External debt sustainability and development

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1 External debt sustainability and development Definitions: Debt: Amount of money borrowed by one party from another. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest. External Debt: Also known as foreign debt. Is that part of the total debt in a country that is owed to creditors outside the country. The debtors can be the government, corporations or private households. The Guide defines gross external debt as follows: Gross external debt, at any given time, is the outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy Sustainability: Is the capacity to endure. For humans, sustainability is the long-term maintenance of responsibility, which has environmental, economic, and social dimensions, and encompasses the concept of stewardship, the responsible management of resource use. Fiscal Policy: Is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy. IMF: International Monetary Fund What is External Debt Sustainability: Sustainable debt is the level of debt which allows a debtor country to meet its current and future debt service obligations in full, without recourse to further debt relief or rescheduling, avoiding accumulation of arrears, while allowing an acceptable level of economic growth. External-debt-sustainability analysis is generally conducted in the context of medium-term scenarios. These scenarios are numerical evaluations that take account of expectations of the behavior of economic variables and other factors to determine the conditions under which debt and other indicators would stabilize at reasonable levels, the major risks to the economy, and the need and scope for policy adjustment. In these analysis, macroeconomic uncertainties, such as the outlook for the current account, and policy uncertainties, such as for fiscal policy, tend to dominate the medium-term outlook. World Bank and IMF hold that "a country can be said to achieve external debt sustainability if it can meet its current and future external debt service obligations in full,

2 without recourse to debt rescheduling or the accumulation of arrears and without compromising growth". According to these two institutions, "bringing the next present value (NPV) of external public debt down to about 150 percent of a country's exports or 250 percent of a country's revenues" would help eliminating this "critical barrier to longer-term debt sustainability". High external debt is believed to have harmful effects on an economy. To qualify as external debt, the debt liabilities must be owed by a resident to a nonresident. Residence is determined by where the debtor and creditor have their centers of economic interest typically, where they are ordinarily located and not by their nationality. The definition of external debt does not distinguish between whether the payments that are required are principal or interest, or both. Indicators of external debt sustainability There are various indicators for determining a sustainable level of external debt. While each has its own advantage and peculiarity to deal with particular situations, there is no unanimous opinion amongst economists as to one sole indicator. These indicators are primarily in the nature of ratios i.e. comparison between two heads and the relation thereon and thus facilitate the policy makers in their external debt management exercise. These indicators can be thought of as measures of the country s solvency in that they consider the stock of debt at certain time in relation to the country s ability to generate resources to repay the outstanding balance. Examples of debt burden indicators include the (a)debt to GDP ratio (b) Foreign debt to exports ratio (c) Government debt to current fiscal revenue ratio etc. This set of indicators also covers the structure of the outstanding debt including the (d) Share of foreign debt (e) Short-term debt (f) Concessional debt in the total debt stock. A second set of indicators focuses on the short-term liquidity requirements of the country with respect to its debt service obligations. These indicators are not only useful earlywarning signs of debt service problems, but also highlight the impact of the inter-temporal trade-offs arising from past borrowing decisions. Examples of liquidity monitoring indicators include the (a) Debt service to GDP ratio (b) Foreign debt service to exports ratio (c) Government debt service to current fiscal revenue ratio etc. The final indicators are more forward looking as they point out how the debt burden will evolve over time, given the current stock of data and average interest rate. The dynamic ratios show how the debt burden ratios would change in the absence of repayments or new disbursements,

3 indicating the stability of the debt burden. An example of a dynamic ratio is the ratio of the average interest rate on outstanding debt to the growth rate of nominal GDP. List of 20 countries by external debt: United States of America European Union United Kingdom Germany France Japan Ireland Netherlands Italy Spain Luxembourg Belgium Switzerland Australia Canada Sweden Austria Hong Kong Norway China Denmark Greece

4 External Debt and Development There are at least three good reasons for developing country Governments to borrow abroad: (i) The economic return on public investment in developing countries is superior to the cost of borrowed capital so that growth can be accelerated by prudent use of debt without excessively reducing current consumption levels; (ii) Domestic firms (particularly small and medium enterprises) cannot easily borrow abroad and terms are better for sovereign borrowers so that it is efficient for the Government to use debt for on lending to productive sectors, particularly exports; (iii) The externalities from public investment in infrastructure, health, education, etc. Are large and positive but cannot generally be captured in returns to foreign direct investors. External debt has to be repaid in foreign exchange, so that trade plays a critical role. The relationship between external borrowing and trade is the key to a successful external debt strategy, as external indebtedness cannot be sustainable in the long run if the development strategy does not lead to an increase in foreign exchange earnings above import requirements sufficient to repay the debt. The point of departure of a sustainable debt strategy is, therefore, a clear vision by the Government of the country s development trajectory and its relation to its trade potential. Relevant UN documents

5 Debt-Sust.pdf Recommended Readings: