Download Session 9 Government financing and debt

Module H4 Session 9
Economic Concepts for Statisticians
Session 9 Government financing and debt
At the end of this session, students will have an understanding of:
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Private borrowing
The justification for fiscal deficits
Government financing (internal and external)
External debt definitions and indicators
Debt relief initiatives
Introduction
In the previous session, we looked at the reasons why governments exist (from the
economics point of view), government revenue – in particular taxation – and expenditure.
We noted that the fiscal deficit for Mauritius in 1999-2000 was 4,143 million rupees (or
3.7% of GDP). The deficit was equal to revenue minus expenditure (plus net acquisition
of non-financial assets). The deficit of 4,143 million rupees was the total which needed to be
financed in 1999-2000. In other words, taking into account all flows into the Treasury and all
outflows, the government was left with a gap of 4,143 million rupees which it had to borrow.
This session will look at government borrowing. Why do governments normally run fiscal
deficits? How do they finance them? What problems might arise? And, finally, the process
of dealing with debt problems in developing countries.
Private borrowing
Before looking at government borrowing, it is helpful to think about private borrowing.
This will throw some light on financing issues. We will use an exercise to do this.
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Exercise 1
Imagine that the interest rate charged by the Central Bank in a country is 5%. When
lending to customers, commercial banks add a certain amount to this rate to cover their
costs – let’s say 3%. So the minimum rate at which a commercial bank could lend would be
8% per annum – but this is unlikely, as lending involves risk. Commercial banks want to
make a profit from their loans, taking into account the risks involved: therefore, they add a
‘risk premium’.
Imagine that you are the Director of Credit at “First Bank”, a leading commercial bank in
your country. Consider the following cases of loan applicants. How much risk would be
involved in lending to each of them? Would you approve their applications? If so, what
interest rate would you charge them?
Mr Green is a married man in his thirties. He wants a loan for a term of 20 years to buy a
house. He has a deposit worth 10% of the value of the house, so he wants to borrow the
other 90%, which is US$36,000. He has a permanent job in the Health Ministry, earning
US$1,300 per month (after tax). His house will be offered as security for the loan.
Miss Pink is 24 years old. She is applying for a credit card with a spending limit of
US$5,000. She has recently finished a university degree in business studies and is looking
for a job in marketing.
Mrs Yellow is a 40-year-old businesswoman. She owns two small factories producing
clothing, and wants to expand into making shoes. She wants a loan of US$150,000 to set
up her new factory and source the inputs. She has submitted her business plan. She aims to
pay the loan off in a period of 5 years. However, the economy is currently in recession.
Mr Blue is a farmer who grows a number of crops for the local market as well as coffee for
export. He wants to invest in some improvements to his land, and is asking for a loan of
US$30,000 with a repayment period of 10 years.
Mrs Orange is married, with two children. Her husband is self-employed. She lives in a
respectable area of the city and drives a new car. She has a credit card with another bank,
on which she has an outstanding balance of US$8,000. She is applying to First Bank for
another credit card, on which she would like a spending limit of US$6,000.
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The justification for fiscal deficits
Until the middle of the 20th century, it was unusual for governments to run fiscal deficits
except in wartime. However, after the Second World War, governments began to realise
that they could borrow a small amount each year, adding to their total outstanding debt
stock, so long as the economy was growing. In other words, they could always spend more than
the revenue flowing into the Treasury in a particular year, as long as the money borrowed
could be repaid in the future. This depends on growth of the economy (GDP) and of
tax revenues, which generally rise in line with GDP. Therefore, the key indicator is not
total debt, but the total debt/GDP ratio. As Miles and Scott (2005) put it:
“If debt is incurred to finance investment that will boost future GDP and enhance
future tax revenues, it will be self-financing. Running deficits to pay for lavish
presidential palaces – which are unlikely to boost future GDP and future tax revenues
– is quite a different matter from government spending to improve the transport
system. So we should always ask what governments are spending their money on”.
Still, we might ask: why should governments want to spend more just because they can do
so? One reason is that it is hard to forecast with complete accuracy how much tax revenue
will flow into the Treasury in a particular year. So if a government is aiming for a ‘balanced
budget’ (no deficit), it will have to err on the side of caution and spend slightly less than
what it is likely to receive, to allow a margin of error.
