Public Debt Indicators in Latin American Countries: Snowball Effect, Currency Mismatch and the Original Sin. Abstract

Transcription

1 Public Deb Indicaors in Lain American Counries: Snowball Effec, Currency Mismach and he Original Sin. Ricardo Marner and Varinia Tromben* Absrac In order o explain public deb accumulaion in Lain America during he las half-decade, we esimae differen public deb susainabiliy indicaors. We emphasize hree salien opics: he fiscal sin (e.g. he pro-cyclical bias of fiscal policy); he snowball effec (e.g. he impac on public deb sock of he combined lack of growh and high ineres raes); and he original sin (e.g. he inabiliy o borrow abroad in heir own currency). Finally we es an early-warning model, and find wo variables reducing he probabiliy of enering ino deb crises (rade openness and economic real growh) while hose increasing he probabiliy are solvency and liquidiy indicaors. * Area of Budgeing and Public Managemen, ILPES, CEPAL, Unied Naions. This version was prepared for he 6 h Banca d Ialia Workshop on Public Finance, Public Deb, Perugia, Ialia, 1-3 April Correspondence: rmarner@eclac.cl ; vromben@eclac.cl 1

2 Index Absrac Inroducion Salien feaures of public deb in Lain America...5 a) Accouning and managemen issues...5 b) The pro-cyclical bias of fiscal policy Public deb dynamics: he snowball effec Deb Susainabiliy Indicaors...16 a) Inroducing governmen s reacion funcion...17 b) A measure of currency mismach An early-warning model Concluding remarks: he Original Sin and roads o redempion...26 References...29 Appendix

3 1. Inroducion In economic models, governmen s behavior is ofen analyzed under an opporunisic perspecive; indeed, some counries or geographic regions are viewed as serial defaulers 1. Deb-inoleran counries have weak fiscal srucures and fragile financial sysems. Thus, as a policy prescripion, as he enhancemen of insiuions is a long erm process, he safe hresholds should be se a a much lower level han in developed counries, perhaps 20 or 30 percen of GDP 2. On he oher hand inernaional invesors sill lend o counries ha have a background of defauling heir deb. A recen sudy demonsraes ha inernaional invesors did no loose in hose counries, considering he very high reurns generally obained in periods preceding he failure o pay 3. Governmens someimes defaul deb no because hey wan o, bu because hey do no have alernaives 4. In his paper we argue ha, in Lain-American counries ha have access o inernaional capial markes, deb susainabiliy sands for a combinaion of endogenous facors, referring essenially o he pro-cyclical bias of fiscal policies, and exogenous facors, like he sudden sop of capial flows which followed he Russian crisis 5. As he pro-cyclical bias (or fiscal sin) is an imporan explanaion of deb accumulaion during he nineies, here are oher salien issues: he snow-ball effec, which quanifies he combined impac of he lack of growh and ineres raes, and he original sin, which emphasizes he role of highly volaile domesic currencies. Hence, i seems very difficul and quie arbirary o fix low hresholds in erms of GDP, as long as he exogenous componen of public deb dynamics remains significan. Afer his inroducion, in he second secion we expose some accouning difficulies concerning he proper definiion of public deb in Lain-American Counries, and hen we inend o find evidence of he fiscal sin. We show ha during he early nineies, rerospecively viewed as good years, here were diverse behaviors, wih some counries ha reduced heir deb burden 1 The expression, referring o serial killers, belongs o Reinhar, Rogoff and Savasano (RRS, 2003). 2 This is he recomendaion of RRS; IMF oulines similar conclusions (see for example World Economic Oulook, 2003). 3 Klinden, Weder and Zeemeyer (2002) calculae ha he long-erm reurn rae in emerging counries is quie similar o he U.S. Treasury bonds. 4 See Neu and Velasco (2003) 5 See Calvo (2003). 3

4 considerably, while ohers were very pro-cyclical. These iniial condiions influenced heavily in he deb dynamics in he los half-decade 6, he period In secion 3 we quanify he snowball effec in ha period, which in a number of counries represened more han five poins of GDP. In oher words, he exogenous componen of public deb accumulaion was significan, depicing an explosive siuaion in which deb servicing absorbs an increasing proporion of fiscal revenues. In general erms, he reacion funcion of fiscal policy (e.g. he possibiliy o generae in he shor erm deb-sabilizing fiscal primary surpluses) was no sufficien o avoid a growing snowball. In secion 4 we inend o combine radiional indicaors of deb susainabiliy wih a measure of currency mismach. As oher auhors do, we compare he foreign currency liabiliies of public secor wih expors, a rough measure of exernal asses. Despie he crudeness of he exercise, i highlighs he significance of currency mismach in he explanaion of recen crisis, and he imporance of including he exernal balance of liabiliies and asses of counries when assessing susainabiliy. Using a logi model, in secion 5 we explore he variables ha can explain he enry ino a deb crisis, consrucing hereby an early-warning model for Lain-American Counries. The significan variables are he level of deb in erms of GDP, ineres deb paymens, growh and openness, among ohers. Sory also maers; deb susainabiliy hence depends on a combinaions of exogenous and srucural facors ha canno be synhesized in a one size fis all safe hreshold. The concluding remarks address he problem of original sin 7, which is defined as counry s inabiliy o borrow abroad in is own currency or o borrow long erm, even domesically. This incompleeness in financial markes creaes fragiliy inside he counry, suffering from currency mismach (when projecs generaing local currency are financed wih foreign currency) and mauriy mismach (when long-erm projecs are financed wih shor-erm loans). Wih original sin, movemens in exchange raes have wealh effecs ha limi he effeciveness of moneary policy (Aghion, Bacchea and Banerjee 2001, Céspedes, Chang and Velasco 2002) 8. Alhough i is argued ha he original sin canno be redeemed, some roads o deliverance are explored. 6 See ECLAC (2003). 7 The expression was used for he firs ime by Eichengreen and Haussman (1999). 8 The fear of floa depics he usual siuaion in which auhoriies fear he wealh effecs of devaluaions when here is a subsanial porion of dollar-denominaed liabiliies, boh public and privae; see Calvo, Reinhar (2002). 4

