UN Compendium on Debt Sustainability and Development 2011 - Agenda 21

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UnitedNationsConferenceonTradeandDevelopment

COMPENDIUMON

DEBTSUSTAINABILITY

ANDDEVELOPMENT

UnitedNations

New

York

and

Geneva,

2009



CompendiumonDebt Sustainability and Development

ii

Note

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Copyright©UnitedNations,2009

Allrightsreserved

UNCTAD/GDS/DDF/2008/1




iii

CONTENTS

COMPENDIUMONDEBTSUSTAINABILITYANDDEVELOPMENT .....................................................i

CONTENTS ................................................................................................................................. iii

CHAPTERI.OVERVIEW:DEBTSUSTAINABILITYINTHEORYANDPRACTICE.....................................1A. Introduction ................................................................................................................................... 1

B. DefinitionandDimensionsof DebtSustainability ......................................................................... 3

C. CountryStudies.............................................................................................................................. 5

D. InstitutionalFrameworkforDebtManagement............................................................................ 7

E. CreditRatingAgencies ................................................................................................................... 8

F. GlobalRulesforInternationalFinanceandTrade ......................................................................... 9

G. ConclusionsandFutureTasks ...................................................................................................... 11

CHAPTERII.DEBTSUSTAINABILITYASSESSMENT:THEIMFAPPROACHANDALTERNATIVES......... 17A. Introduction ................................................................................................................................. 17

B. WhatisDebtSustainability? ........................................................................................................ 18

C. ApproachestoAssessingDebtSustainability:ACriticalReview ................................................. 23

D. ReviewandConclusions............................................................................................................... 36

CHAPTERIII.THEMECHANICSOFDEBTSUSTAINABILITYANALYSIS.............................................. 45A. Introduction ................................................................................................................................. 45

B. DebtIndicatorsandEarlyWarningof Crisis................................................................................. 46

C. ThePresentValueof FutureIncome ........................................................................................... 48

D. TheFinancingGap........................................................................................................................ 50

E. DevelopmentPolicyBasedApproachtoDebtSustainability ...................................................... 58

CHAPTERIV.ANANALYTICALFRAMEWORKFORDEBTSUSTAINABILITYANDDEVELOPMENT ......63A. Introduction ................................................................................................................................. 63

B. Debtandthe“FinanceGap”Model............................................................................................. 66

C. SustainableDebtLevels ............................................................................................................... 71

D. FiscalConsequencesof ExternalDebt ......................................................................................... 77

E. DebtVulnerabilityandExternalShocks ....................................................................................... 78

F. Conclusions:PrinciplesforDebtManagementinDevelopmentStrategies................................ 81

CHAPTERV.THEDEBTEXPERIENCESOFUGANDA,KENYAANDBOLIVIA...................................... 89A. Introduction ................................................................................................................................. 89

B. Uganda ......................................................................................................................................... 90

C. Kenya’sDebtExperience.............................................................................................................. 96

D. Bolivia’sDebtExperience........................................................................................................... 101

E. DebtExperiencesCompared...................................................................................................... 108

F. ConcludingRemarks................................................................................................................... 110

CHAPTERVI.CASESTUDIES:ARGENTINAANDTHEREPUBLICOFKOREA.................................... 115A. Introduction ............................................................................................................................... 115

B. LessonsfromtheArgentineCrisisandDefault.......................................................................... 116

C. ExternalDebtManagementof theRepublicof KoreaduringtheCrisesof19791980 and19971998 ........................................................................................................................... 123

D. ConcludingRemarks................................................................................................................... 130




iv

CHAPTERVII.APPROPRIATEINSTITUTIONALSETTINGSFORPUBLICDEBTMANAGEMENT.......... 143A. Introduction ............................................................................................................................... 143

B. TheContextof PublicDebtManagement.................................................................................. 144C. TheRoleandOrganizationof aDMO ........................................................................................ 148

CHAPTERVIII.CREDITRATINGAGENCIESANDTHEIRPOTENTIALIMPACTON

DEVELOPINGCOUNTRIES ........................................................................................................ 165A. Introduction ............................................................................................................................... 165

B. CreditRatingAgenciesintheInternationalFinancialSystem ................................................... 166

C. CRAs’ProceduresandMethods................................................................................................. 168

D. Impactof Ratings ....................................................................................................................... 172

E. PublicPolicyConcerns ............................................................................................................... 176

F. Conclusions ................................................................................................................................ 180

CHAPTERIX.PURSUINGSUSTAINABLEDEVELOPMENTSTRATEGIES:

THECASEOFTHEBALANCEOFPAYMENTRULESINWTO.......................................................... 191A. Introduction ............................................................................................................................... 191

B. ExchangeControlsandConvertibility ........................................................................................ 194

C. TradeRestrictionsforBalanceof PaymentsPurposes............................................................. 199

D. TradeFinancingandEquity........................................................................................................ 202

E. TheGeneralAgreementonTradeandServices(GATS),Balanceof Payments,andDebt

Sustainability.............................................................................................................................. 204

F. Conclusions ................................................................................................................................ 209

CHAPTER X.RISKASSOCIATEDWITHTRENDSINTHETREATMENTOFSOVEREIGNDEBT

IN

BILATERAL

TRADE

AND

INVESTMENT

TREATIES.................................................................... 211A. Introduction ............................................................................................................................... 211

B. SovereignDebtinBilateralTradeandInvestmentTreaties ...................................................... 211

C. ImplicationsforSovereignDebtProblemsof IncludingNationalTreatmentandMFN

TreatmentinFTAs ...................................................................................................................... 213

D. InvestorStateLawsuitsandSovereignDebt ............................................................................. 216

E. ConcludingRemarks................................................................................................................... 217




1

CHAPTERI

OVERVIEW:DEBTSUSTAINABILITY

INTHEORYANDPRACTICE

AndrewCornford

(FinancialMarketsCenter)

A. Introduction

Debt sustainability, which concerns the feasibility for a country of meeting its debtrelated financial

obligations during a period beginning with the present, has proved an elusive concept. This is not

surprisinginviewof itsdependenceonanintrinsicallyuncertainfuture.Interestintheconditionsfordebt

sustainabilitybuildsonanearliertraditionof workondebtmanagementwherethefocuswasoncountry

riskandonthelikelihoodandconsequencesof debtdefault.

Theshiftinfocusfromcountryrisktodebtsustainabilityreflectsthesearchof nationalandinternational

policymakers for rules forexternaldebtmanagementwhichhaveagood theoretical justificationanda

reasonable track recordof application.Theproblemsof debtmanagementhave traditionallyalsobeencloselyrelatedtoconsiderationof severalotherissuesinvolvingexternaldebt.Therecentshiftinfocusis

much less evident in the way in which these issues are approached. This is true, for example, of

considerationof externaldebtpolicyasanimportantelementof globalregimesforinternationalfinance

andtrade. Inspiteof the lackof adirect link todebtsustainabilitysome featuresof these regimesare

takenupinthepapersinthiscollectionowingtotheirimportancetotheframeworkof internationalrules

withinwhichexternaldebtmanagementiscarriedout.

Traditionalcountryriskanalysishadtwodimensions,politicalriskandtransferrisk.1Thefirstreferstothe

determinantsof thepoliticalwillandthesecondtotheeconomiccapacitytomeetobligationsondebts

incurredthroughsovereignborrowingaswellasthroughthecrossborderliabilitiesof privateinstitutions

operatingwithinthecountry’sfrontiers.Thetwodimensionsarenotcompletelydistinctsinceeconomic

capacitydependspartlyon a country’swillingness to take thepolicymeasures required tomeetdebt

1Goodoverviewsof thetraditionalanalysisof countryriskareFriedman(1983)andKrayenbuehl(1988)



Overview:Debt Sustainability inTheory and Practice

2

obligations,and thiswillingness in turn reflectsabalancingof politicalcostsandbenefits.Nevertheless

analysisunderthetwoheadingscoverslargelydifferentsubjects.

Thesubjects takenupunderpoliticalriskcompriseacountry’sconstitutionalandpoliticalenvironment,

thequalityof Governmentandthelevelof corruption,inequalitiesof incomesandwealth,literacyrates,demographic structures, and ethnic and religious differences. Transfer risk concerns subjects not

necessarily lesscomplexbutmostlymoreeasilyquantifiable.Someof these factorscanbeclassifiedas

having a substantially domestic origin such as fiscal and monetary policy, the exchangerate regime,

access tonatural resources, theuseof fundsacquired through foreignborrowing, the tax system,and

exchange controls for current and capital transactions.Other factors areexternal. These include trade

barriers to a country’s exports, commodity prices, interest rates and other conditions in international

financialmarkets,shippingcosts,theavailabilityof concessionalfinancing,andnaturaldisasters.

Transfer risk varieswith theavailabilityand termsof external financingandwith changes in theother

determinantsof accessto foreignexchange. Intheassessmentof transferriskamajorrole isplayedby

quantitativeindicatorssuchasthefollowing:

The debt service ratio: interest and principal with a maturity of at least one year divided by

receiptsof foreignrevenueduringaperiodT;

Thedebt/GNPratio:externalpublicandprivatedebt(normallyexcludingthatwithamaturityof

lessthanoneyear)dividedbyGNP;

Theinterestserviceratio:interestpayments(normallyexcludingthoseondebtwithamaturityof

lessthanoneyear)dividedbyexportsof goodsandservicesduringaperiodT,which,if subtracted

from thedebt service ratio, indicates thepercentageof foreign exchange receipts required to

serviceprincipal;

Thereserves/importsratio:officiallypublishedreservesdividedbyimportsduringaperiodT;

Theliquiditygapratio:anumeratorconsistingof debtwithamaturityof uptooneyearminusthe

balanceoncurrentaccountdividedby the sumof export receiptsandunilateral transfers.The

ratioindicatestheliquiditygapwhichneedstobecoveredbyshorttermborrowing;

Currentaccountbalance/GNP;

The compressibility ratio: nonessential imports as a percentage of total imports, an indicator

which inprincipaldependsonclassifyingpartof importsasbasicneeds (energy, food,essential

inputs and investment goods) on the basis of knowledge of the economy’s requirements but

whichinpracticeisoftenbasedonaruleof thumbsuchas25percentof imports.

Until the late 1970s analysts tended to focus primarily on mediumterm indicators of transfer risk.However, owing to countries’ greater use of international financial markets to meet their external

financingneedsandexperienceof thedebtcrisisof the1980s,theyincreasinglydevotedgreaterattention

toindicatorsbearingonliquidity(forexample,thereserves/importsratio,theliquiditygapratio,andthe

compressibilityratio).

However, actual experience of countries’ debt problems has indicated limits to the usefulness of the

commonly used indicators. These limits are partly due to lack of information concerning aspects of

countries’positionswithanimportantbearingontheircapacitytomeettheirexternalobligations.During

theAsiancrisisof 19971998,forexample,statistics forofficialreservesdidnot include theauthorities’

commitments in the forwardexchangemarketsor toprivate sector financial institutionswhich inboth

cases reduced the foreignexchange available tomeetexternaldebt service.Moreover, the traditionalindicatorsof countryriskaredesignedfortheassessmentof riskandaremuchlesswellsuitedtobetools

fordebtmanagement.




3

To meet the needs of the latter attempts began to be made to give a more precise meaning to the

conceptof debtsustainability.Theseweredesignedtoprovideaconceptcapableof contributingtopolicy

undereachof thethreemajorheadingsof debtmanagement,namelyavoidanceof financialcrises,debt

management once a debt crisis appears imminent or is under way, and postdefault policy and

rescheduling.Atthesametime,partlyinresponsetothegrowingcomplexityof manycountries’external

commitmentsandtothegreateravailabilityof instrumentsformanagingthem,attentionhasincreasingly

beendevotedtocountries’overallexternalbalancesheets,andtotheproblemsandopportunitieswhich

theypresentforpolicymakers.

Work on sustainability accompanied parallel attempts to investigate the theoretical underpinnings of

conditionsfortheenforcementof crossborderdebtcontracts,andhaslikewisebeenmarkedbyinterest

indevelopingamorerigorousconceptualframeworktoreplace itsmoreadhocpredecessor.2

However,

thepapersinthiscollectionpointtotheprobablyinsolubledifficultiesconfrontingtheattempttodevelop

aconceptof debtsustainabilitycapableof servingasaphilosopher’sstoneforpolicymakers.

B. DefinitionandDimensionsof DebtSustainability

InChapterII,Wyploszprovidesanextensivereviewof thekeyconceptsinvolvedindifferentdefinitionsof

debtsustainability.Theseareasfollows:

Thresholdlevelof debt/GDPratio;

Solvency, i.e. the condition that future surpluses on current account are sufficient to cover

interestobligationsandrepaymentsof principal;

Debt serviceability, i.e. solvency plus the additional condition of no illiquidity, which denotes

inabilitytoservicedebtsatparticularmomentsintime;

Solvencyplusavoidanceof theneed for amajor correction in the formof large cuts inpublic

expenditureorlargeincreasesintaxationrequiredfordebtservice;

Networth,i.e.theconditionthatthepresentvalueof currentaccountsurpluseslesscurrentdebt

isnotdecreasingovertime;

Debtstationarity,i.e.theconditionthatthedebt/GDPratiodoesnotincreasewithoutbounds.

Wyploszpointsoutthatowingtothedependenceof eachof theseconceptsonan inherentlyuncertain

future theycannotbeused to constructuniversallyapplicable rules fordebt sustainability,anattempt

which he characterizes as “mission impossible”. Thus rules using the concepts as a base for policy

prescriptions will necessarily be arbitrary and imprecise. Wyplosz elaborates the implications of thisimpossibilitythroughanexaminationof proceduresforDebtSustainabilityAssessment(DSA)designedby

the IMF and theWorldBank’s InternationalDevelopmentAssociation (IDA) to formalize thenotionof

prudentdebtstrategiesreceptiveoacountry’sdevelopmentneeds.

The startingpoint for the IMF’s DSA is a baseline fiveyear forecast combined with stress testing for

adverse shocks. To allow for the dependence of the probability of debt distress on countryspecific

economic and political conditions this technical exercise is combined with a Country Policy and

InstitutionalAssessment(CPIA)developedbytheWorldBank.TheCPIAgeneratesanindexof governance

qualitybasedon20 component indicators, and countries are classified into three groups according to

theirCPIAindex,thosewithindexesof higherqualitybeingpermittedhigherdebt/GDPthresholds.

2For a concise account of the development of the new conceptual framework for the analysis of crossborder debt see

SturzeneggerandZettelmeyer(2006:chapter2).




4

AsWyplosznotes,thisprocedureincludesanumberof arbitrarychoicesregardingscenariosanddoesnot

allowformutuallyreinforcingeffectsduetocorrelationsamongshocksorforalternativepolicyresponses

to shocks. Moreover, it is not designed to take account of the potential of borrowing for actually

accelerating economic growth, except indirectly to the extent that a good CPIA index is likely to be

associatedwithanincreaseinthispotential.Thus,perhapsunsurprisingly,theIMF’sDSAhasbeenatthe

centreof discussionsondebtpolicybetweentheFundandnationalGovernments.

In view of the intractable nature of DSA, Wyplosz proposes limiting the exercise to less ambitious

objectives.Forthispurposeheprefersafocusontheevolutionof debtlevelsandontherequirementsof

avoiding debt distress (concernswhichwere at the centre of the traditional approach to country risk

described insectionI,thoughthis isnotmentionedbyWyplosz).Inthecaseof countrieswithaccessto

international financialmarkets important indicators forDSAaretheriskpremiums in thetermsof their

borrowing.MoreoverWyploszstresses thatanyprocedure forDSAbeopen,and that it should include

experts other than those of the multilateral financial institutions themselves. DSA should also

accommodatethe factthatdebtaccumulationcanbea legitimatepartof developmentpolicy.Wyplosz

acknowledges that his proposal can only lead to avoidance of debt distress under plausible, normalconditions.Thepossibilityof debtdistressinresponsetoexceptionaleventsissimplytobeacceptedasa

factof life,andonewhoseconsequencesaretobedealtwithasandwhenitoccurs.

Wyploszisnotsuggestingthattheelementsof theIMFapproachtoDSAhavenovalue.Buttheyshould

bepartof theframework forpolicydiscussionandnotamechanicalguidetopolicyconclusions,asthe

IMFitself increasinglyrecognizes.

Theanalyticsof theIMFapproachandof otherschematicapproachestodebtsustainabilityaremorefully

developed in Chapter III and IV by TranNguyen and Tola (henceforth TranNguyen) and Fitzgerald

(Fitzgerald). TranNguyen’s results include “templates” for debt sustainability based on alternative

national accounting identities as points of departure as well as conclusions concerning the longrunstability –and thus feasibility –of timepaths fordebt.Thepaperalsodevelopssimple frameworks for

analyzing the relationbetweendebt and growth. In a similar spirit Fitzgerald also explores theuseof

nationalaccountingidentitiestoderivesimple“golden”rulesfordebtsustainabilityaswellasconstraints

onfiscalpolicywhichtakeaccountof accesstoexternalfinancing.

Fitzgerald provides a critical review of “financing gap” models which were long widely used as an

analytical framework fordiscussionof debt sustainability.Thesemodelsplaceeconomicgrowthat the

centre of the exercise. The objective of the planning authority is tomaximizeGDP growth subject to

constraints imposed by domestic savings, import capacity, and the fiscal ceiling determined by tax

revenueandaccesstosovereignborrowing.

Theshortcomingsof thesemodelsaretheirdependenceonstableandexogenouslygivenrelationships.An alternative approach explored by Fitzgerald, which draws on assumptions now common in

macroeconomics,involvestakinginvestmenttobedeterminedbyintertemporalmaximizationsubjectto

relationshipsbetweenGDP,thecapitalstockdividedbetweenthatwhichisdomesticallyandthatwhichis

externallyfinanced,depreciation,thecostof newinvestment,national incomedefinedasthedifference

betweenoutputand interestcosts,andexternalconstraintsaccordingtowhich importsaredetermined

bynational incomeandexportsbytheproductivityof theexportsector.Thisapproachcangeneratean

expression for the optimal debt level as a function of the allocation of financing to different major

categoriesof investment.

TranNguyen reviews recent literature on earlywarning indicators of currency and debt crises. This

literatureisanaturaldevelopmentof theearlierapproachtocountryriskdiscussedabove.However,toagreaterextentthanearlierwork,themorerecentliteraturemakesuseof econometricanalysis.Moreover




5

italsoincludesnewindicatorssuggestedbyrecentexperienceof financialcrisessuchasindicatorsof the

fragilityof thefinancialsector.

Amajorconclusionof TranNguyenisthattheapproachessurveyedsufferfromtheshortcomingthatthe

concept of debt sustainability is not integrated into a framework which also includes a country’sdevelopmentstrategyandtheimpliedgrowthtrajectory.AlthoughTranNguyen’ssuggestionsastosuch

integrationare limitedtosimpledebtandgrowthanalytics, thesubjectwouldbenaturalcandidate for

inclusion in themoreopen, less ruleboundprocedures to analysisof debt sustainability proposedby

Wyplosz.

C. CountryStudies

Of thefivecasestudiesincludedinthiscollectionof papersthree,Uganda,KenyaandBolivia,wereof low

incomecountrieswhoseexternaldebtwaslargelytheresultof publicbilateralandmultilateralfinancing,

whiletheremainingtwo,ArgentinaandtheRepublicof Korea,werecountrieswhosedebtcrisesreflected

abreakdownintheiraccesstointernationalfinancialmarkets.

1. LowIncomeCountries

The experiences of Uganda, Kenya and Bolivia share key common features in the form of failure to

generatesustainablegrowthandpovertyreductionandcontinuingvulnerabilitytothe impactof higher

interest rates and of lower prices on their commodity exports. All three countries undertook reform

programsconsistingof tightermacroeconomicpolicyandprice liberalization.But theprogramsdidnot

addressmajorweaknesses.Forexample,theydidnotincludeabroadeningof thetaxbase,andthetariff

reductions adopted actuallyharmedprogress towards thisobjective.TheGovernmentsof Uganda and

Kenya are still heavily dependent on foreign aid for the financing of their expenditures. Moreover

substantialproportionsof economicactivityandexports inallthreecountriesremainconcentrated ina

limitednumberof unprocessedprimarycommodities.

Therewerealsoimportantdifferencesbetweenthethreecountries’experiences.

UgandaandBolivia,which(unlikeKenya)arebothHIPCcountries, illustratebothgeneralweaknessesof

thisinitiativeandflawsmorespecificallyapplicabletothesituationsof thetwocountries.Thefirstsetof

weaknesses included inadequate analytical bases, which reflected dependence on unrealistic country

scenariosand failure to takeproperaccountof vulnerability toexogenousshocks.Thesecond included

toonarrowadefinitionof debtsustainability,failuretoallowfortheway inwhichpostHIPCborrowing

couldspeedilyreversegainsinacountry’sdebtposition,andtheinappropriatenessof loansasopposedtograntsforthefinancingof programsof povertyalleviation.

DuringtheperiodcoveredbythecasestudiesUgandaandBoliviaachievedanadequatetechnicalcapacity

fordebtmanagement.Kenyaontheotherhandstilllacksanadequatesystemforthispurpose.

2. LowIncomeCountries

Themain focus of the studiesof the Republicof Korea andArgentina are their recent currencycum

bankingcrises, for the former in19971998and for the latter in20002001.For theRepublicof Korea,

thereisalsoareviewof anearlierdebtcrisisin19791980whichtheGovernmentsucceededinridingout

withoutrecoursetothedeflationarymeasuresusuallycharacteristicof policyresponsesinsuchcases.




6

Therecentcrisesforbothcountriesweredominatedbydevelopmentsaffectingthecapitalaccountafter

periods in which the liberalization of capital transactions led to greater integration into international

financialmarkets.Inbothcasestherewerelargefluctuationsof capitalflows –largeinflowspriortothe

crises followedby largeoutflows. Inbothcases the IMF’spolicyprescriptionswere illsuited todealing

withthecrises.

Theoriginof theRepublicof Koreacrisiswasanunfavorableshiftinitsexportmarketsbeginningin1995.

This ledto inventoryaccumulationand lossesamongstthecountry’s large industrialgroupsthat inturn

provokedareassessmentof thesegroups’prospectsamongsttheforeigninvestorsandlendersonwhich

thegroupswere increasinglycomingtodepend.Asaresultof bankruptciesaccompaniedbyrevelations

concerningpoorcorporategovernanceandcorruption,during1997foreigners’flightfromthecountry’s

stockmarketacceleratedand itsbanks faced increasingdifficulties in rollingover shortterm interbank

loans.TheinitialfinancingpackageagreedlateintheyearbetweentheGovernmentandtheIMF,which

includedawiderangeof conditionsincludingmacroeconomicstringencyandliberalizationof financialand

labormarkets,failedtostemthecrisisasinterestratesreached40percentandthecurrencycontinuedto

depreciate.

A secondpackagewas accompanied by an agreementwith creditorbanks to loan extension and to a

lengthening of maturities in return for government guarantees on private debt. This sufficed to turn

aroundmarketsentiment,andasharprecoveryineconomicgrowthfollowedin1999.Thisexperienceof

theRepublicof Koreahas ledcommentatorstoquerytheappropriatenessof thedeflationaryfiscaland

monetary conditionsof the firstpackageasa response towhatwasprincipallya capitalaccount crisis

ratheronecharacterizedbymacroeconomicimbalances.

ThepaperonArgentina locates the sourceof its crisis in theexchangerate regimeand the impacton

externaldebt dynamics of interest rates required to manage the country’s capital account. This

interpretation isatvariancewith theviewof thecountry’sGovernmentsduring thepredefaultperiodwhereby problemswere seen to bedue to fiscalmismanagement,which called for a policy response

consistingof aseriesof packagesof fiscaltightening.

AsArgentina’scrisisgotunderway,thereweremarkeddisagreementsbetweenthenewGovernmentand

the IMFastoappropriatepolicymeasures.The IMF’srecommendations includedallowingtheexchange

ratetofloatfreelyandanapproachtothebankingcrisiswhichwouldhaveentailedbankliquidations.The

Government’spolicies,whichaccompaniedthebeginningof aneconomicrecoveryfromthefirsthalf of

2002,includedexchangecontrolsandrestrictionsoncapitaloutflowsaspartof apolicyof managingthe

exchange rate, export taxes designed to capture for the Government some of the profits due to

devaluation, anda flexiblemonetarypolicyaimed atassisting the recoveryof thebanking sector.The

Governmentalso resistedpressure from foreignGovernmentsand the IMF to improve the termsof its

offerondebtrestructuringtoitsexternalcreditors.

Owingtothe lackof therequireddata it isnotpossible toconductacontrolledexperimenttotestthe

validityof thenow increasinglywidelyheldbelief asto inappropriatenessof standardfeaturesof policy

programsassociatedwithIMFpolicypackages.However,theRepublicof Korea’sdebtcrisisof 19791980

doesprovideacasestudyof thesuccessfulapplicationof adifferentpolicyapproach.

Thecrisisbeganin1979afteryearsof rapidgrowthpoweredbyaninvestmentboom.Majorfeaturesof

thecrisiswereasharpincreaseinthecurrentaccountdeficit,asevererecession,andariseininflationof

consumerpricestoanannualrateof almost30percent.InsuchcircumstancesthestandardIMFpolicy

prescription would probably have involved macroeconomic stabilization through fiscal and monetary

tightening and allowing the exchange rate to float. The view of the Republic of Korea Government,however,wasthatacceleratinginflationwasthesourceof deterioratingincomedistribution,laborunrest,

anddecliningexportcompetitiveness.Thepoliciesadoptedincludedaoneoff devaluationfollowedbya




7

managed float under which the Won was tied to a basket of major international currencies,

macroeconomicpoliciesgivingpriority to stopping theeconomicdownturn,and continued recourse to

externalfinancingof adecliningcurrentaccountdeficitdespiteanalreadyhighlevelof externaldebt.

Theeconomic recoverywhich followed is likely tohave reflected theeffectsof an improvement in theexternaleconomicenvironmentaswell thepoliciespursued.Commentatorsalsoattributea significant

role to capital controls which prevented capital flight. Conditions associated with different countries’

currencycumdebtcrisesareof courseneverthesame.Nonetheless,theRepublicof Koreaexperienceof

the early 1980s deserves a place in the template of the menu of policy measures for debt crisis

management.

D. InstitutionalFrameworkforDebtManagement

Whatever the approach adopted by a developing country to debt sustainability, properly developed

institutionsfordebtmanagementarerequired.Thetasksof theseinstitutionsassetoutinChapterVIIby

JaimeDelgadilloCortez(Delgadillo)includethefollowing:

Theproductionof reliabledebtdata;

Developmentof thedomesticfinancialmarket;

Ensuringadequatefinancingfordevelopmentalandsocialneeds;

Ensuringcompliancewithdebtserviceobligations;

Controllingcontingentliabilities;

Meetingtherequirementsof negotiationswithcreditors;

Performingcost/riskanalysis;

Designingstrategiesfordebtsustainability.

For this purpose design of the institutional framework for debt management has to focus on the

following:

Governance;

Clarityof therolesof thedifferentinstitutionsdealingwithdebtmanagement;

Specificationof theobjectives;

Coordinationof publicdebtmanagementwithotherpublicpolicies;

Theorganizational structureof theprincipalbody responsible fordebtmanagement, theDebt

ManagementOffice(DMO);

Transparencyandaccountability.

Delgadillo discusses and exemplifies different options under these two headings for this institutional

framework.

Thenetworkof relationsdescribedbyDelgadilloof whichtheDMO isthecentre includetheministryof

finance, the central bank, the national/planning or development office, creditors, international

organizations (whichmay themselvesbeamongthecountry’screditors), thepublicandprivateentities

whichareasourceof guaranteesandinsurancefortradefinance,etc.,andmajorparticipantsindomestic

financialmarkets.

Theinstitutionalframeworkfordebtmanagementcanbeexpectedtoevolveinresponsetothechanging

profileof acountry’sexternalliabilitiesanditslevelof financialdevelopmentaswellastotheincreasingly

comprehensive approach to management of a country’s external assets and liabilities which is now

receiving greater attention (see below). Inter alia, this approach may entail closer working relations

between the DMO as described by Delgadillo and those responsible for the regulation of financial




8

institutionsand thus foroversightof thecurrencyandmaturityrisksassociatedwith these institutions’

balancesheets.

E. CreditRatingAgencies

The ratings industry has its origins in firms which were established in midnineteenthcentury United

States to provide merchants with information on the creditworthiness of their customers. Ratings

originallyreferredtothecapacityof anobligortomeetpaymentsdueonaparticularfinancialobligation

after taking into consideration the creditworthiness of guarantors, insurers, and other forms of credit

enhancement.Butratingsmaynowrefertoissuers,includingcountries,aswellasissues.

Assessmentof developingcountries’creditworthiness long reliedon financial institutions’own systems

for this purpose, guidance from their regulators, services providing information on country risks, and

rankingsof countrycreditriskprovidedbypublicationssuchasinstitutionalInvestorandEuromoney.The

growthintheimportanceof creditratingagenciesinrecentyearsreflectstherequirementsof thegrowth

of international capital markets which has led to increasingly widespread need for creditworthiness

assessments: borrowers are seeking ready recognition from investors; investors require an accessible

vehicle forassessing thequalityof securities;andbanks find ratingsausefulmarketing tool for selling

papertocustomers(Fight,2004:46).

Sincethemid1990stheperformanceof theagencieshasbeencriticizedonseveralgrounds,asdiscussed

inChapterVIIIbyElkhoury:theirslownesstoreacttochangesincreditworthinessandthentheirtendency

onoccasiontooverreact;theiruseof untransparentratingmethods;theirprivilegedregulatoryposition;

theirlackof accountability;andthevulnerabilityof theiroperationstoconflictsof interest.

Criticsviewedtheagencies’responsetotheAsianfinancialcrisisof 19971998ascharacteristicof theirtendencytoslownesstoreactfollowedbyoverreaction.

Althoughtheagenciesmakeknownthefactorstakenintoaccountasinputstotheirratings,their

assignmentof weightstothesefactorsisopaque.

Theagencies’privilegedregulatoryposition isdueto institutional investors’needforaratingof

investmentgradebyanofficiallyrecognizedagencyforthesecuritiesinwhichtheyarepermitted

to invest aswell as toother regulatoryexemptions accorded to such securities. In theUnited

States such recognition is reserved for Nationally Recognized Statistical Rating Organizations

(NRSROs), a designation conferred on only a limited number of agencies including the major

three,Moody’s,Standard&Poor’sandFitch.

Theagenciesarenotaccountablefortheirmistakesortheirabuseof power.

Conflicts of interest may arise owing to the agencies’ involvement in the structuring of

instrumentstheyrate,theirprovisionof consultancyservicestoissuers,thepotentialforpressure

to purchase agencies’ consultancy services in return for an improved rating, and the use of

aggressivesalestacticsto inducean issuerto“solicit”andthuspayforaratingwhich ithadnot

initiallyrequested(an“unsolicited”rating).

Elkhoury reviews some recentofficial initiatives todealwith these criticisms.These include theCredit

RatingAgencyReformActpassedbytheUnitedStatesCongress inSeptember2006,whichtightensthe

procedural requirements forNRSRO registrationand certification,and strengthens theauthorityof the

SecuritiesExchangeCommissionoverNRSROs;andaCodeof Conduct issued inDecember2004by the

International Organization of Securities Commissions (IOSCO), whose objectives include ensuring the

integrityof theratingprocessandachievinggreatertransparencyregardingratingsmethodology.




9

However, these steps areunlikely to satisfy the creditagencies’growingbandof critics.The agencies’

operationshavereturnedtothespotlight inconnectionwithratingsaccordedtotranchesof securitized

assetsduringthecreditcrisiswhichbegan inthesummerof 2007.Againspecialattention isfocusedon

theopacityof themethodsunderlying their ratings, their lackof accountability, and thepotential for

conflictsof interestarisingfromtheirroleasprovidersof “ex anteopinions”and“structuringadvice”as

wellasratingsinthecaseof structuredfinancing.3

The consequences may be more stringent rules for agency certification, minimum standards for the

trainingandqualificationsof agencies’analysts,andincreasedtransparencyregardingtheiroperations.If

one looks further into the future,a large increaseand thenumberof credit ratingagenciesworldwide

seemsquite likely. Interalia,suchan increasewouldbeanaturalconsequenceof the roleaccorded to

credit rating agencies in determining weights for credit risk in the determination of banks’ minimum

regulatorycapitalunderBasel2,whichmorethan100countriesarenowplanningtointroduce.

F. GlobalRulesforInternationalFinanceandTrade

Discussion of global rules in connection with external debt typically focuses mainly on arrangements

capable of making debt cries less likely and of facilitating theirmanagement and resolution. Subjects

include bankruptcy mechanisms for sovereign, and sometimes also private, crossborder debt,

improvements intermsandfundingfor IMFcrisis lending,andprecrisis intervention inthemarkets for

internationaldebt.4Buttheframeworkwithinwhichcountriesmanagetheirexternaldebtisalsoaffected

bydevelopmentselsewhereaffecting rules for tradeand trade finance,balanceof paymentsmeasures

andforeigninvestment.

The importanceof the latter setof ruleswas recognized in theDeclarationon theContributionof the

WorldTradeOrganizationtoAchievingGreaterCoherence inGlobalEconomicPolicyMakingadoptedatthetimeof theestablishmentof theWTO.ThisDeclarationacknowledged the linksbetweeneconomic

policies as follows: “Successful cooperation ineach areaof economicpolicy contributes toprogress in

other areas. Greater exchange rate stability…should contribute towards the expansion of trade,

sustainablegrowthanddevelopment,andthecorrectionof externalimbalances.Thereisalsoaneedfor

anadequateandtimelyflowof concessionalandnonconcessionalfinancialandrealinvestmentresources

todevelopingcountriesandforfurthereffortstoaddressdebtproblems,tohelpensureeconomicgrowth

anddevelopment.”Suchcoherenceinglobalpolicymakingrequiresthat“the international institutionsin

eachof theseareasfollowconsistentandmutuallysupportivepolicies”.

Twopapersinthiscollectiontakeupsomespecificinternationalrulesaffectingnationalpoliciesinareas

characterized by interfaces between trade, investment and external financing. Chapter IX by Howsediscusses the applicabilityof WTO rules to exchange restrictions and tomeasuresdirected at exports,

importsandthebalanceof paymentsfromthepointof viewof theircompatibilitywithnotionsof fairness

andequity. InChapterX,Caliari examines the risks tonational autonomy regardingdebtpolicywhich

couldresultfromprovisionsconcerninginvestmentinrecenttradeandinvestmenttreaties.

1. TradeandBalanceof PaymentsMeasuresunderWTORules

Howsetakesashisstartingpoint thecommitmentof UnitedNationsMemberStates in theMillennium

Declaration to “anopen, equitable, rulebased,predictable and nondiscriminatorymultilateral trading

and financial system”. Whilst acknowledging that the concept of equity in international trade and in

3Differencesbetweencreditratingagencies’rolewithrespecttostructuredfinance,ontheonehand,andbond issues,onthe

other,aredescribedinCommitteeontheGlobalFinancialSystem(2005).4Forasurveyof suchproposalsseeSturzeneggerandZettelmeyer(2006:chapter12).




10

financialrulesandinstitutionslacksagenerallyaccepteddefinition,Howseshowsthatinternationalrules

(includingthoseof theWTOandthe IMFArticlesof Agreement) incorporate fairness,aconceptclosely

relatedtoequity.Moreoverone important ingredientof equity in international instrumentsconcerning

trade,financeanddevelopmentisthenotionthatrulesshouldbeadjustedtothedevelopmentneedsof

countries’differentsituations.Anotheringredientisthatof people’srightto“voiceandparticipation”,i.e.

their rightnot tohave avisionof development forcedon themordecidedbyothers.TheMillennium

Declarationalsocontainsadistributionalcomponentsincetheconceptof globalsolidarityrequiresthat

“globalchallengesmustbemanagedinawaythatdistributesthecostsandburdensfairlyinaccordance

withbasicprinciplesof equityandsocial justice”.

Concerningexchange restrictionsHowsenotes thegenerallyacceptedviewof the intentof GATT/WTO

provisionsforgoodstradethat,regardlessof theeffectof therestrictionsontradetransactions,theydo

notimposedisciplinesgoingbeyondthoseof theIMF.However,suchrulingsarepermissibleforexchange

restrictionsnotendorsedbytheIMF,ascopewhichHowsebelieveshasbeenusedbytheGATTandthe

WTOasthebasisforexcessivelynarrowinterpretationof countries’rightof recoursetotrademeasures.

More generally Howse questions the apparent presumption of GATT/WTO case law that exchangerestrictionsnotendorsedbytheIMFentailviolationof GATT/WTOrules.

TheGATT/WTOprovisions forgoods trade leavenoscope for rulingsonexchangecontrolsapplying to

capital as opposed to current transactions. However, the corresponding provisions for balanceof

payments restrictions in the caseof services trade under theGeneralAgreement on Trade in Service

(GATS) could lead to challenges to capital controls on the ground that they are inconsistent with a

country’s specific commitments interpreted in combination with general GATS obligations. Howse

believesthatguidelinesshouldbedrawnupforsuchcasesbyinstitutionswithamandatetotakeaccount

of equityinthetradeandfinancialsystems.

HowsealsodiscussestwootherrecentWTOrulingssuggestingashifttomorerestrictiveinterpretationof provisions with a bearing on the compatibility of WTO rules with the principles of equity, voice and

participation.

The first ruling involved a case in which the United States challenged India’s continuing use of trade

restrictionsforbalanceof paymentsreasonsinpursuitof developmentpoliciesunderGATTArticleXVIII.

HeretheWTOAppellateBodyruledthatremovalby Indiaof itsbalanceof paymentsrestrictionswould

not requireachange in itsdevelopmentpoliciessince theobjectivesof thesepoliciescouldequallybe

achievedbymacroeconomicmeasures.Howsetakestheviewthatthisrulingisnotinaccordwiththeself

declaratorycharacterof GATTArticleXVIII.

InthesecondrulingtheAppellateBodydecidedagainstBrazil’suseof officialsupportforthefinancingof

aircraftexportson thebasisof argumentswhich includeduseof thebenchmarksof theOECDExportCredit Arrangement. As Howse points out, this Arrangement is an agreement reached through

negotiations involving the organization’s restricted membership which takes no account of structural

differencesbetweenthefinancialmarketsof developinganddevelopedcountries.

2. DebtandBilateralTradeandInvestmentTreaties

Caliaridrawsattentiontotherisksforpolicytowardsexternaldebtwhichareinvolvedintheextensionof

thedefinition of investment to includedebt instruments observed in some recentbilateral trade and

investmentagreements(suchastheUnitedStatesChileFreeTradeAgreementandtheCentralAmerica

FreeTradeAgreement).These risks result from theassociationof investment in such treatieswith the

obligationsof NationalandMostFavouredNation(MFN)Treatment.NationalTreatmentguaranteesnon

discriminatory treatment of domestic and foreign firms. Under MFN Treatment each party to the




11

agreementbinds itself toextend to theallothers thesameconcessionsas thoseaccorded tothemost

favoredparty.

Extended to sovereign debt, National and MFN Treatment could restrict a Government’s flexibility

regardingpostcrisismeasures suchas those involving thedistributionof lossesbetweendomesticandforeigncreditorsandsupporttodomesticasopposedtoforeignbanksaspartof therestructuringof the

financial sector.They couldalso reduce the leverageof thedebtor countryduringnegotiationson the

restructuring of its external debt. In extreme cases theymight even make it difficult to prioritize the

servicingof domesticdebt incurredtomeettheGovernment’swages,salariesandpensionsobligations.

Moreoverapplicationof MFNTreatmenttoexternaldebtmighthavetheanomalousandalmostcertainly

unacceptable effect of according seniority in meeting debt obligations to the parties covered by the

agreementascomparedthosetopartiesnotsocovered.

The risks described cover in the first instance only countries covered by treaties whose definition of

investmentincludesdebt.However,precedentsbasedonbilateraltradeandinvestmenttreatiesarealso

often included among demands submitted by participants and as part of proposed frameworksagreementsduringmuchbroadernegotiationsontradeandfinance.

G. ConclusionsandFutureTasks

Theprincipalfocusof thepapersinthiscompendiumistheneedforaconceptof debtsustainabilitymore

systematic than thepiecemeal indicatorsof country riskpreviouslyused forexternaldebtassessment.

Problemsrelatedtodebtsustainabilityareexaminedthroughtheprismof aseriesof countrystudies.The

papersalsodiscuss the institutional frameworkatnational level fordebtassessmentandmanagement

andtheroleof creditratingagenciesaswellasimportantfeaturesof globalrulesbearingondeveloping

countries’autonomyregardingpoliciesfortheexternalsector.Theconcludingremarkswhichfollowarelimitedtoselectedfeaturesof theconceptualframeworkforassessingdebtsustainabilityandof policies

designed to contribute to theachievementof such sustainability.They include suggestionsas to some

possibledirectionsforfuturework.

1. MacroeconomicPolicy

Likeothercasestudiesof externaldebtmanagement,thoseinthiscollectionhighlighttheimportanceof

appropriate macroeconomic policy to successful debt management. The contents of such policy

necessarilyvaryamong countriesowing todifferences inbotheconomic conditionsandGovernments’

objectives. Thus theexperiencesof Argentina and theRepublicof Korea reviewed in the case studies

illustratethatsuccessfulmacroeconomicpoliciesinacontextof debtcrisisdonotfollowageneralmodel

but rather consistof measuresgeared to countryspecific circumstancesandbasedon countryspecific

balancingof thebenefitsandcostsof alternativeoptions.

The case studies also draw attention to the special vulnerability of lowincome countries to external

shocks.Thisisduetotheirlessdiversifiedstructuresof production,inparticulartheconcentrationof their

exports ina limitednumberof primarycommodities.Theproblemscausedbysuchconcentrationarea

staple featureof the literatureof developmenteconomics.Thestudies in thiscollectionemphasize the

threatposedbythisvulnerabilitytotheachievementof debtsustainability.

Onelessondrawnistheneedforthepoliciestowardsexternaldebtwhichaccommodatetheinvestment

requiredfordiversifyingacountry’sproductivebase.Thislessonconcernsnotonlythedebtmanagementof borrowingcountriesbutalsothetermsandconditionsof financingagreedwithofficialcreditors.Future




12

workon policies in this areamight also includedifferent techniques available forhedging commodity

exportreceiptsandareexaminationof pricestabilizationatthenationallevelthroughmarketingboards.

Inthiscontextitmayalsobeworthrevisitingissuesclassifiedbyanearlierliteratureundertheheadingof

centralbankingprinciplesforanexporteconomy.This literature,towhichamajorcontributorwasRaulPrebisch,firstSecretaryGeneralof UNCTAD,onthebasisof hisexperienceasmanagerof theArgentine

Central Bank from 1935 to 1943, concerned the implications for appropriate monetary, and more

generallymacroeconomic,policyof frequentlyobserveddifferencesbetween theexternaland internal

balanceof commoditydependentcountries,ontheonehand,andof industrialcountries,ontheother.5

Intheformergroupof countriesamacroeconomicupswingtendedtobeassociatedwithamorepositive

balanceof tradeandexternalpayments,andthusariseinreservesof foreignexchange;andconversely

recessionordepression tended toaccompanyanegativeexternalbalanceandacontractionof foreign

reserves.Bycontrasttheexternalbalanceof industrialcountriestendedtodeteriorateduringeconomic

upswingsandto improveduringdownswings.Themonetarypolicyproposed forcommoditydependent

countries in response to their circumstances involved restriction during the upswing with the aim of accumulatingreserves,whichwouldpermitamoreexpansionarypolicyandthefinancingof contracyclical

measuressuchaspublicworksduringthedownswing.Theunderlying ideasof this literaturecouldwell

have continuing relevance for the macroeconomic framework for policy towards external debt in

commoditydependentcountries.

2. TowardsaMoreInclusiveApproachtoDebtSustainability

Thiscollectionof papershasachievedgreaterconceptualclarityconcerningdebtsustainabilitybutcannot

providedefinitive,comprehensiveguidelines forassessmentandpolicymaking.Thepaperspoint to the

need for more flexible approaches to the subject which also take account of essential connections

betweenthemanagementof externaldebtanddevelopmentstrategy.Conclusionswhichcanbedrawnfromthecollectionincludethefollowing.

Assessment of debt sustainability will continue to require quantitative indicators as well as

analysisof qualitativefactorstraditionallyincludedintheassessmentof countryrisk.

Amore inclusiveviewof debtsustainabilitywillsuggestnew indicatorsof countryriskanddebt

sustainabilityinadditiontothetraditionalonessurveyed.

Assessmentandpolicymaking should includediscussionbetween thedifferentparties –debtor

countries, creditors and internationalorganizations to resolve legitimatedifferencesbetween

viewsastowhatconstitutesustainabledebtlevelsforacountry.

Adevelopmentalperspectiveshouldbeanintegralpartof theapproachtodebtsustainability.Thisimpliesthatconsiderationof debtsustainabilityshouldnotbeabstractedfromtherequirementsof development

strategy. Such an approach to debt sustainability requires the involvement not only of those with

responsibility for external financing and debt management but also of other policymakers who are

responsiblefordecisionsregardingdevelopmentstrategy.

These conclusions as to an appropriate framework for assessment of debt sustainability would be

consistent with treatment of the subject as part of a comprehensive approach to monitoring and

managementof acountry’sexternalassetsandliabilitiesoutlinedbelow.

5TheargumentisexplainedinmoredetailinWallich(1950:chapterXV).




13

3. NationalBalanceSheetsandExternalDebt

Atthecentreof theconceptualapproachestodebtsustainabilityreviewedinthiscollectionof papersare

currentand future receiptsandoutflowswhichdetermine the fundsavailable fordebt service.Sucha

focuson“earningpower”(touseterminologycommonamongaccountantsandfinancialanalysts)could

beusefullysupplementedbyinformationcontainedinthebalancesheetsof acountry’sGovernmentand

firms,especiallytheirexternalliabilities.Aprofileof nationalexternalliabilitiesservesastheanalogueat

thisleveltoacorporation’scapitalstructurewhichprovidesnotonlyaguidetothe institution’sfunding

butalsoenablesittoindexandcontroldifferentfinancialrisks.6

A focus on external liabilities and assets would be a natural extension to debt sustainability of

recommendationsintheReportof theWorkingGrouponCapitalFlowsof theFinancialStabilityForumof

April2000 (Financial Stability Forum,2000). These recommendations responded to termsof reference

which included evaluation of prudentialpolicies, regulations and riskmanagement thatmight help to

reducesystemicrisksassociatedwiththebuildupof externalindebtedness.

TheReportwasoneof manyinternationalinitiativesundertakenintheaftermathof thefinancialcrisesof

the 1990s which involved mainly emergingmarket (i.e. middleincome) developing and transition

economies.Nevertheless,manyof therecommendationsconcerningdatacollectionandanalysisandthe

managementof riskscouldapplyequallyto lowincomedevelopingcountries.Therecommendationsof

theReportaredirectedatthepublicsector,thebankingsector,andthenonbankfinancialandcorporate

sectors. For lowincome countries the recommendations of greatest immediate interest are those

directed at the public sector (though theother recommendations canbe expected to assume greater

importancewith thedevelopmentof their institutional infrastructure).This ispartlydue to thegreater

relative importanceof sovereignborrowing insuchcountries’external liabilities.But italso reflects the

likelihoodof lessdevelopedaccessinlowincomecountriestoinformationconcerningassetsandliabilities

of entitiesintheprivatesector.

TheReport argues thatdetailedprofiles of external balance sheets canmake amajor contribution to

monitoringandmanagingacountry’sexposuretodifferentfinancialrisks.Sectoraldataarenotonlypart

of thisprofile(thoughapart,as justexplained,whoseimportancevariesfordifferentsectorsaccordingto

a country’s level of development) but help to identify linkages capable of facilitating transfers of risk

exposurebetweendifferentsectors.

Forthepublicsectortherecommendationsaredesignedtotranscendthenarrowerfocusof publicdebt

management still found inmany countries.Theaimof theprofileof assetsand liabilities shouldbe to

enablethe formulationof astrategybalancingexpectedcostsandriskscontained in thepublicsector’s

external assets and liabilities. This process can benefit from the development of new vulnerability

indicators(forwhich,thoughtheReportdoesnotdiscussthis,accounting indicatorsusedaspartof the

analysisof thefinancialstatementsof firmscanoftenprovideusefulmodels).

Theimportanceof extendingtheprofilesof externalassetsandliabilitiestothebankingsectorreflectsits

strategiceconomicroleandthedangerthat intheeventof afinancialcrisis itsproblemsarecapableof

inflictingeconomywidedamage.Thedevelopmentof profilesforthissectorwilloftenbenefitfromthe

factthateven indevelopingcountriesfinancialreportingbybankstoregulatorsandshareholdersisof a

relatively high quality, though progress may still be required regarding the information necessary for

assessmentof liquidityand foreigncurrency risk –tworiskswhichassumespecialsignificance incrises.

Extension of the profiles of external assets and liabilities to the nonbank financial sector results in

coverageof institutionsoftenmore loosely supervised thanbanksornot supervisedatallwhichwere

nonethelessamajorsourceof vulnerabilityinsomecountriesintheAsianfinancialcrisis.

6Foranilluminatingdiscussionof therolecapitalstructureforbothcountriesandcorporationsseePettis(2001:chapter6).




14

Nomore than theother techniquesdiscussed in this collectionof papers cannationalbalance sheets

provide all the information required for the analysis of debt sustainability and the prevention and

containment of debt crises. They can, however, provide a framework for the further development of

conceptsclarifyingdebtsustainabilityaswellasforthemanagementof therisksassociatedwithexternal

debt.




15

References

CommitteeontheGlobalFinancialSystem (2005).The

Role

of

Ratings

in

Structured

Finance:

Issues

and

Implications.Basel,BankforInternationalSettlements,January.

FightA(2004).UnderstandingInternational Bank Risk .Chichester,JohnWiley.

FinancialStabilityForum(2000).Report of theWorkingGrouponCapital Flows,April.

Friedman IS (1983). The World Debt Dilemma: Measuring Country Risk . Washington, DC, Council for

InternationalBankingStudies,andPhiladelphia,RobertMorrisAssociates.

Krayenbuehl TE (1988). Country Risk Assessment and Monitoring, 2nd edition.Cambridge,Woodhead

Faulkner.

PettisM(2001).TheVolatility MachineEmergingEconomiesand theThreat of Financial Collapse.Oxford,

OxfordUniversityPress.SturzeneggerFandZettelmeyerJ(2006).Debt Defaultsand Lessons fromaDecadeof Crises.Cambridge,

MassachusettsandLondon,TheMITPress.

Wallich HC (1950). Monetary Problems of an Export Economy the Cuban Experience 19141947 .

Cambridge,Massachusetts,HarvardUniversityPress.






17

CHAPTERII

DEBTSUSTAINABILITYASSESSMENT:

THEIMFAPPROACHANDALTERNATIVES

CharlesWyplosz

(GraduateInstituteof InternationalandDevelopmentStudiesandCEPR)7

A. Introduction

Debtsustainability isavexing issue. Its importance is immediatelyobviousbuttheconceptescapesany

easydefinition. This situation is not unheardof in economics;price stability and full employment are

examplesof other crucially importantpolicyobjectives that cannotbe simplydefined.Yet,whileprice

stability or full employment can both be measured with a reasonable degree of precision, debt

sustainabilitycannotevenbemeasureddirectly.

Every country, therefore, must grapple as best it can with the issue of debt sustainability. Private

borrowersareinthesamesituationasGovernments –forpublicdebts –andstates –forexternaldebts –

withonebigdifference:aprivatedefaultispromptlysanctionedaccordingtopreciselegislationunderthecontrolof courts,whilepublicandexternaldebtdefaultsarefollowedbylitigationandnegotiationswithin

fuzzy legal rulesanduncertainenforcementmechanisms.Uncertaintyabout theconsequenceof public

andexternaldebtdefaults is a sourceof perverse incentives todefault (formally calledmoralhazard)

reflectingunwillingnessasopposedtoinabilitytopay.8

Officiallenderscannotavoiddealingwiththedebtsustainabilityissue.Themultilateralorganizationsand

theParisClubhavelongdealtwiththeissueonacasebycasebasis.Theirstatedruleof procedurewasto

encourageborrowingcountriestoadoptprudentstrategies,whilebeingreceptivetotheirdevelopment

needs. “Prudent” and “receptive” are subjective attributes, however, which inevitably lead to

7I am indebted to AnhNga TranNguyen for suggesting the topic and providing me with much knowledge about debt

sustainability analysis. Many useful comments were provided at the UNCTAD Expert Meeting Debt Sustainability and

DevelopmentStrategiesonOctober2628,2005.Alltheviewsexpressedherearemine,asaretheerrors.8ThisdistinctionisintroducedinBulowandRogoff (1989).



Debt Sustainability Assessment:theIMF Approachand Alternatives

18

controversies. It isnatural to try andescape such controversiesbydesigning systematicand therefore

universallyapplicableprocedures.Indeed,theWorldBank’sInternationalDevelopmentAssociation(IDA)

andtheIMFhaverecentlystartedtoformalizetheirdebtsustainabilityassessment(DSA)procedures.IDA

lending isnow informedby abatteryof criteriadevelopedwithin theCountry Policy and Institutional

Assessment (CPIA)approach,while the IMFand theWorldBankhaveput inplacea standardizedDSA

proceduredesignedtoberoutinelyusedaspartof itssurveillanceandlendingoperations.

Thispaperexamines theDSAprocedure.Thenextsectionexplainswhy it ismission impossible.Noting

thatsustainabilityisaforwardlookingconcept,itarguesthatanypracticaldefinitionisarbitrary,andthat

any sustainability indicator will be both arbitrary and too imprecise to serve as a tool for policy

prescription. Section C then examines the IMF’s procedure, intended to deal with this impossibility

principle by being both simple and transparent. Because of the “mission impossible” nature of the

exercise,however,theprocedureseemstobeevolvingtowardsmorecomplexity.Indeedsimplicitymay

comeattheexpenseof precision,whichcallsforincreasingcomplexity.Inaddition,giventheIMF’sown

definitionof sustainability, theprocedure requiresadopting, formallyor informally, theCPIAapproach

developedbythe IDA,asourceof opacity.ThesectionalsoreviewsotherDSAapproaches,somewhichemphasizesimplicityatthecostof precision,whileothersgofurtherinthedirectionof complexityatthe

costof transparency.Arguingthatsimplicityandtransparencyindeedareessentialtomaketheprocedure

acceptable, Section D develops a series of principles that lead to a simpler, less ambitious and less

systematicprocedurethatseekstoreplacearbitrary judgmentswithaframeworkfordialoguebetween

theofficiallendersandtherecipientcountries.

B. WhatisDebtSustainability?

1. Definitions

Debt sustainability is accepted that aims at answering a deceptively simple question: when does a

country’sdebtbecomesobigthatitwillnotbefullyserviced?Thequestioncanbeappliedtotheexternal

debtortothepublicdebt.Theanalyticsare identicalonce it isnotedthattheexternaldebt islinkedto

theevolutionof theprimarycurrentaccountbalanceinthesamewayasthepublicdebtislinkedtothe

primarybudgetbalance.Thisdistinctionwillbeblurredinthepresentsectionbyreferringto“debt”and

“primarybalance”,withoutspecifyingwhetheritappliestopublicorexternaldebtsandbalances.

The IMF’sowndefinitionof sustainability is:adebt“is sustainable if it satisfies the solvency condition

withoutamajorcorrection[…]giventhecostsof financing”(IMF,2002,p.5).Solvency,inturn,needsto

bedefined.Debtsolvency isachievedwhen futureprimarysurplusesare largeenough topayback the

debt,principaland interest.More technically, solvency requires that thecurrentdebtplus thepresentdiscountedvalueof allexpendituresdoesnotexceed thepresentdiscountedvalueof all revenues (or,

equivalently, that the currentdebtnotexceed thepresentdiscountedvalueof future revenuesnetof

noninterestexpenditures).

The solvency definition is clear cut and has long been formalized, but raises many implementation

difficulties.Thesustainabilitydefinition,asstated,isvague.

Solvency Issues

Solvency,andsustainabilityasaconceptthatbuildsuponsolvency,isentirelyforwardlooking.Itisfuture

balancesthatmatter,notthepastandnot justthecurrentdebtlevel.Hugedebtscanbepaidback,and

smalldebtsmaynotbesustainable.Theoutcomedependsonwhattheprimarybalancewill look like in

the future, includingtheverydistant future. In fact,mostGovernmentsare indebted foreverandmany

externaldebtsremainhighfordecades.Forinstance,FigureII.1.showstheevolutionof theBritishpublic




19

debt,measuredinpercentof GDP.Duringthelast300years,itneverdroppedbelow20percent,reaching

270percentontwooccasionsandaveraging117percent.Thisdebtwasalwayssustained inthesense

thattheBritishGovernmentneverdefaulted.Wereturntothisexamplebelow.Fornowwe justnotethat

dealingwith the issueof debt solvency – and therefore sustainability – requirespassing judgment on

eventsthathavenothappenedyet,thatmaycoveravery longhorizon,measured indecades,andthat

arelargelyunpredictable.

FigureII.1.TheBritishPublicDebt –17002004

(Per cent of GDP)

British public debt

0

50

100

150

200

250

300

1700 1738 1776 1814 1852 1890 1928 1966 2004

Source:BurdaandWyplosz(2005).

Thenextdifficultyisthatthedebtmustbescaledsomehowtocountrysize.Themostpopularapproachis

torelatethedebttotheGDP,as inFigureII.1.,butthechoice isnotstraightforward.Itdependswhat is

the sourceof revenues.Publicdebtsare servicedoutof government revenues, sowhatmatters is the

taxingabilityof theGovernment,nowandinthefuture.

If thedebtisexternalorpublicbutpartlyowedtotherestof theworldand/orinforeigncurrency,itwill

beservicedbytheamountof revenuesinforeigncurrencythattheGovernmentcancollect.Thereislittle

relationshipbetweenGDPandtheadequacyof collectiblerevenues.Soanotherscalingfactorisrequired

and it iscustomarytouseexports.But thisassumesthataconstant fractionof exportscanbeused to

service thedebt.The scaling factor –GDP,exportsoranyothermeasure –mustbe forecastover the

relevanthorizonsothat it isnot justthedebt itself thatmustbeguessed.Therecanbenopretenseof precision.

Afurtherdifficultyisthatdebtsarerolledover.Evenlongtermbondsarenotlongtermenoughtocover

quasipermanent debts.9As the debt is refinanced, borrowing costs change and must therefore be

guessedaswell.Thisrequiresmakingassumptionsonthefuturecourseof domesticinterestratesforthe

partof thedebt that is issued indomestic currency,andassumptions regarding future foreign interest

ratesandcountryriskpremiaforthatpartissuedinforeigncurrency.Interestratescanchangebecauseof

externalconditions –includingsometimescontagionfromfarawayevents –whichaffectinunpredictable

waysthesolvencycondition.

9Thisisnotentirelycorrecthistorically.TheBritishgovernmenthasissuedperpetuitiescalledconsols,bondslackingamaturity.

Oncealargeproportionof thepublicdebt,consolsarenowanoddityunlikelytobefeasiblefordevelopingcountries.




20

Inextreme,butnotrare,situations,itmayprovetemporarilyimpossibletorefinancethematuringdebt,

muchlesstoissuenewdebt.Thisdoesnotnecessarilymeanthatthedebtisunsustainable;itisacaseof

illiquidity. Illiquidity may none the less force a debt default, even though the debt is sustainable, as

previouslydefined.

Definitionof Sustainability

Twoqualificationsof theIMFdefinition implythatsustainability isamoredemandingrequirementthan

solvency.The firstqualification istoruleouta“majorcorrection” intheprimarybalance.Thisprobably

referstosevereexpenditurecutsorlargerevenueincreasesachievedthroughtaxationorpricingof goods

andservicessuppliedbythepublicsector.Thedefinitionthereforecoversliquidityconstraints –adrying

upof financing,eitherdomesticorexternal –thatrequiredrasticadjustments.Thesecondqualification

refers to the “cost of financing”. Financing costs are bound to change over time and are therefore

unpredictable. In particular, they may increase as the debt rises, creating a vicious circle of the type

discussedfurtherbelow.Asaconsequence,adebtmaybesustainabletodayandunsustainabletomorrow,

or conversely.Thus thedefinition canbeunstable. Finally,note that “major” is amatterof judgment,whichmeansthattheIMFdefinitionisuncomfortablyvague.

TheIMF’sdefinitionisatvariancewiththesustainabilityconceptproposedbyArrowetal.(2004)inavery

different context (theenvironment).Applied to thedebt issue, theirdefinition couldbe interpretedas

suggestingthatsustainabilityrequiresthatthenetworthof anentity (theGovernmentorthecountry),

definedas thepresentdiscountedvalueof net revenues lessthecurrentdebt,beonanondecreasing

trend.Thisdefinitiondiffers from the IMF’s in two importantways.First, itdoesnot require solvency.

Solvency isachievedonly if networth isnonnegative.Thealternativesustainabilitydefinitiondoesnot

ruleoutthat,initially,networthbenegativeaslongasitisrisingandeventuallybecomesnonnegative,

thusmeeting the solvencycondition.10Second,and importantly forwhat follows, itdoesnot implyany

specificthresholdforthedebt.

Makingdefinitionsoperational

Thus there are many competing definitions of external or public debt sustainability. The Box below

summarizesandinterpretsthesevariousconcepts.Onetheoreticallypureconceptissolvency.Theother

theoreticallyclearconcept,proposedbyArrowetal.(2004),isthatthenetworth(of thecountryforthe

externaldebtortheGovernmentforpublicdebt)beincreasing,oratanyratenondecreasing.Thesecond

concept is lessstrictthanthefirstonesincesolvencyrequiresthatnetworthbealwayspositive.These

conceptscannotbeimplementedassuchbecausetheyrequireknowledgeof thefutureevolutionof the

debt.

IMF (2002) adds to solvency the requirement that solvency be always maintained without any majoradjustment. Bothbecause it relieson solvency andbecause it restson anunspecified limit to “major

adjustment”,thisdefinitioncannotbe implementedassuch.Asexplainedbelow,thedefinition ismade

operationalbyrequiringthatthedebtdoesnotexceedathreshold,tobefurtherdiscussed.Itshouldbe

noted that, if the threshold is conservatively set, the resultingdefinition ismoredemanding than the

previousone(if thethresholdisnotbinding,thedefinitionisempty).

TheArrowetal.(2004)conceptcanbemadeoperationalby ignoringtheunobservablepresentvalueof

primarybalancesandrequiringthatthedebttoGDPratiobestationary.Sincestationarity isdifficultto

assess inpractice,thedefinitioncanbe implementedby requiringthatthedebtratiobeonadeclining

trend,whichdoesnotruleoutoccasionalbuttemporaryincreases.

10ThispointisformallystatedintheAppendix.




21

2. AnImpossibilityPrincipleandItsImplications

Because debt sustainability is a forwardlooking concept, it cannot be assessedwith certainty. In this

rigoroussensedebtsustainabilityassessment (DSA) is impossible.Atbest, followingproceduressuchas

thosepresentedinSection3below,educatedguessesmaybepossiblebutitisimportanttorecognizeat

theoutsetthattheseare justguesses,nomatterhowsophisticatedtheymaybe.Theimplicationsof this

impossibilityprinciplearefarreaching.

Giventhelargenumberof guessesthatarerequiredtoreachanyconclusion,thebestthatcanbehoped

for are statementsof the type: “there is a probability of x per cent that the debt is sustainable at a

particularhorizon”.Twoaspectsof thisstatementneedtobehighlightedatthisstage.First,DSAcanonly

provideprobabilities.Insomeextremecases,thesemaybe0or100percent,11butgenerallytheywillbe

somewherebetween thesevaluesbutnoteasilydefined.Putdifferently,DSA is rarelyblackandwhite

andthereforeanimpreciseguidetopolicy.

Second, theprobability thatadebt is sustainable in the IMF sense isbound to changeover time.For

example,ahighlyindebtedGovernmentthatrunsasizeableprimarysurpluswillseeitsprobabilityof debtsustainability rise over time. This is in accord with definition of Arrow et al (2004). Conversely a

Governmentthatstartswithalowdebtbutsystematicallyrunslargeprimarydeficitswillhaveadeclining

probabilityof debtsustainability.

These twopossibilities imply thatany statementon sustainability isvalidonly foraparticularhorizon.

What should thathorizonbe? In theory, it should be infinitebut, in practice, it isdeterminedby the

availabilityof reliableforecasts:if forecastsof primarybalances,interestrates,GDP,etc.areextendedto

10years, theDSAwillprovideananswerat the10yearhorizon, i.e.amuch shorterhorizon than the

11Thecollapseof theLTCMhedgefundisausefullesson.InSectionC,wewillpointoutthesimilaritybetweenDSAandportfolio

assessment,andwillindeeddiscussvalueatrisk,asophisticatedtechniquedirectlyborrowedfromfundmanagement.Resorting

tothemostadvancedtechniquesavailable,LTCMmanagers –whichincludedNobelPrizewinnerRobertMerton –hadconcluded

thattheirinvestmentwasnear100percentsure.Asitturnedout,anextremelyrareconjunctionof eventsoccurredandLTCM,

arguablythemostprestigiousfund,wentbankrupt.

BoxII.1.TheoreticalandOperationalDefinitionsof DebtSustainability

LetbtbethedebttoGDPratioattimet.Simplifyingsomewhat,thevariousdefinitionsinthetextcanbe

summarizedasfollows.

DSAdefinition:bbt

,whereb isathresholddiscussedinsection3.1below.

Solvency:thepresentvalueof btbecomesnegligibleforlonghorizons(limbt/(1+r)t=0ast),

whereristherealinterestrate.Anequivalentdefinitionisthatthepresentvalueof primary

balancesbt.(Seetheappendixforaformalization.)

Debtserviceability:solvencyplusnoilliquidity.Illiquidityariseswhenthedebtcannotbeservicedat

aparticularpointintime.

IMF(2002)definition:solvencyplusnoneedformajorcorrection.

Arrowetal.(2004):networth,i.e.thepresentvalueof primarybalanceslesscurrentdebt,isnot

decreasingovertime.

Debtstationarity:btdoesnotgrowwithoutbounds.Analternativeisthatbtbe(weakly)

declining.




22

infiniteonelogicallyrequired.However,sinceeven10yearforecastsaretotallyunreliable,thehorizonis

boundinpracticetobemuchshorter.Butthisunderminestheconceptualbasisof thisapproach.

As discussed below, a common way of circumventing the horizon problem is to assume “everything

constant”andextendpasttrendstoaninfinitehorizon.Thisisconvenientbuthasunlikelyconsequences,i.e.theprobabilityof theassumedpathiscloseto0percent.Suchexercisesdescribepathsthatcannotbe

takenatfacevalue,inparticularforthepurposesof policieswithseriousconsequencesforthelivelihoods

of manypeople.

