The Risks of Sovereign Finance

1. The Risks of Sovereign Finance Ugo Panizza Debt and Finance Analysis Unit DGDS UNCTAD http://upanizza.googlepages.com

2. Outline • The risks of sovereign finance • Debt structure matters • Debt Sustainability Analysis

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

4. Developing countries don’t have high levels of public debt… Public Debt around the World (weighted averages) South Asia M. East & N. Africa Advanced Sub-Saharan Africa L. AM & CAR 2001–2005 1996–2000 Emerging Europe 1991–1995 East Asia 0 10 20 30 40 50 60 70 80 90 Source : Authors' calculations based on Jaimovich and Panizza (2006).

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

6. Public Debt and Sovereign Rating (1995-2005) Germany United Kingdom Switzerland France Austria Norway AAA Australia Spain Finland Denmark Canada United States Ireland Belgium New Zealand Luxembourg Portugal Japan Italy Sweden Netherlands AA- Iceland Cyprus Saudi Arabia Malta Botswana Slovenia Israel Chile Czech Republic Korea, Rep. Standard & Poor's Sovereign Rating A- Qatar Bahamas Bahrain Barbados Malaysia Estonia Latvia Investment grade Thailand China Hungary Poland Tunisia Oman Trinidad and Tobago South Africa Slovak Republic Egypt, Arab Rep. Lithuania BBB- Mexico El Salvador Panama Croatia Colombia Kazakhstan Peru India Morocco Uruguay Costa Rica Guatemala Philippines BB- Bulgaria Jordan Brazil Senegal Bolivia Russian Federation Mongolia Belize Benin Ghana Ukraine Papua New Guinea Grenada Paraguay Jamaica Venezuela, RB Indonesia Turkey Argentina Pakistan B- Ecuador 0 10 20 30 40 50 60 70 80 90 100 110 Public Debt as Percent of GDP Source : Jaimovich and Panizza (2006) and Standard and Poor's

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

8. Outline • The risks of sovereign finance • Debt structure matters • Debt Sustainability Analysis

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

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

11. The unexplained part of public debt 15 10 5 INFLATION GDP GROWTH 0 UNEXPLAINED PART INTEREST EXPENDITURE PRIMARY DEFICIT -5 -10 -15 IND SAS CAR EAP ECA MNA LAC SSA

12. The unexplained part of public debt Decomposition of Debt Growth in LAC7 24 Inflation Stock flow adjustment Interest expenditure Primary balance GDP growth 12 Percentage of GDP 0 -12 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source : Authors' calculations based on data from Campos, Jaimovich, and Panizza (2006).

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

14. A tale of two devaluations

15. Debt Management can reduce the risk of sovereign finance Debt-to-GDP Ratio Distribution 0.7 0.6 0.5 Debt-to-GDP ratio 0.4 0.3 0.2 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Foreign Foreign currency– local currency–linked to GDP Foreign currency –local currency currency

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

17. The International Market: Large but Volatile…

18. The International Market: Large but Volatile…

19. Will the good times last? 1400 1200 Actual Spreads 1000 800 600 400 Predicted Spreads 200 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

20. Mark Twain’s quote

21. Outline • The risks of sovereign finance • Debt structure matters • Debt Sustainability Analysis

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

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

24. D = - - d ( r g ) d ps Evolution of public debt • We usually focus on the change in the debt-to-GDP ratio • The change in the debt to GDP ratio is equal to: • Interest payments • minus the growth rate of the economy • minus the primary surplus • If you like math:

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

26. = + ps ( -g r ) d dl ds r r = - + a + b + ps d ( g ( ) + r + + e - f ( 1 r ) 1 1 + g + + p 1 ( ) + + e - f ( 1 r ) 1 1 + - a - b - g ( 1 ) ) + p 1 Thus, DSA becomes MUCH more complicated • We started with: • But in EMs we have:

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

28. DSF for Low Income Countries

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

30. DSF for Low Income CountriesImplications for IDA Grants • Low Risk (Green) • Standard IDA Terms • Moderate (Yellow) • 50% standard IDA terms and 50% grant • High (Red) • 100% grant

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

32. Want to learn more? • UNCTAD E-course on Debt Sustainability Analysis

33. The Risks of Sovereign Finance Ugo Panizza Debt and Finance Analysis Unit DGDS UNCTAD http://upanizza.googlepages.com