5 2. Salien feaures of public deb in Lain America Since he crises of he eighies, public deb managemen has been a consan preoccupaion of fiscal auhoriies. A he Cenral Governmen level 9, deb showed a clear decline, measured in percen of GDP, from he end of he eighies unil Coinciding wih he business cycle reversion, from 1997 his indicaor began o increase again. Sudden sops mus be a rue damnaion in Lain America: when capial flows decrease significanly, public secor borrowing requiremens increase, as he economic aciviy diminish and he cos of public deb measured in local currency begins o climb in flexible exchange rae regimes. a) Accouning and managemen issues There are considerable difficulies in collecing he exising daa on public deb, in erms of availabiliy, coverage and definiion issues. The Governmen Finance Saisics Manual (2001) defines public deb sock as following: Deb consiss of all liabiliies ha require paymen or paymens of ineres and/or principal by he debor o he credior a a dae or daes in he fuure. Thus, all he liabiliies in he Governmen Finance Saisics sysem are deb excep for shares and oher equiy and financia l derivaives (p. 129). I recommends also reaing obligaions for social securiy benefis in he fuure and coningens conracs as a memorandum iem and no as public deb. Despie his clear definiion, he public deb daa is sill quie heerogeneous in Lain America. The major issues ha arise building a daa se in Lain America are: - The consolidaion of liabiliies and asses beween insiuions (for example beween social securiy funds and he Cenral governmen). Doubs sill exis concerning he correc mehodology a he cenral governmen level, which is he coverage used by he majoriy of Lain American counries; many counries publish boh he consolidaed and he non-consolidaed daa. To increase he confusion, hese are ofen called gross and ne deb. Which is he correc number Some say ha he imporan poin is he deb record, whoever is he deb holder, because here is an obligaion o repay. Ohers say ha by doing a consolidaion we recognize ha he financial flows inside he public secor have no he same macroeconomic effecs han deb wih he privae secor. - In some cases, counries include Cenral bank liabiliies bu do no incorporae he corresponding asses, such as inernaional reserves. 9 A complee descripion of public deb daa available for Lain American counries can be found in 5

6 - Some counries include indirec debs; hese should be reaed as coningen liabiliies. I is he case in Bolivia, Ecuador, El Salvador, Nicaragua, and Paraguay. - Some counries do no disseminae official daa of domesic public deb, like Paraguay and Dominican Republic. Concerning he firs poin, he mehodology of he European Union is clear: Governmen deb means he oal gross deb a nominal value ousanding a he end of he year of he secor of general governmen, wih he excepion of hose liabiliies, he corresponding financial asses of which are held by he secor of general governmen (Council Regulaion (EC) N. 475/2000). Of course, credi raing agencies always focus on he highes daa when hey make heir evaluaions. This siuaion produces a huge damage on counries public finances (for example in he case of Brazil, non consolidaed deb of he public secor represened more han 70 percen of GDP a he end of 2002, while he consolidaed public deb represened 50 percen of GDP for he same period (see box 1). Wihou a homogenous mehodology ha allows a complee coverage of liabiliies and asses, he norm should be o record consolidaed gross public deb of General Governmen, excluding Cenral Bank and public enerprises. If here are relevan quasi-fiscal operaions or coningen liabiliies wih a high probabiliy of occurrence, which incorporaes also public guaraneed deb, he mos appropriae is o record hese operaions separaely. 6

