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Reviewing the Debt Sustainability Framework (and some reflections on trends in sovereign debt amid the financial crisis) …

Reviewing the Debt Sustainability Framework (and some reflections on trends in sovereign debt amid the financial crisis)

Carlos A. Primo Braga
Director, Economic Policy and Debt Department

November 2009

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  • 1. Reviewing the Debt Sustainability Framework (and some reflections on trends in sovereign debt amid the financial crisis)
    Carlos A. Primo Braga
    Director, Economic Policy and Debt Department
    November 2009
  • 2. Outline
    • A tale of two crises
    • 3. Trends in sovereign debt
    • 4. Defaults: the usual suspects
    • 5. The Case of the HIPCs
    • 6. The Debt Sustainability Framework
    2
  • 7. A tale of two crisesSource: Eichengreen, B. & O’Rourke, K. – “A tale of two depressions”, VoxEu, (updated) 06/04/09
    9
    3
  • 8. The current crisis will not be a rerun of the Great Depression…(Source: Brahmbhatt and Pereira da Silva, 2009)
    • Larger weight of developing countries in the world economy (24% in 2008 vs. 13% in 1929) plus “decoupling” of underlying trend rates of growth (growth gap = growth in Developing Countries – growth in ICs = 0.8 % in the 1990s/3.5% in 2000-08);
    • 9. Larger share of services in global activity (employment in services less volatile);
    • 10. Changes in the structure of world trade (greater elasticity of trade with respect to GDP);
    • 11. Different policy responses: monetary, financial sector, trade and fiscal policies.
    4
  • 12. Policy reactions to the crisis
    At country level:
    • Monetary easing
    • 13. Recapitalization of financial systems
    • 14. Bailout of household and corporate sectors
    • 15. Fiscal stimulus packages
    • 16. Financial systems regulatory overhaul
    And IFIs are intermediating more funds than ever
    5
  • 17. G20 countries – fiscal stimulus & financial sector support
    Advanced economies:
    Average discretionary fiscal expansion in 2009: 1.5% of GDP
    Average financial sector support: 5.4% of 2008 GDP
    Emerging economies:
    Average discretionary fiscal expansion in 2009: 2.0% of GDP
    1/ In percent of 2009 GDP. Excludes below-the-line operations that involve acquisition of assets.
    2/ As of Apr. 15, 2009, in percent of 2008 GDP. Consists of capital injection, purchase of assets and lending by Treasury, and central bank support provided with Treasury backing.
    Source: IMF
    6
  • 18. Central Bank balance sheets in advanced economies have been rapidly expanding
    UK
    US
    Euro Area
    Collapse of Lehman Brothers
    Japan
    Source: IMF WEO (2009)
    7
  • 19. Government Debt: Medium Term Prospects (Source: Horton et al., 2009)
    • Significant expansion of public debt in advanced economies
    8
  • 20. A recovery is underway, but is relatively weak, uneven, and subject to considerable risks (Source: DEC)
    Real GDP growth rates (%)
    9
  • 21. Recessions
    Credit Crunches
    46
    10
    1
    3
    4
    18
    31
    9
    HousePrice Busts
    EquityPrice Busts
    Historical experiences: the case of the USA
    31
    Source: Claessens, Kose, Terrones (2008)
    Source: JP Morgan
    • Current crisis is one of four of the past 122 recessions to include a credit crunch, housing price bust, and equity price bust
    • 22. Average of past US recessions has shown that it has taken 5-6 quarters before pre-recession output levels were regained; current recovery will take longer
    10
  • 23. Sovereign Debt Defaults: The Usual Suspects
    Walter Wriston, Citibank chairman, 1967-1984: “[a] country does not go bankrupt,” New York Times, 14 September 1982
    • Bad output shocks (defaults are countercyclical)
    • 24. Tighter international financial conditions
    • 25. Overborrowing
    11
  • 26. Debt Defaults: The Usual Suspects
    • Bad output shocks
    • 27. External shocks
    • 28. Domestic macro crises (banking crises; currency crashes…)
    12
  • 29. Sovereign defaults and world GDP growth 1970-2012
    13
    Asian Crisis
    LTCM Collapse
    Tech Bubble Collapse
    Cluster 2
    US Recession
    LatAm Debt Crisis
    Cluster 1
    Source: World Bank, Sturzenegger and Zettelmeyer (2006)
  • 30. Debt Defaults: The Usual Suspects
    • Tighter international financial conditions
    14
  • 31. Private capital flows to developing countries as a percent of GDP 1970-2009 (projected)
    15
    Source: World Bank GDF
  • 32. Relative to past downturns the decline of capital flows has been even more dramatic
    Net private capital flows / GDP in developing countries
    Projection2007-10
    Percent
    1997-02
    1980-83
    Source: DECPG/GDF 2009
