Online Course on Deb Susainabiliy Analysis s (e-dsa) Par 1: Principles of Deb Susainabiliy e-dsa Par 1: Principles of Deb Susainabiliy This raining maerial is he propery of he Inernaional Moneary Fund and is inended for use in IMF Insiue for Capaciy Developmen courses. Any reuse requires he permission of he IMF. The views expressed in his maerial are hose of he course saff and do no necessarily represen hose of he IMF or IMF policy. 1
Par 1 Uni 1: Learning Objecives and Srucure of Par 1 Learning Objecives of Par 1 Learn abou key conceps of deb susainabiliy analysis Undersand he dangers of high deb Derive deb dynamics for differen ypes of deb i h l f fi l dj Discuss he role of fiscal adjusmen and oher macroeconomic policies 2
Srucure of Par 1 Uni 1: Overview Uni 2: Defining i deb susainabiliy Uni 3: Why is deb susainabiliy analysis imporan? Uni 4: Public deb susainabiliy in a closed economy: par 1 Uni 5: Deb dynamics Public deb susainabiliy in a closed economy: par 2 Srucure of Par 1 Uni 6 Public deb susainabiliy in an open economy Uni 7 Chipping away a public deb (Adjusmen pahs and heir implicaions) Uni 8 Role of macroeconomic policies Uni 9 Exernal deb susainabiliy: par 1 Uni 10 Exernal deb susainabiliy: par 2 3
Par 1 Uni 2: Defining Deb Susainabiliy UNI T OBJECT TIVES Undersand he concep of susainabiliy Maser he relevan erminology Idenify relevan indicaors of solvency and liquidiy Familiarizaion wih various ypes of DSA conduced by he IMF/World Bank 4
UN IT OUTL LINE Deb susainabiliy from differen angles Deb burden indicaors Inroducion o IMF/World Bank Deb Susainabiliy Analysis (DSA) Par 1 Uni 2: Lecure 1 Wha is Susainabiliy? 5
OUTL LINE Deb Susainabiliy from Differen Angles: Academic Pragmaic Ineremporal Solvency Condiion Iniial deb Fuure sream of primary expendiure Fuure sream of income Fuure flows should be discouned Primary expendiure= Expendiure Ineres expendiure Discouning: refers o calculaing he presen discouned value 6
Ineremporal Solvency Condiion When a governmen, business or individual is solven, i is able o service is curren deb ou of fuure income or surpluses. A person wih a small deb and large fuure income is solven. Example: Consider a business wih deb of $20,000 and a prospec of annual profis of $10,000. The business is solven as his deb can be serviced from fuure profis. Ineremporal Solvency Condiion A couner-example is a Ponzi-scheme. In such schemes, iniial deb is serviced by relying on new invesors, raher han serviced ou of fuure surpluses. 7
Solvency is very much like honesy: i can never be fully cerified, and proofs are slow o maerialize. Guillermo Calvo Academic Definiion of Deb Susainabiliy Deb is susainable if he ineremporal solvency condiion is saisfied, ha is, if he expeced presen value of fuure primary balances covers he exising sock of deb. 8
The abiliy o pospone generaing primary surpluses o cover for he exising deb obligaions ino he fuure makes solvency a relaively weak requiremen Academic Perspecive Precise Unobservable Forecasing Fuure 9
Pragmaic Definiion of Deb Susainabiliy Deb is susainable if projeced deb raios are sable or decline, while also being sufficienly low. Deb is unsusainable if projeced deb raios increase or remain high. Pragmaic Definiion of Deb Susainabiliy Pragmaism consiss in recognizing ha he raio of deb o capaciy o pay is wha maers in order o avoid a deb crisis. To be susainable deb canno grow To be susainable, deb canno grow faser han incomes and he capaciy o repay i. 10
Pragmaic Definiion of Deb Susainabiliy Anoher aspec of pragmaism is o recognize ha economies are subjec o shocks. A deb raio which is declining bu high can sill be unsusainable if i associaed wih a high risk of defaul. Example of Pragmaic View of Susainable Deb Deb/GDP Time 11
Taking Solvency Condiion o he Daa Solvency vs. Non-explosive Deb Raios: Useful resul when ineres raes are higher han he growh rae: if he raio of deb o GDP is eiher sable or declining in he long run, he solvency condiion is auomaically me. Risks o Susainabiliy The projeced rajecory and he level of deb should be based on realisic assumpions abou he underlying macroeconomic variables The resuling gross financing needs have o be evaluaed The marke percepion of he sovereign The marke percepion of he sovereign risks has o be facored in based on deb mauriy srucure, is currency composiion, is credior base, ec. 12