7 Box 1 PUBLIC DEBT ACCOUNTING METHODOLOGY IN BRAZIL The Federal governmen (defined as direc and indirec adminisraion, public social securiy sysem, and non financial federal public funds) gross deb is composed by naional governmen liabiliies held by sub-naional governmens, public and privae financial sysem, non financial privae secor and he res of he world. Obligaions linked o he exernal secor are convered o reales wih he exchange rae a he end of he period. Values of Federal governmen gross deb are recorded considering porfolio posiions wihou aking ino accoun operaions of he Cenral bank. The iems of he Federal governmen ne deb (36% of GDP) in 2002 are: - Securiies issued by he Naional Treasury - Federal domesic public deb consiued by public bonds issued by he Naional Treasury recorded in he Elecronic Selemen and Cusody Sysem (SELIC) and hose under he cusody of he Cenral Office for Privae Securiies (CETIP) placed and redeemed in Brazilian currency, including securiies a he Cenral Bank s porfolio. (+34.2); - Bank deb - Loans and financing graned by financial insiuions o he non-financial public secor. - Bank deb of decenralized agencies - Loans and financing graned by financial insiuions o eniies of indirec adminisraion (governmenal agencies, universiies, foundaions, ec). - Social Securiies deposis and invesmens - Corresponds o he public securiies invesmen porfolio of he Social Securiy. - Cerificaes of privai zaion (CP) - Securiies issued by he Naional Treasury and usable in he purchase of shares of sae-owned enerprises wihin he framework of he Naional Privaizaion Program. - Debs of he Union and of sae-owned enerprises, assumed and renegoiaed by he federal governmen and securiized hrough he issuance of securiies regisered wih he CETIP. - Agriculural deb securiies (TDA) on he marke - Securiies backed by he INCRA/MA issued by he Naional Treasury in land expropriaion procedures for agrarian reform. - FAT invesmens in public securiies -Worker Proecion Fund invesmens in Naional Treasury securiies. - Invesmens of various funds - Refers o invesmens of public funds oher han financial inermediaries in federal securiies. - Law 8727/93 - Deb of saes, municipaliies, and public enerprises a 6/30/93, refinanced by he Union under Law 8727/93. - Exernal deb - Shor-, medium- and long-erm exernal public deb. Federal governmen deb is disseminaed as ne and gross wih a monhly periodiciy, and he difference beween hem was 15 poins of GDP in 2002 for Federal governmen. The ne consolidaed public secor deb (which is composed by General governmen, Cenral bank and public non financial enerprises) corresponds o ne deb of Naional governmen (Federal governmen and Cenral bank) plus ne deb of local and inermediae governmen wih naional governmen, public and privae financial sysem, non financial privae secor and he res of he world. Social securiy public sysem and public funds are also included. The resuling sock is adjused in order o obain he concep of ne fiscal deb: privaizaion adjusmens, parimonial adjusmens, exernal deb adjusmens (for exchange rae flucuaions) and domesic deb adjusmens (also for exchange rae flucuaions when domesic deb is indexed o he US dollar). Ne deb of he so-called harmonized public secor does no include he moneary basis as he Macroeconomic Monioring Group of MERCOSUR (GMM) recommends. Finally, he quesion surges: which is he appropriae daa BRAZILIAN PUBLIC DEBT Ne Deb Naional Governmen Federal Governmen Cenral Bank Gross Deb General Governmen Ne Deb General Governmen Federal Governmen Saes and Municipaliies Ne Deb Consolidaed Public secor (A) General Governmen Cenral Bank Non Financial Public Enerprises Ne Deb Harmonized Public secor 51.8 Privaizaion Adjusmen (B) Parimonial Adjusmen (C) Adjusmen for exernal deb (D) Adjusmen for domesic deb (E) Fiscal ne Deb (A-B-C-D-E) Source: Cenral Bank of Brazil 7

8 Table 1 shows he evoluion of public deb a he Cenral Governmen level in Lain-American Counries, as well as he percenage of exernal deb. Two endencies emerge; for eleven counries, public deb measured in percen of GDP has decreased during he nineies (for several in a significan way: Chile, Dominican Republic, El Salvador, Honduras, Mexico, Nicaragua, Venezuela). Seven oher counries heavily increased heir public deb sock: Argenina, Brazil, Colombia, Cosa Rica, Ecuador, Paraguay and Uruguay, rising by he same way ineres paymens. Three counries of he region have defauled or resrucured heir public deb in he recen years: Ecuador (1999), Argenina (2001) and Uruguay (2003). Table 1 CENTRAL GOVERNMENT CONSOLIDATED DEBT STOCK AND ITS EXTERNAL COMPONENT, AS PERCENT OF GDP AND AS PERCENT OF TOTAL DEBT Argenina Bolivia Brazil Colombia Cosa Rica Chile Ecuador El Salvador Guaemala Haii Honduras 1/ Mexico Nicaragua Panama Paraguay 1/ Peru Dominican R. 1/ 2/ Uruguay Venezuela 2/ Source: ECLAC, Unied Naions 1/ I only includes exernal public deb. 2/ Public secor deb sock. The 2002 jump of public deb sock in Argenina and Uruguay, resuling from huge devaluaions of local currencies, illusrae in a dramaic way he so-called original sin. In he case of Argenina, he currency board in place unil he end of 2001 diminished somewha arificially he burden of public deb as a proporion o GDP. Wih devaluaion and recession, he indicaor 8

9 almos ripled is value; he equilibrium exchange rae should be lower in he long erm han he one recorded in The opposie siuaion happens in Ecuador where he persisence of a domesic inflaion in spie of dollarizaion has appreciaed he real exchange rae, reducing public deb in erms of GDP. In macroeconomic models wih a represenaive agen wih an infinie horizon and perfec markes, here is neuraliy of governmen deb boh in level (Ricardian equivalence) and in composiion. Bu here is a gap beween heory and pracice: on one hand heory argue for neuraliy of public deb managemen; on he oher, a growing number of counries adop explicily for heir public deb managemen pracices of he privae secor. Referring o public deb composiion, daa shows a clear endency o use in a more inensive way domesic deb insrumens. This siuaion should reduce he exposiion of counries o exchange rae flucuaions (a leas in he case of hose domesic insrumens which are no indexed o foreign currency). The increase of he share of domesic public deb is ousanding in Brazil, Colombia, Cosa Rica, Mexico and Peru. This is in par a resul of he difficulies o borrow abroad, and also he oucome of he disseminaion of inernaional guidelines for deb managemen of IMF and World Bank (see Box 2). The heoreical framework of asses and liabiliies adminisraion for public deb managemen is a useful mehod, because cos and risk analyses of porfolio s insrumens of public deb is direcly linked o fiscal resources. In his framework, characerisics and risks of he asses cash flow are examined, and if i is possible liabiliies wih he same characerisics are seleced in order o minimize probabiliies of a liquidiy shorage caused by a currency or mauriy mismach. The IMF and he World Bank esablish ha he main objecive of public deb managemen is o ensure ha he governmen s financing needs and is paymen obligaions are me a he lowes possible cos over he medium o long run, consisen wih a pruden degree of risk. 9