A second, related, reason, is that economic growth fluctuates during business and other
cycles (see Session 5). During a recession, the government may want to spend more to raise
aggregate demand and output (see Session 8), while during a boom it might want to cut
spending. If it were to aim at a balanced budget, this would mean raising and cutting taxes
at different points during the cycle. Similarly, in the face of a sudden shock to the
economy, or an expensive war, tax rates would have to be changed. But frequent changes
in tax rates are confusing and create uncertainty. It is better to ‘smooth’ taxes over long
periods, and to cover any resulting fiscal deficits with borrowing.
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Government financing
Government financing is about how to raise funds to cover the fiscal deficit. There are two
sources of borrowing: internal – leading to the creation of internal or domestic debt – and
external – leading to the creation of external or foreign debt.
Internal borrowing
Internal borrowing can take place in three ways. The most common method nowadays is
for the Treasury to issue bills or bonds on the local stock exchange1. The investor lends
the government a sum of money and receives a bond entitling him/her to a regular stream
of payments over a period of time. At the end of this period, the original sum is repaid to
the investor. The stream of payments (equivalent to interest payments) are paid at market
rates.
This method of financing is relatively easy for the government, but it has two main
disadvantages:
1. It is expensive, and can get out of hand. The government may try to issue more and
more bonds at higher and higher rates to ‘roll over’ the debt (i.e. to raise more
funds to repay those who invested in earlier bonds).
2. Government bonds are attractive because they carry relatively low risk and high
interest – which means that savers prefer them to bank deposits, where the savings
would have been available for private investment. So private investment is
‘crowded out’ (investors cannot get enough bank loans).
The second method is known as ‘non-market forms of internal borrowing’. Examples are
when governments force public sector institutions and pension funds to invest in
government bonds at below-market rates; or when the government makes below-market
1
Note that bills are just short-term bonds (with terms of less than one year).
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payments, for instance for expropriated property; or deliberately delays payments to
suppliers of goods, public employees (wages) or tax-payers who have over-paid (rebates) –
in which case the government is getting the equivalent of an interest-free loan!
The third type of internal borrowing involves the central bank. If the fiscal deficit rises
sharply and the Treasury gets desperate, it may ask the central bank to ‘print money’ in
large quantities. This involves the Treasury giving the bank ‘securities’ (bills or bonds) in
exchange for cash, which the government spends. The money supply increases dramatically
and inflation is likely to be the consequence2 (see Session 6).
External borrowing
Who – outside the country – lends to the government of a developing country?
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Foreign commercial banks, which make commercial loans.
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Investors based in the world’s big financial markets (e.g. London, New York) who
buy government bonds issued on international markets.
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The multilateral lenders such as the IMF and World Bank, which provide some
loans on ‘concessionary’ terms (better than the market rates offered by commercial
lenders – in other words, with a ‘grant’ element incorporated in them: see below).
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Other governments (known as bilateral lenders), usually from developed countries.
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Suppliers of goods, who provide trade credit.
In addition, there are two other categories of external finance. The first is grants such as
cash donations from foreign governments, commodity aid and project aid. This is different
from lending, as grants do not involve repayment. The second is non-payment of interest
or capital on foreign debt – in other words, when a government fails to pay its debts, the
2
Note that some monetary expansion is natural in a growing economy: not all money
creation is not inflationary. But a big increase in the money supply will cause inflation.
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amounts owing build up on the balance sheet. These are seen as a form of external finance,
even though no flow of money actually takes place!
The decision to lend
From the point of view of most of those lending to governments3, the approach to
deciding whether to lend and at what rate is similar to that of the Director of Credit at First
Bank with private borrowers (Exercise 1). Commercial bank lenders and private investors
in government bonds want to make a profit, but they also want to ensure that the
loan/bond will be repaid, i.e. that the government will be able to keep up with:
(i) interest payments, and
(ii) capital repayments (also called principal repayments) – i.e. the original sum lent.
Theoretically, lending to governments is relatively risk-free because governments have their
future tax revenues as ‘security’. And unlike individuals, governments cannot lose their jobs
or face business failure! Moreover, there is normally sufficient information available about
them, unlike individual clients who the lender may know little about.
However, since the 1980s, there have been a number of debt defaults by governments of
developing countries, which have declared themselves unable to keep up payments (see
page 10). This has made lenders wary of providing financing to some countries.