Another aspect of the impossibility principle is that sustainability as defined by the IMF requires a

judgmentof whendebt istoo large.Figure II.1remindsusthatdebtcanbeverybigandyetsustained.

Recent work has pointed out that “big” is a relative concept.12It is generally considered that the

developingcountriescannotsustainlargedebts.FigureII.2.showsthat,indeed,thepeakinthemid1990s

foremergingmarketswasfollowedbyawaveof crises.Willtherecentriseforthesecountries,nowabove

the previous peak, usher a new wave of crises? No one knows. Yet, framing the debt sustainability

definitionastheIMFdoesmakesunavoidabletheadditionof anewconcept,namelyadebtceiling.Thereisnoprecisewayof definingthisceiling.Itmustbebasedonthemaximumamountof resourcesrequired

toservicethedebt,andthusonassumptionsabouteconomiccostsandpoliticalacceptability.Thiswayof

puttingthequestionleadstoanotherimpossibility,thatof assessingadebtceiling.

Finally,rising interestratesincreasethedebtburdenandreducetheprobabilityof debtsustainability.A

disturbing aspectof this linkage is that interest ratesonpublicdebts,whether indomesticor foreign

currency,includeariskpremium.Theriskitself isrelatedtotheprobabilityof default,i.e.tosustainability.

Theresultisthepossibilityof aviciouscirclethatgoesfromthefearof debtnonsustainabilitytohigher

interestratesandthustoahigherprobabilityof nonsustainability.13Inotherwordsthemerefearof non

sustainabilitymakesitmorelikely.Debtdistresscanthusbeself fulfilling.Thismaymeanthatimproperor

incorrectlyinterpretedDSAcanhaveadeleteriouseffectondebtsustainability.

FigureII.2.PublicDebtsinIndustrialandEmergingMarketCountries –19922002

Source:IMF(2003a).

12Forarecentassessment,includingmanyreferences,seeCordellaetal.(2005).

13ThisprocessisstudiedinBlanchard(2005).




23

3. DebtsandInflation

Inflation isa furthercomplication that isoften ignored inDSA.Even forexternaldebt, inflationmatters

because interestandexchangeratesdonotalwaysreflectactual inflation.Forexample, if theexchange

ratedepreciatesfasterthanprices,foreigncurrencydebtbecomesmoreexpensiveindomesticcurrency.

Thesamehappenswhentheinterestrateondomesticcurrencydebtincreasesbymorethantheinflation

rate.Debt service becomes heavier. Conversely,when interest and exchange rates fail to fully reflect

expected inflationandthedebt isnot indexedand isdenominated indomesticcurrency,rising inflation

temporarilyreducesthecostof borrowing.14

DSA should recognize thesevariouspossibilitiesbutdoesnot incorporate standardprocedures for this

purpose.Onereasonistechnicaldifficulties.Notonlywoulditbenecessarytoforecastinflationbutalso

expected inflationandnonneutralities, i.e.theextenttowhichtheexchangerateandthe interestrate

failtoreflectexpectedinflation.Whileitispossibletoforecastinflationoverarelativelyshorthorizon,say

twotothreeyears, forecastsbeyond thathorizondependonpolicyactions thatareyettobe taken. It

may also be that international institutions, that typically do not condone inflation, are unwilling tospeculateonwhatitcouldbeandhowitcouldbeusedtoalleviatethedebtburden.

15

4. LinkwithEarlyWarningIndicators

A large literaturehasbeendevoted toearlywarning indicatorswhich try to identify irregularities that

eventuallyresultinafinancialand/orcurrencycrisis.LikeDSA,earlywarning indicatorsmustbeforward

looking.Crises,and thereforeearlywarning indicators,arebeyondthescopeof thepresentpaper.The

onlydirectlyrelatedquestioniswhetherahighdebt level isacauseof financialcrises,amongthemany

potentialones.AccordingtotheextensivesurveyinHemmingetal.(2003),theanswerismaybe.Formal

statistical analyses provide conflicting results on this point. A problem is that they use current fiscal

indicators, thebudgetbalanceor thedebt level, aspotentialpointersof impending crisis. So far,DSAindicatorshavenotbeenused,tothebestof myknowledge,inearlywarningindicatorestimates.Todoso

wouldprovideagoodgaugeof theirempiricalrelevance.

C. ApproachestoAssessingDebtSustainability:ACriticalReview

TheimpossibilityprincipledevelopedinSectionB.2representsaformidablehurdle.AllapproachestoDSA

havetorelyonassumptionsaboutthefutureevolutionof budgetbalances,GDP,interestrates,etc.The

usefulnessof theconclusions isdirectlyrelatedtothevalidityof theseassumptions,whichbydefinition

areneithersafenortestable.Thissectionstartswithacriticaldescriptionof theapproachchosenbythe

IMF.Itthenpresentsandevaluatessomealternativeapproaches.

1. TheIMFStandardizedApproach

The IMFhasdecided to systematically attach a standardizedDSA toprogramdesign and toArticle IV

consultations.TheseDSAsexamineboththepublicandexternaldebts.Thestatedintentionistoprovidea

simple, fully transparentandstandardized tool thatcanbe readilyapplied toallcountries.16TheWorld

14Buiter(1985)hasshownthatthegreatreductionof theBritishpublicdebtover19461970hasmostlybeenachievedthrough

the inflation tax.A full account of this process includes regulated interest rates, i.e. some degree of financial repression. In

countrieswithfullcapitalmobility,thiswillnotbepossible.Awiderdiscussionof theroleof financialrepressionisbeyondthe

scopeof thispaper.Awellknowndefenseof somedegreeof financialrepressionisRodrik(1998).15AbiadandOstry(2005)provideevidencethatinflationraisestheprimarybudgetsurplus.

16Infacttherearetwodifferentbutrelatedprocedures,onedesignedforcountrieswithmarketaccessandanotheronedesigned

forlowincomecountrieswhichrelymostlyonpublicfinancing.Themaindifferencesarethefollowing.1)Inthecaseof countries




24

Bankhasadoptedasimilarprocedure.Unfortunately,the impossibilityprinciple is incontradictionwith

these intentions. Simplicity is achieved at the cost of improbable assumptions; these assumptions are

transparent,buttheyarelessinnocuousthantheyaremadetoappearbecausetheunderlyingcomplexity

isconcealed.

Focusinghereon theexternaldebtpartof theexercise, the IMFapproach includes the following four

steps:17

(i) Afiveyearcentralforecast,orbaseline,of thevariablesthataffecttheevolutionof theexternal

debt:theprimarycurrentaccount,GDP,interestandexchangerates,andinflation.

(ii) Theresultingevolutionof thedebt,asashareof GDP,overthenextfiveyears.Thisevolutionis

uncontroversialasitfollowsfromthefollowingaccountingidentity:

t t t t balance primaryb g r bb 11 )(

WherebisthedebttoGDPratio,ristherealinterestrateandgistheGDPgrowthrate.

(iii) Several stress tests that look at the effect on debt of adverse shocks affecting the variablesforecasted instep((i).Theshocksareasfollows:first,eachof threevariables(the interestrate,

realGDPgrowthandtheprimarycurrentaccount)ischangedonebyonehalf standarddeviation

overthesamefiveyearhorizon;thenallthevariablesaresimultaneouslyshockedbyonequarter

standarddeviationeachover fiveyears; finallytheexchangerate isassumedtobedepreciated

onceby30percentatthebeginningof thesimulationperiod.

(iv) TheDSAconcludeswitha judgmentonwhetherthedebtlevelsimpliedbyanyorallof thestress

testsaretoohighforthedebttobeconsideredsustainable.

The result is a figure like Figure II.3., which is based on the November 2005 review of the standby

agreementwithColombia,seeIMF(2005b).18Thefiguredisplaysvarioussimulatedpathsof theexternal

debtoverthefiveyearperiod200610:thebaselineobtainedinstep((ii))andtheeffectsof threeof the

shocksdescribedinstep((iii)).Theseshocksare:aonehalf standarddeviationcurrentaccountshockand

the combined shock,both assumed to last thewhole simulationperiod20062010; and a30percent

exchangedepreciationoccurringin2006.

withmarketaccess,theanalysisconcernsboththeexternaldebtandthepublicdebtand,inthecaseof theexternaldebt,itdeals

with its levelwhile, in thecaseof lowincomecountries, itconcernsonly theexternaldebt,which ismeasured innetpresent

discountedvalueterms.2)Forlowincomecountries,theDSAusesanexplicitproceduretoestablishdebtthresholds,whilethe

threshold is leftopentodiscussion inthecaseof themarketaccesscountries. IMF(2003b)proposestousethesamestandard

proceduretobothgroupsof countries.Thepresentanalysisignoresthesedifferences.17ThisdescriptionfollowstherecentchangesasdescribedinIMF(2005a).

18Thisseemstobethefirst,andsofaronly,countryreviewthatappliesthechangesasdescribedinIMF(2005a).




25

FigureII.3.Exampleof DSA:SimulatedPathsof theDebttoGDPRatio

25

30

35

40

45

2004 2005 2006 2007 2008 2009 2010

Baseline Current account shock

Combined shock 30% depreciation

Source:IMF(2005b).

Whatcanthisinformationbeusedfor?Obviously,thebaselineisnocauseforconcern.Thestresstests,

ontheotherhand,are lessbenign.TheonetimedepreciationraisesthedebttoGDPratiobyabout30

percent,presumablybecausetheexternaldebtisinforeigncurrency.Thisisnotathreattosustainability,

however,becausethedebtstartsdeclininginthethirdyear,mostlikelybecausedomesticpricescatchup

withtherateof depreciation.Moreworrisomearetheeffectsof aworseningof thecurrentaccountand

of thecombinedshocksinceinbothcasesthedebtkeepsonrising.

The unavoidable question is whether these simulations are sufficient to warrant a policy reaction.

Undoubtedly,werethedebtratiotokeepongrowing,thedebtmusteventuallybecomeunsustainable,

butwhen? Inaddition,sincetheshocksareexpectedto last for fiveyears,thedebtshouldpresumably

declinebeyondthehorizon.Inordertobeabletodrawanyconclusionfromthisexercise,therefore,one

must be able to conclude that the debt level reached at some point in Figure II.3. is too high to be

sustainable.This, in turn, requiresestablishingadebt threshold levelbeyondwhichdanger is looming.

Danger means debt distress, i.e. financing difficulties or, worse, partial or total default. In view of

empirical results that show that the riskof debtdistress riseswith the sizeof debt, itseems logical to

establishadebtthresholdbeyondwhichtheriskscanbedeemedunacceptable.This istherationaleof

step((iv)).

Should there be a single threshold for all countries? Here again, empirical research shows that the

probabilityof debt distressdepends not just on thedebt level itself,but alsoon a varietyof factors,

includingtheprevailingmacroeconomicsituationand, importantly,thequalityof economicandpolitical

institutions. A unique common threshold, therefore, is bound either to be too restrictive or too lax,

dependinguponthecountrycharacteristics.ThisiswhytheIMFhasbeguntouseaspartof step((iv))an

additionalprocedurecalledCountryPolicyand InstitutionalAssessment(CPIA).DevelopedbytheWorld

Bank,CPIAproducesanindexof governancequalityforeachcountryproducedbytheWorldBank.19

This index,which ranges from 1 (lowestquality) to6 (highestquality), isbasedon 20 indicators. It is

updatedannually, followinga formalandelaborateprocessthat involves theBank’scountryteamsand

centraldepartments.Foundtoperformwellinstatisticaltests,theindexisusedtoclassifycountriesinto19Thisproceduresofaronlyappliestothelowincomecountries,presumablybecauseitisinuseatIDA.TheFundisconsidering

applyingittocountrieswithmarketaccess.




26

threegroups:countrieswithalowCPIAindexareascribedadebtthresholdof 30percentof GDP,raised

to45percentfortheintermediategroupof countries,andto60percentforthecountriesinthehighest

CPIA indexgroup.These thresholdsarechosen such that theprobabilityof debtdistress is25per cent

whentheyarereached.Followinganexpertreview,theWorldBankreducedthenumberof criteriafrom

20to16andhavemadeindividualratingspubliclyavailableforIDAcountriesin2005.

2. Discussionof theIMFApproach

Steps ((i))and ((ii))aremechanical implicationsof the IMF’s forecasts. If the forecastsareaccurate,the

implieddebt levelisareasonablysafeprevision.TheFundreportsonitsownstudiesthatshowthatthe

forecaststendtoerrontheoptimisticside,withequallyoptimisticdebtpredictions(IMF,2005c).

Probability of Worst CaseScenarios

Thispossibilityof forecastingerrorexplainswhy,“inorderto imposediscipline”onthediscussion,step

((iii))looksatsomeworstcasescenarios.Since“worst”canbevirtuallyanything,theprocedureattemptstobereasonableandtransparent.Tothateffect,theshocksarepreciselycalibrated.Buthowlikelyare0.5

standarddeviationshocks?TheIMFarguesthattheprobabilityof thedebtexceedingtheworstcaseon

thefifthyearisbetween15and30percent,“whichseemsareasonablebalancebetweencapturingthe

mediumtermriskstodebtdynamicswithoutbeingsoextremeastobeirrelevantforpolicydiscussions”

(IMF,2005a;p.3).Theemphasisisrightlyputonpolicyimplicationsbuttheargumentraisesthegeneral

questionof whatcanbelearntfromstresstests.

Thereisnothingwrongwithstresstesting.Indeed,itisacommonapproachtoportfoliomanagementand

widelyused inthe financial industry,asexplained inSectionC.3.Yet,the implicationsprofoundlydiffer

betweeneconomicpolicyandportfoliomanagement. Inthefinance industry,whenstresstestsreporta

dangerzone,evenahighlyunlikelyone,portfoliomanagersmaydecidetochangetheassetcompositionof theirportfolios.Theadjustmentdoesnotcomeforfreesinceitimplieslowerexpectedreturns,butthis

istheusualpricetobepaidfor lowerrisk. Itsacceptabilitydependson investorpreference: if investors

areunhappywiththeirportfoliomanagers,theycanchangethem.

Inthecaseof DSA,whenstresstestssignalariskysituation, therequiredadjustment isto improvethe

primary current account. Inevitably, this calls for contractionary macroeconomic policies designed to

compressdemand.The costs take the formof falling incomesand risingunemployment.Thecostsare

bornebythepopulation.AdmittedlycitizenscanvotetheirGovernmentsoutof office –whentheregime

is democratic – but only ex post. A Government’s decision to react to events that may occur with a

probabilityof 1530percentisconsiderablymoresensitivethanthatof portfoliomanagers.

Characterizationof theWorst CaseScenarios

Thestresstestsinvolvechangesinonevariableatatimeexceptinthecasewhereallof themarevaried

togetherina“bad”directionforfiveyears.Howlikelyaresuchchanges?Itisunclearhowthe1530per

centestimate is constructed.Whydoes it assume that each shock is expected tobemaintainedover

consecutive5years?Does it take intoaccount the fact that someof these shocksmaybe correlated?

Lettingtheshocks lastthewholefiveyearsassumesa100percentautocorrelation.Theoneatatime

shockassumesazerocorrelation,whilethethreevariableshockassumesacorrelationof 100percent.

Theinformationprovided inIMF(2005a)doesnotshedlightonthisimportantquestion,suggestingthat

correlationsareignored.

What canbedone about these problems?Here, aswith the thresholdquestion, the proper technicalresponse isto jackupthe levelof complexity,atthecostof reducingthe intendedtransparency.Faced

with thecriticism thatchanges in justoneof thevariables thatdrive thedebtprocesshavehistorically




27

typicallyaffectedtheothersaswell, thenormal tendency is toacknowledge thepointandtakeup the

challenge.Thismeansusingeconometric techniquestoestimatehow, inthepast, thesevariableshave

beenrespondingtoeachother’sshocks.20

Theprocedureiswellestablishedbuthasmanydrawbacks.Tostartwith,theestimateswouldhavetobeconducted country by country, an enormous task that would face serious data availability and

comparability problems. Next, the quality of the estimates is likely to be poor in many cases,21thus

injectingafurtherdoseof uncertaintyregardingthemeaningof thedebtthresholdandthusundermining

itsusefulness. Inaddition, theprocedurewould turna simpleand transparentprocedure intoahighly

technicalandcompletelyopaqueexercise,withlittleassurancethatthetestsareplausible.

The challenge is formidable,possibly insurmountable.22Itwouldbeamistake togo in thedirectionof

addedcomplexity,usingtheabundantparaphernaliaof econometricinstruments.Resortingtosimplebut

less extreme stress tests (shockswith reasonableoverallprobability)wouldbe an alternative,but the

resultscouldwellbetoomundanetobeworthconsidering.Thelackof asatisfactorysolutionisnothing

morethananimplicationof theimpossibilityprinciplepresentedinSectionII.C.

Borrowingand Growth

MissingfromtheDSAframeworkisthepossiblegrowthenhancingeffectof externalborrowing.Intheory,

acountrywithlowlevelsof humanandphysicalcapitalstandstobenefitfromexternalborrowing.If the

borrowingiswiselyinvested,thereturnsshouldmorethancoverthecosts.Thebenefitscomeintermsof

acceleratedgrowthandcatchingup.23

Thislinkageisexplicitlyignoredinthestresstests.Thismaylooksurprisinggiventhatmultilaterallending

isultimately justifiedby itsgrowthenhancingeffect.Onepossibleexplanation isthatthehorizon istoo

short for the growth effects to materialize. The proper response to this argument is to lengthen the

horizon,not to ignore the link. If debtdistressoccursalong theway, theexpectedgrowthbonus fromexternalborrowingwouldbedissipatedbutthisdoesnot justifyignoringthelink.

Anotherpossibleexplanationisthatborrowedresourcesdonotsystematicallydeliveranygrowthbonus.

There ismuchevidence that thequalityof policies andof political governancematter crucially in this

respect (Cordellaetal.(2005).Thisaspect ispartlytaken intoaccountbyCPIAasthequalityof policies

andinstitutionsareusedtodeterminedebtthresholds.

Giventheoverwhelming importanceof growthamorecomprehensiveframework isneeded.By limiting

theroleof policyandinstitutionqualitytothedeterminationdebtthresholds,DSAputsalltheemphasis

ontherisksof overborrowing.Ignoringtheconditionsunderwhichexternalborrowingcanharmorboost

growthamountstoposingthequestioninadequately.If externalborrowingisgrowthenhancing,theriskof over borrowing is small, possibly nonexistent. If, instead, external borrowing does not exert any

favorable growth effect and possibly stunts growth, the relevance of DSA is moot. Countries in this

20Somepapershave started toexplore this issue, seeGarciaandRigobon (2004),Abiad andOstry (2005)andCelasunetal.

(2005).21The degreeof precisionof such estimates is generallyquite limited but inmostdeveloping countriesdata availability and

qualityproblemsarelikelytobemoreserious.22IMF(2003b)suggestsusingthetechniquetoderivefancharts,i.e.chartsthatdepicttheevolutionof thedebtfollowingashock

byindicatingthemostlikelypathalongwitharangeof possibilities.FanchartshavebeenpopularizedbytheBankof Englandas

partof itsinflationtargetingstrategy.ThisishowtheBankpresentsitsinflationforecasts.Importantly,however,thefancharts

aredesignedbytheBankof England’sMonetaryPolicyCommittee.Theyarenottheresultof acomplexeconometricprocedure

but a snapshot representation of what policymakers believe. Fan charts are a great communication tool, which reflect the

considerationsthatgointopolicydecisionsbutnotoutsideexperts’estimationsof whatislikelytohappen.23Intermsof theformulapresentedinFootnote29,thegapbetweentheinterestcostandthegrowthratedeclines,andthedebt

accumulationbecomeslessdestabilizing,orthegapbecomesnegativeandthedebtisspontaneouslyonadecliningtrend.




28

situation shouldonlyborrow indistress situations andpromptlypayback thedebtbefore theburden

becomescrippling.

Policy Responses

ThestresstestsalsoassumethattheGovernmentdoesnotreacttotheshocks.This is incontradiction

with much evidence that shows that the primary budget reacts to a rising public debt, which should

presumablyalsohaveadampeningimpactontheexternaldebt.24Thustheworstcasescenariosmustbe

seenasapredictionthatassumesthatGovernmentsdonotdowhatinfacttheyusuallydo.Thisfurther

reducestheplausibilityof thetests.

Country Policy and Institutional Assessment (CPIA)

TheinclusioninIMFdefinitionof debtsustainabilitytheconditionthatdebtlevelsnotbe“toolarge”leads

totheneedtoestablishthresholds.Theobservationthatreasonablethresholdsarelikelytovaryfromone

country toanother then requiresanexplanationof why some countriesaremore likely to suffer from

debt distress than others. This explanation involves a large number of economic and political

considerationsandrequiresvalue judgments,averyuncomfortableundertaking.

TheIMFIDAsolutionhasbeentolookforstatisticallinksbetweenvariouscausesof debtdistressandthe

debtlevel.ThetwoacknowledgedbackgroundstudiesareKraayandNehru(2003)attheWorldBankand

anunpublishedIMFpaper.Inlinewiththeliteratureontheroleof governance,25theresultingCPIAindex,

whichisreasonablypreciselyestimated,isfoundtoexertasignificanteffectontheprobabilityof external

debtdistress.OnthisbasisitwouldbepossibletoassertthatanimprovementintheCPIAindexreduces

the probability of distress and even to compute by how much. This is not how CPIA is used in DSA,

however.

Theprocedure insteadusestheestimationtoansweradifferentquestion:whatdebt level impliesa25percentprobabilityof debtdistress?Theanswercannotbebasedonthepartialeffectof theCPIAindex

only but also involves estimates of the effect of other economic variables. If the resulting overall

estimationdoesagood jobof explainingdebtdistressepisodes,itwouldbeagoodcandidatetoestablish

athresholdforeachcountry.Unfortunately,whiletheeffectof eachof thethreevariablesselecteddebt,

CPIA indexandrealGDPgrowthispreciselyestimated,togethertheyexplainonly23.4percentof the

probabilityof debtdistress. Ina study that seeks toexplain163episodesof debtdistressallover the

world,thisisagoodperformanceamongthebest inthe literatureandunlikelytobemuch improved

upon.Yet,thefactthattheanalysisexplainssolittleof thephenomenonof debtdistressimpliesthatthe

answerishighlyimprecise.SubsequenttestsprovidedbyKraayandNehru(2003)candidlyconfirmthis.

A furtherproblem is that theCPIA index isnot applied countryby country. Instead, the countries areclassifiedinthreegroupsdependingontheirownCPIAindex.Theeffectof governanceisappliedgroupby

group,whichimpliesthattheeffectiseitherexaggeratedorunderestimatedforthecountrieswhoseCPIA

indicesdonotlieinthemiddleof therange.Thisdistortionriseswiththedistancefromgroupmeans.

This procedure is surprising. On the basis of the estimation, it is possible to compute individual debt

thresholds.Why is itnotdone?One reason issimplicity.Three thresholdsareeasier todealwith than

countryspecificthresholds.Butthisisaweak justificationforintroducingseriousdistortionswhichimply

thatthethresholdcannotbetakenseriously.Anotherreasonisthepoliticalsensitivityof theCPIAindex

forindividualcountries.Thisisunderstandable,buttheresultisthattheDSAthresholdsaretoocoarseto

leadtofirmpolicyconclusions.

24AgoodsurveycanbefoundChapter3of IMF(2003a).

25AgoodreferenceisManasseetal.(2003).




29

Sustainability Measure

It canbeargued that thedebt level, suitably scaled, is arguably the correctmeasure for sustainability

analysis.26Whentrackingitsevolutionovertime,however,aproblemarises.Whenevertheinterestrate

exceeds the economy’s growth rate, the debt accumulation process is intrinsically unstable. This ispreciselywhysustainabilityisanimportantissue.

27Twodifficultiesfollow.First,relativelysmallchangesin

therealinterestrateandintrendgrowthcantiltthedebtpathfromstabilitytoinstability.Second,when

thereal interestandgrowthratesareclose,smallshockscanhavedramaticallypowerfuleffectsonthe

debtpath.

Thestrengthof thiseffectcanbeseeninFigureII.4.ThefiguredisplaysthebaselinedebttoGDPratioand

theeffectof theDSAstandardcombinedstresstest,bothalreadyshowninFigureII.3.Thethirdcaseadds

tothecombinedtesttheeffectof anexternalinterestrateset3percenthigherthanassumedbytheIMF.

Thus increasingthe interestrateproducesasizeableeffect.Comparingthecombinedshockeffectswith

the lowerandhigherinterestrates,weseethatnotonly isthedebtrisingfasterbut,moreimportantly,

thatthedebtratioisnotstabilized,possiblysuggestingnonsustainabilityunderanydefinition.

Thisexampleillustratesthepointthatdebtaccumulationeffectscanbeeyecatchingand,inthisinstance,

mayraiseconsiderablealarmsincethedebtaccumulationprocessisunstable.Inreality,primarybalances

willbeadjustedastheresultof policymovesandof equilibratingreactionswithintheeconomywiththe

resultthatdebtinstabilityisusuallytakencareof.Of coursetherehavebeenepisodesof explodingdebts,

largely because small slippages can have dramatic effects as the result of the unstable nature of the

process.Thisiswhyputativedebtpathsof thesortproducedbytheIMFaspartof itsDSAprocedurecan

besomisleading.28

26Asnotedinfootnote16,forlowincomecountriesthisprocedureusesthenetpresentvalueof thedebt.While,inprinciple,this

isasuperiormeasure,itscomputationraisesanumberof delicatequestions,whicharenotconsideredhere.Whenwereferto

debtlevels,wedonotdistinguishbetweenthedebtanditsnetpresentvalue.27Whentheinterestrateislowerthanthegrowthrate,thedebttoGDPratioisstableandsustainabilityisassured.Inthelong

run,thisisanunrealisticcasebecausegrowthinexcessof therealinterestrateisacatchupphenomenon(acountrythatdisplays

asteadystaterealinterestratelowerthanthegrowthrateisonthe‘wrong’sideof thegoldenruleinthesensethatitsavesand

invests ‘toomuch’,suboptimallyrepressingconsumption).But intheshortrunthisconditionallowscountriestorundownthe

debttoGDPratio.Theinterestratemaybelowerthanthegrowthrateduringaperiodof fastgrowth(asinChinaorIrelandover

thelastdecade)orduringaperiodof acceleratinginflation(asduringsomeperiodsfortheUKshowninFigureII.1).28ArelatedconcernappliestotheDSAforlowincomecountries.Thechosenmeasure,thenetpresentvalue(NPV)of thedebt,is

very sensitive to interest changes.Thismeasure is compared to theNPVof thedebt ceiling. Should the ceiling itself alsobe

adjusted?TheIMFdoesnotdothis,arguingthatthereareoffsettingeffectsintermsof expectedproductivityadjustments.Thisis

likelytobetrue,eventhoughthetimingandsignof theseeffectsisnotknown.Butitisalsotruethatthesameeffectswillaffect

thepathof thedebtinthesameway.Itisinconsistenttoadjustonemeasureandnottheother.




30

FigureII.4.EffectontheDebttoGDPRatioof aHigherInterestRateontheCombinedShock

25

30

35

40

2004 2005 2006 2007 2008 2009 2010

Baseline

Combined Shock

Combined Shock with higher interest rate

Source:Author’scalculationbasedonIMF(2005b).

Implementation

TheIMFhasexaminedtheshortexperiencewiththeimplementationof DSA.ItemergesthattheDSAhas

notbeenassuccessfulasitspromotersintended:“withsomeexceptions,sustainabilityassessmentshave

generallynotbeenatthecenterof policydiscussionsbetweenstaff andnationalauthorities.Thismaybe

becausethesensitivitytestsareconsideredtooextremetoberealisticor,evenif realistic,tooextremeto

warrantapolicy response.Conversely, there remainconcerns that theassumedshocksare toobenign.

Finally, fromapresentational standpoint,debt sustainabilityassessmentswouldhavegreater impact if

theywereintegratedinthebodyof thestaff reportinsteadof beingrelegatedtoanannex.”(p.15)

ThissituationreflectsreservationsaboutDSAascurrentlypracticed,whichleadstoreluctancetoraisethe

topicwithnational authorities. The intended transparencyof the shocksused for the stress testing is

marredbytheir lowprobabilityof occurrence.Another factor isthe“blackbox”natureof theexercise,

especiallytheassumptionsabouttheeconomy’sresponsetotheshocks.(Infact,itisassumedthatthere

isnoresponse,whichisunrealisticasnotedabove.)Moreimportantly,Staff maybeembarrassedbythe

question: “so what?”. This question immediately brings to the fore the need to decide whether a

temporarybulge inthedebt isthreatening.Theanswer ismeanttobeprovidedbytheCPIA.TheCPIA,

however, is another “black box” with a large degree of uncertainty. This uncertainty reduces theusefulnessof theCPIA thresholdsasa reliableguide forpolicy.Beingunabletoanswer the“sowhat?”

question,IMFStaff downplaytheDSAexercise.

3. OtherApproaches

Until recently, due to the impossibility principle, there have been few other attempts to design

implementableapproachestoDebtSustainability.Theearlyonesacknowledgedtheconcept’ssensitivity

tounavoidableassumptionsbystressingsimplicityandtransparency.Simplicityis justifiedbytheneedto

make heroic assumptions which imply that the conclusions will always be fragile. Transparency is

necessary to allow users to understand what lies behind the result. More recently, DSA has moved

towardsmoreelaborateprocedures,drivenby thehope thatempirical regularities can generatemore

reasonableassumptionsandfacilitateassessmentof theirplausibility.Acommentaryonotherapproaches

totheproblemsraisedabovefollows.




31

TheDebt StabilizingPrimary Balance

The classic approach to sustainability asks what is the primary balance required to stabilize the debt

(Blanchardetal.,1991;Buiter,1985).Theobjectivecanbetostabilizethedebteitheratitscurrentlevel

or at any other level deemed more desirable. This approach is simple, transparent and easilyimplementablebecause itrequiresfewassumptions. In itssimplestform, it looksatthecurrentdebtto

GDP ratio and computes the primarybalancewhichwouldpermanently keep this ratiounchanged. It

requirestwoassumptions:whatwillbetheevolutionof thereal interestrateandwhat isthepotential

growthrate?Typically,pasttrendsareassumedtoremainstableovertheindefinitefuturebutshockscan

befactoredin, justasintheIMF’sDSA.

UltimatelyIMFdebtpathprojectionsandthecomputationof debtstabilizingprimaryaccountsarebased

on the same reasoning and assumptions. Both rest on the debt accumulation identity

t t t t balance primaryb g r bb 11 )(.Yet, there is an important difference. Debtpath projections

either indicatethat thedebt isstableordeclining, inwhichcase thereshouldnotbeanysustainability

issue, or that it is rising, indicating eventual unsustainability. The debtstabilizing primary accountapproach stops there. The IMF’sDSA goesone step furtherby exploring adverse shocks.When these

shocksimplyarisingdebt,newquestionsarise.Sincetheshocksare,byconstruction,temporary,arising

debtpathdoesnotmeanunsustainabilityunlessthedebtbecomestoo large.Thisthenraisesahostof

new issues,whichhavealreadybeendiscussed inSectionB.1.Thevirtueof thedebtstabilizingprimary

accountapproachistoavoidtheseissuesor,moreprecisely,topreventthemfrombecomingprominent.

Of course,thequestionof whatisanappropriatedebtlevelcannotbealtogetheravoided.Lookingatthe

primary account that stabilizes the current debt assumes that the current debt is appropriate. But

alternativetargets forthedebt levelcaneasilybe lookedat.Thequestion isvexingbecausethetheory

doesnotprovideananswer.TheWorldBank’sCPIA isoneattempttoprovideapracticalanswerbut is

subjecttotheproblemsdescribedinsectionC.2.

Howcouldthealternativeconceptof thedebtstabilizingprimaryaccountbeappliedtotheexampleof a

majorshockliketheexchangeratedepreciationpresentedinFigureII.3.?Inthebaselinecaseunderthe

IMFDSAthedebt/GDPratioisassumedtodecline.Thusadebtstabilizingprimarybalancewouldconsist

of adeficit.29Thiswouldprovideananswer to thequestionof what is thebalanceoncurrentaccount

needed to keep the debt level unchanged as a percentage of GDP, ignoring capital inflows? The

alternativeapproachcouldalsobeusedtoanswerthequestionof whatwouldbethebalanceoncurrent

account required to bring the debt level down to a particular level by, say 2010, if the debt level is

perceivedtobetoohigh?Thiswouldbeastraightforwardcalculation.

Asnoted, the conceptof thedebtstabilizingprimaryaccount is formally identical to the IMFDSA,but

interpretationisdifferent,asillustratedinFigureII.5.Herethedebtisassumedinthebaselinescenarioto

decline,and the figuresshow theeffectsof thecombinedshock.Thecorrespondingpaths forexternal

debtandtheprimaryaccountaredenotedas“original”.Theprimaryaccountremains insmalldeficitas

the debtmust be reduced. If it is assumed that the authorities can control the primary account, the

questionishowtheywouldpursuethepolicygoalof stabilizingthedebt.

Onepossibilitywouldbetofixthedebtatitspreshocklevelof 2005.Thisrequiresalargeprimarysurplus,

onethatcompletelyoffsetstheeffectof theshock.Thissurplusisshownas“Stabilized1”intheleftpanel

of FigureII.5.Therightpanelshowsthatthispolicyrequiresahugeimprovementintheprimaryaccount

in response to the sudden increase in the domestic currency value of the external debt due to the

depreciation.Thepolicyresponse isrelaxedwhentheprice increasescatchupwiththedepreciationso

thatthedebtisstabilizedindomesticaswellasforeigncurrency.

29Theformula,itwillberecalled,isprimarybalance=(interestrate –growthrate)xdebt.






33

Fourth,theissueof accesstotemporaryexternalfinancingdrawsattentiontotheallimportantcredibility

issue.Thedownsideof the“Stabilized2”responseisthatthedebtincreasewillbetemporaryonlyif the

authoritiescancommittoasustainedprimaryaccountsurplus.Absentcredibility,theadjustmentmustbe

frontloaded,asinthe“Stabilized1”case.

Credibilityisalsopartof theIMFDSAsinceitliesattheheartof theprocedureof thresholddetermination

carriedoutunderCPIA.Yet,FigureII.5pointstoashortcomingof thisapproachwhichfailstodistinguish

betweencaseswhereanincreaseinthedebtlevelismerelythetemporaryconsequenceof atemporary

shock,on theonehand,and thosewhere it results fromendemicpolicy indiscipline.31This iswhy it is

essentialthatIMFlendingbeaccompaniedbycredibilityenhancingconditionality.

Thisexampleillustratesthepointmadeabove:theIMFDSAprocedureimaginesshockswhichmayresult

insizeabledebtbuildupsbecausetheauthoritiesareassumednottoreact.Weseethat, if giventime,

relativelymoderateprimaryaccount improvementscan stabilize thedebt (this is“Stabilized2”).There

shouldbenoimplicationthattheshockmustbedealtwithimmediatelyaswith“Stabilized1”.

Valueat risk stresstests

Financial institutions havedevelopedprocedures to explore the risks associatedwithportfolios in the

formof thevalueatrisk(VAR)approach.Forfinancialfirms,theobjectiveistheavoidanceof insolvency.

Attheheartof thisapproacharetwomainideas:thathistoryallowstheevaluationof theprobabilityof

variouseventsorcombinationsof events,andthatreactionsshouldtake intoaccountboththepossible

severityof eacheventanditslikelihood.

The techniques used to measure the plausibility of various risks can also be applied to the debt

sustainabilityquestion.The IMF’sapproach takesapartial step in thisdirectionwhen it sets levels for

somevariables instress testingon thebasisof theirpreviousbehavior.But,asnotedabove, it ignores

howthesevariablesreacttoeachother.Inprinciple,onecouldgomuchfurtherinthisdirectionbutonlyatthecostof addingconsiderablecomplexityandopacity.

TheissuehasbeenstudiedbyGarciaandRigobon(2005)andCelasunatal.(2005),sothatitispossibleto

giveasenseof whatshouldandcanbedone.Ratherthanspecifyingshocksonthebasisof thehistorical

evolutionof individualvariables,properlyconstructedstresstestsshouldtakeintoaccountthehistorical

interdependenceamongthesevariables.Forexample,inthecasesdisplayedinFigureII.3.thecombined

shockinvolvesasimultaneousdeteriorationinthecurrentaccount,theinterestrateandGDPgrowth.This

combination may be more or less likely than each of its components. For instance, if GDP growth

systematically worsens when the interest rate increases, the combination is as likely as each of its

components.Allowingforsuchcorrelationsenablesbetterappraisalof theprobabilityof theshocksthat

areconsidered.

This is the first step of the VAR approach which assumes that historical correlations are likely to be

relevantinthefuture –areasonablebutnotnecessarilycorrectassumption.Thenextstepthenistotake

intoaccountallthepossiblecombinationsof shocksbasedonestimatedcorrelations.Theprocedurecan

beautomatedtorandomlygenerateaverylargenumberof shocksbothsmallandbig,inisolationandin

combination.Eachshockisassociatedwithaprobabilityof occurrence.32Thelaststepistoassociatewith

eachshockthecorrespondingevolutionof thedebt,muchasintheIMF’sDSA,exceptthateachdebtpath

nowcomeswithaspecifiedprobabilityof occurrence.

31Thesamefailuremayhelptoexplainwhytheestimatesof KraayandNehru(2003)explainonlyasmallpartof episodesof debt

distress.32Technically,thisiscalledMonteCarlosimulations.




34

Onecanthenaskthefollowingquestion:at,forexample,thethreeyearhorizonwhat istheprobability

thatthedebtbebetweenahighandalowlevel?Thedifferentcombinationsof highandlowlevels,with

associatedprobabilitiescanthenbepresented ina“fanchart” like theoneshown inFigure II.6. Inthis

figuredifferentlyshadedranges identifyalternativeprobabilitiesforpublicdebtof SouthAfricaoverthe

20052009horizon.33Thedarkestrangecorrespondstoanestimatedprobabilityof 80percent,witheach

lighterrangereducingthe likelihoodby20percent.Thefigureshowsthat,thefurtheroutwe look,the

greatertheuncertainty.

This presentation resembles the debt paths shown in Figure II.3. but with important differences. In

contrast to Figure II.3., the shocks are not identified. This is a step forward since the shocks under

considerationinFigureII.3.arearbitraryandthereforeunlikelytobewellsuitedtoanyparticularcountry.

The largenumberof randomly generated shocksunderlying theVARexerciseof Figure II.6. avoid this

criticism.Standardizationof theIMFDSAistheconsequenceof simplicity,butitscostisarbitrarinessand

therefore limited credibility.Moreover theVAR approach enablesone to judge at a glancehow likely

someof thedramaticscenariosare.

FigureII.6.ValueatRiskAnalysis:TheFanChartforSouthAfrica’sPublicDebt

(Externaldebtasaproportionof GDP)

Source:IMF(2005d).

HowevertherearecostsassociatedwiththeVARprocedure.Tostartwith,itiscomplex.Fewdeveloping

countries are equipped to carry out such estimations and it would stretch even the staff of anymultinationalinstitutiontodealwithalargenumberof countries.Inordertoprovidereasonablyreliable

estimates, the procedure requires good data, possibly going farback in the past, and few developing

countrieshavesuchdata.

Complexfanchartexercisesmayalsoprovidean illusory impressionthatuncertainty iswellunderstood.

Whilefanchartsdoprovideuseful information,theirprecision isunknown. Itdependsonthequalityof

thedata,ontheperformanceof theunderlyingeconometricanalysis,andontherelevanceof historyfor

the future. Importantly,perhaps, its“blackbox”naturegoesagainst thegoalof transparencyandmay

deterpolicyaction.Thustheunavoidablecomplexityandopaquenessmaynotbeworththeeffort.34

33Thechartdisplaysthepublic,nottheexternaldebt.34Itmaybe ironic that themostadvancedcountries,whichcanandoftencarryoutsimilarexercises,pay limitedattention to

thematdecisionmakingtime,whileIMF(2003b)andIMFandIDA(2004)callforprioritizingDSAimplicationsinthecaseof the

lessadvancedcountries.




35

ReactionFunctions

AkeymessagefromFigureII.5.isthatpoliciesdomatter.Adequatepolicyreactionscandealwithshocks,

andthesereactionsneednotbedrastic,giventimeandcommitment.Thisobservationleadstotheidea

thatdebtsustainabilitycanbeachievedthroughtheadequacyof policyreactionstoshocks.

Viewed thisway,debt sustainabilitycanbeassessedbyobservinghowa country’sauthoritiesbehave.

Thisleadstotheestimationof policyreactionfunctions.Intheareaof monetarypolicy,suchfunctionsare

knownasTaylorreactionfunctionsandhavebecomeroutine.Theapproachhasstartedtobeappliedto

publicdebt,butapparentlynotyettoexternaldebt.

Thekeyquestionhereiswhethertheprimarysurplusissystematicallyraisedwhenthedebtlevelrises.It

ispossibletoestimatethestrengthof thisreactionandtodetermineathresholdbeyondwhichthedebt

accumulationprocess is stable, andwhich thusprovidesanalternativedefinitionof sustainability. IMF

(2003a)presentsanoverviewof theemergingresultsonpublicdebtreactionfunctions.Whilethisworkis

stillpreliminary,itseemsthatmanycountriesdopassthesustainabilitytest.Thisisgenerallythecasefor

theadvancedeconomies.Fortheemergingmarketcountriesthereactionisadequateatmoderatedebt

levelsbutprobablynotforhighlyindebtedcountries.35

Theadvantageof thisapproachisthatitdoesnotrequireassumptionsaboutlikelyshocksandestimation

of theirrespectiveprobabilities.Nordoesitrequirepassing judgmentonwhatisanacceptabledebtlevel,

thusavoidingthecontentiousCPIAprocess.Thelimitof theapproachis,onceagain,aconsequenceof the

impossibility principle. Debt sustainability is a forwardlooking concept: future Governments are not

boundbypastgovernmentbehavior.Evidenceof pastsustainability,orthelackthereof,isnotguarantee

thatfutureGovernmentswillcontinuetoreactinthesameway.Allthatcanbeconcludediswhetherpast

practicesaredeliveringdebtsustainabilityornot.

Itmightbearguedthatsimplylookingattheexistingdebtlevel,orthehistoryof pastdefaults,providesthesameanswer inamuchsimplerway.Butthis isnotcorrect.Thedebtmaybehighcurrentlyeither

becauseof undisciplinedpastpoliciesorbecauseof adverseshocks.Inordertoassesswhetherhighdebt

is the resultof bad luckorof badpoliciesweneedtodisentangle these twoassumptions.This iswhat

reactionfunctionsaredesignedtodo.Forinstance,if thereactionfunctionindicatesthattheauthorities

havesystematicallyreactedinastabilizingwaytodebtbuildups,wecanconcludethatahighdebtisdue

tobadluck.Inasmuchasbadluckdoesnotstrikeagainandagain,insuchinstancesadebtcanbeassessed

ashighandyetsustainable.ThisisthekeylessonfromFigureII.1.,confirmedbyFigureII.5.

Onebenefitof thisapproach is that it focusesattentionon the issueof policymaking institutions.The

best guarantee that the authorities will always react to shocks in a debtstabilizing way is that their

decisions are embedded in a framework that constrains them to do so. Put differently, sustainabilityrequiresthatthedebtlevelbesystematicallytreatedasapolicyobjective.Thiscanbedoneinmanyways.

Onesolutionistheadoptionof rules.Thishasbeenthecaseintheareaof monetarypolicywithrulesfor

moneygrowthorwiththeadoptionof exchangerateanchors.Fiscalruleshavebeenproposedtoensure

publicdebtsustainability;theStabilityandGrowthPactof theEconomicandMonetaryUnioninEuropeis

oneexample.Ahugeandinconclusiveliteraturehasexploredthetradeoff betweenrulesanddiscretion.

More recently there has been attention to intermediate solutions in the form of institutions that are

boundbystrictobjectivesbutarealsogivensomeleewaytoexercisediscretion.Muchprogresshasbeen

achieved in the area of monetary policy with the adoption of inflation targeting and independent

monetarypolicycommittees.Similarconsiderationscouldbeappliedtofiscalpolicy(Wyplosz(2005b)).

35SeealsoWyplosz(2005a)foracomparisonof BrazilandtheOECDcountries.




36

D. ReviewandConclusions

Alongwithpricestability, lowunemploymentandbalancedgrowth,sustainabilityof externalandpublic

debt is an essential attribute of goodmacroeconomic policies.36

Alongwith these other attributes, itsprecise definition is elusive and its assessment challenging. This section takes stock of the previous

analysis,developsanumberof principles,andadvancessomesuggestions.

1. Assessment

Theoverviewof theIMF’sDSAandalternativeapproachesyieldsanumberof conclusions.

Thevariousapproachestodebtsustainabilitydiffer fromoneanother intwomainrespects:the

definitionof sustainabilityandthewaytheyattempttodealwiththeimpossibilityprinciple.

Strict definitions of sustainability start from the solvency condition. These are, sometimes

strengthened,forexample,wheretheIMFaddsanomajoradjustmentcondition,andsometimesrelaxed, for example, in the approach of Arrow et al. (2004) to the eventual achievement of

solvency.Weakerdefinitionsfocusonthestationarityof thedebtlevel,usuallyscaledbyGDPor

exports.

Implementationof thesedefinitions requiresmakingguessesabout the futureevolutionof key

variables.Thisgivesrisetothe impossibilityprinciple:becausethe future isunknown,anydebt

sustainabilityassessmentisonlyvalidwithintheboundsof theunderlyingguesses.

There isnowaytoescape impossibilityprinciple.Anyapproach isbasedeitheronananalysisof

thepast,whose relevance isunknown,oronsimulationsof what the futuremightbe,which is

unknownbydefinition.Someapproaches –e.g.VARstresstests –combinebothprocedures.

TheIMFapproachcombinessimpleandtransparentprocedures(computingdebtpathsbasedon

scenarios) with more elaborate procedures (CPIA) for determining country debt ceilings. The

formerarenecessarilyarbitrary.Thelatterattempttoextractinformationfromthepastthrough

“blackbox”procedures.

The impossibility principle does not necessarily provide support for the view that added

complexityallowsformorepreciseassessmentsof sustainability.VARstresstesting,forinstance,

isstateof theartbut,asfaraspolicymakingisconcerned,thebenefitsareillusory.37

Debt sustainability is intimately related to credibility.Credible authoritiesmay adopt aweaker

definitionof debt sustainability,eschewing the seriouseconomicandpoliticalcosts inherent in

strictdefinitions.Credibility, in turn,emphasizes the role indebtsustainabilityof policymaking

institutions.

PolicyconclusionsdrawnfromDSAexercisesmustbeconsideredwithcare.Sacrificinggrowth –in

theshortandeveninthelongrun –toimpreciselyknownrisksconcerningdebtsustainabilitycan

be very costly. Trading off growth and debt sustainability will always remain more art than

science.

2. Principles

Likeanyguidetopolicymaking,DSAmustbebothsimpleandtransparent.Simplicityisneededtomakeit

possible foreverycountry –especially the lessdevelopedcountrieswheregrowthcruciallydependson

36Debtsustainabilitymaybeseenasapreconditionforalltheotherattributes.Itiscertainlynotasufficientcondition.Whether

itisanecessaryconditionremainsopentodebate.37ThispointismadebyGoldfajninhisexcellentdiscussionof GarciaandRigobon(2005).




37

externalborrowing –tobeabletoproduceitsownanalysis.Transparencyisimportantbecausetherange

of possiblecausesof debtdistressis infinite.Vagueand lowprobabilitythreatsshouldnot informpolicy

choices.

ThispaperarguesthatDSAoughttorelyonanumberof principles.

Accept theImpossibility Principle

Except forobviousbutextremecases, itwillneverbepossibletoassert thatadebt isunsustainableas

definedbytheIMF.Itsowndefinitionrequirescheckingforsolvency,whichisimpossible.Italsorequires

passing judgmentof what isamajoradjustment,which involvesassessing thewillingnessandpolitical

abilityof theGovernmenttocarryoutunpopularpolicies.Thisturncallsforanevaluationof theimpactof

thesepoliciesandof the likely reactionof various segmentsof society,whichdependson thepolitical

regimeand,indemocraticcountries,ontheelectoralcalendar.Finally,exceptforconcessionalloans,DSA

isdirectly influencedbymarket sentiment,which canbe a sourceof unpredictable viciousorvirtuous

cycles.

ThereisNoTradeOff betweenImpossibility and Simplicity

Theimpossibilityprinciplerestsontheuncertaintyinherentinpredictingthefuture.Whileeliminatingthis

uncertainty is plainly not an option, a natural temptation is to reduce uncertainty by adopting

sophisticatedtechniquesof assessment.Mostusersareunlikelytograsphowthesetechniquesfunction.

Complexitymeansopacity. It isan illusion to think that somedegreeof opacity isworthwhilebecause

eventhemostsophisticated instrumentsdonotavoidthe impossibilityprinciple.Moreoveropacitymay

also result in themistakenuse of the instruments.By contrast simplicity,which laysbareour lackof

knowledgeof thefuture,isavirtueinitself.

Adopt aWorkableDefinitionof Debt Sustainability

Thedifferentdefinitionsandapproachesrevealthatdebtsustainabilityisandwillremainavagueconcept.

Inadditionthereisahugegapbetweentheoryandimplementation.Fromanoperationalviewpoint,two

mainapproachesarepossible:thefirstonerestsondebtthresholdsandthesecondontheevolutionof

debtlevels.Giventheimpossibilityprinciple,if DSAistoestablishuncontroversialdebtthresholds,atleast

for the time being it should rest on a variant of the second approach which specifies that debt is

sustainableif itisonanonincreasingtrend.

EvenBetter,ReplaceDebt Sustainability withDebt Distress Avoidance

However,thatadebt levelbetrenddecreasingisneithernecessarynorsufficienttoavoiddebtdistress.

Numerousdebtcriseshaveoccurredwhile thedebtGDP ratiowasdeclining.On theotherhandmanycountrieswith long risingdebt levelshavenot run into trouble. Intheend, themain reason forpaying

attention to the evolution of debts is concern with the possibility of debt distress which, unlike

sustainability,isaclearconcept.

Recognizethat Debts AreNot Necessarily Bad

Many countriesand virtually allGovernments arequasipermanently indebted, forboth good andbad

reasons.Theviewthatdebtsshouldalwaysbereducedassumesthatalldebtsarebad,whichcannotbe

generally true.Separatinggood frombaddebts isahopelessundertaking,but it is important tomove

awayfromthepresumptionthatdebtaccumulationistobeavoidedunderallcircumstances.38

38It ispuzzling that the IFIs,which routinelyemphasizedebt reduction,existmainly togrant loansandareactually themain

creditorstomanydevelopingcountries.




38

OpenUptheProcessof DeterminingWhether Debts AreExcessive

Howshouldoneassesswhetheradebtisexcessive?Whenthedebtistraded,theriskpremiumprovidesa

reasonableguide.ItalsoprovidestherightincentiveforGovernmentstolowertheirdebtlevels.Butwhen

thecountrydoesnothavemarketaccess,thereisnosuchgauge.Yet,thelendersarenaturallyentitledtohaveaview.Given thatanyassessment isbound tobe controversial,as the shortcomingsof theCPIA

exercisewell illustrate,themultilateralfinancialinstitutionsshouldhaveaproceduretoassessexcessive

indebtednessthatisopenandinvolvesexpertsotherthantheirownstaffs.39

Timeisof theEssence

Whencurrentdebtlevelsareconsideredexcessive,avoidanceof debtdistresscallsforadecliningtrend.

Howsteepshouldtherateof declinebe?Obviously,bringingthedebtdowntoasafe levelbeforedebt

distressoccursishighlydesirable,butitmaybecostlyintermsof growthandemployment.Thereisthusa

tradeoff betweenafastdebtrollbackandtheassociatedcosts.Thistradeoff mustbecarefullyassessed,

takingdueaccountof eachcountry’sspecificities.

Accept Risk

Unlesscurrentdebt levelsareconsideredexcessive,keepingthemstable is likely toavoiddebtdistress

undermostplausible conditions.Tobe sure, therewillalwaysbeexceptionalevents thatwill result in

debtdistress.Likealldisastrousevents,thisriskmustbeacceptedasafactof life.Acompleteguarantee

thatdebtdistresswillneveroccurisillusory,andahighlevelof protectionisboundtobeverycostly.

3. Suggestions

Useboth Approaches

DSA rests on the debt accumulation process, which is nothing more than an accounting identity:

t t t t balance primaryb g r bb 11 )(. At the operational level, one approach is to make

assumptions about theevolutionof theprimarybalance, interest rate randgrowth rateg inorder to

projectthedebtpath.ThisistheIMF’sDSAapproach.Theotherapproachistoaskwhatshouldhappento

the primary balance to achieve a desirable debt path, given assumptions about the evolution of the

interestraterandgrowthrateg.Thisisthedebtstabilizingprimaryaccountapproach.Whichapproachis

moreappropriate?

WhiletheIMFalsocomputesdebtstabilizingprimaryaccounts,itspolicyanalysisandgraphicalapparatus

emphasizesdebtpathprojections.Thepresentpaperhasarguedthatthepolicy interpretationof debt

path projections, already subject to the impossibility principle, inevitably leads to a search for debtthresholds,anothermission impossible.Thissuggeststhat it ispreferabletorelyonthedebtstabilizing

primaryaccountapproach.

Butinfactthereisnoreasontochooseoneovertheother.BothcanbeusedasFigureII.5.shows.Allthat

isneededistheclassicdistinctionbetweentargetsandinstruments.Thedebtpathisatarget.Theprimary

account is the instrument (assuming that the authorities can control it). The policy implications then

follownaturally:DSAbecomesaprocedurethatexplorestheeffectonthedebtpathof varioussettingsof

the primaryaccount instrument. What should this combined approach include and what assumptions

shouldbemade?

39Thisisinlinewiththerecommendationsof theexternalpanelthatreviewedtheWorldBank’sCPIA,seeWorldBank(2004).




39

Parameter Settings

Abaselineprojection,suchascarriedoutbythe IMF,showshowthedebtaccumulationunfoldsonthe

basisof thecurrentlyforeseenprimarybalance,exchange,interestandgrowthrates.Inassociationwith

thisprojection it isstraightforwardtocomputetheprimarybalancethatwouldstabilizethedebtundercurrent conditions, aswell as the primary balance required to lower the debttoGDP ratiowhen the

currentlevelisperceivedexcessive.

The baseline is not a forecast, only a statement of where current conditions lead. Currently the IMF

provides twobaselines:one that isbasedonStaff forecastsandone that isbasedonhistorical trends.

Neither isadequate. Staff forecasts introduce adegreeof arbitrariness. Indeed, IMF (2003b) reportsa

tendency forthese forecaststoerronthesideof optimism.Producingabaselineonthebasisof these

forecastshas themeritof consistency,but this comes at the costof a self inflicted lackof realism. In

addition, the baseline should extend over a horizon which goes beyond the ability to make credible

forecasts.

Historicaltrendshavetheadvantageovercurrentvaluesof providingsomestability,butthisstability is

illusory.TrendprojectionisadequateforGDPgrowth,whichtendstofluctuatearoundareasonablystable

level,withgoodyearsmakingupforbadyears.Butthis istheonlyhistoricaltrendthatshouldbeused.

Theothervariables,theexchangeandinterestratesandtheprimarybalancearepotentiallyvolatileand,

partlyatleast,controlledbytheauthorities.Exploringthedebtimplicationsof thecurrentsettingsismore

informativethanrelyingonhistoricalaveragesthatareoftenoutdated.

Thehorizonshouldbelong,saytenyears.AsarguedinSectionC.3,debtcorrectionsarebestcarriedout

slowly,with small changes in theprimaryaccountmaintainedovera longperiod.Debtcorrectionsare

inherentlycostly –andmorecostly,thesharpertheyare.Thesamecorrectioncanbeachievedatamuch

lowercostif itistheresultof changessustainedovermanyyears.

Policy Implications

Projected over a longhorizon, the chartsdisplayed in Figure II.5.provide an adequate framework for

policy discussions. The impossibility principle means that DSA should not lead to automatic policy

conclusions, a fact well recognized in IMF (2003b). For this reason, the more transparent are the

parametersettings,thesmalleristheriskof theirbeinggivenanoverlyprominentrole.

Thebaselinedebtprojectionimmediatelyindicateswherethedebtisheading.Theprimaryaccountwhich

isdebtstabilizing –ordebtreducingwhenthedebtisdeemedexcessiveandalowerlongruntargetcan

beagreedupon –providesareasonableevaluationof whatisrequiredtoachievedebtsustainability.

Itisthenpossible,indeeddesirable,toask“whatif?”questions.Inpolicydiscussions,manyquestionscanbeaskedandeasilyanswered. It isstraightforwardtoproducechartssimilar toFigure II.5.showingthe

mechanicaleffectsondebtand the stabilizingprimaryaccountof changes in interestor growth rates,

whethertheyarepermanentortemporary.But it is importanttokeep inmindthatsuchanexercise is

purelymechanical,becauseitignoresthelinkagesamongthevariablesthatdrivedebtaccumulation.For

example,changesintheprimarycurrentaccountmayrequireactingontheexchangerate,whichinturn

willnotonlyaffectthedebtGDPratio intermsof localcurrencybutmayalso leadtodifferent interest

ratelevels.

ThishassomeresemblancetotheIMFapproachtoDSAbutdiffersfromitintwoimportantways:1)there

isnopretenseof providingforecastsandof assessingtheir likelihood;and2)theresultsareanswersto

questions asked by policymakers and not simply readymade suggestions that thedebtmight be in adangerzone.




40

InstitutionsMatter

Credibility is an essential component of DSA, yet it is largely hidden. Credibility affects exchange and

interest rates, and can trigger virtuous or vicious circles. The CPIA is one way of recognizing the

importanceof credibilitybutsuffers from itsassumption that institutionsaregiven.Policymaking isnot justaboutsettingmacroeconomicvariables.Itshouldalsogiveaprominentroletoshapingpolicymaking

institutions.

Anumberof countrieshavetakenstepsto improvetheirpolicymaking institutions intheareaof fiscal

policy,withmuchsuccess.BrazilandChile,forinstance,haveadoptedformalproceduresthatbindpolicy

actionswithinaframeworkthatputsdebtsustainabilityattheforefront.MostEastAsiancountrieshave

informallydonethesame,relyingonnormsinsteadof legalarrangements.MechanicalDSAimplicitly(and,

as just noted, CPIA explicitly) takes institutions as given. It would seem important to downplay the

mechanical part of DSA and, in contrast, to emphasize forcefully the contributions that adequate

institutionscanmaketoavoidingdebtdistress.




41

References

Abiad A and Ostry JD (2005). Primary Surpluses and Sustainable Debt Levels in Emerging MarketCountries.IMFPolicyDicusssionPaperPDP/05/6.

ArrowKetal.(2004).AreWeConsumingTooMuch? Journal of EconomicPerspectives,18(3):147–172.

Blanchard OJ (2005). Fiscal Dominance and Inflation Targeting: Lessons from Brazil. In: F. Giavazzi, I.

GoldfajnandS.Herrera(2005) InflationTargeting,Debt and theBrazilianExperience.MITPress:

49–80.

BlanchardOJet al. (1990).The Sustainabilityof Fiscal Policy:NewAnswers to anOldQuestion.OECD

EconomicStudies15:7–36.

Borensztein E et al. (2004). Sovereign Debt Structure for Crisis Prevention. Occasional Paper, 237,

InternationalMonetaryFund.

BuiterW(1985).AGuidetoPublicDebtsandDeficits.EconomicPolicy ,1:13–62.

Bulow J and Rogoff K (1989). A Constant Recontracting Model of Sovereign Debt. Journal of Political

Economy ,97(1):155–78.

BurdaandWyplosz(2005).Macroeconomics, AEuropeanText.FourthEditions,OxfordUniversityPress.

CelasunO,DebrunXandOstry JD (2005).PrimarySurplusBehaviorandRisks toFiscalSustainability in

EmergingMarketCountries:A“FanChart”Approach.IMFPolicyDiscussionPapers,PDP/05/6.

ChangRandVelascoA (1999).LiquidityCrises inEmergingMarkets:TheoryandPolicy. In:B.Bernanke

andJ.Rotemberg,eds.NBERMacroeconomics Annual ,theMITPress.

CordellaT,RicciLAandRuizArranzM (2005).DebtOverhangorDebt Irrelevance?Revisiting theDebtGrowthLink.IMFWorkingPaper05/223.

Garcia M and Rigobon R (2005).A Risk ManagementApproach to Emerging Market’s Sovereign Debt

Sustainability with an Application to Brazilian Data. In: F. Giavazzi, I. Goldfajn and S. Herrera

(2005).InflationTargeting,Debt and theBrazilianExperience,MITPress:163–188.

HemmingR,KellMandSchimmelpfenningA(2003).FiscalVulnerabilityandFinancialCrisesinEmerging

MarketEconomies.OccasionalPaper218,InternationalMonetaryFund.

Hostland D and Karam P (2005). Assessing Debt Sustainability in Emerging Market Economies Using

StochasticSimulationMethods.IMFWorkingPapersWP/05/226.

IMF (2002).AssessingSustainability.PolicyDevelopmentandReviewDepartment,SM/02/166.Availableat:www.imf.org/external/np/pdr/sus/2002/eng/052802.htm.

IMF(2003a).PublicDebtsinEmergingMarkets:IsItTooHigh?World EconomicOutlook ,September:113–

152.

IMF (2003b). Sustainability Assessments—Review of Application and Methodological Refinements.

Availableat:www.imf.org/external/np/pdr/sustain/2003/061003.pdf .

IMF and IDA (2004). Debt Sustainability in LowIncome Countries: Further Considerations on an

Operational Framework and Policy Implications. Available at:

www.imf.org/external/np/pdr/sustain/2004/091004.pdf .

IMF(2005a).InformationNoteonModificationstotheFund’sDebtSustainabilityAssessmentFramework

forMarketAccessCountries.Availableat:www.imf.org/external/np/pp/eng/2005/070105.htm.




42

IMF(2005b).Colombia:FirstReviewUndertheStandByArrangement.Country Report ,05/392.Available

at:www.imf.org/external/pubs/ft/scr/2005/cr05392.pdf.

IMF(2005c).AreFundStaff Projectionsof DebtMoreOptimisticUnderProgramContexts?Availableat:

www.imf.org/external/np/pp/eng/2005/110905.pdf.

IMF(2005d).SouthAfrica:SelectedIssues.Country Report ,05/345.

JeanneO and Zettelmeyer J (2001). InternationalBailouts,MoralHazard andConditionality. Economic

Policy ,33:407–32.

KraayA andNehruV (2003).When Is ExternalDebt Sustainable?Available at:www.imf.org/external/

np/res/seminars/2003/lic/pdf/kn.pdf .

ManasseP,RoubiniNandSchimmelpfenningA (2003)PredictingSovereignDebtCrises.WorkingPaper

03/221,InternationalMonetaryFund.

MissaleA(2000).PublicDebt Management.OxfordUniversityPress.

RodrikD(1998).WhoNeedsCapitalAccountConvertibility? In:S.Fischerandothers(1998).Shouldthe

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FinanceSection,Departmentof Economics,PrincetonUniversity,May.

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IDA/Resources/CPIAExpPanRepSecM20040304.pdf .

WyploszC(2005a).InstitutionsforDebtStabilityinBrazil.In:F.Giavazzi,I.GoldfajnandS.Herrera(2005 ).

InflationTargeting,Debt and theBrazilianExperience.MITPress:193–222.

WyploszC(2005b).FiscalPolicy: InstitutionsVersusRules.National InstituteEconomicReview ,191:70–

84.




43

Annex: An AlternativeDebt Sustainability Condition

SectionB.1. suggestsanalternativedefinitionof debt sustainability.Thisappendixbriefly characterizesthelinkof thisdefinitionwiththesolvencycondition.

LetBtbethedebtoutstandingatbeginningof periodt,Rt,t+ithediscountfactorbetweenperiodstand

t+i,andSttheprimarybudgetbalance.Thedebtaccumulationprocessimplies:

n

i

it it t t nt nt t S R B B R0

,,

Solvencyisdefinedbytheusualtransversalitycondition:

0lim ,

nt nt t n B R

whichcanberewrittenas:

0

,

i

it it t t S R B

Thenetworthof theentity(Government,country)is:

t

i

it it t t BS RV

0

,

andthereforesolvencysimplyrequiresVt0.

Thealternativesustainabilitycondition(basedonArrowetal.(2004))isthatVtbetrendincreasing,i.e.:

Vt+n –Vt0formostn.

Thus, itmaybethat initiallyVt0butthesustainabilitycondition impliesthatthereexistsahorizonN

suchthat,foralln>N,Vt+n0.






45

CHAPTERIII

THEMECHANICSOF

DEBTSUSTAINABILITYANALYSIS

AnhNgaTranNguyenandAlbiTola

(UNCTAD)

A. Introduction

Debtsustainabilityhasbecomeakeyissueinthediscussionondebtindifferentfora.Theconceptof debt

sustainabilityisdifficulttodefineinpracticeanddependsonanswerstoanumberof questions.Whenisa

certain levelof debttoohighandunsustainable?How importantisdebtsustainabilityfordevelopment?

Shoulditbeamajorobjectiveandshouldeconomicpoliciesbeadjustedaccordingly?Alternativelyshould

developmentbeanobjectivewhichcanoverridedebtsustainability?If so,whatdoesthismeaninterms

of policies? Or on the contrary should there be acknowledgement that debt sustainability and

developmentaretoointerconnectedforsuchaseparationof objectivestobefeasible?

Answers to thesequestionsarenot straightforward.The literatureondebt sustainabilityoffersawide

rangeof analysesof theissuefromdifferentperspectives.Thebasicelementsof thedifferentapproachesare highlighted in this paper, with particular reference to their practicality and relevance. Four main

approachesarecovered:

Presentvalueanalysis;

Financinggapsanalysis;

Theindicatorsof debtcrisis;and

Adevelopmentpolicybasedframework.

Theanalyticalunderpinningsof theseapproachesare linked,but the focusonparticularaspectsof the

debt problems is typically different. The last approach attempts to address various concernswithin a

comprehensivemacroeconomicandpolicybasedmodel.



TheMechanicsof Debt Sustainability Analysis

46

B. DebtIndicatorsandEarlyWarningof Crisis

In the aftermathof recentdebt criseseconomistshaveattempted to identifyearlywarning indicators

whichwouldsignalinadvancetheprobabilitythatacurrencyordebtcrisiswilloccur.Suchindicatorsare

intendedtofacilitatecorrectivemeasures.Onesuchindicatorisanunsustainablecurrent account deficit

associatedwithlowGDPgrowth.Thattypicallycharacterizeddebtcrisesinthe1980s.

Accordingtothemodelsof debtdynamicsdiscussedbelow,acountry’sdebtaccumulationissustainable

as long as the growthof GDP is greater than the real interest rate.However, access to credit canbe

abruptlystoppedif creditorsbecomeworriedaboutincreasingdebt.Inaddition,highgrowthratesof GDP

accompaniedbycapital inflows,cancausetherealexchangeratetoappreciate.Thiscan leadto lossof

competitivenessandfurtherdeteriorationof thecurrentaccount.

Anotherimportantindicatorof debtsustainabilityisthesizeof exports,whichenhancethedebtor’sability

togenerate the foreigncurrency revenuesneeded to servicedebt.However,a largeexport sectorcan

makeacountryvulnerabletotermsof tradeandforeigndemandshocks.Forexample,as itisshownbyCorsettietal. (1998),theexportsof SouthEastAsiancountriesweresubjecttonegativetermsof trade

shocks in1996priortothefinancialcrisisof 1997followingthefall inthepricesof semiconductorsand

other exports, the increasing competitionof cheaper goods fromChina, anddecreasingdemand from

Japanduetolongstagnationof itseconomy.

Radelet and Sachs (1998) point out that so long as investments financed by external borrowing are

channeled to productive activities, they can contribute to growth. However, over reliance on external

financingcanbethesourceof macroeconomicinstabilityif itinducesanappreciationof therealexchange

rate.PriortotheAsianfinancialcrisisasignificantpartof capitalinflowswasdirectedtosectorsproducing

nontradedgoodsandtorealestate,neitherof whichgenerateforeignexchangerevenue.

RadeletandSachs(1998)alsoidentifytheincreasing fragility of financial sector asasignof anupcoming

debtcrisis.AscredittotheprivatesectorgrewrapidlypriortotheAsianfinancialcrisis,banks increased

theirrecoursetoshorttermforeignborrowing.Bankswerethusexposed intwoways: (1)toexchange

rate risk since theywereborrowing in foreigncurrency foronlending indomesticcurrency;and (2) to

maturitymismatchessincetheyborrowedshortandlentlong.

Traditional indicatorssuchasaslowingof export growth,adeterioratingcurrent account deficit and an

overvalued exchangeratearenotnecessarilyareliablesourceof warnings.Somerecentresearchonearly

warningsystems(EWS),describedinBergetal(2004),hasbeenmodelbased.Theaimof thisresearch,of

which examples are Kaminsky, Lizondo and Rienhart (KLR) (1998) and work of the IMF Developing

CountriesStudiesDivision(DCSD),hasbeentodevelop“theexchangemarketpressureindex”.If thevalue

of thisindexexceedsitsmeanbymorethanthreestandarddeviations,thenthecurrencyisexposedtoa

serious riskof devaluation.Although themodelsdeveloped for thispurposeusedifferenteconometric

techniques,theyaredesignedtoestimatetheprobabilityof an“event”onthebasisof variousindicators.

The indicators of theDCSDmodel include realexchangedevaluation, changes in foreign reserves, the

ratioof shorttermdebttoforeignexchangereserves.TheKLRmodelusesalsoincludesindicatorssuchas

thedomesticcreditgrowth,changeinmoneymultiplier,andtheratioof foreignexchangereservestoM2.

TheIMFalsoexaminedtheratioof theshort termdebt toreservesasawarningindicatorbutfoundthatit

performedbetterasanindicatorof liquiditythanof externalsolvencyproblems.Forexample,priortoits

debt crisis of January 2002 Argentina had a better indicator for this ratio than Turkey in 19992000.

However, its ratio of debtservice to current receipts was twice as large as that of Turkey and more

successfullyanticipateditssubsequentsolvencyproblems.




47

TheIMFhasdrawnattentiontothepossibilityof includingmodelsof countryriskmodelsandsovereign

risk indices in the EWS, pointing to an econometric model of Eichengreen and Moody (2000) in this

context. This model is used to estimate the determinants of emergingmarket debt spreads and to

forecast currencyproblemson thisbasis. Inter alia the authors found that thedebtservicetoexports

ratiowashighlycorrelatedwiththelevelof spreads.

Otherstudiesof EWSmodels(reviewed inBergetal.,2004)pointtoamixedperformance inpredicting

crises.While they tend toperformbetter thannonmodelbased indicators suchas sovereign spreads,

sovereign ratings ormarket surveys, they haveoften signaled false alarms.On the otherhand, these

modelshavecoveredalargenumberof macroeconomicandfinancialvariablesformanycountriesandfor

longperiods.Theyhavehighlighted invaluable information about the relative vulnerabilityof different

countries(BergandPatillo,2000).

Aliquidity problemarisesbecauseof abunchingataparticulartimeof debtobligationswhichcannotbe

fullyservicedonthebasisof existingrevenues.However,thedebtcanberepaid if recoursetoexternal

fundingisavailableonatemporarybasisorif thedebtisrestructuredsothatdebtobligationsarebettermatchedtothedebtor’srevenues. Insolvency ,ontheotherhand,denotesthe inabilityof thedebtorto

pay in fullhisdebtobligationsowing tomore structuralproblemswhichcannotbe solved simplybya

rearrangementof paymentsdue.

In theorya country is solventeven if it runsahuge current accountdeficit as long as it is capableof

producingcurrentaccountsurplusesinthefutureand,asdescribedbelow,GDPincreasesatarateabove

the rateof interest. In practice this conditionhasbeen shown tobeunrealistic.According toRoubini

(2001)themainproblemwithsuchdebtdynamics lieswiththefactthataGovernmentcannotcredibly

committoruntherequiredfiscalandbalanceof paymentssurplusesinthefuture.Thisauthorprefersthe

simpleratioof foreigndebttoGDPratioasanindicatorof bothsolvencyandsustainability.If thisratiois

increasing,thenalargertradesurpluswillberequiredtoachievesolvencyandthismustbeincreasedstillfurtherif therealinterestrateisbiggerthanGDPgrowth.

Otherstudieshaveattempted todetermineempirically thethresholdsbeyondwhicha“debtcrisis” (or

solvency problems) will develop. The debt crisis is defined as an event in which there are arrears of

principal or interest on external obligations, or in which the country reschedules or restructures its

externaldebt.Thesestudies (IMF,2002a)have found thatadebtcrisisoccurs typicallyatdebt toGDP

ratiosbelow5060percent.The“transferproblem” implies thatacountrymustalsogenerate foreign

exchange receipts throughanexport surplus sufficiently large to service itsdebt.This implies that the

exportstoGDP ratio (or another indicator for the same purpose such as the debt servicetoexports

ratio)isrelevant.Thesurveyof IMF(2002a)showedthatfordebtcrisesatexporttoGDPratiosbelow20

percentthreequartersoccurredatdebttoGDPratiosof lessthan60percentof GDP,whileforcrisesat

exportGDPratiosof between20and40percentthecorrespondingdebttoGDPratiowasbetween60

and80percent.

Themain indicatorsusedtomeasure liquidityaretheratioof foreignexchangereservesto imports,the

ratioof foreignexchange reserves to shorttermdebt, the shareof shorttermdebt in totaldebt, and

interestpaymentstoforeignexchangereserves.Althoughacountrycanbesolvent,itrisksadebtdefault

orcrisisif itdoesnothaveenoughliquiditytoserviceitsshorttermdebt,perhapsowingtoabunchingof

loansmaturingataparticulartime.Thismighthappenduringafinancialpanicwhereshorttermcreditors

decide not to renew their loans or ask for a repayment. Thus debtor countries should monitor their

maturity structure to make sure that they have enough shortterm assets to cover their shortterm

liabilities.

Assessingthesolvencyandthe liquidityof acountry isadynamicprocesswhichshouldtakeaccountof

differentshocksthatmightreduceitscapacitytoserviceitsdebt.Theseshockscouldbedropsinexport




48

earnings,unfavorablemovements inthetermsof trade,or increases inoilprices.Roubini (2001)draws

theattentiontowhathecalls“self fulfillingsolvencytraps”.Thisiswhereahighexternalorpublicdebt –

but not necessarily at a level entailing insolvency will be considered by the markets as a situation

sufficientlyriskyforthespreadsoninterestratestoincrease.Asaresult,thedebtorcountrywillpaymore

interestandwillaccumulatedebtmorerapidly.Thisisanothercasewherealiquiditycrisismayturnintoasolvencycrisis.

Liquidityandsolvencyconceptsareusuallyinterlinkedinpracticesothatitisverydifficulttodistinguish

between the two. It is generally difficult to determine whether incapacity to pay is temporary or

permanent.Moreoverproblemsof illiquiditycanturnintoinsolvencyif theyarenottackledintime.

C. ThePresentValueof FutureIncome

Howshoulddebt sustainabilitybedefined?Sincedebt isgenerally incurred to finance investment,one

approachinvolvesananalogywiththemicrolevelanalysisof investmentprojects.Heredebtsustainabilityisdeterminedbytheconditionthatthepresentvalueof thefuture incomestream(netof expenditure)

derivedfrom investmentprojectsshouldbeat leastequaltothenominalvalueof debtusedtofinance

them.Therearetwowaystoobtainthepresentvalueof futureincomestreams.Thepresentvaluecanbe

computed by discounting the streams of income by the interest rate of the debt. Another way is to

compute theexpected internal rateof return,definedasthe rateof discountapplied to future income

whichwouldmakestheexpectedpresentvalueof incomeequaltothenominalvalueof debt.Inthiscase

debtsustainabilityisassuredif theexpectedinternalrateof returnisatleastequaltotheinterestrateof

thedebt.

Applicationof thepresent value approach todebt sustainability to thedebtof a countrynonetheless

involvesaddressingmanychallengesatonce: Theinvestmentprojectsfinancedbydebtarethesumof privateandpublicprojectswithdifferent

ratesof return.Thelattermayincludeprojectsaddressingsocialratherthaneconomicneeds.

The income generated by investment can be denominated in foreign currency (in the case of

exports)orinlocalcurrency.

Externaldebt sometimes isused to smoothout cyclical changes inconsumption (whichdonot

generateany income),debtbeing incurredduring timesof depressedgrowthandrepaidduring

highgrowthperiods.

Debt can carry concessional or market interest rates and have different maturities and grace

periods,whichmakethechoiceof theappropriatediscountrateacomplicatedissue.

Notwithstanding these difficulties, the present value approach has beenwidely applied to developing

countries’ debt. The IMF implicitly uses this concept of the present value in their approach to debt

sustainability (see IMF, 2002a). It defines debt sustainability as “a situation in which a borrower is

expected tobeabletocontinueservicingitsdebtswithout anunrealistically large futurecorrectiontothe

balanceof incomeand expenditure”.40Underlyingthisdefinitionof sustainabilityareconceptsof solvency

andliquidity,whicharedefinedonthebasisof thepresentvalueapproach.

40Sustainability, according to the IMF, rules out: (1) debt restructuring; (2) Ponzi games where the borrower indefinitely

accumulatesdebt faster than itscapacity to servicedebt isgrowing); (3)moralhazardwhereby theborrower livesbeyond its

meansbyaccumulatingdebtintheknowledgethatamajordebtservicereductionwilleventuallybeneeded.




49

Solvency issecuredwhenthepresentvalueof adebtor’scurrentandfutureprimaryexpenditure(E)isno

greaterthanthepresentvalueof itscurrentandfuturepathof income(Y),netof anyinitialindebtedness

(D):

))1(

)1(

(

)1(1

0

1

0

1

t t

ii

j

jt

it

ii

j

jt

it Dr

r

Y

r

E

.

A liquidity crisisoccurswhenadebtor’s liquidassetsandavailable financingare insufficient tomeetor

rollover its maturing liabilities, regardless of whether the solvency condition is met. Sustainability is

reachedwhenadebtor’sliabilitypositionsatisfiesthepresentvaluebudgetconstraintwithouttheneed

foramajorcorrectioninthebalanceof incomeandexpenditure,givenitscostsof financing.

Thepracticalityof suchanotionof solvencyisquestionable.First,thetimehorizonisinfinitelylong,which

makes planning or time framing of Government’s budget impossible. Furthermore, the appropriatediscountratemuststillbechosen.Differentchoiceswillresultindifferentestimatesof presentvalue.

Thepresent value approach is also applied to the analysisof the primary balanceof theGovernment

budget or the balance of payments on current account excluding payments. Based on the national

accounting identities, thebalance, Pt, that is the difference between revenue and expenditure or the

currentaccountbalance,inbothcasesexcludinginterestpayments,isequaltothechangeindebtDtplus

interestpayments:

11)1( t t t P Dr D

Assumingaconstantinterestrate,recursiveapplicationof thisformulagives:

1

1

11 )1()1(

i

it i

j j

jt

t r

D

r

P D

Asitendstoinfinity,thetermontherighthandsidetendstozero.Thismeansthatthepresentvalueof

debt in the indefinite future converges to zero and reflects the unwillingness of lenders to allow the

debtor perpetually to pay its interest obligations by borrowing more. Hence, for i sufficiently

large,

01)1( j

j

jt

t r

P D

,which impliesthatalldebtmusteventuallybepaidbackforsustainabilityto

ensue.

Thisobservationleadstotheinterestingconclusionthattheabilitytogenerateasurplusisaprecondition

forlongtermdebtsustainability.Inthecaseof thefiscalbalancethisisaprimarysurplus.Inthecaseof

thebalanceof paymentsoncurrentaccountthedebtorcountrymusteventuallyexportandearnenough

foreignexchangethroughatradesurplustorepaydebt(thesocalledtransferproblem).

Adifferentversionof thepresentvalueapproachistheIMF Net Present Valueof Debt .Inthecaseof low

incomecountriesthatreceive loansonconcessionalterms,creditorsapplytheconceptof “Netpresent

Value”41(NPV)of loanstocalculatethe“realburden”of debt,usingaformulaforwhichthedebtservice

onconcessionalloansisdiscountedatthemarketrateof interestinordertoreflectthe“trueopportunity

41Theterm«NetPresentValue»(NPV)isusedhereinawaythatdivergesfromstandardcorporatefinance jargonforwhichNPV

isthedifferencebetweenthepresentvaluesof theincomeandcostof aninvestmentproject.Infact,amorecorrecttermhere

wouldbethe“presentvalue”(PV).




50

cost” of the loans. This NPV concept was first applied in the context of Paris Club rescheduling on

concessionaltermsandtheninthecontextof theInitiativefortheHeavilyIndebtedPoorCountries(HIPC).

The IMFapplies it tothe lowincomecountries in itsdebtsustainabilityanalysis framework (IMF,2003,

May).

Therationalebehindtheuseof thisversionof NPV isthatdiscountingthestreamof futuredebtservice

paymentsbyanappropriatemarket interest rateprovidesanaggregatemeasureof theeffectivedebt

serviceburdenimpliedbyagivendebtstock.However,asseenatthebeginningof thissection,inorderto

gaugewhetherthedebtorcanserviceitsdebt,thedebtor’s futurestreamof incomehastobediscounted

either at the rate of interest on the loanwhich has been contracted or at the rate of return on the

investmentproject.

ThisNPVapproachdoesnot,therefore,reflectthedebtor’scapacitytopay.If atall,thiscapacityistaken

intoaccountwhenconcessionaltermsaregrantedtolowincomecountries.Theversionof NPVisrathera

conceptof interesttocreditors,usedtomeasurethegrantelementof aid.Itcanalsobeusefulasameans

to determine comparable opportunity costs for donors for burden sharing purposes in debtrelief operations.

D. TheFinancingGap

Thefinancinggapanalyticalapproachesarebasedonthethreenationalaccountidentitiesrelatedtothe

balanceof payments,domesticinvestmentandsavings,andgovernmentbudget,whichlinkexternaldebt

withdifferentfinancinggaps:thecurrentaccountdeficit,ortheshortageof domesticsavingscompared

todomesticinvestments,orthegovernmentbudgetdeficit(partof whichcannotbefinancedbydomestic

publicdebt).

Assuch,thefinancinggapsare justaccountingidentities.Economistshaveexpandedtheseidentitiesand

added behavioral equations in order to project financing gaps or to analyse the dynamic stability

conditionsof externaldebt.Theuseof gapmodels toproject financinggapsandaid requirementshas

been widely accepted by international financial institutions. However this approach has been much

criticized,notablybecauseof expost inaccuraciesof theseprojectionsandbecauseof the instabilityof

the key variable, the incremental capitaloutput ratio (ICOR),42used to determine the growth path of

income.

Despite these shortcomings, financing gaps as determined by accounting identities remain useful

indicators forpolicymakers in the short run for the analysisof theoriginsof externaldebt andof the

burdenof debtservicingongovernmentbudget.

1. DebtandNationalAccountingIdentities

Threenationalaccountingidentitiesrelatedtothebalanceof payments,domesticinvestmentandsavings,

andthegovernmentbudgetshowthelinksof externaldebttodifferentfinancinggaps.

(1)Thebalanceof paymentsidentity isstatedasfollows:

)()( 11

**

1 t t t

E

t t t t t t t

E

t

E

t t R R FDI Di E X P M P E D D E

42SeeEasterly(1997).




51

where E

t Distheexternaldebtstock indomesticcurrency, t E

thenominalexchangerate(domesticper

unitof foreign currency),*

t P foreignprices, t M

importvolume, t P domesticprices, t X

export volume,*

t i theforeigninterestrate, t FDI thenetflowof foreigndirectinvestment(includinglongtermportfolio

equityinvestment),and t Rthestockof foreignexchangereserves.

This identity shows that new debtcreating capital inflows fill that partof the current account deficit

( E

t t t t t t t Di E X P M P E 1

**

)notfinancedbyFDIandthechangeinreserves.

(2)Theinvestment savingsidentity isderivedfromthenationalincomeidentity:

)(*

t t t t t t t t t t M P E X P I C S C Y

Where t C isconsumption, t S issavings,and t I isinvestment.

sothat t t t t t t t M P E X P I S *

Combiningthebalanceof paymentsandinvestmentsavingsidentitiesgivesanotherequationforexternal

debt:

t t

E

t t t t t

E

t

E

t t R FDI Di E S I D D E 1

*

1 )()(

Thisidentityshowsthatnewdebtcreatingcapitalinflowsfillthegapbetweendomesticinvestmentplus

InterestspaymentsanddomesticsavingswhichnotfinancedbyFDIandthechangeinreserves.

(3)TheGovernment budget identity isstatedas:

where D

t DisGovernment’sdomesticdebt, 1t G is government consumptionexpenditureand t P is the

primarysurplus.

)( t t t t t t DT IGG ET T P

Where t T isgovernmentrevenue, t ET

externaltransferstoGovernment, t Ggovernmentconsumption,

t IG governmentcapitalformation,and t DT domestictransfersandsubsidies.

This identity above shows thatnewdebtcreating capital inflows fill thegapbetween the totalbudget

deficitandtheamountof thedeficitthatcanbefinancedbyissuingdomesticdebt.

2. TheStabilityof ExternalDebtDynamics

Theroleof foreigncapitalinthedevelopmentprocesshasfirstbeenanalysedinthecontextof thetwo

gapmodels,wherebydebtorcapital inflowhelps in filling the resourcegap resulting fromof shortage

foreignexchangeearnings(derivedfrom identity(1))orof savings(derivedfrom identity(2)).Asdebt is

assumedtocontributetogrowth,overtimetheresourcegapisgraduallynarrowedandtowardstheendof thecycle,thedebtorcountrywillhaveenoughsurplusesinresourcestorepayitsdebt.

t

E

t t t

D

t t

E

t t

D

t t P DGi E Di DG E D DG 1

*

1




52

This virtuous cycle of debt is characterized by a stable dynamic path of debt accumulation, which

decreases over time. Assuming unchanged exchange rate and expressing the variables in the same

currency(withE=1),thedynamicinteractionsbetweendebtononehandandincomegrowthandexport

growthontheotherhand,woulddeterminetheconditionsunderwhichthedebtaccumulationprocess

canbecontrolled.Thebasicmodelshownbelowillustratessuchdebtdynamics.43

Thefirstequationdescribesdebtaccumulation(D)tofinancetheresourcegap,whichisdefinedhereas

thedifferencebetweenimportsandexports(MX)andtheinterestpaymentsonearlierdebt(iD).

(1)iD X M

dt

dD

Theincreaseinoutputissimplytheproductof investment(I)andtheinverseof theincrementalcapital

outputratio(1/k):

(2) I

k dt dY 1

Thesavingsgap(thedifferencebetween investmentIanddomesticsavingsS)andtheforeignexchange

gap(thedifferencebetweenimportsMandexportsX)areequalexpost:

(3)iD

dt

dD X M S I

Other specifications canbeadded to thisbasicmodel.Forexample, imports canbebrokendown into

importsof capitalgoodsandimportsof consumptiongoods.Exportscanbespecifiedtogrowexogenously

ortodependontheinvestmentrate.

Considerthesavingsgapfirst.

Thesavingsfunctionsimplystatesthatsavingsaretheproductof themarginalpropensitytosave(s)and

domesticproduct:

(4) S=sY

Usingthesavingsgap(IS)andrearrangingtheterms,debtaccumulation(expressedasaratioof debtto

output)canbesetinfunctionof theoutputgrowthrate(g),investment(gk)andsavings(s)rates:

(5))()(

)/( s gk g i

Y

D

dt

Y Dd

Equation5statesthatthechangeintheratioof debttodomesticproductdependsonthecurrentlevelof

this ratio,aswellas thedifferencebetween the interest rateand thegrowth rate,and thedifference

betweentheinvestmentrateandsavingsrate.Thesolutiontothisdifferentialequationwilldeterminethe

conditionof stabilityof thedebtaccumulationprocess:

(6)

t g iei g

s gk

Y

D

i g

s gk

Y

D )(

0

0

whereD0/Y0isthevalueof D/Yattimet=0.

43Notethatthemodelisinrealterms,i.eallvariablesaredividedbytheGDPdeflator.




53

Fromequation6 itcanbeseenthatthedynamicpathwillbestableandconvergetoequilibriumonly if

the rateof GDP growth ishigher than the interest rate. If the interest rate ishigher than the rateof

growth,debtwillgrowataneverincreasingrateandwillreachanexplodinglevel.

Withg>i,theasymptoticvalueof thedebtincomeratiois:

LimD/Y[(gk –s)/(g –i)]

t

Themaximumamountof D/Y (or themaximum levelof sustainabledebttoGDP) isdeterminedby the

differencebetweenthemarginalinvestmentrate(gk)andsavingsrate(s).

Alternatively,using the trade gap (M X)and rearranging the terms,debtaccumulation canbe set in

functionof theinterestrate(i)andtherateof growthof exports(x).

(7) X

X M xi

X

D

dt

X Dd )(

)/(

whereD/Xisthedebttoexportratio.

Equation7statesthatthechangeintheratioof debttoexportisthesumof thecurrentlevelof thisratio

multipliedbythedifferencebetweentheinterestrateandtherateof growthof exports,andthecurrent

trade gap divided by the current level of exports. The solution to this differential equation gives the

followingtimepathof thedebtexportratio:

(8)

t xie X

X M

i x X

D

X

X M

i x X

D )(

0

0 11

whereD0/X0=debtexportratioattimet=o.

Here,thestabilityconditionisthattheinterestrateshouldbelowerthantherateof growthof exports(i<

x).Thetrajectoryof D/Xcanbeexponentiallyascendingordescending,dependingonwhetherxisgreater

orsmallerthani.

Withi<x,D/Xwillconvergetoanequilibriumwiththefollowinglimit:

LimD/X[1/(xi)][(M –X)/X]

t

Asthesizeof thedebttoexportratiodependsonthetradegap,this limittosustainabilitycanbevery

highif thetradegapisverylarge.

Finally, taking into consideration the fiscal gap, asderived from theGovernmentbudget identity (and

assumingthattheGovernmentincursonlyexternaldebtanddoesnothavedomesticallycontracteddebt),

applyingthesameprocedureasaboveyieldsthefollowingequation:

(9) Y

PB

g iY

D

dt

Y Dd

)(

)/(




54

PBistheprimarydeficitof theGovernmentbudgetandgistherateof growthof theeconomy.Thistime

thestabilityconditionisthatgexceedsi.

The debt dynamics depicted above imply that as long as GDP grows faster than real interest rate, a

countryissolventevenif theratioof foreigndebttoGDPkeepsgrowing.Thesameappliesforfiscaldebt.Likewise,as longasexportgrows fasterthan real interest rate,acountry issolventeven if the ratioof

foreigndebttoexportsisincreasing.

Inpractice, theseconceptshave shown tobenotvery realistic. Inparticular,even though the stability

conditionscanbesatisfied,theasymptoticvaluesof debt,aswellasthetradegapandfiscaldeficitwhich

determinethesevalues,canbeveryhigh.Nothing inthemodelsignalsthecapacityof debtorstorepay

thefullamountof thisdebt.Unlesslendersarewillingtolendoveraprolongedperiodwhileknowingthat

debtisnotgoingtoberepaid,debtorsneedtorunfiscalsurplusortradesurplusinordertoreducetheir

debt.

3. TheIMFandWorldBankDSAFramework

Thethreefinancinggapidentitiesarealsousedasthebasisof theframeworkemployedbytheIMFand

theWorldBankfordebtsustainabilityassessment(DSA).Theframeworkconsistsof twotemplates,one

relatedtotheexternaldebtsustainabilityandtheothertothefiscalsustainabilityof thepublicsector.

The external debt sustainability template analyses the debt incurred externally by domestic residents

(boththepublicandtheprivatesector).Usingthebalanceof paymentsidentityasthepointof departure

and rearranging the terms derived from the algebraic transformations of this identity, the following

equationcanbeusedtodecomposechangesinexternaldebt:

11 ))1()1(()1(

1 t t t t tbd r g g r g g d d

where d isthedebttoGDPratio, istheshareof domesticcurrencydebt intotalexternaldebt, is

the change in the exchange rate expressed in US$ per local currency unit, tb is the currentaccount

balanceexcluding interestpayments inpercentof GDP, is thechange in thedomesticGDPdeflator

expressedinUS$, g istherealGDPgrowthrate,and r istheinterestrate.

Thisequationallowsthefollowingdecompositionof theseparatechannelsaffectingtheevolutionof the

debtGDPratio:

thenoninterestcurrentaccountdeficit,tb;

therealinterestrate,t d

g g

r

1( ;

therealgrowthrate,t d

g g

g

)1(

;

priceandexchangeratechanges,t d

g g

r g

)1(

)1()1(

.

Thethreelasteffectscanbecharacterizedasthecontributionsof endogenousdebtdynamics.




55

The fiscal sustainability template analyses the behavior of the debttoGDP ratio with all variables

expressed indomestic currency.Using theGovernmentbudget identity as thepointof departure and

rearrangingthetermsderivedfromalgebraictransformationsof thisidentity,thefollowingequationcan

beusedtodecomposechangesinpublicdebt:

1 1

1ˆ ˆ( (1 ) (1 ))

(1 )t t t t d d r g g r d pb

g g

whered is thedebttoGDP ratio,pb is theprimarybalance, r̂ isaweightedaverageof domesticand

foreign interest rates, the shareof foreigncurrency denominated public debt, the change in the

domesticGDPdeflator,andgtherealGDPgrowthrate.Changesintheexchangerate(localcurrencyper

U.S.dollar)aredenotedby ,with 0 indicatingadepreciationof thelocalcurrency.

Thisequationallowsthefollowingdecompositionof thechannelsaffectingtheevolutionof thedebtGDP

ratio:

theprimarydeficit pb ,

therealinterestrate,t d

g g

g r

)1(

)1(

;

therealgrowthrate,t d

g g

g

)1(

;

exchangeratedepreciation,t d

g g

r

1(

)1(

.

Again,thethreelasteffectscanbecharacterizedasthecontributionsof endogenousdebtdynamics.

By identifyingdifferentfactorscontributingtothegrowthof thedebtratios,thetemplates indicatethe

channelsthroughwhichdebtcanbereduced,if thelevelistoohigh.Notethatinthetemplatesthereal

GDP growth rate and export growth rate are exogenously given so that there is only a oneway

relationshipfromGDPandexportgrowthtodebtaccumulation.Theshortcoming,therefore,isthelackof

areverserelationshipfromGDPanddebtgrowthtogrowthof exports,whichlimitsuseof thetemplates

forexaminingcertainscenariosfordebt,GDPandexportgrowth.

Furthermore,theIMFandWorldBankDSAframeworkleavesopenthequestionof theappropriatelevel

of debt aroundwhichdebt shouldbe stabilized.Anexampleof adhoc characterof the applicationof IMF/WorldBankDSAframeworkindeterminingasustainablelevelof debtisthesettingof theindicative

thresholdsfortheratiosof NPVof debttoGDP,toexportsandtogovernmentrevenueatdifferentlevels

forlowincomecountriesaccordingtothepolicyperformanceof borrowingcountriesasmeasuredbythe

CountryPolicyandInstitutionalAssessment(CPIA)Index.Thefollowingtableillustratesthesethresholds.




56

TableIII.1.IndicativeExternalDebtBurdenIndicators1/

Qualityof PoliciesandInstitutions2/

Poor Medium Strong

NPV of debt in per cent of:

Exports 100 150 200

GDP 30 40 50

Revenue3/ 200 250 300

Debt servicein per cent of:

Exports 15 20 25

Revenue3/ 25 30 35

1/SeeIDAandIMF“OperationalFrameworkforDebtSustainabilityAssessmentsinLowIncomeCountriesFurther

Considerations”,2005.

2/Country’swithaCPIAbeloworequalto3.25aredefinedtohaveapoorqualityof policiesandinstitutions,while

aCPIAabove3.75indicatesagoodquality.

3/Revenueisdefinedexclusiveof grants.

There are severalproblemswithusing theCPIA as the sole criterion fordetermining debt thresholds.

Historicalseries for theCPIA indexarenotpubliclydisclosed (onlydata for IDAcountriesstarting from

2005aredisclosed).Asaconsequence,allanalyses that linkdebt sustainability to theCPIAhavebeen

conductedbyWorldBank/IMFstaff andnoexternalresearcherhasbeenallowedtotesttherobustnessof

thelinksbetweenthesetwovariables.Itisalsoquestionablewhetherthequantitativeimpactof theCPIA

ontheprobabilityof debtdistress is largeenoughtoformulatedebtthresholdsonlybasedontheCPIA.

Moreover,itisnotclearwhethertheCPIAisindeedameasureof policiesor justaleadingindicatorof a

debtcrisis.

4. Debt,TradeandGrowth

Interlinkagesbetweentrade,growthanddebtcanbeshownmoredirectlybyrearrangingthebalanceof

payments identity of section B.1 in accordance with the algebraic transformations in section I of the

Appendix.Thesegivethefollowingequation:

111 )()( t t f f t t d g ctot d pi xmd d

wheredistheratioof externaldebttoGDP,mtheratioof importstoGDP,xtheratioof exportstoGDP,

if theforeigninterestrate,pf therateof changeof foreignpriceindex,phthedomesticpriceindex,ctot(=

e+pf –ph) therateof changeof thetermsof trade (ebeing the rateof changeof theexchangerateexpressedasdomesticperunitof foreigncurrency),variablesbeingexpressedindomesticcurrency.

Ignoringtheeffectof realforeigninterestrateandincludingatermrepresentingtheeffectof FDI(fdi,the

ratioof netflowsof FDItoGDP),thisequationhasbeentestedempiricallythroughapanelregressionof

data for seven countries (Argentina, Bangladesh, Bolivia, Kenya, the Republic of Korea, Malaysia, and

Uganda)overtheperiod19812004.Theresultsareasfollows(tstatisticsinparentheses):

dt –dt1=0.270.36(xt –mt)0.37fdi0.14g0.18ctot

(6.07)(5.54)(2.30)(1.68)(0.66)

R2=0.1858




57

Thevariablesontherighthandsideof theequationexplain1819percentof thevariationsindebtratios.

Thecoefficientsaresignificantatthe5or10percentlevelexceptforthatof thetermsof tradechange.

Allthecoefficientshavetheexpectedsigns.Understandably,thetradebalanceplaysahighlysignificant

role indebtaccumulation:atradedeficitaddstodebt,whileatradesurplusreduces it.FDIandgrowth

reducedebtaccumulation.

5. Contributionof DebttoGDPGrowth

Theprecedingsuggeststhatgrowthreducestheexpansionof thedebtratio.Butwhatisthecontribution

of debt togrowth? Inorder toassess this relationship, thebalanceof payments identity is rearranged

again to show the relationshipbetween growth as adependent variableandother variables including

debtflows(seeappendixforthealgebraictransformations).Thisrelationshipisreflectedinthefollowing

equation(derivedinsectionIIof theAppendix).44

wwee

Y dY D Dd P dP E dE P dP Y dY /)/)()(1()///)(1(

**

where istheinitialratioof exportstoimports,thepriceelasticityof imports,theincomeelasticity

of imports, thepriceelasticityof exports, theincomeelasticityof exports,Dethenetexternaldebt

flows, P the export price index, P* the importprice index, E the exchange rate (domesticperunitof

foreigncurrency),andYwworldincome.

Panelregression,coveringthesamecountriesandthesameperiodasintheanalysisabove,wasusedto

estimatealternativerelationships((i)and(ii))basedonthisequation.

(i)g=0.040.109d+0.049ctot+0.054x(10.75)(5.25)(2.00)(1.91)

R2=0.25

whereg is realGDPgrowth,d thechange in the ratioof externaldebt stock toGDP,ctot the rateof

changeof thetermsof trade(UNCTADindexof termsof trade),andxthegrowthrateof constantUS$

exports

Allcoefficientsaresignificant.Thesignof thecoefficientof debtisnegative,signifyingthatanincreasein

thedebttoGDPratioreducesgrowth.

(ii)g=0.338+0.127f +0.094ctot+0.045x

(8.05)(2.22)(3.23)(1.46)

R2=0.11

inwhichthedebtstockisreplacedbyavariable(f)measuringtheratioof netexternalresourceflowto

GDP:f = ft ft1and f =nd+ fdi+oda,ndbeingtheratioof nettransfersondebt (debt flowsnetof

amortizationminusinterestpayments)toGDP,fditheratioof netflowsof FDItoGDP,andodatheratio

of grantstoGDP.

44Thirwall and Hussain (1986) derived a similar equation, expressing growth in terms of the volume effect of relative price

changes,thetermsof trade,andthegrowthof theworldeconomyandcapitalflows.




58

The variables on the righthand side of (ii) explain only 11 per cent of GDP growth However, the

coefficients except that of export growth are statistically significant. This time external debt is not

specified intheequationassuchbut is includedasoneof thecomponentsof thevariablerepresenting

netexternalresourceflowswhichhaveastatisticallysignificantpositiveimpactongrowth.

E. DevelopmentPolicyBasedApproachtoDebtSustainability

Theabovediscussionshowsthatthereisadiversityof approachestoDSA.Eachapproachhasaparticular

focusandservesadifferentpurpose,whether itbedebtmanagement,crisisprevention,ordebtrelief.

Technical indicators should be supplemented by policy considerations and other kinds of analysis if

countriesaretomanagetheirexternaldebtinasustainableway.

Bearing in mind all external and domestic factors contributing to debt sustainability, under a

developmentpolicy approach, debt sustainability is not viewed only from the narrow perspective of

reducinganunsustainable levelof debtbut isalso integrated intotheoveralldevelopmentstrategyof acountry.Underthisapproach,debtshouldbemanaged insuchawayastomaximize itscontributionto

sustainabledevelopment.

Suchanapproachincorporatestheviewthatexternalindebtednesscannotbesustainableinthelongrun

if thedevelopmentstrategyadopteddoesnot leadtoan increase inforeignexchangeearningstorepay

thedebtonlyaftertheotherdomesticresourcerequirementsof thedevelopmentstrategyhavebeenmet.

Thusthepointof departureof asustainabledebtstrategyisaclearvisionof thecountry’sdevelopment

trajectory.Debt shouldbe integrated into thisdevelopment trajectoryby encouraging efficientuseof

externaldebtwhichbalancesitscostsandbenefitsinthecontextof thetrajectory.

Thepanoplyof policies integratingdebt intoacountry’sdevelopmentstrategywouldaimataddressingdifferentsituations:

policiestoenhanceanefficientuseof debtinlinewithdevelopmentobjectives;

policiestoadjusttoshocksinordertoavoiddebtcrises;

policiestodealwithdebtcrisesandtorestoregrowth.

Integrationof debtanddevelopmentstrategydoesnotexcludepoliciestoreduceexcessivelevelsof debt

but emphasizes the context of a growthoriented approach to debt sustainability. Furthermore such

integration isbasedon acknowledgement that in an interdependentworldpreventionof adebt crisis

often also requires actions at the international level, based on international cooperation to ensure

adequatetransferof resourcesfordevelopmentaswellastradingopportunitiesfordebtorcountries.

Theestablishmentof aneffective institutional frameworkup fordebtmanagement isessential for the

implementationof asustainabledebtstrategy.Within this frameworkspecific rolesandresponsibilities

shouldbeassignedtotheministryof finance,thecentralbankandthedebtmanagementagency,i.e.the

differentgovernmententities,andtheframeworkitself shouldbeadaptedtotheadministrativecapacity

of eachdebtorcountry.

Development isnot a smoothprocess, andno country canbe sheltered from the threatof adebtor

financialcrisis.Countriescanmoreeffectivelyadjusttodebtandcurrencycrisesif theymanagetoforesee

theeventslikelytotriggerthem.Takingearlyadjustmentmeasures,wherepossible,couldinsomecases

help tomitigate thegravityof thecrisisandshorten itsduration.The indicatorsreviewed in thispaper

should help in this respect. They should also help countries to assess the costs and benefits of debtrenegotiations.




59

References

BergAandPattilloC(2000).TheChallengesof PredictionEconomicCrises.IMF

Economic

Issues.22,July.BergA,BorenszteinEandPattilloC(2004).AssessingEarlyWarningSystems:HowHaveTheyWorkedin

Practice?IMFWorkingPaper(WP/04/52),March.

CorsettiG,PesentiPandRoubiniN (1998).WhatCaused theAsianCurrencyandFinancialCrisis.NBER

WorkingPapers,6833,December.

EichengreenBandModyA(2000).WouldCollectiveActionClausesRaiseBorrowingCosts?NBERWorking

Papers,7458,January.

IMF(2002a).AssessingSustainability.PreparedbythePolicyDevelopmentandReviewDepartment,May.

IMF(2002b).EarlyWarningSystemModels:TheNextStepForward.In:Global Financial Stability Report.

Washington,DC,InternationalMonetaryFund,March.IMF(2003).DebtSustainability inLowIncomeCountries:TowardsaForwardLookingStrategy.Prepared

bythePolicyDevelopmentandReviewDepartment,May.

InternationalDevelopmentAssociationandInternationalMonetaryFund(2005).OperationalFramework

forDebtSustainabilityAssessmentsinLowIncomeCountries:FurtherConsideration(IDA/R2005

0056).

KaminskyG,LizondoSandRienhartC(1998).Leadingindicatorsof CurrencyCrises.IMFStaff Papers,47,

0:62–98.

RadeletSandSachsJ(1998).TheOnsetof theEastAsianFinancialCrisis.Mimeo,February.

RoubiniN (2001).Debt Sustainability:How toAssessWhether aCountry is Insolvent.NewYork, SternSchoolof Business,NewYorkUniversity,20December.

ThirwallAPandNureldinHussainM(1982).Thebalanceof paymentsconstraint,capitalflowsandgrowth

ratedifferencesbetweendevelopingcountries.OxfordEconomicPapers,November.




60

ANNEX

1. Debt,TradeandGrowth

FromtheBalanceof Paymentsidentity:

1)0 EF EDiM EP X P f f h

X arerealexports(orvolumeof exports)

M arerealimports(orvolumeof imports)

h P isdomesticpriceindex

f P isforeignpriceindex

D isexternaldebtexpressedinforeigncurrency

F areexternalflows,includingnewdebtandnetFDI,expressedinforeigncurrency

E isnominalexchangerate(domesticcurrencyperunitof foreigncurrency)

f iistheforeigninterestrate

Weassumethattherearenochangesininternationalreserves.

DividingallvariablesbynominalGDP,Y P h ,weget:

2)

0Y P

EF

Y P

EDim xhh

f

where x = PhXPhY ,Y

M

P

EP m

h

f *

and for simplicity it is assumed that all external flows are debt

relatedsothat dt

dD F

DefineY P

EDd

h

and

Y P

EF f

h

Differentiatetheexpressionford :

2)(

)()(

Y P

dY P Y dP EDY P DdE EdD

dt

dd

h

hhh

2)(

)(

Y P

dY P Y dP ED

Y P

DdE EdD

h

hh

h

Y P Y

EDdY

Y P P

EDdP

Y P

DdE EdD

hhh

h

h

11

Y P

EDg

Y P

EDp

Y P

DdE EdD

hh

h

h




61

Y P

g p E dE DdD ED

h

h

//

Wecanrewritetheaboveexpressionas:

D

F

Y P

ED g ped

dt

dd

h

h )(

=f g ped h )(

e rateof changeof exchangerate

h prateof changeof domesticprices

grealGDPgrowthrate(dY/Y)

Finally,wereplace f withtheaboveexpressioninequation2:

0)( dt

dd d g ped im x h f

or

3)

d g pei xmdt

dd h f )(

Further,wecanrewriteequation3as:

d p g p ped i xm

dt

dd f h f f )(

where f prepresentstherateof changeof foreignprices

or

d g ctot d pi xmdt

dd f f )()(

where ctot (=ph pf e) is therateof changeof

thetermsof trade.

2. Contributionof DebtandCapitalFlowstoGrowth

First,thebalanceof paymentsidentity:

4))()( 11

**

1 t t t

e

t t t t t t

e

t

e

t R R FDI Di X P M P E D D

Deisexpressedindomesticcurrency.

Forsimplicity,wewillassumethatallcapitalinflowsaredebtrelatedandsoincludedintoe

t D,thatthese

inflowsareestimatedonanetbasis(i.e.afterallowingfori*Dt1),andthattheforeignexchangereserves

areunchanged( 0

t R ).Then:

t t t t t

e

t M P E X P D *** *




62

Takinglogsonbothsides:

)**ln()*ln( *

t t t t t

e

t M E P X P D

Differentiating:

M

dM

E

dE

P

dP

X P D

X P Dd e

t

e

t

*

**

)*(

Since dX P X dP X P d **)*( and t t t t t

e

t M P E X P D *** *wecanrewritethisexpressionas:

{P*X/P**E*M}{dP/P+dX/X}+{Det/P**E*M}{d(Det)/Det}=dP*/P*+dE/E+dM/M

Replacing M E P X P **

**by and M E P

D

e

t

***

by 1 weget.

5)M

dM

P

dP

E

dE

X

dX

P

dP

D

Dd e

e

*

*)()1(

where representstheinitialratioof exportstoimports.

Substitutingtheexpressionforrealimports,

R R Y dY P dP E dE P dP M dM /)///(/ **

andrealexports,ww Y dY P dP E dE P dP X dX /)///(/ **

,

whereisthepriceelasticityof exports,thepriceelasticityof imports,theelasticityof demandfor

imports,theelasticityof demandforexports,YrtheGDPof thedebtorcountry,andYwforeignincome,

andsolvingfordYr/Yr,weget:

6)dYr/Yr=

wwee Y dY D Dd P dP E dE P dP /)/)()(1()///)(1( **

OntheRHSof thisexpression,weseethatthebalanceof paymentconstrainedgrowthrateof realGDP

dependson:

therateof changeof termsof trade )///( ** P dP E dE P dP ;

thecombinedeffectof priceelasticityof importsandexportand relativepricechanges/changes in the

termsof trade )///)(( ** P dP E dE P dP ;

thecombinedeffectof rateof changeof debtrelated foreigncapital inflowsand the tradedeficitasa

proportionof imports,(1)ee D Dd /)( ;

thecombinedeffectof growthrateof theratioof exportstoimports,theelasticityof demandforexports,

andforeignincome,Yw.




63

CHAPTERIV

ANANALYTICALFRAMEWORKFORDEBT

SUSTAINABILITYANDDEVELOPMENT

ValpyFitzGerald

(Universityof Oxford)

A. Introduction

1. ExternalDebtandDevelopment

This paper is intended to contribute to the further development of debt sustainability analysis for

developing countries,withina framework thatdoesnot take thenarrowviewof debt sustainabilityas

beingreachedsolelybyreducingexcessivecurrentlevelsof debt.Ratheritviewsdebtsustainability,asan

integralpartof asuccessfuldevelopmentstrategy,closelylinkedtoexportgrowth.

There are at least three good reasons for developing countryGovernments to borrow abroad: (i) the

economicreturnonpublicinvestmentindevelopingcountriesissuperiortothecostof borrowedcapitalso that growth can be accelerated by prudent use of debt without excessively reducing current

consumption levels;(ii)domesticfirms(particularlysmallandmediumenterprises)cannoteasilyborrow

abroadandtermsarebetterforsovereignborrowerssothatitisefficientfortheGovernmenttousedebt

foronlendingtoproductivesectors,particularlyexports;and(iii)theexternalitiesfrompublicinvestment

ininfrastructure,health,education,etc.arelargeandpositivebutcannotgenerallybecapturedinreturns

toforeigndirectinvestors.

Foreignprivateinvestorscanbenefitfrominvestingindevelopingcountrysovereigndebtastheratesof

return are higher than those obtainable on OECD government bonds, while the risk due to possible

defaultcanbemitigatedbyappropriatediversificationof portfolios.However,financefromthissourceis

available only for “emerging markets” – that is middleincome countries and a few large lowincome

countries.Most lowincomecountries,ontheotherhand,donothaveaccesstoexternalprivatecapital

except for foreign direct investment in natural resource sectors owing to problems associated with

contractenforcement, informationasymmetry,andeconomicexternalities. Inconsequencebilateralaid



An Analytical Framework for Debt Sustainability and Development

64

donorsandmultilateraldevelopmentbanksactas financial intermediaries toprovide loanson suitable

termsonthebasisof theirownabilitytoraisefundsinglobalcapitalmarkets.

Externaldebthas tobe repaid in foreignexchange, so that tradeplaysa critical role.The relationship

between external borrowing and trade is the key to a successful external debt strategy, as externalindebtedness cannot be sustainable in the long run if the development strategy does not lead to an

increaseinforeignexchangeearningsaboveimportrequirementssufficienttorepaythedebt.Thepoint

of departureof asustainabledebtstrategyis,therefore,aclearvisionbytheGovernmentof thecountry’s

developmenttrajectoryanditsrelationtoitstradepotential.

2. TheCurrentEmpiricalContextforExternalDebtAnalysis

It isessential to take into account the situationof different typesof debtor countries (middleincome

countries, lowincomecountries,HIPCs,etc.)bothbecause lendersarediverse (withdistinctobjectives

andleverages)andbecausecountries’economicstructuresandvulnerabilitytoexogenousshocksdiffer.

Inthissubsectionwetakeabrief lookataggregatedataorganizedbyregionalgroups,incomelevels,and

debtdifficulties.Thisdisguisesmanyproblemsat thecountry levelbutgivesagood ideaof theoverall

issues.

AsTableIV.1.indicates,thedebtburdeninrelationtoexportsisthreetimeshigherinlowincomethanin

middleincomecountries.Howevermiddleincomecountriesowethreequartersof alldevelopingcountry

debt.Thusthe“debtproblem” isan issueof integration intotheworldeconomy if consideredfromthe

point of viewof amiddleincome country,but an issue of economicdevelopment if viewed from the

perspectiveof alowincomecountry.

TableIV.1.ExternalDebtandExportsbyIncomeLevel,2003

Exports

(US$bn)

ExternalDebt

(US$bn)

Debt/Exports

(Per cent)

Lowincomecountries 176 523 297

Middleincomecountries 1813 1815 100

Totaldevelopingcountries 1999 2339 117

Source:WorldBank(2005b).

Thetotalvalueof externaldebtanddebtservicevarieswidelybyregionandbydebtorstatus,atTableIV.2. indicates.By2003netexternalborrowingwasquite lowcomparedtooutstandingdebt inallthree

regionsidentifiedhere,45butonlyinDevelopingAsiaarereservessufficientlylarge(particularlysincethe

mid1990sfinancialcrises)tocoverexternaldebt liabilities. InLatinAmerica(andbyextension in“UDC”

countries with recent debt difficulties) reserves barely cover debt service, leading to serious liquidity

difficulties. InAfrica(andbyextensiontheHIPCgroup)reservesareat leastfourtimesdebtservicebut

thishasnopracticalsignificancebecause thedebt isnot traded. It isworthnoting that if theoverseas

assets of the private sector were recorded and entered here, the net asset position of developing

countrieswouldbepositive –and inthissensethere isno“developingcountry debt issue” assuchbut

ratheraserioussovereigndebtproblem.

45TheCISandEasternEuropewereinfactthemainnetborrowersin2003.




65

TableIV.2.ExternalDebtof DevelopingCountriesbyRegionandDebtorStatus,2003(US$bn)

Totalof

which

Developing

Asia

Latin

America

and

Caribbean

Africa UDC HIPC

Externaldebt 2724.3 695.7 759.0 278.0 804.2 145.8

OfficialReserves 1412.6 670.1 196.2 90.9 168.7 19.7

Debtservice 437.8 105.5 174.3 25.2 112.3 3.6

Netexternalborrowing 91.5 18.7 0.6 3.8 3.8 2.0

Exceptionalfinancing 32.4 6.2 14.4 6.7 13.0 5.1

Source:IMF(May2005).Notes:“UDC”areUnsustainableDebtCountries(author’sdefinition)witharrearsand/orreschedulingduring19972001;

HIPCare“highlyindebtedpoorcountries”underconsiderationbytheWorldBankandIMFfordebtcancellation;

“debt service” is actual payments of interest on total debt plus amortization payments on longterm debt,

incorporating exceptional financing; “exceptional financing” is arrears on debt service, rescheduling of debt

serviceanddebtforgiveness.

Theexternaldebtstructurevariesintwodimensions –maturityandcreditor.AstableIV.3.shows,most

debtis“longterm”(thatiswithamaturityof oneyearormore)andhasanaveragematurityof theorder

of tenyears.AfricaandtheHIPCcountriesrelymostlyonofficialcreditors,whileAsiaandLatinAmerica

relymoreonprivate lenders.Within this lattercategorybondspredominateoverbankcredit,although

thedifferenceisnotgreatinpracticefromthepointof viewof theborrower.

TableIV.3.Structureof ExternalDebt,byMaturityandCreditor,2003(US$bn)

Total

of

which

Developing

Asia

LatinAmerica

andCaribbean

Africa UDC HIPC

Shortterm 377.9 106.3 89.7 19.4 34.8 3.3

Longterm 2344.9 589.4 669.3 258.6 769.4 142.5

Totaldebt 2724.3 695.7 759.0 278.0 804.2 145.8

Officialcreditors 1021.9 292.6 204.5 213.1 491.3 132.0

Privatecreditors:

bankcredit

722.1

161.9

185.8

42.5

183.2 10.8

bonds 960.0 241.3 368.7 22.4 129.7 3.0

Source:IMF(May2005).

Notes:ForUDCseenotestotableIV.2.

In relation to exports it is clear from Table IV.4. that the major “debt overhang” difficulties are

encounteredinLatinAmericaandAfrica,wheremostof theUDCandHIPCaretobefound.Inrelationto

debtserviceLatinAmerica(andbyextensiontheUDCs)hasthemostseriousproblem.Africancountries

(andthustheHIPC)benefit fromsofter,aidrelateddebtterms –and, indeed,donot fullyservice theirdebt.Thedifferencesininterestratespaidreflectthedifferencesbetweenmiddleincomecountrieswith

accesstoprivate lendingand lowincomecountrieswhichrelyonofficial lenders,ontheonehand,and

thehigherdefaultriskinLatinAmericacomparedtoAsia,ontheother.




66

TableIV.4.Indicatorsof DebtinRelationtoTrade,2003

Totalof

which:

Developing

Asia

Latin

America

and

Caribbean

Africa UDC HIPC

Per cent of exports

ExternalDebt 111.3 73.2 199.3 144.6 208.9 321.1

InterestPayments 4.3 2.6 10.8 4.1 6.8 3.6

Amortization 13.6 8.5 34.9 9.0 22.3 6.6

Per cent of debt

Interest 3.9 3.6 5.4 2.8 3.3 1.1

Amortization 12.2 11.6 17.5 6.2 10.7 2.1

Source:IMF (May 2005).

3. Coverageof thePaper

This paper focuses on external debt. It does not examine domestic debt, even though with currency

convertibilitypublicdebtdenominatedindomesticcurrencycanrepresentacontingentclaimonforeign

exchangereserves –albeitatanundefinedexchangerate.Nordoesthispaperaddressdebtcrisesassuch

and thesubsequent renegotiationsand restructurings.None the less,manyof theanalytical results for

prudentdebtmanagementdiscussedbelowarerelevanttodebtsustainabilityatthedomesticaswellas

theexternallevelbecauselattersustainabilitycannotbesensiblyplannedforeitherexceptinthecontext

of asustainabledebttrajectory.

The structure of the paper is as follows. Section B provides the appropriate national accounting

framework fordebtanalysis,and then setsout the traditional “gapmodels” (savings, tradeand fiscal)

along with a summary of the modern critique of this approach. Section C outlines the modern

intertemporalapproachtodebtanalysis,derivestheoptimaldebtlevelinrelationtooutputandexports

foranopendevelopingeconomy,andproposestwo“goldenrules”forexternaldebtmanagement.The

macroeconomic consequences of external debt are addressed in SectionD,which startswith the key

impact on real exchange rates and follows thiswith the framework for analysing the effectson fiscal

balancesandincomedistribution.SectionEexplainshowcreditrationinginglobalcapitalmarketsmeans

thatdebtlevelsarenotdeterminedbyborrowers,andgoesontoanalysetheimpactof interestrateand

trade shocksunder thesecircumstances.Finally,SectionFderivespolicyconclusions forbothdomesticGovernmentsandtheinternationalcommunity.

B. Debtandthe“FinanceGap”Model

1. NationalAccountingsandDebt

Debtaccountingisquitecomplexbecausedebtflows –inflowsof freshdebtcapitalandoutflowsof debt

service –enterintotheprocessof savingsandinvestment,thebalanceof payments(onbothcurrentand

capital account) and the fiscal framework. In the savings and investment balance, net debt flows

constitute“externalsaving”.Inthecurrentaccountof thebalanceof paymentsinterestpaymentsondebtareanoutflowof factorincome.Inthecapitalaccountnetdebtflowscreatechangesinthenetexternal

assetposition.Inthefiscalaccountsgrossdebt inflowsareanexternalresource,whileamortizationand




67

interest payments are major expenditure items. Furthermore net debt flows in a particular year, in

combinationwithinheriteddebt,determinedebtfornextyear,thusintroducingadynamicelementinto

debtaccounting.

Theseaccountingidentitiestellusnothingaboutthebehaviorof thevariouscomponents:inotherwordstheyarenotamodel.However,theydoclarifythecomplexrelationshipbetweendebtandthedomestic

economy,andalsounderlinethefactthatthecomponentsmustbereconciledinotherwords,“addup”.

Weusethefollowingnomenclature:

Yaggregateoutput(i.e.GDP)

Caggregateconsumption

Xexportsof goodsandservices

M importsof goodsandservices

Sdomesticsaving

I investment(grossfixedcapitalformation)i interestrateonexternaldebt

amortizationrateonexternaldebt

Dexternaldebt

Ggovernmentexpenditure

Tgovernmentrevenue

Rofficialforeignexchangereserves

Westartwiththeaggregatedemandsupplybalance

X I C M Y [B.1]

which,whenthesavingsinvestmentidentityisinserted,yieldsthe“accumulationbalance”

[B.2]

Thebalanceof paymentsoncurrentaccountincludesnotonlyexportsandimportsof goodsandservices,

but also factor income (income from capital andworkers’ remittances). To simplify the expositionwe

includehereonly the interestpaymentson (public)externaldebtat this stage.Note that, if theseare

includedin[B.2],thenthedefinitionof savings(S)isnationalsavingsandthatof output(Y)isGNP.

Thecurrentaccount(CAB)andthecapitalaccount(KAB)areoppositeandequal.Thus

iDM X CAB [B.3]

andthecapitalaccountis

R D KAB [B.4]

sothat

0

KABCAB [B.5]




68

Note that private capital flows (and the corresponding factor payments) can be inserted into this

accounting framework very simply. Foreign private assets (A) include portfolio holdings overseas

(sometimesmisleadinglycalled“capital flight”)andFDIabroadbydomesticcompanies.Foreignprivate

liabilities(L)includebothforeignborrowingbydomesticfirmsandinwardFDI.Thefullcapitalaccountcan

thusbewritten46

}{ A R L D KAB [B.4a]

However,intherestof thispaperweshallassumethattheGovernmentistheonlyexternaldebtor –not

leastbecausethe“externaldebt”statisticsreflectpublicsectorandpubliclyguaranteedexternaldebt.

Inthisframeworkweassumethatthefiscalbalanceisclosedonlybyforeignborrowing –thusexcluding

monetaryissue(“seignorage”)anddomesticborrowingfromconsideration:

iDG DT [B.6]

Last,butfarfromleast,wehavethelawof motionfortheexternaldebtitself (D)intermsof itsprevious

periodvalue(D1),andnewborrowing(D)andthedepreciationrate()inthefollowingtwoalternative

forms:

11

11

D D D D

D D D D

[B.7]

2. “FinancingGap”Modelsof DebtandGrowth

In the contextof work ondevelopment strategies from the 1960s through the 1980s “financing gap”

modelsprovidedthebasicanalyticalframeworkforbothlendersandborrowers.47Inthesemodels,

48the

objectiveof theplanneristomaximizetherateof outputgrowth(y)subjecttotheconstraintsimposedby

domestic savings (i.e. the capacity to invest), the external sector (i.e. the capacity to import)or fiscal

balances(i.e.thecapacitytospend).

The savings constraint exists because available funds are determined by the domestic economy’s

propensitytosave(s)andtheinflowof externalfinance(F),whichinturndeterminesthemaximumlevel

of investment(I)thatcanbeundertakenandthustherateof growth(y).

The external constraint exists because the level of imports (M) cannot exceed the foreign exchangeavailable fromexports (X)and capital inflows (F).Exportsareassumed fixed in the short term,due to

capacityconstraintsand/orlimitedexternalmarkets.Theavailabilityof importsdeterminesthemaximum

levelof output(Y)foragivenimportpropensity(m).

The fiscalconstraintexistsbecausegrowthdependsonpublic investment (eitherbecause itconstitutes

the bulk of investment, as in poor countries, or because it is essential in order to promote private

investment,asinmiddleincomecountries).Publicinvestmentisassumedtobeaconstantproportion(p)

of totalinvestment.Publicinvestment,andthusgrowth,isconstrainedbybudgetarybalance(Z).

46Acompletecurrentaccountidentitywouldincludeprivateinflowsandoutflowsof factorincome

47Avramovicandothers(1964)isagoodsurveyof thetraditionalmethodologyforanalysingtherelationshipbetweendebtand

growth.48There isa large literatureonthesemodels,whichoriginateswiththeHarrodDomargrowthmodelof thesavingsconstraint,

andcontinueswithChenery&Strout(1955),whomodeledtheexternalconstraint.Thismodelwasthenextendedtoincludealso

thefiscalconstraint.Goodformalexpositionsof allthree‘gapmodels’aregivenbyBacha(1990)andTaylor(1994).




69

Inconsequenceof theseassumptionsexternalfinance(F)actsasasourceof “externalsaving”,tofillthe

gapbetweendomesticsavingsandtotalinvestment,actingasaformof “importsupport”andasasource

of fiscalrevenue.ThroughthesechannelsFaffectsboththelevelof investmentandtherateof growthof

GDP.Thismodelstillinformsmostof theempiricalpolicydebateaboutaid,debtandforeigninvestment.

Theplanningproblemisthustomaximizeywhere

t t t

t t t t

t 2t 1t

t t t

t 1-t t

t t

pI Y t g Z

Di D D F

I m+Y m=M

Y g t Y s=S

I + K = K

K k =Y

)(

)(

)(

11

[B.8]

subjecttothethreeconstraints

t t

t t t

t t t

F Z

F + X M

F +S I

[B.9]

(wheretistaxrevenueandggovernmentexpenditureasaproportionGDP).

Theoutcomedependsonwhichof thethreeconstraintsactuallybindsatanyonepointintime,whichis

anempiricalissue.

Thesavingsconstrainedmaximumgrowthrate(*

s y)canbederivedas:

Y

F g t sk y s )(*

[B.10]

The main concern of aidrelated policy modeling in most developing countries is the externally

constrainedmaximumrateof growth(*

e y),whichcanbederivedas:

1* mY

F X

m

k = y

2

e

[B.11]

Finally,thefiscallyconstrainedrateof growth(*

f y)canbederivedas

)(* g t

Y

F

p

k = y f

[B.12]

Allthreegrowthratesareof course increase inresponsetonetdebtinflows(i.e. 0/ F y ),butwith

differentderivatives.Whichbindsdependsonthecharacterof theeconomy.Generallyitisreasonabletoassumethatinthepooresteconomiesthesavingsconstraintisbinding,andthatexternalandfinallyfiscal




70

become binding as economic development advances. The effect of net debt flows is likely to be

progressivelygreaterineachof thesethreestagesbecausegenerally

F

y

F

y

F

y

m p

se f

***

2 1

[B.13]

3. TheLimitationsof “FinancingGap”Models

The “financing gap” model continues to form the basis for the trade, aid and growth linkages in the

mediumtermmacroeconomicprogrammingmodelusedbytheWorldBank:theRevisedMacroeconomic

StandardModel(RMSM).49Italsoinformstheshorttermmonetaryprogrammingframeworkusedbythe

IMF.50Thesetwomodelsstillformtheessentialanalyticalunderpinningforthemissionreportsof thetwo

BrettonWoodsinstitutionsonstabilizationandadjustmentprograms.51TheUNDPmakesestimatesof the

externalfinancingrequirementsof poorcountriesonasimilarbasiswhenpreparingformeetingsof donor

consortia.

However,thelastdecadehaswitnessedgrowingawarenessof thelimitationsof thesemodels,whichno

longercorrespondeithertomodernmacroeconomictheoryortomacroeconomicpolicypracticeinopen

economies. Indeed fromaneoclassicalviewpointthisanalyticaltradition isregardedas invalidatingthe

proposals from the Bank and the Fund on additional lending and debt forgiveness.52However, their

persistenceisdoubtlessdueinlargeparttotheiranalyticalsimplicityandthefactthattheparameterscan

beestimatedeasilyandquicklyfromavailablemacroeconomicdataindevelopingcountries.

Withoutgoingsofarastoreject“financinggap”models,itispossibletoidentifyfourareasof weaknesswhichneedtoberemediedinordertoproduceasounderconceptualframeworkandanalyticalmodelfor

quantifyingdebtsustainability.Theseare:

First,thecoefficientsinthebehavioralequations(particularlytheconstraints)areassumedtobe

stable andexogenous, rather thanendogenouslydetermined. In the caseof savings,empirical

evidence and Keynesian theory suggest that domestic saving (and thus consumption) in fact

adjuststothe levelof fixed investmentandforeign inflowsof capital.53Again,thefiscalbalance

canalwaysbeadjustedbyvaryinggovernmentexpenditure.

Second,intheexternalbalanceof trade,exportsareassumedtobegivenandimportstodepend

onlyonthe levelof economicactivity.This ignorestheeffectof therealexchangerateonboth

importandexportvolumes,and thus thepossibilityof adjusting to foreignexchangeshortageswithouthaving to reducegrowth.54Italsounderplays the roleof exchangerates indetermining

thefiscalbalance.

Third,“financinggap”modelsassumethatextraexternalfinancealwayscontributestogrowth,by

simply and directly adding to savings, import capacity or fiscal resources and thus allowing

investment –andthusgrowth –torise.However,itisestablishedthatexternalresourcesoftenin

49SeetheAddison(1989)andhttp://www.worldbank.org/data/rmsm/index.htmforanupdatedversionof thispaperplusother

RMSMdocuments.50See IMF (1987),which in turnderives fromPolack (1957).SeealsoBaquirandothers (2003) for thegrowth linkages in IMF

models.51SeeAghenorandMontiel (2003) fora recentsurvey,andKhanandothers (1990) fora formalstatementof therelationship

betweenthetwomodels.52SeeEasterly(1999).

53SeeFitzGerald(2003a).

54SeeDornbusch&Helmers(1988).




71

practice leadto increasedconsumption.55Moreoverthe investmentundertakenmaynot leadto

increasedexportsandthusdebtrepaymentcapacity.

Fourth,andmostseriouslyfromananalyticalviewpoint,the“financinggap”modeldoesnotallow

for intertemporaloptimizationbyeconomicagents: that is, the fact thathouseholds, firmsandGovernmentstakeinvestment,savingandborrowingdecisionslookingforwardovermanyyears.

Theassumptionof intertemporaloptimizationisthebasisof modernmacroeconomicsingeneral

and for small open economies in particular; and allows resource allocation behavior to be

endogenized.56

C. SustainableDebtLevels

1. TheOptimalDebtLevel,ExportCapacityandIntertemporalMaximization

The contemporary approach to debt sustainability starts from the same foundation as the modernmacroeconomictheoryof openeconomies,whereapparentbalanceof paymentsdisequilibriaintheshort

run canbe seenaspartof an intertemporalequilibriumbaseduponexpectationsbyeconomicactors

about the future. The small open economy is composed of overlapping generations of households

optimizingconsumptionandsavingovertimeandof firmsmaking investmentdecisionsbasedonprofit

maximization.57Currentaccountsurpluses(ordeficits)generatenetasset(or liability)positionswiththe

restof theworld,whichinturnaffectthefuturebehaviorof firmsandhouseholds.

If there isfreeaccessto international financialmarketsatagiven interestrate(i)andno issuessuchas

debtdefault,thenthecountryobeystheFisherianmaximandseparatesthedecisionto investfromthe

decisiontoconsume.58Focusinghereonthedecisiontoinvest,firmschoosetheirinvestmentstrategyso

as to maximize the wealth of their shareholders when measured at world interest rates. Theintertemporalequilibriumstrategy

59amountstoselectinganinvestmentrate(k*)thatisasolutionto

t t

t t t

t t

t t k

Q I k

K I K

K QQ

dt J Qit

/

)(

))(exp(max0

[C.1]

whereQ isthelevelof netoutput,Jthecostof installingnewcapital,Kthecapitalstockandtherateof depreciation.

Inorderto findatractablesolution tothisgeneralproblem,wehavetospecifytherelevant functional

forms.Westartoff bydefiningnationalincome(W)asoutputminusdebtinterestcosts,wheredebtalso

playsaroleincapitalformation,suchthat

55AtleastsinceGriffin(1970).

56SeeObstfeld&Rogoff (1995)andSen(1994).

57Thisisnowastandardformulation:seeforinstanceObstfeld&Rogoff (1995).58Thesavingsratedependsonthesocialratediscountfactorandtheintertemporalelasticityof substitutionof consumption,on

theonehand,andthe(world)interestrate,ontheother.SeeSen(1994).59SeeCohen(1994)forthederivation.




72

0)(''

0)('

DW

DW

iDY W

[C.2]

inorderthatamaximumshouldexist.60Thisformulation isalsoconvenientbecausethetwoconstraints

reflectdecliningabsorptioncapacityanddebtoverhangeffectsrespectively.Undertheseconditions,the

optimaldebtlevelwillbedefinedbytheconditionformaximizingWwithrespecttoD:

0)(

D

i Di

D

Y

D

W

[C.3]

Inotherwords,debtshouldbecontracteduptothepointwherethemarginaladditiontooutputequals

themarginaladditiontointerestcosts.Ceteris paribus,thehighertheinterestrate,thelowertheresultingoptimaldebtlevel;andthelargerthepositiveimpactof thatdebtonoutput,thehighertheoptimaldebt

level.

Tofindtheoptimaldebtlevel,westartwithastandard61endogenousgrowthproductionfunctionof the

form

aK Y [C.4]

Leavingasidethelasttermin[C.3]andthusassumingthattheinterestrateisunaffectedbythedebtlevel,

wehavethefollowingmaximizationcondition:

a

i

D

K

i D

K

K

Y i

D

Y

D

W

0

[C.5]

Thekeyissueisthusshowntobetheeffectof debtoninvestment.Weshallexaminetheparticularcase

where the domestically funded capital (K1) is already installed, there is no previous debt, and the

authoritiescontemplatemoving inoneperiodtotheoptimaldebt level,byprovidingextracapitalstock

(K2)fundedbyexternaldebt

21 K K K [C.6]

Externaldebt(D)isthencontracted.Afixedproportion()of thisisusedtofundtheinstallationof new

productivecapital(directlyasinruralinfrastructure,orindirectlyasloanstoexporters),whiletherestis

allocatedtootheractivitiessuchassocial investments(healthetc),coverageof currentaccountdeficits,

ornoneconomicinfrastructure.Thecostof thisproductivepublicinvestment(J)isaquadraticfunctionof

theinvestmentrate:62

60Otherwisetheoptimaldebtlevelwouldbeinfinite,of course.61SeeRebelo(1991)forthebasisof the‘AK’modelusedhere,andAghion&Howitt(1999)foracomprehensivesurveyof modern

endogenousgrowththeory.62SeeHeijdraandvanderPloeg(2002:40)andalsoCohen(1994:490).




73

1

2

2 21 K

K

K J

J D

[C.7]

With>I

Sowecannowspecifytheobjectivefunction[C.2]as

1

2221

21)(

K

K K

i K K aW

[C.8]

anddifferentiatingwithrespecttoK2yieldstheoptimalsolution intermsof theratio()betweendebt

fundedcapitaland“domesticallyfunded”capital:

11ˆ

01

1

2

1

2

2

i

a

K

K

K

K ia

K

W

[C.9]

Notethattheoptimalcapitalstructurecoefficient()canbenegative –whichwouldimplyaccumulation

of foreignassetsinsteadof borrowingabroad.

Wefindtheoptimaldebttooutputratio(),bysubstituting[C.9]into[C.7]and[C.4]:

)1(

)1(

ˆ

ˆ

)1()ˆ(ˆ

1ˆ

1ˆ

ˆ

121

1

1

22

aY

D

aK K K aY

K K

K K D

[C.10]

Clearly isincreasingin,andthusby[C.9]theoptimaldebtoutputratiowillbeloweredbyanincrease

intheinterestrate(i)(asweshouldexpect),butwillbeloweredbyanincreaseintheproportionof debtfundsallocatedtoproductiveinvestment()orintheoverallproductivityof capital(a).Thisresultcanbe

generalizedtoasteadystategrowthsituationbecauseinsuchasituationY/Kisconstant(andthusboth

componentsof capitalgrowat theoutputgrowth rate),and thusD/Ymustbeconstant. If theoptimal

debtlevel()ishigher,thendebtcanbesafelyraised.

Overall capitalproductivity requires some further comment in the contextof this study.Weassume a

simplifiedformof theexternallyconstrainedeconomydiscussedintheprevioussectionsuchthat:

K X

X M

mY M

[C.11]




74

whereexportsareafunctionof theproportion()of thecapitalstock located intheexportsectorwith

knownproductivity().If itisassumedthatthesecondconstraintof [C.11],i.e.thatM=X,substitutionof

thefirstexpressionof [C.11]into[C.4]andtheresultintothethirdexpressionof [C.11]gives

11ˆ

1

2

im K

K

ma

[C.9a]

Inotherwords,theoptimaldebtlevelriseswiththeproportionof debtfundedcapitalstockallocatedto

theexportsector.However,itfallswithanincreaseininterestratesortheimportcoefficient.Toputthis

anotherway:longrundebt solvency – and thustheavoidanceof debt crisesarising fromtradeor capital

market shocks– requirestheallocationof ahigher proportionof the fundsraised not only to productive

investment but alsotoinvestment intheexport sector.

Finally,wecanalsodefinetheoptimaldebtserviceratio()fromthisresult,where

X

Di

ˆ

ˆ)(

[C.12]

bysubstituting[C.10]and[C.11]into[C.12]toyield:

ai

X

Y

Y

Di )(

ˆ

ˆ

ˆ

ˆ)(

[C.13]

The optimal debt service ratio () will decrease with a higher interest rate (i) because its negative

influenceontheoptimaldebtoutputratio()outweighsthatof theexplicititermin[C.13].

2. The“GoldenRules”forDebtSustainability

The “lawof motion” for externaldebt from theprevious section (equation [B.7]) canbe expressed in

termsof theprimary63currentaccountbalance(P)ontheassumptionthatthisdebt istheonlyformof

externalfinance:

11)1( t t t P Di D [C.14]

whichthroughrepeatedsubstitutionyields

1

0 )1()1(

t

t t

t

t

t

i

P

i

D

+D0 [C.15].

Whenngoestoinfinity,thepresentvalueof debt(i.e.thelefthandsideof theequation)goestozeroand

weretrievetheintertemporalbalanceof paymentsconstraint

63Thatis,excludinginterestpayments.




75

0

0)1(t

t

t

i

P D

[C.16]

Inotherwords,alldebtmusteventually bepaidback.

However, in practice, developing country financial authorities and debt managers have to work on a

shortertimescaleandwithouttheluxuryof searchingforoptimalsolutions.Theceilingon“prudent”debt

is conventionally expressed as a share of output or as a ratio of debt service to exports, the former

reflectinglongertermsolvencyconsiderationsandthelattershortertermliquidityones.

Oncetheprudentialceiling(d)onthedebtoutputratiohasbeenreached,debtmanagementstrategyis

logicallynottoexceedit.Thusthe“goldenrule”isthat

d

Y

D

Y

D

t

t

t

t

1

1

[C.17]

Foragivenrateof outputgrowth(y)andexpressingtheprimarydeficitasaratio(p)of outputwehave

pd y

id

Y

P

Y y

Di

Y y

P Di

Y

Dd

t

t

t

t

t

t t

t

t

1

1

)1(

)1(

)1(

)1(

1

1

1

1

[C.18]

sothatthe“goldenrule”forthedebtoutputratiois

d yi y

id p )(1

1

1

[C.19]

Inotherwords,aprimarydeficit (p<0)canonlybesafely incurred if thegrowthrate ishigherthan the

interestrate(y>i).

If weexpresstheruleintermsof thecurrentaccountbalanceproper,asaproportion(c)of outputthen

thegoldenrulebecomes

yd cid pc

[C.20]

In other words, themaximum current account deficit as a proportion of GDP is the rate of growth

multiplied by the prudent debt GDPratio.

We can now turn to the second “golden rule” related to the ratio of debt service to exports. The

derivationisverysimilartothatforthefirstrule,butexpressedintermsof thesecondceiling():

Oncetheprudentialceiling(d)ondebtinrelationtooutputratiohasbeenreached,thenextrequirement

of debtmanagementstrategy is thatservicepaymentsontheresultingDt in relation toexportsshould

notexceed.Thusthe“goldenrule”isthat




76

1

1)()(

t

t

t

t

X

Di

X

Di

[C.21]

Foragivenrateof exportgrowth(x)andexpressingtheprimarydeficitasaratio(p’)of exportswehave

pi x

i

X

P i

X

Di

x

i

X x

P Dii

X

Di

t

t

t

t

t

t t

t

t

)(1

1

)()(

1

1

)1(

})1){(()(

1

1

1

1

[C.22]

sothatthe“goldenrule”forthedebtserviceratiois

i

xi

x

i

i p 1

1

1

[C.23]

Inotherwords,andmoregenerallythataprimarydeficit(p’<0)canonlybesafely incurred if theexport

growthrate ishigherthanthe interestrate (x>i). If weexpressthesecondrule intermsof thecurrent

accountbalanceproper,asaproportion(c’)of exports

i

xc

i pc

[C.24]

3. ConvergenceandExpectations

Policymakerswithresponsibilityfordebtattempttoadoptatleastamediumtermview,andwhentheir

debtlevelsareabovetheprudentlimits,thena“convergence”strategymustbeadoptedinordertoreach

theselimitswithinareasonablenumberof years.Supposethatwewishtoreachtotheprudentiallimit(d)

of the debtGDP level over a number of years from the present level (d’) by reducing the debt by a

proportionueachyearovernyears,then

n

d d d u

/1

[C.25].

Thefirstgoldenruleisthenreexpressedas:

d yuc

d yui p

)(~)(~

[C.26]

Whethernewdebtissustainabledepends,therefore,onexpectationsaboutthefuturegrowthof output

andof thedeterminantsof thebalanceof tradeandof thecurrentaccount,namelyexportgrowthand

future interest ratesand termsof trade.Aswehaveseen, thedebt level itself willaffectgrowth inanoptimalsolutionsothattheusetowhichthedebtistobeput,andthusfutureproductivity,arealsopart

of the solution. Debtors and creditors should have agreed on these forecasts before signing a debt




77

contract.Forinstance,if weexpecttherateof changeof thetermsof trade(h)tohaveaprojectedvalue

inthefuture,thenthisisdistinguishedfromexportvolumegrowth( x )sothat[C.24]isrewrittenas

i

xhc

[C.24a]

Foradebt contract tobeagreeduponbydebtorand creditor,bothmustagreeonprojectionsof key

parameters;or if theydisagree,at least theoveralloutcomemustbeanticipatedasprofitable toboth

sides..Butasexemplifiedbythedebtcrisesof theearly1980sandof themiddle1990sandbythepresent

plightof theHIPCs,eventsdonotalwaysturnoutasexpected.Expectationsonbothsidesarethuscrucial

tothelending/borrowingdecision –therecanbeno“over borrowing” without “over lending”.

D. FiscalConsequencesof ExternalDebt

Analytical frameworks suchas thosedeveloped in sectionsBandC canbeusedexplore theeffectsof

policy towardsexternaldebt.One important issueunderthisheading isthe relationbetweendebtand

fiscalpolicy.Heretheanalysisstartsfromanadjustedversionof equation(B.6)inwhichtaxrevenueand

foreignfinancingconstrainfeasiblelevelsof governmentexpenditureandservicespayments(interestand

amortization)onexternaldebtasfollows:

F T DiG )( [D.9]

Thusanincreasedgrossdebtflow(F)allowsafiscalexpansion(i.e.Gtorise).However,accumulateddebt

itself generateslargebudgetaryitemswhichinsomecasesbecomethelargestsingleitemof government

expenditure,crowdingoutotherexpenditurecategories.64

Thisconstraintcanbeelaboratedandsimplifiedtotakeaccountof additionalassumptions:

Sinceexternaldebtisdenominatedinforeigncurrencyandtherestof theGovernment’sbudget

indomesticcurrency,thedebttermismultipliedbytherealexchangerate(e=(Epf/)/pd);

Debtamortizationflowsarenettedout:,

A strict budgetary rule is observed that only allows a maximum fiscal deficit (q) in domestic

currencytobefinancedfromseignorageand/ordomesticborrowing;

Theprudentdebtoutputratio(d)ismaintained;

Taxrevenueisagivenshare(t)of nationalincome

(D.9)isthenrewrittenas:

Y deY qt ieDG )( [D.10]

Diving through by Y and rearranging, we then obtain the constraint on the share (g) of government

expenditureinnationalincomeintermsof thefamiliardebtparameters(d,i)andtherateof growth(y)of

output:

d i yeq g )()( [D.11]

Absenta serious tax reform ()oramore relaxedmonetarystance (q), thegovernmentexpenditure

share (g) in national income is highly dependent on the debt parameters, on the one hand, and the64Foralldevelopingcountriesin2003,theaverageratioof externaldebtservicetoGDPwas6percent.Theaverageratioof tax

revenuetoGDP(t )was15percentandof publichealthexpendituretoGDPwas3percent(WorldBank,2005a).




78

growth rate (y)and the realexchange rate (e),on theother, bothof whichvariablesare themselves

stronglyaffectedbythedebtstrategy.Inparticular,anincreaseineconsequentupondevaluationwhen

therateof outputgrowthislow(i.e.y<i) –acommonoccurrenceduringdebtcriseswillhaveastrongly

negativeimpactonthefiscalconstraintandthusongovernmentexpenditure.

This subordination of government expenditure as illustrated by the fiscal constraint [D.11] to debt

managementhasatleastthreemajorconsequences:

(a) It isdifficult togivepriority to increasingsocialprovision ingeneral (andpoverty reduction in

particular)byexpandingrealhealthandeducationexpenditurefasterthanpopulationgrowth;

(b) Itisnotpossibletoengageinanactivecountercyclicalfiscalpolicyinordertoreducetheimpact

of exogenous shocks on investment and growth, for example, by expanding infrastructure

expendituretomaintaincapacityutilization;

(c) Longtermplanningof publicexpenditureisrenderedmeaningless,withnegativeeffectsforthe

efficiencyof publicservices, infrastructureprovisionandtheutilizationof scarceadministrative

skills.

E. DebtVulnerabilityandExternalShocks

1. Determinantsof DebtFlows

Sofarwehavebeenworkingontheassumptionthatdevelopingcountriescanchoosethelevel(D)of debt

thattheycontractatagiveninterestrate(i).Thisistheconventionalassumptionineconomicanalysisas

well as in policy debates when reference is made to “overborrowing”. In fact, however, lenders

determinethevolumeof changesindebtandthe interestrate isnotgiven.Internationaldebtflowsaresubjecttoaformof creditrationing.

Official lending (that is by bilateral donors or multilateral organizations) is always determined by the

lenderon itsowncriteria,althoughtheseshould inprinciplesupportsustainabledevelopmentandthus

coincidewiththoseof theborrower.However,theborrowerdoesnotdecidethedebt level.Ratherthe

overallvolumeof officiallendingisdeterminedbytheinstitutionalstrategyof thelender.Withinthetotal

regionalandcountryallocations lendingdependsuponboth the technicalappreciationof development

prospectsandthusthesustainabilityof debt;ontheonehand,andthegeopoliticalpressuresof donor

Governments,ontheother.

Givenaceilingof officiallendingfromdonorsinanyoneperiod,developingcountryGovernmentstendto

contractdebtuptothislimit.Itisinthissensethat“creditrationing”existsforthiscategoryof lending.It

is extremely rare fordeveloping countries –particularly small lowincome countrieswithout access to

privatecapitalmarkets –toturndownofficiallendingproposals.Theinterestrateandmaturityof official

debtisalsosetbythelender,usuallyonasubsidizedbasis.Eligibilityisdecidedbythedonor.

Ininternationaldebtmarketsforbothbondsandbankloanstothegreatmajorityof developingcountry

Governments (“sovereigns”) another form of credit rationing obtains. This reflects the influence of

uncertainty in the loanmarketcreateswhichcausesadverse selection,as the two sideshavedifferent

perceptionsof riskand lenderscannotdistinguishbetweenborrowersastotheirabilitytorepay inthe

future.Italsoreflectsthelowertoleranceof riskonthepartof OECDinvestorsinforeignthanintheirown

markets,asituationwhichleadstoaninefficientallocationof theirportfoliosknownas“homebias”.65

65SeeFitzGerald&Babilis(2005).




79

Consider the initially upwardsloping supply schedule of bank loans or bond purchases in Figure IV.1.

below.Thisshowsthereturnspread,r(theexcessof theriskyovertherisklessrate,thelatterbeingthe

rateof interestongovernmentbonds,alongtheordinateandthevolumeof lendingalongtheabscissa.

The competitive international banking market is made up of many noncollusive bank lenders and

borrowers. Banks are pricetakers in deposit markets but set lending rates (i.e. spreads) to maximize

expectedreturns.Higher lendingrateshaveanadverseselectioneffectsonborrowersby increasingthe

perceivedrisksof lending.Theseinturnthusincreaseactualdefaultriskowingtotheincreasedburdenof

interestpaymentsandtheenhancedincentivetodefaultduetoriseswithdebtandinterestrates.Beyond

acertainpoint thedebtsupplyschedulewillbebackwardsloping.Banks’unwillingness todifferentiate

betweendifferentriskreflectstheir imperfect informationonfundamentals(e.g.defaultrisk)aswellas

theirfearof covariantriskbetweenborrowers(contagion).

Thedemandschedule(Dd)infigureIV.1.fordebtisthebackwardslopingcurveforthesupplyof capital.

Competitive lendersmaximizetheirdebtholdingsatthepoint(Dd,r*):atthisprice(i.e.returnspread)

thepotentialsupplyof capitalordemand fordebtassets fromdevelopingcountries (Ds) is inexcessof

demand forcapitalor thesupplyof assets (Dd)– inotherwords,thewillingnesstoborrowexceedsthewillingnesstolend.

*)(*)( r Dr D D sd [E.1]

Themarket interest rate in foreign currency (if) to emergingmarket borrowers is determinedby two

elements, the risklessworld rate (iw)and the riskpremium (r).The riskpremium is theproductof the

perceived66probability of default () and an appropriate of investors’ degree of risk aversion (A).67

PerceiveddefaultriskdependsuponindicatorsdiscussedinsectionC.BsuchasthedebtGDPratio(d)and

thedebtserviceratio().68

66Theperceptionisthatof lenderstypicallyinfluencedbycreditratingsagencies.

67Thus the riskpremium isonlyequal to theunderlyingdefault risk if the financialmarket is strictly riskneutraland there is

perfectinformation;sothatyieldspreadsshouldnot generallybeinterpretedasmeasuresof ‘countryrisk’ –seeCunninghamand

others(2001).68Aswellascruderliquiditymeasuressuchasthe‘quickratio’mentionedinSectionF.1.

FigureIV.1.CreditRationinginGlobalDebtMarkets




80

Thuswehave:

),(

d Ar

r ii w f

[E.2]

Clearly an increase in d or default risk (which is why the loan supply curve eventually

becomesbackwardsloping)andthusnotonlyraisesinterestcostsbutalsoreducesloanavailability.Note

that theriskpremium (r)dependson forecastsof debtdefaultprobability,andthusonexpectationsof

exportandoutputgrowth,ontheonehand,andontherisktoleranceof investors,ontheother.

2. CapitalMarketShocks

Oneshockisanincreaseinratesof interestinacountrywithamajorfinancialmarket.Thisshockaffectsinterestratespaidbydevelopingcountrysovereignborrowers(if)intwowaysasEquation[V.2]indicates:

firstly,bysimplyraising)theriskfreerate(iw),and,secondly,byraisingtheriskpremium(r)owingtothe

increaseinthedebtserviceratio().

However, another more commonly observed market shock results from shifts in the demand for

emergingmarketdebtduetochangeswithindevelopedcountrymarkets –suchaschangesinregulations,

fluctuations inriskaversionamongst lendersandinvestors,orcontagionfromotherdebtors.These lead

to“horizontal”downwardshiftsintheassetdemandcurveinFigureIV.1.

The macroeconomic and distributional consequences for emerging markets can be disproportionately

large.69This results froma fundamentalasymmetry in internationalcapitalmarkets:whilecapital flows

arerelativelysmall inrelationtothehomeeconomiesof lendersand investors,theyaremuch larger in

relation to host markets. The effect of the shocks is exacerbated by hysteresis:70owing to the

irreversibilityof investmentandwagepricestickiness,adownswingdoesnot leadtheeconomybackto

whereitwasbeforetheupswing.Fluctuationsintherealexchangerateassociatedwithshorttermcapital

flowsalsoleadfirmstomisallocateinvestmentbetweenthetradedandnontradedsectors,withnegative

consequencesforgrowth.71

Another potentially serious negative effect of debt shocks on growth is not felt directly through the

balanceof paymentsbutratherthroughtheeffecton investoruncertaintyaboutfuturemacroeconomic

conditions72andpolicychanges

73whenthedebt levelexceedstheprudential limit,apositioncommonly

knownas“debtoverhang”.Butthisriskcanbereducedbygovernmentaction.Even if theGovernment

cannotcrediblyprecommittorepaydebt,investingingrowthbeforeborrowingcanmakeforeignlendersaswellasdomesticinvestorsmoreoptimisticaboutgrowthprospects.

3. GlobalTradeShocks

Globaltradeshockscantakevariousformswhichinclude:

69SeeFitzGerald (2001). Interestingly, thiswas theposition takenby the IMF in the1998World EconomicOutlook (‘Financial

Crises:Characteristicsand Indicatorsof Vulnerability’).However,by2005theWorld EconomicOutlook hadbecomemuchmore

sanguine,attributingmostof emergingmarketvolatilitytodomesticfundamentals.70Amodelof thisprocess is setout inChapter6of FitzGerald (2003).On themacroeconomic theoryof hysterisis andpath

dependencyseeHeijdra&vanderPloeg(2002),Chapter2.2andAppendixA.6.4.71SeeFitzGerald&Perosino(1999).

72SeeFitzGerald,Jansen&Vos(1994).

73SeeRodrick(1991).




81

Suddenmovements inexportprices,particularlyforprimarycommodities,duetodemandshifts

indevelopedcountriesorsupplychangesbyotherproducers;

Unexpectedshiftsinimportprices,particularlythoseforessentialcommoditiessuchasoil;and

Thelossof accessforexporterstoparticulardevelopedcountrymarketsduetochangesintrade

barriersordomestic(e.g.health)regulations.

Theseshocksobviouslyhaveaneffectonthedebtserviceexportratiobychangingthedenominator:for

example,asuddenfallinprimarycommoditypriceswillraisethisratio,eventhoughdebtserviceitself has

notchanged,andcan renderapreviouslysustainabledebtunsustainable.Secondordereffectsdepend

uponwhatpolicyresponsetheauthoritiestake.Insummarytheyhavefouroptions:

Incurringmoredebt inorder tosustain import levelsand maintainthe level of economicactivity.

Thisislikelytoappreciatetherealexchangerate(oratleastpreventitfromdepreciating)andto

preventanincreaseinexports.Theresultisafurtherriseinthedebtserviceratiothroughlower

exportsinadditiontothehigherdebt.

Maintainingthedebt level and allowingthecurrency todepreciateinorder toimprovethecurrent

account balanceand stimulateexports.Inthiscaseexportsdonotfallandthedebtserviceratio

does not increase. However, owing to the increased burden of servicing the external debt in

domesticcurrencythefiscalbalanceisworsenedwithconsequentcutsinsocialexpenditurecuts.

Moreovertheincomedistributionworsenswithdecliningrealwagesandinflation.

Maintaining thedebt level and stabilizing the real exchange rate.This is likely tobeassociated

with cutting the level of economic activity in order to depress imports, prevent inflation and

balancethecurrentaccount.

Any oneof theabove policiescombined witha reallocationof debt funds toexportswithgood

marketssoastomaintainexportgrowthandthusreducethedebtserviceratio.

Which policy option is adopted determines the impact of a trade shock on debt sustainability. The

domestic policy choice between exchange rate shifts and demand management depends on local

economic structures and political processes, as well as pressures from creditors or international

institutions.The “golden rule” in this context iswell known: “treatnegative shocks aspermanent and

positiveshocksastemporary”.Itisclearlybettertoreducedebtinresponsetoimprovedtradeconditions

thantoincreaseitwhentheydeteriorate.Nonetheless,developingcountryGovernmentsfrequentlydo

theexactopposite: increasingdebtduringdownswingsandnotreducing itagain inupswings.Moreover

the tendency to apply public external debt to nontraded sectors (which is often encouraged by the

internationalinstitutions)reducestheabilitytocopewithtradeshocks.

F. Conclusions:PrinciplesforDebtManagementinDevelopmentStrategies

1. TheParametersof DebtPolicy

Themain indicatorsunderlyingprudentdebtmanagementareshown inTableIV.5.It isclearthatthose

economies with unsustainable debt (i.e. the UDCs which were in arrears and/or undertook debt

reschedulingduringthe19972001period)stillhaveveryhighdebtGDPratiosclosetotheconventional

upperboundof 60percent.Thisceilingisderivedfromexperienceof countrieswhichgetintomajordebt




82

difficultiesandisinfactconsiderablylowerthanthatsetbytheWorldBank74inthecontextof theHIPC

initiative.

ThoseUDCswhichdependonprivatecreditorsaremainlyinLatinAmerica:theirdebtserviceratiosand

interestpayments as aproportionof debt arehigherand the averagematurity shorter than forothercountriesintheregion.TheLatinAmericanUDCsaretypicallysufferingfromaliquidityproblem,reflected

in the fact that the ratioof reserves to shorttermobligations (or “quick ratio”as it isknownbydebt

traders) is lessthanunity,makingthemsusceptibletospeculativeattack.TheAfricanHIPCs incontrast,

appear tobe insolvent rather than illiquid: their inability to repayprinciple results invery long implicit

maturities(i.e.yearsrequiredtopayoff debtatpresentratesof amortization). Inmarkedcontrast,Asia

appearstobebothsolventandliquid.

TableIV.5.Indicatorsof DebtVulnerability,2003

Total

of

which:

Developing

Asia

LatinAmerica

andCaribbeanAfrica UDC HIPC

ExternalDebt(per cent of GDP) 38.1 25.4 43.9 49.9 63.2 86.9

DebtService(per cent of exports) 17.9 11.1 45.8 13.1 29.2 10.2

InterestPayments(per cent

of debt)

3.9 3.6 5.4 2.8 3.3 1.1

Implicitmaturity(years) 8.2 8.6 5.7 16.1 9.4 48.7

LiquidityRatio 1.73 3.16 0.74 2.04 1.14 2.86

Source:Author’scalculationsbasedonIMF(May2005).

Notes: “UDC” are Unsustainable Debt Countries’ with arrears and/or rescheduling during 19972001; HIPC are “highly

indebtedpoorcountries”underconsiderationbytheWorldBankandIMFfordebtcancellation;interestpayments

divided by debt outstanding should be comparedwith longterm average interest rates in advanced economies

averaging 5 percent in this period; “implicit maturity” is outstanding debt divided by amortization payments;

“liquidity ratio” is the ratio of reserves to payments in the form of interest and principle on short term debt

principleplusservicepaymentsonlongtermdebt.

Nonetheless,asTable IV.6.shows,sustainabilityasmeasuredbyall indicatorsand foralldebtorclasses

clearlyimprovedbetween1996and2003.Thisappearstobeduetoexportgrowthandcontrolof imports

(whichallowedcurrentaccountbalancestomove intosurplus inmanycountries,especially inAsiaand

LatinAmerica)ratherthantosignificantreductionsindebtlevels.Indeed,allregionsappeartoberunningcurrentaccountdeficits thatare lessor surpluseswhichare larger than indicatedby theprudent rules

showninthetable.

Theseindicatorspointtotheeffectsof creditrationingonthepartof creditorsandstabilizationeffortson

thepartof debtors.Theysuggestthatthereisroomtoinitiateanewcycleof increaseddebtlevelssolong

asitisaccompaniedbyprudentmacroeconomicpolicy.

74See World Bank (2004). ‘Moderately indebted’ countries are those with a ratio of the present value of contracted debt

payments (PV)toGNPof over132percentandof PVtoexportsof goodsandservices (XGS)of over48percent,while ‘highly

indebted’countrieshavePV/GNPof over220percentandPV/XGSof over80percent.Noexplanationisgivenforhowtheseexact

figuresarederived.These ratiosarealsodifficult tocomparewith the IMFdataused in thispaperbecause the ratioof PV to

nominaldebtdependsonthetermsof thedebtitself.




83

TableIV.6.ChangesinDebtSustainability19962003

Totalof

which:

Developing

Asia

Latin

America

and

Caribbean

Africa UDC HIPC

ExternalDebt(per cent of GDP)

1996 37.8 31.2 35.0 69.0 51.0 126.9

2003 38.1 25.4 43.9 49.9 63.2 86.9

GDPgrowth(per cent)

19962003

5.1 6.6 2.6 3.9 3.5 4.8

Currentaccount balance (per

cent of GCESR(2005para.117).DP)

1996 1.9 2.2 1.1 2003 3.1 0.3 0.1

“prudentvalue”( ) 1.9 1.9 1.0 2.3 2.0 5.1

DebtService(per cent of exports)

1996 21.5 13.9 46.7 20.3 29.2 22.6

2003 17.9 11.1 45.8 13.1 29.2 10.2

Exportgrowth

19962005

10.8

12.0

7.0

8.1

8.1

7.1

Currentaccount balance (per

cent of exports)

1996 7.3 14.7 3.6

2003 8.9 1.4 0.29

“prudentvalue”( ) 2.1 1.5 3.2 1.4 2.4 1.24

Source:author’scalculationsfromIMF(May2005).

Note:fordefinitions,seeSectionIIIabove..Thedebt/GDPanddebtservice/exportlevelsusedinthecalculationof prudential

CABand“goldenrule”arethesimpleaveragesof 1996and2003.

2. PolicyImplicationsforDevelopingCountries

Debt levels must clearly be kept within prudent limits and Governments should make credible

commitments to keepwithin these constraints, employing appropriate legislation if necessary. Such apolicyisessentialtoreduceuncertaintyfordomesticfirmswhicharethemainvehiclesfortheinvestment

onwhich growthdepends.Adebtoverhangand theprospectof deflationary stabilizationpoliciesand

debtrestructuring(orevenmoratoria)implyfuturelossesof sales,profitsandassetvalues.

Debt should be contracted on the longest terms possible. The cost of servicing should be kept at a

minimum subject to appropriate controlover the vulnerability to future capitalmarketorworldtrade

shocks.Suchcontrolmayimplythathigherinterestratesareareasonablepricetopayforloansof longer

maturityif vulnerabilitycanbereducedthereby.75

The use of funds generated by external debt should be geared to ensuring repayment capacity. This

meansthatasubstantialproportionof thesefundsshouldbeallocatedtothesupportof exportgrowth.

ThisdoesnotimplythattheGovernmentshouldbedirectlyengagedinexportproductionbutratherthat

75Missale(1999)demonstrateshowthisprinciplehasbeenappliedinOECDcountries.




84

fundsshouldbeused tosupportappropriate infrastructureprovision, thesupplyof longtermcredit to

exporters,andtrainingfortheworkforce.

The support of export growth also involves maintaining a competitive real exchange rate, which has

implicationsboth fornominalexchangeratemanagementand forwagebargainingpolicy.Thepoliticaleconomy constraints on excessive reduction of real wages are best countered by appropriate

commitments to output and employment growth. Low real interest rates and an expansionary credit

policyareneededtosupporttheinvestmentratelikelytoberequiredforthetargetrateof growth.Thisin

turnmeans that the domestic financial system should to some extent be shielded from international

capitalmarkets.

The recent popularity of inflation targeting as the core of stabilization policy in emergingmarket

economiesdoesnothelpreducedebtvulnerabilitybecauseithastheeffectof increasingvulnerabilityto

cyclicalcapitalflows.Openingof thecapitalaccountandafloatingexchangeratehasbeenaccompanied

byrelianceonasinglemonetarypolicy instrument (the interestrate)andrigid fiscalrules inemerging

marketeconomiesinpursuitof pricestability.Thisprecludesnotonlycountercyclicalmonetaryandfiscalpolicybutalsotheuseof theexchangeratetomaintainexportcompetitivenesswhichisakeyelementof

prudentdebtmanagement. There is a strong argument foremergingmarketGovernments to adopt a

countercyclicalmonetarystance inresponse tocapital flows.Thiswouldneedtobesupportedbyreal

exchangeratetargeting,bankcreditregulationandamoreactivefiscalstance.76

If suchapolicy istobesuccessfulinmiddleincomecountrieswithsubstantialshorttermprivatecapital

flows, there is thus a strong case for intervention through various controls to reduce the volatility of

capital flows.77Thesecontrolsnowusually take the formof taxes, regulatorymeasures (suchassetting

specialreserveordeposit levelsfor inflows),andtargetedmoneymarketoperations,whilequantitative

controlshavebecomelesscommon.

3. PolicyImplicationsfortheInternationalCommunity

Thereareanumberof otherpolicyareasthatcanonlybeaddressedbytheinternationalcommunity.

Substantialdebt reductionhasnotyetbeen forthcoming,even forHIPCcountries,due todifficulties in

budgetaryallocationsforthecorrespondingassetwritedowns.This isan internalaccountingmatterfor

OECDcountriesandrequiresurgentsolution.Furtherdebtrestructuringcanreducetheliquidityproblem

of debtservicepressureonthecurrentaccount.However,itdoesnotreducetheinvestmentdisincentives

fromdebtoverhangandmayevenmakethemworsebyincreasinguncertainty.78

Giventhatexportgrowthisakeycomponentof prudentdebtmanagement,accesstoOECDmarketsfor

developing country exporters is crucial to their ability to contract debt prudently, while accelerating

economicgrowthandpovertyreduction.Thesameistrueof measurestoreducespeculativefluctuations

inprimarycommodityprices.Ideally,thesewouldbecombinedwithlinkageof debtrepaymentstoexport

levels –atleastinthecaseof paymentstoofficialcreditors.79

Since capital shocks to developing countries usually originate within OECD financial markets, policy

towardsthemshouldbebasedonrecognitionof theirexternalcharacter.Onesteptoreducetheimpact

of theseexogenous shockswouldbe for the IMF toprovide temporary financeona larger scale,more

quicklyandwithlessconditionalityinordertofacilitatesmoothdebtmanagement.Inthelongerrun,itis

76SeeFitzGerald(2005b).

77SeeFitzGerald(2005a).78Thiseffectfaroutweighsanypotentialmoralhazardimplicitin‘frontloading’debtforgiveness.

79Inpracticemarketsare veryunlikely toaccept sovereignbondswith yields linked to commodity exports.However, certain

primarycommoditiescanbeusedascollateralforborrowing.




85

essentialtodeepenthemarketfordevelopingcountrydebtinOECDcountriesby:lengtheningthetenor

of instruments, taking measures to increase their liquidity, and encouraging their inclusion in the

investmentsof pensionandinsurancefunds.80

80Suchmeasureswouldalsoreducetheriskinessof sovereigndebt.




86

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SachsJD(1989).DevelopingCountry Debt and theWorld Economy .Chicago,IL,Universityof ChicagoPress

forNBER.

Sen P (1994). Savings, Investment, and theCurrentAccount. In: vanderPloeg Fed. TheHandbook of

International Macroeconomics.Oxford,Blackwell.

TaylorL(1994).GapModels. Journal of Development Economics,45.

Taylor L (ed.) (1993). The Rocky Road to Reform: Adjustment, IncomeDistribution, and Growth in the

DevelopingWorld.Boston,MA,MITPressforUNU/WIDER.

TranNguyenAN (2004).Debt ServicingCapacity of Developing Countries: ConceptualApproaches and

MeasurementProblems.Geneva,UNCTAD(processed).

UNCTAD(2005).World Investment Report 2005.Geneva,UNCTAD.

WorldBank(2004).Global Development Finance2004.Washington,DC,WorldBank.




88

WorldBank(2005a).World Development Indicators.

WorldBank(2005b).World Development Report.




89

CHAPTERV

THEDEBTEXPERIENCESOF

UGANDA,KENYAANDBOLIVIA

DamoniKitabire,PeterMichaelOumo,FrancisM.Mwegaand

PaulBeckerman

81

A. Introduction

Thischapter reviews thedebtexperiencesof threeof theworld’spooresteconomies,namelyUganda,

KenyaandBolivia.Thechapterhighlightstheconditionsanddebtproblemsthatunderpinnedthefailure

of successivedebtinitiativestorendertheirdebtpositionsustainable.

Amajorcontributoryfactortothisfailure isthatthethreecountries’exportsremainconcentratedona

handfulof commodities,allof which suffered significantdeteriorations in the termsof trade since the

1980s.Moreover, the threecountriesalsoexperienced severeclimatic shocks, suchasseveredroughts

(Kenya)andEl Nino(Bolivia).Tothesefactorsmustbeaddedpoliticalturmoil,instabilityandwars.

Uganda and Bolivia have records of having been exemplary pupils of Washington Consensus policies.

Kenya followed similarly orthodox approaches to macroeconomic management, albeit against a

background of turbulent relations with creditors. All three countries went through a succession of

programs. The reform efforts revived growth at the outset but sustained per capita gains failed to

materialize.

ThecountryreviewsinsectionsII,III,andIVhighlighttheroleof factorsaffectingsustainabilitythatshould

havebeenincorporatedinpastdebtrelief analyseswithspecialemphasisonexportdiversification,fiscal

81Section B is based on a paper by Damoni Kitabire and Peter Michael Oumo (Ministry of Finance, Planning and Economic

Development of Uganda) (Kitabire and Oumo (2005)), Section C is based on a paper by Francis M. Mwega (Department of

Economics,Universityof Nairobi) (Mwega (2005)),SectionD isbasedonapaperbyPaulBeckerman (IndependentConsultant)

(Beckerman(2006)).



TheDebt Experiencesof Uganda,Kenyaand Bolivia

90

positions, and new financing. The three experiences are then compared and contrasted in Section E.

SectionFsummarizestheprincipalfindings.

B. Uganda

1. Introduction

Despite threedecadesof attempts to reduce the external debtburden,debt sustainability stilleludes

Uganda.Thecountry’sprincipaldebtproblemhasbeenitsheavydebtserviceburden.Despiteremarkable

GDPgrowthsincethe1990sand improvements inexportearnings,theeconomyremainsdependenton

rainfedagricultureandvulnerabletoshocksdeliveredbyworldcommoditymarkets.Thecountryisalso

stillheavilydependentondonoraidwhichcurrentlyfinancesabout40percentof thebudget.

Since the 1991 debt crisis, Uganda has developed a fairly coherent debt strategy. However, its debt

burden remained high until the HIPC Initiative put Uganda on a sustainable debt path momentarily.

UnfortunatelytheHIPC Initiativedidnot leadtoapermanentexitfromdebtproblems.Thecountryhas

borrowedheavilypostHIPCtoachievetheMDGsanditsdebtindicatorsareunsustainableagain.

2. EconomicPerformanceandPolicies

Ugandaentered the1980swithadegreeof political stability thatallowedGDPgrowth to recover toa

positive1.7per cent in19801983.Thereafter, industrialproductiondeclineddue to foreignexchange

shortageandthepoorstateof infrastructure,whileagriculturalproductionalsolagged.In1983/84fiscal

there was fiscal slippage on an IMF stabilization program which was cancelled in late 1984. Political

instabilityandaprotractedguerrillawarledtoanewGovernmenttakingpowerinJanuary1986.

InMay1987,thenewGovernmentembarkedonanEconomicRecoveryProgrammewiththesupportof

IMF,WorldBankandothers.Thiswasfollowedin1989byaStructuralAdjustmentProgramme(SAP).Its

focus was on limiting the involvement of the state in economic activities, the liberalization of trade,

financialsectorandmarketingactivities,theprivatizationanddivestitureof publicenterprises,andmore

generally the promotion of privatesector participation in production. The program resulted in an

acceleration of GDP growth to an average rate of 6.9 per cent per annum between 1991/92 and

1999/2000(seeFigureV.1.).

By 2000, the structure of the Ugandan economy had changed dramatically. In 1982/83, agriculture

accountedfor53.6percentof GDP,butitssharedeclinedto36.3percentin2004/05.Atthesametime,

thesharesof industryandservicessteadilyincreased,thatof servicesrisingfrom35.2percent1982/83to36.6percent in1990/91andbecomingthe largest in2001/02.However,Ugandaremainsvulnerableto

weatherchangesasthecountry’sagriculturalsystemreliesheavilyonrainfedsmallholderagriculture.




91

FigureV.1.Uganda’sGDPGrowth1982/83 –2004/05

(Per cent)

-10%

-5%

0%

5%

10%

15%

20%

25%

1 9 8 2

/ 8 3

1 9 8 4

/ 8 5

1 9 8 6

/ 8 7

1 9 8 8

/ 8 9

1 9 9 0

/ 9 1

1 9 9 2

/ 9 3

1 9 9 4

/ 9 5

1 9 9 6

/ 9 7

1 9 9 8

/ 9 9

2 0 0 0

/ 0 1

2 0 0 2

/ 0 3

2 0 0 4

/ 0 5

Agriculture Industry Services GDP at Market Prices

Source:Ugandabureauof Statistics.

Largelydependentonprimarycommodities,Uganda’sexportgrowthhasbeenerratic.Followingreform

efforts,growthrebounded intheearly1990s.Thiswasreinforcedbythecoffeepriceboomof 1993/94

1996/97. Following efforts todiversify away from coffee, the shareof coffee inUganda’s exports has

declined from70percent inthe1990stoabout20percentsince2000/01.FishhasbecomeUganda’s

leadingexport,followedbycotton,tea,tobacco,andflowers.

As shown in FigureV.2.,Uganda’s terms of trade (TOT)have been erratic butwith anoverall secular

decliningtrend,largelydeterminedbytheinternationalpriceof coffee.TheTOThaverecentlyimproved

andchangeshavebeenpositivesince2002/03.Deterioratingtermsof tradehaveadirectimpactondebt

sustainability.Coffeeexportpricesin2003/04were49percentlowerthanenvisagedatthetimeof HIPC

IIcompletion.64percentof thedeterioration intheratioof theNPVof debttoexportsbetween2002

and2004wasduetofallingcoffeeexportprices.

FigureV.2.ChangesinUganda’sTermsof Trade1989/90 –2004/05

(Per cent)

-40%

-20%

0%

20%

40%

60%

80%

100%

1 9 8 9

/ 9 0

1 9 9 0

/ 9 1

1 9 9 1

/ 9 2

1 9 9 2

/ 9 3

1 9 9 3

/ 9 4

1 9 9 4

/ 9 5

1 9 9 5

/ 9 6

1 9 9 6

/ 9 7

1 9 9

7 / 9 8

1 9 9 8

/ 9 9

1 9 9

9 / 0 0

2 0 0

0 / 0 1

2 0 0

1 / 0 2

2 0 0 2 / 0 3

2 0 0 3

/ 0 4

2 0 0 4

/ 0 5

Source:Bankof Uganda.




92

Under the Economic Recovery program initiated in 1987, reforms in trade policy gradually eased

quantitative restrictions and were geared towards export promotion. Trade licensing schemes were

abandonedandcoffeemarketingwasliberalizedinthelate1980s.In1992,thetaxoncoffeeexportswas

abolished.Itwasbrieflyreintroducedin1994tolimittheappreciationof theexchangerateasaresultof

thecoffeeboom,andabolishedagainin1996.Importdutieswererationalizedin1992toarangeof 1060

percent,andwerefurtherreducedtoarangeof 1050percentin1994.

Initially, theexchangeratepolicy involved repeateddevaluationsand rationingof theavailable foreign

exchange under various schemes. A foreigncurrency retention scheme was introduced in 1988 and

extended in 1989. In 1990, the exchange market was liberalized with the legalization of the parallel

(kibanda)market. In1992,anexchangerateauctionmarketwascreated.The foreignexchangemarket

was fully liberalized and the exchange rate was floated in 1993. In 1997, the capital account was

liberalized.

Topromoteforeigninvestment,UgandaenactedanInvestmentCodein1991.Thisreversedlongstanding

antipathy towards foreign investment and introduced standard provisions regarding investmentincentives, profit repatriation and protection against expropriation. FDI rose from US$43.2 million in

1992/93toUS$670millionasof end2004/05.

Successive reforms have enabled Uganda to manage its fiscal balances more prudently but have not

reduced the country’s dependency on donor aid for financing its budget. In the 1990s, over half of

Uganda’sbudgetwasfundedbydonoraidandthisratiowasstill40percentin2005/06.Upto1996over

half of theaid receivedwas in the formof loans, thoughgrantsbecamemore important subsequently

(AtingiEgo2005).

DealingwiththeDutchDiseaseeffectsof theseflowshasbeenthesourceof asignificantriseindomestic

debtservicing.DutchDiseaseeffectsputappreciationpressuresontheexchangerate,withinterestrate

risesowing to the attempt to contain the inflationaryeffectsof the inflowson liquidity.According to

AtingiEgo (2005), since1998DutchDiseaseeffects inUgandahaveadverselyaffected investmentand

imports.

3. ExternalDebt

Uganda’s debt problems date back to the 1980s. Debt continued to accumulate (despite the

Government’s increasing inability to service it)due to continuing foreignexchange shortages.By1986,

Uganda’sdebt stockhadgrown toUS$1.4billion,up fromUS$680million in1980.Between1986and

1990,becauseof thereconstructionandrecoveryprogramandof alackof aneffectivedebtmanagement

strategy, both the debt stock and debt service went out of control. Large sums were borrowed onunfavorabletermsandarrearsaccumulated,theburdenbeingexacerbatedbydelinquentprivatesector

loansguaranteedbytheGovernment.

By the late 1980s,Uganda faced a debt crisis. In 1990, theGovernment ran out of foreign exchange

followingasharpdecline in termsof tradedue largely toadecline in thepriceof coffee.Debtservice

obligationsamounted toover60percentof exportearnings.Drasticactionwas thereforenecessary to

reversethecollapseinthebalanceof payments,promptingthedevelopmentof Uganda’sfirstintegrated

debtmanagementstrategyin1991.

AsshownintableV.1.,mostof Uganda’sdebt(63percentin1991to88percentasof 2004)isowedto

multilateral institutions and is therefore longterm. Owedmainly to IDA and ADF the debt is also on

concessionalterms,i.e.has10yearsof grace,andarepaymentperiodof 30yearsforIDAandof 40yearsforADF.ThedebttoGDPratiohasdeclineddrasticallyfromapeakof 98percentin1992andhasrecently

stabilized ina rangeof 60 70percent.The ratioof debt service toexportshasalsoundergone sharp




93

fluctuationsbutsincetheendof the1990shasstabilizedataround20percentlargelyduetoHIPCdebt

relief initiativeandthepromotionof nontraditionalexports.

TableV.1.Uganda’sDebtStructureandIndicators1980 –2004

US$ Million 1980 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

T otal Deb t S to ck 6 89 .0 1 ,4 22 .0 1 ,9 45 .0 1 ,9 23 .0 2, 17 7. 0 2 ,5 83 .0 2 ,5 91 .6 2 ,6 47 .4 2 ,6 37 .1 2 ,9 99 .4 3 ,3 86 .9 3 ,5 15 .8 3 ,6 60 .2 3 ,6 31 .6 3 ,4 99 .6 3 ,5 79 .9 3 ,3 97 .5 3 ,8 25 .2 4 ,2 96 .3 4 ,3 10 .0

o/w arrears 101.0 92.0 99.0 136.0 190.0 298.0 370.9 583.1 301.8 251.0 233.4 250.3 316.6 275.5 241.5 232.0 286.8 301.7 318.7 342.9

Mul ti la te ra l n .a n .a n .a n .a n .a n .a 1 ,643 .6 1, 755. 9 1 ,815 .9 2, 156. 1 2 ,487 .9 2, 655. 1 2 ,763 .0 2, 826. 8 2 ,782 .6 2, 936. 3 2 ,893 .3 3, 318. 1 3 ,720 .4 3, 782. 8

Bi lateral n.a n.a n. a n.a n .a n.a 8 11.8 6 51.4 6 97. 3 730.4 7 87 .9 7 55.1 7 96 .0 7 48.6 6 49.9 5 93.2 4 76.1 4 88.5 5 55 .5 5 10 .3

o/w Paris Club n.a n.a n.a n.a n.a n.a 285.5 273.2 281.7 332.0 380.1 350.6 339.1 325.0 288.2 260.6 131.5 111.4 122.8 66.1

Non Paris Club n.a n.a n.a n.a n.a n.a 526.3 378.2 415.6 398.4 407.9 404.5 456.9 423.6 361.7 332.6 344.7 370.1 432.7 444.2

Other n.a n.a n.a n.a n.a n.a 136.2 240.1 123.9 112.9 111.1 105.6 101.2 56.2 67.1 50.5 28.1 18.5 20.4 16.9

Mulitilateral (% Debt Stock) n.a n.a n.a n.a n.a n.a 63.4% 66.3% 68.9% 71.9% 73.5% 75.5% 75.5% 77.8% 79.5% 82.0% 85.2% 86.7% 86.6% 87.8%

Bilateral (% Debt Stock) n.a n.a n.a n.a n.a n.a 31.3% 24.6% 26.4% 24.4% 23.3% 21.5% 21.7% 20.6% 18.6% 16.6% 14.0% 12.8% 12.9% 11.8%

Other (% Debt Stock) n.a n.a n.a n.a n.a n.a 5.3% 9.1% 4.7% 3.8% 3.3% 3.0% 2.8% 1.5% 1.9% 1.4% 0.8% 0.5% 0.5% 0.4%

Debt Service 57.0 172.0 160.0 202.0 186.0 147.0 148.0 131.0 140.6 167.8 150.7 142.2 155.9 154.6 162.9 133.4 146.1 133.6 172.0 179.7

Debt/GDP 54.6% 32.7% 66.4% 54.2% 59.5% 86.0% 83.4% 98.2% 87.4% 81.3% 64.3% 64.0% 64.0% 59.5% 62.0% 65.9% 65.0% 71.3% 74.4% 68.8%

Debt Service/Exports 17.2% 43.2% 43.8% 62.3% 61.2% 59.8% 66.1% 65.2% 83.2% 66.1% 22.6% 19.7% 18.9% 24.4% 22.4% 20.1% 21.6% 19.1% 22.2% 19.4%

D ebt / Ex port s R at io 208 .2% 357 .3% 532 .9% 593 .5% 716 .1% 1050. 0% 1157. 0% 1317. 1% 1560. 4% 1180. 9% 507 .8% 486 .3% 443 .8% 573 .1% 481 .8% 540 .0% 501 .9% 545 .7% 555 .1% 464 .4%

Source:Ministryof Finance,Planning&EconomicDevelopmentandBankof Uganda.

Firstattemptsatdevelopingadebtmanagementsystemcamein1983withtheformationof theExternal

DebtManagementOffice (EDMO)withintheBankof Uganda (BoU). In1986,twootheroffices;theAid

CoordinationUnit(ACU)intheMinistryof FinancePlanningandEconomicDevelopment(MFPED),andthe

TreasuryOfficeof Accounts (TOA)weremandatedtomanageanddisburseexternaldebttogetherwith

the EDMO. The ACU, now called Aid Liaison Department (ALD), was responsible for seeking and

negotiatingnewloansinlinewithGovernment’sfinancingrequirements.

The key featuresof Uganda’sdebt adopted in the1995 strategy include seeking grant fundingbefore

contracting any loan and ensuring that all loans are strictly on IDAcomparable terms. Loansmust be

approvedby thebeneficiarysectorand thedevelopmentcommitteebeforebeingcontracted,and they

mustbeinlinewithsectoralandpovertyreductiontargets.LoansarethenscrutinizedbytheMinistryin

chargeandcheckedagainstbudgetarytargets,afterwhichcabinetandparliamentaryapprovalaresought.

TechnicalcapacityfordebtmanagementinUgandaiswelldeveloped.Particularlysince1995,Ugandahas

madesustained,tangibleprogressincapacitybuildinginallaspectsof debtmanagement.Moreover,BoU

hasnowagooddebt recordingcapacityandacompleteuptodatecomputerizeddatabasewhichuses

UNCTAD’sDebtMonitoringandFinancialAnalysisSystem(DMFAS).

4. DomesticPublicDebt

InUganda the issuanceof Governmentdebthasnotonlyhad thenormal functionof meeting revenue

shortfalls, but also that of financing the sterilization of foreign aid inflows. As sterilization efforts

intensifiedattheendof the1990s,Treasurybillsalesrosefrom23percentto32percentof commercial

bankholdingsbetween1998and2004despitethefactthatdomesticdebtwastypicallyintherangeof 1

2percentof GDP(seeTableV.2.).Interestpaymentsondomesticdebt,however,doubledin19952000

owingtothepolicyof highinterestratesassociatedwiththeattempttomanagetheconsequencesof high

aidinflows.ByaddingtopressuresonthefiscalbalancetheseinterestpaymentscontributedtopostHIPC

difficulties.




94

TableV.2.DomesticDebtinUgandaandKenya,19802000

(Per cent)

5. TheDebtStrategyfrom1991to1995

Inearly1991, theGovernmentof Ugandaembarkedonacomprehensivedebtstrategy, includinga full

debt audit. The 1991 Debt Strategy focused on overcoming the immediate debt payment crisis and

developing mechanisms to ensure that it did not reoccur. The first objective of this strategy was to

provideasolutiontothecashflowproblemthroughdebtrestructuring.Thisnecessitatedclearingarrears

andreducingdebtserviceto levelsconsistentwithUganda’sabilitytopay.Thesecondobjectivewasto

improve debt management structures. This resulted in the strengthening of debt management by

requiringministriestoworkwiththeAidCoordinationUnit(ACU) intheMinistryof Finance.Inaddition,

strictlimitsonborrowingwereputinplace,witharequirementtoexhaustallsourcesof grantfinancing

beforeconsideringnewloans,whichhadtocomefromhighlyconcessionalsources.

By1991,Ugandahadalreadyundertakenfourrestructuringoperationswithintheframeworkof theParis

Clubin1981,1982,1987,and1989.Unfortunately,theserestructuringoperationswerenotsufficientto

easethedebtoverhangfortworeasons.First, intheParisClubs1to3,negotiationscoveredonlydebtfallingdueduringashortconsolidationperiod(1218months).Second,untilParis8,onlyprecutoff debt

(accountingfor4percentof thetotaldebtstock)waseligiblefordebtrelief.Moreover,thedeminimis

clauseexcludedloansof lessthanSDR500,000fromrescheduling.

The1991strategyalsoaddressedthecountry’scommercialdebt.Although thisdebtaccounted for just

over9percentof totaldebtstockin1992,mostof itwasinarrears.Ugandaembarkeduponadebtbuy

backstrategy,financedbytheWorldBank.Theofferpricewasfixedat12centsperdollar inDecember

1992,andtheclosingdatewasinFebruary1993.Overall,thebuybackwasverysuccessful.

The1991debtstrategywassuccessfulinmanyways.Itestablishedclearproceduresfornegotiatingnew

loansand strengtheneddebtmanagement. Ithelped to increase theproportionof paymentsmadeontime.Itledtolargereductionsincommercialdebtanddebtservice.Consequently,thedebttoGDPratio

fellfrom83percentin1991to64percentin1995.Thestockof arrearsfellfrom15percentin1991to7

percentin1993,whilemultilateraldebtincreasedfrom61percentto75percentof totalexternaldebt

Kenya Uganda Average HIPCDecisionPoint2/

NonHIPC3/

Domesticdebt 198089 21 2 11 9 10 14(in percent of GDP) 199094 23 1 12 6 7 18

199500 22 2 15 8 8 23Total debt 198089 81 2 62 69 73 53(in percent of GDP) 199094 100 74 102 138 143 59

199500 74 59 118 169 164 59Domestic/Total debt 198089 25 100 25 22 25 30

199094 23 1 19 6 7 35

199500 29 4 22 6 7 40199094 71.7 14.4 49.7 42.3 43.6 60.8199500 74.5 29.4 51.9 42.5 43.2 65.3

Source: Christensen(2004)Notes:

1/BothdomesticdebtsincludeTreasuryBillsandGovernmentStocks,withKenyaalsoissuingbonds

2/IncludesUganda

3/IncludesKenya

Domesticinterest payments/ total debt




95

overthesameperiod.However,thisputthecountryinadifficultpositionbecausemultilateraldebtcould

notberestructured.

Therewerethreemainweaknessesinthe1991debtstrategy.Firstwastheinsufficientreductioninlong

termmultilateraldebt. Secondly, the country continued to require large amountsof new financing tosupportthereformprogramwiththedangerof increaseddebtservicingobligationsif thenewfinancing

wasnotconcessionalenough.Thirdly,therewerestillsomeproblemswithdebtmanagementstructures.

A comprehensive review of the debt strategy was carried out in 1995 with help from the Swedish

Government.Thenewstrategywhichemergedfocusedonfourobjectives:

(a) Reductionof themultilateraldebtserviceburdenthroughbilateralgrants;

(b) Increasingtheconcessionalityof newborrowingandthequalityof loanfinancedinvestment;

(c) Improvingdebtandreservemanagement;

(d) Improvingcoordinationwithdonors,and lobbyingfor longtermmultilateraldebtreduction. In

fact, in November 1995, a MultilateralDebt Fund (MDF) was established, with contributions

usedtoservicedebt.Thestrategyalsointroducedtherequirementof parliamentaryapprovalof

newloans.

6. TheHIPCDebtRelief Initiative

InApril1998,UgandabecamethefirstcountrytobenefitfromHIPCDebtRelief Initiative.PriortoHIPC

debtrelief,thenominalvalueof Uganda’sexternaldebtstockwasUS$3.5billion,andtheNPVof debtto

exportsratiowas294percent.UnderHIPCI,Ugandareceiveddebtrelief of US$347millioninNPVterms.

Of thisamount,79percentwasduetomultilateralcreditorssothatforthefirsttime,debtrelief hada

largemultilateralcomponent.Uganda’sNPVof debttoexportsratiowassupposedtofall196percent,i.e.

belowthethresholdratioof 202percent.

However, Uganda’s debt swiftly returned to unsustainable levels, mainly on account of the El Nino

weatherphenomenon,whichseverelyaffectedexportperformancein1999.Hence,inMay2000,Uganda

received further relief underEnhancedHIPC.Prior to this, in June 1999,Uganda’sexternaldebt stock

reachedUS$3.6billion.Totalrelief underHIPCIIwasexpectedtoamounttoanadditionalUS$656million,

withmultilateralcreditorscontributing83percent.Thetotalrelief undertheHIPCasawholewasUS$1

billioninNPVterms,orunderonethirdof thepreHIPCnominaldebtstock.

7. PostHIPCDevelopments

SinceHIPC IIcompletion,Uganda’sexternaldebt sustainabilityasmeasuredbyNPVof debt toexports

ratiohasdeteriorated.Uganda’sNPVof debt toexportsratiohad reached280percentaccording toa

June2004analysis.

Anumberof factorshavecontributedtothedeteriorationindebtindicators.

First,istheimpactof fallingcoffeepricesonexportearnings,whichwere57percentand36per

centlowerin2002/03and2004/05thaninitiallyenvisaged.

Secondly,risinginterestratesreducedtheconcessionalityof thecountry’sdebt.

Thirdly,attheEnhancedHIPCdecisionpoint,estimatesfornewfinancing inthemacroeconomic

framework and balance of payments projections were not fully incorporated in the Debt

SustainabilityAnalysis. Fourth,theinitiativewasweakenedbytherefusalof somecreditorstoparticipate.




96

Fifth, and most importantly, Uganda has borrowed more than US$1.6 billion since HIPC II

completion, 85 per cent of which is owed to IDA and ADF, primarily to finance the Poverty

EradicationActionPlan(PEAP),Uganda’soverarchingpolicyframeworktoeradicatepoverty.This

heavyrelianceonborrowedfundsreflectslimitedimprovementsindomesticrevenues,whichhas

leftthecountryhighlydependantonexternalassistance.

Inthe2004budgetspeech itwasannouncedthatceilingswouldbeputonannualtoachieveagradual

declineintheNPVof debttoexportsratiotosustainablelevels.

Its tumultuoushistory aside,Uganda’sexperience serves tounderscore thatwithout a comprehensive

debtstrategyitisimpossibletousedebtfordevelopment.Inaddition,thefailuretodiversifytheexport

basehasleftthecountryatthemercyof primarycommodityprices

Ugandaneedstoconsolidatethegainsof thedebtstrategy ithaspursuedsince1991.The institutional

arrangementsforexternalborrowingshouldclearlyoutlinetheroles,responsibilities,andobligationsof

all stakeholders. Uganda is currently attempting to ensure that borrowing is strictly for enhancingproductivityand competitiveness.Moreover thequalityof infrastructurebuiltwithpastborrowinghas

fallen into a dilapidated state even before the loans are repaid so that there is a serious risk of

accumulatingfurtherdebtforitsrepair.

C. Kenya’sDebtExperience

1. Introduction

Kenyadidnotexperienceonebigdefault.Rather, ithashadseriousrecurrentdebtservicingproblems,

withadebtcrisispeakingin1991.Theseproblemsoccurredagainstabackgroundof negativeexogenousfinancialand trade shocksarising from the vulnerabilityof theKenyaneconomyand thepricesof key

primarycommoditiestoweatherconditions.

2. TheEconomicEnvironment

(a)Overall Economic PerformanceThe 198084 period was characterized by various adverse external and internal shocks (including two

severedroughts),globalrecessionandreducedcapital inflowsfollowingthe1982debtcrisis.Itwasalso

characterizedby inability to satisfy the IMF credit ceilings andGovernmentborrowing conditionalities,

leadingtothecancellationof anumberof programs. In198590,economicgrowthwasrelativelyrapid,

partlydue to an increase in coffee and teaprices andadecline inpetroleumprices.TheGovernment

adoptedaprocyclicalpolicyand increasedpublicexpenditure (bothcapitalandcurrent)morethanthe

increaseinrevenue.

Inthefirsthalf of 1990s,theeconomyreceivedmoreshocks:adroughtin1991/1992,oilpriceincreases

due to the Gulf War, an aid embargo in 199193, and ethnic clashes in 1992. These shocks were

accompaniedbyanincreaseinthebudgetdeficit,risinginflation,andlargeexchangeratedepreciations,

astheforeignexchangemarketwasliberalized.Inthesecondhalf of the1990s,economicgrowthdeclined

furthertoanaverageof 1.9percent,assimilarinstabilitiescontinued.

Asshown in tableV.3., theperformanceof Kenya’sexportsectorhasbeen lacklustreandexportshavegrown lessthanGDPsince independence.Theshareof exports inGDPdecreased from21.8percent in

1980 to 12.5 per cent in 2004. Tea, horticulture and coffee are by far the most important exports,




97

accounting for 54 per cent in 20002004. Kenya’s terms of trade have also declined substantially.

Dependenceonprimarycommodityhasalsomeantthatthetermsof tradeareveryvolatile.

TableV.3.Kenya:of Exports,Termsof Trade(TOT)andForeignDirectInvestment(FDI)

Year

Exports

(K£ million)

GDP

(K£ million)

Exports

(in per cent of

GDP)

Exports

(US$million)

Growthof

exports

(per cent)

TOT

1982=100

FDI/GNI

(per cent)

1980 487.64 2235.37 21.8 1318.0 123 1.1

1981 513.86 2597.23 19.8 1388.8 5.37 108 0.2

1982 545.74 2944.62 18.5 992.2 28.56 100 0.2

1983 633.08 3316.63 19.1 994.8 4.78 94 0.4

1984 754.81 3851.78 19.6 1041.2 10.20 110 0.2

1985 785.10 4374.62 17.9 957.4 8.05 92 0.5

1986 957.97 5083.98 18.8 1182.6 23.52 103 0.5

1987 753.41 5648.23 13.3 913.2 22.78 85 0.51988 917.74 6480.62 14.2 986.8 8.06 88 0.0

1989 999.83 7451.34 13.4 925.8 6.18 79 0.8

1990 1232.38 8377.78 14.7 1022.8 10.47 69 0.7

1991 1533.83 9540.33 16.1 1091.6 6.73 82 0.2

1992 1708.08 11402.53 15.0 943.6 13.55 79 0.1

1993 3625.21 14185.41 25.6 1063.2 12.67 90 0.0

1994 4170.72 16903.24 24.7 1162.0 75.13 101 0.1

1995 4656.18 19205.79 24.2 1674.8 10.05 95 0.4

1996 5696.30 21865.55 26.1 2071.2 23.67 93 0.1

1997 5722.95 31161.76 18.4 1944.9 6.10 102 0.4

1998 5722.25 34701.44 16.5 1738.3 10.63 100 0.4

1999 5770.3 37173.95 15.5 1528.9 12.05 86 0.42000 5988.2 39817.15 15.0 1529.2 0.02 84 1.3

2001 6071.7 48391.90 12.5 1560.1 2.02 79 0.5

2002 6569.7 51938.20 12.6 1715.2 9.94 78 0.4

2003 6835.45 57089.00 12.0 1781.4 3.86 81

2004 7953.05 63685.80 12.5 2056.5 15.44 77.4

Average 0.10

Source:EconomicSurvey,VariousIssues.

CollierandGunning (1999)attributemuchof Kenya’sweakgrowthperformancetogeographyandrisk.

Muchof thecountryisalsosemiaridsothatagriculturalproductionintrinsicallyrisky.Kenya’sgeography

alsomeans that transport costsarehigh,quite aside fromdeficiencies in infrastructure.But they alsoargue that trade shockscausedaneconomicdeclinebecauseof overregulationand theGovernment’s

lossof controloverpublicexpenditure.Azam(1997)showsthat insufficientprivate investmentandthe

failure to increasehuman capitalaccumulation contributed to the slowingof growth in the1980sand

1990s.

(b)LiberalizationStrategiesInthe1980s,Kenyahada“managedfloat”exchangerateregime.Theperiodwitnessedacuteshortages

of imported inputs due to nonavailability of foreign exchange. This resulted not only in frequent

interruptions inproductionbutalsoinchronicunderutilizationof installedcapacity.Kenyatookaseries

of measures that gradually removed foreign exchange controls and liberalized the exchange rate,

includinga largedevaluationof theshilling. In19921993 theofficialexchange rateand the interbank

foreignexchangerateweremerged,controlsoncurrentandcapitalaccounttransactionswereremoved.

Furtherliberalizationfollowedin1995.




98

Similarly in the 1980s and 1990s Kenya implemented trade reforms,which eliminatedmostnontariff

barriersand lowered tariffs, substantiallyopening theeconomy.Themaximum tariff ratewas reduced

from 170 per cent to 70 per cent over 19871993. Recently, under obligations of the East African

Communitycustomsunion,tariff bandswerereducedtothreewithamaximumexternaltariff of 25per

centsinceJanuary2005.

Kenyaliberalizeditscapitalaccountoverthesameperiod.Reformsalsoincludedtheeasingof restrainton

foreignownershipand theestablishment in1990of theCapitalMarketsAuthority (CMA).TheNairobi

StockExchangemarketopenedtoforeigninvestorsinJanuary1995.Toinsureagainstthepotentialriskof

liquidity crises delivered by exogenous shocks or speculative activities, Kenya has followed other

developingcountriesinaccumulatingforeignreserves.

Kenyaalsoembarkedon financial sector reforms.Positive real interest rates, the targetof themarket

reforms,aimedatenhancingefficiency.InstitutionalreformsfocusedonstrengtheningtheCentralBank,

particularly in itssupervisoryandregulatoryroles. Inmonetarypolicytherewasashifttomore indirect

instrumentslikeopenmarketoperations.Therewasafinancialcrisisin1998whichledtotheliquidationof severalbanks.Muchof thefinancialdeepeningwhichhasresultedisduetotheconversionof deposits

of nonbankingfinancialinstitutionstocommercialbanksdeposits.

The Central Bank has maintained a high interestrate regime to stabilize the exchange rate and has

pursuedagenerallytightmonetarypolicyinthefaceof inflationarypressures.Oneof theconsequences

hasbeenwidespreaddistressedborrowingsothatbanks’portfolioshaveincludedmanynonperforming

loans.Thedeclineincredithasbeenassociatedwithdeclininginvestment.

Kenya’sfiscalpolicyislinkedtoitsexternalindebtedness.Kenyaisheavilydependentonaidinflowsforits

governmentfinances,withaidaccountingfor45percentof thebudgetatthepeakin1991(O’Brienand

Ryan,1999).Throughoutthe1990s,foreignaidaveragedabout9percentof GDP,accountingforabout

20per centof the annual governmentbudget and financing slightlyover80per centof development

expenditures(Njeru2004).

3. ExternalDebt

Kenya isasamoderately indebtedcountry.Thecountry’sexternaldebt increasedfromUS$4.2billion in

themid1980stoapeakof US$7.5billionin1991,decliningtoUS$6billionin2002.Asaproportionof GNI

itincreasedfrom70.8percentof GNIin1985toapeakof 156percentin1993butthendeclinedto49.2

percent in2002.(SeeTableV.4.)Externaldebtservice increasedtoapeakof 39percentof exports in

1988butthendeclinedto13percentin2002.

Almost all of Kenya’s external debt is either public or publicly guaranteed and owed primarily to

Governments and multilateral organizations. For the period 19852002, private nonguaranteed debt

generallyaccountedforlessthat15percentof thetotal.Shorttermdebtaccountedforbetween54and

69percentof outstandingstocks.Theaveragegraceperiodisabout6.9years,theaveragegrantelement

about50.9percent,andtheaveragematurityperiodabout26.5years.Bilateralaidhasbeenmainly in

theformof grants(72percentof thetotal),whereasmultilateralaidhasmainlybeenintheformof loans

(86percent),mostlyfromtheWorldBankgroup.

While Kenya’s externaldebt toGNI ratios are currently less unfavorable than at thebeginning of the

1990sandareevensustainableaccordingtoHIPCcriteria(IMF2003),thestockof externaldebtand its

servicing nevertheless poses a major problem for two reasons. First, debt servicing is still a large

proportion of export earnings and government expenditures. Second, a large external debt createsuncertaintiesforinvestmentsandunderminesthecredibilityof domesticpolicies(Elbadawietal.,1997).

Pattilloetal.(2002),usingapaneldatasetof 93developingcountriesover196998,findthattheaverage




99

impactof externaldebtongrowthbecomesnegativeforadebttoGDPratioof 3540percent.Kenya’s

externaldebtsignificantlyexceedsthisthreshold.

TableV.4.DebtIndicatorsof Kenya

Year

Totaldebt

stocks

(US$million)

External

debt

(as per cent

of GNIa )

ExternalDebt

service

(as per cent of

Exportsof

goodsand

services)

Principal

arrears

(US$

million)

Interest

arrears

(US$

million)

Budget

deficit

((as per

cent of GDP

b )

Domestic

Debt

(as per cent

of GDPb )

Foreign

financing

(as per cent

of budget

deficit b )

1985 4180.6 70.8 38.7 4.1 10.9 12

1986 4602.8 65.9 35.6 6.2 17.3 3.7 16 42.7

1987 5782.9 75.4 39.8 12.6 28.3 4.8 27.8 40.6

1988 5808.9 71.2 39.0 25.5 40.3 7.5 27.1 21.9

1989 5889.6 73.7 36.6 49.4 64.6 3.7 26 17.91990 7057.6 87.2 35.4 71.8 94.7 3.8 24.6 21.3

1991 7457.8 98.3 32.6 155 140.9 4.3 26.9 54.3

1992 6902.6 90.7 31.1 263.3 188.8 5.0 25.9 40.4

1993 7115.4 156.0 27.1 409.8 241.7 1.3 33.5 44

1994 7128.9 105.5 32.9 9.2 81.2 4.5 27.2 42.6

1995 7313.4 84.2 30.4 6.1 31.4 5.8 24.9 6.2

1996 6811.4 75.4 27.8 14.8 9.9 1.3 21.5 175.1

1997 6455.6 62.2 22.1 56.6 27.5 1.2 22.4 12.7

1998 6808.1 60.9 23.2 105.7 58.2 2.2 21.1 48.8

1999 6450.2 64.5 25.7 177.9 68.8 0.8 20 135.8

2000 6159.2 61.1 18.7 133.6 42.1 0.7 19.7 168.5

2001 5561.6 49.9 15.8 149.9 34.4 0.9 18.1 268.72002 6031.2 49.2 13.6 236.5 56.8 1.6 84.9

aSource:WorldBank,GlobalDevelopmentFinance,2004.

bSource:KenyaEconomicSurvey,VariousIssues.

Kenya has yet to develop a coherent strategy for managing aid flows. Aid design, process and

implementationhavebeenad hoc through issuesof circulars from theMinistryof Finance (MOF).The

defaultpolicyistoaccommodateasmuchforeignaidasismadeavailable.TheexternalLoansandCredits

Actspecifies limitsonborrowing toaprincipalamountoutstanding tonomore than650millionKenya

poundsattheprevailingexchangerate,or“suchhighersumastheNationalAssemblymaybyresolution

approve”.Thelatterisaloopholeroutinelyusedbyministersinparliament.Themanagementof foreign

aid and external debt are the responsibility of several government ministries and agencies. Themaingovernmentsdepartmentsdealingwithdonorsandloans(theExternalResourcesDepartment(ERD)and

Loans Division and the External Debt Management (DMD)) are highly constrained in human resource

capacityintermsof numbersandskills.Thecountryalsolacksdebtmanagementobjectives.

4. PublicDomesticDebt

Tofinanceitsbudgetdeficits,Kenyahasborrowedondomesticmarketsaswellasabroad.AsTableV.4.

shows, Kenya’s domestic debt accounted for 25 per cent of GDP formuch of the 1990s, and foreign

financinginsomeyearscoveredahighproportionof thebudgetdeficit.Attheirpeakin1993/94interest

paymentsondomesticdebtamounted to47.6per centof government revenuesand24.8per centof

governmentexpenditurerespectively.Thesepercentagesexceedwidelyusedbenchmarksforsustainableratesof interestondomesticdebt.Sterilizationof the inflows associatedwith the foreign financingof




100

budget deficits contributed to tight credit markets and recession, thereby undermining growth and

contributingtodebtproblems.

5. TheEvolutionof Kenya’sExternalDebt

Kenya’s first debt problems followed the drought and trade shocks of the early 1980s, with external

debt/GNIratioexceeding70percentby1985.Afterabrief improvement,followingmoreexternaltrade

shocksand theethnicclashesof 1992,debt levels roseagain,andKenyaaccumulatedarrearsonboth

interestandprinciple.Arrearspeakedinmid1993afterthecuttingof aidandof relationswithdonors.By

1994KenyahadrescheduleddebtsworthUS$500millionitowedtotheParisClub(WorldBank2003).In

1998itbegannegotiationstorescheduledebtowedtoprivatelendersattheLondonClub.82

Debt indicators improvedasa resultof the1994debt rescheduling.WhenHIPCwas launched in1996,

Kenyawasdeclaredcapableof achievingsustainabilitywithanNPVof debttoexportsof lessthan150per

cent(148percent).However,furthertrade,climateandpoliticalshocks(surroundingthe1997elections

andanother suspensionof foreignaid)worsened thesituationagain in the late1990s (seeTableV.4.).

Following the approval of an IMF program in 2000, Kenya rescheduled with the Paris Club under

“Houston”termswithanagreementcoveringUS$300millionof arrears.However,arrearscontinuedto

accumulateand, followinga third IMFprogram in2003,anewParisClubdealwas secured in January

2004 covering US$353 million of arrears. External debt stocks were not significantly reduced by the

agreementsof 2000and2004.Indeed,thestockincreasedfromUS$5.5billionin1999toUS$5.7in2004.

Inrecentyears,therehasbeensome improvementineconomicperformance.Afiscalstrategyhasbeen

establishedtocontrolexpenditureoverthemediumtermandtherehasbeenareversalof thedeclining

trendindomesticrevenuesaswellasasmallrepaymentof publicdebtin2004/05.However,Kenyahas

beendemandingmoredebtrelief followingtheMDRI initiative,particularlysince itsserviceburdenhas

beenexceedingMDGspendingforyears.

As with Uganda, Kenya’s debt accumulation has been closely related to its fiscal needs. Kenya’s case

shows that in theabsenceof adebtstrategy,externaldebt isunlikely toserveadevelopmentagenda.

Kenya’s development and public investment expenditure suffered from both fluctuations in external

financingandtheburdenof debtservice

Kenya’s debt woes are also related to its continued dependency on agriculture and on primary

commodities.Severeclimaticandtermsof tradeshockshaveunderminedgrowthanddeepenedpoverty.

Despite diversification in theproduction and exportbase the economy remains vulnerable to adverse

exogenousshocks.

Kenyahas failed todevelopsignificantdebtmanagementcapacityorclearaidstrategies.Arrearshave

tended toaccumulateevenwhenexternaldebtstockswerenotgrowing.Owing topoor relationswith

donorsthecountryhasalsomissedoutonmajordebtreductioninitiatives.Mostdebtrestructuringshave

concentratedonliquidityproblems,i.e.arrears.Weaknessindebtmanagementandaidstrategyarelikely

toresultinacontinuationof thecountry’shistoricalpatternof debtproblems.

82Theformeragreementledtothecancellationof US$21millionof arrearsandmaturities,whilethelatterdealeventuallyledto

thereschedulingUS$45millionof debt.




101

D. Bolivia’sDebtExperience

1. Introduction

Bolivia is topologically ruggedcountrywitharidagriculturalconditionsand lowpopulationdensity.The

natural resourcesbasedeconomyhasgeneratedonly limitedemployment,andexportsearningshave

contributedlittletorelievingpoverty.Boliviawasoneof thefirstbeneficiariesof HIPCInitiativesbecause

itstrackrecordasaliberalizingreformer.However,sincethelate1990sBolivia’spercapitarealGDPhas

stoppedgrowing.Politicaloppositiontoreformhasintensified.ThedebtstockreturnedtopreHIPClevels.

Bolivia’sexperienceraisesquestionsconcerningcurrentdebtrelief arrangements.

2. OverallEconomicPerformance

In the early 1980s, like many other Latin American economies, Bolivia’s economy slid into recession

associatedwithsurgingworldinterestratesandthe1982debtcrisis(seeFigureV.3.).Between1981and1988percapitarealGDPdeclinedby15percent.Overthesubsequent10yearspercapitarealGDPgrew

atanannualaveragerateof 2percent.In19982003itstagnated.

In the 1990s economic growth was revived by rising investment associated with the “capitalization”

process (seebelow)andwith theexportof naturalgas.FDI inflowsbecamemore important thandebt

from themid1990s, and remittanceswere also an important source of external financing. Inflows of

financing from private foreign creditors have been adversely affected by past experience of losses.

However,recentlymultilaterallendersliketheAndeanDevelopmentCorporation(CAF)andtheIDAhave

beenasignificantsourceof credit.

As an exporter of naturalresource products Bolivia has been vulnerable to adverse price shocks andtermsof trade movements. The prices of its key exports collapsed spectacularly in the early 1980s.

Commodity pricesdidnot recover significantly in the1990s. FigureV.4. shows thedecline inBolivia’s

termsof tradesince1991.Exportpriceslostaquarterof theirvaluebetween1991and2000,whileimport

pricesdriftedupwardswithworldinflation.Decliningtermsof tradeunderminedebtexportratios.

Additionally Bolivia was affected by a series of shocks as of 1997: El Niño; the East Asian crisis in

September1997;theRussiancrisisof August1998;andtheBrazilianandArgentinecrisesof 19992001.

Moregenerallycountryspecific factorshavehinderedgrowththough toanextentdifficult tomeasure.

Thesefactorsincludeharshtopographyandclimate,ethnicandlinguisticdiversity,regionaldivisions,and

ahistoryof politicalinstability.




102

FigureV.3.Bolivia:PercapitarealGDP,PrivateConsumption,andPublicExternalDebt,

19702004

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

1970 1975 1980 1985 1990 1995 2000

Per-capita real GDP

Per-capita real non-government consumption

Per-capita real public external debt (incl. debt to IMF and interest arrears)

Source:InternationalFinancialStatistics(InternationalMonetaryFund).

FigureV.4.Bolivia:Termsof Trade,19912004

(June;1991=100)

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Terms of trade (1991 = 100) Export prices (1991 = 100) Import prices (1991 = 100)

Export prices -->

Im ort rices -->

Terms of trade -->

Source:CentralBankof Bolivia(website).

3. Bolivia’sLiberalizationandStructuralReformPolicies

Since1985 successiveBolivianGovernmentshave carriedout someof LatinAmerica’smostambitious

liberalizationandreformprograms.Thereformprocessbeganwiththe1985stabilizationprogram,which




103

vanquished hyperinflation. The Bolivian Government introduced a “New Economic Policy” of: fiscal

discipline;priceandinterestrateliberalization;liftingof controlsoncrossborderfinancialflows;aunified

marketbasedexchange rate;and trade liberalization.Price liberalization,whichhadended the control

and subsidies of prices,was none the less replacedby price capping in 2000 after export prices rose

sharply.

Exchangerate management has been at the centre of Bolivia’s stabilization efforts since 1985. The

authoritiesallowedthepesotofloatandendedmultipleexchangeratepractices.InJanuary1987,anew

currency, the “boliviano”, was introduced, at a rate of one peso per million. In early 1988 the new

currencystabilizedatabout2.3bolivianosperdollar.TheCentralBankhasmanagedtheexchangerateas

acrawlingpeg,movingitinlinewiththedifferencebetweenBolivia’sandworldinflationrates.Thispolicy

hasledtothemaintenanceof relativelyhighforeignexchangereserves(seeFigureV.5.).

Persisting dollarization has complicated exchangerate policy.Despite compulsory conversion of dollar

bank deposits into Bolivian pesos in the early 1980s, there has remained a large amount of informal

dollarization, which has contributed to inflationary pressure. Since 1985 dollardenominated accountshaveaccountedfor8590percentof depositsandloans.Bolivia’scocatradehasalsocontinuedtobringa

largeinflowof dollars,contributingtodollarization.

Tightmonetarycontrolhasbeen fundamental to themaintenanceof priceandexchangerate stability.

Between1987and2004,theaverageannualrateof increaseinconsumerpriceswasonly8.7percent;and

theaverageannual rateof increase in thepriceof theU.S.dollar inbolivanoswas8.2percent.On the

whole,Bolivia’sexchangeratepolicyhascontinuedtosupportstabilizationsince1985.

FigureV.5.Bolivia:YearendForeignExchangeReserves,19802003

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1980 1985 1990 1995 2000

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

Months of imports of goods and non-factor services Per cent of GDP

Months Per cent of GDP

Source:CentralBankof Bolivia

The mid1990s witnessed a “second generation” of reforms, which centered on three elements:

restructuring and capitalization of key sectors; pensions’ reform; and significant decentralization. The

“capitalization” program of 19951996 was an alternative to politically unfeasible privatization. The

Governmentauctionedtherightto50percenttemporaryownershipstakeandmanagementcontrol inselected enterprises accompanied by a commitment to carry out specified capital expenditures. The

program was successful in the sense that the enterprises which were capitalized exceeded agreed




104

investment targets, and services improved (IMF2005). A closely associated reform was the 1996

HydrocarbonsLawdesignedtoenhanceforeigninvestment,particularlyinthedevelopmentof newfields.

The reformdid succeed in attracting substantial investments, and led todiscovery andexploitationof

large gas reserves. However, government revenue from the sector was disappointing, and deepening

foreignparticipationhasbeensourceof popularresentment.

In 1997 theGovernment undertook reformof the troubledpensions system along the linesof Chile’s

pension reform, i.e. shifted to a contribution system.As fordecentralization, representative governing

bodiesweresetupfordepartmentsandprovinces.These institutionsweregivensignificantfiscalroles,

including sharesof government revenue.However, the transferof revenue and responsibilitiesproved

politicallycontentious,andcontributedtoBolivia’sfiscaldifficulties.

Throughoutthesechanges,theGovernmentlackedfirmpoliticalsupport.Ambitiousasthereformswere,

theydidlittleforordinaryBolivians.Inresponse,manyBolivianstriedtoescapepovertyby“rentseeking”

strategies involving publicsector employment, smuggling activities, or participation in the illicit coca

derivatives trade. Thus the political process became closely linked to persistent pressures for publicemploymentandsubsidization;smugglingbecameubiquitous;andsuppressionof thecocatradehasbeen

impossible.Since securingpublicpositionshasbecome abasic functionof politicalparties, it ishardly

surprisingthattheadministrationhasbeenpronetoinefficiency,overstaffingandcorruption.

Thereformsof the1990shavebeguntounderminefiscalbalancesdespitetheexistenceof policyrules

such as forbidding theprintingof money andmechanisms to control government expenditure and to

ensureagoodflowof foreigntraderevenues.Taxrevenuehasstabilizedsince1998atabout1213per

cent of GDPwith customs revenues steady at about 1per cent of GDP.Hydrocarbons reformhad an

unexpectedly large upfront fiscal cost, especially when royalties were cut in 1997. Earnings from

hydrocarbonshadbeenaround10percentof GDPbutby2004theyhadslidto6.4percent.Receiptsfrom

fuel excises initially rose after 1997 but stagnated in 2000 when fuel prices were frozen. On theexpendituresidepersonnelcostsare10percentof GDP.Thecostsof decentralizationandof thepension

reformturnedoutwellabovewhatwasanticipated.Lastly,domesticinterestpaymentshavebeenrising

inlinewithdomesticborrowing.

4. Bolivia’sExternalDebt:StructureandMainFeatures

Externaldebtgrewindollartermsfromthe1970suntilHIPCdebtrelief in2001.Inthe1970sthebulkof

thedebtwasbilateraldebtowedtocommercialsourcesandborrowedmostlyfordevelopmentpurposes,

notablyinfrastructure(communications,roads,airports).Between1980and1987thegrowthof Bolivia’s

totalexternaldebtaccelerated,increasingfromUS$2.7billiontoUS$5.8billionfrom justunder60to just

over 140per cent of GDP. The prime reason for this surge was increases in world interest rates. Inaddition, international recessiondrovedownBolivianexportprices.Asa resultBoliviacouldno longer

meetitsdebtserviceobligationstocommercialbanks,andwentintoarrearsanddefault.

Between1989and1992,Bolivia’soverallexternaldebt stock stabilized at aboutUS$4billion, rising to

US$5billionafter1996.Meanwhile,highereconomicgrowthduringthemid1990sreducedthedebtGDP

ratio somewhat. In1998and2001Bolivia receivedaboutUS$1billion inHIPCdebt relief, reducing the

debtGDPratio.However,thisreductionprovedtransitoryandwithintwoyearsslowgrowthandheavy

borrowing frommultilateral sources raised thedebtGDP ratio towhere ithadbeenbeforeHIPCdebt

reduction.

Since the second half of the 1980s Bolivia has cut its dependence on commercial bank finance.

Multilateralagencies increasedtheir lending inthe late1980stoassiststabilization,and inthe1990sto

support liberalizationand structural reform.Thus,of theend2004 totalexternaldebtof US$4.6billion




105

US$4.3billionwasowedtomultilateralentitieswiththeIDAaccountingforUS$1.7billion(seeFiguresV.6.

andV.7.).

FigureV.6.Bolivia:YearEndPublicandPubliclyGuaranteedExternalDebt,19702004

(US$billion)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Multilateral Bilateral Private sources:

Source:GlobalDevelopmentFinance(WorldBank).

Debtserviceremainedwithinarangeof 4to5percentuntiltheendof the1990s.Itthensurgedbrieflyin2000and2001duetorelativelyhighrepaymentflows.Bolivia’sexternaldebtservicetoexportsratiowas

generallybeenabove20percentuntilitfellbelow20percentafterHIPCdebtreduction.Bolivia’sinterest

burdenwaskeptdownbytheconcessionalnatureof muchof itsdebtsincethesecondhalf of the1980s.

FigureV.7.Bolivia:YearEndPublicandPubliclyGuaranteedExternalDebt,19702004

(Per cent of GDP)

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

200.0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Multilateral Bilateral Private sources:

Source:GlobalDevelopmentFinance(WorldBank).




106

Boliviadebtmanagementhas improved significantlysince theearly1980s.At that time,Boliviahadno

administrative system of debt management and governance as such, though theGovernment formed

committeestodealwithcommercialbanks.In1985debtwasconsolidatedinthenationalTreasury,anda

ministeriallevelcommitteewasformedtoworkoutastrategy.In1987commercialbanksdecidedtooffer

relief throughdebtbuybacksbuttheoperationswerecarriedoutadhocbyexpertswithoutthehelpof

sophisticateddebtmanagementsystems.

Under the basic institutional arrangement eventually adopted the Government assigned the bulk of

managing and monitoring of external debt to the Central Bank because of its institutional depth and

analyticalcapacities.Sincethe1980sBolivia’stechnicaldebtmanagementcapacityhasimprovedsteadily

andBolivia’sdebtpoliciesarenowhighlytransparent.TheConstitutionrequiresparliamenttoapproveall

newborrowing.

5. DomesticPublicDebt

Alongside of its external borrowing to finance government expenditures Bolivia has also borrowed

domesticallyparticularlyafter the1985 reforms.Thusdomesticpublicdebt rose steadily from1991 to

overUS$1bnin2000,thendoublingto justunderUS$2billionby2004,i.e.from13to21percentof GDP.

The issuanceof domesticobligationscanhelpGovernmentstodeepentheir financialsectorandwiden

theirrevenuebase.ButaswithotherHIPCs,Boliviahadtopayhigh interestrateson itsdomesticdebt,

which isnotcontractedonconcessionalterms. Interestpaymentson internaldebtrodefrom0.4to1.8

per cent of GDP between 1998 and 2004,while interest payments on external debt remained stable

aroundonepercentof GDP.Domesticdebtreached21percentof GDPin2004,andtotalpublicdebt95

per cent of GDP. Initial fiscal sustainability targets under HIPC programs overlooked this source of

indebtednessandtheresultingpressureonfiscalbalances.




107

TableV.5.Bolivia:DomesticPublicDebt19912004

Year

DomesticDebt

(US$million)

TotalPublicdebt

(US$million)

Domesticdebt

(as per cent of

GDP)

TotalPublic

debt(as per cent

of GDP)

1991 385.6 4258.4 7.2 86.9

1992 396.2 4429.8 7.0 85.5

1993 296.8 4300.1 5.2 80.2

1994 97.5 4576.5 1.6 78.3

1995 217.0 4999.6 3.2 77.8

1996 438.8 5080.8 6.0 74.8

1997 508.4 5040.0 6.4 70.1

1998 827.9 5487.3 9.8 74.5

1999 983.6 5557.4 11.9 79.3

2000 1100.1 5560.1 13.2 79.7

2001 1508.6 5920.6 18.7 92.22002 1504.3 5804.7 18.3 89.1

2003 1724.4 6768.7 20.1 98.8

2004 1992.9 6944.0 21.3 95.5

Source:Cowanetal2006.

6. PastandPresentExternalDebtPracticesandStrategy

Sincetheearly1980sthreebroadphasesof Bolivia’sdebtstrategycanbedistinguished.Thefirstbegan

withtheonsetof thedebtcrisis in1982.AtthattimeBoliviareliedheavilyonexternaldebttocover its

fiscaldeficit,andwhendebtflowswerecutoff,theGovernmentshiftedtomonetaryfinancing,generating

hyperinflation.In1984Boliviadeclaredamoratoriumondebtservice.Themarketvalueof Bolivia’sdebtto commercialbanksplunged to1015per centof its face valueby themid1980s.The secondphase

lasted from the August1985 stabilization program until 2000 and consisted largely of reducing debt

throughvariousinitiativesandincreasingrecoursetoconcessionalflows.Since2001newmultilateraldebt

inflowshaveoffsetHIPCdebtreduction,politicalturmoilhasintensified,andGDPgrowthhasstagnated.

OncethestabilizationprogrambeganinAugust1985,theauthoritiesrestoredrelationswiththeIMFand

other creditors. The 1986 IMF program opened the way to new financing. Bolivia took a pioneering

approachtoitscommercialbankdebt(aboutUS$650millionin1986).Usingfundsprovidedbydonors,it

retired thebulkof itsdebtbypurchasing itatdeeplydiscountedvalues.83Bolivia’sdebt tocommercial

bankswasmostlyeliminatedbytheearly1990s.

Thereafter, Bolivia sought relief on its bilateral debt through the Paris Club. It went through six

reschedulingsbetween1986and1995.Between1986and2003,BoliviahadthreeIMFprogramsinvolving

SDR515million, including one of the first Poverty Reduction and Growth (PRG) Facilitiesin 1998. In

April2003,Bolivia securedan IMFagreement forSDR129millionamidsteconomicandpolitical crises.

Fearing that the collapseof the agreementwould aggravateBolivia’sproblems, the IMFwaived some

conditions,andBoliviadrewSDR102millionbyMarch2005(IMF2005).

In September1998, multilateral and bilateral creditors provided Bolivia debt relief amounting to

US$449million innetpresentvalue (NPV) terms,at the“completionpoint”of itsHIPCprocess.Of this

total,bilateralcreditorsandtheIADBeachaccountedforabout35percent,theWorldBankforabout12

per cent, CAF for 9 per cent, and the IMF for about 6percent. The conditions Bolivia satisfied for

83TheBolivianbuybackoperationof 1987,whereUS$253millionwererepurchasedatabout11centsperdollar,wasoneof the

firstlargescalebuybackcarriedoutwiththespecificpurposeof reducingacountry’sexternaldebtsincethe1930s.






109

privateenterprisesandthefiscalcostsof domesticborrowing(orboth).Exchangeratedevaluationfailed

to make primary commodity exports more competitive, and trade liberalization undermined the

government revenue base. Cuts in government spending undermined public investment, thereby

weakeningprivateinvestmentandhumancapitalformation.

Inallthreecasesthereformsadoptedwerenotsufficienttoovercomemanydeeprootedproblemsand

structuralweaknesses.Fiscaldisciplinehasbeenbeneficial,butitdoesnotexpandataxandrevenuebase

curtailedbymeasuressuchastariff removals.Hence,4050percentof governmentactivities inUganda

and Kenya continue to be financedby foreign aid. Likewise,orthodox reformshavenot reducedhigh

productionandtransportationcostsinherenttothethreecountries’difficultgeographyandtopography.

Neither the reformsnor thedebt initiativeshave adequately recognized orproduced solutions to the

extremevulnerabilityof the threecountries tostrongexternalshocks.All threecountrieshaveaheavy

concentrationof economicactivityandexports ina fewprimaryandunprocessedcommodities,whose

prices have been highly volatile and subject to sharp declines. The effects of this concentration are

exacerbatedbythedependenceof largepartsof thepopulationonrainfedagriculture.

Itisagainstthiscontextthatthethreedebtorshavehadtomanagetheirexternaldebtburdens.Whilethe

countries were catapulted into debt traps at different times and with different intensities, debt

sustainabilitycontinuestoeludeallthree.Although inheriteddebtstockshavebeenreducedandthere

have been shifts to concessional financing and grants, the three debtors continue to experience the

pressuresof highdebtburdens.

Recentdebt crises inall three caseshaveoriginated in the government sector, i.e. the inabilityof the

Government to service foreign loans. However, the defaults and arrears were caused less by the

ballooningof debtstocksthanbysuddenandunexpectedsharpshortfallsinrevenuesduetoexogenous

shocks,namelyrisinginterestratesorcollapsingexportearningswhichleddebtratiostosoar.

AllthreeGovernmentshave increasinglyresortedtodomesticborrowing,albeittodifferentdegrees,to

financegovernmentbudgets.Domesticdebtsanddebtburdenshaveonlyrecentlybeenincludedindebt

sustainability analyses (World Economic and Social Survey 2005). Domestic debt tends to be more

expensive thanexternal finance, so that its costsworsen fiscaldifficultiesorwiden fiscaldeficits. This

underminesthebeneficialeffectsof operationsreducingexternaldebt,andisoneof thereasonsforthe

failureof HIPCinitiatives.InUgandaandKenyadomesticdebthasalsobeenissuedtosterilizeofficialaid

inflows.InUgandasuchsterilizationhashadtheconsequencethattherewouldbenoimprovementinits

debtserviceafterHIPCIIafterallowanceforthecostof theTreasuryBillsissuetosterilizeaidflows.

Atthetimeof theirfirstcrisesnoneof thethreecountrieshadinplaceameaningfuldebtstrategyoreven

goodmanagement systems to monitor or analyse debt. This has changed substantially in the case of UgandaandBolivia,whichbothnowhaveadequatetechnicalcapacitytomanagetheirdebt.OnlyKenya

stilllacksanadequatedebtmanagementsystem.

Since the1990s,debt strategieshavebeendeterminedbyofficial creditors.Rescue fromdefaults and

fresh finance depended on the IMF and multilaterals, which initiated the countries’ adjustment and

reformprogramsaspreconditionsfordebtrestructuringswiththeLondonandParisClubs.Thedetailsof

theagreementsreachedexplainwhytherewasaneedforcontinuousandrepeatedreschedulingefforts.

These resulted fromearly cutoff points, theexclusionof toomany typesof debtsand creditors,debt

relief inadequatetoeaserepaymentdifficulties.

Thelaunchof theHIPCinitiativewasarecognitionof thefollowing: Debtproblemsparticularlyforpoorercountriesreflectinsolvencyratherthanilliquidity;

Partialandprotractedreschedulinghasnotprovidedapermanentexitfromrestructuring;and




110

Reachingsustainabledebtpathsrequiresdebtreduction.

The fact thatHIPChad tobe enhanced almost as soon as itwasbornhighlighted its similarity to the

reluctantandpartialapproach todebtproblems thatcharacterizedprevious initiatives. Italsoreflected

weak analytical bases,which, for example, overlooked fiscal criteria for sustainability. More seriously,

debt sustainability analyses were not based on realistic and comprehensive scenarios, and

underestimatedthevulnerabilitytoand theextentof exogenousshocks (see forexampleNissankeand

Ferranini (2006). Even the most compliant countries included in the initiative had been consistently

thrownoff coursebysuchshocks,includingduringandafterHIPC.

ThepostHIPCproblemsof UgandaandBoliviarevealotherflaws:

Thelimitsof anarrowfocuswhichdefinestheattainmentof debtsustainabilityintermsof debt

ratiosbelowthresholdsatonepointintime;

Failuretotake intoaccountthattheriseinpostHIPCborrowingcouldquicklyreversegains(the

resultinUganda’scaseof afailuretoplacealimitonthestockof newborrowing); Theproblemof usingloansinsteadof grantstofinancepovertyalleviationprograms;

Themoregeneraldifficultyforpoorereconomiesof achievingthereformsof fiscalpolicywhich

makepossibleobservanceof domesticdebtthresholds.

In 2007 Bolivia had unsustainable debt based on fiscal criteria and Uganda’s debt sustainability has

deteriorated since HIPC II completion. Kenya’s debt indicators remain unsatisfactory and its second

PovertyandGrowthFacilityisunderreview.

F. ConcludingRemarks

All three countries coveredby this studyhave extensively liberalized their trade and foreignexchange

regimes and their financial sectors. Part of this liberalization was undertaken at the countries’ own

initiative.Butwithrespecttomanyof themeasuresthecountrieshad littlechoice,sincereceivingdebt

relief andaid frommultilateralsdependedon implementationof conditions inagreedprograms.These

conditionslimitedthespaceof policymakersandfailedtodelivereitherbroadbasedorsustainedgrowth.

These experiences show that the programs on which debt relief was conditional were based on an

inadequateapproach.Byfailingtodelivergrowthortostabilizerevenuesandexportearnings,theyalso

failed toprovidea sufficient improvement in theability to repayor servicedebt.Debt initiativeswere

blinkeredandpartialintheircoverage,draggingeachcountryintoanunendingseriesof negotiationsand

reschedulings.

Onelessonof theseexperiencesistheneedforamuchdeeperandmorecomprehensiveunderstanding

of debt sustainability and of solvency which goes beyond thresholds and liquidity ratios, however

rigorously derived. Another lesson is that it is impossible to use debt to spur economic growth and

development without a coherent debt management strategy. A third lesson is that new external

borrowingbypoorer countrieswill contribute to growthonly if directed atexpenditures thatenhance

productivityandcompetitiveness.




111

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115

CHAPTERVI

CASESTUDIES:ARGENTINAAND

THEREPUBLICOFKOREA

MarioDamill,RobertoFrenkel,MartínRapettiandYungChulPark84

A. Introduction

Thispaperexaminesrecentcrises thatshook theeconomiesof ArgentinaandtheRepublicof Koreaas

well as the international financial system. Both were capitalaccount crises in apparently successful

middleincomedevelopingeconomies.Whilebothcountrieshadexperienceddebtcrisesbeginninginthe

late 1970s, Argentina’s default of 20002001 and the Republic of Korea meltdown of 1998 were

exceptional in their severity. International rescue packages led by the IMF were organized in both

instancesandwereasourceof politicalcontroversy.

TheArgentinecrisisanddefault,thelargestinrecentyears,isstillsubjecttodisagreementastoitscauses.

SectionIIascribescentralimportancetoawrongdiagnosisof thecrisisbytheIMF,whichconcentratedon

addressinga fiscaldisequilibriumduringa liquiditycrunch.Thecountry’spolitical leadershipsharedthe

IMF’s belief, as is evident from the various fiscal adjustment programs undertaken. Several factors

externalaswellasinternaldidpushpublicdebttowardsunsustainablelevels,particularlyinthecontext

of a recession.However, structural featuresof theeconomy such as the convertibility regime and the

dollarizationof thebanking systemwereof critical importance to thedefault,which led toahistorical

fallingoutbetweenArgentinaandtheIMFandanacrimoniousdebtrestructuring.

84Section B is based on a paper byMarioDamill, Roberto Frenkel andMartín Rapetti (Researchers at CEDES, BuenosAires)

(Damill, Frenkel and Rapetti (2005)), Section C is based on the paper by Yung Chul Park (Graduated School of International

Studies,SeoulNationalUniversity)(Park(2005)).



CaseStudies: Argentinaand theRepublicof Korea

116

Theexperienceof theRepublicof KoreadescribedinSectionIIIalsosuggeststhatIMFpolicyprescriptions

worsened the crisisbyhelping topush theeconomy intodefault.Section IIIalsohighlights the roleof

banking crises,collapsing financialmarkets,and irresponsible foreignborrowingby chaebols.Yet,as in

Argentina,theimmediatetriggersof thecrisiswereadverseexternalshocks,namelytheweakeningof the

Yenandregionalcontagion.SectionIVcomparesmajorfeaturesof thetwocrises.

B. LessonsfromtheArgentineCrisisandDefault

1. Introduction

This section challenges the leading explanations of the latest Argentinean debt crisis, whereby

uncontrolledpublicspendingisperceivedasthemaincauseof debtaccumulation,crisisanddefault.

Firstly, it is shown that the effectsof rises in interest rates riseswere themaindriverof publicdebt

dynamicsattheendof the1990s.Even if allowance ismadefortheeffectof uncertaintiesaboutpublic

debt sustainability on investors’ assessment of the country’s position, the main source of the

deteriorationwasnotfiscalpolicybutfinancialfragilityandcontagion.

Secondly, the role of macroeconomic policies – particularly exchange rate policy in generating an

unsustainabledebtpathisemphasized.InthisregardtheArgentinecaseisanextremeexampleof badly

managed financial integration leading tohigh interest rates, low growth, and vulnerability to financial

contagionandvolatilityof capitalflows(Frenkel,2003b).

Thirdly,thepaperchallengesacommonlyheldopinionthatthedefaultdecisionwasmainlyresponsible

for the deep crisis in Argentina. It shows on the contrary that the abrupt contraction in activity and

employmentoccurredbefore thedefault as theGovernment tried to keep debt serviceon track. Thedefaultprovedtobeoneof triggersthatsubsequentlyallowedrecovery.

Fourthly, the section examines how debt restructuring took place in the context of a confrontational

relationshipbetweentheIMFandArgentina.Themostunusual –indeedunprecedented featureof this

processwasthattheIMFdidnotparticipateinthedesignof therestructuring.

2. MacroeconomicPerformanceinthe1990s

Between 1977 and 1982 Argentina went through a phase of financial opening and accelerated

indebtednessthatendedinmassivecapitalflight,exchangeratecrisis,anddefault.Thiswasfollowedbya

longperiodof internationalcreditrationingbetween1982and1990.The19912001periodalsoendedincrisisanddefault.Adistinguishingfeatureof thesetwoperiodsistheroleplayedbytheprivatesectorin

thegenerationof externalfinancialobligations.Despitethestrongriseintotalexternaldebtinthe1990s

theshareof publicexternalintotaldebtdeclinedbyover20percentagepointswhichsuggeststhatfiscal

disequilibriumwasnotthemaincauseof thecrises.85

Argentinaenteredbothphasesof acceleratedindebtednessinthecontextof stabilizationprogramsbased

ona fixednominalexchange rate.Theseprogramsset inmotionprocyclicalmacroeconomicprocesses

which left the economy vulnerable tonegative external financial shocks. (Frenkel, 1983; Taylor, 1998;

Frenkel,2003a).

In1981thestabilizationpolicybasedontheexchangerateanchorwasabandoned.Anewphasefollowed,

characterized by massive devaluations of the peso. These devaluations were accompanied by higher

85SelectedindicatorsforArgentina’seconomyduring19772006aregivenintable1.




117

internationalinterestratesandaneventualpeakof theratioof foreigndebttoGDPof nearly60percent

in 1982. The public sector’s share in external debt also rose in this period because the Government

assumed a considerableproportionof theprivate foreigndebt.During the secondphaseof the1990s

totalexternaldebtincreasedbutmostof thatrisewasgeneratedbytheprivatesector.

Thefiscalbalancewentthroughthreeperiodsinthe1990s.(seetableVI.2.)During199194theaverage

deficit,which inthe1980swasabout7percentof GDP,decreasedto lessthan1percentof GDP.This

wasmainlyduetoanimprovementintheoverallpublicsectorbalance.Nonetheless,publicdebtrosein

theearly1990sbecausetheGovernmentassumeddebtsthatwerenotregistered in the fiscalbalance,

especiallydebtsof publicsectorpurveyorsandof thesocialsecuritysystem.

In1994newnegativepressuresemergedonpublicfinancesduetothreefactors.Firstly,asocialsecurity

reform that created the Private Pension Funds led to a significant fall in contributions. Secondly, the

regionalboomwasfollowedbytheconsequencesof theTequilaeffectin1995,whichwasmanifestedina

sharp rise in the countryrisk premium of Argentina’s interest rates (see table VI.3.). Thirdly, the

Governmentattemptedtocountertheseconsequencesbyloweringthetaxburdenontradables.Between1995and1997thepublicdebt/GDPratioroseslightlybeforestabilizing.

TheRussianandBraziliancrises in1998 resulted inanew jump in the countryriskpremium.Thiswas

accompanied by a recession and increased financial vulnerability of debtors. A sharp rise in interest

payments had already begun in 1996. By 2000 these payments amounted to nearly 19 per cent of

governmentrevenues.Recessionandhigherinterestrateslargelyexplaintheexplosivepathstakenbythe

publicdebtanddeficit,whichhadtheconsequencethatthepublicdebt/GDPratioincreasedbyalmost20

percentagepointsbetween1997and2001.

3. MacroeconomicPerformanceBeforeandAftertheDefault

Themacroeconomicstoryof thelate1990scanbedescribedasaswingfromeuphoriatodepression.The

negative turnaround in the external environment experienced in 19971998 left the economy with a

significantandgrowingcurrentaccountdeficit,anappreciatedrealexchangerate,andavisible lackof

policyinstrumentstodealwiththeproblem.Hence,restrictivefiscalpolicieshadtobearthemainburden

of attemptsatadjustment.Theexpectationwas that fiscaldisciplinewould triggergreater confidence,

leading toa recovery indomesticexpenditurewhichwouldpush theeconomyoutof recession.De la

Rua’sadministrationacceptedthisargument,andtheIMFgaveitssealof approval.

However, the result was failure. Fiscal policy alone was impotent to counter large macroeconomic

imbalances,whichweremostlyrootedintheexternalsectorof theeconomy.Theeconomysufferedthe

longestrecessionsincetheFirstWorldWar.

Capital inflows contracted sharply in response to the contagion caused by the Mexican crisis at the

beginningof 1995(seetableVI.4.).Foreignexchangereservesalsofell.However,therecessionwasshort

livedthankstotheeffectsof theIMFledpackageof financialsupport.Afterabrief recoverythecountry

risk premium began to increase again after the devaluation in Thailand in 1997. As noted above, a

sustainedcontractionstartedaftertheRussiandefaultin1998.

Duringtheearly1990stherewerelargeprivatecapitalinflows,followedbyacontractionin1995.Capital

inflowstothepublicsectorweremorestable,beingsustained intherecessionof 1995andduringthat

whichbegan in1998.Privatecapital inflowsrecovered in1996butwereaccompaniedbyoutflowsof a

similarmagnitude.From1998onwardsthenetinflowturnedintoalargenetoutflow.




118

The increase intheforeignpublicdebtof theentireperiodfrom1991onwardsexceededUS$35billion.

Thisamount isquiteclosetotheincrease intheforeignfinancialobligationsof thenonfinancialprivate

sectorwhich,however,weremorethanoffsetbytheriseof thesector’sexternalassets.

InDecember1999,anewGovernment tookoffice.Aspreviouslymentioned, thisGovernmentbelievedthatthemaincauseof theeconomicdepressionwasfiscalmismanagement.Successivepackagesof tight

fiscalmeasureswereapplied.Effortstopreventdefault includedaFiscalResponsibilityLaw in1999that

setamandatorydecliningtrendforthepublicdeficitdesignedtobringittozeroinafewyears.Bymid

2001themeasuresbecamedesperateand includedanunprecedented13percentacrosstheboardcut

in public wages and pension benefits. Coming after years of severe recession, these cuts did not

contributetosocialpeace.

Theexpected“confidenceshock”nevermaterialized.Indeed,theroundsof contractionaryfiscalpolicies

onlyreinforcedthedeflationarytrend.During2000and2001theGovernmentattemptedtocomplement

fiscal measures with some financial initiatives. It also implemented important debt swaps aiming at

convincingthepublicthattherewasnoriskof default.Bytheendof 2000,apackageof localandexternalsupport of about US$40 billion was announced (the “blindaje” or financial shield). The IMF led the

operationwithaUS$13.7billionextensionof thestandbycreditinforcesinceMarch2000.However,two

monthslater,acrisisinTurkeyledtoasharpriseinthecountryriskpremium.

Asareactionavoluntarydebtswap(the“megacanje”)of bondsof US$30billionwas launched in June.

However,because thenewly issuedbondscarried interest ratesof about15percent, they fuelled the

perception that debt had become unsustainable. Another voluntary swap directed at domestic

bondholdersinvolvingUS$42billionof publicbonds,waslaunchedinNovember2001.Allthesemeasured

failed to halt the withdrawal of bank deposits and the fall of international reserves which began in

October2000.

From the beginning of December 2001 the Government established tough restrictions on capital

movements andon cashwithdrawals from banks. Itwas hoped thesemeasureswould hold back the

demandforforeigncurrency,preservethestockof reserves,andmakeitpossibletoavoiddevaluation.In

fact,theyushered intheendof theregime.TheDecembermeasuresthrewthecountry intosocialand

politicalunrest.Inthefirstdaysof 2002,thecurrencyboardregimewasofficiallyabandoned,andwithit

theonetooneparityof thepesototheUS$.

Afterthreeyearsof recessioneconomicactivitysufferedaparticularlyabruptfallasof mid2001.Social

indicators such us the unemployment rates and poverty indexes, which had worsened in the 1990s,

deteriorated further, adding to social tensions and to thepolitical crisis (Damill, Frenkel andMaurizio,

2003).

Thecatastrophicfall inoutputandemploymentcontinuedforawhileaftertheendof theconvertibility

regime.However,contrary tomainstreambeliefsandquiteextraordinarily,arecoverystartedonlyone

quarterafterthedevaluationanddefault.Itwastriggeredbythesuddenchangeinrelativepricesinfavor

of sectorsproducingtradables.

The turnaround was associated with a set of policies aimed at recovering basic macroeconomic

equilibrium.Thepoliciesincludedthefollowing:

(a) The impositionof restrictionson capitaloutflows and exchange controls, includingunder the

lattertherequirementthatexporterssellapartof foreigncurrencyearnings;

(b) Theestablishmentof taxesonexports,whichallowed theauthorities to capture someof thebenefitsof thedevaluationforexporters’incomes;

(c) Aflexiblemonetarypolicyaimedtoassisttherecoveryof banks;




119

(d) Anexchangeratepolicyaimedatavoidingtheappreciationof thepeso.

The IMFhad insistedon the immediate free flotationof thepeso.Fora shortperiod theGovernment

adoptedthisregime.Oncetheexchangeratewasfreetofloat,theexchangeratemovedabruptlytolevels

of close to4pesosperUS$.The reintroductionof exchange controlswasdesigned to contain further

movement. Soon afterwards thedemand forpesos started to recoverwithUS$ inexcess supply. This

resultingstabilizationhelpedtohalttheriseindomesticprices,asdidthefreezingof publicutilityrates.

GDP recoveryof the firsthalf of 2002hada short firstphase inwhichaggregatedemandbarely rose.

Whatstoppedtherecessionwasarecoveryindomesticproductionwhichwasnowmeetinganincreased

proportionof domesticdemand as imports contracted sharply. Investment rosebynearly40per cent

between2002and2004,beingfollowedcloselybyprivateconsumption.

Economicrecoverytookplaceinacontextof severecreditrationing.Investmentwasfinancedbyretained

profits.A“wealtheffect”fromtheexternalassetsholdingsof theprivatesector,alsohelped.Theseassets

–now estimated atoverUS$100billion rose in value as resultof exchange ratedepreciation, and inrelationtothepricesof domesticassetssuchasrealestate.

Improvement inthecurrentaccountstarted in1998.Theabruptcontractionof importsaftertheendof

convertibilityhelpedtotransformadeficitof almostUS$3billionin1998intoasurplusof US$17billionin

2002.

On the fiscal front between 2001 and 2004 there was an improvement in the overall balance of the

ConsolidatedPublicSectorfromadeficitof 5.6percentof GDPin2001toasurplusof 3.5percentin2004

(see table VI.5.). This reflected improvements in the three major components, the primary balance,

interestpayments,andtheaggregatebalanceof theprovinces.

The most important factor in the improvement of the primary balance was an improvement in tax

revenues due mainly to those on exports and income. In table VI.7. interest payments are shown as

decliningby2.5percentof GDP.However,thisdoesnotindicatetheeffectof thesuspensionof payments

onexternalpublicdebt,whichatthe2004exchangeratewouldhaveamountedtoabout10percentof

GDP:

4. DefaultonExternalDebtandtheRestructuringProposals

Thesuspensionof servicepaymentsonpartof publicdebtwasdeclaredon24December2001.Outof a

totalof US$144.5billionUS$61.8billion inpublicbondsandsomeUS$8billion inother liabilitieswere

affected.Thedevaluationof thepesohadamajorimpactontheeconomy’scontractualobligations,given

thepervasivedollarizationof contracts.Afewdaysafterthedevaluation,aspartof policiestoattenuate

theshock,theauthoritiesissuednewdebt.

Themainsourceof thenew indebtednesscamefrom interventions inthefinancialsystem,and ledtoa

US$14.4billionriseinpublicdebt.InFebruary2002theGovernmentdecidedtoundertakeacompulsory

conversion of foreigncurrency bank deposits at a rate of 1.4 pesos per dollar.86The withdrawal of

depositswasrestrictedto1,500pesosperpersonperweek.Bankcreditsinforeigncurrencyweresubject

to conversionata rateof onepesoperdollar.This “asymmetricpesoification”of creditsanddeposits

causedasignificantlossinbanks’networththatwascompensatedbytheGovernment.Newdebtissued

forthispurposeamountedUS$5.9billion.

86Whenthemeasurewassanctioned,thedollarwasataround2.15pesos.Fourmonthslater,thedollarexchangeratereached4

pesos,decliningsmoothlythereafter.FromMarch2003,theparitystabilizedatbetween2.83pesosperdollar.






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acceptance.92Later,itwasmadeclearthattheswapwouldcomprisebothcapitalandinterestarrearsand

theamountof thenewbondswas increasedtoamaximumof US$38.541.8billion.Thethreedifferent

bondsweremaintainedinthenewproposal.

TheBuenosAiresproposalimpliedahigherfuturefiscaleffort.TheGovernmentwasineffectcommittedtoaprimarysurplustargetof 2.7percentof GDPduringthefirstfiveyears,thistargeteasingtoaround

2.3percentof GDPasof 2014.Undertheassumptionof 3.3percentannualaveragegrowth,projections

indicatedthatthe fiscaleffortwould financemost interestpayments.However,even if themultilateral

organizationsagreedtorefinancedebtduetothem, theGovernmentwouldstillhavetoobtainannual

fundingof about2percentof GDPfortenyearsaftertheswap.

EvidencethatArgentinawouldfaceaheavydebtburdenaftertheswapdidnoteasecreditors’demands.

ImmediatelyaftertheannouncementinJunebondholders’organizationsrejectedtheproposal.Financial

analysesshowedthatasubstantialhaircutof about7380percentwas implied.Thesizeof thehaircut

depended crucially on the discount rate used in the calculation. That usedwas the yield of assets of

emergingmarketcountriesratedasof similarrisk,i.e.1214percent.

By late 2004 developments on international capital markets unexpectedly started to play in favor of

Argentina.Greaterworldliquiditystimulatedtheappetiteforriskandforemergingmarketsdebt,andled

to a reduction of developing countries’ risk premium.93In this new context estimates of the haircut

impliedbyArgentina’sproposalwerereducedandtheswaplookedmoreattractive.Thepresentvalueof

offeredbondscalculatedatthenewdiscountratewas3035centsonthedollar.Thiswassimilartothe

marketpriceof thedefaultedbonds.

The improvement in the financialenvironmentpavedtheway fortheGovernment finally to launchthe

swapwithoutintroducinganychangetotheJune2004proposal.94TheswapstartedonJanuary14,2005.

OnMay3,2005, theGovernmentannounced thatacceptancehad reached76.15percent.Thismeant

thatUS$62.3billionof theoldbondswouldbeexchangedforaboutUS$35.3billionof new instruments

andGDP growthlinked coupons. Theoperation reducedpublic externaldebtbyUS$67.3billion,95and

attenuatedthepublicfinances’exposureto foreignexchangerisk,sincearound44percentof thenew

bondsweredenominatedinlocalcurrency.

5. Argentina,theIMFandtheInternationalFinancialSystem

At first glance it may seem striking that the crisis and the massive default took place in a country

considered an example of the success of Washington Consensus policies. From the IMF’s perspective

Argentina’s currencyboardhadbeen aprime exampleof a feasible corner solution for exchangerate

policy inanemergingmarket(Fischer,2001).Yetatthesametime itwaswidelybelievedthatthedebtandtheconvertibilityregimewerenotsustainable,astheprogramdidnotinvolveanysubstantialchanges

tomacroeconomicpolicy.

Argentina’s program aimed at reestablishing confidence through commitments to fiscal austerity.

However, the recessionand the liquiditycrunchmeant that itwas implausible that the issuingof fiscal

92In the loweracceptance scenario the recognitionof interestarrearswould include theperioduntilDecember31,2003 for

aboutUS$18.1billion,whereasinthehigheracceptancescenarioitwouldincludeinterestsarrearstillJune30,2004,forUS$1.4

billion.93The JPMorganEMBI+ indexdecreased toanaverageof 375basispoints in the lastquarterof 2004,whereas theBrazilian

countryriskpremiumfellto417basispoints.94Torelieve itself fromcreditors’pressures,thegovernmentgaveuptherighttochangetheguidelinesbysendingabilltothe

Congresspreventingtheadministrationfromdoingso.Congressquicklyapproved.95AccordingtoministerLavagna,at theendof 2004, thehaircutwould reducedebtstocks fromUS$191.2billiontoUS$123.9

billion.Thepublicdebt/GDPratiowouldhavefallenfrom113to72percent.




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signalswouldbesufficienttostopthecrisis.Bythetimeof thereductionsingovernmentexpenditurein

mid2001,thereweregood reasonstothink thatmultilateralresourceswouldendup financingprivate

capitalflightwithoutpreventingadefault.

After the changes at the head of the IMF in 2001, the Fund’s relationship with Argentina becameincreasinglystrained.IMFrecommendationsplayedanegativeroleinstabilizationandrecovery.Aprime

examplewasexchangeratepolicy.InFebruary2002theIMFdemandedthe immediateflotationof the

exchange rate, threatening not to reestablish negotiations in its absence. The implementation of this

measure predictably led to an abrupt rise in the price of the dollar and an acceleration of inflation.

Similarly, there was a clash over the management of the crisis in the banking sector. The Lavagna

Governmentwanted gradualaction and voluntaryoptions,while the IMFpromotedheroic “solutions”

suchasbankliquidations.

TheseexamplesshowthattheFundoperatedonthebasisof thediagnosisthat(1)theexchangemarket

couldnotbestabilized,(2)ahyperinflationaryprocesswasunavoidable,and(3)reestablishmentof some

degreeof financialintermediationindomesticcurrencysoonwouldbeimpossible.Theimplementationof themeasurespromotedbythe IMFwouldhavetransformed itsdiagnosis intoaself fulfillingprophecy.

The IMFmaintained itspolicy lineuntilMay2003when theDeputyManagerDirector recognized the

deficiencyof theFund’sdiagnosis.

The 2002 and 2003 agreements were signed in the context of a highly confrontational relationship

betweenArgentinaand the IMF. InSeptember2003,a threeyearagreement torefinancedebts to the

IMFwasagreed.Thetermsof conditionalitywereonlyestablishedforthefirstyear,astheGovernment

refusedtocommittohighertargetsforsubsequentones.Targetsincludednewregulationsof privatized

publicutilities,measures to strengthen financial system,andanew lawabout thedistributionof fiscal

revenues between the national and provincialGovernments. The conditionality also included a clause

underwhichthecountrywastodisplay“goodfaith”inthetreatmentof externalcreditors.Theambiguityof thetermlefttotheIMFagreatmarginof discretioninitsevaluation.

AyearlaterArgentinahadcomfortablyfulfilledthequantitativetargetsbutnotthequalitativeones.The

most significant one under the latter heading was probably the finalization of the renegotiation of

contractsandtheestablishmentof anewregulatory frameworkforprivatizedpublicutilities.Whilethe

IMF was conducting its evaluation, Argentina was presenting the debt restructuring proposal and

organizing the swap. The relationship betweenArgentina and the Fund reached an impasse. The IMF

couldhaveterminatedtheagreementonthebasisof thefailuretofulfillqualitativetargets.Thatwould

havesignifiedaseriousnegativeshock foracountry in themiddleof thedebt restructuringprocess. It

couldalsohaveledtofinancialdifficultiesfortheIMFsinceArgentinawasalargeborrower.

Theimpassewasovercomebythesuspensionof theprogramuntilthebeginningof 2005atArgentina’srequest.Thereafter,ArgentinarepaidtotheIMFallprincipalandinterestthatcouldnotbepostponed.In

theperiod20022004itmadenetprincipalpaymentsof morethanUS$2.1billion,andinterestpayments

of US$1.9 billion. As these figures compared with net receipts of US$23 billion in 19942001, the

ArgentineanMinisterof theEconomydescribedtheIMFasmovingfrombeinga“lastresortlender”toa

“privilegeddebtpaymentscollector”.

A crucial element in the process was the Government’s view that international financial crises and

defaults are the result of excessivedebts attributable to the irresponsible behaviorof borrowers and

lenders.This irresponsiblebehavior isencouragedby the implicit guarantee givenby the IMF’s rescue

packages. Hence, there should be less intervention by the IMF both under normal conditions and in

defaultsituations.Argentina’sGovernment requestednoninterventionof the IMF,arguing further thatthe restructuringproposaldidnot involveadditionalmultilateral funding.Thehighhaircutwas seenas




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proportionaltotheirresponsibilityshownbythemarket.Indeed,Argentina’sstrategyillustratedboththe

flawsof theinternationalfinancialsystemandtheviabilityof alternativewaystosolveproblems.

By2006ArgentinahadrestartednegotiationswiththeIMFfromapositionstrengthenedbythehighlevel

of acceptanceof theswap.Thenegotiationsgavegreater legitimacytotheoperation.Toorigidpositionby the IMF risked being politically uncomfortable for some G7 Governments, and would have

contradictedtheacceptanceof thehaircutbyprivatecreditors.

Moreover,with the high acceptance of the swap, the IMF faced a fait accompli in that the outcome

indicatedanassumptionbythemarketthatArgentina’smultilateraldebtwouldberefinanced.Stillmore

uncomfortably for the IMF the Fund had not participated in the design of the proposal. This clearly

clashedwithIMF’sinstitutional logic inthattherefinancingof acountry’sdebtwassupposedtorequire

itsapprovalof newloans.Therefore,byacceptingArgentina’sdemandstheIMFappearedtobeaccepting

achangeinitsrole.

Thesetensionswereexacerbatedbythespecialcircumstancesthattheinstitutionwasgoingthrough.TheIMFhadactivelyparticipated in the restructuringsof sovereigndebtswith theprivate sector since the

1980s.TherecentSDRMinitiativewasintendedtobeanextensionof thattradition,andwasanattempt

todefine,formalizeandstrengthentheIMF’sroleincasesof sovereigndebtdefault.AfterWallStreetand

theUnitedStatesrejectedtheSDRMinitiative,thisroleof theIMFremainsilldefined.Thisisnotthefirst

time that theGovernmentsof developedcountries –particularly theUnitedStateshave redefined the

functionsof theIMFduringtheprocessof dealingwithimmediateandspecificproblems.Forexample,the

1995 Mexican crisis led to IMF rescue packages for capital as opposed to currentaccount crises.

Argentina’s case may eventually contribute to a redefinition of the functions of the IMF in the

internationalfinancialsystem.

C. ExternalDebtManagementof theRepublicof KoreaduringtheCrisesof 1979

1980and19971998

1. Introduction

During thepast fourdecades, theRepublicof Koreahasexperienced anumberof periodsof financial

stress.Themostseriouswasthe199798crisisthatbroughtthecountrytothebrinkof default.Theother

periodsof stress,includingthecrisisof 197980,werelessdamaging(Park,1986;Cooperet al.,1994).In

many respects the causeswere similar: they included investmentbooms in theperiods leading to the

crises,largeandgrowingcurrentaccountdeficits,andappreciationsof therealexchangerate.However,

the 199798 financial meltdown was a capitalaccount crisis, of which the Republic of Korea had nopreviousexperience.96

TheRepublicof Koreaengineeredaquickrecoveryfrombothcrises.Intermsof economicfundamentals

therewasno reason tobelieve theRepublicof Koreawas anymore vulnerable to a crisisduring the

secondhalf of the1990s than ithadbeen twodecadesearlier.Nevertheless, thecostof resolving the

secondcrisiswasfargreater,andthetwocrisesfolloweddifferentadjustmenttrajectories.

SectionBdiscussesthebuildupandresolutionof the197980debtcrisis.This isfollowed inSectionsC

andDbyanexaminationof macroeconomicdevelopmentspriortoand intheaftermathof thesecond

crisis.SectionEexploresthelessonsandSectionFcontainsasummaryof themainpoints.

96SelectedeconomicindicatorsforRepublicof Koreafor19751985and19952004aregivenintables6and7.




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2. The19791980DebtCrisis

TheRepublicof Koreaeconomy slowed in1979 after three yearsof strong growth,while the current

accountslidintodeeperimbalance,risingtoadeficitof 6.6percentof GDPin1979andof 8.3percentin

1980fromoneof 2percent in1978. In1980outputcontractedby1.5percentandtheconsumerprice

index (CPI) soared to29percent.Theeconomywas thusexperiencing stagflationwitha large current

accountimbalance.Atthesametimetotalexternaldebtasaproportionof GDPswelledto42.6percent.

In these circumstances a traditional IMFsupportedprescriptionwouldhave included a strongdoseof

stabilizationmeasurestogetherwithacurrencydevaluation.ButRepublicof Koreapolicymakersoptedfor

adifferentgrowthfirstpolicy.Tothesurpriseof theIMFandthe internationalfinancialcommunity,the

economyreboundedin1981,growing6.2percent.

At the centreof Republicof Korea economicpolicy in themid1970swas theplan for theheavy and

chemicalindustries.Thispolicyentailedtaxincentives,lowcostbankcredit,andothersubsidiesmostlyto

large firms belonging to the Republic of Korea’s industrial groups or chaebols. The result was aninvestmentboomleadingtoariseintheratioof grossinvestmenttoGDPfrom28.7percentin1977to36

percentin1979.Atthesametimetheeconomyoverheated,withannualincreasesinrealwagesin1976

78averagingover18percent.Asteephikeinagriculturalpricescausedbyapoorharvestin1978further

aggravatedinflationarypressures.

Despite this, theRepublicof KoreaGovernmentwasdetermined tomaintainadollarpeggedexchange

rate.Thisledtoanappreciationof therealexchangerate,whichinturnunderminedexportearnings.At

thesametime,theRepublicof Koreasufferedadverseexternalshocks.Itwashitbythesecondoilcrisisin

1979,sufferinga15percentdeteriorationinitstermsof tradein19791980.

Furthermore, theRepublicof Koreawas thrown intopolitical turmoilby theassassinationof President

Park in 1979. The new military Government of May 1980 was hardly in a position to adopt a strong

stabilization program. Political uncertainties worsened Republic of Korea economic prospects. Not

surprisingly,businessesadjustedbycutting investment, fixed investment fallingby11percent in1980.

Theeconomysankintoadeeprecessionin1980,whichwasaggravatedbyacrisisintheinformalcredit

market.However, surprisingly thecurrentaccountdeficitdidnot shrinkasexpected.Thiswasbecause

consumption remained strong:consumersconsidered the fall inoutput transitoryandcut theirsavings

rather than their consumption. As a result the share of saving in GDP dropped more than that of

investment.

Lackingsupportforastabilizationprogram,thecaretakerGovernmentfocuseditspolicyresponsetothe

deteriorating current account on the exchange rate. The won was devalued visàvis the US$ by 27

percentin1980,andthereaftertheRepublicof Koreamovedtoamanagedfloattiedtoabasketof majorinternational currencies. On the macroeconomic front the Government gave priority to stopping the

economicdownturn.

Hereitscommitmentwastobroadlyconceivedstabilizationtogetherwithfinancialreformandcorporate

restructuring. In its view inflationwas at the rootof thedeterioration in incomedistribution,of labor

unrest, and of the weakening of the country’s export competitiveness. A growthfirst strategy would

succeedonlyif thedeficitonthecurrentaccountwasbroughtundercontrolandfinancedexternally.The

prospectforsuchapolicywasuncertainastheRepublicof Koreahadoneof largestexternaldebtsamong

developingcountries.Nevertheless,debtservice levelsremainedwithinasustainablerange.Thegamble

paid off. The Government maintained an expansionary policy until 1983 when it began restraining

domesticdemand.By1981 inflationwasalreadysubsidingandtheeconomyrecoveredfullyonlyayearaftertherecessionof 1980.




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Whatwere the factors responsible for thedramatic turnaround?HaggardandCollins (1994) singleout

threedevelopments:

An improvement in theexternalenvironmentdue to (1) fallingpricesof oil and rawmaterials

leading toabetter termsof tradeand lower inflation, (2)declining international interest rates,and(3)anappreciationof theyenagainsttheUS$;

Decliningrealwagesinboth1980and1981,partlyduetomoreflexiblelabormarkets;

The depreciation of the real exchange rate, which improved the Republic of Korea’s export

competitiveness.

However,otherimportantfactorsalsohelpedpulltheRepublicof Koreaeconomyoutof crisis.Onewas

theclosedcapitalaccount.Thisallowedflexibilityaswellaseffectivenessformonetarypolicy inafixed

exchange rate regime.Despite theeconomic crisis andpolitical turmoil, theRepublicof Koreadidnot

experienceanycapitalflightoranywithdrawalof foreignloans.TheothercrucialfactorwastheRepublic

of Korea’sabilitytofinanceitscurrentaccountdeficitexternally.Thecountrywasneverdeniedaccesstointernationalfinancialmarkets,althoughitsborrowingcostswentup.

By1983, stability returnedalongsideof the resurgence ingrowth.Bynowbothdomesticdemandand

exportearningswerestrong.Inthesecircumstancesacontinuationof loosemonetaryandfiscalpolicies

couldhaverekindledinflation.Furthermore,totalexternaldebtremainedatover47percentof GDP.To

reduce thedebtburden thecurrentaccounthad tomove in thedirectionof surplus.Thisexplains the

Government’sshifttoastabilizationpolicywhichwassustaineduntil1988.

3. The19971998Crisis

(a)Investment BoomFueled by ForeignBorrowingTheRepublicof Koreaeconomyreboundedstronglyfromaslowdownin1992and1993.Thisgrowthwas

ledbyexportsand investment(39percentof GDP in1996). Inthatyear,thedeficitoncurrentaccount

wasa littleover4per centof GDPandapparentlymanageableyetamajor financial crisis followed in

19971998.

Expansion of investment on this scale in an economy with still small financial markets led to higher

externalborrowing.Twomajordevelopments canhelp toexplain thisdebtfinanced investment surge.

Thefirstwasthestrengtheningof theyenfromthesecondhalf of 1992tothefirsthalf to1995.Thisrise

ended inthespringof 1995whentheyenhitthe levelof 79.5yentothedollar.Theyen’sappreciation

broughtaboutasharpincreaseinRepublicof Koreaexportearningsbecausemanyof itsindustrieswere

indirectcompetitionwiththoseof Japan.

Theseconddevelopmentwas increased financialopenness,which increased theavailabilityof lowcost

foreigncredit. In theperiod19961998externaldebt rose from28 to47percentof GDP.Muchof the

inflowsduring 19951997 consistedof shorttermborrowingsbydomestic financial institutions,which

usedtheproceedstofinance investmentsbychaebols.Theconsequences includedseriouscurrencyand

maturitymismatchesinthebalancesheetsof financialinstitutions(Park,1998,andParkandSong,2002).

Atthesametime,Republicof Koreaindustrialgroupswereincreasingtheirinvestmentsabroad.Muchof

this investmentwas financedwith foreign credits. This helps to explain a rise in the foreigndebts of

domestic firms fromUS$35.6billion in1996toUS$43.2billionayear later.The liabilitiesof theforeign

subsidiariesandbranchesof Republicof Korea firmswereestimatedtohaveexceededUS$51billionattheendof June1997.






127

Reflectingthe ineffectivenessof theGovernment,exchangeratepolicy inthe lastthreemonthsbefore

the crisis drifted into inconsistency and unpredictability. Thewon had been under strong pressure of

depreciation since early 1997. Throughout the year, the Government stated that itwould defend the

exchangerate.Whenthewon/US$exchangerateapproachedthepsychologicallyimportantlevelof 1000,

theGovernmentintervenedheavilyinthemarket,onlysuddenlytowithdrawafewdayslater.

Between June and November 1997, the Bank of Korea’s reserve holdings fell by US$10 billion. The

Government furtherstrained investors’credulityby failing todivulge thetrue levelof foreignexchange

reserves.ItassertedthattheBankof KoreastillheldaboutUS$30billioninreserves,whentheactuallevel

of usablereserveshadalreadydroppedbelowUS$22billioninMarch.Bytheendof Novemberthefigure

hadfallentoUS$7billiondollars.

The dire financial situation was further compounded by changes in sovereign credit ratings. Between

JanuaryandNovember1997,Moody’sadjustedtheratingdownwardtwice,andS&Pthreetimes.Bythe

sametokenthepremiumonRepublicof Koreasecuritiesrose.Foreignbanksbegantorefusetorollover

shortterm loanstotheRepublicof Korea.Theactionsof thecreditratingsagenciesgeneratedaviciouscycleof decliningratingsandmarketsentiment.

4. Managementof andRecoveryfromthe199798Crisis

Bytheendof October1997thefinancialsituationwasoutof control.Foreigninvestorsmovedoutof the

stockmarketindroves,andRepublicof Koreabankswereincreasinglyunabletorollovertheirshortterm

foreignloans.Toavoiddefault,theywereforcedtoturntotheBankof Koreaforliquidityortoresortto

foreignovernightloans.

No action was taken until the announcement on 19 November of a reform package, which included

measures for the disposal of nonperforming loans and a widening of the band for exchangeratemovements. In theprevailingpanic, themarkethardlynoticed.Threedays later,unable tocontrol the

situation,theGovernmentpubliclyapproachedtheIMFforassistance.NegotiationsbetweentheRepublic

of KoreaGovernmentandtheIMFwerecompletedinarecordtimeof 10days.TheIMFagreedtoprovide

atotalof US$21billiontobedisbursedoverathreeyearperiod. Italsosecuredfinancialcommitments

totalingUS$36billionfromtheWorldBank,theAsianDevelopmentBank,theUnitedStates,Japan,and

othersasasecondlineof defense.

IMF conditionality required tight monetary policy, a fiscal surplus, sweeping financialsector reform

includingfurther liberalization,greater flexibility inthe labormarket,andrestructuringthechaebols.By

theendof December,a25percent interest rateceilingandmostcapitalcontrolswereabolished.The

limitonaggregate stockownershipby foreignerswas raised to55percent,and the shorttermmoneymarketwas also tobederegulated.However, the swift conclusionof negotiationsdid little to change

marketsentimentwhichwasalsoaffectedby thepoliticaluncertaintiesconcerning theoutcomeof the

presidential elections due in December 18. The won/dollar exchange rate continued to depreciate;

interestratessoared;andstockpriceswentintoanosedive.

The squeeze on the money supply together with banks’ efforts to meet the 8 percent Basel capital

adequacyratiobyApril1998reducedtheavailabilityof bankcredit.InDecemberthepercentagerateof

loan defaults jumped to 1.49 from 0.14 a year earlier,while business failureswere five times higher.

External lenderssawthatthe IMF financingwhichhadbeenagreedwasshortof theamountof foreign

debt repayment due. Therewere also concerns that tightmonetary and fiscal policieswould depress

economicactivitysomuchthattheRepublicof Korea’sabilitytoservice itsdebtwouldbeundermined.

Interestratesshotuptothedizzyingheightof 40percent,andthewon/depreciatedtoalevelof 1,995per

dollar.




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Thefinancialsituationwasclearlyunsustainable,andrumorsbegantocirculatethattheRepublicof Korea

mighthavetodeclareadebtmoratorium.OnChristmasEve,theIMFandtheG7countriescameupwith

anotheremergencyfinancingprogramof US$10billion,drawingonthesecondlineof defense.Thenew

package succeeded in turning around market sentiment as itdemonstrated the resolve to rescue the

Republicof Koreafromfinancialcollapse.Foreignlenderswantedtobeassuredof paymentsof principle

and interest.They asked for and received government guaranteesonprivatedebton thebasisof the

argument that this would facilitate debt restructuring and new credit extension. By January 1998,

internationalcreditorbanksagreed toconvertmostof theshorttermdebtof Republicof Koreabanks

(US$24billion) into longterm loans,withgovernmentguarantees thatmatureoverone tothreeyears,

andinterestratesof 2.252.75pointsaboveLibor.

In1998thegrowthrateof GDPplungedto6.9percentfrom+4.7percentayearbefore.Pricesleaped

by7.5percent,thewondepreciatedby27percentvisàvisthedollar,andtheunemploymentreached8

per cent, thehighest since the1960s.Surprisingly, the crisiswas short lived.The reboundwasno less

drastic thanpreceding fall.TheRepublicof Koreaeconomygrewby9.5percent in1999,andrecovery

continuedthereafter.

The initialGDPcontraction in1998was largelycausedbythecollapseof investment.Theconsumption

GDPratioremainedfairlystable,whiletheinvestmentGDPratiodroppedsharplyto25percent.In1998,

therewasahugecurrentaccountsurplusof almost12percentof GDP.Thiswasbecauseimportdemand

declinedby22percent in1998,whileexportsfellbyunder3percent,movementswhichreflectedthe

influenceof boththerecessionandthedepreciationof thewon.

AnempiricalexaminationbyParkandLee (2002)of worldwidepatternsof adjustment in160currency

crisis episodes from 1970 to 1995 shows a widespread tendency for countries to undergo a Vtype

recoveryof realGDPgrowth similar to thatexperiencedby theRepublicof Koreaafter the19971998

crisis.Thestudyalsoshowsthatalargerealdepreciation,expansionarymonetaryandfiscalpolicy,andanimprovement in theglobaleconomicenvironmentareusually responsible for theupturns.Allof these

developmentswerepresentduringthesecondRepublicof Koreacrisis.WhatdistinguishestheRepublicof

Koreaexperiencefromothersarethedegreeof theinitialcontractionandsubsequentrecovery.Thiswas

duetothefollowingfactors:

ExchangeRateDepreciationandOpenness:inviewof theRepublicof Korea’srelativelyhighlevel

of opennessandrelativelylargetradesector,adepreciationof therealexchangeratewasgoing

tohaveanespeciallylargeimpact.

Favorable External Environment: the Republic of Korea economy was the beneficiary of an

improvement in the external trading environment. The global economy was strong in 1999.

Moreover,theRepublicof Koreaexportsalsobenefitedfromhigherpricesof semiconductors,andfromanappreciationof theyenwhichimproveditsindustries’competitiveness.

MacroeconomicPolicyAdjustments:realizingthedepthof theslowdown,theIMFagreedtorelax

monetary and fiscal policies as early as April 1998. The ensuing expansion of money supply

preventedafurthercontractionof domesticdemand.

The positive role of expansionary macroeconomic policies in the postcrisis recovery has raised the

questionof whetherthe initialtighteningwastooharsh,maintainedfortoo long,andasaconsequence

deepened the crisis. In order to deal with the crisis, the IMF chose a traditional policy prescription

designedformanagingacurrentaccountcrisis,whichcomprisedtightmonetarypolicyandfiscalausterity.

However, the Republic of Korea crisis involved principally the capital account. In these circumstances

increased interestratesresulted inwidespreadbankruptcieswhichdid littletorestorefinancialstability

andtheconfidenceof foreignlendersandinvestors.




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TheIMFandsupportersof thecontractionarymonetarypolicyarguethatintheabsenceof suchapolicy

capitaloutflowsandthebankrunwouldhavecontinued.ThosewhodisputetheIMFviewsuchasRadelet

andSachs(1998)andFeldstein(1998),ontheotherhand,maintainthattheRepublicof Koreaproblem

wasoneof liquidity.Therefore,thetraditionalIMFstrategywaslikelytohavedonemoreharmthangood

asitdrovemanyhighlyleveragedbutviablefirmsoutof business,therebydeepeningeconomicrecession.

5. Lessonsof theTwoCrises

Bothdebtcriseswereinpartprecipitatedbyinvestmentboomsfinancedbyforeignborrowing.Theratios

of externaldebttoGDPweresimilar,andtheRepublicof Koreaexaggeratedthecrisesbyadheringfortoo

longtorigidexchangerateregimes.Inbothcases,TheRepublicof Koreaeconomyreboundedswiftlyin

bothcases,butthescarsof the199798crisisweremoreextensiveanddeeper.

Themostsignificantdifferencebetweenthetwocrisesinvolvedthepolicyresponses.Inthe197980crisis

theRepublicof Koreapolicymakers took advantageof the country’s continuing access to international

financialmarketstofinancethedeficitoncurrentaccountinthebelief thateconomicfundamentalswere

strongandthattheeconomywasafflictedbyatransitoryimbalance.InthesecondcrisistheGovernment

hadtoseekIMFfinancingthatsubjectedtheeconomytoawiderangingarrayof policychanges.Itpaida

highpriceintermsof lostoutputandof thecostof resolvingbankruptfinancialinstitutionsandbailingout

insolventcorporations,whichamounted16percentof GDP in1998. Ithadnochanceof replicatingthe

strategyof relianceonexternalborrowing followedafterthe19791980owingto its increasedfinancial

opennessandthemorelimitedpossibilityof recoursetocapitalcontrols.

Greaterfinancialopennesswastheresultof thepolicyof economicliberalizationpursuedsincethemid

1980s,whichhadalsoresulted inamoreopentraderegime.TheGovernmenthadopenedthefinancial

sectorandderegulatedcapitalaccounttransactionaheadof thebidto jointheOECDintheearly1990s.

By the time of the 199798 crisis broke out the Government had been reforming institutions andrestructuringitsfinancial,corporate,andpublicsectorsformorethanadecade.

A financially open economywith a relatively inflexible exchange rate lacks an effective buffer against

external financial shocks. Moreover orderly financial opening requires an efficient financial regulatory

systemtomonitor risks.The reformof the regulatorysystem lagged intheRepublicof Koreaata time

whenfinancialinstitutionsweretakingonnewrisks,especiallyintheiroperationsabroad.

AccordingtoEichengreen,WyploszandRose(1996)therearethreetypesof distortionthatcangiverise

toafinancialcrisis.Thefirstisasymmetricinformationwhereborrowersorissuersof debtorequitytake

advantageof superiorinformationascomparedwiththatof lendersandinvestorsabouttherisksof their

business.Asymmetric information, isassociatedwiththedangerof herdbehavioronthepartof foreigninvestorsand financial institutions.Second ismoralhazard inbothdomesticand international financial

markets. This denotes the danger that thosewho expect protection against loss through bailouts by

publicauthoritieswilltakegreaterrisksthantheywouldotherwise.Thethirdisanydistortionthatcould

leadtotheinstabilityintheexchangerateassociatedwithmultipleequilibriainforeignexchangemarkets.

Allof thesedistortionswerepresentintheRepublicof Koreaintherunuptothe199798crisis.

Beforeandduring theearlyyearsof market liberalization foreign lendersand investorsdidnotcare to

learnaboutthestructuralweaknessesof Republicof Koreabanksandcorporategovernancebecauseof

governmentguarantees.Onlywiththegrowingexposureof theKoreaneconomytointernationalfinancial

marketsdidtheirawarenessincreaseof balancesheetmismatchesatbanksandchaebols.Bythetimethe

Thai crisis spread to other parts of East Asia in September 1997, the Republic of Korea began losing

reserves. Lacking confidence concerning the adequacy of Republic of Korea reserves, lenders and

investorsbegantoreducetheirexposuretothecountry,refusingeventorenewshortterm loans.Both




130

borrowersand lendersweretoblameforbringingonthecrisis borrowersowingtotheirdisregardfor

prudenceandriskmanagementandlendersowingtotheirshorttermismandherdmentality.

InternationalfinancialmarketsandRepublicof Koreapolicymakersshareresponsibilityforfailingtocarry

outreformswhichwouldhavereducedmoralhazard.Commercialandmerchantbankhadlongoperatedwith implicitgovernmentguarantees.Togetherwith inadequate supervision theseguaranteesprovided

incentivestobankstoborrowlargeramountsof fundsabroad,andtoinvestinriskierprojectsthanthey

wouldotherwise.

Moralhazardalsoappearstohaveaffectedthe lendingbehaviorof foreign financial institutions.These

expected to receive national treatment. Assuming that they too would benefit from government

guarantees, foreign banks did not conduct careful credit analyses of Republic of Korea borrowers.

Moreover, when the crisis broke out, few foreign banks attempted to reschedule loans to troubled

Republic of Korea banks in sharp contrast to their behavior towards delinquent borrowers in their

domesticmarkets.

Finally, creditorsbelieved that, as a group, they couldpressurize theRepublicof KoreaGovernment if

there was a crisis. In the event this assumptionwas to prove justified since their pressure played an

importantroleinthedecisionof theRepublicof KoreaGovernmenttoseekIMFfinancing.Thebankswere

aware that a debt moratorium was not a realistic option owing to the large number of lenders and

borrowers involved.Banks’ recourse to thispressurealso reflected theirknowledge that IMFprograms

favorcreditorsoverdebtors(Soros1998).

Thecrisisof 199798wasacapitalaccountcrisis inwhichthe initialcurrentaccount imbalancedidnot

playaprimaryrole.Massivecapitaloutflowsprovokedaliquidityandcreditcrisis.Intheseconditionsthe

traditional IMFstabilizationprogramdidnotwork,andan infusionof freshcapitalwasrequiredtostop

thebleedingof theeconomy.

It is natural to askwhether theGovernment could have followed the samepolicy as thatpursued in

response to the crisis of 19791980, i.e. combining a growthoriented macroeconomic policy with

continuedrelianceonexternalborrowing.Itishardtobelievethatfinancialmarketstodaywouldsupport

anythingbutamacroeconomicstabilizationprogram,even if thereweregoodgroundsforthinkingthat

thecrisiswouldbetransitory.Insuchanenvironmenttheaccumulationof largereservesthroughcurrent

account surpluses by major emergingmarket countries as insurance against the imposition of

inappropriatestabilizationprogramsbecomesfullyunderstandable.

D. ConcludingRemarks

Thesecondcrisesof boththeRepublicof KoreaandArgentinawerecapitalaccountcrisesthattookplace

ineconomies thathad liberalized capital transactions and thatwere thus integrated into international

financialmarkets.CapitalinflowswhichfuelledthegrowthprecedingthecrisesandwhichintheRepublic

of Koreacasebecameaninvestmentboomweretransformedintooutflowswhichledtomeltdowns.In

bothcasesIMFpolicyprescriptionsworsenedthecrises.

During much of the 1990s Argentina experienced strong growth. However, as early as 1995 adverse

developmentsintheexternalenvironmentbegantotriggereconomicdifficultiesandthecountrysuffered

aminicrisistogetherwithasharpdeteriorationinitsfiscalbalancefollowingtheMexicancrisisof 1995.

Afterarecoveryin19961997Argentina’sriskpremiumbegantoriseagainandforeignborrowingbecame

more costly. Externaldebtwas increasing,while the ability topaywasbeingundermined.A seriesof rescue packages failed to restore confidence, and were unable to stop eventual bank runs and the

bleedingof foreignexchangereserves.Thedollarizationof bankcreditsandof thecontractualstructureof




131

theeconomymadethecollapsemoresevere.Publicsectordebtroseafterthedefaultowingtomeasures

takenbytheGovernmentaspartof itsinterventioninthefinancialsystem.

The Republic of Korea crisis also came after a period of high growth, and was triggered by the

depreciationof theyenandadverseshocksto itsexports.Thesechangestriggeredgreaterattentiononthepartof foreign lenders to thescaleof foreignborrowingbychaebolsand todeteriorations in their

balance sheets. The rises inbankruptcies andnonperforming loans that followedheralded a financial

market crisiswith foreign borrowers refusing to rollovermajor bank loans.Given the context of the

earliercrisisinThailandthewoncameundermassiveattackasbankrunsandcapitaloutflowscontinued.

Thesedevelopmentsunderlinedtheimportanceof betterfinancialregulationandcorporategovernance

andnot justgoodmacroeconomicmanagementasessentialelementsof successfuldebtmanagement.

In both countries the meltdowns led to sharp falls in GDP growth. Resolution of the debt problems

followeddifferentcourses. In theRepublicof Koreacase,bank lending toprivateborrowerswasmore

importantand resolution involved theconversionof shorttermbank loans into longerterm loanswith

government guarantees. InArgentina debt securitiesweremore important and restructuring involvedtheirconversionintoalternativesecuritieswithlowercouponsorvaluesandlongermaturities.

InbothcasestheIMFprogramsincludedillconceivedpolicymeasuresduetomistakesindiagnosis,which

worsenedtheimpactof thecrises.InArgentina,theausteritymeasuresdeepenedtherecession,thereby

underminingpayment capacityand acceleratingdefault. In theRepublicof Korea,earlier relaxationof

monetaryandfiscalpolicycouldhavemeantthatbankruptciesand lostoutputwouldhavereached less

than16percentof GDP.

Inbothcases, the recoverywasaidedby favorableexternaldevelopmentssuchas the improvement in

appetiteamongstlendersandinvestorsfordevelopingcountryrisk,easingof interestratesandimproved

export markets. In Argentina default also provided a respite to the fiscal balance and the domestic

economy.

Inbothcases,devaluationcompressedimportsaswellashelpingexports(whoseincreasewasparticularly

notable for theRepublicof Korea). The turnaroundswere surprisinglyquick: theworstof the crisis in

Argentinawas inDecember2001,andsignsof recoverywereevident in the firsthalf of 2002;and the

Republicof Koreacrisiscollapseof 1998was followedbya spectacular recoveryasearlyas1999.This

followsapattern identifiedbyLevyYeyatiandPanizza(2006)accordingtowhich,bythetimeadefault

occurs,thelossesintermsof outputandgrowthhavealreadytakenplacesothatitsoccurrencecoincides

withthebeginningof economicrecovery.Animplicationof thispatternisthat,oncefirmexpectationsof

defaulttakeholdandthemeltdownstarts,measurestopostponethedefaultmaywellbemorecostly

thanthedefaultitself.

Beyondacertainpoint,neithercountrycouldhavedoneanythingtostopexternaldebtfromfollowingan

exploding path. Herd behavior delivered the final blows, As Park (2005) notes, international financial

markets are not a good source of shortterm liquidity for emerging economies, when they are

experiencing financial instability. The lesson drawnby several emergingmarket countries has been to

accumulate reserves as a form of insurance. If these economies felt assured of adequate liquidity

assistance from international financial institutionsor regional financial cooperative arrangements, they

wouldbelessinclinedtofollowthispolicy.

IMFpolicyfailuresandtheperceptionthatitsidedwithcreditorsinthesetwocriseshavecontributedto

underminingof itsauthorityamongstdevelopingcountries.Argentina’sdebtrestructuringproposalsand

independent recovery program have set a precedent for crisis resolution not mediated by the IMF.However, the faithof theUnitedStatesandprivate creditors in individualdebtworkoutsunder rules

subjecttoonlyminormodificationsincomparisonwiththepresentregimeisunlikelytoconstituteafully




132

fledged, unquestioned alternative. Moreover impetus from these quarters in favor of further capital

accountliberalizationhasnowbeenlost.




133

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C a s e S t u d i e s : A r g e n t i n a a n d t h e R e p u b l i c o f K o r e a

136

T a b l e V I . 1

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C o m p e n d i u m

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1 . 7

S o u r c e : U

N N a t i o n a l A c c o u n t S t a t i s t i c s ; I M F B a l a n c e o f P a y m e n t s S t a t i s t i c s , I n t e r n a t i o n a l F i n a n c i a l S t a t i s t i c s a n d W o r l d E c o n o m i c O u

t l o o k d a t a b a s e s ; W o r l d B a n k G l o b a l D e v

e l o p m e n t F i n a n c e

d a t a b a s e .




138

TableVI.2.Consolidatedfiscalbalance(NationalAdministrationandProvinces)

(asa percentageof GDP,annual average)

Source:Authors´calculationsbasedonMinistryof Economy,CetrángoloandJiménez(2003)andGaggero(2003).

(1)Primarybalanceexcludingreceiptsandexpendituresof nationalsecuritysystem.

(3)=(2)+ProvincesandBuenosAiresCitybalances.

TableVI.3.Totalpublicinterestpayments,TaxcollectionGDPratioandsovereignrisk

premium

(inpercent)

Source:Authors´calculationsbasedonMinistryof Economy.

(1)IncludesSecuritySystemreceipts.

(2)Calculatedasaratiobetweeninterestpaymentinperiodtanddebtattheendof t1.

(3)Taxreceiptsincludethosefromsocialsecuritysystem.

Primary Surplus

without Social

Security

(1)

Primary

Surplus

Interest

payments

Total

Balance

(2 )

Average 1981-90 nd -4.4 1.9 -6.2 -7.0

Average 1991-94 2.1 1.3 1.2 0.1 -0.6

Average 1995-97 1.7 -0.3 1.7 -2.0 -2.6 Average 1998-01 3.1 0.5 3.1 -2.7 -4.1

Average 1991-01 2.3 0.6 2.0 -1.5 -2.4

Consolidated

Public Sector

Balance

(3 )

Period

National Adm inistration

Year

Tax

collection as

percentageof GDP

(1)

Average

interest rate

on publicdebt

(2)

Interest

payments /

tax collectionratio

(3)

Sovereing

risk premium

(annual

average)

1991 18.8 s.d 5.5 9.6

1992 20.8 6.6 8.3 6.9

1993 21.3 5.0 6.0 4.9

1994 21.1 5.5 6.9 5.9

1995 20.9 6.1 9.2 12.4

1996 19.6 5.8 9.7 6.5

1997 21.0 6.7 10.9 3.3

1998 21.4 7.6 12.2 5.8

1999 21.4 8.3 15.9 7.2

2000 21.9 8.9 18.5 11.5

2001 21.0 9.4 23.4 14.8

2002 19.2 5.2 13.3 -.-

2003 23.1 1.9 9.6 -.-




139

TableVI.4.Changeinforeigndebtandforeignassetsbysectorandperiod

(US$million)

Source:Authors ́estimationsonthebasisof datafromtheMinistryof Economy.

(1)IncludingtheCentralBank.

TableVI.5.Fiscaladjustment:Resultsof theConsolidatedPublicSector(CPS)

(as per cent of GDP)

Source:Authors ́calculationsbasedonMinistryof Economy.

(*)Taxonbankdebitsandcredits.

(**)Includestaxessharedwithprovinces,whichareincludedas.

expendituresinPrimaryexpendituresastransferstoprovinces.

(***)IncludingtheCityof BuenosAires.

Public

Sector (1)

Financial

Sector

Private

Sector (2)Total

Financial

Sector

Private Sector

(3)

8,529 5,726 10,321 24,575 1,728 566 9,755

5,924 2,952 4,361 13,238 821 11,174 -6,813

9,222 11,579 15,607 36,407 15,307 15,050 557

8,523 -555 3,139 11,107 -4,274 11,876 -8,737

2,975 -8,053 -688 -5,766 -10,665 12,865 -13,553

35,173 11,649 32,740 79,561 2,917 51,531 -18,791

1995:4 to 1998:2

1998:2 to 2000:4

Period

External debt of

Changes in

Net external

debt of private

sector (2)-(3)

1991:4 to 1994:4

1994:4 to 1995:4

External assets of

2000:4 to 2001:4

Total

Tax receipts 13.8 18.7 4.9Taxes on exports 0.0 2.3 2.3

Financial tax (*) 1.1 1.5 0.4VAT 3.1 3.4 0.4Income tax 2.5 3.4 0.9

Other taxes (**) 7.2 8.1 0.9Other receipts 4.9 4.8 -0.1Total receipts 18.8 23.5 4.7

Total expenditures 22.0 20.9 -1.1Primary expenditures 18.2 19.6 1.4

Interest services 3.8 1.3 -2.5Primary result 0.5 3.9 3.3Total result of the NPS -3.2 2.6 5.9

Provinces (***) -2.4 0.9 3.3

Total result of the CPS -5.6 3.5 9.2

Variation(2004-2001)

Concept

N a t i o n a l P u b l i c

S e c t o r

2001 2004



C a s e S t u d i e s : A r g e n t i n a a n d t h e R e p u b l i c o f K o r e a

140

T a b l e V I . 6

. R e p u

b l i c o f K o r e a : S e l e c t e d E c o n o m i c I n d i c a t o r s , 1

9 7 5

1 9 8 5

M a c r o e c o n o m i c I n d i c a t o r s

1 9 7 5

1 9 7 6

1 9 7 7

1 9 7 8

1 9 7 9

1 9 8 0

1 9 8 1

1 9 8 2

1 9 8 3

1 9 8 4

1 9 8 5

( P e r c e n t )

R e a l G D P a n n u a l g r o w t h

5 . 9

1 0 . 6

1 0

9 . 3

6 . 8

1 . 5

6 . 2

7 . 3

1 0 . 8

8 . 1

6 . 8

I n v e s t m e n t

8 . 9

2 0 . 7

3 0 . 2

3 4 . 4

1 0 . 0

1 0 . 7

3 . 1

1 1 . 1

1 7 . 4

1 0 . 9

5 . 3

S a v i n g a s p e r c e n t a g e o f G D P

1 9 . 8

2 5 . 0

2 8 . 4

3 0 . 3

3 0 . 0

2 5 . 0

2 5 . 4

2 6 . 3

2 9 . 5

3 1 . 8

3 2 . 2

I n v e s t m e n t a s p e r c e n t a g e o f G D P

2 8 . 7

2 6 . 7

2 8 . 7

3 3 . 1

3 6 . 1

3 1 . 8

2 9 . 6

2 8 . 7

2 9 . 0

3 0 . 3

3 0 . 0

I n f l a t i o n C P I c h a n g e

2 5 . 3

1 5 . 3

1 0 . 2

1 4 . 7

1 8 . 3

2 8 . 7

2 1 . 4

7 . 2

3 . 5

2 . 2

2 . 4

R e a l w a g e s a n n u a l g r o w t h

1 7 . 6

1 9 . 8

1 8 . 2

8 . 5

4 . 0

0 . 5

7 . 9

7 . 2

6 . 4

6 . 6

E x t e r n a l S e c t o r I n d i c a t o r s

1 9 7 5

1 9 7 6

1 9 7 7

1 9 7 8

1 9 7 9

1 9 8 0

1 9 8 1

1 9 8 2

1 9 8 3

1 9 8 4

1 9 8 5

( p e r c e n t u n l e s s o t h e r w i s e s t a t e d )

C u r r e n t A c c o u n t a s p e r c e n t a g e o f G D P

8 . 8

1 . 1

0 . 0

2 . 0

6 . 6

8 . 3

6 . 4

3 . 3

1 . 8

1 . 4

0 . 8

R e a l e x p o r t g r o w t h

1 3 . 9

5 1 . 8

3 0 . 2

2 6 . 5

1 8 . 4

1 6 . 3

2 1 . 4

2 . 8

1 1 . 9

1 9 . 6

3 . 6

T e r m s o f T r a d e ( 1 9 8 5 = 1 0 0 )

8 7 . 0

9 9 . 3

1 0 6 . 2

1 1 1 . 3

1 0 8 . 9

9 4 . 4

9 2 . 5

9 6 . 5

9 7 . 4

9 9 . 5

1 0 0 . 0

N o m i n a l E x c h a n g e R a t e ( W o n / U S D )

4 0 4 . 5

4 8 4

4 8 4

4 8 4

4 8 4

4 8 4

6 0 7 . 4

6 8 1

7 3 1

7 7 6

8 0 6

R e a l e f f e c t i v e e x c h a n g e r a t e ( 1 9 9 3 = 1 0 0 )

9 3 . 4

1 0 8 . 6

1 1 3 . 1

1 0 7 . 6

1 2 0 . 1

1 0 7 . 6

1 0 8 . 4

1 0 6 . 3

1 0 1 . 9

9 9 . 3

9 3 . 4

T o t a l e x t e r n a l d e b t a s p e r c e n t a g e o f

G D P

3 9 . 5

3 5 . 5

3 3 . 2

2 8 . 1

3 2 . 1

4 2 . 6

4 5 . 4

4 8 . 7

4 7 . 8

4 6 . 2

4 8 . 4

S h o r t t e r m D e b t a s p e r c e n t a g e o f e x

t e r n a l d e b t

2 8 . 2

2 8 . 6

2 9 . 4

2 6 . 2

2 7 . 1

3 4 . 6

3 1 . 5

3 3 . 4

3 0 . 0

3 6 . 5

2 2 . 9

D e b t S e r v i c e R a t i o ( l o n g t e r m d e b t o

n l y )

1 2 . 7

1 0 . 4

1 1 . 3

1 3 . 7

1 4 . 0

1 4 . 7

1 6 . 1

1 6 . 3

1 6 . 3

2 1 . 3

F o r e i g n E x c h a n g e R e s e r v e s ( U S $ b i l l i o n )

1 . 6

3 . 0

4 . 3

4 . 9

5 . 7

6 . 6

6 . 9

7 . 0

6 . 9

7 . 6

7 . 7



C o m p e n d i u m

o n D e b t

S u s t a i n a b i l i t y a n d D e v e l o p m e n t

141

T a b l e V I . 7

. R e p u

b l i c o f K o r e a : S e l e c t e d E c o n o m i c I n d i c a t o r s , 1

9 9 5

2 0 0 4

M a c r o e c o n o m i c I n d i c a t o r s

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

( P e r c e n t )

R e a l G D P a n n u a l g r o w t h

9 . 2

7 . 0

4 . 7

6 . 9

9 . 5

8 . 5

3 . 8

3 . 1

4 . 6

I n v e s t m e n t

1 3 . 1

8 . 4

2 . 3

2 2 . 9

8 . 3

1 2 . 2

0 . 2

6 . 6

4 . 0

1 . 9

S a v i n g a s p e r c e n t a g e o f G D P

3 6 . 5

3 5 . 7

3 5 . 8

3 7 . 9

3 5 . 8

3 3 . 9

3 1 . 9

3 1 . 4

3 3 . 0

3 5 . 0

I n v e s t m e n t a s p e r c e n t a g e o f G D P

3 7 . 7

3 8 . 9

3 6 . 0

2 5 . 0

2 9 . 1

3 1 . 0

2 9 . 3

2 9 . 1

3 0 . 0

3 0 . 2

I n f l a t i o n

4 . 4

5 . 0

4 . 4

7 . 5

0 . 8

2 . 2

4 . 1

2 . 7

3 . 6

3 . 6

R e a l w a g e s a n n u a l g r o w t h

6 . 4

6 . 7

2 . 5

9 . 3

1 1 . 2

5 . 6

1 . 5

8 . 6

5 . 7

2 . 8

E x t e r n a l S e c t o r I n d i c a t o r s

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2

0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

( p e r c e n t u n l e s s o t h e r w i s e s t a t e d )

C u r r e n t A c c o u n t a s p e r c e n t a g e o

f G D P

1 . 7

4

. 1

1 . 6

1 1 . 7

5 . 5

2 . 4

1 . 7

1 . 0

2 . 0

4 . 1

R e a l e x p o r t g r o w t h

3 0 . 3

3

. 7

5 . 0

2 . 8

8 . 6

1 9 . 9

1 2 . 7

8 . 0

1 9 . 3

3 1 . 0

T e r m s o f T r a d e ( 2 0 0 0 = 1 0 0 )

1 3 8 . 5

1 2 5

. 4

1 2 2 . 2

1 1 6 . 7

1 1 4 . 1

1 0 0 . 0

9 5 . 5

9 5 . 0

8 9 . 0

8 5 . 3

N o m i n a l E x c h a n g e R a t e

7 7 1

8 0 4

9 5 0

1 , 4 0 1

1 , 1 8 9

1 , 1 3 0

1 , 2 9 1

1 , 2 5 2

1 , 1 9 2

1 , 1 4 6

R e a l e f f e c t i v e e x c h a n g e r a t e ( 1 9 9

3 = 1 0 0 )

1 0 5 . 0

1 0 8

. 1

1 0 0 . 5

7 3 . 7

8 4 . 3

9 0 . 7

8 5 . 1

8 9 . 7

9 2 . 1

9 4 . 6

T o t a l e x t e r n a l d e b t a s p e r c e n t a g e o f G D P

2 3 . 2

2 8

. 2

3 3 . 7

4 7 . 3

3 4 . 4

2 9

2 7 . 1

2 6 . 1

2 6 . 6

2 6 . 1

S h o r t t e r m D e b t a s p e r c e n t a g e o

f e x t e r n a l d e b t

4 5 . 8

4 8

. 2

3 6 . 6

2 4 . 2

2 8 . 2

3 3 . 7

3 2 . 2

3 4 . 8

3 3 . 9

3 3 . 8

D e b t S e r v i c e R a t i o ( l o n g t e r m d e b t o n l y )

F o r e i g n E x c h a n g e R e s e r v e s ( U S $

b i l l i o n )

3 2 . 7

3 3

. 2

2 0 . 4

5 2 . 0

7 4 . 1

9 6 . 2

1 0 2 . 8

1 2 1 . 4

1 5 5 . 4

1 9 9 . 1

S o u r c e : B a n k o f K o r e a .






143

CHAPTERVII

APPROPRIATEINSTITUTIONALSETTINGS

FORPUBLICDEBTMANAGEMENT

JaimeDelgadilloCortez

(WorldBank97)

A. Introduction

Weak institutionsdealingwithpublicdebtmanagement in transitionandemergingeconomiesas

well as external shocks can be major sources of debt distress. While shocks cannot be totally

controlled,theinstitutionalsettingfordebtmanagementcanbestrengthened.Thusvulnerabilityto

debtproblemscanbereducedorbettermanagedwhensolidinstitutionsareinplace.

Publicdebtmanagementcanbedefinedastheprocessof establishingandexecutingastrategyfor

managingtheGovernment’sdebtportfolio inordertomeetgovernmentfundingrequirements,to

achieveobjectiveswithregardtocostsandrisks,andtomeetotherobjectivesrelatedtodebtsuch

aspromoting investment for economic growth anddeveloping thedomestic financialmarket forgovernmentsecurities.Effectivedebtmanagementcanalsohelptoensurethatboththe leveland

growthof debtarefiscallysustainable.98

In emerging and transition economies the main emphasis in debt management is put on the

following:

Theproductionof reliabledebtdata;

Marketdevelopment;

Ensuringadequatefinancingfordevelopmentalandsocialneeds;

Ensuringcompliancewithdebtserviceobligations;

97TheauthorwasaSeniorEconomicAffairsOfficerof UNCTADwhenhewrotethischapter.

98SeeWorldBankandIMF(2002),andDMFAS,EffectiveDebtManagementaRevision,forthcoming.



AppropriateInstitutional Settings for PublicDebt Management

144

Controllingcontingentliabilities;

Negotiatingagreementswithcreditors;

Performingcost/riskanalysis;

Designingstrategiestoattainasustainabledebtposition.

An appropriate institutional framework for debt management can contribute to achieving the

objectivesof effectivedebtmanagement.Institutionalarrangementsshouldfocusonthefollowing:

Governance;

Clarityof therolesof theinstitutionsdealingwithdebtmanagement;

Specificationof theobjectivesforpublicdebtmanagement;

Coordinationof publicdebtmanagementwithotherpublicpolicies;

Theorganizationalstructureof DMOs;

Transparencyandaccountability.

Thispaper isdivided in twoparts. Section II provides anoverviewof the contextof publicdebtmanagementanddescribesthechallengeswhichDMOsandotherareasof publicdebtmanagement

mustmeet as part of the broad framework of macroeconomic policies. Section III examines the

different issues related to the institutional frameworkof debtmanagement includinggovernance,

mandates, accountability and transparency, the separation of executive and operational debt

management,andtheneedforanexecutivedebtmanagementcommittee.Theprincipalfocusisthe

role,organizationandfunctionsof DMOsinlowandmiddleincomecountriesfromtheperspective

of developmentneeds.

B. TheContextof PublicDebtManagement

1. TheChallengesandConstraintsFacingInstitutionsDealingwithDebtManagement

Proactive debt management is essential in today’s market conditions. DMOs must face the

challengeof morecomplexportfoliosof publicandprivatedebt,theglobalizationof capitalmarkets,

andthevolatilityof capitalflows.Furthermore,manyemergingmarketeconomiesobtainsubstantial

financingintheformof equityflows.

External factorssuchasvolatility in thepriceof exportproductsandexchangeand interestrate

fluctuations, and contagion effects are beyond the DMO’s control. However, in normal

circumstances,DMOscanplayacrucialroleincrisispreventionandresolution.

Inadequate legal arrangements,uncleardefinitionof functions and responsibilities, inappropriate

organizational structures, inadequate staff and insufficient training, and the failure to define

strategicobjectivesandresponsibilitiesarealltoocommonfeaturesof DMOs.Theseweaknessesare

manifest in theabsenceof strongmiddleofficeswhich shouldbeequipped to conductanalytical

workrequired fordefiningadebtstrategy.Uncleardebtmanagementobjectivesandbenchmarks

andtheinabilitytoconductDebtSustainabilityAnalysis(DSA)arealsofrequentproblemsof DMOs.

Other deficiencies involve the implementation of strategies and the lack of coordination with

monetaryandfiscalpolicies.

Factorswhicharenotunderthecontrolof DMOsbutwhichnonethelesscanimpedetheirefficient

performance include structuraldeficiencies inmoneymarkets and in theprimary and secondarymarkets for financial instruments as well as inadequate management of quasifiscal deficits and




145

internationalreserves.MoreoversomeDMOs lacktheresourcesormandate(orboth)totransmit

clearmessagestootherlevelsof theGovernment.

Thisdocumentdoesnotaddressallof theseissues.Itfocusesonwaysinwhichtheconstraintsand

challenges facingDMOs canbe addressedby strengthening the abilityof DMOs tomanage theirdebt portfolios and by strengthening other institutional and legal arrangements for debt

management.

FigureVII.1. illustrates thecoreactivitiestypicallyperformedbyDMOs in lowandmiddleincome

countries. In the former, debt management is concerned principally with captive markets for

domestic debt and concessional financing or grants. Government financing depends heavily on

shortterm instrumentswithhigh interestrates.DMOsthusattempttodiversifythedebtportfolio

bydevelopingprimary and secondary financialmarkets andby eventually accessing international

capitalmarkets.

In the case of middleincome countries, debt management has a wider role in involving themanagementof thecostsandrisksof amorediversifiedportfolioincludingrecoursetotransactions

inderivatives,providingarangeof financialservicestotheGovernment,andeventuallyparticipating

inaintegratedfinancialriskmanagementwithotherpartsof theGovernment.99

FigureVII.1.

99See,forexample,TheChangingRoleof thePublicDebtManager,presentationmadebyPhillipAnderson,WorldBank,in

UNCTAD(2005).

LowIncome

Countries

Debt

Management

ExpandedRole

MiddleIncome

Countries

Debt

Management

BasicRole

IntegratedCost/RiskManagement

of Liabilities;

Supplyof Financial

ServicestoGovernment;

Managementof FinancialAssets;

TransactionsinDerivativeMarkets;

OperationalRiskManagement.

AccessInternationalCapital

MarketstoDiversifyDebt

Portfolio;

DevelopDomesticPrimary&

SecondaryMarkets;

IssueShortTermGovernment

Securities;TapCaptiveSourcesof

DomesticDebt;

ManageODAandIDAGrants.




146

2. PublicDebtManagementasanIntegralPartof theFrameworkof Macroeconomic

Policies

Figure VII.2. below indicates the relationship between public debt, external debt and the real

domesticsectorsof theeconomy.Publicinvestmentprogramsarefinancedwithinternalorexternal

resourcesintheformof loansorgrants.

Debt flows are recorded in theBalanceof Payments.DSA relatespublicdebt information to the

balanceof paymentsdataandmacroeconomicvariables includinggrowthobjectivesandeconomic

and social programs. Information regarding debt stocks and flows (including debt service and

disbursements), interest rates, exchange rates, capitalaccount movements, etc. is combined to

determinethesizeof thefinancinggap.Thisneedstobefilledwithacombinationof externaland

domesticfinancingand,if necessary,withdebtrestructuringordebtrelief.

Given the importance of domestic debt and the necessity of incorporating it into the overall

managementof governmentliabilities,theconceptof TotalPublicDebtisusedinthispaper,whichthusincludesbothexternalanddomesticdebt.

FigureVII.2.

EXTERNAL SECTOR

R E A L S E C T O R

PUBLIC FINANCIAL SECTOR

PUBLIC DEBTEXTERNAL

Flow chart for public debt management in developing economieswithin macroeconomic framework

D i s b u

r s e m e

n tr e c

e i p t s

D e b t

s e r v i

c ep a y m

e n t s

P r i n c

i p a l &

i n t e r e

s t

F i n a n c i n g p r o j e c t s

Imports - Exports

L o c a l c u r r e n

c y

Internal Financing

Requirements

Tax and revenues

L o c al c o un t er p ar t f un d s

P u b l i c i nv e s t m en t pr o gr am s

G.D.P. B.O.P.

BUDGET

DOMESTIC DEBT

External Financing requirements

Loans and grants

G r o w

t h O b j e c t i v e s

Sincepublic debt is often the largest liability in the national balance sheets of low and middle

income countries, its management cannot be seen as isolated from the overall macroeconomicmanagementof acountry.Publicdebthasmajorlinkageswithmacroeconomicandfinancialstability.




147

Theobjectivesof fiscal,monetaryandpublicdebtpolicies shouldbe coordinated to achieve and

maintaindebtsustainabilityandfiscaldiscipline.

Moreover, an effective system of overall financial management is essential not only for

macroeconomicmanagementbutalso forprovidingreliable financial informationtoprevent fraudandwaste.

Publicdebtmanagementaspartof suchasystemcansignificantlycontributetotheattainmentof

itsobjectives.Relevant informationondebtmanagement strategies,DSA,andpublicdebt stocks

andflowsareessentialingredientsof soundpublicfinances.Thisisparticularlytrueinthecontextof

budgetingandexpendituremanagement.Inthisarea,Governmentswantto improveplanningand

budgetformulation;setrealisticandachievablespendingceilings; improvespendingprioritization;

monitorcommitmentsanddisbursements;andensureaccurateandtimelyinformationflowsamong

governmentinstitutions.

As isnoted in theWorld Bank’sPublic ExpenditureManagementHandbook, theory andpracticeshowthatreformof acountry’s institutionsof financialmanagementbothformaland informal –

can have a decisive influence on budgetary outcomes at three levels. At the first level, the

introductionof institutional reforms inpublic financialmanagement can improveaggregate fiscal

discipline andplanning aswell as the traditional control functionsof public expenditure through

budgetparameters.Atthesecondlevel,thesereformscanimprovetheplanningfunctionof public

expendituremanagementthroughimprovementsinthecapacitytoallocateresourcesinaccordance

withstrategicprioritiesandbaselinedataonpriorexpendituresandrevenuepatterns.Atthethird

level, the reforms contribute to political decisionmaking concerning the allocation of scarce

resourcestoselectedpriorities.

Figure VII.3. illustrates the flows of information between a consolidated DMO and its main

stakeholders: the Ministry of Finance, the Central Bank, the National Planning Agency, and its

externalcreditors including InternationalOrganizations. Incomingandoutgoing informationtoand

from the DMO contribute to a close and coordinated relationship regarding debt management

amongkeyinstitutions.Thisfacilitatestheimplementationof debtmanagementoperationssuchas

debtservicepayments,andenablestheDMOtoassisttheGovernmentinconductingaDSA.






149

transactionandborrowing costs.Consolidationof theauthority fordebtmanagement ina single

wellstructuredDMOcanenormouslycontributetotransparencyandaccountability.

Legislation on fiscal responsibility can bring the debt management objectives in line with fiscal

targets. This is particularly important when local Governments have a certain degree of independencetoincurdebts,bothforeignanddomestic,especiallyinfederalcountries.

Delegationimpliesaccountability.Therefore,itishighlydesirablethattheActof Parliamentspecifies

thattheMinisterof FinancepreparesanannualorsemiannualreportwithParliamentonactivities

related topublicdebtmanagement,andonplans regardingpublicdebtmanagement in thenext

fiscalyear.Thishelpspromotetransparencyandaccountability,andencouragesadomesticdebate

on these issues. Investors and international financial institutionswould alsobe able to acquire a

better knowledge of the Government’s future funding plans and of its developmental priorities.

(Majorfeaturesof thelegalframeworkforDMOsandof itsresponsibilitiesaresummarizedinBoxes

1and2.)

BOXVII.1.DMOs’MainFunctionsandResponsibilities

Toimplementthedebtstrategy,debtmanagementpolicies,procedures,benchmarksandguidelines

prescribedintheregulationsdesignedattheappropriatelevelof Government;

Toissuedebtortocontractdebtonbehalf of theMinisterof Finance,toparticipateinDSAtogether

withotherareasof theGovernment,toalerttheauthoritiesconcerningsituationsof unsustainable

debt,andtorecommendtimelyadjustmentswhenneeded;

Tomaintainatimelyandreliabledatabaseonpublicdebtandtoconductregulardatavalidation;

Tominimizecostsandrisksassociatedwithpublicborrowingandpubliclyissuedguarantees;

To order debt service payments to the financial agent of the central Government through the

Treasuryand/ortheBudgetDepartment,fortheloansandbondissuesof thecentralGovernment.

Togenerateandprovidereliableandtimelyinformationonpublicdebtpoliciesanddatatoavariety

of usersandtothepubliconaperiodicbasis;

Toprovidegovernmentguaranteesafterriskevaluation.TheCongressonannualbasisthroughthe

budget law normally authorizes guarantee coverage. The DMO should monitor all forms of

contingentliabilities;

Tomonitortheloansandbondsissuesof publicentitiesandenterprises;

Tomonitordebt incurred at the subnational level, including the loans andbonds issuesof local

Governmentsandentitiescontrolledbythem;

Tomonitorgrants,privateexternaldebtandonlendingtobothpublicandprivateentities;

Toensure that theprovisionsof internationalagreementswithcreditors (ParisClub,LondonClub,

otherbilateralcreditors,multilateralcreditors,etc.)arecompliedwith.




150

Sound practice under the heading of accountability requires regular auditing of the financial

transactionsundertakenbythedebtmanagerstoassesstheircompliancewithgenerallyaccepted

accountingpracticesandwiththeGovernment’sportfoliomanagementpolicies.Thisauditingwould

reviewtherisksintheportfolioandcompliancewiththeriskmanagementframework.Itcouldalso

facilitate the establishment of multiyear targets for debt. The results of the audits would be

disclosedinthereportstotheMinisterof FinanceandParliament.

2. Policies,ProceduresandOperations

Risks of losses from inadequate operational controls should be managed according to soundbusinesspractices, includingwellarticulatedresponsibilities forstaff,clearmonitoringandcontrol

policies,andadequatereportingarrangements.

Debt management activities should be supported by an accurate and comprehensive

managementinformationsystemwithpropersafeguards.

Staff involved indebtmanagementshouldbesubjecttoacodeof conductandconflictof

interestguidelinesregardingthemanagementof theirpersonalfinancialaffairs.

A framework shouldbedeveloped to enabledebtmanagers to identify andmanage the

tradeoffsbetweenexpectedcostsand risks in theGovernment’sdebtportfolio.Portfolio

benchmarksshouldreflectthelevelof riskthatisacceptabletotheDMO.

Aspartof riskassessment,debtmanagersshouldregularlyconductstresstestsof thedebtportfolioonthebasisof economicandfinancialshockstowhichtheGovernment –andthe

countrymoregenerally –arepotentiallyexposed.

In order to help/guide decisions and reduce Government’s risk, debt managers should

considerthefinancialandotherriskcharacteristicsof theGovernment’scashflows.

Theresponsibilityforidentifyinganddevelopingplanstomanageoperationalrisksalso lies

with theDMOwhich shouldhaveaplan tominimizedamages causedby such risks. (For

moredetailonoperationalrisksseeAnnex1.)

BOXVII.2.LegalandRegulatoryProcessesforDebtIssuancebyaDMO

A DMO needs to be able to operate in accordance with rules which ensure that debt issuance is

consistent with specified borrowing limits, and which do nothing to undermine the confidence of

lendersandinvestorsconcerningtheobligationtoserviceandrepaygovernmentdebt.Thedelegation

of authorityshouldbeclear,asshouldbeaccountabilityandreportingobligations.ManyGovernments

have in place legislation of this kind. Usually the legislation authorizes the Minister of Finance toconductallborrowingandrelatedfinancialtransactionsonbehalf of theGovernmentandestablishesa

maximum amount of new funding and guarantees that can be extended over a specified period

(generallyone year). This avoids theneed for specific authorizations from Parliament for individual

transactions,whichmight increase the roleof political factors in thedecisionmakinganddelay the

executionof transactions.




151

DMOs can implement a “Code of Conduct for Staff andManagement” that rests on a tripod of

professionalismandintegrity;honesty,faithfulness,efficiency,staff courtesyinofficialconduct;and

dignifiedconductinprivatelife.

Professionalism and integrity requires staff to openly demonstrate professionalism and

integrityinexecutingthepoliciesandprogramsof theDMO;

Honesty, faithfulness,efficiency,and courtesy inofficial conduct requiresstaff tokeepfaith

to their official responsibilities by not allowing personal considerations or activities to

interferewithofficialduties,maintainingconstancyandsincerityof purpose,being result

oriented,andrespectingthepeopleitdealswith;

Dignified conduct in privateliferequiresstaff toexerciserestraintintheirprivatelivesandin

theconductof privateactivitiesthatcouldhavebearingsontheirofficialengagements.

Annualworkplansshouldbetightlyintegratedwithdebtstrategywork.Thereisastrategyhierarchy

extendingfromoverallstrategicdebtmanagementobjectivestoannualdebtmanagementreviews

andplansconsistentwiththeoverallobjectivesandtooperationalplansforindividualworkareasto

giveeffecttotheannualstrategy.

BOXVII.3.Typesof RiskMarketRisk.Theriskassociatedwithchangesinmarketindicators,suchasinterestrates,exchangerates,commodity

prices.Forbothdomesticandforeigncurrencydebtchangesininterestratesaffectdebtservicingcostsonnewissues

and on floating rate debt at the ratereset dates. The market risk of debt denominated in or indexed to foreign

currencies is due to the vulnerability of debtservicing costs as measured in domestic currency to exchange rate

movements.Bondswithembeddedputoptions (i.e.rightsfor investorstosellthebondstothe issuerataspecified

priceduringacertainperiod)canexacerbatemarketandrolloverrisks.

RolloverRisk.Theriskthatdebtwillhavetoberolledoveratahighcostor,inextremecases,cannotberolledoverat

all.Totheextentthatrolloverriskislimitedtotheriskthatdebtmighthavetoberolledoverathigherinterestratesit

maybeclassifiedasatypeof marketrisk.However,becauserolloverriskcanleadto,orexacerbate,adebtcrisis,itis

oftentreatedseparately.Managingthisriskisparticularlyimportantforemergingmarketcountries.

LiquidityRisk.Therearetwotypesof liquidityrisk.Oneconcernstherisksof situationsinwhichaborrowerdoesnot

haveaccess to liquidassetswhentheyareneeded.Theotherreferstotheriskof penaltyratesof interestorother

costswhenaborrowerwantstoexitapositionthroughthesaleof assetsforwhichthemarket isilliquid.Thisrisk isparticularlyrelevanttothemanagementof liquidassetsandliabilitiesandtotheuseof derivativescontracts.

CreditRisk.Theriskof nonperformancebyaborrowersorbyoneof thecounterpartiestootherfinancialcontracts.

Thisriskarisesinvariouscontextssuchastheacceptanceof bids inauctionsof securitiesissuedbytheGovernment

andinrelationtocontingentliabilitiesandderivativecontracts.

SettlementRisk.Thepotentiallossthatacounterpartycouldsufferasaresultof thepossibilitythatitdoesnotreceive

funds or other assets, for reasons other than default, from another counterparty in accordance with an agreed

timetable.

OperationalRisk.This includesarangeof differenttypesof risksdueto involvement invariouskindsof business. It

includesrisksduetotransactionerrorsinthevariousstagesof executingandrecordingtransactions,toinadequacies

orfailuresininternalcontrols,systemsandservices,andtotheeffectsof naturaldisasters.Itmaybedefinedtoinclude

reputationalriskandlegalrisk.




152

3. TheSeparationof ExecutiveandOperationalDebtManagement

TheExecutiveDebtManagementfunctions(thatisthepolicy,regulatoryandresourcingfunctions100)

are the responsibilityof theMinisterof Financeandotherhighgovernmentofficials, suchas the

Headsof theDMO,NationalPlanning, andBudget andTreasuryOffices. These functionsmaybe

subjecttooveralldirectionandcoordinationthroughahighlevelbodywhichcouldbedenominated

astheExecutiveDebtManagementCommittee(EDMC).

Theroleof theEDMC istoapprovedebtmanagementguidelinesandtheprinciplesto implement

them. It meets at intervals to analyse the DMO’s performance and evaluate compliance with

establishedregulationsandtargets.TheGovernorof theCentralBankcanbepartof thisCommittee

tohelptoensurecoordinationbetweenmonetarypolicy,debtmanagementandfiscalpolicy.Day

todayoperationsaredelegatedby theEDMC to theDMOand then reported toandcoordinated

withtheMinisterof Finance.

Anorganizationalstructure foreffectivedebtmanagement is shownschematically in figureVII.5.,andtheproposedcompositionof theEDMCinfigureVII.6.ItsdifferentfunctionsarespecifiedinBox

VII.4.

FigureVII.5.EffectivePublicDebtManagement

TheDMOmusthaveaclearmediumtermstrategy,performance indicators,andstrictmonitoringandcontrolfunctions.Thesefunctionsshouldnotberelatedonlytodebtissuanceanddebtservice.

Theyshouldalsoencompasseffectivemanagementof therisksassociatedwiththedebtstructure

andensuringcompatibilitywiththefiscaltargets,whilereducinggovernmentfinance’svulnerability

toshocks.

BasedonpreviousworkoneffectivedebtmanagementdevelopedbyDMFAS/UNCTADandother

international organizations such as the World Bank and the IMF and best practices in debt

management implemented in several countries, the recommended Executive Debt Management

(EDM)functionscanbesummarizedasfollows:

100SeeDMFAS/UNCTAD(1993).

ExecutiveDebtManagementCommittee

(HeadedbyMinisterof Finance)

DebtManagementOffice

MiddleOfficeFront Office BackOffice

ExecutiveDebtManagement

Operational

DebtManagement




153

(a) EDMfunctionsforexternaldebtincludetheestablishmentof debtsustainabilitystandards;

determinationof borrowingneedsand limits,anddesired termsandborrowing sources;

formulation of guidelines for debt operations such as debt conversions, buybacks, on

lending,etc;apolicyframeworkforgovernmentguaranteesandcontingentliabilities;and

arrangementsandregulationsforborrowing,disbursements,anddebtservice.

(b) EDMfunctionsfordomesticdebtconcerntheformulationof debtmanagementobjectives

and strategy; establishing borrowing ceilings according to budgetary and fiscal goals;

developmentof abenchmarkdebt structure;determinationof thevolume and typesof

instrumentstobeusedandtheirmaturity,timing,frequency,andsellingtechniques;and

developmentof communicationlinkageswithstakeholders.

(c) Operational Debt Management is the responsibility of the DMO itself. Basic functions

underthisheading includerecording,operating,monitoring,controlling,coordinatingand

negotiating public debt. These functions are best performedwithin the frameworkof a

Back,Middle,andFrontOfficetypeof organization.Separationof functionsinthiscontext

helps promote the independence of those designing strategies and monitoring them

(MiddleOffice) from those registeringdebtandperformingoperations (BackOffice)and

fromthosecarryingoutnegotiationsanddebttransactions(FrontOffice).

FigureVII.6.PossibleCompositionof theExecutiveDebtManagementCommittee

Head of Treasury

Head of Budget

Economic Adviser to the President

Head of PlanningOffice

Governor of Central Bank

Head of DMOSecretary

Minister of Finance

Chairman




154

Consolidationof thedebtmanagementfunctionsinasingleofficecanleadtoefficiencygains.Thisis

crucially important to avoid fragmentation of the debt strategy. When conducting DSA and risk

analysisitisimportanttohaveanintegratedviewof thetotaldebtportfolio.

The termsof referenceof theDMO should incorporateall functions related to the contractingof domesticandexternaldebt.Therefore,theorganizationalstructuremusthaveunitsresponsiblefor

theregistrationandmanagementof bothtypesof liabilities.(FordetailsseeBoxVII.1).

Theorganizationalstructureof theDMOshouldbebasedonaFunctionsManualthatdeterminesits

role, responsibilities and functions together with a staff table detailing job descriptions and

responsibilities.Thefunctionsof eachelementof theDMOstructureshouldbeclearlyspecifiedhere.

There shouldbeeffective coordination and information sharingwithin theDMO embodied in an

internalcommunicationsstrategy.

TheDMOshouldhavethepersonnelrequiredforefficientresponsetoitsmandates,andapolicyof

adequateremunerationtoattractandretainqualifiedstaff.

BOXVII.4.Functionsof theExecutiveDebtManagementCommittee

Approvethedebtmanagementstrategyoverthemediumterm;

Decideonsectorsthatwillhaveaccesstoexternalordomesticfinancingandonwhatterms;

Definethelevelandcharacteristicsof domesticdebtissuesforfiscalpurposes;

Establishborrowingceilingsbydebtorandcreditorcategories;

Establishguidelinesforextendinggovernmentguarantees; Definetherequiredmixof externalanddomesticindebtednessandthedesiredamortizationprofiles;

DecideondebtrestructuringsproposedbytheDMOtoconformwiththedebtstrategy;

Providelaws,guidelinesandregulationsforeffectivedebtmanagement;

Define institutional framework for the DMO and other institutions involved in debt management

operations,includingpropercoordinationof activities;

Put inplace theorganizational framework for theDMO, including information flows, functions, and

schedulesof duties;

Through the Budget Law, for each fiscal year, establish the debtservice targets and ceilings on

indebtednessforforeignanddomesticdebt;

Establishbenchmarksforcertaindebtindicators,suchasdebtservicetoexports,stockof publicdebttoGDP,debtservicetogovernmentrevenues,etc.;

Definepolicies,includingthosecoveringsalaries,careerperspectivesandallowances,forattractingand

retainingDMOstaff withrelevantqualifications;

PutinplacetrainingprogramsforDMOstaff;

Supportimprovements,maintenanceandextensionsof thedebtdatabase.




155

4. TheFront,Middle,andBackOfficesof aDMO

(a)Back OfficeThe Back Office centralizes all aspects of the registration, monitoring and control of

disbursements/subscriptions,of theexecutionandmanagementof publicdebtserviceoperations,

andof theproductionof statisticalinformation.Thefunctionscomprisetheadministrationof thefull

cycleof thelifeof acontract/instrumentfromthesignature/issuetoitsfullpayment.

TheOfficeisresponsibleforthemanagementof therecordsof debtholdersandfortheregistration

of governmentdebt instruments.Forecastsof forthcomingdebtservicepayments fordomesticas

wellasexternaldebtneed tobeproducedandsentto the financialagentof theGovernment for

compliancewiththedebtserviceobligations.

TheOfficeperformsthebasic functionswhichpermitallotheroperational functions tobecarried

out.Thedistributionof taskstocomplywiththesefunctionscouldbedividedintothefollowing:(1)the Areaof Registrationconcerningtheregistryof debtinformationinthedatabase;(2)the Areaof

AccountingOperations,whichismainlyconcernedwiththeissueof thePayment Orders;and(3)the

Areaof theDatabase Administrator inchargeof thesystemandnetworkmaintenanceincludingthe

requiredinformationtechnology.ThesefunctionsshouldberegulatedbyaProceduresManualthat

setsnormsfortheflowof informationintheoperativecycleandthatlinkstheoperationalactivities

withthestructureandfunctionsof theDMO.

Under Areaof Registrationgrants,onlending,guaranteeddebtandcontingentliabilitiesshouldbe

registeredandmonitoredclosely,asshouldprivatenonguaranteeddebtanddebt incurredatthe

subnationallevel.

TheBackOfficenormallyhastodealwith largescalerequirementsfor informationonpublicdebt.

Internationalorganizations,differentareasof theexecutiveand legislativebranches, researchers,

and the media require reliable and continuously updated debt information. Transparency and

efficiencyingeneratinginformationisthusakeytaskof the“Areaof Registration”.101

Animportantactivityof thispartof theBackOfficeistoconductdatavalidationatregularintervals

inordertoensurethereliabilityof thedatabase.Normally,thisalsorequiresregularreconciliations

of data with creditors. The dissemination of information on public debt should be closely

coordinatedwiththeFrontandMiddleOffices.

The preparation of payment orders to service public debt can be performed by the Area of

AccountingOperations,withpaymentschedulesgeneratedbythefunctionalgroupsof the Areaof Registration,althoughtheactualaccountingfordebtservicepaymentsisnotnecessarilydoneinside

theDMO.With a reliable debt database and a debt system, the preparation of paymentorders

shouldberapidandefficient.Thepaymentorderscanbegeneratedandprinteddirectlyfromthe

databasesystem,basedonthedebtsystem’sinformation.Theprocessof debtservicepaymentsto

creditorsisperformedafterthereconciliationof thecreditors’requestswiththeamountsscheduled

inthedebtsystem’sdatabase.Thiscentralizationof publicdebtregistrationandmonitoringandthe

operative process for the issue of the payment orders represent important savings through the

reductionof processingtimeandtheeliminationof penaltiesforlatepayments.

101FormoredetailsonthistopicseeInformationandTransparencyinDebtManagement,presentationbyUdaibirS.Das,

IMF,inUNCTAD(2005).




156

The Areaof AccountingOperationsof theBackOfficeshouldalsoensurethatbudgetaryprovisions

exist for (external and domestic) public debt service, including contingent liabilities, and that

sufficientsumsareallocatedtoreserves.

AwellorganizedBackOfficewillhave a structure for ensuring the efficient flowof information,adequate business processes, and the quality of information produced. Therefore, the structure

shouldbeorganizedwithadistributionof functionsthatclearlydefinesandestablishesthesources

of financingandthecoordinationof thedifferententitiesinvolved.

Under the Area of the Database Administrator the monitoring and control of publicdebt

information should be based on a methodical centralization of public credit operations in the

databaseof theDMO.Thedebtdatabase shouldcontainuptodate informationon thedomestic

andexternaldebtregistered in thesystem.The registrationof operationsof domesticorexternal

financinginthedatabasesystemisinitiatedwiththeopeningof loanfilesclassifiedbythetypeand

use of the financing, creditor, debtor, and executing agency. This registration will facilitate an

adequatecontrolof themanagementof disbursementsandpaymentsmadeduringthefiscalyearaswellastheprojectionof futuredebtservice.Thecontrolandmonitoringof theregistrationof new

loansinthedatabaseshouldbecarriedoutbytheheadof eachfunctionalgroup.Thestatusof the

database and its evolution should be evaluated in regular meetings among the heads of the

functionalgroupswhohavetheresponsibilityof executingtheworkprogram.

The inputof loan information to thedatabaseshouldbemonitoredandcontrolledperiodicallyby

the head of unit of the Back Office of the DMO. The technicians of the units should have the

responsibilitytorunlistsof loanstoverifytheconsistencyof theinformationandtocorrectthemif

necessary. The Database Administrator should perform the validation of the consolidated debt

information periodically. Errors and inconsistencies in the information can be detected through

consolidatedreports,andtheheadof eachgroupshouldbenotifiedforcorrections.Thestatusof thedatabaseand itsconsistencyshouldbeanalysed inperiodicmeetingswith theheadsof units

whohavetheresponsibilityof executingtheagreedworkprogram.

Confidence in thedebt informationprocessedand reportedby theDMOhasadirect relationship

withthequalityof datathatisenteredinthesystem.Inordertoensuretimelinessandhighquality,

theprocessingandreportingof debtinformationshouldberegulatedbyaresolutionorlegalnorm

thatinstructsalltheentitiesof thepublicsectortorespondtodatarequirementsof theDMO.

Thecontrolandsupervisionfunctionsof aDMOrequirethatdebtinformationbecollectedwithout

obstacles.Thiswillguaranteethattheauthoritieshaveaccesstouptodatedetailedandaggregated

information.Therefore it is important that theDMOestablishesdirectcontactwith theexecuting

agenciesorusersof resourcesandcreditors.InformationfromthesesourceswillbereconciledwiththatreceivedfromothersourcesincludingtheCentralBank.

It is also important that the institution in charge of monitoring the public investment program

providesallitsinformationtotheDMO.Thisinformationwillguaranteethattheprojectionsof debt

servicearecompatiblewithestimatesof disbursementsfor investmentprojects.Thiswillenhance

thequalityof theestimatesprovidedbytheDMOforthepreparationof theGovernment’sbudget.

(b)TheMiddleOfficeThe main function of the Middle Office is to conduct the analytical work required for assisting

executivemanagementlevelsindesigningadebtstrategyandaframeworkforriskmonitoringand




157

control.Regulardebtportfolioreviewshouldbepartof theactivitiesof thisoffice incoordination

withothergovernmentoffices.

Otherimportantrolesof thisofficearethegenerationof managerialreportsonpublicdebtforusers

insidetheDMOandtheGovernment,andthepublicationandotherdisseminationof statisticsandother information related to policies concerning external and domestic debt. The preparationof

debt information and reports should be in accordance with standard requirements and specific

requests. The Procedures Manual should specify the reports that are required by various

governmententitiesandbyexternaluserssuchastheWorldBank,theIMF,regionaldevelopment

banks,ParisClubcreditors,civilsocietyandotherprivateparties.

Theworkprogramof theMiddleOffice should include thepreparationof monthlyandquarterly

managerial reports for the Ministry of Finance. The reports would comprise the stock of debt

outstandingandtransactionsthattookplaceduringspecificperiods.Thisworkprogramshouldalso

besupportedbythepreparationanddistributionof aStatisticalBulletinof PublicDebt.

The work program should also include estimates mainly used for analytical purposes such as

projectionsof disbursementsandpublicdebtservicewithvariousassumptionsconcerning interest

andexchangerates.Theusefulnessof suchestimateswillbeenhancedbythedevelopmentof the

capacitytoincorporatedebtdataintotheframeworkof balanceof paymentsandmacroeconomic

dataanalysis.Suchanexpanded frameworkwill facilitate thedesignand implementationof debt

strategies.

Forthisworkitmaybeusefultoestablishan Analytical Functionand aRisk AnalysisFunction.