10 Box 2 PUBLIC DEBT MANAGEMENT STRATEGIES Public deb sraegies in which counries appeal o excessiv e exernal deb in foreign currencies and shor-erm deb (including also floaing ineres raes) are very risky. For example, deb expressed in foreign currencies may appear, ex ane, less expensive han deb expressed in local currency wih he same ma uriy, bu may resul more expensive in insable capial marke or in he case of a depreciaion of he local currency. Furhermore, public deb managemen auhoriies mus ake ino accoun ha he exchange regime can affec linkages beween deb managemen and moneary policy. For example, deb expressed in foreign currency may appear less expensive in a fixed exchange regime where exchange insabiliy is limied, bu may resul very risky if he exchange regime urn o be unsusainable. A framework should be elaboraed ha allow public deb managemen auhoriies o idenify and find an arbirary soluion beween anicipaed cos and risk of he public deb insrumens porfolio. Generally public deb managemen auhoriies deal wih differen ype of risk; he major role of he uni in charge of he public deb managemen is o idenify hose risks, evaluae if possible heir magniude and elaborae he bes feasible sraegy in order o find an arbirary soluion beween cos and risk. To accomplish his ask, hey mus have access o financial and macroeconomic projecions. To assess risk, deb managers should regularly conduc sress ess of he deb porfolio on he basis of he economic and financial shocks o which he governmen and he counry more generally are poenially exposed. When consrucing such assessmens, deb managers needs o facor in he risk ha he governmen will no be able o roll over is deb and be forced o defaul, which has coss ha are broader han jus governmen s budge. Moreover, deb managers should consider he ineracions beween he governmen s financial siuaion and hose of he financial and non-financial secors in ime of sress in order o ensure ha governmen s deb managemen aciviies do no exacerbae risks in he privae secor. In general, models used should enable governmen deb managers o underake he following ypes of risk analysis: - Projec expeced fuure deb servicing coss over a medium-o long-erm horizon based on assumpions regarding facors affecing deb-servicing capabiliy, such as: new financing requiremens; he mauriy profile of deb sock; ineres rae and currency saisics of new deb; assumpions for fuure ineres raes and exchange raes and he behavior of relevan non-financial variables (e.g., commodiy prices for some counries); - Generae a deb -profile, consising of key risk indicaors of he exising and projeced deb porfolio over he projeced horizon; - Calculae he risk of fuure deb servicing coss in boh financial and real erms by summarizing he resuls of sress ess ha are formulaed on he basis of he economic and financial shocks o which he governmen and he counry more generally are poenially exposed. Risks are ypically measured as he poenial increase in deb servicing coss under risk scenarios relaive o he expeced cos; and - Summarize he coss and risks of alernaive sraegies for managing he governmen s deb porfolio as a basis for making informed decisions on fuure financing alernaives. Source: Guidelines for public deb managemen (2002), IMF and World Bank. b) The pro-cyclical bias of fiscal policy During he nineies, in mos Lain American counries argeing he shor-erm defici raher han he srucural defici has given rise o a pro-cyclical bias. The analysis of 45 episodes of changes of he cyclically-adjused primary balance reveals ha 12 of hem were neural 10 ; in 25 cases fiscal policy had a pro-cyclical behavior, and in only 8 he resul was couner cyclical. Figure 1 compares, for he 45 episodes analyzed, he posiion of he economies in he business cycle wih he changes in public deb a he Cenral Governmen level. 10 See Marner and Tromben (2003) for deails of his esimaion. The episodes are included when he annual average change in cyclically adjused balance or in public deb sock is bigger han 0.25% of rend GDP, for a leas wo successive years. 10

11 Figure 1 GDP GAP AND CHANGE IN PUBLIC DEBT STOCK, Bolivia Cosa Rica Guaemala Haii Paraguay Honduras Change in public deb sock Primary balance conribuion Snowball effec Sock-flow adjusmen Source: Marner and Tromben (2003) When he relevan variable is public deb, we can idenify 15 ani-cyclical episodes, where he dividend of growh was spen in he reducion of public deb: Chile ( ), Ecuador ( ), Peru ( ), Mexico ( and ) and Venezuela ( and ). In oher cases public deb grew heavily in good periods, especially in Argenina (from 1993) and Uruguay (from 1996). To a lesser exen Brazil ( ), Colombia ( ), Cosa Rica ( ) and Paraguay ( ) did no manage o conrol deb dynamics in he conex of posiive oupu gap. 3. Public deb dynamics: he snowball effec Even if many counries did significan effors o reduce heir public deb sock, he combinaion of high ineres raes, sharp devaluaions and recessive episodes has had devasaing consequences on public finance. An explosive deb dynamics a snowball effec can resul, in which deb servicing absorbs an increasing proporion of fiscal revenues. In order o calculae he snowball effec, public deb dynamics can be expressed by he following equaion: B B 1 GB SF (1) 11

12 Where B is public deb sock, GB he global governmen balance, SF he sock-flow adjusmen ha ensures he consisency beween governmen balance and he variaion in he sock of deb; denoes he year. The sock-flow adjusmen includes he accumulaion of financial asses, he change in he value of deb sock denominaed in foreign currency and remaining saisical adjusmens. The equaion can be presened emphasizing he role of he primary balance: B B (1 i) PB SF 1 (2) Where PB is he primary balance, and i is he implici ineres rae. The implici ineres rae is calculaed as he ineres paid as a percenage of deb sock a he end of he year (-1). Re-wriing he equaion in erms of GDP (Y ): B Y B Y i n PB Y SF Y (3) Where n is he rae of growh of GDP. Re-arranging: B Y B Y 1 1 PB Y B Y 1 1 i 1 n n SF Y, (4) If lower case leers represen raios in erms of GDP: i n b pb b 1 sf (5) 1 n The deb dynamics ( b ) can be separaed in hree componens, he primary balance (pb), he conribuion of ineres and real growh raes or snowball effec, and he sock-flow adjusmen 11 (sf). The daa used for he calculaions are shown in Table A.1 in he appendix. Table 2 shows he imporance of he snowball effec for several episodes and counries, and a comparison wih he European Union counries. 11 The devaluaion of he local currency his direcly in wo of he componens of deb dynamics: on he snowball effec hrough he increase of he flow of ineress paid measured in erms of GDP, and on he sock-flow adjusmen hrough he increase of he sock of deb. 12