Par 1 Uni 2: Lecure 2 Define Deb Susainabiliy OUTL LINE Deb Susainabiliy from Differen Angles: Economic Policy Definiion 13
Economic Policy Definiion of Deb Susainabiliy Deb is susainable if he counry (or is governmen) does NOT, in he fuure, need o defaul or renegoiae or resrucure is deb or make implausibly large policy adjusmens. Defaul 14
Deb Resrucuring Policy Adjusmens 15
Economic Policy Definiion of Deb Susainabiliy Susainabiliy rules ou any of he following siuaions: a deb resrucuring is already needed he borrower accumulaes deb a a rae faser han he growh in is capaciy o service deb he borrower lives beyond is means by accumulaing deb in he knowledge ha a major rerenchmen will be needed o service hese debs REC CAP Ineremporal solvency condiion is weaker han he economic policy definiion of susainabiliy We call deb susainable if a counry or a governmen is able o service is debs wihou he need for implausibly large policy adjusmens; renegoiaing he erms of deb; or simply defauling. 16
Par 1 Uni 2: Lecure 3 Deb Burden Indicaors for Solvency and Liquidiy: Commonly Used Raios OUTL LINE The concep of liquidiy Deb burden indicaors and heir role Key solvency indicaors Key liquidiy indicaors 17
Liquidiy We define an eniy as liquid if, regardless of wheher i saisfies he solvency condiion, is liquid asses and available financing are sufficien o mee or roll-over is mauring liabiliies. Wha o Wach for o Minimize Liquidiy Risks The projeced rajecory AND he level of deb should be based on realisic assumpions Risk facors include Marke percepion of he sovereign Deb mauriy srucure The currency composiion of deb The availabiliy of liquid asses The credior base (noably, he share of nonresiden crediors) 18
Insolvency vs. Illiquidiy Someimes i can be difficul o disinguish beween insolvency and illiquidiy siuaions Liquidiy problems are ofen sympoms of underlying solvency problems: crediors refuse o roll over mauring deb because of solvency concerns Liquidiy problems may give rise o insolvency, by raising ineres raes or pressuring he exchange rae Vulnerabiliy When we alk abou deb susainabiliy, vulnerabiliy is defined as a risk ha he liquidiy or solvency condiions are violaed and he borrower eners a crisis 19
How Do We Assess he Deb Burden? By examining he projeced evoluion of a se of deb burden indicaors over ime Wha are he indicaors? Deb Burden Indicaors Raios of he deb sock or deb service relaive o wha we define as measures of he abiliy o service deb (repaymen capaciy), e.g. GDP expor proceeds fiscal revenue Oher Gross financing needs, eiher in level or scaled by he above measures 20
Deb Burden Indicaors as Measures of Solvency and Liquidiy Raios of deb sock relaive o repaymen capaciy are indicaors of solvency Raios of deb service are indicaors of poenial liquidiy problems Gross financing needs is an indicaor of poenial liquidiy problems Definiions of Gross Financing Needs Gross financing needs are he amoun of financing necessary o cover he defici plus amorizaion of deb GFN = Defici + Amorizaion GFN = Primary Defici + Deb Service GFN can be posiive or negaive 21
Definiions of Deb Service and Amorizaion Deb service DS = Ineres + Amorizaion Amorizaion = principal paymens coming due on medium- and long- erm deb plus shor-erm erm deb coming due (mauriy of 1 year or less) Illusraion: deb/gdp vs. deb/expors Deb Raios for an Open Economy (expors/gdp=60%) Deb Raios for a Closed Economy (expors/gdp=10%) 180 800 160 700 140 120 100 80 60 40 Deb/Expors Deb/GDP 600 500 400 300 200 Deb/X Deb/GDP 20 100 0 +1 +2 +3 0 +1 +2 +3 Boh counries have he same deb/gdp raio, bu very differen deb/expors raio. 22
Illusraion: Gross Financing Needs and Oher Deb Burden Indicaors STD=10% oal deb STD=60% oal deb (bill LCU) Gross Financing Needs (defici plus amorizaion) 360 906 Defici Primary defici 22 22 Ineres paymens 108 108 Amorizaion Paymens Shor-erm deb 121 728 Medium and long-erm deb 109 49 Deb service (ineres plus amorizaion) 338 884 (%) Gross financing needs-o-gdp 18% 44% Gross financing needs-o-revenue 73% 184% Deb service-o-gdp 17% 43% Deb service-o-revenue 69% 180% Toal public deb-o-gdp 66% 66% Toal public deb-o-revenue 273% 273% REC CAP Concep of Liquidiy Deb Burden Indicaors: Repaymen Capaciy (he abiliy o service deb). Solvency and Liquidiy 23
Par 1 Uni 2: Lecure 4 Scope of Deb Susainabiliy Analysis OUTL LINE Scope of he IMF/World Bank Deb Susainabiliy Analysis (DSA) DSA for Differen Types of Deb 24
DSA and DSF A DSA is produced for a paricular counry The Deb Susainabiliy Framework (DSF) is he framework wihin which DSAs are produced. The DSF is needed o ensure comparabiliy across DSAs produced for differen counries. MAC DSA For advanced and emerging economies wih access o financial markes, we use he Framework for Fiscal Policy and Public Deb Susainabiliy Analysis in Marke- Access Counries (MAC DSA) 25
MAC DSA (www.imf.org) LIC DSF The DSF originaed as he framework o assess deb susainabiliy in lowincome counries (LICs) 26
LIC DSF (www.imf.org) 27
Sample DSA (www.imf.org) Scope of Public DSA The public DSA (also called he fiscal DSA) covers oal deb of he public secor, o exernal and domesic crediors MAC DSA for public deb covers only public deb, no publicly guaraneed deb (PPG) LIC DSA for public deb covers public and publicly guaraneed deb (PPG) 28
Scope of Exernal DSA The exernal DSA covers exernal deb in he economy MAC DSA for exernal deb covers deb owed by boh he public secor and he privae secor LIC DSA for exernal deb covers public and publicly guaraneed (PPG) exernal deb Seleced Feaures of DSA To inform a judgmen on deb susainabiliy, he DSA for MAC and LIC combine he indicaors of solvency and liquidiy he rajecory and he level of deb and financing needs under a baseline scenario he adverse scenarios recognizing he uncerainy and macro-fiscal risks, e.g. economic cycle (boom-bus) analysis shocks o coningen liabiliies, growh, ineres rae, exchange rae, ec. 29
Seleced Feaures of MAC DSA DSA MACs for public deb considers The marke percepion of he sovereign Risks semming from he deb profile Credior base Mauriy Currency composiion The realism of he underlying assumpions Seleced Feaures of LIC DSA LIC DSA considers a long-erm prospecive he concessionaliy of deb risk raing: an explici assessmen of he risk of exernal deb disress 30
REC CAP Scope of Deb Susainabiliy Analysis (DSA) MAC or LIC DSA for Differen Types of Deb Public or Exernal Par 1 Uni 3: Why is Deb Susainabiliy Analysis Imporan? 31
UNI T OBJECT TIVES Undersanding he coss of high deb Learn he definiion and origin of deb and oher crises Undersanding he mechanism of deb crisis UN IT OUTL LINE Coss Associaed wih High Deb Types of Economic Crisis Mechanism of Deb Crisis 32
Par 1 Uni 3: Lecure 1 Coss Associaed wih High Deb UN IT OUTL LINE Consequences of High Deb Vulnerabiliy o Sudden Sops Crowding ou of privae invesmen Loss of policy flexibiliy Deb Overhang Deb Resrucuring 33
Consequences of High Deb For boh public deb and oal exernal deb: Vulnerabiliy o a sudden sop in financing (official or privae flows) Impac of Sudden Sops Exernal deb: curren and capial accoun resricions i currency crisis, banking crisis, recession, defaul Public deb drasic reducion in primary spending currency crisis, banking crisis, recession, defaul 34
Consequences of High Deb For public deb, consequences include Higher ineres raes and crowding ou of privae invesmen Less flexibiliy o conduc counercyclical policy Deb overhang Deb Overhang Definiion: The expeced ax burden o finance deb is so high ha i is a disincenive o curren invesmen/consumpion and hence a drag on he economic aciviy Consequences: lower growh, lower governmen revenues insufficien funds for primary expendiures higher chance of defaul 35
Deb Overhang Worries abou deb susainabiliy Rising risk premium Concerns abou fuure financing of he sovereign Worries abou fiscal deficis Concerns abou economic growh Consequences of Sovereign Deb Resrucuring Poliical and economic penalies Spillovers across segmens of he economy (especially if banks are major holders of governmen deb) Conagion o oher counries The 1998 Russian sovereign defaul and fears in 2010 of a possible Greek defaul are examples of srong conagion o oher counries 36
REC CAP Coss Associaed wih High Deb: Vulnerabiliy Crowding ou Loss of flexibiliy Deb Overhang Deb Resrucuring Par 1 Uni 3: Lecure 2 Types of Economic Crises 37
OUTL LINE Types of Economic Crises Currency Crises Banking Crises Exernal Deb Crises Sovereign Deb Crises Currency Crises Wha: an aack in a counry s currency resuls in one, or a combinaion, of he following large devaluaion sharp depreciaion large increase in ineres raes large fall in reserves When: concerns abou he viabiliy of he exchange rae regime or he level of he exchange rae 38
Why: Currency Crises marke expecs ha foreign exchange (FX) reserves will run ou because of inconsisen policies or be insufficien o cover shor-erm deb marke expecs governmen o devalue in order o address a policy goal, such as improved compeiiveness Banking Crises Wha: run on banks or large-scale governmen inervenion o rescue banks When: concerns abou solvency and liquidiy of banks 39
Why: Banking Crises bursing bubble in equiy or real esae prices ineres rae, exchange rae, or growh shocks bus ypically follows lending booms (simulaed by financial liberalizaion/capial inflows) Deb Crises Deb crises can be associaed wih eiher sovereign (public) or commercial (privae) deb 40
Sovereign Deb Crises Wha: defauls, involunary resrucuring of sovereign deb, or belief ha his is abou o occur When: ofen combined (or immediaely following) banking crises: his was rue for over 60 percen of all sovereign deb crises afer 1970 (Rogoff and Reinhar, 2010) Why: Sovereign Deb Crises financial i rescue packages exended period of low growh fiscal profligacy (including war finance) failed sae-owned enerprises naural disasers ec. 41
Exernal Deb Crises Wha: paymen arrears on a subsanial fracion of exernal deb When: cash flow problems or difficulies obaining foreign exchange Why: sudden sops following capial inflow episode ineres rae, exchange rae, or growh shocks REC CAP Differen Types of Economic Crises: Currency Crises Banking Crises Exernal Deb Crises Sovereign Deb Crises 42
Addii ional Resou urces Please wach he video on Lavia : Deb and BoP crisis wih inernal devaluaion and fiscal adjusmen Par 1 Uni 3: Lecure 3 Mechanism of Sovereign Deb Crises 43
OUTL LINE Sample Mechanism of Deb Crisis Bank-sovereign Inerdependence A Sample Mechanism of a Sovereign Deb Crisis Financial secor rescue packages weigh on public deb and he defici Economic aciviy nosedives Fiscal revenue collapses while expendiures skyrocke 44
A Sample Mechanism of a Sovereign Deb Crisis The resuling spike in deficis and deb causes concerns abou he fiscal balance and deb susainabiliy Coss of borrowing for he sovereign increase Fiscal posiion furher worsens Bank-Sovereign Inerdependence Damage o bank balance shees bailou coss and increase in sovereign deb Increase in sovereign deb higher possibiliy of sovereign defaul, lower raings damage o bank balance shees 45
Bank-Sovereign Inerdependence Lower sovereign raings Recession REC CAP Sample mechanism of deb crisis Bank-sovereign Inerdependence 46
Par 1 Uni 4 Public Deb Susainabiliy in a Closed Economy UNI T OBJECT TIVES Learn how o derive he law of moion for public deb Learn how o derive he formal solvency condiion for public deb 47
UN IT OUTL LINE Closed economy: Law of moion for public deb Solvency condiion for public deb Par 1 Uni 4: Lecure 1 Law of Moion for Public Deb 48
OUTL LINE The deb-defici relaionship The primary balance The governmen budge consrain The Relaionship beween Defici and Public Deb Curren Sock of Deb = Pas Sock of Deb + Defici i + Oher Flows + Exchange Rae Valuaion In he closed economy, we assume deb is In he closed economy, we assume deb is issued in local currency, so ha here is no conribuion of exchange rae valuaion. In he open economy, we allow for deb issued in local currency and in foreign currency. 49
Vicious Circle of Deb and Defici Higher ineres paymens Defici Increase in deb Borrowing Relaionship beween Defici and Public Deb Budge defici can be financed by borrowing or oher means (e.g., prining money or selling asses) Ne new borrowing necessary o finance budge defici adds o he curren sock of deb 50
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Oher flows include Noe asse purchases and expendiure iems no included d in G bank recapializaion assumpion of guaraneed sae enerprise deb non-deb sources of financing asse sales such as privaizaion revenues seigniorage Such non-deb sources of financing ener wih a negaive sign 104 52
Focusing on Primary Balance: Subsiue he primary balance definiion: PB i D OT D D 1 1 Assume oher flows are zero: OT 0 Equaion for Deb Dynamics: D (1 i ) D 1 PB 106 53
Example: Evoluion of Deb over Time D (1 i ) D 11 PB 160 140 120 100 80 60 40 20 0-1 +1 +2 +3 +4 +5 +6 +7 +8 +9 +10 D 100 1 2% PB 2 i Par 1 Uni 4: Lecure 2 Deriving he Solvency Condiion 54
OUTL LINE Deriving he Solvency Condiion from he Flow Budge Consrain: Derive he Ineremporal Budge Consrain Impose Transversaliy Obain Solvency Condiion Checkpoin: Where Are We? We alked abou he deb-defici relaionship We derived he governmen budge consrain We derived one-period law of moion for public deb 55
Checkpoin: wha s nex? We will sar wih he flow budge consrain We will use forward subsiuion o derive he ineremporal budge consrain Which we need o obain solvency condiion (in presen-value erms) 56
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Par 1 Uni 5 Public Deb Susainabiliy In Closed Economy: Par 2 59
UNI T OBJECT TIVES Learn how o derive he law of moion for he raio of public deb-o-gdp for an closed economy Analyze conribuions of key macroeconomic variables o deb dynamics Obain he deb-sabilizing i primary balance UN IT OUTL LINE Closed economy: Law of moion for public-deb- o GDP raio Auomaic deb dynamics Deb-sabilizing primary balance 60
Par 1 Uni 5: Lecure 1 Law of Moion for Public Deb-o-GDP in a Closed Economy OUTL LINE Law of moion for public-debo GDP raio Key macroeconomic variables affec deb susainabiliy Primary balance Iniial level of deb Growh Real ineres rae 61
Checkpoin: Where Are We? We are sill in he case of a closed economy (o avoid worrying abou he exchange rae-induced variaions in deb) Checkpoin: wha s nex? We are abou o ge pragmaic and do some derivaions in erms of raios of deb sock o he economy s capaciy (GDP) Law-of-moion for deb-o-gdp in hand, we will look a he impac of he key macroeconomic variables on deb dynamics 62
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Par 1 Uni 5: Lecure 2 Sabilizing Deb in an Closed Economy OUTL LINE Auomaic deb dynamics Deb sabilizing primary balance Sabiliy of deb The danger of deb momenum 65
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Primary Balance o Sabilize Deb: Assuming d is consan one can solve for he deb sabilizing primary balance pb*: pb r g d * 1 1 g Auomaic deb dynamics 134 67
Primary Balance o Sabilize Deb: The primary surplus needed o keep he deb/gdp consan equals he deb dynamics. I is proporionae o he gap beween real ineres rae and real growh rae The primary balance needed o keep he deb/gdp consan will rise direcly wih he size of he iniial deb/gdp, if r>g We can also inerpre he equaion as elling us he level of deb which can be susained for a given primary balance 135 The Danger of Deb Momenum: The primary surplus needed o keep he deb/gdp consan will rise direcly wih he size of he iniial deb/gdp The higher is he iniial deb sock, he more difficul i is o sabilize he deb/gdp raio Danger of buil in momenum, he higher deb-o-gdp o raio ges, he less likely i is o run a sufficienly large primary surplus deb rises Thus, vulnerabiliy rises wih deb-o-gdp raio 136 68
Illusraion: Evoluion of Deb/GDP over Time: d ( 1 r ) (1 g ) d 11 pb %GDP 102 100 98 96 94 92 90 88 86-1 +1 +2 +3 +4 +5 +6 +7 +8 +9 +10 d 1 100% r 2% g 5% pb 2% UNI IT REC CAP Law of moion for public-debo GDP raio Auomaic deb dynamics Deb-sabilizing primary balance 69
Par 1 Uni 6 Public Deb Susainabiliy In Open Economy UNI T OBJECT TIVES Learn how o derive he law of moion for public deb for an open economy Obain he deb-sabilizing primary balance Analyze conribuions of key macroeconomic variables o deb dynamics 70
UN IT OUTL LINE Open economy: Law of moion for public deb Deb-sabilizing primary balance Comparaive saics Par 1 Uni 6: Lecure 1 Law of Moion for Public Deb in an Open Economy 71
OUTL LINE Flow budge consrain wih exernal financing Law of moion for he deb-o-o GDP raio Auomaic deb dynamics 72
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Par 1 Uni 6: Lecure 2 Sabilizing Deb in an Open Economy 77
OUTL LINE Deb sabilizing primary balance Comparaive saics: role of key macroeconomic variables: Iniial level of deb Growh Ineres Rae Exchange Rae 78
Key Comparaive Saics: The required primary balance is higher when: The real ineres rae -growh differenial is large Oher flows conribue o an increase in deb (e.g. financial secor suppor measures, naionalizaion of privae pensions) There is exchange rae depreciaion (ε) in counries wih large foreign exchange denominaed deb (α) Noe: The las wo are examples of sock-flow adjusmens because hey help reconcile he change in he value of deb wih he defici 79
Illusraion: Key Macro-Economic Variables Counry W Counry X Counry Y Counry Z (% change) r d 5 4 5 5 r f...... 5 g 4 5 4 4 ε* 0 0 0 5 (% GDP) d d 100 100 20 50 d f 0 0 0 50 pb* 0.96-0.95 0.19 3.49 Illusraion: We can calculae pb* by applying he formula, while being careful o express ineres raes and growh raes as a percen: w ( r g ) d * (1 r pb* (1 g ) For counry Z for example: f ) d (0.05 0.04) 1 0.05 (1 0.05) 0.5 pb* 0.0349 3.49% (1 0.04) f 80
