External Debt Management and the HIPCs Livingstone, Zambia10-21 April 2006Thorvaldur Gylfason
Debt: Good or bad? • It depends • If foreign credit is used well, • to finance profitable investments, etc., • then borrowing may be a good thing • Many countries have developed rapidly with the aid of external loans • This is how the US built its railways and how Korea managed to develop so rapidly from the 1960s onwards • Both countries paid back their debts
Debt: Good or bad? • Many other countries have fared less well with their external debt strategies because ... • ... they did not use their foreign loans well • Too often, countries have borrowed to finance consumption, not investment • Consumption does not increase the ability of indebted countries to service their debts, nor does low-quality investment • But high-quality investmentdoes • Too much debt can hurt growth
Conceptual framework If the world interest rate is lower than the domestic interest rate, it pays to be a borrower in world financial markets Domestic firms will want to borrow at the lower world interest rate Domestic households will reduce their saving because the domestic interest rate moves down to the level of the world interest rate
Real interest rate Domestic equilibrium World interest rate World equilibrium Borrowing Domestic saving Domestic investment Conceptual framework Saving Investment 0 Saving, investment
Real interest rate Conceptual framework Saving A Domestic equilibrium B D World interest rate World equilibrium C Borrowing Investment 0 Saving, investment
Real interest rate Consumer surplus before borrowing A B C Producer surplus before borrowing Conceptual framework Saving Domestic equilibrium World equilibrium Investment 0 Saving, investment
Real interest rate Consumer surplus after borrowing A B D C Borrowing Producer surplus after borrowing Conceptual framework Saving Domestic equilibrium World interest rate World equilibrium Investment 0 Saving, investment
Conceptual framework Before borrowing After borrowing Change Consumer surplus A A + B + D + (B + D) Producer surplus B + C C - B Total surplus A + B + C A + B + C + D + D The area D shows the increase in total surplus and represents the gains from borrowing
Gains from borrowing: Three main conclusions • Borrowers are better off and savers are worse off • Borrowing raises the economic well-being of the nation as a whole because the gains of borrowers exceed the losses of those who save • If the world interest rate is above the domestic interest rate, savers are better off and borrowers are worse off, and nation as a whole still gains
External debt: Key concepts • Debt stock • Usually measured in dollars or other international currencies • because debt needs to be serviced in foreign currency • Debt ratio • Ratio of external debt to GDP • Ratio of external debt to exports • More useful for some purposes, because export earnings accrue in foreign currencies and reflect the ability to service the debt
External debt: Key concepts Debt burden • Also called debt service ratio • Equals the ratio of amortization and interest payments to exports q = debt service ratio A = amortization r = interest rate DF = foreign debt X = export earnings
External debt: Key concepts LDC debts tend to be rolled over Interest burden • Ratio of interest payments to exports Amortization burden • Also called repayment burden • Ratio of net amortization to exports q = a + b
External debt: Magnitude and composition Magnitude of the debt • Debt should not become too large • How large is too large? • Measurement of the debt • Gross or net? • May subtract foreign reserves in excess of three months of imports • Composition of the debt • FDI vs. portfolio equity • Long-term vs. short-term loans
External debt: Magnitude and composition • Composition of the debt • Foreign direct investment • Least likely to flee, most desirable • Portfolio equity • Long-term loans • Short-term loans • Most volatile, least desirable • As a rule, outstanding short-term debt should not exceed foreign reserves of the central bank Indonesia and Korea broke this rule in 1996
External debt: Numbers How can we figure out a country’s debt burden? • Divide through definition of q by income Now we have expressed the debt service ratio in terms of familiar quantities: the interest rate r, the debt ratio DF/Y, and the export ratio X/Y as well as the repayment ratio A/Y
Numerical example Suppose • r = 0.06 • DF/Y = 0.50 • A/Y = 0.05 • X/Y = 0.20 Here we have a country that has to use 40% of its export earnings to service its external debt Heavy burden!
Numerical example Suppose • r = 0.06 • DF/Y = 1.50 • A/Y = 0.05 • X/Y = 0.20 Here we have a country that has to use 70% of its export earnings to service its external debt Heavy burden!!
Numerical example Suppose • r = 0.06 • DF/Y = 1.50 • A/Y = 0.05 • X/Y = 0.20 Here we have a country that has to use 45% of its export earningsjust to pay interest on its external debt Heavy burden!!