13 Table 2 THE MAGNITUDE OF THE SNOWBALL EFFECT Maximum of he snowball effec Public deb associaed wih maximum of he snowball effec Accumulaed snowball effec Accumulaed public deb sock Lain American counries Argenina 8.8 (2002) Bolivia 1.3 (2001) Brazil 5.7 (1998) Chile 0.4 (1999) Colombia 4.3 (1999) Cosa Rica 4.4 (1996) Ecuador 12.2 (1999) El Salvador 0.5 (2002) Guaemala 1.0 (2001) Haii 0.8 (2002) Honduras 5.7 (1994) Mexico 5.5 (1995) Panama 4.2 (2001) Paraguay 1.4 (2002) Peru 4.7 (1992) Dominican Republic 0.3 (2001) Uruguay 4.7 (2002) Venezuela 8.8 (2002) European counries Belgium 7.2 (1993) Denmark 6.4 (1993) Germany 2.7 (1996) Greece 0.7 (1996) Spain 1.7 (1996) France 3.0 (1993) Ireland 1.1 (1992) Ialy 9.9 (1993) Luxembourg 0.3 (2002) Neherlands 4.1 (1993) Ausria 2.5 (1993) Porugal 5.1 (1993) Finland 4.0 (1993) Sweden 4.7 (1996) Unied Kingdom 1.7 (1992) Source: auhors calculaion for Lain American counries and European Commission (2003) for European counries. In he period , he maximum snowball effec reached on average 4.1 poins of GDP associaed wih a public deb of in Lain American counries, wih peaks of 12.2 in Ecuador, 8.8 in Argenina and Venezuela, and more han 5 poins of GDP in Brazil, Honduras and Mexico. By conras, in he early nineies he maximum in European counries averaged 3.7 poins of GDP -- wih an associaed deb of wih peaks of 9.9 in Ialy and 7.2 In Belgium. 13

14 The problem was hen more acue in Lain American counries in , and will coninue o hi severely if he financial condiions remain unchanged. Figure 2 shows deb dynamics for he period , separaing 18 counries ino hree groups: in group A, counries ha have access o he inernaional capial markes o issue public deb (marke access counries) and public deb increased; in group B, counries ha have access o inernaional markes, and public deb decreased; and in group C, counries ha canno issue sovereign bonds. In he firs group, he main reason of he rising of he deb is currency devaluaion in 2002, as i can be seen in he magniude of he sock-flow adjusmen in Argenina and Uruguay. In Brazil, he posiive primary balance was no sufficien o impede he increase of deb, due o exogenous facors. In Colombia, and o a lesser exen in Peru, he negaive impac of hese facors came ogeher wih a persisen primary defici. In Chile and Venezuela he increase was quie small. I is noneheless remarkable he complee absence of snowball effecs in Chile, a counry wih very low levels of public deb and ineres raes. The case of Brazil deserves o be highlighed; he counry began o generae sysemaic primary surpluses since The Brazilian fiscal responsibiliy law, approved in 2000, esablishes definiions of annual fiscal arges for he nex hree exercises. The aim is o achieve primary surpluses allowing he public deb-o-gdp raio sabilizaion. Bu he effor was no sufficien o conain public deb growh, because of he deerioraion of economic growh rae and of financing condiions. In he case of Brazil, fixing primary surplus arges (insead of global balance) was per se a success, because i permied he separaion of fiscal goals from ineres and exchange raes flucuaions. Thus, if during he period global deficis were bigger han expeced, he year 2003 should represen he beginning of a viruous circle, leading o he absorpion of he public deb-o-gdp raio if he exchange rae converge o a lower level. 14

15 Figure 2 CONTRIBUTION TO THE CHANGE OF PUBLIC DEBT STOCK IN LATIN AMERICA, A MARKET ACCESS COUNTRIES WITH INCREASING PUBLIC DEBT Argenina Brazil Chile Colombia Peru Uruguay Venezuela Change in public deb sock Snowball effec Primary balance conribuion Sock-flow adjusmen B MARKET ACCESS COUNTRIES WITH DECREASING PUBLIC DEBT Ecuador El Salvador Mexico Panama Dominican R. Change in public deb sock Primary balance conribuion Snowball effec Sock-flow adjusmen C COUNTRIES THAT CANNOT ISSUE SOVEREIGN BONDS Bolivia Cosa Rica Guaemala Haii Paraguay Honduras Change in public deb sock Primary balance conribuion Snowball effec Sock-flow adjusmen 15