The decision to borrow
From the point of view of the governments which borrow money to finance the fiscal
deficit, the following considerations should apply if they are serious about repaying the loan
and avoiding damage to the country’s reputation so that they can continue to borrow.
3
The main exception to the rule is multilateral lenders like the IMF and the World Bank
who, when making concessionary loans are not motivated by profit – although they are still
concerned to ensure that the borrower will be able to keep up with repayments.
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First, the government should assess whether it will be able to pay back the loan in ‘normal
circumstances’. This implies making careful calculations such as:
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What proportion of the budget will interest payments absorb? Can we afford the
interest payments each year, or will we have to cut back essential spending?
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Will we have enough money available when the capital repayments fall due?
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Will we have to raise taxes or cut expenditure in future, and will this be feasible?
Second, the government should pay particular attention to the risks involved. What would
happen if circumstances change? The risks are particularly high in relation to foreign debt,
and the consequences of default are particularly serious. The risks include:
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What happens if local currency (in which tax is collected) depreciates against
foreign currency (in which payments on foreign debt have to be made)?
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Could a shock such as a collapse in the price of country’s main export undermine
payment capacity?
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If the government issues international bonds and then market conditions
deteriorate, will it be able to continue borrowing to ‘roll over’ this type of debt?
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What are the consequences of getting it wrong? e.g. loss of confidence by foreign
lenders and investors, and application of IMF conditionality (see Session 10).
External debt definitions and indicators
On the one hand, government borrowing is necessary to finance the fiscal deficit. On the
other hand, there is a delicate balance between getting financing decisions right and getting
them wrong! And mistakes are costly for developing countries in terms of loss of capital
inflows, which are vital for growth (see Session 10). Therefore, it is important for
governments to monitor their debt positions carefully, particularly for external debt.
The World Bank’s annual publication Global Development Finance (GDF) is the most
authoritative international publication on foreign debt. It consists of two parts. Part I
(World Bank, 2007a) comprises an overview of key issues and an analysis of current and
expected developments in different parts of the world. Part II (World Bank, 2007b), which
is only available by subscription, and should be in the library of every Ministry of Finance,
shows a detailed breakdown of the external debt position of each country in the world. In
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this section, we will present some of the indicators used by GDF to assess a country’s
external debt position. First, some definitions….
GDF divides total external debt stocks (EDT) into three parts:
1. Long-term debt (LDOD).
2. Short-term debt.
3. Use of IMF credits, i.e. drawings from the IMF general resources account.
Again, LDOD is divided into three parts (World Bank, 2007b):
 “Public debt, which is an external obligation of a public debtor, including the national
government, a political subdivision (or an agency of either), and autonomous public
bodies.
 “Publicly guaranteed debt, which is an external obligation of a private debtor that is
guaranteed for repayment by a public entity.
 “Private nonguaranteed external debt, which is an external obligation of a private debtor
that is not guaranteed for repayment by a public entity”.
Of LDOD, only public debt is strictly speaking debt owed by government – although
government is also responsible for publicly guaranteed debt if the private debtor fails to
pay. Similarly, not all short-term debt is owed by the government (but the data is
insufficient to provide a breakdown). Use of IMF credits is entirely government debt.
Indicators such as EDT, LDOD and public debt are given as absolute numbers (millions of
US dollars) but also as percentages of GDP or GNI. This allows us to compare different
countries’ debt burdens on a like-for-like basis (see Table 1, page 9).
Another useful denominator which allows us to make comparisons on a like-for-like basis
is exports of goods, services and income (XGS). In Table 1, EDT is expressed as a
percentage of XGS. The rationale for using this denominator is that in order to make
payments on foreign debt, you need foreign currency – the main source of which is XGS.
Debt service, which consists of interest payments plus principal repayments made in a
given year, may also be presented as a percentage of GDP/GNI and XGS. The ratio of
total debt service to XGS is called the ‘debt service ratio’. A debt service ratio of less than
15-20% (depending on the country) is normally considered acceptable. In addition, debt
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service may be compared to foreign reserves, or to tax revenue. Again, these comparisons
are designed to give an idea of the country’s payment capacity.
