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Debt Sustainability: A Practitioner’s view Multi-stakeholder consultation on “Sovereign debt for sustained development: Issues for countries that access financial markets” by Khalid Sheikh Senior Vice President Emerging Markets Analysis & Multilateral Organisations New York March 7-8, 2005 Definition Debt Sustainability (1): Three key drivers “ a situation in which a borrower is expected to be able to continue servicing its debts without an unrealistic largecorrection to the balance of income and expenditure ” (IMF, 2002 Assessing Sustainability) Key drivers 1. Solvency 2. Liquidity 3. Vulnerability Emerging Markets Analysis & Multilateral Organisations Definition of debt sustainability (2) 1. Solvency: the present discounted value of future primary fiscal surpluses must be at least equal to the value of the existing stock of public debt 2. Not practical nor demanding, because this would permit a government to run large primary deficits for a period of time, if it could commit itself to running primary surpluses of a sufficient size thereafter. 3. In reality, running large primary surpluses for a long period of time would be costly and politically very difficult. 4. Sustainability needs to be viewed in relation to a fiscal adjustment path that is both economically and politically feasible, and it should imply that the budget constraint is satisfied without an unrealistically large future correction in the primary balance. Emerging Markets Analysis & Multilateral Organisations Definition raises practical questions? How do we define payment capacity ? Which types of debt (public/private, local/foreign) should be included in the measurement? How do we measure or model vulnerability risk? (e.i. myopic market behaviour) What is perceived as an “ unrealistic large correction” ? Should debt sustainability be seen as unrelated to social and political goals of the debtor country (e.i. MDG) Emerging Markets Analysis & Multilateral Organisations Obvious problematic cases can be identified Emerging Markets Analysis & Multilateral Organisations PITFALLS IDENTIFIED 1. Taxes are denominated in local currency, while bulk of debt is often still in foreign currency. The ability to generate exports and foreignexchange revenues needs to be analyzed separately. 2. Focus on government debt misses potential debt problems in the private sector, that can become liabilities of the public sector. We incorporate “skeletons” in our scenario’s. 3. But in case of a shock, a country can get into a “vicious cycle” with adverse movements in growth, tax revenue, credit flows, spreads all interacting, which is difficult to capture in the scenarios. Emerging Markets Analysis & Multilateral Organisations Lessons learned Debt sustainability should be assessed by looking at many indicators simultaneously and comparing them against empirically set benchmark values, which are adjusted for country specific factors. More and more frequent Scenario-analysis and Portfolio stress testing. Low hanging fruit can be poisonous as bad decisions are taken in good times. Do rely on your own sentiments and information Emerging Markets Analysis & Multilateral Organisations Assessing Debt sustainability: a new thought model Two step model (aim to develop more dynamic indicators): 1. Three (macro) sector (corporate, bank and government) model: develop a set of equations that attempt to define the correlation and trigger mechanisms to measure debt dynamics 2. define flexible thresholds (barriers of default) above which debt is unsustainable. Setting benchmarks for domestic and private sector debt. Emerging Markets Analysis & Multilateral Organisations Modern anatomy of a crisis 1. Severe currency volatility Attempts to stabilize, risk premia Attempts to flee Exchange rate risk 4. Massive capital outflow Loss of confidence 2. Sharp rise in interest rates Interest rate risk 3. Overextension of risk exposure 3d. Corporations & Households 3a. Financial institutions Risk transfers due to financial inter-linkages (claims and obligations) between sectors 3c. Rest of the world 3b. Government sector Emerging Markets Analysis & Multilateral Organisations Scenario analysis with key debt ratios remains one of the most used analytical tools 80 70 60 50 40 30 20 10 Brazil, debt/GDP projections 1994 1996 1998 2000 2002 2004 2006 2008 Baseline projections Ex ternal grow th shock in y ear t and temporary slippage in policies. Internal shock in y ear t by slippage in fiscal policy for an ex tended period Emerging Markets Analysis & Multilateral Organisations Scenario analysis Russia: “appears manageable, even in face of oil price shock” 90 Russia, debt/GDP projections 80 70 60 50 40 30 20 10 1995 1997 1999 2001 2003 2005 2007 1. B asline pro jectio ns public debt-to -GDP ratio 2. Real interest rate at 1997-04 averages plus two standard deviatio ns in 2005 and 2006 3. Real GDP gro wth at 1997-04 averages minus two standard deviatio ns in 2005 and 2006 4. P rimary (no n-interest) surplus at 1997-04 averages minus two standard deviatio ns in 2005 and 2006 5. Co mbinatio n (2-4) using a single standard deviatio n sho ck 6. One-time 30 percent real depreciatio n in 2005 7. Fall in o il prices to USD 15 in 2005 and 2006 andd to USD 20 afterwards Emerging Markets Analysis & Multilateral Organisations Debt sustainability: the broader context (1) Debt sustainability should be stronger canvassed in the Monterrey Consensus and MDG. 1. Enhance south/south trade 2. Develop local capital market to reduce vulnerabilities of financing projects in foreign currency 3. All stakeholders in important infrastructure projects (public and private) should work closely together in a joint monitoring panel to ensure adequate management of all major social, economic and political risks in large infrastructure projects. Emerging Markets Analysis & Multilateral Organisations Debt sustainability: the broader context (2) Enhance relationship with creditors thru stronger IRP’s and compliance to Principles Enhance risk management practice: 1. as Basel 2 could curtail the supply of resource flows (FDI/Trade) 2. By enhancing financial soundness and governance (disclosure, facilitate market discipline) Emerging Markets Analysis & Multilateral Organisations Key Challenges View on Top of the Pyramid Private Business Sector Civil Society & NGO Community Private Financial Sector Public Sector Co-operation & strategic alliances among 4 sectors are crucial for Achieving Debt Sustainability!! Emerging Markets Analysis & Multilateral Organisations