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DEBT INDICATORS DEBT INDICATORS Content 1. Introduction 2. Financial Indicators 3. Vulnerability Indicators 4. Sustainability Indicators 5. Final Consideration 2 1.-Introduction DEBT INDICATORS Three groups of indicators Liabilities’ performance as market variables Risk of current conditions’ impact on debt status Government’s ability to address future contingencies 3 1.-Introduction DEBT INDICATORS Aim of Work Analyzing and describing the most accepted vulnerability, sustainability and financial indicators, along with their implementation scope within public debt management and auditing policies. 4 DEBT INDICATORS 2- Financial Indicators Risk Classification Market risk Credit risk Reputation risk 5 2- Financial Indicators DEBT INDICATORS Risk Classification Market Risk Most accepted indicators : 1. Interest Rates and Yield Curve These are the gain measure for those who decide to save. Capital markets provide an efficient mechanism to transfer capital between economic agents. 6 2- Financial Indicators DEBT INDICATORS Risk Classification Market Risk 1. Position and Slope of the Yield Curve Slope Market Expectations Theory Liquidity Preferences Theory Market Segmentation Theory Positive Short-term rates Positive price are expected to to liquidity rise Excessive supply regarding longterm demand Negative Short-term rates Negative price are expected to (punishment) decrease to liquidity Excessive supply regarding shortterm demand 7 2- Financial Indicators DEBT INDICATORS Risk Classification Market Risk 1. Position and Slope of the Yield Curve Slope Market Expectations Theory Liquidity Preferences Theory Market Segmentation Theory Horizontal Short-term rates are expected to remain the same Absence of liquidity price Equilibrium between supply and demand in all terms Concave Positive price to liquidity followed by a negative price to liquidity Excess of supply regarding midterm demand Short-term rates are expected to rise and subsequently decrease 8 2- Financial Indicators DEBT INDICATORS Risk Classification Market Risk 2. Weighted Average Maturity and Duration These statistics measure the average time in which issuers must face debt’s service. The weighted average maturity term possesses a limited use because it only considers payment dates of the principal, while the duration additionally takes into account the interests payment dates. 9 DEBT INDICATORS Risk Classification 2- Financial Indicators Market Risk 3. Modified Duration It is used to measure the risk of a bonus. It indicates the impact on the bonuses’ prices resulting from interest rates’ variations. 10 DEBT INDICATORS Risk Classification 2- Financial Indicators Market Risk 4. Standard Deviation It indicates the average detachment between a data set and its average value. 11 DEBT INDICATORS Risk Classification 2- Financial Indicators Market Risk 5. Risk-Adjusted Yield (RaR) It indicates the way in which an expected interest rate associated to an issue, could cover the expected loss due to an increase in such interest rate. This indicator shows the number of times that the loss expectations surpass the expected earnings. 12 DEBT INDICATORS Risk Classification 2- Financial Indicators Market Risk 6. Amortization Profile It is used for distributing on a timeline payments to capital. The main idea is creating a regular series of amortizations intended to minimize the risk of refinancing large portions of debt if unfavorable market conditions arise. 13 2- Financial Indicators DEBT INDICATORS Risk Classification Market Risk 7. Risk Cost (CaR) Together with the term and the amortization profile, CaR is used for risk-management purposes in a debt portfolio. This indicator allows assessing the cost-related consequences resulting from different issue strategies. 14 2- Financial Indicators DEBT INDICATORS Risk Classification Credit Risk CONCEPT The potential loss resulting from noncompliance of a party in a financial transaction, or noncompliance with the terms and conditions of a transaction. It is conceived as the weakening of a party’s credit quality, or the weakening of an originally agreed guarantee or collateral. 15 DEBT INDICATORS Risk Classification 2- Financial Indicators Credit Risk 1. Credit default Swap (CDS) CDS provide an insurance against bankruptcy risk from any entity used as reference . The seller of the protection is obliged to purchase the referred bonus at its par value in case of a credit event. The purchaser periodically makes payments to the seller during the term of the contract or until a credit event occurs, whatever happens first. 16 2- Financial Indicators DEBT INDICATORS Risk Classification Reputation Risk CONCEPT Reputation Risk refers to losses resulting from untaken financing opportunities, due to issuer’s bad reputation resulting from failure in payment or from a damaged fiscal situation. 