Table 1: External debt indicators 2005, SADC countries
EDT
(US$m)
NPV of debt
(US$m)
11,755
11,462
61
74
473
408
6
10
10,600
7,624
171
533
690
512
43
67
Malawi
3,155
1,080
169
474
Mauritius
2,160
2,137
37
61
Mozambique
5,121
1,555
94
281
675
696
102
100
30,632
28,578
15
50
532
582
22
24
Tanzania
7,763
2,494
69
295
Zambia
5,668
1,562
106
290
Zimbabwe
4,257
4,396
83
220
Angola
Botswana
D.R. Congo
Lesotho
Seychelles
South Africa
Swaziland
EDT/GNI
(%)
EDT/XGS
(%)
Notes: Namibia is not shown. Figures shown in bold include the effects of traditional debt relief and HIPC
(but not MDRI) relief and are based on publicly guaranteed debt only. GNI and XGS are 2003-05 averages.
Source: World Bank (2007b).
Net Present Value
Net Present Value (NPV) of debt is an indicator which has become widely used in recent
years. The standard GDF definition of NPV of debt is: “the nominal amount outstanding
minus the sum of all future debt-service obligations (interest and principal) on existing debt
discounted at an interest rate different from the contracted rate”. This needs a bit of
explanation! The UN Statistics Division provides the following definition:
“The face value of the external debt stock is not a good measure of a country's debt
burden as a significant part of the external debt is contracted on concessional terms
with an interest rate below the prevailing market rate. The net present value (NPV) of
debt is a measure that takes into account the degree of concessionality. It is defined as
the sum of all future debt-service obligations (interest and principal) on existing debt,
discounted at the market interest rate. Whenever the interest rate on a loan is lower
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than the market rate, the resulting NPV of debt is smaller than its face value, with the
difference reflecting the grant element”. (UN Stats, 2007)
Debt sustainability
A key concern in recent years has been debt sustainability. By this, we mean ‘Are the
levels of debt of a country manageable? Will the country be able to repay its debt? Or has it
got into a situation where payments owed are beyond its payment capacity?
The 2003 World Economic Outlook (IMF, 2003) argued that sustainable public debt to GDP
ratios are much lower in ‘emerging markets’ (i.e. developing countries) than in industrial
economies. It suggested that a public debt to GDP ratio of 25% was the maximum
desirable for developing countries, compared with 60% for developed countries. The
reasons for this difference are (i) that developing economies tend to have relatively low
government revenue to GDP ratios compared with industrialised economies (which
limits their payment capacity), and (ii) that they suffer from more marked business cycles
and greater volatility. Countries with greater stability should be able to sustain higher debt
burdens.
The generally accepted indicators of a sustainable debt position – originally developed in
relation to the enhanced HIPC initiative (see page 11), are:
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NPV of public and publicly guaranteed debt to XGS ratio of under 150%,
Or, for very open economies (with high XGS) that are making serious tax efforts:
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NPV of public and publicly guaranteed debt to revenue ratio of under 250%.
Debt relief
In the 1970s, many developing country governments borrowed money imprudently. The
lenders, in particular commercial banks which were swimming in ‘petrodollars’ (the profits
made by oil-producing countries), were active in persuading them to borrow, and with low
interest rates and high prices for primary exports, the climate seemed favourable. But then
crisis hit. In the early 1980s, several countries in Latin America declared themselves unable
to keep up with debt payments: they defaulted. Since then, debt default has become quite
common for developing countries, despite the serious consequences (loss of access to
external financing, often accompanied by reduced inflows of foreign direct investment).
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From the 1980s debt crisis onwards, the creditors (those who lent money) recognised that
they must take action to deal with defaults. It was in the creditors’ interest to provide some
debt relief so that defaulting debtors could recover and resume payments; otherwise, the
creditors would not get paid at all. The first initiatives, however, provided relatively low
levels of support to debtors. They can be divided into deals which simply rescheduled
payment (giving countries more time to pay), and those which reduced either debt service
payments or debt stock. The first debt relief initiatives were:
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The Baker Plan of 1985-88, which involved no reduction in debt stocks, just
rescheduling of payments.
The Brady Plan in the 1990s, which reduced commercial debt mainly by reducing
debt service payments over time.
The Paris Club initiative, which involved a group of bilateral creditors, and
originally focused on debt payment rescheduling. From 1991 an element of debt
reduction was included (50% of NPV of debt, rising to 67% under the ‘Naples
terms’ in January 1995 and up to 80% under the ‘Lyons terms’ in December 1996).
