The Risks of Sovereign Finance

 Ugo PanizzaDebt and Finance Analysis Unit

DGDSUNCTAD

http://upanizza.googlepages.com

Outline

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

The risks of sovereign finance

• Two types of risk– Probability of financial or debt crisis– Constraints on the conduct of

macroeconomic policies

• Two types of policies– Domestic– International

Developing countries don’t have high levels of public debt…

Public Debt around the World (weighted averages)

0 10 20 30 40 50 60 70 80 90

East Asia

Emerging Europe

L. AM & CAR

Sub-Saharan Africa

Advanced

M. East & N. Africa

South Asia

2001–2005

1996–2000

1991–1995

Source: Authors' calculations based on Jaimovich and Panizza (2006).

Developing countries don’t have high levels of public debt…

• …and yet, they tend to have low credit ratings

• …and are the object of recurrent debt crises…

Public Debt and Sovereign Rating (1995-2005)

Italy

Jamaica

Japan

Israel

Belgium

Ghana

Jordan

Saudi Arabia

Pakistan

Egypt, Arab Rep.

Mongolia

Senegal

Morocco

Grenada

Argentina

Barbados

Bolivia

Panama

Indonesia

Bulgaria

Portugal

Cyprus

Hungary

Sweden

Philippines

Papua New Guinea

Austria

Tunisia

Malta

Denmark

Ecuador

India

Benin

CanadaFinland

Qatar

Netherlands

SpainFrance

Uruguay

Russian Federation

Venezuela, RB

United Kingdom

Peru

Croatia

Brazil

Poland

South Africa

Ireland

Malaysia

Trinidad and Tobago

United States

Iceland

Belize

Turkey

Costa Rica

Ukraine

El SalvadorColombia

Bahamas

New Zealand

Paraguay

Germany

Slovak RepublicMexico

Switzerland

Lithuania

Bahrain

Slovenia

Norway

OmanChinaThailand

Kazakhstan

Guatemala

Korea, Rep.Czech RepublicChile

Australia

Latvia

Botswana

Estonia

Luxembourg

0 10 20 30 40 50 60 70 80 90 100 110

Public Debt as Percent of GDP

Sta

nd

ard

& P

oo

r's

So

ve

reig

n R

ati

ng

AAA

B-

BB-

BBB-

A-

AA-

Source : Jaimovich and Panizza (2006) and Standard and Poor's

Investment grade

Developing countries don’t have high levels of public debt…

• …and yet tend to have low credit rating.

• …and are the object of recurrent debt crises…

• Why is it so?• Something may have to do with

debt structure rather than debt levels

Outline

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

Why is Debt Structure Important

• The economics 101 debt accumulation equation states that:– CHANGE IN DEBT = DEFICIT

• Practitioners know that the real equation is:– CHANGE IN DEBT = DEFICIT+SF

• But the Stock-Flow reconciliation is often considered a residual entity of small importance

• So, the Stock-Flow reconciliation is the unexplained part of public debt

The unexplained part of public debt

0

1

2

3

4

5

6

7

8

% of GDP

IND EAP ECA MNA LAC

All ObservationsExcluding Outliers

Source: Campos, Jaimovich, and Panizza (2006)

The unexplained part of public debt

-15

-10

-5

0

5

10

15

IND SAS CAR EAP ECA MNA LAC SSA

INFLATIONGDP GROWTHUNEXPLAINED PARTINTEREST EXPENDITUREPRIMARY DEFICIT

The unexplained part of public debt

Decomposition of Debt Growth in LAC7

-12

0

12

24

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Per

cent

age

of G

DP

InflationStock flow adjustmentInterest expenditurePrimary balanceGDP growth

Source : Authors' calculations based on data from Campos, Jaimovich, and Panizza (2006).

The unexplained part of debt

• What explains the “Unexplained part of debt”– Skeletons

•Fiscal policy matters!

– Banking Crises– Defaults– Balance Sheet Effects due to debt

composition

A tale of two devaluations

Debt Management can reduce the risk of sovereign finance

Debt-to-GDP Ratio Distribution

0.2

0.3

0.4

0.5

0.6

0.7

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Deb

t-to

-GD

P r

atio

Foreign currency

Foreign currency–local currency

Foreign currency–local currency–linked to GDP

The problems with foreign borrowing

• One problem has to do with the fact that foreign borrowing tend to be in foreign currency – Original sin

• Another problem is that the international interest rate is very volatile– Only a problem for EM

The International Market: Large but Volatile…

The International Market: Large but Volatile…

Will the good times last?

0

200

400

600

800

1000

1200

1400

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Predicted Spreads

Actual Spreads

Mark Twain’s quote

Outline

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

What do we mean by sustainability?

• A policy stance is sustainable if a country is expected to be able to continue servicing its debt without an unrealistically large future correction to its policies (IMF, 2002, page 4).

• So, we define as sustainable a situation that satisfies the following two conditions: – A country can satisfy its current period budget

constraint without recurring to default or excessive debt monetization

– A country does not keep accumulating debt by knowing that a major future adjustment will be needed in order to be able to service its debt.

Two reasons for conducting debt sustainability analysis

• Predict potential debt crises and give policy advice in order to avoid them – Mostly for middle income countries with

market access

• Allocate concessional resources – The IMF/WB DSF for low-income

countries determines the grant element in IDA loans

• We usually focus on the change in the debt-to-GDP ratio

• The change in the debt to GDP ratio is equal to: – Interest payments– minus the growth rate of the economy– minus the primary surplus

• If you like math:

Evolution of public debt

psdgrd )(

Why are EM different

• In emerging markets we have– Large external shocks– Weak fiscal position– Non-Renewable resources– Default history – Sudden Stops

• And this leads to a much more complex debt structure which includes– Concessional debt– Liability dollarization and original sin– Volatile risk premia and interest rate

Thus, DSA becomes MUCH more complicated

• We started with:• But in EMs we have:

dr-gps )(

dsdl rrgdps (

1

11)1( fr

)

1

11)1()1(

fr

DSF for Low Income Countries

• Threshold based on debt levels and CPIA– Evaluate sustainability– Allocate IDA grants

DSF for Low Income Countries

Policies NPV of debt in percent of

EXP GDP REV

WeakCPIA<3.25

100 30 200

Medium3.75>CPIA>3.25

150 40 250

StrongCPIA>3.75

200 50 300

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

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

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

Want to learn more?

• UNCTAD E-course on Debt Sustainability Analysis

The Risks of Sovereign Finance

 Ugo PanizzaDebt and Finance Analysis Unit

DGDSUNCTAD

http://upanizza.googlepages.com