    16
  • 33. Private capital flows are unlikely to recover to pre-crisis levels for some time
    percent
    US$ billion
    Net Private Capital Flows to Developing Countries
    Percent of GDP (right axis)
    17
  • 34. Yields on 10-year US T-Bond and number of sovereign defaults 1970-2008
    T-Bond yields lower than at any point in nearly 50 years
    Source: Federal Reserve, Sturzenegger and Zettelmeyer (2006)
    18
  • 35. Yields on 10-year US T-Bond and defaulting issuer spreads
    19
    Russia
    Source: Federal Reserve, World Bank, Sturzenegger and Zettelmeyer (2006)
  • 36. Short-term debt as percent of total external debt in low and middle income countries
    20
    Source: World Bank, Sturzenegger and Zettelmeyer (2006)
  • 37. Sovereign and corporate external debt refinancing needs ($b)
    21
    Source: IMF
  • 38. 22
    Bank non-performing loans relative to total loans
    Note: Median across 59 countries = 2.7% in 2007 and 4.4% in 2009
    Source: IMF Global Stability Report (Oct. 09), World Bank
  • 39. Debt Defaults: The Usual Suspects
    • Overborrowing
    Willingness to pay vs. ability to pay
    23
  • 40. “Cluster 1” defaults and other developing countries: lessons from the 1980s
    24
    Note: Other Developing Countries include LICs and MICs for whom data was available; year for measurement of developing country ratios was 1980, which represented the lowest level of annual GDP growth during the ‘76-’89 crisis period.
    Source: World Bank
  • 41. “Cluster 1” defaults and other developing countries: lessons from the 1980s
    25
    Note: Other Developing Countries include LICs and MICs for whom data was available; year for measurement of developing country ratios was 1980, which represented the lowest level of annual GDP growth during the ‘76-’89 crisis period.
    Source: World Bank
  • 42. “Cluster 2” defaults and select emerging market countries: Asian crisis
    26
    Notes: Select Emerging Market Countries includes countries known to have experienced stress during the ‘97-’03 period; y-axis represents the most severe negative annual growth rate for each country during the crisis period.
    Source: World Bank
  • 43. “Cluster 2” defaults and select emerging market countries: Asian crisis
    27
    Notes: Select Emerging Market Countries includes countries known to have experienced stress during the ‘97-’03 period; y-axis represents the most severe negative annual growth rate for each country during the crisis period.
    Source: World Bank
  • 44.
    • The Case of the HIPCs
    Primo Braga and Doemeland (2009)
    28
  • 45. 29
    Combined HIPC and MDRI Debt Relief
    1/ Assumptions include timing of HIPC decision and completion points, and where applicable, of arrears clearance
    Source: HIPC Initiative country documents; IDA and IMF staff estimates
    1/ Data are simple averages; subject to data availability
    Source: HIPC Initiative country documents; IDA and IMF staff estimates
  • 46. HIPC 2008 countries
    30
    Note: Burundi, Haiti and CAR, due to their recent attainment of Completion Point status, have not yet fully benefitted from debt stock reduction; figures used here are pro-forma for debt stock reduction in 2009. 3 Decision Point countries—DRC, Guinea-Bissau, and Liberia—have PV Debt/Export ratios >200% and are not shown on this graph.
    Source: World Bank, CIA World Factbook
  • 47. HIPC 2008 countries
    31
    Note: Burundi, Haiti and CAR, due to their recent attainment of Completion Point status, have not yet fully benefitted from debt stock reduction; figures used here are pro-forma for debt stock reduction in 2009. 2 Decision Point countries—DRC and Guinea-Bissau—have Total Debt Service/Export ratios >10% and are not shown on this graph.
    Source: World Bank, CIA World Factbook
  • 48. Cluster 1 countries now in the HIPC Initiative: past versus 2008
    32
    Note: Liberia—currently a HIPC Decision Point country—had a PV Debt/Export ratio >200% at end-2008 and is not shown here.
    Source: World Bank
  • 49. Cluster 1 countries now in the HIPC Initiative: past versus 2008
    33
    Source: World Bank
  • 50. External debt to GDP ratios, top 25 countries: 1995, 2000, 2007(Red = Small State)
    34
    HIPC Completion Point = Underline
    HIPC Decision Point = Box
    Source: World Bank
  • 51. Volatility of export growth: small states and regional groupings, 2007
    35
    Note: Developing countries for which data was available; 1 SSA country—Chad—had a standard deviation of growth greater than .5, and 1 SSA country—Liberia—had an Ext. Debt/GDP ratio in excess of 200%. Neither country is shown here. Y-axis values were calculated for each country using the standard deviation of annual export growth of goods and services from 1998-2007.