The HIPC initiative
By the mid-1990s, public awareness of the plight of very poor countries with debts too
large to pay had grown – both in the developed and the developing world. The NGOs
organised a major campaign to put pressure on developed country governments and the
international financial institutions (principally the IMF and the World Bank). They argued
that even if the government of a highly indebted poor country was partly to blame for its
position, it was the poor who suffered, as developing country governments were having to
cut essential social expenditure to keep up with debt payments. This was unfair.
In September 1996, the Highly Indebted Poor Countries (HIPC) initiative was agreed,
providing much greater debt relief than before. It applied to all HIPCs, not just defaulters.
An ‘enhanced HIPC’ was agreed in 1999 after further public campaigns against debt.
What does the HIPC initiative offer? Very poor countries with unsustainable external debt
burdens (after the full application of traditional debt-relief mechanisms, in particular that of
the Paris Club) and a good track record in the eyes of the IMF can apply for debt relief
under the HIPC initiative. First they agree with the international financial institutions on a
‘decision point document’, which sets out what measures (economic reform, poverty
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reduction etc) must be implemented in order to reach ‘completion point’. Between decision
and completion points, some debt relief is provided. At completion point, there is a
substantial debt write-off. So far (in August 2007), 22 countries have reached this point.
What is different about HIPC?
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First, it provides much bigger debt reductions than before.
Second, for the first time it involves multilateral creditors (the IMF, World Bank,
the African Development Fund and other regional development banks), as well as
bilateral creditors (governments) and commercial creditors (banks and investors).
Third, it places debt relief within an overall framework of poverty reduction. To
qualify, countries have to prepare a Poverty Reduction Strategy Paper (PRSP) and
show sustained progress on poverty reduction. PRSPs involve civil society and
monitor progress towards their goals4.
The MDRI
Despite the progress achieved under the HIPC initiative, the NGO anti-debt campaigners
argued that it did not go far enough. In 2005, they succeeded in persuading G8 leaders to
announce another big debt relief package at the ‘Gleneagles Summit’ in Scotland.
The Multilateral Debt Relief Initiative (MDRI) promises 100% write-offs of multilateral
debt owed to the IMF, World Bank and African Development Fund to all countries which
have reached – or are on track to reach – the HIPC completion point. This represents a
major breakthrough for some of the poorest countries. For instance, Malawi had US$3.1
billion cancelled in 2006 – almost all of its external debt (see Table 1, page 9).
4
However, critics point out that the HIPC process also imposes standard IMF ‘structural
adjustment’ conditionality (see Session 10) under Poverty Reduction and Growth Facilities
(PRGFs). Some of the measures required under PRGFs conflict with PRSP goals.
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Exercise 2
Read the IMF account of the HIPC initiative and the MDRI at:
www.imf.org/external/np/exr/facts/hipc.htm and
www.imf.org/external/np/exr/facts/mdri.htm
And compare it with the viewpoint of Jubilee 2000 at:
www.jubileedebtcampaign.org.uk/?lid=97 and www.jubileedebtcampaign.org.uk/?lid=902
Then discuss the following:
1. The points on which the IMF and Jubilee 2000 agree.
2. The points on which they disagree (or have different interpretations!).
3. In your view, what lessons have been learnt from the debt crises and the HIPC
processes? How can these lessons be incorporated into future policies?
References
IMF website ‘Debt Relief Under the Heavily Indebted Poor Countries (HIPC) Initiative’:
http://www.imf.org/external/np/exr/facts/hipc.htm (also in French and Spanish)
IMF (2003) World Economic Outlook: Growth and Institutions, IMF, Washington D.C.
Miles, D. and Scott, A. (2005) Macroeconomics – Understanding the Wealth of Nations, 2nd edn.
John Wiley & Sons, Chichester, West Sussex.
UN Stats (2007) http://unstats.un.org/unsd/cdb/cdb_dict_xrxx.asp?def_code=455
World Bank (2007a) Global Development Finance 2007 – The Globalization of Corporate Finance in
Developing Countries I: Review, Analysis, and Outlook, The World Bank, Washington D.C.
Available at http://siteresources.worldbank.org/INTGDF2007/Resources/37630691179948748801/GDF07_completeFinal.pdf
World Bank (2007b) Global Development Finance 2007 – The Globalization of Corporate Finance in
Developing Countries II: Summary and Country Tables, The World Bank, Washington D.C.
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