The Framework A Framework for Dealing with the Debt-related Risks of Highly Indebted Small States

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1 Background Paper The Framework A Framework for Dealing with the Debt-related Risks of Highly Indebted Small States Sudarshan Gooptu The World Bank Auguste T. Kouame The World Bank

2 The Framework A Framework for Dealing with the Debt-related Risks of Highly Indebted Small States 1 January 31, 2013 Introduction Borrowing for productive purposes can be an important element in boosting GDP growth but, conversely, excessive borrowing or poorly structured debt in terms of maturity, currency or interest rate composition can quickly offset the positive impact, deter new foreign and domestic investment, compromise reform programs, depress GDP growth, exacerbate the challenge of meeting the government s basic obligations, and may induce or propagate the risks of economic crises. In the small states, for instance those in the Caribbean and Pacific Islands, the risks of natural disasters compound the other sources of external shock they face from the trade and financial channels. With small populations, low productive capacity and high fixed costs associated with even basic investments for these economies to function, carrying our public functions and stimulating growth are more likely to put pressure on public finances. Public debt and growth are intrinsically intertwined more significantly than in larger, more diversified economies. Empirical evidence also shows that the higher the quality of a country s policies and institutions, the better is its capacity to carry debt and withstand exogenous shocks. 2 Looking at the Caribbean region as a sample, public debt indicators in the 8 most indebted Caribbean countries (C-8) are among the highest in the world today [averaging over 100% of GDP]. This high debt situation emerges from the unique characteristics of these countries: (i) past government efforts to boost growth through public spending in part due to the small scale of private sector activities; (ii) repeated natural disasters that have forced governments to respond to such contingencies through public spending. Addressing the high debt situation in these small highly vulnerable economies has proven difficult. The require debt stabilizing annual growth rates ranging from 2% to 11% across the eight countries are often well above what these countries have achieved in the past (i.e. ranging from 0.3% to 5% per year on average over the past decade). Moreover, if such GDP growth rates were to be achieved under the 1 Small states are defined as states with a population of less than 2 million. The focus here is on small states classified by the World Bank as low- or middle-income. 2 Kraay, A and Nehru, V, 2006, When is External Debt Sustainable?, World Bank Economic Review, Vol. 20, No. 3, pp See also, WB-IMF (May 2007), Strengthening Debt Management Practices - Lessons from Country Experiences and Issues Going Forward - Background Paper (Chapter III prepared by A. Prasad and F. Rowe). Another paper by Prasad, A, Pollock, M and Li, Y (2013) looked at the status of public debt management performance in 17 small states through the findings of the Debt Management Performance Assessment (DeMPA) reports. 1

3 current circumstance where public spending plays a leading role in fueling growth, this will further exacerbate the public debt situations in these countries. In theory, an alternative way to stabilize debt is through fiscal consolidation. Such efforts in these Caribbean countries will entail an improvement ranging from 2.5% to 15% of government balances from their current levels. Such pressures may put at risk the government s efforts to meet its basic service delivery responsibilities to its citizens. Debt restructuring, including through concessional financing could be another way out, however, this again cannot be done alone especially in middle-income countries whose financing needs are met largely through borrowing at market interest rates, thus limiting the fiscal space for undertaking countercyclical fiscal policies in the face of shocks or limiting governments ability to carry out expenditures that could crowd in private investments and boost private sector-led growth. The repeated occurrences of debt creating events make one-off debt restructuring operations inadequate. The Framework therefore emerges as a necessary approach to comprehensively and sustainably address this conundrum. It is structured around four pillars, three instruments and two implementation stages. Four pillars Enhancing private sector led growth. The lack of growth or low levels of economic growth is one of the possible causes of the high debt-to-gdp ratios in the Caribbean. By growing faster, Caribbean countries can solve part of the debt problem. However, this will require a stronger and different type of effort than in the past. To reduce C-8 countries debt level to 60 percent of GDP by 2020 the target set by the Eastern Caribbean Central Bank (ECCB) for its member countries 3 would require a doubling of the average real GDP growth from their historical average. Moreover, replicating the old model of public sector driven growth can lead to more public sector debt. For most Caribbean countries, being small comes with the structural constraint of high fixed costs of providing public services and high overhead costs of running government operations. This, combined with a tradition that favors an important role for the government in the economy, has meant that the role of the public sector relative to the nonpublic sector has historically been more prominent in Caribbean countries. Government expenditures represent on average 30 percent of GDP in the Caribbean (and this does not include state-owned enterprises and other public bodies). This important role played by the public sector in the economy has been a factor in the accumulation of public sector debt. Generating growth in a way that does not put pressure on public spending but generate additional public revenue in the form of tax revenues will require that the private sector play a more important role in growth creation than has traditionally been the case in the Caribbean. Moreover, there is a need to engage structural policies that create conditions for a virtuous cycle of faster private sector-led growth and the emergence of a healthy financial system. Improving fiscal balance. To reduce their debt level, countries often need some form of fiscal consolidation in order to generate fiscal space to help meet their debt service requirements, reduce future borrowing needs, and possibly reduce their debt stock. For the highly indebted 3 Six of the 8 countries studied as members of the ECCB. 2