17 2- Financial Indicators DEBT INDICATORS Risk Classification Reputation Risk 1. Credit Ratings This indicators represents the private perception of a country’s debt situation. agents’ Rating Agencies 18 DEBT INDICATORS Risk Classification 2- Financial Indicators Reputation Risk 2 A. Country Risk Indicators They measure the degree of risk operating within a country for foreign investments. Investors seek for earnings’ maximization and take risk into consideration, i. e., the possibility of less than expected earnings, or loss occurrence. 19 DEBT INDICATORS Risk Classification 2- Financial Indicators Reputation Risk 2 B. Country-Risk Indicators The country-risk index equals the over-rate that a country pays for its bonuses related to the rate paid by the Treasury of the United States. 20 DEBT INDICATORS Risk Classification 2- Financial Indicators Reputation Risk 2 C. Country-Risk Indicators The more damaged the country-risk rating is, the larger it will be the cost of debt, and the lesser economic policies can be handled; hence, the risk of noncompliance will be bigger. 21 DEBT INDICATORS 3.- Vulnerability Indicators The 90´s Monetary crisis effects Emerging market economies Main issue of economic policy: Analysis and research on fiscal vulnerabilities and their link to debt. 22 3.- Vulnerability Indicators DEBT INDICATORS Emerging market economies • They are vulnerable to variation of investors’ attitude • Special attention was placed on this group of countries and their vulnerability assessment work 23 3.- Vulnerability Indicators DEBT INDICATORS Vulnerability analysis • Data’s quality and transparency • Availability of timely and detailed data on international stocks, external debt and capital flows • Definition of critical values • Conduction of strain tests • Applying early-warning system models 24 3.- Vulnerability indicators DEBT INDICATORS Vulnerability analysis Vulnerability indicators encompass: • Public sector • Financial sector • Households • Enterprises When economies are under strain, one sector’s problems spread to others. 25 3.- Vulnerability indicators DEBT INDICATORS Vulnerability analysis These are useful indicators to define debt’s evolution and payment capability. They offer certain signals about the worsening or improvement of the government’s position. 26 DEBT INDICATORS 3.- Vulnerability indicators Vulnerability analysis Most accepted indicators by international institutions and governments and the academic sector: 1. Debt’s balance / domestic budgetary revenue 27 DEBT INDICATORS 3.- Vulnerability indicators Vulnerability analysis Most accepted indicators by international institutions and governments and the academic sector: 2. Debt’s service / domestic budgetary revenue 28 DEBT INDICATORS 3.- Vulnerability indicators Vulnerability analysis Most accepted indicators by international institutions and governments and the academic sector: 3. Current value / domestic budgetary revenue 29 3.- Vulnerability indicators DEBT INDICATORS Vulnerability analysis Most accepted indicators by international institutions and governments and the academic sector: 4. Interests / GDP 30 DEBT INDICATORS 3.- Vulnerability indicators Vulnerability analysis Most accepted indicators by international institutions and governments and the academic sector: 5. Interests / domestic budgetary revenue 31 3.- Vulnerability indicators DEBT INDICATORS Vulnerability analysis Frequently used indicators in a cross-cutting way with the aforementioned : 6. Foreign debt / exports 32 DEBT INDICATORS 3.- Vulnerability indicators Vulnerability indicators Frequently used indicators in a cross-cutting way with the aforementioned : 7. Net International reserves / foreign debt 33 DEBT INDICATORS 3.- Vulnerability indicators Vulnerability analysis Frequently used indicators in a cross-cutting way with the aforementioned : 8. • Amortization / external debt disbursements 34 3.- Vulnerability indicators DEBT INDICATORS Minimal suggested levels for emerging countries, provided by two different international organizations. Minimal Suggested Levels Vulnerability Indicator International Debt Relief * International Monetary Fund** Debt Service /income 28%-63% 25%-35% Debt VP /income 88%-127% 200%-300% Interest/income 4.6%-6.8% 7%-10% Debt/GDP 20%-25% 25%-30% Debt/Income 92%-167% 90%-150% * Debt Relief International: “Key Aspects of Debt Sustainability Analysis”, 2007 ** International Monetary Fund, Foreign Affairs Department: Technical Note “Vulnerability Indicators”, April 30, 2003 and several research documents. 35 4.- Sustainability indicators DEBT INDICATORS Fiscal sustainability indicators Public debt and the corresponding interest payment became a structural problem in countries showing persistent deficits. 36 4.- Sustainability indicators DEBT INDICATORS Fiscal sustainability indicators Fiscal sustainability indicators seek to describe public finances’ inter-temporal aspects, based on year-to-year available information. 37 4.- Sustainability indicators DEBT INDICATORS Fiscal sustainability indicators Systematic fiscal imbalances will mean future pressures concerning interest expenditure, which will in turn contribute to new debt accumulation. 