UNI IT REC CAP Deb Law-of-Moion Deb-sabilizing Primary Balance Key Comparaive Saics Par 1 Uni 7 Chipping Away a Public Deb 81
UNI T OBJECT TIVES Undersand differen adjusmen pahs and heir implicaions Undersand how fiscal adjusmen may affec GDP and he risk premium on governmen deb UN IT OUTL LINE Adjusmen Pahs and Their Implicaions Fron-loaded and back-loaded adjusmens Fiscal Adjusmen, he Business Cycle, and he Risk Premium Hisory of Pas Fiscal Adjusmens (video) 82
Par 1 Uni 7: Lecure 1 Adjusmen Pahs and Their Implicaions OUTL LINE Definiion of fron-loaded and back-loaded adjusmen Circumsances favoring each 83
Fron-loaded and Back-loaded Adjusmen: Fron-loaded adjusmen: pb ime Back-loaded adjusmen: pb ime Fron-loaded and Back-loaded Adjusmen: Fron-loaded fiscal adjusmen quickly raises he primary balance o he argeed level Back-loaded adjusmen phases in he adjusmen over ime 84
Circumsances Affecing he Timing of Adjusmen: Fron-loading may be necessary: when facing severe financing i consrains o build credibiliy o seize opporuniy of poliical suppor Back-loading may be preferable o: suppor o economic aciviy i ensure qualiy of measures Circumsances Affecing he Timing of Adjusmen: Credibiliy is very imporan in he conex of high deb, because of is effec on he risk premium and herefore deb dynamics In he case of back-loading, credibiliy can be enhanced by insiuional mechanisms, such as balanced budge rules and procedural rules 85
Circumsances Affecing he Timing of Adjusmen: If fiscal adjusmen has a negaive impac on growh, i may undermine deb susainabiliy underake fiscal adjusmen in he upswing of he business cycle underake fiscal adjusmen during worldwide recoveries suppor fiscal adjusmen wih accommodaing moneary policy Fron-loaded and Back-loaded Adjusmen In he Addiional Resources we provide a formula for he fiscal adjusmen necessary o reduce deb over a given number of periods. The formula allows one o disinguish fronloaded adjusmen from back-loaded adjusmen. 86
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Addii ional Resou urces This maerial ook sock of: The primary balance necessary o reduce deb o cerain level he poenial impac on cos of funding 88
REC CAP The radeoff beween fronloaded and back-loaded fiscal adjusmen is fron-loading o ease financing consrains and gain credibiliy vs. back-loading o suppor growh and work ou qualiy measures Par 1 Uni 7: Lecure 2 Fiscal adjusmen and he business cycle 89
OUTL LINE How he budge balance affecs GDP How he budge balance affecs he risk premium Fiscal Adjusmen and he Business Cycle 90
Fiscal Adjusmen and he Business Cycle Three main channels from primary balance o deb/gdp: direcly via he primary balance in he deb dynamics via GDP hrough demand lower governmen spending and higher axes reduce demand via ineres raes hrough credibiliy (risk premium) and demand crowding ou Fiscal Adjusmen and he Business Cycle Fiscal consolidaion may lead o slower GDP growh High muliplier (closed economy, high unemploymen) Coordinaed consolidaions in economic parners Fiscal consolidaion may lead o lower ineres raes In high-deb counries credibiliy effecs are paricularly imporan 91
UNI IT REC CAP Fron-loaded vs back-loaded adjusmen The speed a which deb can be reduced depends on how fiscal adjusmen affecs GDP and ineres raes. Addii ional Resou urces Please wach he video on Chipping Away A Public Deb 92
Par 1 Uni 8 Role of Macroeconomic Policies UNI T OBJECT TIVES Undersand he role of moneary policy Undersand he economic policy radeoffs 93
UN IT OUTL LINE Moneary Policy Sance and Deb Policy Tradeoffs Par 1 Uni 8: Lecure 1 Moneary Policy Sance and Deb 94
OUTL LINE Expansionary moneary policy possible effecs The effec of moneary policy on ineres raes and inflaion Moneary policy sance and deb Ineres rae Inflaion Exchange rae Growh 95
Moneary policy sance and deb Expansionary moneary policy possible effecs Lower nominal ineres raes Lower real ineres raes Higher inflaion Higher growh Depreciaed exchange rae Moneary policy sance and deb Use he deb dynamics equaion and assuming a firs no foreign currency deb: if real ineres raes fall and growh improves (herefore improving he primary balance), deb is reduced. d ( 1 r ) d (1 g ) ( pb o 1 ) 96