    Source: World Bank
  • 52. 36
    Risk of debt distress
    IDA-only countries
    HIPCs
    In the case of IDA, the graph reflects only countries for which a DSA is available. The graph for HIPCs includes: Bolivia and Honduras (both Blend countries) and Somalia (for which a DSA is not available)
  • 53. What is the DSF?
    The DSF was introduced in 2005 and reviewed in 2006.
    It is a tool (thermometer) aimed at informing Bank-Fund analyses on countries’ debt vulnerabilities (diagnostic), and allow better informed decision making by donors, lenders and borrowers (treatments).
    37
  • 54. Why reviewing the DSF?
    The DSF has been criticized on two grounds:
    It restricts financing needed to meet countries’ development goals (MDG)
    It is too pro-cyclical
    The G20 and the IMFC called on the Bank and the Fund to review the DSF with a view to increasing its flexibility.
    38
  • 55. Staff’s approach to responding to the request
    The DSF is an analytical tool used to assess a country’s debt burden (thermometer).
    Increased flexibility should respect its integrity and reliability.
    Reforms to how the Bank and the Fund better meet members’ financing needs should be directed to its concessional lending and their policies on non-concessional borrowing (treatments).
    39
  • 56. 40
    Table: Debt Sustainability Framework Thresholds
    PV of debt in percent of
    Debt service in percent of
    Exports
    GDP
    Revenue
    Exports
    Revenue
    Weak Policy (CPIA≤3.25)
    100
    30
    200
    15
    25
    Medium Policy (3.25 < CPIA < 3.75)
    150
    40
    250
    20
    30
    Strong Policy (CPIA≥3.75)
    200
    50
    300
    25
    35
    How the DSF works: three pillars
    20 year projections of debt burden indicators in baseline, alternative and stress test scenarios.
    For external debt such indicators are compared against country specific (policy dependent) thresholds:
    Risk ratings of low, moderate, high, or in debt distress are assigned to countries.
  • 57. Flexibility already inherent in the DSF
    Multi-year framework addresses criticism of pro-cyclicality;
    Staffs are required to exercise judgment in applying risk ratings (not a mechanistic approach) by looking at other aspects;
    The paper details many instances where flexibility has been applied.
    41
  • 58. Adding flexibility to the DSF
    Four areas were considered:
    • Investment-growth nexus
    • 59. Treatment of remittances
    • 60. Threshold effects
    • 61. Treatment of state-owned enterprise debt
    In addition the paper proposes changes to some operational aspects
    42
  • 62. The investment-growth nexus
    Boards agreed that the country specific approach proposed in 2006, based on studying a number of indicators (structural/macro constraints, historical rates of return, etc.), remains largely valid.
    If a scaling-up of public investment is ongoing or imminent, or if high policy capacity increases the likelihood of such scaling-up, more formal model-based approaches should be considered (ex., country specific GE; growth diagnostics; etc.)
    Full DSAs should document staffs’ analysis of the investment-growth nexus
    43
  • 63. Remittances: Growing importance
    An important source of FX for LICs
    44
  • 64. 45
  • 65. Remittances: Treatment in DSF
    Boards agreed that insufficient data prevented remittances from being formally included in the empirical model underlying the DSF
    Remittances are important for DSAs—size, counter-cyclicality
    Greater flexibility in taking account of remittances is justified on a case-by-case basis and more in depth analysis is granted
    46
  • 66. Threshold effects: What is the problem?
    For countries close to the cut off points of CPIA ranges (≈ 3.25 and 3.75), small changes in a country’s CPIA may imply “large” changes in applicable debt thresholds (i.e., a CPIA drop from 3.26 to 3.24  threshold falls by 10% of GDP)
    This could result in changes to debt distress ratings
    Such changes are hard to relate to a country’s underlying capacity to service its foreign debt
    47
  • 67. Threshold effects: How do we address the problem?
    Board favored (in line with staffs’ recommendation)
    Add inertia to the CPIA score applicable for determining countries’ debt thresholds
    At present a 3-year moving average CPIA score is used to determine the policy performance category
    In the future, when the CPIA crosses its boundary
    The new threshold will apply at once if the new 3 yr average CPIA lies outside a range of 0.05 from the boundary
    Otherwise, the CPIA will have to remain above/below the new boundary for 2 consecutive years
    48
  • 68. State-owned enterprise debt
    The current rule is that generally all SOEs external debt is included in the DSA.
    The Boards agreed that when SOEs can borrow without government guarantee and their operations pose a limited fiscal risk to public balance sheets, they could be excluded from consideration in DSAs.
    49
  • 69. In addition: Discount rate
    The current rule requires that the discount rate (used to calculate PV of Debt) needs to be lowered by 100 basis points to 4 percent (in September ‘09).
    Simulations showed that a change in the discount rate to 4 percent generally resulted in relatively small increases in PV of debt.
    And a small number of countries were to experience small and temporary breaches of their respective thresholds (for some others, the size of existing breaches were to increase).
    These effects needed to be weighed against the cost of having a more sticky rule which would increase the lag of interest rate adjustments vis-à-vis market movements.
    The suggestion was not to change the existing rule
    50
  • 70. Other issues: Streamlining DSAs and reflecting authorities views
    Full DSAs will be required to be produced once every three years, with lighter annual updates in the interim:
    Essentially, this will entail not having to do the full write-up each year (but a risk rating needs to be provided)
    If there is a significant change in circumstances (macroeconomic, debt outlook, or program requirements) a full DSA may be required in interim years
    This will be introduced only after the present crisis has passed
    And more effort/space than in the past is needed to reflect the authorities’ views in the DSAs.
    Staff Guidance Note: Coming soon—before end 2009.
    51
  • 71. Debt management and the crisis
    52
    While a debt sustainability analysis focuses on the long-term sustainability of debt, which is influenced by both its level and composition, a debt management framework focuses on how the composition of debt is managed.
    The crisis creates particular challenges for debt managers:
    • How to close an increasing financing gap and finance a country’s development needs at low cost with a prudent degree of risk, especially at a time when conditions in financial markets are severely constrained?
    • 72. Given limited external financing options, how can potential benefits from developing domestic markets be exploited at an acceptable cost and prudent degree of risk?
    • 73. Given the efforts by many governments to strengthen their balance sheets over the past decade, how can these sounder public debt structures be protected?
    • 74. Since the crisis implies substantial macroeconomic adjustments, how should debt management strategy reflect the new reality?
    • 75. The Debt Management Facility (www.worldbank.org/debt) a World Bank-led initiative funded by a multi-donor trust fund that supports technical assistance and capacity building efforts in this area.
  • Concluding remarks
    • Slower world economic growth and higher cost of capital will mean a more difficult environment for developing countries seeking to accelerate growth and progress toward the MDGs.
    • 76. In this environment, countries’ efforts to enhance efficiency of resource use and improve productivity will be even more important.
    • 77. Financial crisis: scale of policy responses is country specific, but, given the procyclicality of the financial system, it is important to coordinate financial sector reform and to synchronize macroeconomic responses;
    • 78. The severity of the downturn highlights the need for an increase in high-impact fiscal expenditures. But embedding stimulus packages in a credible medium-term strategy, that safeguards fiscal sustainability, is key;
    • 79. Expansion of public debt will be massive. Countries need to design exit strategies to the ongoing fiscal interventions and to introduce growth-enhancing reforms to reassure markets of the public sector’s solvency;
    • 80. Debt sustainability implications for LICs: a function of the crisis duration. Implications of non-concessional borrowing need to be carefully evaluated;
    • 81. Debt management: the crisis further underscores the importance of debt management practices and makes the Debt Management Facility even more relevant.
    53
  • 82. Concluding remarks (cont.)
    • DSF Flexibility -- the review focused on:
    • 83. Investment-growth nexus
    • 84. Treatment of remittances
    • 85. Threshold effects
    • 86. Treatment of state-owned enterprise debt
    • 87. In addition, the WB/IMF (2009) paper proposes changes to some operational aspects of the DSF. The Staff Guidance Note is being updated.
    • 88. Adjustments are also being made with respect to the IMF’s debt limits policy and IDA’s Non-Concessional Borrowing Policy with a view to increase flexibility, in particular, for high-capacity LICs.
    54
  • 89. References
    • Brahmbhatt, M. and L. Pereira da Silva (2009) “The Global Financial Crisis: Comparisons with the Great Depression and Scenarios for Recovery” PREM Note 141;
    • 90. Claessens, S., M.A. Kose, and M.E. Terrones, (2008) “What Happens During Recessions, Crunches and Busts?” SSRN Working Paper Series, December;
    • 91. Eichengreen, B. & K. O’Rourke (2009) “A tale of two depressions”, VoxEu, (updated) 06/04/09;
    • 92. Horton, M., M. Kumar, and P. Mauro (2009) “The State of Public Finances: A Cross-Country Fiscal Monitor,” IMF Staff Position Note, SPN/09/21;
    • 93. Primo Braga, C.A. and D. Doemeland (eds.), (2009) Debt Relief and Beyond, The World Bank;
    • 94. Sturtzenegger, F. and J. Zettelmeyer (2006) Debt Defaults and Lessons from a Decade of Crises, MIT Press;
    • 95. World Bank (2009) Global Development Finance: Charting a Global Recovery;
    • 96. World Bank and IMF (2009), “A Review of Some Aspects of the LIC Debt Sustainability Framework.”
    55