16 Source: elaboraion of he auhors. In he group B, i can be seen ha here has been a sharp decline in Panama and El Salvador, wo dollarized counries. In El Salvador, he recen official dollarizaion is par of he explanaion. The paricular case of Ecuador is highlighing: his counry needed o cumulae 18 poins of GDP of fiscal primary surpluses o reach a decrease of is public deb of 0.6 poins of GDP from 1997 o There has been also a negaive sock-flow adjusmen, which can be aribued o he dollarizaion process, which diminished he burden of deb in GDP since 2000 (see able A.1). In Dominican Republic, he decline in deb has been compleely reversed wih he crisis of he financial sysem of The consolidaed public deb rose from 27 poins in 2002 o 38 poins of GDP in In he case of Mexico, he fiscal auhoriies managed o balance he negaive impac of he exogenous variables wih primary surpluses. The negaive sock-flow adjusmen also conribued o reduce public deb. In group C, he impac of he snow ball effec is much lower, excep for Cosa Rica. In Honduras, Haii, Guaemala and Bolivia he implici ineres rae is quie low. In hese counries, exernal financing relies mainly on he Povery Reducion and Growh Faciliies programs. The required deb-sabilizing primary balances are hus exremely flucuan, as a consequence of he volailiy of ineres, exchange and real growh raes. In such a conex, i is really a hard ask o fix shor erm arges in he public deb-o-gdp raio. Deb susainabiliy indicaors should ake ino accoun his exogenous componen; analyss ha aim o formula e general policy prescripions should do he same. 4. Deb Susainabiliy Indicaors During he period , some counries had sysemaically a negaive difference beween heir effecive primary balance and he required one o sabilize deb. A combined process of generaion of primary balances and improvemen in he financial condiions seem o be he only way o ensure deb susainabiliy. In figure 3 we represen, as an average for he period, he effecive primary balance and he deb-sabilizing primary balance, calculaed as he sandard shor erm Blanchard s (and ohers, 1990) indicaor. To do so, we assume no sock-flow adjusmen and we suppose b = 0. From (5), he shor erm deb-sabilizing primary balance can be derived as: pb i n b 1 (6) 1 n 16

17 Figure 3 EFFECTIVE AND DEBT-STABILIZING PRIMARY SURPLUS, AVERAGE FOR (% OF GDP) Deb-sabilizing primary balance (% of GDP) 4 Ar Ec Ve Co Br 3 Uy Cr Mx 2 Pa 1 Py Pe G Hn Cl 0 Bo Sv H Rd Effecive primary balance (% of GDP) Source: auhors calculaions. I clearly appears ha here has been a significan negaive difference beween hese wo variables, excep for Chile, Dominican Republic, Mexico and Panama. The gap represened up o five poins of GDP in Colombia, and hree poins in Brazil, Uruguay, Venezuela and Argenina. Recen papers develop some refinemens o his kind of indicaors, inroducing a fiscal policy reacion funcion and aking ino accoun he currency mismach of deb. a) Inroducing governmen s reacion funcion Croce and Hugo (2003) propose a fiscal susainabiliy indicaor, calculaed wih an operaionally simple recursive algorihm ha is derived from he deb-o-gdp raio subjec o he governmen s reacion funcion. The auhors suppose ha governmen has he abiliy o reac when he deb-o- GDP raio exceeds he arge raio, by generaing a primary surplus consisen wih he arge raio. We sar from equaion (3), assuming here is no sock-flow adjusmen. The same equaion can be wrien in lower cases as follow: 1 i b b1 1 n ps (6-bis) 17

18 We define now as ps he primary surplus, insead of he primary balance pb. The auhors add wo addiional equaions in order o define arges on primary surplus and deb and he governmen s reacion funcion: b ps Where b1 (6-bis) n * * * ( 1) b (7) ps ps * ps * ( b b ) (8) i In equaion 7, * and ps * are respecively he discoun facor and he primary surplus ha would prevail once convergence o he arge deb b * is reached. In equaion(8), is a parameer ha indicaes he inensiy of he policy response a ime, namely he deviaion of he observed public deb raio from he arge. From equaions (6-bis)), (7) and (8) we ge he budge consrain ha include he governmen reacion abiliy: b * * ( ) b 1 ( 1) b (9) The auhors assume furhermore ha would converge o of fiscal susainabiliy (IFS): * b, if and only if 1 * b 1 b. This implies, following he equaion (9), ha b. Therefore, hey propose o use as an indicaor IFS * 1 i ps ps ( ) (10) * 1 n b 1 b If IFS 1 fiscal policy is susainable; if IFS 1hen fiscal policy is unsusainable. According o he auhors, one advanage of his indicaor over Blanchard s is ha no esimaions of fuure GDP and ineres raes are required: he indicaor can generae is resuls based on curren, pas, and arge values of relevan variables. Croce and Hugo fix ß * a 1.02 for developed counries and 1.03 for developing counries; his values represen he median of he disribuion of he observed values. However, his value is far 18

19 from being represenaive; able 3 shows he calculaions for Lain American counries ha issue sovereign bonds and whose public deb increased in he period I can be seen ha he value of ß is very dissimilar for differen years and among counries. On average, he observed spread beween ineres raes and he rae of growh was very high, excep for he case of Peru. If we fix a arge value of public deb b* of 25 per cen of GDP for all counries, we can esimae he arge primary surplus, using alernaive values for ß *. Table 3 INDICATOR OF FISCAL SUSTAINABILITY WITH A GOVERNMENT FUNCTION REACTION FOR SELECTED COUNTRIES, ß Argenina Brazil Colombia Ecuador Peru Uruguay Venezuela ß * 1 ps* IFS 1 Argenina Brazil Colombia Ecuador Peru Uruguay Venezuela ß * 2 ps* IFS 2 Argenina Brazil Colombia Ecuador Peru Uruguay Venezuela Source : elaboraion of he auhors. Noes: ß * 1 is he average for for each counry; ß * 2 is he value suggesed by Hugo and Croce (2003). For boh indicaors he arge value of deb is 25%.). We omi o show values when b* = b. When we esimae ß* as he spread beween ineres rae and real growh rae in he period, we can see ha his indicaor is above 1 for all he counries excep for Chile. Criical values are reached by Brazil, Colombia and Venezuela where he spread is 12 poins percen. The IFS shows problems of susainabiliy for mos of he counries in he recen years (excep for Ecuador), which is sill anoher way o confirm ha deb rose. Of course, if he bad financing condiions and he lack of growh of his period are aken ino accoun, he indicaor worsens, and he associaed saionary primary surplus is higher. If on he conrary we assume ha hese 19