MEFMI countries:External debt 2003 (present value, % of exports) Look at some numbers Ceiling: 150%
MEFMI countries:Exports 2003 (% of GDP) Average: 32%
MEFMI countries:Current account balance 2002-2003(% of GDP) Average: -6.3%
MEFMI countries:Gross foreign reserves 2003 (months of imports) Floor: 3 months
External debt dynamics Debt accumulation is, by its nature, a dynamic phenomenon • A large stock of debt involves high interest payments which, in turn, add to the external deficit, which calls for further borrowing, and so on Debt accumulation can develop into a vicious circle • How do we know whether a given debt strategy will spin out of control or not? To answer this, we need a little arithmetic
External debt dynamics Balance of payments equation: • BOP = X – Z + F where • F= capital inflow = DF where • DF = foreign debt • Capital inflow, F, involves an increase in the stock of foreign debt, DF, or a decrease in the stock of foreign claims (assets) • So, F is a flow and DF is a stock
External debt dynamics Now assume • Z = ZN + rDF • Z= total imports • ZN = non-interest imports • rDF = interest payments Further, assume • X = ZN • BOP = 0 A flexible exchange rate maintains equilibrium in balance of payments at all times Then, it follows that BOP = X – Z + DF = 0 so that DF = rDF In other words:
External debt dynamics So, now we have: Now subtract growth rate of output from both sides:
External debt dynamics But what is ? This is proportional change in debt ratio: This is an application of a simple rule of arithmetic: %(x/y) = %x - %y
Proof z = x/y log(z) = log(x) – log(y) log(z) = log(x) - log(y) But what is log(z) ? So, we obtain Q.E.D.
Debt, interest, and growth Need economic growth to keep the debt ratio under control We have shown that Debt ratio r g where r = g r g Time
What can we learn from this? It is important to keep economic growth at home above – or at least not far below – the world rate of interest Otherwise, the debt ratio keeps rising over time External deficits can be OK, even over long periods, as long as external debt does not increase faster than output and the debt burden is manageable to begin with A rising debt ratio may also be OK as long as the borrowed funds are used efficiently Once again, high-quality investment is key
Debt dynamics: Another look Let us now study the interaction between trade deficits, debt, and growth Two simplifying assumptions: • Dt = aYt (omit the superscript F, so D = DF) • Trade deficit is constant fraction a of output • Yt = Y0egt • Output grows at constant rate g per year Y Exponential growth t
Pictures of growth Y log(Y) g 1 time time Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate
Debt as the sum of past deficits at time T
Debt as the sum of past deficits at time T
Debt as the sum of past deficits at time T Evaluate this integral between 0 and T
Debt as the sum of past deficits at time T So, as T goes to infinity, Dt becomes infinitely large. But that may be quite OK in a growing economy! Evaluate this integral between 0 and T
Debt as the sum of past deficits So, as T goes to infinity, DT/YT approaches the ratio a/g
Numerical example Debt ratio 3 Suppose • Trade deficit is 6% of GNP a = 0.06 • Growth rate is 2% per year g = 0.02 Then the debt ratio approaches • d = a/g = 0.06/0.02 = 3 This point will be reachedregardless of the initial position ... • ... as long as a and g remain unchanged Time
What to conclude? Must adjust policies Must either • Reduce trade deficit by stimulating exports or by reducing imports, or • Increase economic growth Otherwise, the debt ratio will reach unmanageable levels, automatically • No country can afford an external debt equivalent to three times annual output
And why not? Because the debt burden then becomes unbearable • Recall our earlier numerical example Where we looked at the relationship between the debt ratio and the debt burden • Korea is a case in point Its export-oriented growth strategy reduced the numerator and increased the denominator of the debt ratio, thereby quickly reducing the country’s debt burden An import-substitution strategy would reduce both numerator and denominator with an ambiguous effect on the debt burden
Numerical example, again Here we have a country whose entire export earnings do not suffice to service its debts Suppose • r = 0.06 (as before) • D/Y = 3(our new number) • A/Y = 0.05 (as before) • X/Y = 0.20 (as before) Heavy burden, indeed!
Numerical example, again Suppose that • r = 0.06 (as before) • D/Y = 2(our new number) • A/Y = 0.05 (as before) • X/Y = 0.20 (as before) Heavy burden, still!
Numerical example, again Suppose that • r = 0.06 (as before) • D/Y = 1(new number) • A/Y = 0.05 (as before) • X/Y = 0.20 (as before) Heavy burden, still!