Debt Sustainability Analysis at Subnational Level. Analytical Foundations

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1 Debt Sustainability Analysis at Subnational Level Analytical Foundations

2 Why DSA? Sustained economic growth a critical objective of macroeconomic policy... depends on a Sound Macroframework... which depends on a Fiscal Policy... whose main indicator is the Fiscal Deficit

3 Fiscal Policy has several objectives... Equity -- income distributional impact of tax and spending, Efficiency -- which taxes and spending improve economic efficiency and foster growth? Macroeconomic stabilization -- consistent with monetary, exchange rate policies by avoiding fiscal deficits and public debt accumulation

4 Macro Effects of the Fiscal Deficit Keynes revolution and the role of the fiscal deficit Basic National Accounts Gross Domestic Product GDP = consumption(c) + investment(i) + exports(x) imports(m) Gross National Income GNI = GDP - net income paid abroad(yf) Gross National Disposable Income GNDI = GNI + net transfers received from abroad(trf) GNDI is the amount of income available for an economy to consume and save, so GNDI = C + S

5 Macro Effects of the Fiscal Deficit Basic National Accounts Given GNDI + YF - TRF = C + I + X M and GNDI = C + S we conclude that S I = X M YF + TRF where the savings-investment gap can be disaggregated into private and public sector gaps S I = (Sp Ip) + (Sg Ig) = (Sp Ip) + (T Cg TRG Ig) Therefore, (Cg+TRG+Ig-T) = (Sp Ip) + (M X + YF TRF) Budget deficit = Private S-I gap + BOP current account deficit

6 Financing the Budget Deficit The Keynesian analysis of fiscal policy must take off from the extreme short-run nature of the Keynesian model. Asset stocks are assumed fixed in the model, therefore, the consequences of the method by which the budget deficit is financed are not pursued. How can the deficit G-T be financed?

7 Financing the Budget Deficit There are four ways of financing the public sector deficit G-T: G-T = money printing (seignorage) + foreign reserve use + foreign borrowing + domestic borrowing.

8 Financing the Budget Deficit G-T = money printing + foreign reserve use + foreign borrowing + domestic borrowing. Remember Foreign reserve use + money printing emphasize the link between G-T and BOP CAD is equal to the creation of credit by the central bank (which is an alternative to borrowing from markets)

9 Financing the Budget Deficit G-T = money printing + foreign reserve use + foreign borrowing + domestic borrowing. Each of the forms of financing can be associated with a major macro imbalance: Money printing inflation Foreign reserve use onset of exchange rate crises Foreign borrowing external debt crises Domestic borrowing higher interest rates and possibly explosive debt dynamics as borrowing leads to higher interest charges on debt and larger deficits.

10 Financing the Budget Deficit Money printing Revenues from Seignorage Government Revenue A 0 Inflation Rate

11 Financing the Budget Deficit Use of Foreign Exchange Reserves Run down foreign exchange reserves This policy appreciates the exchange rate which may slow down inflation (carried out not only through reserve use but also through increased foreign borrowing) It cannot be maintained unless fiscal policy is made compatible with lower inflation Use of international reserves to finance the deficit has a clear limit Private sector s expectation can provoke capital flight

12 Financing the Budget Deficit New Borrowing and Consequences Foreign borrowing excessive reliance on external borrowing to finance the budget deficit has led to debt crisis. Domestic borrowing may bring high real domestic interest rates may lead to credit rationing/crowding out of private investments. link between fiscal and external deficits is close whe the capital account is highly open Are there limits, thresholds? How to analyse it? Long-term consequences of running deficits we need debt dynamics

13 Debt Sustainability Analysis at Subnational Level Debt Sustainability Analysis (DSA) a. Basic notions b. Debt dynamics

14 What is Debt Sustainability Analysis (DSA)? Analysis of the government s capacity to meet its future financial obligations given. fiscal policy (revenues, expenditures). financing strategy (sources of budget financing) Debt dynamics induced by budget deficits and borrowing decisions Forward-looking framework based on. long-term projections of macro/fiscal/debt variables. debt burden indicators driven by macro/fiscal variables. uncertainty deterministic vs stochastic scenarios

15 Definition of Public Debt Public sector coverage Central government ( national ) Regional and local government ( subnational ) SOEs Instruments Investor base - Maturity Currency - Rates Bank loans, loans extended by other government entities, marketable securities, arrears in wage payments, arrears in payments to suppliers Risks and vulnerabilities