20 facors are emporary, he evaluaion of susainabiliy is less severe. For example, in Brazil he effor ha has been made o generae high primary surpluses is well capured by he second indicaor, delivering he counry from he unsusainable condiion. Several observaions can be made o his aemp o inroduce a fiscal reacion funcion, ha ry o encapsulae in one number he complex issue of susainabiliy. Firs, his indicaor only applies when he curren public deb-o-gdp raio is higher han he argeed value, loosening hen generaliy. Anoher deficiency (indeed poined ou by he auhors) is ha he indicaor does no incorporae he effecs of real exchange rae misalignmen on fiscal susainabiliy. Tha would be he case for Argenina for example, where he public deb-o-gdp raio jumped o 134 % following he real exchange depreciaion of December In hese circumsances he IFS falls (before he sudden correcion of he real exchange rae akes place), signaling an improvemen of he fiscal susainabiliy posiion. This is however a big failure of he IFS if we have in mind, as we have poined ou in his paper, ha all Lain American counries suffer from original sin. These caveas apply indeed o al indicaors of fiscal susainabiliy. b) A measure of currency mismach A currency mismach is a siuaion in which he currency denominaion of a counry s or a secor s asses differs from ha of is liabiliies such ha is ne worh is sensiive o changes in he exchange rae. In almos all emerging counries, public deb is labeled in foreign currency, while governmen revenues relies o a large exen on domesic oupu. This siuaion creaes a currency mismach in he public secor balance shee, making fiscal susainabiliy very sensiive o exchange rae movemens. Calvo, Izquierdo and Talvi (2002) analyze he specific case of Argenina and propose a fiscal susainabiliy indicaor ha compares he composiion of deb wih he degree of openness, linking in a very aggregae manner he evoluion of exernal deb wih he capaciy o obain resources from expors. In order o obain a deb-o-gdp raio consan (b ), from equaion (6) we can see ha he primary surplus mus saisfy: (1 i) ps b 1 (11) (1 n) Deb-o-GDP raio can be expressed as: 20

21 b n * B B eb (12) n * Y Y ey Where e is real exchange rae (defined as relaive price beween radable and non-radable goods); B n is deb in erms of non-radables; B* is deb in erms of radables; Y n is oupu in erms of non-radables and Y* is oupu in erms of radables (proxied by expors). The currency mismach n * n * measure is ( B / eb ) /( Y / ey ). Consider he limi cases: eb - If b hen all valuaion effecs ake place on deb only. This is he wors scenario in n Y which real exchange rae depreciaion his fully on susainabiliy. n n - If ( B / eb*) ( Y / ey*) 1, he composiion of deb and oupu is perfecly mached, and real exchange rae depreciaion has no effec on fiscal susainabiliy. In able 4, we calculae for some Lain American counries wo public deb mismach measures (he lower, he worse), only wih exernal deb firs and hen using also domesic deb denominaed in foreign currency o esimae B *. Table 4 PUBLIC DEBT MISMATCH MEASURES, 2002 Argenina Brazil ChileColombia Ecuador El Salvador Mexico Peru Uruguay Venezuela Exernal deb/oal public deb Expors/GDP (%) Public deb mismach, measure Public deb mismach, measure Source: auhors calculaion. Noes: 1/ Public secor deb mismach measure 1 considers only exernal public deb. 2/ Public secor deb mismach measure 2 includes also domesic deb expressed in foreign currency. The indicaor may be inappropriae in dollarized counries like Ecuador and El Salvador, bu i clearly shows high degrees of mismach in Argenina, Brazil, Colombia, Peru, Uruguay and Venezuela. Mos of hese counries exhibi a relaively low degree of openness (when measured by expors in GDP), when compared o heir exernal public deb level. Of course, he public/privae composiion of expors should also maer in his evaluaion of susainabiliy. Neverheless, in recen years many counries are collecing expor axes in primary secors, and royalies in he mining secor, in order o diminish heir own currency mismach. 21

22 Mexico and Chile are in a much beer posiion, when we use he firs mismach indicaor. Wha is he ideal number If he value is one, counries could pay in a year heir exernal obligaions if all he amoun of expors were used o his purpose. Obviously, his would be an implausible siuaion. May be somehing like 0.5 would be an indicaor of currency alignmen, from he public finance poin of view. Of course, public deb mismach measure worsens when we ake ino accoun domesic deb denominaed in dollars 12. In Brazil for example, around 30% of domesic public deb is indexed o he dollar, increasing his way heir currency mismach. An excepion is Mexico where public inernal deb is enirely issued in domesic currency. I appears hus ha he radiional indicaors of susainabiliy are no well suied o address he key issue of currency mismach. 5. An early-warning model Susainabiliy has become a cenral elemen of he work of IMF. As emphasized by Ter- Minassian (2004), his encompasses boh he assessmens of exernal and fiscal susainabiliy and is probabilisic in naure, as he deb dynamics depend on uncerain macroeconomic and fiscal developmens and changes in asse prices. Thus, assessing susainabiliy is analyzing he probabiliy ha deb dynamics become unsable. The emplae can provide upper-bound esimaes of he likely evoluion of he deb sock, bu does no indicae wha level of deb is oo high. Thus, his approach is flexible enough o avoid general conclusions concerning deb hresholds. From a comparaive perspecive, which is he one adoped here, more flexible ways o address his issue han single-number indicaors is o esimae eiher fiscal policy reacion funcions (IMF, 2003) or logi models (Manasse, Roubini and Sachimmelpfenning, MRS, 2003). In he firs case, he primary fiscal balance responds o boh he level of public deb and oher emporary facors, like he business cycle, inflaion and commodiy prices. This approach has he meri o esimae for each counry a primary balance arge, depending on exogenous condiions. A second way o assess fiscal susainabiliy is o esimae an early warning model. Using a panel daa se for 47 marke access counries, he auhors (MRS) esimae a logi model of deb crisis o find criical hresholds, ha depend on many variables. In his secion we will apply he same mehodology for marke access Lain American counries. The discussion behind predicing sovereign deb crises is highly imporan, and i is crucial also o undersand he naure of sovereign deb defaul: 12 In he case of Chile, his indicaor is misleading. The domesic deb of he Treasury is mainly owned by he cenral bank, issued in dollars wih a very long mauriy. 22