38 4.- Sustainability indicators DEBT INDICATORS Main indicators 1 A. Fiscal Consistency Indicator It takes into consideration the consistency of the current tax policy, while keeping the debt-to-GDP ratio constant. 39 4.- Sustainability indicators DEBT INDICATORS Main indicators 1 B. Fiscal Consistency Indicator n tn* t g n ( r q ) d * t where tn* is the fiscal burden stabilizing, in a period of (n) years, the debt-to-GDP ratio in level d*, g being the expenditure r being the interest rate, and q being the GDP’s growth rate. 40 4.- Sustainability indicators DEBT INDICATORS Main indicators 2 A. Buiter’s Indicator It calculates the gap between the sustainable primary balance and the primary effective balance. The sustainability condition is defined starting from a wider net wealth concept than the one implicit in the ratio debt / GDP. 41 4.- Sustainability indicators DEBT INDICATORS Main indicators 2 B. Buiter’s Indicator b* bt (r q) wt bt where b* is the ratio debt / sustainable GDP, b is the ratio debt / GDP, wt is the net / real government wealth value as a GDP proportion, r is the interest rate, and q is the GDP increase rate. 42 4.- Sustainability indicators DEBT INDICATORS Main indicators 2 C. Buiter’s Indicator A tax policy is defined as sustainable by this indicator if the net government wealth is kept steady, in a ex-ante sense. 43 4.- Sustainability indicators DEBT INDICATORS Main indicators 3 A. Short-term primary gap indicator It provides the primary balance level needed to stabilize debt as a proportion of the GDP. 44 4.- Sustainability indicators DEBT INDICATORS Main indicators 3 B. Short-term primary gap indicator BP * BP (rt nt )b BP where BP* is the primary balance needed to stabilize debt, BP is the prevailing primary balance r the real interest rate trend n is the population growth’s rate, and b is the ratio debt / GDP. 45 4.- Sustainability indicators DEBT INDICATORS Main indicators 3 C. Short-term primary gap indicator If the permanent primary balance exceeds the current primary balance, the primary path is positive. This means that the fiscal policy is not sustainable. On the contrary, when the permanent primary balance is lower than the current primary balance, the fiscal policy tends to reduce the debt level regarding the GDP. 46 4.- Sustainability indicators DEBT INDICATORS Main indicators 4 A. Macro-adjusted primary deficit This indicator was created due to the high volatility of macroeconomic variables, which leads deficit in a specific moment to be different from the one that would appear within normal macroeconomic conditions. 47 4.- Sustainability indicators DEBT INDICATORS Main indicators 4 B. Macro-adjusted primary shortage I M t (r g ) bt 1 dtM 1 g where r is the real interest rate, g represents the analyzed year’s real growth d tM is the primary macro-adjusted balance 48 4.- Sustainability Indicators DEBT INDICATORS Main indicators 4 C. Macro-adjusted primary shortage The inconvenience of this indicator lies within the need of establishing what a “normal economy condition” is. 49 4.- Sustainability Indicators DEBT INDICATORS Main indicators 5 A. Sustainable fiscal position indicator It considers a historical methodology which explicitly assess the tax authority reaction in face of changes in those variables defining debt’s sustainability in time. 50 4.- Sustainability Indicators DEBT INDICATORS Main indicators 5 B. Sustainable fiscal position indicator I PFS t 1 rt BPt BP * ( t t ) 1 gt bt 1 b* where β is the relation between the real interest rate (r) and the GDP’s growth rate (g) λ is the function of fiscal policy’s reaction, defined as the ratio between the primary effective balance gap (BP) related to the primary sustainable balance or goal (BP*), and the current gap between the ratio debt / GDP from the last period (b) respect to the ratio debt / sustainable GDP or goal (b*). 51 4.- Sustainability Indicators DEBT INDICATORS Main indicators 5 C. Sustainable fiscal position indicator If the ratio debt / GDP of the last period is higher than the goal, it will converge to b* if, and only if | βt - λt | <1. 52 4.- Sustainability Indicators DEBT INDICATORS Main indicators 5 D. Sustainable fiscal position indicator In static terms, an indicator value superior or equal to 1, is an evidence that the fiscal authority maintains an inconsistent fiscal policy with the convergence of the ratio debt/sustainable GDP levels. An indicator value minor than 1 indicates that the fiscal position is consistent with the conditions required to ensure sustainability. 53 4.- Sustainability Indicators DEBT INDICATORS Main indicators 6 A. Currency availability indicator The initial assumption is that volatility of capital flows’ variables is higher than that of macroeconomic variables. 54 4.- Sustainability Indicators DEBT INDICATORS Main indicators 6 B. Currency availability indicator This indicator compares the proportion of external debt related to internal debt with the proportion of tradable goods related to the nontradable goods in economy: 55 4.