4 vulnerable small states, a key pillar of debt reduction strategy in therefore the need to put their fiscal house in order, manage efficiently tight public resources, avoid unaffordable public investments, and manage public debt strategically. The overall fiscal balance for the C-8 countries deteriorated from an average deficit of 3.3% of GDP in 2005, to a deficit 3.7% in 2008 and 5.4% in An effort is underway in most countries to reverse this trend. However, given the high debt levels, improving the fiscal balance alone is unlikely to be sufficient. In fact, the fiscal adjustment required to achieve a debt-to-gdp ratio of 60 percent by 2020, would be gigantic and perhaps unfeasible for some C-8 countries without undermining economic growth or critical social services. To place public finances on a sustainable path, permanent structural improvements in public financial management, resource mobilization and allocation will be necessary so that debt reduction is not achieved at the expense of long term economic growth and social stability. Mitigating the fiscal impact of natural disasters and other exogenous shocks. Given the location and small size of Caribbean countries, natural disasters are frequent and tend to have large systemic impacts when they occur. As a result, the annual expected costs associated with natural disasters are significant in most Caribbean countries. The annual expected cost of hurricanes alone is estimated to be as high as 1.6% of GDP in St. Kitts & Nevis and 1.9% in the case of Dominica. In fact, actual costs of disasters have occasionally reached much higher levels. Grenada, for example, suffered massive damage caused by Hurricane Ivan in 2004, estimated at nearly twice the annual GDP; public sector losses accounted for approximately 30% of the damage. Some countries, such as Belize, Guyana and the Eastern Caribbean islands, face risks of rising sea levels due to global warming or threats to their coral reef. Considering the significant vulnerability of Caribbean countries to natural disasters and global cyclical downturns, investing in the capacity of governments and society as a whole to deal with exogenous shocks, smooth out the impact of disasters on public finances and mitigate the risk of sharp increases in public sector borrowing in the aftermath of natural disasters should be a critical component of any strategy to contain public sector debt in the long term. The impact of natural disasters on public finances could be mitigated through insurance mechanisms. For example, countries could use existing insurance schemes such the Caribbean Catastrophe Risk Insurance Facility (CCRIF) or additional mechanisms such as regional cat-bonds. In addition, public investment in areas that increase countries resilience to natural disasters could further reduce the fiscal impact of these exogenous shocks in the medium term. Restructuring debt portfolios. For some highly indebted Caribbean countries, the aforementioned measures would be insufficient and will need to be complemented with reductions in debt service and possibly debt stocks in order to provide some fiscal relief in the short term and achieve debt sustainability in the medium to long term. A number of Caribbean countries undertook debt restructuring in the past few years, but in many cases this provided some relief in the short term simply by pushing the debt service burden into the future. Going forward, debt restructuring should seek to achieve more permanent reductions in debt service burden and debt to GDP ratios. The type of restructuring and the coverage of the restructuring (whether domestic or international) will depend on countries debt and creditor profiles. In some cases care should be taken to avoid or mitigate the impact of debt restructuring on the health of domestic financial institutions holding public debt. 3

5 Three instruments The debt restructuring pillar can be implemented using three instruments, namely: (A) a discounted debt buy-back operation; (B) a debt-debt swap operation; and (C) a debt-equity swap or, more broadly, sale of government assets. Debt-for-nature swaps could also be considered in certain country situations. To this end, and to ensure credibility to the overall effort to deal with its debt problems in a manner sustainable that is and that signals the private sector is seen as future growth engine, a government would identify public assets that can be sold and use the proceeds of asset sale to pay down public debt. In addition to helping pay down public debt, debt-equity swap may help eliminate debt owed by the public entities being sold, ensures that the debtor shares in the burden of the restructuring process (fairness argument), and contributes to achieving a larger and more dynamic private sector and, therefore, a faster private sector led growth. Two stages This framework could be implemented in two stages since the sale of government assets (C) might take significantly longer to implement than a debt buy-back operation (A) or debt-debt swap (B). In stage one the government would list assets immediately available for privatization as well as those which will be privatized at a later stage (in stage two). The first group should comprise assets for which the value is known to the market and whose privatization does not present the risk of being potentially detrimental to growth. The second group will comprise assets for which the value needs to be assessed through an appraisal and/or where privatization presents some major difficulties. For instance, investors may need to acquire detailed information about the specific industries and the underlying regulatory frameworks (i.e., utilities), or some serious legal or institutional issues may need to be resolved before privatization. [Two stage policy implementation design + implementation stages] Finally, a county-by-country implementation of the proposed framework would seem to be more realistic and more amenable to swift and high impact actions on the part of the highly indebted small states. The World Bank and other IFIs could are supporting interested countries in the design of their programs on the basis of these pillars of the framework. 4