23 is i associaed o liquidiy problems or o solvency issues The model proposed here will help o answer his quesion. A counry is defined o be in defaul if i is classified in defaul by Sandard & Poor s or if i receives a disbursemen in he firs year of a large Fund Arrangemen (over 100 percen of quoa). The explanaory variables are divided ino six groups: exernal deb variables, public deb variables, variables from he Fund s currency crisis Early Warning Sysem, oher macroeconomic variables, fiscal variables and poliical variables. Therefore, hey proceed along a hree-sage sraegy: firs, hey regress each variable agains sovereign defaul indicaor; second hey pool he bes performers wihin each group of variables and run he logi regression; and hird hey combine he bes performers from each group in a general model. In formal erms, he probabiliy of being in deb crises, in year is given by: P f (( 1 SCI 1 )* X 1; SCI 1 * X 1) (13) Where SCI denoes he sovereign deb crisis indicaor and X denoes he vecor of explanaory variables. The firs argumen corresponds o he probabiliy of enering ino a crisis in (given ha he counry was no in crisis in -1), and he second argumen corresponds o he probabiliy of being in crisis, or in oher words no exiing from crisis in (given ha he counry was in crisis in -1). Table 5 summarizes he deb crisis episodes for he welve emerging marke access counries in Lain America, heir number and heir average lengh for each counry. In he daabase here are 25 crisis episodes during he period Table 6 shows means of some of he variables ha will be used in he regression esimaes, during crisis and non-crisis episodes, for he period, for 12 counries. 23

24 Table 5 COUNTRIES AND DEBT CRISIS YEARS IN THE DATABASE ( ) Number of crisis Average lengh (years) Years in crisis Crisis episodes Argenina , , Brazil , , Chile Colombia Dominican Republic , Ecuador , El Salvador Mexico , Panama Peru , , Uruguay , , Venezuela , , Source : auhors calculaion. Table 6 MEANS OF VARIABLES IN THE DATABASE ( ) All Non-crisis Crisis Number of observaions Fiscal variables Toal Public Deb/GDP ( ) Deb ineres paymens on oal public deb / GDP Shor erm deb / GDP Shor erm ineres /GDP Primary balance / GDP Exernal variables Exernal public deb / GDP Curren accoun balance / GDP Financial accoun balance / GDP Foreign Direc Invesmen (ne inflows) / GDP Reserves / GDP Ineres on exernal deb / GDP Ineres on exernal deb / XGS Oher variables Openness / GDP Real growh GDP (%) Inflaion (%) Source : auhors calculaion. As i can be observed, he mean of he exernal public deb-o-gdp raio is 42.1%, when counries are in crisis; his raio is 25.4% in normal circumsances. Exernal liquidiy variables, like shor-erm public deb, he curren accoun balance, he financial accoun balance and he foreign direc invesmen (inflows), measured as percenage of GDP, are significanly differen when counries are in crisis. For insance, he Financial Accoun balance represens 3.7% of GDP 24

25 during normal periods and -1.8% of GDP during crisis. These numbers illusrae he episodes of sudden sop of capial flows. Referring o fiscal variables, i can be seen ha all he relevan variables have he expeced differences: deb ineres paymens and shor-erm deb are higher in crisis episodes. By conras, primary balances are higher during crisis, showing he pro-cyclical adjusmen effors of Lain American cenral governmens. Table 7 shows he resuls of he regression, using he logi approach wih a robus variance esimaor. The coefficiens have he expeced signs, and z-values are significan a a 5% level. The calculaed marginal effecs show ha liquidiy variables, such as he financial accoun balance, he ineres deb paymens o GDP raio and inernaional reserves, are higher han solvency variables, like oal exernal deb o GDP raio. Trade openness and real growh also maers; he former encapsulae he effecs of currency mismach, while he laer reveal he imporance of he snowball effec in crisis episodes. Table 7 REGRESSIONS RESULTS: COEFFICIENT ESTIMATES (Dependen variable: deb crisis indicaor) Marginal effec Logi coefficien z-value Exernal public deb / GDP Financial accoun balance / GDP Inernaional Reserves / GDP Shor erm deb / GDP _ Public Deb ineres paymens / GDP Openness / GDP Real growh GDP (%) _ Consan Lagged crisis indicaor Source : auhors calculaion. Noes: 1/ Logi regression wih robus variance esimaes, allowing for counry-specific variances (Huber Whie sandwich esimaor). 2/ Marginal effecs calculaed a sample means for each variable. For he crisis indicaor (dummy variable) marginal effec has been calculaed for change from 0 o 1. Finally, he model performance is summarized in able 8. Our logi model prediced he majoriy of deb crises enries, while sending no false alarm. The performance of he model could be improved significanly if daa were in a quarerly frequency, which would allow more deb crisis enries. 25