- Sustainability Indicators DEBT INDICATORS Main indicators 6 C. Currency availability indicator where b B e B* y y* B eB * (a ) b y ey * is the ratio debt / GDP, is the debt in terms of non-tradable goods, is the type of real exchange, is the debt in terms of tradable goods, the GDP of non-tradable goods, and the GDP of tradable goods. 56 4.- Sustainability Indicators DEBT INDICATORS Main indicators 6 D. Currency availability indicator When B y eB * 1 (b) ey * The debt’s composition and the production are perfectly consistent. When this condition occurs, the variations in the exchange rate have no effects in fiscal sustainability holding the ratio debt / constant GDP. 57 4.- Sustainability Indicators DEBT INDICATORS Main indicators 6 E. Currency availability indicator When the value is closer to 0 instead of 1, the fiscal position becomes highly sensitive to variations of the real exchange rate. 58 4.- Sustainability Indicators DEBT INDICATORS Main indicators 6 F. Currency availability indicator Thus, to estimate indicator (a) it is necessary to determine (b) and, therefore, the indicator to be estimated is: B y eB * I (0 I 1) ey * 59 4.- Sustainability Indicators DEBT INDICATORS Main indicators 7 A. Fiscal Sustainability Indicators with Long-Term Restrictions Debt and fiscal sustainability indicators fail when no long-term budgetary restrictions are represented by them. 60 4.- Sustainability Indicators DEBT INDICATORS Main indicators 7 B. Fiscal Sustainability Indicators with Long-Term Restrictions In order to try to cover these possible upcoming events, Bagnai (2003) presents two indicators consistent with these restrictions, in order to keep debt sustainability. 61 4.- Sustainability Indicators DEBT INDICATORS 7 C. Indicators that consider the budgetary restrictions Bagnai, 2003. First case In the mid- and long-term, generations from a country will act as a governmental funding source regarding debt (financial markets) and tax payment (macroeconomic). Objetive To keep the debt / GDP ratio (B/y) stable in time. 62 DEBT INDICATORS 4.- Sustainability Indicators 7 D. Indicators that consider the budgetary restrictions Bagnai, 2003 Dynamic fiscal stability will be reached only when the following two conditions are met: B ~ (1 n) b k n r (1 ) y 1 (a) (1 n) s (1 ) 1 (1 s) 0 r ( 1 ) (b) 63 DEBT INDICATORS 4.- Sustainability Indicators 7 E. Indicators that consider the budgetary restrictions Bagnai, 2003 where n s r k is the population growth rate, is the income tax, is the income proportion that is saved, is the real tax rate is the elasticity of savings related to the interest rate, is the investment elasticity related to the interest rate, is the elasticity of consumption related to income, is the ratio capital GDP, and is the elasticity of the product related to capital. 64 4.- Sustainability Indicators DEBT INDICATORS 7 F. Indicators that consider the budgetary restrictions Bagnai, 2003 ~ If debt exceeds the b level, the economic system turns dynamically unsustainable and debt will respond to any exogenous shock, acquiring an explosive trajectory. 65 DEBT INDICATORS 4.- Sustainability Indicators 7 G. Indicators that consider the budgetary restrictions Bagnai, 2003. Second case Inter-temporal restrictions The equilibrium’s steadiness depends on the provisions regulating fiscal and monetary policies 66 DEBT INDICATORS 4.- Sustainability Indicators 7 H. Indicators that consider the budgetary restrictions Bagnai, 2003. Second case When a monetization coefficient is zero and public expenditure endogenously vary with the strengthening of debt, then the necessary condition to achieve a dynamic equilibrium is the following: r (1 )w (1 ) L B y 0 (a) L1 y r 67 4.- Sustainability Indicators DEBT INDICATORS 7 I. Indicators that consider the budgetary restrictions Bagnai, 2003. Second case Formula: r (1 )w (1 ) L B y 0 L1 y r where y is GDP, is the income proportion by the total income capital, L represents currency, L1 is the first derivate of the former variable respect to the real interest rate, and w is the wealth as a proportion of the GDP. 68 4.- Sustainability Indicators DEBT INDICATORS 7 J. Indicators that consider the budgetary restrictions Bagnai, 2003. Second case Public debt balance in real terms B rw B 1 b* y r where elasticity of money’s demand related to the interest rate (1 ) L1r L 0 69 DEBT INDICATORS 4.- Sustainability Indicators 7 K. Indicators that consider the budgetary restrictions Bagnai, 2003. Second case When an expansive fiscal policy is funded through deficit, the interest rate needs to be increased in order to induce the economic agent to reallocate its balance portfolio to the new debt. 70 5.- Final consideration DEBT INDICATORS These three main indicators groups: financial vulnerability sustainability aim understanding the public debt phenomena from different angles, with the objective of allowing governments to control and manage public debt based on sound credit practices. 71