Moneary policy sance and deb If here is foreign currency deb, he effec is no longer unambiguous. Deb/GDP could increase, in he case of less han complee pass-hrough of exchange rae depreciaion o inflaion. d ( 1 r (1 g d ) d ) f ( 1 i )( 1 ) d (1 g )(1 ) ( pb o d f 1 1 ) Illusraion: Impac of Moneary Easing d d d f ( r g ) d 1 ( i g ) f 1 pb Easing of moneary policy Depreciaion No change in Passhrough Passhrough No easing exchange rae 20% 100% (% change) d o r d 6 4 4 4 i f 3 3 3 3 ε* 0 0 10 10 π 0 0 2 10 g 3 4 5 4 pb -2-1.5 15-1 -1.5 15 (% GDP) d d -1 50 50 50 50 d f -1 50 50 50 50 d 105.0 103.0 106.1 103.0 97
Moneary Policy Sance and Deb The effec of moneary policy on ineres raes and inflaion needs o be qualified Expansionary moneary policy ends o reduce shor-erm ineres raes bu increase long-erm ones, reflecing expecaions of fuure inflaion Moneary Policy Sance and Deb Fischer equaion: i=r*+π e Ineres raes are se based on a required real reurn r* Given r*, higher πe ranslaes ino higher h i Ex pos r need no equal r* if here is surprise inflaion (in which case r<r*) 98
Par 1 Uni 8: Lecure 2 Policy Tradeoffs OUTL LINE Susainable Deb vs. Inflaion Susainable Deb vs. Compeiiveness Susainable Deb vs. Fairness 99
Policy Tradeoffs Fiscal dominance Fear of floaing Fairness/income disribuion Policy Tradeoffs: Susainable Deb vs. Inflaion Fiscal dominance: inabiliy o conduc conracionary moneary policy because i would jeopardize governmen deb dynamics Conracionary moneary policy, which would resul in higher real ineres raes lower growh higher deb/gdp 100
Policy Tradeoffs: Susainable Deb vs. Compeiiveness Fear of Floaing: relucance o allow a floaing exchange rae o depreciae Loose moneary policy is helpful for compeiiveness and growh, bu will raise he value of foreign currency deb expressed in local l currency (public and privae) and may cause bankrupcies Policy Tradeoffs: Susainable Deb vs. Compeiiveness Fear of floaing follows from he original sin he inabiliy of emerging markes o issue exernal deb in heir own currency. 101
Policy Tradeoffs: Susainable Deb vs. Fairness Inflaion as defaul There is a hin line separaing inflaion from defaul since inflaion erodes away he value of deb (especially when here is financial repression capping nominal ineres raes) Inflaion creaes a redisribuion of wealh from crediors o debors Par 1 Uni 9 Exernal Deb Susainabiliy 102
UNI T OBJECT TIVES Undersanding similariies beween exernal and fiscal susainabiliy Undersanding exernal deb creaing flows Undersanding solvency condiion for exernal deb UN IT OUTL LINE Exernal DSA Exernal deb creaing flows Deb law-of-moion Solvency condiion for exernal deb 103
Par 1 Uni 9: Lecure 1 Exernal Deb Creaing Flows OUTL LINE Exernal DSA Exernal deb creaing flows The adjused balance 104
Exernal DSA: Similariies beween exernal and fiscal susainabiliy apply similar mehodologies Focus on exernal deb of he counry (including he privae secor deb) The curren accoun balance of he balance of paymens akes he place of he overall budge balance. Key Differences wih Public Deb: The governmen does no direcly conrol he CAB In a healhy cycle, expors and CAB will improve over ime, allowing for repaymen of deb Exchange rae normally plays larger Exchange rae normally plays larger role in exernal susainabiliy 105
Exernal Deb Creaing Flows: Our goal in his uni is o derive a law of moion for exernal deb, which links deb o pas deb and he curren accoun balance. D f ( 1 i f )D f 1 AB In he process we will define he adjused balance, AB, which is a modified curren accoun balance. Noaion: CA AB I KA FA A L D f E curren accoun balance adjused balance ineres paymens on exernal deb capial accoun financial accoun exernal asses exernal liabiliies exernal deb liabiliies exernal equiy liabiliies (P Y ) GDP expressed in USD = P Y /e All variables are expressed in USD 106
The Adjused Balance: Define: AB ( CA I) ( E A ) non-ineres curren accoun balance non-deb financing The curren accoun (he sum of ne expors, income and curren ransfers) records ineres paymens on deb as a negaive income iem. Here we add ineres back o obain he nonineres CAB. Par 1 Uni 9: Lecure 2 Exernal Financing Consrain and Deb-Lawof-Moion 107
OUTL LINE Exernal Financing Consrain Deb Law-of-moion Exernal Financing Consrain Using he erminology of he BOP and IIP manual (6 h ediion), we wrie: CA KA FA We assume for simpliciy ha he capial accoun KA (capial ransfers for he mos par) is zero. KA 0 108