16 Definition of Public Debt Explicit financial obligations are backed by enforceable contracts and law Non-contingent liabilities are payable regardless of circumstances Gross debt Implicit financial obligations arise from social expectation (e.g. pension liabilities in PAYG, bank bailouts?) Contingent liabilities are payable if certain events eventually materialize (e.g. PPPs, financial guarantees, coverage of SOE losses, municipalization ) Net debt subtracting assets hold by the public sector

17 Measuring the Fiscal Deficit Public Sector borrowing requirement Central Government Subnational (local) Government Public Enterprises Overall Balance = Total Revenue Total Expenditure (Cash or Accrual) Primary Balance = Overall Balance Interest Payments

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19 Assessing Debt Sustainability 3 approaches Projections of debt burden indicators ( accounting ) Identifying macro/fiscal drivers of debt dynamics (primary deficit, interest rates, real GDP growth, inflation, exchange rate) Debt sustainability indicators ( analytical ) Analytical definitions of solvency (e.g. stable debt, IBC, debt target) Fiscal adjustment needed to satisfy solvency condition (e.g. debt-stabilizing primary balance, EU indicators S2 and S1) Debt thresholds and debt distress risk ( empirical ) Estimation of critical values of debt burden indicators that limit zones of acceptable/unacceptable probability of debt distress (e.g. Bank-Fund DSF thresholds for external debt)

20 Assessing Debt Sustainability shortcuts A pragmatic combination of the 3 approaches Public debt-to-gdp ratio (exponential trend?) Debt service-to-revenue ratio (capacity to service debt, coverage) Debt-stabilizing primary balance (adjustment to keep debt stable) Analysis of vulnerability/sensitivity to shocks (baseline vs alternative scenarios, deterministic vs stochastic, thresholds?) Use your best judgment and analysis

21 How does the government accumulate debt? Economic principle Debt dynamics Borrowing covers the excess of spending over income Accounting identity Change in the value of debt D is given by D t+1 D t = expenditures revenues + other factors accounting overall balance adjustment factor (deficit or surplus) (e.g. valuation effect)

22 Debt dynamics + Primary expenditures (uses of funds) - Revenues (sources of funds) current expenditures (payroll, transfers, subsidies) and capital expenditure (investments) taxes, non-tax income (interest income), transfers from abroad or other government entities = Primary balance (primary deficit or surplus) + Interest expenditure (uses of funds) = Overall balance (overall deficit or surplus) + Adjustment factors valuation and accounting effects, privatizations, exceptional financing, recognition contingent liabilities = Change in value of debt

23 Debt dynamics - Analytics Budget and borrowing flows GG TT + ii dd DD dd + ii ff eedd ff = DD dd + ee DD ff Value of debt and change in the value of debt DD = DD dd + eedd ff DD DD dd + ee DD ff + eedd ff Debt dynamics decomposition DD = GG TT + ii dd DD dd + ii ff eedd ff + eedd ff D = debt, with f = external and d = domestic G T = primary deficit i = nominal interest rate, with f & d e = exchange rate (NC per unit of FC)

24 Debt-to-GDP dynamics - Analytics Debt-to-GDP ratio Debt-to-GDP dynamics decomposition Change in debtto-gdp ratio Primary deficit as share of GDP Real interest rate effect Real growth effect Real exchange rate gains/losses Y = nominal GDP d = D/Y is debt-to-gdp ratio dd = Dd/Y is domestic debt ratio df = edf/y is external debt ratio

25 Debt-to-GDP dynamics - Summary Debt-to-GDP dynamics Primary balance Endogenous debt dynamics Other adjustments Real interest rates Real GDP growth Changes in real exchange rate

26 Debt Sustainability Analysis (DSA) Basic notions and Debt dynamics Main references Burnside, Craig (Editor), Fiscal Sustainability in Theory and Practice A Handbook, Washington, DC, World Bank, Chapters 2, 3 and 4. Ianchovichina, Elena, Liu, L. and Nagarajan, M., Subnational Fiscal Sustainability Analysis - What Can We Learn From Tamil Nadu? World Bank Policy Research Working Paper No Ianchovichina, Elena, Liu, L., Subnational Fiscal Sustainability Analysis. Washington, DC, World Bank, PREM Note No Stanley Fisher and W. Easterly, The economics of the government budget constraint. Washington, DC, The World Bank Research Observer, Vol.5, No. 2 (July 1990).