The Analytical Functionwillperformportfolioanalysisinamacroeconomicframeworkandanalysis

of longtermdebt sustainabilityon a regularbasis.DSAneeds to include fiscal sustainability and

should also include scenario analysis of ways of meeting medium and longterm social and

economicneeds.ThiscanbeaccomplishedbyusingdifferentDSAanalyticaltools,suchastheWorld

Bank/IMFdebtdynamicstemplates,DebtProorDSM+.102

Performanceof sensitivity analysiswithdifferent assumptions about exchange rates and interest

rates allows theMiddleOffice toprovide information about the impactof differentdebt service

scenariosonfiscalandmonetaryvariables.Proposeddebtmanagementtargetsregardingcurrency

composition and amortization profiles are also part of the Middle Office’s responsibilities. This

functionwill provide a basis for theMinisteror the EDMC to evaluate themacroeconomicdebt

strategy and amend it, if necessary. The Analytical Functionwould also allow theDMO to adopt

strategieswithinthemandategiventoitandtoproposestrategychangestotheMinisterof Finance.

TheRisk AnalysisFunctionwillberesponsiblefortheevaluationandestablishmentof costandrisk

limits for the debt portfolio. This can be accomplished by scenario analysis involving different

assumptionsconcerningnotonlyexchangeandinterestratesbutalsoothermajormacroeconomic

variablessuchasglobaleconomicgrowthaswellasgrowthandpricesinthecountry’smajorexport

markets.

102Information on these analytical tools can be obtained through the websites of Debt Relief International or the

DMFAS/UNCTADProgramme.




158

(c)TheFront OfficeThefunctionsof theFrontOfficearemostlyrelatedtothegatheringof financialresourcestocover

resourceutilizationandneedsrelatedtothepublicdebtordebt.Theythusincludealltheprocesses

involvingthenegotiationandcontractof newborrowing.

Thefrontofficeperformsthefunctionsthatcouldbedescribedasthoseof anEDMCSecretariat,i.e.

toensurethatthelaw,therulesandregulations,andtheguidelinesissuedbytheEDMCareapplied

andfollowed.ForthispurposetheFrontOfficerequiresproperlegaladvice.

Twomajor functionsof theFrontOfficeare the Implementation/Monitoring/NegotiatingFunction

andtheGovernment SecuritiesMarket Function.

The Implementation/Monitoring/Negotiating Function is responsible for the following up and

implementationof thedecisionstakenattheexecutive levelandforensuringthatimplementation

bytheGovernmentisestablishedinaccordance.Inlowerincomecountriesthisfunctionisalsolikely

tocoverattractingOfficialDevelopmentAssistance(ODA)andgrants.

The Government Securities Market Function comprises numerous responsibilities regarding the

developmentof markets for governmentdebt, and carryingout issuance, redemption, andother

tasksrelatedtomanagementof theGovernment’sdebt.

Theseincludethefollowing:

The development of securities market regulation to support the issuance and trading of

governmentsecurities;

The development of market infrastructure to help increase market liquidity and reduce

systemicrisk;

Strengtheningthedemandforgovernmentsecuritiesbybuildingthepotentialinvestorbase;

Improving the quality government securities in primary and secondary markets through

extendingmaturitiesandconsolidatingthenumberof issues;

MatchingtheGovernment’sfinancingneedswiththetermstructureof itsdebt;and

Creatingefficientchannelsforthemarketinganddistributionof governmentsecurities.

In itsGovernment SecuritiesMarket FunctiontheFrontOfficeshouldaimas faraspossibleat the

separationof instrumentsusedfordebtmanagement,ontheonehand,andformonetarypolicy,on

the other. When the market for government securities is limited to shortterm instruments, it

conflictsbetweenthepursuitof theobjectivesof monetaryanddebtpoliciesaredifficulttoavoid.

InmoresophisticatedDMOstheFrontOfficehasrolesinvolvingderivativestransactions,integrated

riskmanagement,accessingthe internationalcapitalmarkets,andprovidingvariousotherfinancial

servicestotheGovernment.

5. InstitutionalLocationof theDMO

AunifiedDMOwithconsolidatedfunctionsregardingoperationaldebtmanagementappearstobe

themostappropriatesettingforeffectivedebtmanagement.103Theexistenceof asingleinstitution

in charge of implementing debt policies permits a greater attention and concentration to debt

management issues and helps to ensure a clear separation between fiscal, monetary and debt

managementpolicies.103SeealsoCurrie,Dethier,andTogo(2003).




159

Regardingthelocationof theDMOwiththeGovernmentpresentpracticesvary.

SeparateDMOs aremore frequent indeveloped economieswith sophisticated financialmarkets.

UnderthisarrangementDMOsimplementthedebtstrategiesdeterminedbytheMinisterof Finance

as an agency of the Government.104To ensure Government monitoring and control of debtmanagement, for example, through an EDMC, clear governance, legal and institutional

arrangements are put in place and strategic objectives and benchmarks for debt management

established.

Themainadvantagesof separateDMOscanbesummarizedasfollows:

(a) Greaterefficiencyinmanagingdebt;

(b) Moreindependencefrompoliticalinfluence;

(c) Thepossibilityof attractingqualifiedstaff atbettersalaries;and

(d) Latitude for the application of privatesector management practices and debt

techniques.

Anexampleof theorganizationalstructureof aseparateDMOisprovidedinBoxVII.5.

DMOsinsidetheMinistryof Finance(MOF)aremorecommoninlessdevelopedeconomies,where

morecoordination isneededbetweendebtmanagementandotherpoliciesowingtothevitaland

strategicroleof theformer.

Advantagesof thisarrangementarethefollowing:

(a) Greater coordination of debt management with the core activities of the MOF,

suchasfiscalandbudgetarypolicies;

(b) Moreflexibilityinmanagingcontingentliabilitiesandonlending;and

(c) Facilitationof handlingissuesrelatedtothefiscalsustainabilityof debt.

Fiscaldiscipline,socialandeconomicgrowth,anddebtsustainabilityareinextricablyintertwinedin

lessdevelopedeconomies.105

IneithercasetheMOFisultimatelyaccountableforincurringdebtonbehalf of theGovernmentand

delegatessomeof itsauthoritytotheDMOforthispurpose.Whenthedebtmanagementactivities

are consolidated in a single office with an appropriate organizational structure and governance

arrangements, there arenogreatdissimilaritiesbetween a separateDMO and aDMO inside the

MOF.

104RecentExperiencesintheOrganizationof DebtManagementOffices,presentationbyFredJenseninUNCTAD(2005).

105SeeBorresenandCosioPascal(2002).




160

BoxVII.5.TheSeparateDMOof Nigeria

ThereareafewdevelopingcountriessuchasNigeriawithseparateDMOs.Thefigurebelowshows

thearrangementsof theNigerianDMO.

Supervisory Board

(Executive Debt Management)

DirectorGeneral (OPERATIONAL

(Operational Debt Management)

Public debt committee headed by

Minister of Finance

(Executive Debt Management)

Internal Audit

Front Office

Corporate

Affairs

Department

Back OfficeMiddle Office




161

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163

Abbreviations

ALM AssetandLiabilityManagement

BIS BankforInternationalSettlements

BOP Balanceof Payments

CB Centralbank

ComSec CommonwealthSecretariat

DMFAS DebtManagementandFinancialAnalysisSystem

DMOs DebtmanagementOffices

DSA DebtSustainabilityAnalysis

DSM+ DebtSustainabilityModelPlus

EDM ExecutiveDebtManagement

EDMC ExecutiveDebtmanagementCommitteeGDP GrossDomesticProduct

G8 Groupof Eight

G77 Groupof 77

IDA InternationalDevelopmentAgency

IFMS IntegratedFinancialManagementSystems

INTOSAI InternationalOrganizationof SupremeAuditInstitutions

IT/IS InformationTechnology/InformationSystems

IMF InternationalMonetaryFund

MDGs MillenniumDevelopmentGoals

MEFMI Macroeconomic&FinancialManagementInstituteof EasternandSouthernAfrica

MOF Ministryof FinanceODA OfficialDevelopmentAssistance

OECD OrganizationforEconomicCooperationandDevelopment

SAI SupremeAuditInstitutions

UN UnitedNations

UNCTAD UnitedNationsConferenceonTradeandDevelopment




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Annex

Source:INTOSAIGuidanceforPlanningandConductinganAuditof PublicDebt.

ManagingOperationalRisks

Operations risks arise in the areas that provide support services to the management of public debt.

Auditorswouldrecognizethefollowingoperationalriskswhentheyexaminetheorganizationalstructure

of publicdebtmanagement.

(a) Lack of separation of duties or functions. Public debt transactions must be independently

processed,confirmed,valued,andreviewed,andmonitoredbyanindependentadministrative

office.

(b) Inadequatestaff expertise.Supervisorsmusthave theproperexpertise toavoidbecominga

“rubberstamp”tothoseresponsiblefordebttransactions.Supportstaff isusuallythefirstline

of defensetouncovererrorsandirregularitiesthatmayoccurinprocessingdebttransactions.(c) Productrisk.Newdebtinstrumentscanbetoocomplexorpoorlyunderstood.Thiscanleadto

theinabilityof supportstaff toprocess,value,andcontrolnewdebtinstruments.

(d) System and technology risks. These risks exist when staff fails to stay up to date in its

understanding of technological developments associated with new information systems or

adopts computerized information systemswithout“reengineering” theirdebtmanagement

practices.

(e) Proceduresrisks.Theserisksexistwhenthedebtmanagementfunctionsdonothavewritten

proceduresand thework flow isnot structured inapredictableandwelldesignedmanner

withproperaudittrails.Thesewrittenproceduresbecomemoreimportant,themorecomplex

debtinstrumentsare.

(f) Disaster recovery risks. These risks exist when the debt organization has not planned for

alternativesites,computerresources,communications,resources,tradingfacilities,andothersupportservices inthecaseof adisaster.Thoseresponsiblefordebttransactionsmusthave

alternativeremotetradingandtechnologysites.

(g) Documentation risks. These risks exist when debt transactions do not have welldesigned

agreements that are legally authorized, properly executed and supported by appropriate

confirmation inatimelymanner.Legaldepartmentsandsupportstaff mustmaintainmaster

agreementsandsupportingconfirmations.

(h) Valuationrisks.Theserisksexistwhenthesupportstaff cannotperform,atleastonaregular

basis,anindependentvaluationof alldebtinstrumentsorif thevaluationof thesupportstaff

differs from the valuation of the Supreme Audit Institutions (SAI) or an independent third

party.




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CHAPTERVIII

CREDITRATINGAGENCIESANDTHEIRPOTENTIAL

IMPACTONDEVELOPINGCOUNTRIES

MarwanElkhoury

(IndependentConsultant)

A. Introduction

Credit rating agencies (subsequently denoted CRAs) specialize in analysing and evaluating the

creditworthiness of corporate and sovereign issuers of debt securities. In the new financial

architectureCRAsareexpectedtobecomemore important in themanagementof bothcorporate

and sovereign credit risk.Their rolehas recently received aboost from the revisionby theBasel

CommitteeonBankingSupervision(BCBS)of capitalstandardsforbanksculminatinginBaselII.

The logicunderlyingtheexistenceof CRAs istosolvetheproblemof the informationalasymmetrybetween lenders and borrowers regarding the creditworthiness of the latter. Issuers with lower

credit ratingspayhigher interest ratesembodying larger riskpremiums thanhigherrated issuers.

Moreover,ratingsdeterminetheeligibilityof debtandotherfinancialinstrumentsfortheportfolios

of certain institutional investorsduetonationalregulationsthatrestrict investment inspeculative

gradebonds.

The rating agencies fall into two categories, recognized and nonrecognized. The former are

recognizedby supervisors ineach country for regulatorypurposes. In theUnitedStatesonly five

CRAs(of whichthebestknownareMoody’sandStandard&Poor’s)arerecognizedbytheSEC.The

majority of CRAs such as the Economist Intelligence Unit (EIU), Institutional Investor (II), and

Euromoneyare“nonrecognized”.



Credit Rating Agenciesand their Potential Impact onDevelopingCountries

166

ThereisawidedisparityamongCRAs.Theymaydifferinsizeandscope(geographicalandsectoral)

of coverage.Therearealsowidedifferences in theirmethodologiesanddefinitionsof thedefault

risk,whichrenderscomparisonbetweenthemdifficult.

Regardingtheirrolevisàvisdevelopingcountries,thesovereignratingisparticularlyimportant.AsdefinedbyNagy (1984),“Country risk is theexposuretoa loss incrossborder lending,causedby

events in a particular country which are at least to some extent under the control of the

Governmentbutdefinitelynotunder thecontrolof aprivateenterpriseor individual”.Under this

definitionall formsof crossborder lending inacountry,whether totheGovernment,abank,a

privateenterpriseoran individualareincluded.Countryrisk isthereforeabroaderconceptthan

sovereignrisk.Thelatterisrestrictedtotheriskof lendingtotheGovernmentof asovereignnation.

However, sovereign and country risk arehighly correlated as theGovernment is themajor actor

affectingboth.Moreover,thereonlyrareexceptionstotheprincipleof thesovereignceiling;i.e.the

debtratingof acompanyorbankbasedinacountrycannotexceedthecountry’ssovereignrating.

Thefailureof bigCRAstopredictthe19971998Asiancrisisandtherecentbankruptciesof Enron,WorldComandParmalathaveraisedquestionsconcerningtheratingprocessandtheaccountability

of CRAsandhaspromptedlegislatorstoscrutinizeratingagencies.Thisreportgivesanoverviewof

thesovereigncreditratingindustry,analysesitsimpactondevelopingcountriesandassessessome

of theCRAs’shortcomingsinthecontextof concernsthathaverecentlybeenraised.

B. CreditRatingAgenciesintheInternationalFinancialSystem

1. Asymmetryof InformationandCRAsas“Opinion”Makers

A credit rating compresses a large variety of information that needs to be known about thecreditworthiness of the issuer of bonds and certain other financial instruments. The CRAs thus

contribute to solving principalagent problems by helping lenders “pierce the fog of asymmetric

information that surrounds lending relationships and help borrowers emerge from that same

fog”(White(2001)).

CRAs stress that their ratings constituteopinions.Theyarenota recommendation tobuy, sellor

holdasecurityanddonotaddressthesuitabilityof aninvestmentforaninvestor.Ratingshavean

impacton issuersviavariousregulatoryschemesandbydeterminingtheconditionsandthecosts

under which they access debt markets. Regulators have outsourced to CRAs much of the

responsibility forassessingdebt risk.For investors ratingsareascreening tool that influences the

compositionof theirportfoliosaswellastheirinvestmentdecisions.

2. CreditRatingsandBaselII

Regulatory changes inbanks’ capital requirementsunderBasel IIhave resulted inanew role for

creditratingagencies.Ratingscanbeusedtoassigntheriskweightsdeterminingminimumcapital

chargesfordifferentcategoriesof borrower.UndertheStandardizedApproachtocreditriskBaselII

establishes credit risk weights for each supervisory category which rely on “external credit

assessments”(seeBoxVIII.1.).Moreover,creditratingsarealsousedforassessingrisks insomeof

theotherrulesof BaselII.

Theimportanceof ratingsbasedregulationsisparticularlyvisibleintheUnitedStates,whereitcanbetracedbacktothe1930s.Theseregulationsnotonlyaffectbanksbutalsoinsurers,pensionfunds,




167

mutual funds and brokerdealers by restricting or prohibiting the purchase of bonds with “low”

ratings, i.e. noninvestment grade or speculativegrade ratings.106While ratingsbased regulations

arelesscommoninEurope,theyarepartof thenewCapitalRequirementsDirectivethattheEUwill

implementthroughBaselII.

Various writers such as Reisen (2002) have expressed the view that the Basel II Accord may

destabilizeprivatecapitalflowstodevelopingcountries.Thiswouldbetrueif thecloserlinksunder

Basel II between the levels of banks’ regulatory capital and their assessment of credit risks

accentuated procyclical fluctuations in their lending.Moreover the same linkmay also result inhigher interest rates than under the 1988 Accord for less creditworthy developingcountry

borrowers. The ratings of CRAs may contribute to unfavorable effects under both headings. As

discussedbelow, changes in these ratings sometimes follow closely cyclical changes ineconomic

conditions.Moreoverowingtotheirlowcreditratingscertaindevelopingcountriesmaybeassigned

higherweights forcreditriskthanunder1988CapitalAccordandthusbechargedhigher ratesof

interestontheirborrowing.

106ThemajorCRAshave theirown ratingsschemeswhichdiffer fordifferentcategoriesof debt – longand shortterm,

bankandnonbank and in thecaseof Fitch’s ratings forbanks include the likelihoodof external support, should this

becomenecessarytoenablethemtocontinuemeetingtheirfinancialobligationsonatimelybasis.Thebestknownratings

arethoseof StandardandPoor’sandMoody’sforlongtermdebt,whichvarybetweenAAAandBBBforinvestmentgradeforStandardandPoor’s(AaaBaa3 forMoody’s)andbetweenBB+andCC forspeculativegradeforStandardandPoor’s

(Ba1CforMoody’s).Formoredetailsseetable1of Annex2.

BOXVIII.1.BaselII

Themajorobjectiveof Basel II istorevisetherulesof the1988BaselCapitalAccord insuchawayasto

alignbanks’regulatorycapitalmorecloselywiththeirrisks,takingaccountof progressinthemeasurement

andmanagementof theserisksandtheopportunitieswhichtheseprovideforstrengthenedsupervision.

UnderPillar1of Basel2 regulatorycapital requirements for credit riskare calculatedaccording to two

alternative approaches, the Standardized and the Internal RatingsBased. Under the Standardized

Approach(SA)themeasurementof creditriskisbasedonexternalcreditassessmentsprovidedbyexternal

creditassessment institutions (ECAIs)suchascreditratingagenciesorexportcreditagencies.Underthe

internal ratingsbasedapproach (IRBA), subject to supervisoryapprovalas to the satisfactionof certain

conditions,banksusetheirownratingsystemstomeasuresomeorallof thedeterminantsof creditrisk.

Underthefoundationversion(FIRBA)bankscalculatetheprobabilityof default(PD)onthebasisof their

ownratingsbutrelyontheirsupervisorsformeasuresof theotherdeterminantsof creditrisk.Underthe

advancedversion (AIRBA)banksalsoestimate theirownmeasuresof allthedeterminantsof creditrisk,

includinglossgivendefault(LGD)andexposureatdefault(EAD).

Under the regulatory capital requirements foroperational risk thereare threeoptionsof progressively

greater sophistication. Under the Basic Indicator Approach (BIA) the capital charge is a percentage of

banks’gross income.UndertheStandardizedApproach(SAOR)thecapitalcharge isthesumof specified

percentagesof banks’gross income fromeightbusiness lines (oralternatively for twoof thesebusiness

lines,retailandcommercialbanking,of differentpercentagesof loansandadvances).UndertheAdvanced

MeasurementApproach (AMA), subject to the satisfactionof more stringent supervisory criteria,banksestimatetherequiredcapitalwiththeirowninternalsystemsformeasuringoperationalrisk.

Pillars 2 and 3 of Basel 2 are concerned with the supervisory review of capital adequacy and the

achievementof marketdisciplinethroughdisclosure.




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C. CRAs’ProceduresandMethods

1. QuantitativeandQualitativeMethods

TheprocessesandmethodsusedtoestablishcreditratingsvarywidelyamongCRAs.Traditionally

CRAshave reliedon aprocessbasedon aquantitative andqualitative assessment reviewed and

finalizedbya rating committee.More recently therehasbeen increased relianceonquantitative

statisticalmodelsbasedonpublicly availabledatawith the result that the assessmentprocess is

more mechanical and involves less reliance on confidential information. No single model

outperformsalltheothers.Performanceisheavilyinfluencedbycircumstances.

A sovereign rating is aimed at “measuring the risk that a Government may default on its own

obligationsineitherlocalorforeigncurrency.Ittakesintoaccountboththeabilityandwillingnessof

aGovernment to repay itsdebt ina timelymanner” (Moody’s,SpecialComment (2006)).Thekey

measure increditriskmodels isthemeasureof theprobabilityof default,PD,butexposure isalsodetermined by the expected timing of default and by the recovery rate, RE, after default has

occurred.

(a) S&P ratings seek to capture only the forwardlooking probability of the occurrence of

default.Theyprovidenoassessmentof theexpectedtimeof defaultorof modeof default

resolutionandrecoveryvalues.

(b) BycontrastMoody’sratingsfocusontheExpectedLoss,EL,whichisafunctionof bothPD

andtheexpectedrecoveryrate,RE.ThusEL=PD.(1RE).

(c) Fitch’s ratings also focusonbothPD andRE (Bhatia,2002).Theyhaveamoreexplicitly

hybridcharacterinthatanalystsarealsoremindedtobeforwardlookingandtobealertto

possiblediscontinuitiesbetweenpasttrackrecordsandfuturetrends.

The credit ratings of S&P andMoody’s are assigned by rating committees and not by individual

analysts. There is a large dose of judgment in the committees’ final ratings CRAs provide little

guidanceastohowtheyassignrelativeweightstoeachfactor,thoughtheydoprovideinformation

on what variables they consider in determining sovereign ratings. Identifying the relationship

betweentheCRAs’criteriaandactualratings isdifficult, inpartbecausesomeof thecriteriaused

areneitherquantitativenorquantifiablebutqualitative.Theanalyticalvariablesareinterrelatedand

the weights are not fixed either across sovereigns or over time. Even for quantifiable factors,

determiningrelativeweightsisdifficultbecausetheagenciesrelyonalargenumberof criteriaand

thereisnoformulaforcombiningthescorestodetermineratings.

InassessingsovereignriskCRAshighlightseveralriskparametersof varyingimportance:economic,

political, fiscal and monetary flexibility and the debt burden (see Box VIII.2.). Economic risk

addresses the ability to repay its obligations on time and is a function of both quantitative and

qualitative factors.Politicalriskaddressesthesovereign’swillingnesstorepaydebt.Willingnessto

pay is a qualitative issue that distinguishes sovereigns from most other types of issuers. Partly

becausecreditorshaveonly limitedlegalredress,aGovernmentcan(andsometimesdoes)default

selectively on its obligations, even when it possesses the financial capacity for debt service. In

practice,politicalriskandeconomicriskarerelated.AGovernmentthatisunwillingtorepaydebtis

usuallypursuingeconomicpolicies thatweaken itsability todo so.Willingness topay, therefore,

encompasses the rangeof economic andpolitical factors influencing governmentpolicy (seeBox

VIII.2.).




169

Broadly speaking, the economic variables aim at measuring three types of performance: (1)

measuresof domesticeconomicperformance,(2)measuresof acountry’sexternalpositionandits

ability to service its external obligations and (3) the influence of external developments. Bhatia

(2002) notes that CRAs’ analysis prior to the Asian financial crisis focused on traditional

macroeconomic indicatorswith limitedemphasisoncontingent liabilityand international liquidity

considerations.Moreoverprivatesectorweaknesseswerenotincludedintheanalysisof sovereign

rating.

Inpractice,asmallnumberof variablesGDPpercapita,realGDPgrowthpercapita,theconsumer

priceindex(CPI),theratioof governmentfiscalbalancetoGDP,andgovernmentdebttoGDPhave

a large impacton credit ratings.(The relationshipbetween these indicators and S&P’s ratings are

illustrated in figures15of Annex1.).Byand large,higherGDPpercapita lead tohigher ratings;

higherCPI to lower ratings, the lower the rating, the lower thegovernmentbalanceasa ratio to

GDP;higherfiscaldeficitsandgovernmentdebtinrelationtoGDPalsolowerratings.




170

Source:S&P,“SovereignCreditRatings:APrimer”,October2006.

Notes:NFPEs:Nonfinancialpublicsectorenterprises.

BoxVIII.2.S&PSovereignRatingsMethodologyProfile

Politicalrisk

Stabilityandlegitimacyof politicalinstitutions

Popularparticipationinpoliticalprocesses

Orderlinessof leadershipsuccessions

Transparencyineconomicpolicydecisionsandobjectives

Publicsecurity

Geopoliticalrisk

Incomeandeconomicstructure

Prosperity,diversityanddegreetowhicheconomyismarketoriented

Incomedisparities

Effectivenessof financialsectorinintermediatingfunsavailabilityof credit

Competitivenessandprofitabilityof nonfinancialprivatesector

Efficiencyof publicsector

Protectionismandothernonmarketinfluences Laborflexibility

Economicgrowthprospects

Sizeandcompositionof savingsandinvestment

Rateandpatternof economicgrowth

Fiscalflexibility

Generalgovernmentrevenue,expenditure,andsurplus/deficittrends

Revenueraisingflexibilityandefficiency

Expenditureeffectivenessandpressures

Timeliness,coverageandtransparencyinreporting

Pensionobligations

Generalgovernmentburden

Generalgovernmentgrossandnet(of assets)debtasapercentof GDP

Shareof revenuedevotedtointerest

Currencycompositionandmaturityprofile

Depthandbreadthof localcapitalmarkets

Offshoreandcontingentliabilities

Sizeandhealthof NFPEs

Robustnessof financialsector

Monetaryflexibility

Pricebehaviorineconomiccycles

Moneyandcreditexpansion

Compatibilityof exchangerateregimeandmonetarygoals

Institutionalfactorssuchascentralbankindependence

Rangeandefficiencyof monetarygoals

Externalliquidity

Impactof fiscalandmonetarypoliciesonexternalaccounts

Structureof thecurrentaccount

Compositionof capitalflows

Reserveadequacy

Externaldebtburden

Grossandnetexternaldebt,includingdepositsandstructureddebt

Maturityprofile,currencycomposition,andsensitivitytointerestratechanges

Accesstoconcessionallending

Debtserviceburden




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2. EmpiricalAssessmentsof CreditRatingDeterminants

Anumberof economistshaveestimatedeconometricallythedeterminantsof creditratingsforboth

matureandemergingmarkets(CantorandPacker(1995,1996),Haqueetal.,(1996,1997),Reisen

andvonMaltzan(1999),JuttnerandMcCarthy(2000),andBhatia,(2002)).Inthesestudiesasmall

numberof variablesexplain90percentof thevariationintheratings:

GDPpercapita;

GDPgrowth;

Inflation;

Theratioof nongoldforeignexchangereservestoimports;

Theratioof thecurrentaccountbalancetoGDP;

Defaulthistoryandthelevelof economicdevelopment.

Indeed, a single variable, GDP per capita, explains about 80 percent of the variation in ratings

(Borenszstein and Panizza (2006)). It is worth noting that the fiscal position, measured by theaverageannualcentralgovernmentbudgetdeficit/surplus ratio toGDP, in the threeyearsbefore

the rating year and the external position measured by the average annual current account

deficit/surplus in relation to GDP, in the three years before the rating year, were found to be

statisticallyinsignificant.

Whileincludingpoliticaleventscanimprovetheexplanatorypowerof theregressions,theexclusion

of politicalvariablesdoesnotbiastheparameterestimates(Haqueetal.,1996;CantorandPacker,

1996). In addition, for developingcountry ratings, two other variables adversely affected ratings

independentlyof domesticeconomicfundamentals(Haqueetal.,1996,1997):

Increasesininternationalinterestrates;

Thestructureof itsexportsanditsconcentration.

JüttnerandMcCarthy(2000)foundastructuralbreak inratingsassessmentin1997 inthewakeof

theSouthEastAsiancrisis.“[…]Econometricestimatesmayconveywrongormeaninglesssignalsto

investorsduringaratingcrisis…thereisnosetmodelorframeworkfor judgmentwhicharecapable

of explaining the variations in assignment of sovereign ratingsover time” (Jüttner andMcCarthy

(2000)).Theauthorsaddinafootnotethatthismeansthatinaglobalfinancialcrisisratingsmodels

might become completely obsolete since a stable relationship between rating and their

determinantsmightbeimpossibletoidentify.

In theiranalysisof thedeterminantof ratingsduring theAsiancrisis, JüttnerandMcCarthy found

thatthefollowingvariables:

TheCPI;

Theratioof externaldebttoexports;

Adummydefaulthistory,and;

Theinterestratedifferential;

Therealexchangerate.

Neither the interest rate differential nor the real exchange rate were found to be significant

determinantspriortotheAsiancrisisthusindicatingthatthesevariablesmayhavebeenoverlooked

by the agencies before the crisis. Variables denoting financial strength were not found to be

significantdeterminantsof sovereign ratingsevenoneyearafter theAsian crisis.However, these

variables were subsequently included in ratings assessments by the major CRAS following their

unsatisfactoryperformanceduringAsiancrisis.




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3. RatingDifferences,Notching,SolicitedandUnsolicitedRatings

Although CRAs have different concepts and measurements of the probability of default, various

studieswhichhavecomparedMoody’sandS&P’ratings,havefoundagreatsimilarityforinvestment

graderatings(CantorandPacker,1996;AmmerandPacker,2000).Inthecaseof speculativegrade

issues,Moody’sandS&Passigndivergentratingsmuchmorefrequentlytosovereignbondsthanto

corporate bonds. The literature also finds clear evidence of differences in rating scales oncewe

movebeyondthetwolargestagencies.Forexample,ratingsforthesameissuertendtobelowerfor

thetwolargestagenciesthanforotheragenciessuchasFitchorDuff andPhelps.

Someof thesedifferences canbeexplainedby sample selectionbias.The analysisof Cantorand

Packer(1996)pointstoonlylimitedevidenceof significantselectionbiasandsignificantevidencefor

differences in rating scalesbetween larger and smallCRAs.Regardlessof ratingsdifferences, the

market appears to reward issuers with a lower interest costs when a third rating is assigned,

especiallywhentheratingishigher(BCBS(2000)).

Fitch and the EganJones Ratings Company have accused the two big CRAs of practicing the

“notching”, a practice whereby S&P and Moody’s would initiate an automatic downward of

structuredsecurities,if thetwoagencieswerenothiredtoratethem(EganJonesRatingsCompany,

2002).Moody’s response toFitch’saccusations is thatunsolicited ratingsusually result ina lower

rating for debt securities because of either a lack of information or the use of different

methodologiestodeterminetheprobabilityof default.

Unsolicitedratingsraisepotentialconflictsof interest.BothMoody’sandS&Pstatethattheyreserve

therighttorateandmakepublicratingsforUnitedStatesSECregisteredcorporatebonds,whether

ornot requestedbyan issuer. If the issuerdoesnot request the rating, the ratingwill simplybe

based on publicly available information. If the issuer requests the rating, then it providesinformationtotheratingagencyandpaysthefees.Manynewentrantsinthecreditratingindustry

issueunsolicitedratingstogaincredibility inthemarket.Some issuershaveaccusedCRAsof using

unsolicitedratingsandthethreatof lowerratingsinduceissuerstocooperateintheratingprocess

andpaythefeesof solicitedratings.107

Since2001,Moody’sclaimsthatithasnotdoneanyunsolicitedratinginEurope.S&Palsoclaimsnot

todo anyunsolicited ratingoutside theUnitedStates.Asunsolicited ratings arebasedonpublic

information and thus lack issuer input, the issue of unsolicited ratings could be addressed by

requiring CRAs to disclose whether it has been solicited or not. Both Moody’s and S&P already

specify in their ratingswhether the ratinghasbeen solicited and give issuers theopportunity to

participateatanystageof theprocessif theywish.

D. Impactof Ratings

1. CostsandBenefitsof ObtainingaRating

Asmentioned earlier, the primary purpose of obtaining a rating is to enhance access to private

capitalmarkets and lowerdebtissuance and interest costs. Theoreticalwork (Ramakrishnan and

Thakor, 1984; Millon and Thakor, 1985) suggests that credit rating agencies, in their role as

informationgatherersandprocessors,can reducea firm’scapitalcostsbycertifying itsvalue ina

107SEC,‘Concept’Release.RatingAgenciesandtheUseof CreditRatingsundertheFederalSecuritiesLaws,Securitiesand

ExchangeCommission.ReleaseNos.338236;3447972;IC26066.




173

market,thussolvingorreducingtheinformationalasymmetriesbetweenpurchasersandissuers.For

sovereign borrowers, there is evidence of a clear correlation between bond spreads and rating

grades,asshowninFigureVIII.1.,(BIS(2006)):thelowertherating,thehigherthespread.

FigureVIII.1.BondSpreadsbyRatings

Source:BISQuarterlyReview,March2006fromJPMorgan

ChaseEMBIGlobalDiversified(EMBIGD).

There areother indirectbenefits from ratings for low income countries,namely to fosterFDI, to

promote more vibrant local capital markets, and increase publicsector financial transparency(StandardsandPoor’s(2004)).Asaresult,evensomesovereignsthatdonot intendto issuecross

borderdebtintheimmediatefutureseekcreditratingsfromCRAs.

Foremergingmarkets,thereisanimportantexternalityof obtainingarating,thatof the“sovereign

ceiling”effect.Borenzsteinetal.(2006)findthat,althoughithasbeenrelaxedsince1997,theeffect

of thesovereignceilingremainsstatisticallyhighlysignificant,especiallyforbankcorporations,being

more importantforbanksthatreside incountrieswithahigh levelsof sovereigndebtandsmaller

forbankswithstrongforeignparents.

2. BoomsandBusts:FinancialCrisesinEmergingMarketsandtheProcyclicalityof

Ratings

The19971998Asian crisishighlightedCRAs’potential for reinforcingboomsandbustsof capital

flows.As ratingswere lagging insteadof leadingmarketeventsandoverreactedduringboth the

preandpostcrisisperiods,theymayhavehelpedtoamplifythesecycles.

Severalempiricalstudiesshowthatsovereignratingsaresticky,laggingmarketsentimentandover

reactingwithalagtoeconomicconditionsandthebusinesscycle.Larrain,ReisenandvonMaltzan

(1997)havefoundthatratingsarecorrelatedwithsovereignbondyieldspreads.Intheaftermathof

the19941995Mexicancrisis,theauthorsfindatwowaycausalitybetweensovereignratingsand

marketspreads.Notonlydo internationalcapitalmarkets react tochanges inthe ratings,but the

ratingssystematicallyreact,withalag,tomarketconditionsasreflectedinthesovereignbondyield

spreads.Thisstudyalsoindicatesahighlysignificantannouncementeffectwhenemergingmarkets

sovereignbondsareputon reviewwithnegativeoutlook.Moreover, the study findsa significant




174

negative effect of rating announcements: following a rating downgrade investors readjust their

portfolios.Positiveratingannouncements,bycontrast,donotseemtohaveasignificanteffecton

bondspreads.

Moody’s more recent (2003) report on procyclicality claims that the relative stability of creditratings compared to marketbased indicators suggests that ratings were more likely to dampen

ratherthantoamplifythecreditcycle,andthatmostratingchangesreflectedlonglastingchanges

in fundamentalcredit riskratherthan temporarycyclicaldevelopments.The relationshipbetween

creditratingsandcyclicality –andthustheimpactof changes intheCRAs’practicesinresponseto

shortcomingsrevealedbythecrisesof the1990sthusremainsanopenempiricalquestion.

3. AccuracyandPerformanceof Ratings

CRAs’failuretopredicttheMexicanandAsianfinancialcriseswasdue,amongotherthings,tothe

fact that contingent liability and international liquidity considerations had not been taken into

accountbyCRAs..

ConcerningtheAsiancrisis,Moody’sacknowledgedthat ithadbeenconfrontedwithanewsetof

circumstancesrequiringaparadigmshiftinthefollowingareas:

Greater analytic emphasis on the risks of shortterm debt for otherwise creditworthy

countries;

Greateremphasisontheidentityandcreditworthinessof acountry’sshorttermborrowers;

Greaterappreciationof therisksposedbyaweakbankingsystem;and

Greaterattentiontotheidentityandlikelybehaviorof foreignshorttermcreditors;

Increasedsensitivity to the risk thata financialcrisis inonecountrycan lead tocontagion

effectsforothercountries.

Abalancehastobefoundinthetradeoff betweenaccuracyandstability.Ratingagenciesareaverse

toreversingratingswithinashortperiodof time.BothMoody’sandS&Pintendtheirratingstobe

stablemeasuresof relativecredit risk.Moody’sclaims that thiscorresponds to issuers’aswellas

institutionalinvestors’wishesandthatits“desire for stableratingsreflectstheview that morestable

ratingsare“better” ratings.

Bhatia (2002)hasmeasured“failures”basedon ratingsstability.Withexceptions for someof the

lowestratingshedefinesa“failedrating”asonethatisloweredorraisedby“threeormorenotches

within12months.Thechoiceof threenotches isrelatedtothesmallprobabilityof athreenotch

ratingchangeamongCRAs.ApplyingtheBhatiadefinitionof ratingfailuretothe longtermforeign

currency sovereign ratingsof S&PandMoody’s in19972002, shows thatS&PandMoody’sboth

experienced failures during the Asian crisis; S&P also failed during the Russian and Argentinean

crisis; and Moody’s failed during the Russian but not the Argentinean crisis (see table VIII.1.).

Bhatia’sfailuredefinitionsuggeststhatratingfailureswerelessprevalentin19992002thanin1997

1998.




175

TableVIII.1.SovereignRatingsFailureStatistics,199720021/

Source:Bhatia,2002,Box5.

In response to criticism concerning such failures, Moody’s has introduced “Watchlist” and S&P’s

launched “Outlook” reports in order to alleviate the tension between accuracy and stability by

providingtimelywarningsof likelyratingchanges.

Ratings performance can also be compared with market indicators. IMF (1999) conducted an

analysisof yieldspreadsinrelationtotheAsiancrisisandfoundthatoneyearaheadof thecrisisin

Thailand, Indonesiaand theRepublicof Korea,sovereignspreadswerequite low of theorderof

100150basispoints.InRussiaandBraziltheywerehigherabout300basispoints.Thus,inrelative

terms the markets were in broad agreement with the CRAs with respect to these countries,

indicating a higher risk of default for Russia and Brazil than for the Asian countries. Moreover,

spreads did not widen much initially in response to the onset of the Asian crisis, a patternconformingtothatof theratings.Thustheperformanceof financialmarketsbroadlyparalleledthat

of themajorCRAs.

4. Impactof RatingsonPoliciesPursuedbyBorrowingCountries

Forborrowingcountriesaratingdowngradehasnegativeeffectsontheiraccesstocreditandthe

costof theirborrowing(CantorandPacker,(1996)).Althoughpreciseinformationisnotavailableon

the way in which macroeconomic policies are taken into consideration by CRAs in establishing

sovereign ratings, it is reasonable to assume thatorthodoxpolicies focusingon the reductionof

inflation and governmentbudgetdeficits are favored. There is a risk, therefore, that in order to

avoidratingdowngradesborrowingcountriesadoptpoliciesthataddresstheshorttermconcernsof




176

portfolioinvestorsevenwhentheyareinconflictwithlongtermdevelopmentneeds.However,this

isanissuewhichhasnotbeenthesubjectof systematicresearch.

E. PublicPolicyConcerns

1. RecentRegulatoryInitiatives

Inviewof thecriticalroleplayedbyCRAs inthemodernfinancialarchitecture,policymakershave

recentlyfocusedonsomeshortcomingsarisingfromthefollowingconcerns:

Barrierstoentryandlackof competition;

Conflictsof interest;

Transparency;

Accountability.

These concerns have been raised by the International Organization of Securities Commission,

(IOSCO), theUnitedStatesSecuritiesandExchangeCommission, (SEC), theEuropeanCommission

Committee of European Securities Regulations, (CESR), and by the United States Congress and

Senate.

Onthebasisof Section702of theSarbanesOxleyActof 2002theUnitedStatesCongressmandated

theSECtoissueaReportontheRoleandFunctionof CreditRatingAgenciesintheoperationof the

SecuritiesMarkets.Thiswastoaddressseveralissuespertainingtothecurrentroleandfunctioning

of CRAs including the information flow in the creditrating process, barriers to entry artificially

createdby theNationallyRecognizedStatisticallyRatingOrganizations (NRSRO)designation in the

UnitedStates,andconflictsof interestorabusivepractices.

Areviewof theconceptof NRSROwasalreadyunderwayattheSEC.InJune2003,theSECissueda

ConceptRelease seeking commentswith respect towhetherCRAs’ ratings should continue tobe

usedforregulatorypurposes,andif so,whethertheNRSROcertificationprocedurewasappropriate

aswellasmoregenerallywhat shouldbe theadequate levelof regulatoryoversight forCRAs. In

April2005,theSECreleasedaProposedRuleaimingatinsuringahigherlevelof transparencywith

respecttotheNRSROconcept.

The technicalcommitteeof the IOSCO issued three reports inSeptember2003: (i)Reporton the

Activitiesof CreditRatingAgencies; (ii) Statement of Principles Regarding theActivitiesof Credit

Rating Agencies; (iii) and Report on Analyst Conflicts of Interest. These reports highlighted the

important role CRAs play in financial markets, and aimed at ensuring greater reliability for their

ratings.InDecember2004,theIOSCOpublisheditsCodeof ConductFundamentalsforCreditRating

Agencies (the IOSCOCode)which aimed atdeveloping “governance rules” forCRAs to ensure (i)

quality and integrity of the rating process, (ii) independence of the process and avoidance of

conflicts of interest and (iii) greater transparency in the methodology of ratings and adequate

treatment of confidential information. However, the IOSCO Code did not address the issue of

enforcementof theCode,recommendingthatCRAsadopttheserulesvoluntarily.

InresponsetoIOSCO’sCodeof ProfessionalConduct,Moody’sandS&PpublishedtheirownCodeof

Professional conduct in the secondhalf of 2005, thus aligning theirpolicies andprocedureswith

IOSCO’s Code. In the spring of 2006, Moody’s and S&P published their first report on the

implementationof theCodeof conduct.Hereitwasstatedthat,evenbeforetheSECandIOSCOhad

recommended new rules of conduct in 2003, the two agencies had already established internal




177

codes of conduct and procedures to prevent and manage potential conflict of interest and to

safeguardtheindependenceandobjectivityof theirratingprocesses.

Considerationof theissuesrelatedtoCRAsbytheUnitedStatesCongresseventuallyculminatedin

the Credit Rating Agency Reform Act which was signed into law in early September 2006. Thisamended theSecuritiesExchangeActof 1934 to redefineanNRSROasanyCRA thathasbeen in

business for at least three consecutive years and is registered under the Act. It also prescribed

procedural requirements for mandatory NRSRO registration and certification. It granted the SEC

exclusiveenforcementauthorityoveranyNRSROandauthorizedtheSEC(i)totakeactionagainstan

NRSRO that issued credit ratings in contravention of procedures, criteria and methodologies

included in its registration application, and (ii) to censure, or limit, suspend or revoke the

registrationof anNRSROforviolationsof theAct.

IntheEU,theEnronandParmalatcollapsesprompteddiscussionsonCRAreliability.Inresponsetoa

call by Commission for advice the CESR released inMarch 2005 “CESR’s TechnicalAdvice to the

EuropeanCommissiononpossibleMeasuresConcerningCreditRatingAgencies”.

2. Issuesof Concern

(a)Barrierstoentry and lack of competitionIntheUnitedStatesthereareonly5CRAsdesignatedbytheSECasNRSROs:A.M.Best.,Dominion

BondRatingService(DBRS),Fitch,Moody’sInvestorsService(Moody’s)andtheStandard&Poor’s

(S&P)divisionof McGrawHill.DBRSisCanadianbasedwitharegionalscopeandtheonlynonU.S.

NRSRO designated agency. A.M.Best is a global agency which rates the debt only of insurance

companies.Thus there are three globalNRSROsprovidinga comprehensive service in theUnited

States,of whichtwoagencies,Moody’sandS&P,controlover80percentof themarket.Themeannumberof CRAsrecognizedamongtheBCBS’membercountriesisaroundsixandtherearebetween

130150creditratingagencies intheworld.However,onlyasmallnumberof CRAsarerecognized

internationallyandthenumberhasnotchangedmuchsincethe1970s(BCBS,2000).

AccordingtotheUnitedStatesDepartmentof Justice,theNRSROdesignationhasactedasabarrier

toentry inacatch22manner108.Anew ratingagencycannotobtainnational recognitionwithout

NRSROstatusand itcannotobtainNRSROstatuswithoutnationalrecognition.Inthewordsof the

RapidRatingstestimonybeforetheCommitteeonFinancialServices(H.R.2990(2005b,p.8)),“the

effect of this catch22 has been to preserve a duopoly that has thwarted competition and

innovation”.

In an effort to increase competition and improve the quality of credit ratings Representative

FitzpatrickintroducedH.R.2990,TheCreditRatingAgencyDuopolyRelief Actof 2005.Hebelieved

thattheSECNRSROdesignationconstitutedan“insurmountableandartificialbarriertoentry…[…]

Lackof competition in the industryhas led to inflatedprices, stifled innovation, lowerqualityof

ratings,anduncheckedconflictsof interestandanticompetitivepractices.”(H.R.2990(2005a),p.4

5)).Thisbillwasthebasisof theCreditRatingAgencyReformActof 2006(H.R.2990(2005b)).

Inits2005reporttotheEUCommissionmentionedabovetheCESRalsostatedthatnewCRAsfacea

numberof barrierstoentryandexistingCRAsfaceanumberof naturalbarrierstoexpansion.Issuers

usuallyonlydesire ratings from thoseCRAs thatare respectedby investorsandwhich tend tobe

only those with a long performance record (CESR (2005), paras. 247248). The CESR report

108http://www.sec.gov/rules/concepts/s71203/rapid110603.htm#P69_8177#P69_8177.




178

concludedthat“theimpactof regulatoryrequirementsoncompetitionisnotclearandthereforeit

cannot conclude that any regulatory requirements would either increase or decrease the entry

barrierstotherating industry.ThusCESRdoesnotrecommendtheuseof regulatoryrequirements

asameasuretoreduceorremoveentrybarrierstothemarketforcreditratings”(CESR(2005),para.

252).TheCESRrecommendeda“waitandsee”attitudeandimplementationof IOSCO’s“Code”.

In a response to such initiatives Moody’s stated that it “has supported eliminating regulatory

barrierstoentry”.But,withregardtocompetitionissues,Moody’sarguesthatthe“costlynatureof

executive time” would not allow issuers to have many different ratings. Because of network

externalities, only a small number of CRAs would be favored by investors, who would desire

“consistencyandcomparabilityincreditopinions”.NewlyestablishedCRAswouldneedtimetogain

credibilityinthemarket.

S&Palsorecommendeditssupportto“amoreopenandtransparentprocesstodesignateNRSROs,

reduce barriers to entry and ensure that the markets remain the ultimate judge of the rating

process”(StandardsandPoor’s(2003)).However,S&PdidnotbelievethatthewholeNRSROprocessshouldbewithdrawn.

(b)Potential conflictsof interest InitsSeptember2003“Reportof AnalystConflictsof Interest”,IOSCOhighlightedpotentialconflicts

of interestfacingtheindustrythatcaninterferewiththeindependenceandobjectivityof itsanalysis.

Conflictsof interestmayarisewhenaratingagencyoffersconsultingorotheradvisoryservicesto

issuersitratessinceissuerscouldbeundulypressuredtopurchaseadvisoryservicesinreturnforan

improved rating.The reportalsodrewattention to the issueof “notching”byCRAs, i.e. lowering

ratings for issues which they had not rated, and that of “solicited” versus “unsolicited” ratings,

whereaggressivetacticsmightbeusedtoinducepaymentsforaratinganissuerdidnotrequest.

TheIOSCOCodeaddressesthefirstof theseissueswiththefollowingrecommendation:“Thecredit

ratingaCRAassignstoan issuerorsecurityshouldnotbeaffectedbytheexistenceof orpotential

forabusinessrelationshipbetweentheCRA(oritsaffiliates)andtheissuer(oritsaffiliates)orany

otherparty,orthenonexistenceof sucharelationship”(IOSCOCode(2004),Section2,para.2.2).

This principle has been integrated into Moody’s and S&P own Codes of Professional Conduct

(StandardsandPoor’s(2003)).”

(c)Transparency Manymarketparticipantshaveexpressedconcernoverthelackof transparencyoverCRAs’ratings

methodologies,procedures,practices andprocesses. In this context the IOSCOCode stresses the

following :“Inorder topromote transparencyand improve theabilityof marketparticipantsand

regulators to judgewhether aCRA has satisfactorily implemented the Code Fundamentals,CRAs

shoulddisclosehoweachprovisionof theCodeFundamentalsisaddressedintheCRA’sowncodeof

conduct. CRAs should explain if and how their own codes of conduct deviate from the Code

Fundamentals and how such deviations nonetheless achieve the objectives laid out in the Code

FundamentalsandtheIOSCOCRAPrinciples.Thiswillpermitmarketparticipantsandregulatorsto

draw theirown conclusionsaboutwhether theCRAhas implemented theCodeFundamentals to

theirsatisfaction,andtoreactaccordingly”(IOSCOCode(2004),p.2).

IOSCOrequirestheCRAs’methodologiestobecomepublictoenhancetransparency inan industry

whichisveryopaqueinnature.CESRgoesfurtherandproposes,asanalternativetoself regulation,“theneedtointroducesomespecificrulesonfairrepresentationwhichwouldestablishaminimum




179

levelof disclosureonthoseelementsandassumptionswhichmakeclearformarketoperatorsand

investors to understand how a specific rating was determined by a credit rating agency” (CESR

(2005),para.117).

Thenatureandextentof informationmadeavailabletothepublicstillvariesfromagencytoagency.Sincethepublicationof theIOSCOCodeanditsintegrationintotheCRAs’ownCodeof Conduct,the

CRAshaveincreasedthenumberof lengthyresearchreportsandpublicationsontheirwebsitesand

published some of the criteria used to assess credit risk in their bid to improve transparency.

However, theview is stillwidespread thatCRAs’methodologies, thevariablesandweightswhich

theyemploy,andthecriteriausedinthedeliberationsof ratingscommitteesremainopaquetoboth

investorsandborrowers.TheCESRsummedupthecontinuingproblemwhenitstatedthat:“Credit

ratingagenciesshouldaimfortransparencyasthebestwayforwardtoenableinvestorsandissuers

tounderstandthequalityandobjectivityof thecreditrating.Creditratingagenciesshouldtherefore

implementmeasure2.7of theIOSCOCode”.

(d) Accountability There isnomechanismtoprotect investorsand/orborrowersfrommistakesmadebyCRAsorany

abuseof poweron theirpart.This is trueeven if reputational interests and competitionprovide

incentives for generating quality financial information. In order to promote transparency and

improvetheabilityof marketparticipantsandregulatorsto judgewhetheraCRAhassatisfactorily

implementedwhatitpledgesitisdoing,theIOSCOCoderecommendsonlythatCRAsgivefulleffect

totheCodebypublishingtheirown,adheringtoitand justifyingpubliclyanydeviationbetweenthis

codeandtheiractivities.

There remains the need for more formal regulation to address market failures in the form of

imperfectcompetitionandprincipalagentproblemsinthecreditratingindustry.TheCESRtechnicalreportclearlyputs itsfingeronthe issue involved:“Thereasonforhavingaregulatorymechanism

shouldratherbethatthereexistssomemarketfailurethathastobedealtwith.Inessenceallthe

issuesdiscussedinthepreviouschapterarisebecausetheexistenceof conflictsof interestsbetween

the CRAs and the issuers and/or the users of ratings (the investors). These types of conflicts of

interestsbetweenprofessionalplayersonthe financialmarketsarenaturalandexist innumerous

areasof themarkets.Theybecomeespeciallyapparent intheratingmarketbecauseof the lackof

balanceof powerbetweenthedifferentplayers. IssuersarerelativelyweakcomparedtotheCRAs

becauseof theirdependenceontheratingstheyget. Investorshavenothistorically invested large

resources in improving rating agencies behavior, perhaps because there was insufficient

transparencyonthewayCRAsoperated to facilitatethis.ThismeantthatCRAshistoricallyhavea

verystrongposition.WhattheIOSCOCodeistryingtodoistorebalancetheinterestsbetweenthedifferentplayers”(CESR(2005),para.260).

Rousseau(2005) –not inreferences sumsupconcernsovertheresulting“accountabilitygap”as

follows:“ThisaccountabilitygapisworrisomeforCRAsaswellasmarketparticipants.Fortheformer,

theaccountabilitygapmayaffecttheircredibilityinthemarketplace.Forthelatter,itisof particular

concerngiven therole thatCRAsplay incapitalmarkets...There isaneed fora […]mechanism to

takeoverif reputationfails.”

Forthefirsttimeinthehistoryof ratingsintheUnitedStatestheCreditRatingAgencyReformActof

2006 has clearly designated the SEC to monitor CRAs’ compliance with new securities laws and

regulations. The SEC will be able to act as deemed necessary and to study and report to

congressional committees any problems faced in the future with anything relating to the creditratingindustry.




180

F. Conclusions

CRAsplayakeyroleinfinancialmarketsbyhelpingtoreducetheinformationalasymmetrybetween

lenders and investors,onone side, and issuerson theother side, about the creditworthinessof companies (corporate risk) or countries (sovereign risk). CRAs’ role has expanded with financial

globalizationandhas receivedanadditionalboost fromBasel IIwhich incorporates the ratingsof

CRAsintotherulesforsettingweightsforcreditrisk.

Inmakingtheirratings,CRAsanalysepublicandnonpublicfinancialandaccountingdataaswellas

information about economic andpolitical factors thatmay affect the ability andwillingnessof a

Governmentorfirmstomeettheirobligationsinatimelymanner.However,CRAslacktransparency

anddonotprovideclearinformationabouttheirmethodologies.

Ratingstendtobesticky, laggingmarkets,andthentooverreactwhentheydochange.Thisover

reactionmayhaveaggravatedfinancialcrisesintherecentpast,contributingtofinancialinstability

andcrosscountrycontagion.Moreovertheactionsof countrieswhichstrivetomaintaintheirrating

gradesthroughtightmacroeconomicpoliciesmaybecounterproductivefor longterm investment

andgrowth.

The recentbankruptciesof Enron,WorldCom,andParmalathaveprompted legislative scrutinyof

theagencies.Criticismhasbeenespeciallydirectedtowardsthehighdegreeof concentrationof the

industry,whichintheUnitedStateshasreflectedaregistrationandcertificationprocessintheform

of NRSROdesignationbiasedagainstnewentrants.Theeffectof suchconcentrationhasbeenthe

absenceof thedisciplineenforcedbycompetitionandalowlevelof innovation.

IntheUnitedStatespolicyactionhasincludedthe2006CreditRatingAgencyReformActwhichhas

overhauled the regulatory framework by prescribing procedural requirements for NRSROregistrationandcertificationandbystrengtheningthepowersof theSEC.

At the international level the main initiative has been the publication by IOSCO of its Code of

Conduct.ThisCodeaimsatdevelopinggovernancerulesforCRAstoensurethequalityandintegrity

of theratingprocess,theindependenceof theprocessandtheavoidanceof conflictsof interest,and

greater transparency. In its 2005 Technical Advice to the European Commission on possible

MeasuresConcerning Credit RatingAgencies the CESR recommended the implementationof the

IOSCOCodeandadoptionof a“waitandsee”attitude.

Definitiveassessmentof these initiativeswouldstillbepremature.The industrywillreceiveafillip

from implementationof Basel II.ThemajorCRAswillundoubtedlyseekasubstantialshareof the

new business which will result. The promotion of competition may require policy action at the

nationalleveltoencouragetheestablishmentof newagenciesandtochannelbusinessgeneratedby

newregulatoryrequirements intheirdirection.Regulatoryactionatthenationallevelmayalsobe

necessary to ensure that the agencies operate in accord with levels of accountability and

transparencymatchingtherecommendationsof theIOSCOCode.




181

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Annex I.SovereignRatingsMethodology ProfileFigure1.GDPperCapita

Source:S&P,Oct.2006,“SovereignCreditRatings:APrimer”.

Figure2.RealGDPGrowthperCapita





186

Figure3.ConsumerPriceIndex(CPI)


Figure4.GeneralGovernmentBalanceasPercentageof GDP





187

Figure5.NetGeneralGovernmentDebtasPercentageof GDP

Source:S&P,Sept.2005,“SovereignCreditRatings:APrimer”.




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Annex II Table1.RatingSymbols

RATING SYMBOLS FOR LONG-TERM AND SHORT-TERM DEBT

InterpretationLong-Term Short-Term Long-Term Short-Term Long-Term Short-Ter

INVESTMENT-GRADE RATINGS

Highest Credit Quality Aaa AAA AAA

High Credit Quality Aa1 AA+ AA+

Aa2 Prime-1 AA A1+ AA F1

Aa3 AA- AA-

Strong Payment Capacity A1 A+ A+

A2 A A1 A

A3 Prime-2 A- A-

Adequate Payment Capacity Baa1 BBB+ A2 BBB+ F2

Baa2 Prime-3 BBB A3 BBB F3

Last Rating in Investment-Grade Baa3 BBB- BBB-

SPECULATIVE-GRADE RATINGS

Speculative Ba1 BB+ BB+

credit risk developing Ba2 BB B BB B

due to economic changes Ba3 BB- BB-

Higly Speculative, B1 Not Prime B+ B+

credit risk present B2 B B

with limited margin of safety B3 B- B-

High Default Risk, Caa1 CCC+ C CCC+ C

capacity depending on sustained, Caa2 CCC CCC

favorable conditions Caa3 CCC- CCC-CC CC

Default, Ca, C C, D D C, D D

although prospect of partial recovery

Moody's S&P Fitch

Source:BasedonS&P,Moody’sandFitch.




189

Table2.RatingAgenciesRecognizedinVariousCountries

Source:BCBS(2000),Table2,p.46.

Note: Table2showstheratingagenciesrecognizedbythebankingsupervisorsinBCBScountriesand

selectednonmembers.The totalnumberof agencies recognized ineachcountry isshown in

therighthandcolumn.Itisevidentthereisconsiderabledisparityinthenumberof recognitions

grantedbysupervisors.ThebigthreeCRAs,S&P,Moody’sandFitch,arerecognizedbyallBCBS

membersandalmostallnonBCBScountriesshown.






191

CHAPTERIX

PURSUINGSUSTAINABLEDEVELOPMENT

STRATEGIES:THECASEOFTHEBALANCEOF

PAYMENTRULESINWTO

RobertHowse,AleneSmithandAllanF.Smith

(Universityof Michigan)

A. Introduction

1. Equity

InSection IIIof theMillenniumDeclarationentitled“DevelopmentandPovertyReduction,”United

NationsMemberStatescommittedthemselvesto“tocreateanenvironment atthenationaland

global levels alike which is conducive to development and to the elimination of poverty.” This

dependson“goodgovernancewithineach country”,“goodgovernanceat the international level,

andontransparencyinthefinancial,monetaryandtradingsystems.”Hence,they“arecommittedto

anopen,equitable,rulebased,predictableandnondiscriminatorymultilateraltradingandfinancial

system.”

The concept of equity in international trade and financial rules and institutions has not been

explicitly defined and is the subject of debate and speculation among philosophers and political

theorists. Economists are often skeptical of whether the trade and financial systems should be

understood atall in termsof justice rather than as instrumentsof economicpolicy coordination.

Nevertheless,itwillbeobservedthattheactualrulesoftendodepend,explicitlyorimplicitly,ona

conceptof fairness.For instance,oneof therulesthatwillbediscussed inthispaper,contained in

Article IVof the IMFArticlesof Agreementrequiredthat IMFMembersnot“manipulateexchange

rates or the international monetary system in order to prevent effective balance of payments

adjustmentortogainanunfaircompetitiveadvantageoverothermembers.”



PursuingSustainableDevelopment Strategies:TheCaseof theBalanceof Payment RulesinWTO

192

The conceptof equity is thus inescapable in the interpretation and applicationof the lawof the

internationaltradeandfinancialsystems.Thequestioniswhethertherearelegalandpolicysources

thatallowustogiveadefinitemeaningtothisconceptasweapplyittoparticularrulesanddisputes

inthetradeandfinancialsystems.

One ingredient of equity that is widely reflected in international instruments concerning trade,

financeanddevelopmentisthenotionthatrulesshouldbeadjustedtothe individualsituationsof

countrieswithrespecttotheirdevelopmentneeds.Thus,thereiswidespreadagreementthatformal

legalequality,treatingeveryonethesameregardlessof theirparticularsituation,isnotequitable.At

thesametime,thereisdisagreementamongstatesonhowmuchdifferentialtreatment is justified

inagivensituation.

Thereisaninterestingparallelismbetweentheconceptionof equityastreating“unlikes”differently

and the recognition in recent economic literature that—contrary to what was implied in the

WashingtonConsensusformula—thereisnotasingleformulaorpathwaytodevelopmentthatwill

workforallcountries.109

Anotherdimensionof equityreflectedininternationalhumanrightsinstrumentsisthatof voiceand

participation.Theseinstrumentssuggestthatpeopleshouldnothaveavisionof developmentforced

onthemordecidedbyothers.TheDeclarationontheRighttoDevelopment,forexample,stipulates

thattheRighttoDevelopmentincludes“freeandmeaningfulparticipationindevelopment.”

Closelyrelatedtothenotionof equityistheconceptof socialandeconomic justiceexpressedinthe

UnitedNationsCovenanton Social andEconomic andCulturalRights.Article11of theCovenant

provides: “1. The States Parties to the present Covenant recognize the right of everyone to an

adequatestandardof livingforhimself andhisfamily,includingadequatefood,clothingandhousing,

and to the continuous improvementof living conditions. The StatesPartieswill take appropriatesteps toensure the realizationof this right, recognizing to thiseffect theessential importanceof

internationalcooperationbasedon freeconsent.”Whilenotall states mostnotably theUnited

StateshaveembracedtherightsintheCovenantastreatyorcustomaryinternationallaw,eventhe

UnitedStateshasparticipated intheDeclarationontheRighttoDevelopment,which incorporates

toalargeextentandaffirmstheserights.Aconcreteimplicationof thisnotionof equityisthatthe

rules of the international trade and financial system should, at aminimum, not undermine, and

ideally should facilitate, theabilityof states todischarge theirobligationsunder theCovenant to

implementsocialandeconomicrights.

Finally, equity has been considered by United Nation Member States to imply a fair global

distribution of burdens andbenefits from theoperationsof the international trade and financial

system.Thisgoesbeyondanotionsimplythatthesystem(s)shouldenablestatestoachievesocial

and economic justice within their borders to a conception of global solidarity. According to the

MillenniumDeclaration,solidarityrequiresthat“globalchallengesmustbemanaged inawaythat

distributes the costs and burdens fairly in accordance with basic principles of equity and social

justice.”110

In itsexaminationof WTO rulesand jurisprudenceas they relate to thebalanceof paymentsand

other international financial issues this paper will draw on the dimensions of equity articulated

above.

109RodrikD (2001). TheGlobal Governance of Trade as if Development Really Mattered .UnitedNationsDevelopment

Programme.110See alsoBeviglia ZampettiA (2005).Progressing Towards a Just Future Through theMDGs:What is theRoleof an

“Equitable”MultilateralTradingSystem?Draft:12.October.




193

TheWTOAgreementdefinesthegoalof themultilateraltradingsystemintermsof theprinciplethat

“relations inthefieldof tradeandeconomicendeavorshouldbeconductedwithaviewtoraising

standardsof living,ensuringfullemploymentandalargeandsteadilygrowingvolumeof realincome

and effective demand, and expanding the production of and trade in goods and services, while

allowingfortheoptimaluseof theworld’sresourcesinaccordancewiththeobjectiveof sustainable

development...”Clearly,thegoalsof raisingstandardsof livingandensuringfullemploymentare

closely linked to the conception of social and economic justice in the UN Covenant on Social

EconomicandCulturalRights.

2. Coherence

Arguablycoherenceisalogicalimplicationof therecognitionof equityasafundamentalelementof

the internationaltradeand financialsystems.Coherencerefers, firstly,totherulesandpoliciesof

theinstitutionswhereequityisarticulatedanddefinednormativelyand,secondly,totherulesand

policies of the international trading and financial systems themselves. Inequity may result from

uncoordinated rulesbetweenthetradingandthefinancialsystems.

Forexample,theIMFmayrequireacountrytoimproveitsbalanceof payments.However,therules

of the trading systemmaynotpermit theuseof certain instruments fordoing so.Theremaybe

goodreasonswhytheseinstrumentsareconstrainedbytherulesof theinternationaltradingsystem.

However,intheabsenceof abroadandpalatablerangeof policyoptionsfortrade,thecountrymay

pursue thegoal specifiedby the IMF through recourse topolicy instruments that threaten social

equity,andresultinpovertyandunemployment.

AnearlyexplicitattempttoaddresscoherenceattheWTOistheUruguayRoundDeclarationonthe

Contributionof theWorld TradeOrganizationtoGreater CoherenceinGlobal EconomicPolicymaking.

Paragraph2of theDeclarationreads:

“Trade liberalization forms an increasingly important component in the success of the

adjustment programs that many countries are undertaking, often involving significant

transitionalsocialcosts. In thisconnection,Ministersnote theroleof theWorldBankand the

IMF in supporting adjustment to trade liberalization, including support tonet foodimporting

developingcountriesfacingshorttermcostsarisingfromagriculturaltradereforms.”

Themostimportantpartof theDeclarationisarguablytobefoundinParagraph5:

“The interlinkages between the different aspects of economic policy require that the

international institutions with responsibilities in each of these areas follow consistent andmutually supportive policies. The World Trade Organization should therefore pursue and

developcooperationwiththeinternationalorganizationsresponsibleformonetaryandfinancial

matters, while respecting the mandate, the confidentiality requirements and the necessary

autonomy in decisionmaking procedures of each institution, and avoiding the imposition on

Governments of crossconditionality or additional conditions. Ministers further invite the

DirectorGeneral of the WTO to review with the Managing Director of the International

Monetary Fund and the President of the World Bank, the implications of the WTO’s

responsibilitiesforitscooperationwiththeBrettonWoodsinstitutions,aswellastheformssuch

cooperation might take, with a view to achieving greater coherence in global economic

policymaking.”

Paragraph 2 draws attention to the significant social costs of trade liberalization and economicreform. But the Declaration does not extend the idea of coherence to cooperation with those






195

currency),thiswouldbefinancedbyborrowingfromtheInternationalMonetaryFund.Inthecaseof

astructuralorpersistentimbalance,acountrywoulddevalueitscurrencyunderthesupervisionof

theIMF,whichmightrecommenddomesticpolicyadjustmentstoensurethatfurtherdevaluations

werenotrequiredsubsequentlyinordertomaintainthebalanceof payments.

TheBrettonWoodssystembrokedownin1971whentheUnitedStatesunilaterallyoptedoutof the

systemwhenitannouncedthesuspensionof convertibilityof thedollarintogold.Theresultiswell

summarizedina2004UNCTADdocument:

“Unfortunately, after the breakdown of the Bretton Woods system at the beginning of the

1970s, theworldmonetary system slipped back into the kind of “monetary chaos” that had

characterizedtheprewarperiodanditsdismaleconomicandpoliticaloutcomes.Nevertheless,

the liberalizationof the tradingsystem,evenafter theendof theBrettonWoodssystem,was

pushed forward by policymakers as if a consistent approach on the monetary side, i.e. a

coherentmonetaryorder,wouldhaveexisted.Onlyrecently,withtheAsiancrisisaswellaswith

the LatinAmerican currency turmoil,have the shortcomingsof the “monetary chaos”and its

repercussionsonthetradingsystembeenacknowledged,evenbymainstreameconomictheory

andtheWTO.Butinstabilityisonlypartof thestory.....if changesintheinternationalvalueof

moneyareinnowayrelatedtothefundamentalsof countrieswithopenmarketsforgoodsand

capital,traditionaltradetheoriesquicklylosetheirgrasponrealityandtradeliberalizationloses

muchof itsalleged justification.”112

In the caseof developing countriesprogress towards convertibility and the removalof exchange

controlswasamajorfeatureof theeconomicorthodoxyinthe1980sand1990s.Suchreformswere

thought to have the effect of encouraging foreign investment and creating domestic financial

systems as well as access to the global financial networks that would underwrite growth and

development.

