of public debt… …and yet tend to have low credit rating. …and are the object of recurrent debt crises… Why is it so? Something may have to do with debt structure rather than debt levels

Outline The risks of sovereign finance Debt structure matters Debt Sustainability Analysis

Why is Debt Structure Important The economics 101 debt accumulation equation states that: –CHANGE IN DEBT = DEFICIT Practitioners know that the real equation is: –CHANGE IN DEBT = DEFICIT+SF But the Stock-Flow reconciliation is often considered a residual entity of small importance So, the Stock-Flow reconciliation is the unexplained part of public debt

The unexplained part of public debt Source: Campos, Jaimovich, and Panizza (2006)

The unexplained part of public debt INDSASCAREAPECAMNALACSSA INFLATION GDP GROWTH UNEXPLAINED PART INTEREST EXPENDITURE PRIMARY DEFICIT

The unexplained part of public debt Decomposition of Debt Growth in LAC Percentage of GDP Inflation Stock flow adjustment Interest expenditure Primary balance GDP growth Source : Authors' calculations based on data from Campos, Jaimovich, and Panizza (2006).

The unexplained part of debt What explains the “Unexplained part of debt” –Skeletons Fiscal policy matters! –Banking Crises –Defaults –Balance Sheet Effects due to debt composition

A tale of two devaluations

Debt Management can reduce the risk of sovereign finance Debt-to-GDP Ratio Distribution Debt-to-GDP ratio Foreign currency Foreign currency –local currency Foreign currency– local currency–linked to GDP

The problems with foreign borrowing One problem has to do with the fact that foreign borrowing tend to be in foreign currency –Original sin Another problem is that the international interest rate is very volatile –Only a problem for EM

The International Market: Large but Volatile…

Will the good times last? Predicted Spreads Actual Spreads

Mark Twain’s quote

Outline The risks of sovereign finance Debt structure matters Debt Sustainability Analysis

What do we mean by sustainability? A policy stance is sustainable if a country is expected to be able to continue servicing its debt without an unrealistically large future correction to its policies (IMF, 2002, page 4). So, we define as sustainable a situation that satisfies the following two conditions: –A country can satisfy its current period budget constraint without recurring to default or excessive debt monetization –A country does not keep accumulating debt by knowing that a major future adjustment will be needed in order to be able to service its debt.

Two reasons for conducting debt sustainability analysis Predict potential debt crises and give policy advice in order to avoid them –Mostly for middle income countries with market access Allocate concessional resources –The IMF/WB DSF for low-income countries determines the grant element in IDA loans

We usually focus on the change in the debt-to-GDP ratio The change in the debt to GDP ratio is equal to: –Interest payments –minus the growth rate of the economy –minus the primary surplus If you like math: Evolution of public debt psdgrd  )(

Why are EM different In emerging markets we have –Large external shocks –Weak fiscal position –Non-Renewable resources –Default history –Sudden Stops And this leads to a much more complex debt structure which includes –Concessional debt –Liability dollarization and original sin –Volatile risk premia and interest rate

Thus, DSA becomes MUCH more complicated We started with: But in EMs we have: dr-gps)(   dsdl rr gdps  (         1 11)1( f r  ) 1 11)1( )1(       f r

DSF for Low Income Countries Threshold based on debt levels and CPIA –Evaluate sustainability –Allocate IDA grants

DSF for Low Income Countries PoliciesNPV of debt in percent of EXPGDPREV Weak CPIA< Medium 3.75>CPIA> Strong CPIA>

DSF for Low Income Countries Risk Categories Low Risk (Green) –All (or most) indicators are below the burden thresholds in both baseline and stress-testing scenarios Moderate (Yellow) –All (or most) indicators are below the burden thresholds in the baseline scenario but above the thresholds in stress- testing High (Red) –All indicators are above thresholds in the baseline scenario but no current payment problems Debt crisis –Like red but with arrears

DSF for Low Income Countries Implications for IDA Grants Low Risk (Green) –Standard IDA Terms Moderate (Yellow) –50% standard IDA terms and 50% grant High (Red) –100% grant

DSF for Low Income Countries Do these thresholds make sense? –Weak econometric exercise –Broad groups Does the CPIA make sense? –Politics may play a role –Used for too many purposes

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The Risks of Sovereign Finance Ugo Panizza Debt and Finance Analysis Unit DGDS UNCTAD