Exernal Financing Consrain The financial accoun of he BOP records he acquisiion of asses and he incurrence of liabiliies (e.g. as he resul of exernal borrowing). These flows are called ransacions. We assume for simpliciy ha valuaion effecs are zero, so ha he change in he value of asses and liabiliies is equal o hese BOP ransacions. CA A L FA Exernal Financing Consrain Liabiliies can be eiher deb liabiliies or equiy liabiliies: i CA A D E f ( ) ΔL Deb includes deb securiies, loans, currency and bank deposis. Equiy includes shares and foreign direc invesmen. 109
Deb Law-of-moion Rewriing he previous equaion in erms of curren period deb and adding and deducing ineres: D f D f 1 CA E A I I Nex assume as before: -AB f f I i D 1 Deb Law-of-moion Finally, using he definiion of he adjused balance and grouping erms involving lagged deb, we find he law-of-moion we had se ou o find: f f f D ( 1 i )D AB 1 110
Par 1 Uni 9 Lecure 3: Solvency condiion for exernal deb Solvency condiion for exernal deb From he deb law-of-moion we can obain he ineremporal budge consrain hrough repeaed subsiuion, as we did for public deb. We hen obain he solvency condiion for exernal deb by imposing he ranversaliy condiion or No-Ponzi condiion. Specifically, we require ha he presen discouned value of exernal deb a ime infiniy approaches zero. 111
Solvency Condiion For Exernal Deb Using a he same mehod as for public deb, he ineremporal budge condiion exended o N periods is: ( N f 1 ) ( j 1 ) N f D 0 ABj DN j 1 1 i 1 i f We exend his formula o ime infiniy and impose he ransversaliy condiion. f Solvency Condiion Solvency: he presen value of all surpluses (of he adjused balance) is equal o iniial deb. ( 1 ) D f 0 j 1 1 i f j AB j 112
REC CAP Exernal Deb Susainabiliy Analysis Exernal Deb Creaing Flows Deb Law-of-moion Solvency condiion for exernal deb Par 1 Uni 10 Lecure 1: Deriving Exernal Deb Law-of-Moion 113
OUTL LINE Deb Law-of-moion: The Deb-To-GDP Raio Auomaic Deb Dynamics Exernal Deb Law-of-Moion: he Deb-o-GDP Raio Evoluion of exernal deb a ime : D f ( 1 i f We divide by GDP expressed in USD, (P Y )*, since exernal deb is expressed in USD. Using (P Y )*= P Y /e )D f 1 AB D f ( 1 i )D g )(1 ) P f f 1 ( PY ) * (1 1Y 1 / e AB ( P Y ) * P Y 114
Deb Law-of-Moion: he Deb-To-GDP Raio We conver GDP in local currency back o GDP in USD and use 1+ε =e /e -1 f D f f ( 1 i )( 1 ) D 1 ( PY ) * (1 g )(1 ) ( P 1Y 1 ) * AB ( P Y ) * df d f d f -1 ab Deb Law-of-Moion: he Deb-o-GDP Raio I is easy o show ha f ( 1 i )( 1 ) f ( 1 r )( 1 (1 * ) ) where f f (1 i ) (1 r ) (1 *) (1 )(1 *) (1 *) (1 ) *= foreign inflaion rae r f = real ineres rae on foreign deb ε*= real exchange rae depreciaion 115
Deb Law-of-Moion: Analyical Represenaion Evoluion of he deb-o-gdp o raio φ d f f ( 1 r )( 1 * (1 g ) ) d f 1 ab For ab =0 and d -1 >0: If φ <1, deb converges o zero If φ >1, deb explodes Auomaic Deb Dynamics Deducing pas deb from boh sides and simplifying: d f d f d d f * ( 1 r )( 1 f ) f f 1 d 1 d 1 (1 g ) r g * (1 r ) f f f f 1 d 1 (1 g ) ab auomaic deb dynamics φ -1 ab 116
Deb-Sabilizing Adjused Balance Wha level of ab keeps deb consan? To find he answer, simply se d =d -1 in he previous expression (denoe he consan deb level by d*) f f r g * (1 r ) * ab* d (1 g ) ab* is he deb-sabilizing primary surplus. Noe ha i equals he auomaic deb dynamics. If ab>ab * deb falls coninuously; if ab<ab *, deb explodes and is herefore unsusainable Key Comparaive Saics Deb dynamics are affeced by: Real ineres rae Growh rae of he economy Curren level of indebedness Ne expors Long-erm level l of oher flows Real exchange rae changes 117
Illusraion Counry X Counry Y Counry Z (% change) r f 5 5 5 g 4 4 4 ε 0 0-2 (% GDP) d f 100 20 100 ab* Illusraion We can calculae ab* by applying he formula, while being careful o divide he parameers by 100: f f r g * (1 r ) ab* d (1 g ) For counry Z for example: 0.05 0.04 0.02(1 0.05) ab* 1 0.0106 1.06% (1 0.04) * 118
Summary Key Takeaways for Exernal Deb Key Equaions Deb law-of-moion D f Adjused balance AB ( 1 i f )D f 1 Deb law-of-moion (%GDP) AB ( CA I) ( E A ) d f d r g * (1 r f f f f 1 d 1 (1 g ) ) ab 119
Deb dynamics Deb dynamics are affeced by: Real ineres rae Growh rae of he economy Curren level of indebedness Ne expors Long-erm level of oher flows Real exchange rae changes 120