TheAsianandLatinAmericanfinancialcrisesof the1990s ledtorethinkingof thisorthodoxy.Well

knowneconomistssuchasJagdishBhagwatiandJosephStiglitzmaintainedthattoorapidfinancial

liberalization contributed to the crises, which led to widespread human misery in a number of

countries,expressedtheirsupportforcapitalcontrolsasaninstrumentforstemmingapanicflight

of shorttermcapital.113114

TheGATTrulesconcerningexchangemeasuresandconvertibilityarecontained inArticleXVof the

GeneralAgreement:

Article XV:4 states that “Contracting parties shall not, by exchange action, frustrate the

intentof theprovisionsof thisAgreement,norbytradeaction,theintentof theprovisions

of theArticlesof Agreementof theInternationalMonetaryFund.” According to the InterpretativeNoteAdArticle XV: “Theword “frustrate” is intended to

indicate, forexample, that infringementsof the letterof anyArticleof thisAgreementby

exchangeactionshallnotberegardedasaviolationof thatArticleif,inpractice,thereisno

appreciabledeparturefromtheintentof theArticle.Thus,acontractingpartywhich,aspart

of its exchange control operated in accordance with the Articles of Agreement of the

InternationalMonetary Fund, requiredpayment tobe received for its exports in itsown

currencyorinthecurrencyof oneormoremembersof theInternationalMonetaryFundwill

112World TradeOrganization (2004). Economic PolicyChallenges in anOpen Economy:Coherence between Trade and

Finance. Communication of UNCTAD to the WTO Working Group on Trade, Debt and Finance (WT/WGTDF/W/27),

November.113BhagwhatiJ(2004).InDefenseof Globalization.Oxford,OxfordUniversityPress,199200.

114StiglitzJ(2002).Globalizationand ItsDiscontents.NewYork,W.W.Norton.




196

nottherebybedeemedtocontraveneArticleXIorArticleXIII[of theGATTonquantitative

restrictions].Anotherexamplewouldbe thatof a contractingpartywhich specifiesonan

import licensethecountryfromwhichthegoodsmaybe imported,forthepurposenotof

introducing anyadditionalelementof discrimination in its import licensing systembutof

enforcingpermissibleexchangecontrols.”

ArticleXV:9of theGATTprovides:“NothinginthisAgreementshallpreclude:(a)theusebya

contracting party of exchange controls or exchange restrictions in accordance with the

Articlesof Agreementof the InternationalMonetaryFundorwith thatcontractingparty’s

specialexchangeagreementwiththeCONTRACTINGPARTIES,or(b)theusebyacontracting

partyof restrictionsorcontrolsonimportsorexportsthesoleeffectof which,additionalto

theeffectspermittedunderArticlesXI,XII,XIIIandXIV,istomakeeffectivesuchexchange

controlsorexchangerestrictions.”

AccordingtoArticleXVI:2of theGATT,thereshallbedeferenceto“thedeterminationof the

Fundastowhetheractionbyacontractingpartyinexchangemattersinaccordancewiththe

Articlesof Agreementof theInternationalMonetaryFund,...”

Taken together, theseprovisions suggest that,wheremeasureshavebeen takenwith respect to

exchange controls or restrictions, even if such measures would otherwise be considered trade

restrictionsbecauseof theireffectonimportandexporttransactions,theintent of theGATT isnot

toimposedisciplinesbeyond thoserequired by theIMF.

Itisinaccuratetoviewtheseprovisions,assomecommentatorshave,essentiallyceding jurisdiction

to the IMF. According to this view, when an exchange measure is not consistent with the IMF

Articles, the“safehaven”of ArticleXVdisappearsand themeasuremaywell then fallafoulof a

provisionof theGATTsuchasArticleXI.Thus,whenacountrydisagreeswiththeFundonthebest

course for solving a financial crisis, including one that does not worsen the plight of the leastadvantaged, theGATTpermitscountry tobe“punished”throughbeing found inviolationof GATT

rules.InsuchcasestheGATT/WTOwouldbecomearesidualenforcerfortheIMF.

Arguablythiswasnottheintentof theGATTframers.Firstof all,priortotheWTOtheGATTdispute

settlementsystemcontainedmanydiplomaticsafetyvalves.Secondly,theoriginalIMFArticleswere

premisedonaworldof largelyfixedexchangeratesadjustedthroughIMFsupervision.However,in

today’sworldof speculationdriven currencymarkets and thewidespread liberalizationof capital

controls(generallyendorsedbytheIMF)there isnoagreed internationalstandardagainstwhicha

currencycanbeviewedasoverorundervalued,thustriggeringareasonableobligationtoadjust

economicfundamentalsthroughmeansthatdonotimposeunreasonablecostsonothercountries.

Inthisworldrecoursetoexchangerestrictionsmaybea justifiableoptionforacountryseekingto

avoidacurrencycrisisortoprotect itself fromthecontagioneffectsof acrisiselsewhere.Thiscan

beillustratedwiththecaseof Malaysia.

In September 1998 Malaysia decided to defy the IMF’s advice and to impose selective capital

controlsinordertohelptoresolveitsfinancialcrisisaswellastoenablethemaintenanceof afixed

exchangerate.KaplanandRodrikconcludethat,incomparisonwithothercountriesthatfollowIMF

prescriptions, and taking into account differences in those countries’ situations, “the Malaysian

policywasmoresuccessfulinaccomplishinganimmediatereductionininterestrates,stabilizingthe

currency, and stemming financialpanic.Thiseased, for the short term at least,worries that the

banking systemwouldgounderand that therewouldbeadevaluation spiral.The turnaround in

marketconfidencewascorrespondinglymorerapid. Inaddition, fiscalpolicywasonbalancemore






198

askhow far China’s exchangeratemeasures undermine the development policies of otherWTO

Members.

InGATT/WTOpracticeand jurisprudence, the justifiabilityof measuresunderArticleXVhasbeen

consideredonanumberof occasionsinrelationtomanagementof thebalanceof payments.

AccordingtotheGATTAnalyticalIndex,“DuringtheReviewSessionin195455,Italybrought

acomplaint concerningactionbyTurkeyprovidingexportbonuses forcertainagricultural

productsandlevyingspecialimporttaxesoncertaingoodsdeemedlessessentialinorderto

providethenecessaryfundsforthebonuses.Italystatedthattheexportsubsidieshadnot

beennotifiedasrequiredbyArticleXVI:1andthattheimporttaxeswere inconsistentwith

Article II:1(b).Turkeystatedthataspartof areformof itsforeignexchangesystem, ithad

establishedanEqualizationFundwhichwasfinancedbythesaleof importpermits,andthat

thissystemhadbeenapprovedbytheInternationalMonetaryFund.Arepresentativeof the

Fundconfirmed that thepracticesunderquestionweremultiplecurrencypracticesunder

the Fund Articles of Agreement and that in a Decision concerning Turkey the Fund hadstated that itdidnotobject to the temporary continuanceof thesepractices andwould

remaininconsultationwithTurkeyonthesepractices.”118

In1998 in the ArgentinaTextilesand Apparel case,Argentinaargued thata3percentad

valoremtaxthatitcollectedwasforpurposesof fundingthecollectionof accuratestatistical

dataonimportandexporttransactionsaspartof itsoverallunderstandingwiththeIMFon

stabilization and adjustment.119In its ruling the panel held that there was no exception

undertheGATTthatwould,forthesereasons,limitArgentina’sobligationsunderArticleVIII

withregardtocustomsfees.Thepaneldidnotconsiderwhether,giventhatArgentinawas

maintaining the tax in the context of its arrangements with the IMF, the tax could be

deemedtobeanexchangemeasurewithinthemeaningof XV:9of theGATT.Thefactthat

thetaxappliedtoallimportsindicatesthatitwasnotintendedasaprotectionistmeasuretoshelterArgentineindustriesfromcompetitionwhile lendingplausibilitytoitsconnectionto

Argentina’s exchange arrangements. The Appellate Body upheld the panel’s approach.

Argentinahad argued that theDeclarationonCoherence and the subsequentAgreement

betweenthe1996IMFandtheWTO,referredtoabove,were“legislativedevelopments”in

the WTO which had the effect of creating a metanorm of avoidance of “cross

conditionalities,” such that its relationswith the IMFwould require a state to engage in

conductthatwouldviolateWTOlaw.TheAppellateBodyfirstof allobservedthatArgentina

hadnotshowntothepanel’ssatisfactionthatthetaxhadbeenrequestedof itbytheIMFor

therewasaconflictof legalobligation, i.e.thatArgentinahada legallybindingagreement

withtheIMFthatwouldbeviolatedif itdidnotimposethetax.

Thefindingsof theAppellateBodyinthe ArgentinaTextilesand Apparel casesuggestanarrowand

formalistic view of the problem of coherence and conflicting conditionalities. In many cases the

IMF’srequirementsareof ageneralnature,and linked totheachievementof certain results.The

IMF leavesthe instrumentalitiestothecountry’sGovernment.Thatthe IMFhasnotrequested“x”

policydoesnotmeanthat“x”policydoesnotresult fromrequirements imposedby the IMF—the

policyinquestionmaybeoneof theonlyfeasiblewaysof satisfyingtheIMFdemandsatreasonable

social cost. Moreover the notion of legal conflict suggested by the Appellate Body is equally

problematic. It reduces the challenge of coherence to a notion of avoiding conflicting treaty

requirements.However,internationallawisnottheonlyoreventheprimaryleverthattheIMFuses

118

WorldTradeOrganization(1995)GuidetoGATT Law and Practice.Geneva,1:439.119World Trade Organization (1998). ArgentinaMeasures Affecting Imports of Footwear, Textiles, Apparel and Other

Items,Reportof theAppellateBody.(WT/DS56/AB/R),(adopted22April1998),paras.6974.




199

to“enforce”conditionality;rather,theIMFwillsimplynotdisbursefurtherfundstoacountrythat

does not meet its conditions, regardless of whether those conditions are formalized as legal

requirementsorexpressedasistypicallythecasein“memoranda”or“lettersof intent”.120121

In its decision the Appellate Body placed considerable emphasis on the notion that neither theDeclarationonCoherencenorthesubsequentCooperationAgreementbetweentheWTOandthe

IMF added to or diminished the rights and obligations contained in the WTO Agreements. The

Appellate Body noted that the effect of crossconditionalities or possible conflicts between

measuresthatmightresultfromIMFprogramsandWTOobligationswasspecifiedas“consultation”

betweentheFundandtheWTO.Yetwhenitconsideredwhetherthepanel’sfailuretoconsultwith

theFundconstitutedaviolationof itsobligationtomakeanobjectiveassessmentof thematter,the

Appellate Body ignored the consultation requirement as set out in the Paragraph 10 of the

Agreementbetween the IMFand theWTO.The thrustof theDeclarationonCoherence and the

subsequent Agreement between the IMF and the WTO is that issues that arise from possible

inconsistenciesbetweenmeasures taken in relation toFundprogramson theonehandandWTO

obligationsontheotherought,atleastinthefirstinstance,tobeaddressedthroughconsultationsandcooperationbetweentheWTOSecretariatandtheFund.

Insummary,as interpreted inthepracticeof WTOdisputesettlement inthecasesdiscussedhere

and in others, the WTO rules on exchange actions are likely to be permissive regarding any

macroeconomicpolicyinterventionthathastheexplicitblessingof,orisspecificallyrequiredbythe

IMF.However,where aWTOMember takes an action that the Fund isnotprepared toendorse

explicitly,or that ithasnotrequired,andsuchanaction fallsgenerallywiththekindof exchange

measurescoveredbyArticleXV,thereissomethingclosetoapresumptionthattheWTOruleshave

beenviolated .Yet,acompletereadingof theagreementestablishingtheWTOandof IMFrulesand

proceduressuggeststhattheydonotnecessarily justifythispresumption.

C. TradeRestrictionsforBalanceof PaymentsPurposes122

ArticlesXIItoXIVof theGATTelaborateacomplexcodedesignedtogovernanddisciplinetheuseof

import restrictions for balanceof payments purposes. Article XII:1 states the basic right of any

Contracting Party to impose quantitative restrictions in derogation from Article XI “in order to

safeguard itsexternal financialpositionand itsbalanceof payments”.ArticleXII:2establishesthat

suchrestrictionsshallbelimitedtowhatis“necessary:(i)toforestallthe imminentthreatof,orto

stop,aseriousdeclineinmonetaryreserves,or(ii)inthecaseof aContractingPartywithverylow

monetaryreservestoachieveareasonablerateof increaseinitsreserves”.Suchrestrictionsmustbe

progressivelyrelaxedasthebalanceof paymentsimproves.

Furthermore, Contracting Parties “undertake, in carrying out their domestic policies, to pay due

regardtotheneedformaintainingorrestoringequilibriumintheirbalanceof paymentsonasound

andlastingbasis”(ArticleXII:3).Atthesametime,noContractingPartyisobligatedtotakedomestic

balanceof paymentsmeasuresthatwouldthreatentheobjectiveof fullemployment).Aprocessof

consultations is envisagedwith the GATT Council concerning any new restrictions or increase in

120SeeEldarO (2005).Reformof IMFConditionality;aProposal forSelf ImposedConditionality. IILJWorking paper,10.

NewYorkUniversityLawSchool,CentreGlobalAdministrativeLawSeries.121Siegel DE (2002). Legal Aspects of the IMF/WTO Relationship: The Fund’s Articles of Agreement and the WTO

Agreements. American Journal of International Law ,96:561581.122The following draws from Michael J, Trebilcock and Howse R (2005). The Regulation of International Trade. Third

Edition,Routledge,LondonandNewYork,ch.5“Trade,ExchangeRatesandtheBalanceof Payments.”




200

restrictions,withperiodicreviewof thenecessityof thetrademeasuresandtheirconsistencywith

Articles XII–XIV. In addition, Article XII contains provisions on dispute settlement, including the

authorizationof retaliationwhereaPartypersistsintraderestrictionsthathavebeenfoundbythe

ContractingPartiestoviolatetheGATT.

ArticlesXIIIandXIVcontain,respectively,therequirementthatmeasurestakenpursuanttoArticle

XII:1 be implemented on a nondiscriminatory basis and certain narrow exceptions to this non

discrimination requirement,e.g.wherediscriminatoryexchangecontrolshavebeenauthorizedby

theIMF(seethediscussionof substitutabilitybelow).

In thecaseof developingcountries, there isamuchbroaderexemption fromGATTdisciplines for

traderestrictionsundertakenforbalanceof paymentsreasons.ArticleXVII:2(b)statestheprinciple

that developing countries should have additional flexibility “to apply quantitative restrictions for

balanceof paymentspurposes inamannerwhichtakesfullaccountof thecontinuedhigh levelof

demandforimportslikelytobegeneratedbytheirprogramsof economicdevelopment”.

This suggests that even though a developing country could address its balance of payments

difficultiesthroughexchangerateadjustmentsortightermacroeconomicpolicies, itshouldnotbe

expectedtodosoinviewof theharmtodevelopmentthatmaycomefromtheresultantdeclinein

needed imports. It is recognized that quantitative restrictionswill allow a developing country to

conserveitslimitedforeigncurrencyresourcesforpurchasesof importsnecessaryfordevelopment

–whereasadevaluationof itscurrencywouldresultinallimportsbecomingmoreexpensive.Inthis

connectionitbearsemphasisthatbalanceof paymentsrestrictionsingeneralmaybediscriminatory

withrespect toproductsalthoughnotwith respecttocountries. Indeed, it isexplicitlystated that

“the contracting party may determine (the) incidence (of restrictions) on imports of different

productsorclassesof productsinsuchawayastogiveprioritytotheimportationof thoseproducts

whicharemoreessentialinthelightof itspolicyof economicdevelopment”(ArticleXVIIIB(10)).

In 1979 the Contracting Parties, without formally amending the General Agreement, made the

“Declaration on Trade Measures taken for Balanceof Payments Purposes”, which expanded the

ambitof ArticlesXII–XIVandXVIIIbeyondquantitativerestrictionsto include“all importmeasures

takenforbalanceof paymentspurposes”.

TheUnderstandingontheBalanceof PaymentsProvisionsof theGeneralAgreementonTariffsand

Trade 1994 (BOP Understanding), incorporated in the Uruguay Round Final Act, is aimed at

improvingGATT/WTOdisciplineregardingtrademeasurestakenforbalanceof paymentspurposes.

Memberscommitthemselvestopublish,assoonaspossible,timeschedulesfortheremovalof such

trade measures. Furthermore in perhaps the most important modification of the existing GATT

regimeMemberscommitthemselvestogivepreferencetotrademeasuresof apricebasednature,

suchas tariff surcharges,and toonly resort tonewquantitative restrictionswhere“becauseof a

criticalbalanceof paymentssituation,pricebasedmeasurescannotarrestasharpdeterioration in

theexternalpaymentsposition”(Articles2,3).

PursuanttotheUnderstanding,on31January1995theWTOGeneralCouncilestablishedtheWTO

CommitteeonBalanceof PaymentsRestrictions.From its inception through2003, theCommittee

has conducted consultations with numerous Members concerning the existence and possible

reductionandphaseoutof theirbalanceof paymentsrestrictions.Insomeinstances,withrespect

for example to India and Tunisia, there was controversy within the Committee itself as to how

rapidly thebalanceof payments situationof the country could reasonablypermit the removalof

measures.




201

Dissatisfied with the lack of consensus on India’s use of balanceof payments based trade

restrictionstheUnitedStateschallenged India’scontinueduseof traderestrictionsforbalanceof

paymentsreasonsindisputesettlement,claimingviolationsof theGATTandtheBOPUnderstanding.

A key issue here was the relationship between the mandate of the BOP Committee and the

jurisdictionof theWTOdisputesettlementorgans. Indiaarguedthat,giventheexplicitroleof the

Committee inthesurveillanceof thechallengedmeasures, thedisputepanelshoulddefer to that

process.Thepanelbelowfoundthatthecompetenceof theBOPCommitteeandthatof thepanel

werenotmutuallyexclusiveinthesematters.Indiaappealedthisfinding.

The Appellate Body (AB) first observed that, according to Article 1.1 of the Dispute Settlement

Understanding (DSU), the dispute settlement procedures in the DSU apply generally to disputes

broughtunderthedisputesettlementprovisionsof thecoveredagreements(inthiscaseArticleXXIII

of theGATT1994).Moreoveronecouldnot inferany limitationontherightsof accesstodispute

settlementundertheDSU,oronthecompetenceof panelsto interpretandapplythebalanceof

payments provisions of the GATT, from the grant of competence to review Article XVIII:B

justificationsforsuchrestrictionstotheCONTRACTINGPARTIES.

India, however, had argued that GATT practice with respect to Article XXIII precluded access to

disputesettlementregarding trade restrictionsmaintained forbalanceof paymentspurposes.The

BOP Understanding limited the competence of the dispute settlement organs in balanceof

paymentsdisputesinfavorof thatof theMembership,sittingastheBOPCommittee.Thedistinction

thatIndiadrewwasbetweendisputesaboutthe“application”of balanceof paymentsmeasuresand

thosethatconcernedthesubstantive justificationof themeasures.

TherewerealsodifferencesbetweenIndiaandtheABoverthescopeof developmentpolicieswhich

could justifyTraderestrictionsforbalanceof paymentsreasons.

India argued that under Article XVIII balanceof payments restrictions are to be removed as the

conditions towhich theywere addressed improveonly so long as the removalwasnot likely to

provoke the return of those conditions. Moreover under a further proviso of Article XVIII a

developing country shouldnotbe required to removebalanceof payments import restrictions, if

doing so could requirea change in that country’sdevelopmentpolicies.123India’s relianceon this

provisionrequiredtheABtodeterminewhatisadevelopmentpolicyandwhetherremovalbyIndia

of itsbalanceof paymentsrestrictionswouldrequireachangeinthesepolicies.

In its ruling the AB relied on a judgment of the IMF that India did not need to change its

developmentpoliciesbecauseitcouldaddresstheconsequencesof removingitsimportrestrictions

through“macroeconomic”policies.However,thisrulingisquestionableonvariousgrounds.

Had theAB considereddevelopmentpolicy informedbya conceptionof equity that includes the

notion thatdevelopmentpolicy isamatter in the first instance forparticipationof thosewhoare

affected,itwouldhaveanalyzedthelegalissuequitedifferently.

Firstly,theABwouldnothaveacceptedthatoneinstitution,particularlythetechnocratsin

thatinstitution,have“ownership”of themeaningof a“development”policy.

Secondly,theABwouldnothaveembracedthestarkcontrastbetweendevelopmentpolicy

andmacroeconomicpolicy.Thiscontrast impliesthatdevelopmentpolicy isrestrictedtoa

series of techniques that “experts” view as formulae for “development,” rather than

123The followingdrawsonHowseR (2004).Mainstreaming theRight toDevelopment into InternationalTradeLawand

PolicyattheWorldTradeOrganization.(E/CN.4/Sub.2/2004/17),320.UnitedNations,Geneva.




202

includingall thosepolicies thatpeople—in thiscase, thoseof India—viewasaffecting the

fulfillmentof theirapproachtodevelopment.Fromtheperspectiveof equity,asinformedby

the social and economic rights recognized in the UN Covenant on Social, Economic and

CulturalRights,macroeconomicpoliciesareclearly“developmentpolicies.”

Thirdly,on thequestion of whether India shouldbe required to change itsdevelopment

policy inordertobeabletoremovethebalanceof paymentsrestrictionswithoutareturn

to crisis conditions, for thepurposesof bothequityandcoherence theABought tohave

solicited theviewsof abroaderrangeof institutionsandsocialactors—ataminimumthe

internationalorganizationswithexpressmandatesregardingdevelopmentsuchasUNCTAD

andtheUNDP.

Finally,theABmighthavetakenaccountof theself declaratorycharacterof ArticleXVII.B,

i.e.that itempowersIndiatochart itsowncourse indevelopmentpolicy.This impliesthat

theprovision isnot intended to invite thedispute settlementorgans toexaminedenovo

India’s judgmentthatremovalof therestrictionswouldrequireachangeinitsdevelopment

policy.

D. TradeFinancingandEquity

Increasing exports is recommended as part of policy packages for addressing indebtedness and

balanceof payments difficulties since, unlike macroeconomic deflation, it actually increases

employmentand reducespoverty.Trade financing is crucial tomanyexport transactions.Yet the

very economic conditions that export receipts are needed to address may make access to such

financingdifficult,particularlyfordevelopingcountriesthathavesufferedfinancialcrises.Thisissue

isbroached inthe2005ReporttotheWTOGeneralCouncilof theWorkingGrouponTrade,Debt

andFinance.124Ina1999WTOstudyFingerandShulnechtexplainthe importanceof government

backed export credit agencies in trade financing as follows: “the commercial andpolitical riskof

international trade transactions is often much larger than for domestic transactions. . . . well

functioningECAs[ExportCreditAgencies]areprobablyevenmoreimportantfordevelopingcountry

exporters [than for industrial country exporters in developed countries]. [Developing country

exporters](andtheirbanks)areoftenrelativelysmalland,therefore,lessabletogeneratetheirown

information on commercial and political risk abroad. They are also often likely to obtain less

favorablefinancingtermsbecauseof mistrustbyimportersfromothercountries.”125

WTOrules,however,arenotconcernedwithfacilitatingdevelopingcountryexportsthroughexport

financing, but rather with disciplining or curbing such financing to the extent it is viewed as an

export subsidy. The relevantprovisions areparagraphs (j) and (k)of Annex I (“Illustrative Listof

Export Subsidies”) to the WTO Agreement on Subsidies and Countervailing Measures (SCM

Agreement). Paragraph (j) states that the following would be examples of prohibited export

subsidies: “The provision by Governments (or special institutions controlled by Governments) of

export credit guarantee or insurance programs, of insurance or guarantee programs against

increasesinthecostof exportedproductsorof exchangeriskprograms,atpremiumrateswhichare

inadequatetocoverthelongtermoperatingcostsandlossesof theprograms.”

124WorldTradeOrganization (2005).Reportof theWorkingGrouponTrade,DebtandFinance to theGeneralCouncil.

(WT/WGTDF/4).10October.125FingerKM and Schulknecht L (1999). Trade, Finance and FinancialCrises.World TradeOrganization Special Studies.

WorldTradeOrganization,Geneva.910.




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Furtherexamplesaretobefoundinparagraph(k)of AnnexI:“ThegrantbyGovernments(orspecial

institutions controlledby and/or actingunder the authorityof Governments)of export credits at

ratesbelowthosewhichtheyactuallyhavetopayforthefundssoemployed(orwouldhavetopay

if theyborrowedoninternationalcapitalmarketsinordertoobtainfundsof thesamematurityand

othercredittermsanddenominatedinthesamecurrencyastheexportcredit),orthepaymentby

themof allorpartof thecostsincurredbyexportersorfinancialinstitutionsinobtainingcredits,in

sofarastheyareusedtosecureamaterialadvantageinthefieldof exportcreditterms”.

This characterization is subject to following important exception in paragraph (k): “Provided,

however, that if aMember isaparty toan internationalundertakingonofficialexport credits to

whichat least twelveoriginalMembers to thisAgreementarepartiesasof 1 January1979 (ora

successor undertaking which has been adopted by those original Members), or if in practice a

Memberappliesthe interestratesprovisionsof therelevantundertaking,anexportcreditpractice

whichisinconformitywiththoseprovisionsshallnotbeconsideredanexportsubsidyprohibitedby

this Agreement.” The international undertaking referred to here is the OECD Export Credit

Arrangement. By incorporating this Arrangement in paragraph (k) the WTO SCM Agreementessentiallydrawsa linebetweenprohibitedandpermissibleformsof exportfinancingbasedonan

Agreementnegotiatedbyandfordevelopedcountriesinadevelopedcountryforum,theOECD.

Thebenchmarks inparagraphs (j)and (k) fordecidingwhetherornota trade financingmeasure

shouldbeclassifiedasanexportsubsidypresupposethematurecapitalmarketsandsophisticated

riskspreadingandallocationvehicles typicalof fullydevelopedeconomies.Whether theyarealso

appropriatefordevelopingcountries,especiallyonesthathavehadaccesstoprivatecapitalseverely

limited due to debt and/or other financial crises is questionable. The Center for International

EnvironmentalLawnotesconcerningtheOECDArrangement:“TheArrangementcanbeunderstood

asacartellike,pricefixingmechanism,wherethe largest lendersof exportcreditsestablish limits

oncompetition…Itisanagreementbytherichestcountriesintheworld,andthereforeitsprovisionsaretailoredfortheirneeds.”126

Implications inpracticeof theSCMAgreementcanbe illustratedbytheBrazil Aircraft case,where

the issuewasthesaleforexportof commuter jetssupportedbyexportcreditsbybothBraziland

Brazil’scompetitorCanada.

IntheBrazil Aircraft caseBrazilarguedthat“duetothehighlevelof riskperceivedbyinternational

markets with respect to Brazilian borrowers, the cost to EMBRAER and to Brazilian financial

institutionsof raisingfundstofinanceexportsof Brazilianregionalaircraftishigherthanthecostto

Bombardier and Canadian financial institutions of raising funds to finance exports of Canadian

regionalaircraft.BecausePROEXpaymentsmerelyoffsetinpartthathighercostof funds,allowing

export credit financing for Brazilian regional aircraft on terms that are closer to, but still less

favorablethan,thoseavailableforcompetingCanadianregionalaircraft,thosepaymentsarenotin

Brazil’sviewusedtosecureamaterialadvantageinthefieldof exportcreditterms.”Inotherwords,

Brazilwasarguingthattheparticularfinancingbarriersfacedindevelopingcountriesshouldbeused

todeterminethebenchmarkagainstwhichanexportcredit isassessedtodecidewhether it isan

unfairexportsubsidy.(Para7.21)

Thepanel curtly and almost scornfully rejectedBrazil’s approach.Mostdisturbingly, it suggested

thatBrazil’sargument that thebaselineof the“marketplace” inparagraph (k)beadjusted to the

circumstancesandneedsof developingcountrieshadtoberejectedbecausetheparagraphwasnot

126Centerof InternationalEnvironmentalLaw(2003).ExportCreditAgenciesandtheWorldTradeOrganization.Draft Issue

Brief.November:45.




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a provision concerning special and differential treatment (for developing countries) (Para. 7.32).

Article 27of the SCMAgreementdoes provide limited relaxationof WTO disciplines applying to

export subsidies fordeveloping countries.Nevertheless, the interpretative approachof thepanel

suggeststhat,evenwherespecialanddifferentialtreatmentexists inaWTOAgreement,theother

provisionsshouldbeinterpretedinamannerthatisblindastotheequitiesasbetweendeveloped

anddevelopingcountrymembers.

Article 27.1 of the SCM Agreement states a general principle much broader than the specific

exceptions and limitations of Article 27.215: “Members recognize that subsidies may play an

importantroleineconomicdevelopmentprogramsof developingcountryMembers.”However,the

panel tendentiously characterizedBrazil’sapproach to themeaningof “used to secureamaterial

advantage” in para. (k) as a “general lowering” of SCM disciplines, which might be harmful to

developingcountriesasawhole.ButonamorereasonableinterpretationBrazil’sargumentwasnot

intendedtoleadtoanacrosstheboardloweringof disciplines,butrathertotakeintoaccountthe

differenceinfinancialmarketconditionsof aparticulardevelopingcountryinrelationtothoseof its

developedcountrycompetitors. It ishardtoseehowsuchanapproachcouldbeharmfultootherdevelopingcountries,manyof which facemuchmoreseriousstructuraldisadvantages in termsof

accesstofinancingthanBrazil.

TheAppellateBody compounded the indifference todevelopingcountry concerns and challenges

shownbythepanel.Althoughparagraph(k)refersonlytotheOECDArrangementasa“safehaven”

in terms of the disciplines of that paragraph, the Appellate Body used the benchmarks of the

Arrangementastheappropriatemethodologyfordetermining inBrazil’scasewhethertheratesof

interestonitsexportcreditsweresuchastoleadtotheconclusionthatthey“areusedtosecurea

materialadvantage”.

Intheaftermathof thisdecision,somedevelopingcountrieshave justifiablyputparagraph(k)of theSCMAgreementontheagendaof thepresentDohaRoundof negotiations.127

E. TheGeneralAgreementonTradeandServices(GATS),Balanceof

Payments,andDebtSustainability

The regulation of banks and other financial institutions is critical to management of debt and

financialcrises,especially fromanequityperspective.Thecollapseof financial intermediariescan

destroythesavingsand jobsof ordinarycitizens.Thus,theWTOhasaspecialsetof rulesthatapply

toliberalizationof financialserviceswithinthegeneralcontextof GATS.

Beforeconsidering thesespecial rules, it is important tounderstand theprovisionsof thegeneral

WTOframeworkforservicesliberalization,theGATS,whichmayapplytothemanagementof debt

and financial crises. The GATS applies to trade in services through four modes: (1) crossborder

delivery; (2)presenceof theconsumer intheterritoryof thevendor (e.g.tourism,education,and

health care); (3) commercialpresenceof thevendor in the consumer state; and (4) crossborder

movementof workersengaged inproviding services.Certainobligations in theGATS apply to all

services trade in these four modes. There are also general exceptions, including in relation to

balanceof payments measures (which are examined below). Many of the most important

obligationsinGATS,suchastherulesapplyingtothegrantingof MarketAccesstoforeignsuppliers

127CIEL,supra.n.20.




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andaccordingthemtheNational(i.e.nondiscriminatory)Treatmentobligationapplyonlywherea

specifiedservicesectorislistedinaWTOMember’sscheduleof specificcommitments.

Article XI:1 of GATS creates a general rule that “a Member shall not apply restrictions on

international transfers and payments” applicable to sectors where a Member has made specificcommitmentsArticleXI:2states:“NothinginthisAgreementshallaffecttherightsandobligationsof

theMembers of the InternationalMonetary Fund under theArticles of Agreementof the Fund,

including the use of exchange actions which are in conformity with the Articles of Agreement,

providedthataMembershallnotimposerestrictionsonanycapitaltransactionsinconsistentlywith

its specificcommitments regarding such transactions,exceptunderArticleXII [of GATS]orat the

requestof theFund.”

Thelanguageof XI:2indicatesanextremelyimportantdifferencebetweenGATTandGATS.However

narrowlyorrestrictivelyinterpreted,therelevantprovisionsof theGATT,aswehaveseen,contain

only disciplines on current account measures. However, under the GATS a Member’s specific

commitmentsmaypreventitfrominstitutingcapitalaccountcontrols.TounderstandtheflexibilityundertheGATSwithregardtocapitalcontrolsitisthereforenecessarytolookcarefullyatArticleXII,

the balanceof payments exception. This exception can only be utilized after satisfying a very

complexandlongseriesof conditions.Thiscanbeillustratedfromthetextof ArticleXIIisasfollows:

Article XII:RestrictionstoSafeguard theBalanceof Payments

1. In theeventof seriousbalanceof paymentsandexternal financialdifficultiesor threat

thereof, a Member may adopt or maintain restrictions on trade in services on which it has

undertakenspecificcommitments,includingonpaymentsortransfersfortransactionsrelatedto

such commitments. It is recognized thatparticularpressureson thebalanceof paymentsof a

Memberintheprocessof economicdevelopmentoreconomictransitionmaynecessitatetheuseof restrictionstoensure,interalia,themaintenanceof alevelof financialreservesadequatefor

theimplementationof itsprogramof economicdevelopmentoreconomictransition.

2. Therestrictionsreferredtoinparagraph1:

(a) shallnotdiscriminateamongMembers;

(b) shall be consistent with the Articles of Agreement of the International

MonetaryFund;

(c) shallavoidunnecessarydamagetothecommercial,economicandfinancial

interestsof anyotherMember;

(d) shallnotexceedthosenecessarytodealwiththecircumstancesdescribedinparagraph1;

(e) shallbetemporaryandbephasedoutprogressivelyasthesituationspecified

inimproves.

3. In determining the incidence of such restrictions, Members may give priority to the

supply of services which are more essential to their economic or development programs.

However,such restrictionsshallnotbeadoptedormaintained for thepurposeof protectinga

particularservicesector.

4. Anyrestrictionsadoptedormaintainedunderparagraph1,oranychangestherein,shall

bepromptlynotifiedtotheGeneralCouncil.




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5. (a) Members applying the provisions of this Article shall consult promptly with the

CommitteeonBalanceof PaymentsRestrictionsonrestrictionsadoptedunderthisArticle.

(b) TheMinisterialConferenceshallestablishprocedures128forperiodicconsultations

withtheobjectiveof enablingsuchrecommendationstobemadetotheMemberconcernedasitmaydeemappropriate.

(c) Such consultations shall assess the balanceof payment situation of the Member

concerned and the restrictions adoptedormaintainedunder thisArticle, taking into account,

interalia,suchfactorsas:

i) the nature and extent of the balanceof payments and the external

financial;

ii) difficulties;

iii) the external economic and trading environment of the consulting

Member;iv) alternativecorrectivemeasureswhichmaybeavailable.

(d) Theconsultationsshalladdressthecomplianceof anyrestrictionswithparagraph2,

inparticulartheprogressivephaseoutof restrictionsinaccordancewithparagraph2(e).

(e) In such consultations, all findings of statistical and other facts presented by the

International Monetary Fund relating to foreign exchange, monetary reserves and balance of

payments,shallbeacceptedandconclusionsshallbebasedontheassessmentbytheFundof the

balanceof paymentsandtheexternalfinancialsituationof theconsultingMember.

6. If aMemberwhichisnotamemberof theInternationalMonetaryFundwishestoapplytheprovisionsof thisArticle,theMinisterialConferenceshallestablishareviewprocedureand

anyotherproceduresnecessary.

Anumberof featuresof ArticleXIIareworthyof specialattention.

Firstof all,XII:1givesdevelopingor transitionaleconomiesaclear right to takemeasures

thatprovidealevelof financialreserves“adequate”fortheMember’sprogramof economic

transition or development. Thus, Article XII:1 affirms that development goals are the

legitimatebasisforaWTOMemberdeterminingthekindsof balanceof paymentsmeasures

itneeds. Whereasthemeasuresmust“notexceedthosenecessary”todealwith“seriousbalanceof

payments and external financial difficultiesor threat thereof,”Article XII:3 affirms that a

Member “may give priority to the supply of services which are more essential to their

economicordevelopmentprograms.”

Moregenerally,theconceptof “necessity”oughttobeinterpretedinthecontextof Article

XIIasawhole,whichgivesconsiderableemphasis toan individualMember’sapproach to

development.ArticleXII canbe readasnot requiringaMember tousealternativepolicy

measures,even if theseare less restrictiveof services trade,wheresuchmeasureswould

underminetheconceptof equityimplicitorexplicitintheMember’sdevelopmentprogram.

128Itisunderstoodthattheproceduresunderparagraph5shallbethesameastheGATT1994procedure.




207

Unliketheprovisionsof theGATT,ArticleXIIof theGATSspecifiesthatdeferencetotheIMFextends

only to statistics and facts and conclusions drawn from such statistics and facts. Therefore, a

judgmentabouttheconsistencyof measureswiththe IMFArticlesmaybemade independentlyat

theWTO.

ArticleXIIenvisagesconsultationsonbalanceof paymentsmeasures intheCommitteeonBalance

of PaymentsRestrictions.However,according to the logicof the IndiaBalanceof Payments case

discussedabove,sincetheGATSprovidesnoexceptionfromdisputesettlementforArticlesXIand

XIIof theGATS,theexistenceof theCommitteeonBalanceof Paymentswouldnotleadtoremoval

orrestrictionof panelandAB jurisdiction.

ItisimportanttoappreciatetheextenttowhichGATSspecificcommitmentsmayimplylimitstothe

ability to impose capital account controls. Footnote 8 of Article XVI:1 reads: “If a Member

undertakesamarketaccesscommitmentinrelationtothesupplyof aservicethrough[mode1]and

if the crossbordermovementof capital is anessentialpartof the service itself, thatMember is

thereby committed to allow suchmovementof capital. If aMemberundertakesamarketaccesscommitmentinrelationtothesupplyof aservicethrough[mode3],itistherebycommittedtoallow

relatedtransfersof capitalintoitsterritory.”Situationswhere“movementof capitalisanessential

part of the service itself” would apply most obviously to certain kinds of financial services (for

example,mutualfunds),buttheotherkindof situationmentioned inFootnote8 ismuchbroader,

applyingtoallcaseswheretheserviceisbeingsuppliedthroughacommercialpresenceintheWTO

Member.Nevertheless, in such circumstances, the requirementof liberalization seems limited to

inward movementof capital.

Somekindsof controlsover (outbound)capitalmightbeviewedasconditionsonwhocansupply

services(numberof servicesuppliers)inviolationof XVI:2(a),oras“limitationsonthetotalvalueof

servicetransactionsorassets”inviolationof XVI:2(b)or“totalnumberof serviceoperationsorthetotal quantity of service output” in violation of XVI:2(c). This possibility would follow from an

extremelybroadinterpretationof XVI:2(a)and(c)bytheABintheUSGamblingcase.Essentially,the

ABsuggestedthattoviolateeitherprovision,measuresneednottaketheexplicitformsdescribedin

thoseprovisions,providedthattheyhavecomparableeffectsonrestrictingmarketaccessandare

quantitative innature (Reportof theAppellateBody,paras. 232,247). Since capital controls are

clearly measures that are quantitative in nature, they may well have effects on the number of

servicesuppliersorthetotalvalueof servicestransactionsorassetsunderArticleXVI.

Commitmentswith respect to financial servicesaregovernedby theAnnexonFinancialServices.

TheAnnexcontainsthefollowingprovision:

DomesticRegulation

(a) Notwithstanding any other provisions of the Agreement, a Member shall not be

preventedfromtakingmeasuresforprudentialreasons,includingfortheprotectionof

investors,depositors,policyholdersorpersonstowhomafiduciaryduty isowedbya

financialservicesupplier,ortoensuretheintegrityandstabilityof thefinancialsystem.

Wheresuchmeasuresdonotconformwiththeprovisionsof theAgreement,theyshall

notbeusedasameansof avoidingtheMember’scommitmentsorobligationsunder

theAgreement.

The first sentence of this provision appears to allow any measure “to ensure the integrity and

stabilityof thefinancialsystem”withouttheneedtoshowthatthemeasureisnecessaryortheleastrestrictive of trade in services. The second sentence, however, seems drafted in a manner to




208

underminetheregulatoryflexibilitygranted inthe firstsentence, inthat itqualifiestheuseof the

provisionasanexception toGATScommitmentsandobligations.Thus,whereameasure isnot in

conformitywithGATS,it“shallnotbeusedasameansof avoidingtheMember’scommitmentsor

obligationsundertheAgreement.”

Itisdifficulttodiscerntheexactimplicationof thisqualifyingorconditionallanguage.Onepossible

reading would be that it imports an intent requirement into 2(a), namely the notion that the

measuresmustbegenuinelyintendedto“ensuretheintegrityandstabilityof thefinancialsystem”

ratherthantoprotectdomesticfinancialindustries.Suchanintentrequirementmightbedifficultto

apply inthecaseof a financialcrisis,whereensuringthesurvivalof domesticfinancial institutions

maywellbepartandparcelof ensuringthe“integrityandstabilityof thefinancialsystem”itself.

Finally,anycommitmentorobligationunderGATSissubjecttothegeneralexceptionsinArticleXIV

of GATS.Thus,whetherornotaMember’smeasuremeetsthecriteriasetforthinArticleXIIof the

GATSor theAnnexonFinancial services, themeasuremay stillbe justified if “necessary” for the

protectionof human lifeorhealthorof publicmoralorpublicorder.According to footnote5of ArticleXII,Thepublicorderexceptionmaybeinvoked“onlywhereagenuineandsufficientlyserious

threatisposedtooneof thefundamentalinterestsof society.”Inthiscontextitisnoteworthythat

intheUnited StatesGamblingcasetheABupheldthepanelapproachthatsuggestedtheremustbe

somedeferencetoaWTOMember’sowndeterminationof themeaningof publicmoralsandpublic

order(AppellateBodyReport,paras.296297).

Asageneralmatterotherpoliciessuchasexchangeratestabilization,depreciationorappreciation

undertakeninresponsetoafinancialcrisismaybeunsustainableintheabsenceof capitalcontrols.

Experiencewith applicable parts of theGATSwill thus eventually play a role in determining the

rangeof macroeconomicpolicyresponses.




209

F. Conclusions

WTO rules on exchange actions and the balanceof payments justifications for trade restrictionsclearlyreflectaconceptionof equitythattakes intoaccounttheparticularneedsandsituationsof

developing countries. In certain, carefully defined matters the WTO rules entail deference to

judgmentsof theIMF.

However,inactualdisputesettlementelementsintherulesthatreflectequitytowardsdeveloping

countrieshavebeenminimizedorignored.Moreover,thedisputesettlementorganshavegonewell

beyondtheexplicitlimitsof deferencetotheIMF,deferringsuchtotheIMFeveninsuchamatteras

the meaning of a country’s “development policy” (the IndiaBalance of Payments case). Since

developing countries have limited representation and voice in the IMF, from the perspective of

equityasparticipationindecisionmakingconcerningdevelopmentthesetendenciesof thedispute

settlementorgansseemdifficultto justify.

More generally, the concept of coherence reflected in relevant WTO instruments and activities

directedtowardsbalanceof paymentsandexchangematters is toonarrowly focusedon relations

between the IMF and the WTO, and does not include cooperation with other international

institutionsconcernedwithequity indevelopment.Theconceptof coherenceshouldberevisedto

accommodate the relationship with equity implied in the Millennium Declaration and related

instruments.

Moreover even within the narrow conception of coherence embraced in the WTO, the agreed

mechanism foravoiding crossconditionalities,namelyobligatory consultationsbetween theWTO

SecretariatandtheIMFpriortoeithertakingdecisionsthatcouldresultincrossconditionalities,has

not been closely followed. A review should be undertaken of the justification for not using thisprocess and of the extent to which avoidance of crossconditionalities has been achieved in

experiencesofar.

Inthecaseof theGeneralAgreementonTrade inServices(GATS),there isarealpossibilitythata

WTOMember’s specific commitments combinedwith the general obligations of theGATS could

meanthataMember’sadoptionof capitalcontrolsconstitutesaGATSviolation,eventhoughsuch

controls may be necessary to address a financial crisis in a manner consistent with social and

economic justice. In viewof theexceptions and limitations in theGATS that couldnone the less

justifysuchmeasuresthereisacaseforthedrawingupof guidelinesinthisareawhichtakeaccount

of equity inthetradeandfinancialsystem inthe interpretationof such limitsandexceptions.This

task should be undertaken by international institutions with a mandate related to equity indevelopment.

As exemplified by the Brazil Aircraft case, the rules on export subsidies in the SCM Agreement

appear to limit the capacity of developing countries to provide support for export transactions

throughexportcredits.This reflects theuseof marketbenchmarksdevised forandbydeveloped

countries in the OECD Arrangement for the assessment of export credit arrangements.

Considerationshouldbegiventoanalternativeapproachwhichwouldtakeintoaccountstructural

differences between the financialmarketsof developed anddeveloping countries aswell as the

specialchallengesregardingaccesstocapitalmarketsforexportfinancingfacingcountriesthathave

facedfinancialordebtcrises.






211

CHAPTER X

RISKASSOCIATEDWITHTRENDSINTHE

TREATMENTOFSOVEREIGNDEBTINBILATERAL

TRADEANDINVESTMENTTREATIES

AldoCaliari

(Centerof Concern)

A. Introduction

ThereisagrowingtrendinFreeTradeAgreementsfortheinclusionof provisionsthatsubjectpolicy

towardsthefinancialsectorto legaldisciplinesenshrined intradeand investmentagreementsand

totheassociateddisputesettlementmechanisms.Thistrendplaceslimitsontheusebydeveloping

countries of several tools designed to build and preserve stable and healthy financial sectors

responsive to national development priorities and supportive of trade. The limits are capable of

increasingdevelopingcountries’vulnerabilitytofinancialanddebtcrises.

B. SovereignDebtinBilateralTradeandInvestmentTreaties

In bilateral Free Trade Agreements recently negotiated by the United States Government a

controversialissuehasbeentheinsistenceof theUnitedStatesonpursuinginclusionof clausesthat

wouldapplytosovereigndebtissuedbythepartiesprinciplessuchasNationalTreatmentandMost

FavoredNation(MFN)Treatmentwhicharepartof bilateral investmenttreatiesandof GATT/WTO

rulesfortradeingoodsandservices.

A review of some recent treaties reveals at least two different approaches to the treatment of

sovereigndebt.



Risk Associated withTrendsintheTreatment of SovereignDebt inBilateral Tradeand Investment Treaties

212

1. SovereignDebtExplicitlyExcludedfromApplicationof thePrinciples

UnderNAFTA, investmentcoversasweepingarrayof typesof ownership interests, including loans

and securities. However, in conformity with Article 1416 in the section on Financial Services,

“investmentmeans “investment”asdefined inArticle1139 (InvestmentDefinitions),except that,

withrespectto“loans”and“debtsecurities”referredtointhatArticle:(a)aloantoordebtsecurity

issuedbyafinancialinstitutionisaninvestmentonlywhereitistreatedasregulatorycapitalbythe

Partyinwhoseterritorythefinancialinstitutionislocated;and(b)aloangrantedbyordebtsecurity

owned by a financial institution, other than a loan to or debt security of a financial institution

referredtoinsubparagraph(a),isnotaninvestment;”

Tothisisaddedthefollowing:“forgreatercertainty:(c)aloanto,or debt security issued by,aParty

or astateenterprisethereof isnot aninvestment” (author’sitalics).

Therefore,underNAFTA,sovereigndebtsareexplicitlyexcludedfromthedefinitionof investment.

2. SovereignDebtExplicitlyIncludedwithintheScopeof Applicationof Investment

Principles

In the2003UnitedStatesChileFreeTradeAgreement (FTA) specificprincipleson investmentare

explicitlyapplicable to sovereigndebt.TheUnitedStatesChileFTA containsabroaddefinitionof

investmentbasedonthefollowingstandardadoptedbytheUnitedStatesinitsmostrecentBilateral

InvestmentTreaty(BIT)Model.129

“Investmentmeanseveryassetthataninvestorownsorcontrols,directlyorindirectly,thathasthe

characteristicsof aninvestment,includingsuchcharacteristicsasthecommitmentof capitalorother

resources,theexpectationof gainorprofit,ortheassumptionof risk.Formsthataninvestmentmaytakeinclude:

Anenterprise;

Shares,stock,andotherformsof equityparticipationinanenterprise;

Bonds,debentures,loans,andotherdebtinstruments;

Futures,options,andotherderivatives;

Rights under contract, including turnkey, construction, management, production,

concession,orrevenuesharingcontracts;

Intellectualpropertyrights;

Rights conferred pursuant todomestic law, such as concessions, licenses, authorizations,

andpermits;and Othertangibleor intangible,movableor immovableproperty,andrelatedpropertyrights,

suchas leases,mortgages, liens,andpledges;but investmentdoesnotmeananorderor

judgmententeredina judicialoradministrativeaction…”

Thisdefinitiongenerallyincludes“bonds,debentures,loansandotherdebtinstruments”.130Inwhat

represents a significant departure from NAFTA, the treaty explicitly makes the agreement’s

129ThisdefinitionhasbecomestandardblueprintfortheUSnegotiatingpositionintreaties.SeeUnitedStates2004Model

BIT,Art.1130

Usuallywithafootnotethatclarifies“Someformsof debt,suchasbonds,debentures,andlongtermnotes,aremorelikely to have the characteristics of an investment, while other forms of debt, such as claims to payment that are

immediatelydueandresultfromthesaleof goodsorservices,areleslikelytohavesuchcharacteristics.”




213

provisionsapplicable to sovereigndebts issuedby theChileanGovernment.131The same rulesare

contained in theCentralAmericaFreeTradeAgreement (CAFTA).132Thus, theUnited StatesChile

FTAandCAFTAmakeNationalTreatmentandMFNTreatmentapplicabletosovereigndebtsissued

bytheGovernmentsof thecountriesinvolved.

3. The“Elliptic”Inclusionof DebtintheUnitedStatesUruguayFTA

TheUnitedStatesUruguayFTA(signedin2004)raisesaninterestingquestionbecauseitsprovisions

could lead to reinterpretation of previous treaties. The FTA contains the standard definition of

investmentas including“Bond,debentures,otherdebt instrumentsand loans” Italsocontains, in

AnnexF,aclausewithlanguagesimilartothefirstpartof theNAFTAarticleabove.133

Uptothispointof thetext,althoughthere isnoexplicitexclusionas intheNAFTAsupplementary

clause, the agreement seems to imply that sovereign debt is excluded from the definition of

investment.

However,thisdoesnotappeartobethecase.AnnexGof theUnitedStatesUruguayFTAheaded

“SovereignDebt”,readsasfollows:

“1.Noclaimthatarestructuringof adebt instrument issuedbyUruguaybreaches

an obligation under Articles 5 through 10 may be submitted to, or if already

submitted continue in, arbitration under Section B, if the restructuring is a

negotiated restructuring at the time of submission, or becomes a negotiated

restructuringaftersuchsubmission.”

Thiswouldappeartomeanthatsovereigndebtis,indeed,includedinthescopeof thedefinitionof

investmentforthepurposesof theTreaty. Italsowouldopentheway forthe interpretationthat,absentanexplicitexclusion,sovereigndebt isconsidered to fit into thescopeof thedefinitionof

investment.Thiscouldhavetheconsequenceof leadingtoanexpansionof thescopeof theterm,

“investment”, in treatiesworded similarly to theUnited StatesUruguay FTA, such as theUnited

StatesSingaporeFTA.

C. ImplicationsforSovereignDebtProblemsof IncludingNationalTreatment

andMFNTreatmentinFTAs

Whatarethepossibleimplicationsof applyingNationalTreatmentandMFNTreatmenttosovereign

debt?

131SeeAnnex10B(Annextothechapterof thetreatythatdealswithinvestment):“Thereschedulingof thedebtsof Chile,

orof itsappropriateinstitutionsownedorcontrolledthroughownershipinterestsbyChile,owedtotheUnitedStatesand

thereschedulingof itsdebtsowedtocreditorsingeneralarenotsubjecttoanyprovisionof SectionAotherthanArticles

10.2and10.3”Articles10.2and10.3intheTreatyrefertoNationalTreatmentandMostFavoredNationTreatment.132SeealsoUgarteche(2004,1418and3435).

133Art.4reads:

“(b) Investmentmeans“investment”asdefined inArticle1,exceptthat,withrespectto“loans”and“debt instruments”

referredto inthatArticle: (i)a loantoordebt instrument issuedbya financial institution isan investment inafinancial

institutiononlywhereitistreatedasregulatorycapitalbythePartyinwhoseterritorythefinancialinstitutionislocated;and(ii)aloangrantedbyordebtinstrumentownedbyafinancialinstitution,otherthanaloantoordebtinstrumentof a

financialinstitutionreferredtoinsubparagraph(b)(i),isnotaninvestmentinafinancialinstitution”.




214

These principles were originally developed in different historical contexts. National Treatment

featured from the firsthalf of the twentiethcenturyonwards in treatiesof friendship,commerce

andnavigation(FCNtreaties),i.e.bilateraltreatiescoveringmiscellaneoussubjectssuchasaccessto

ports,tariffs,thepowersandresponsibilitiesof consuls,andprotectionagainstappropriation.The

lastof theseheadingstypicallyincludedprovisionsconcerningnationaltreatment,i.e.guaranteesof

nondiscriminatory treatment of foreign firms. MFN clauses were included in reciprocal trade

agreementsnegotiatedbetweentheUnitedStatesandvariouscountriesunderaprogramlegislated

in1934.Under theMFNclauses included in theseagreementseachof thepartiesbound itself to

extendtotheothertariff concessionsatleastasgreatasthoseextendedtothemostfavorednation

withwhich it traded.BothNationalTreatmentandMFNTreatmentwere included in theGATTas

principlesapplyingtotradeingoods.

The extension of National Treatment and MFN Treatment to other subjects is neither

straightforwardnoruncontroversial.134Indeed, theirextension tosovereigndebt raises issues that

could be more harmful to developing countries than those considered under their traditional

applicationtoforeigninvestment.Adiscussionof anumberof theseissuesfollows:

1. DismantlingToolsNeededfortheRecoveryof theLocalEconomyinPostCrisis

Situations

The application of National Treatment to sovereign debtwould restrict the ability of thedebtor

Government to take certain policymeasures aimed at the recoveryof the local economy in the

aftermathof financial crises.NationalTreatment in this contextmeans that foreign creditors are

offeredtreatmentindebtrestructuringsnolessfavorablethanthatofferedtodomesticcreditors.135

However,thereareseveralreasonswhyacountryrestructuring itssovereigndebtafterafinancial

crisismightneedtoresorttoofferingpreferentialconditionstodomesticcreditors.

In a financial crisis, domestic creditors often suffer a double adjustment . First, they are

typically forced toaccepta“haircut”on theirclaims,whichmeans that thevalueof their

loansarereducedbyacertainpercentage.Secondly,theyoftensuffercostsrelatedtothe

internaladjustment,suchashighinterestrates.Infact,theimpactof debtrestructuringon

domesticcapitalmarketsand,inturn,ontheresumptionof growthandrepaymentcapacity

needs tobe taken into account in assessing the consequencesof debt crises (Machinea,

2004:188)..”

Dealing with domestic before foreign debt might also allow the Government to return

rapidlytodomesticcapitalmarketsduringwhatislikelytobeasustainedinterruptioninits

accesstointernationalcapitalmarkets(IMF,2002:13).

The debtor may also need to accord priority to domestic debt in order to protect the

financialsystem.TheIMFhassaidthat“therestructuringof certaintypesof domesticdebt

mayhavemajor implications for economic performance, as a resultof its impacton the

financialsystemandtheoperationof domesticcapitalmarkets”(IMF,2002:13).Sovereign

debtrestructuring typicallyhasadouble impacton the financialsystem.Ontheonehand

134SeeKhor(2002),whostates:“Itiscertainlynotclearthattheprinciplesof theWTO(includingNationalTreatmentand

MostFavoredNationtreatment)thatapplytotradeingoodsshouldapplytoinvestment,northat,if applied,theywould

benefitdevelopingcountries.”SeealsoChangandGreen(2003),ActionAid(2003),OxfamInternational(2003).135

Thisisimportantinthecontextof thedevelopingcountrysignatoriesof CAFTA,since,withtheexceptionof Honduras,an importantshareof publicdebt inallthesecountries isowedtodomesticcreditors. Insomeof them, likeCostaRica,

domesticdebtisactuallyhigherthanexternaldebt.




215

financial institutionsareweakenedbythe impactontheircapital levelsof thereduction in

the value of bonds. On the other hand, debt restructuring is associated with a general

increase in uncertainty, which can inflict widespread damage on the creditworthiness of

firms (Machinea,2004: 188189). Thus, in such cases special treatment todomesticdebt

mayenablethedebtortoprotect“acoreof thebankingsystembyensuringtheavailability

of assetsrequiredforbankstomanagecapital,liquidityandexposuretomarketrisks”(IMF,

2002:13).

Asovereigndebtormayalsoneedtoaccordspecialtreatmenttodomesticdebtorsforthe

samereasonsthatcanleadittoaccordspecialtreatmenttonationalsectorsandindustries

aspartof anationaldevelopmentstrategyandtheachievementof developmentgoals.

In the IMF’sview shelteringdomestic investors from the full impactof debt restructuring

maybenecessary inorderto“garnersupportforanambitiousadjustmentprogram”(IMF,

2002:13).

2. PreventingtheStatefromPayingSalariesandPensionsinDebtCrises

Theapplicationof NationalTreatmenttosovereigndebtmeansthattheGovernmentwillbeunable

toprioritizedomesticdebtassociatedwithmeetingwages,salariesandpensionobligations.Inother

words, theGovernment isbound to treat thesedebts in the sameway as foreigndebtsheldby

transnationalbanksandinstitutionalinvestors.If itsresourcesareenoughtocoveronlyaportionof

itsdebts,thestatewillnotbeabletochoosetodirect those fundstomeetingthesepriorities,at

leastnotaslongasitdoesnotdevoteequalamountforpaymentstoforeigncreditors.

Unlikeanindebtedprivatecompany,anindebtedsovereignhashumanrightsobligationsandsocial

responsibilitiestowardsitspeople.Thismeansthat,indealingwithsovereigndebt,thereareissues

that cannotbe addressedby strict analogieswithbankruptcyprinciples applicable to theprivate

sector.Thusproposalsof civilsocietyforarulesbasedframeworkhavetypicallycalledforrecourse

toanalogieswithframeworkswhichaccommodatetheoverallmissionthatthestateisexpectedto

fulfill. Such frameworks include Chapter 9 of United States Bankruptcy Law applicable to

municipalities. Even the IMF’smuchcriticized SovereignDebt RestructuringMechanism proposal

excluded“Wages,salariesandpensions”fromitsapplication(IMF,2003:24).

3. ReducingtheLeverageof DebtorsinaDebtRestructuring

Byfirstgatheringthesupportof domesticcreditorsaGovernmentcanacquiresubstantialcloutfor

thenegotiationsoverdebtrestructuringwithothercreditors.Theofferof preferentialconditionsto

thesedomesticcreditorscanbecriticalinthiscontext.Thusif theprincipleof NationalTreatmentis

applied to sovereign debt, this avenue for the indebted country to strengthen its negotiating

positioniseffectivelyforeclosed.

Theofferof preferentialconditionstodomesticcreditorswascrucialtoenhancingtheGovernment’s

leverageinArgentina’snegotiationswithitscreditorsafteritsDecember2001default.InSeptember

2003theGovernmentreleaseditsinitialproposedconditionsfordebtrestructuring,whichincluded

a75percenthaircut forbondholders.TheGovernment contended that thiswas the sizeof the

reduction that would enable it to recover sustainable economic growth, while ensuring that its

promisesof paymentwerekept.Somegroupsof bondholdersquicklyrejectedthisoffer,claiming

thatitwaswoefullyinsufficientand,inthelightof thecountry’smostrecentgrowthfigures,below

thecapacityof thecountrytorepay.ThecreditorsalsostronglylobbiedtheG7which,directlyand




216

through the IMF,putpressureonArgentina to improve itsoffer.136Withpressuremounting from

thesequarters,Argentinaturnedtodomesticpensionfundswithanofferof inflationlinkedbonds

thatrepresentedanimprovementovertheoffermadetotheotherbondholders.Bythusgranting

these institutions preferential conditions, Argentina was able to reach agreement with creditors

holdingmorethan17percentof itstotaldebt.Thiswasacriticalfirststepingarneringthesupport

of amajorityof creditors that eventually totaled76per cent.However, theofferof preferential

treatmenttodomesticpensionfundswouldnothavebeencompatiblewiththeprincipleof National

Treatment.

4. Creationof aPrivilegefortheDebtOwned(orAcquired)byCreditorsfromthe

Party

Applicationof NationalandMFNTreatmentonlytocreditorsof countriesthatarepartiestobilateral

investmenttreaties(whichhaveinrecentyearslargelyreplacedtheFCNtreatiesmentionedearlier)

would have the discriminatory result of granting seniority to creditors from such countries overthosefromothercountries.Thiswouldaffect therightsof bondholders fromnonpartycountries

without their consent since theyare,bydefinition,excluded from intervening in thenegotiations

under the bilateral agreement. For these bondholders such treatment might be equated to an

involuntarydebtswapunderwhichtheyfindthemselvesholdingadowngradedinstrument.

D. InvestorStateLawsuitsandSovereignDebt

Oneeffectof applyingtheprinciplesof investmenttreatiestosovereigndebt isthatGovernments

that violate investor protections can face expensive lawsuits. As under NAFTA and numerous

bilateral investment treaties,CAFTA grantsprivate foreign investors the right tobypassdomesticcourtsandsueGovernmentsininternationaltribunals(Peterson,2004:3).

Such“investorstatelawsuits”arehighlycontroversialforanumberof reasons(Peterson,2004and

2004a). Many arbitration tribunals operate with a lack of transparency, having no obligation to

disclose relevant documents or allow any form of public participation. The system for choosing

arbitratorshas alsodrawn criticism as the arbitrators canbedrawn from the ranksof practicing

investment lawyersand there isnoobligation toappointarbitorswhowillbe independent in the

senseof nothavingastakeinhowthetreatyisinterpreted.

Moreover,arbitraltribunalsdonothavetopayregardtolegalprecedents(Peterson,2004:6).This

feature, which creates a lot of uncertainty in the investment arena, could become particularly

troublesomewhenappliedtosovereigndebtcrises.Indeed,themainrationaleformoresystematic

arrangements for handling sovereign debt defaults has been the need to provide greater

predictability forbothdebtorsandcreditors in themessyprocessof exitingsovereigndebtcrises.

Clearly,theexistingsystemof arbitrationtribunalswoulddoapoor jobataddressingthoseconcerns

andwouldinjectadditionaluncertaintyintoexistingarrangementsforthefollowingreasons:

136InitsIMFagreementtheArgentinegovernmenthadpromisedto“negotiateingoodfaith”andwassingledoutinsome

G7statementsasnotcomplyingwithsuchapledge.Privatecreditorsmaintainedthatnegotiationsingoodfaithrequired

theagreementof 80percentof creditors,whilethegovernmentof Argentinaclaimedthatafigureabove6570percentwouldsuffice. Itwas incongruous thatthe IMFandG7countries,whichwerethemselvesamongst thecreditors,should

haveunilaterallyattemptedtodefinetheconditionsof anacceptabledebtrestructuring.




217

Theapplicationof theprinciplesof NationalTreatmentandMFN tosovereigndebtmight

givethesearbitraltribunalstheauthoritytodefinedifficultquestionsthatarguablybelong

tothedomestic jurisdictionof states.

The application of these principlesmight alsoopen theway for the application of othermore general principles that are becoming common in investment treaties, such as

“minimumstandardof treatment”or“fairtreatment.As illustratedabove inthediscussion

of Argentina’sdebtrenegotiation,there isnorulesbasedframeworktodeterminewhat is

an“acceptable”levelof repaymentor“negotiationingoodfaith”,etc.indebtnegotiations

andrestructurings.Noristhereanycertaintythatprinciplesorrulesoriginallyformulatedin

thecontextof bankruptcylawwillbeappliedbyanarbitrationtribunal.

These generalprinciples are contentiouseven in the contextof investment treaties.That

minimum or fair standards of treatment apply only to investors, while considerations

involving workers and other human rights as well as the environment, which might

counterbalancethem,arenotgivenequalweightisasourceof controversy.

Closelyrelatedtopointsraised insectionC.2 isthepointthatapplicationof thesegeneral

principlestosovereigndebtwouldnottakeaccountof theresponsibilityof theGovernment

of thedebtorcountrytoitspopulation.

E. ConcludingRemarks

The existing regime for dealing with sovereign debt crises lacks a rulesbased, multilateral

framework.Thisleavesdebtorsvulnerabletopowerasymmetriesascomparedwithcreditors.These

asymmetries would be reinforced by extension of the definition of the investment instruments

coveredinbilateralinvestmenttreatiestoincludeallormostdebtinstruments,particularlythoseforsovereigndebt.Therehavealreadybeenmovestowardsamoreinclusivedefinitionof investmentin

somerecenttreaties.Thishastheconsequencethatdebtinstrumentsaresubjecttoprinciplessuch

asNational Treatment andMFN Treatmentwhichwereoriginallydeveloped tohandleproblems

arisingunderbilateral investmenttreatiesandgoodstradeundertheGATT,andnotdebtcrises.A

notableexceptiontotherecenttendencyforextendingsuchprinciplestodebtistheNAFTA,which

explicitly excludes sovereign debt from the definition of investment. In view of the dangers to

developing countries from theextensionof principlesdesigned for foreign investmentand goods

tradetodebtinstruments,theNAFTAapproachfurnishesasuperiormodelforthefuture.




References

ActionAid (2003).UnlimitedCompanies.TheDevelopmental Impactsof an InvestmentAgreementattheWTO.UnitedKingdom,June.

ChangHJandGreenD(2003).TheNorthernWTOAgendaonInvestment:DoasWeSay,NotasWe

Did.Geneva,SouthCentreandCAFOD,June.

Correa C (1999). Key Issues for Developing Countries in a Possible Multilateral Agreement on

Investment.In:International Monetary and Financial Issues for the1990s,5.NewYorkand

Geneva,UnitedNations.

IMF (2003).Proposed Featuresof aSovereignDebt RestructuringMechanism.WashingtonDC,12

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UN Compendium on Debt Sustainability and Development 2011 - Agenda 21

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