FINANCIAL STABILITY AND DEBT MANAGEMENT Yilmaz Akyüz

Financial Liberalization and Public Debt • Shift from money printing to indirect financing • Interest rate deregulation • Capital account liberalization • EMs public debt now around 60% of GDP • External debt stable/falling, domestic debt rising.

Debt Management and Sustainability Now dominates all other fiscal objectives Constrains macroeconomic management Promotes pro-cyclical fiscal policy Distorts income distribution

Mechanics of Sustainability • Theoretical notion of solvency over infinite horizon is pretty useless in practice. • Debt projections and stress tests are very crude. • They fail to account for endogeneities and feedbacks among debt, fiscal policy, interest rates, exchange rates, growth etc.

SOVEREIGN DEBT SUSTAINABILITY d = (D + ε E*)/Y (1) dt = dt-1 [(1 + rt )/(1 + gt )] – Pt (2) r = β ρ + (1− β) ρ* (3) (1 + i*) (1 + έ) ρ* = ───── − 1 (1+ π) (4) P ≥ [(r – g)/(1 + g)] d (5)

BOP and Public Debt Sustainability • Treacherous link between external finance and public debt. • Circumstances may develop wherein there can be a trade-off between external sustainability and public debt sustainability: – public debt improves while the CA is driven into an unsustainable position. – conversely, external adjustment creates serious problems for debt management.

Capital surges and currency appreciations make debt managers happy because they: • lower the average real interest rate; • lower the debt ratio, particularly when forex debt is large relative to traded goods sectors; • push growth above its potential. • 3% depreciation has the same effect on debt ratio as 300 bp rise in interest rate or 1 % fall in growth (Brazil).

But they can also worsen external position • The external debt ratio may fall because of appreciations and surges in non-debt creating inflows (FDI). • However, net external asset position and CA deteriorate, creating fragility and vulnerability to shocks. • Governments and IFIs ignore external fragility because they are driven by market forces (free capital flows and floating). • They focus on dual targeting: inflation and primary surplus.

Recent Trends • Such “unusually favourable combination of circumstances” (IMF) have improved public debt position in EMs in recent years • The debt ratio fell from 68% to 60%. • Appreciations alone accounted for 5 points of this. Likely much more in TR.

Taking Long-View • Extrapolating such conditions in decisions regarding debt management is highly risky. • About 85 % of EM defaults during 1970 -2000 were linked with currency crises. • Timing of currency crises difficult to predict even when fragility is visible. Models are useless outside their sample periods. • Rating agencies are no good for predicting currency crises, but pretty good in predicting defaults, because they lower ratings after crises.

Vulnerability to BOP Crises • Lawson doctrine (that BOP deficits do not matter as long as the budget is in balance) is now discredited (East Asia). • With liability dollarization, fiscal sustainability is also vulnerable to BOP shocks even if the budget is in balance (as in TR today).

Crisis response and debt sustainability • Inflation targeting and hikes in interest rates make life difficult for debt managers. • Higher rates can signal rising risks and even lower risk-adjusted return on government paper. • Socialization of private debt (Indonesia 50%). • Recessions aggravate debt positions.

Safe Debt Ratio? • The threshold above which a country becomes vulnerable to shocks that may threaten sustainability. • Varies among countries, but 25% is regarded as safe. • More than half of sovereign debt crises occurred at ratios below 40% and two-thirds below 60%. • Current ratios in EMs are much higher, even without accounting for unrecognized debt (skeletons). • Fund’s assessments of sustainability are very optimistic; they invariably show declines in D/Y (on average by 12 points over 5 years).

Social and political Limits to Primary Surplus • Argentina could not produce 1. 5% but TR 6. 5%. • TR needs such a high PS under highly favourable external conditions and IMF/EU anchors. More would be needed if there is a sharp external correction. Is such a rate of PS socially and politically sustainable? • UN defines sustainability as “the level of debt that allows a country to achieve the MDGs without an increase in debt ratios. ” Thus, if the level of debt does not allow these objectives, it should be reduced.

Acting on the Stock of Debt • Public debt in many EMs has become a main conduit of redistribution from the poor to the rich. • Taxation is generally regressive. Public spending is normally expected to rectify that, but now it has also become regressive. • Not only that this situation may not be tolerated forever, but it should not be sustained (Keynes). • But governments are averse to orderly debt workoutsnationally or internationally (SDRM). Messy defaults, as in Argentina, may become unavoidable.

KEYNES ON DEBT AND INFLATION (1) The active and working elements in no community, ancient or modern, will consent to hand over to the rentier or bond-holding class more than a certain proportion of the fruits of their work. When the piled-up debt demands more than a tolerable proportion, relief has usually been sought in one or other of two out of the three possible methods. The first is repudiation. But except as the accompaniment of revolution, this method is too crude, too deliberate, and too obvious in its incidence. The victims are immediately aware and cry out too loud; so that, in the absence of revolution, this solution may be ruled out at present, as regards internal debt, in Western Europe.

KEYNES ON DEBT AND INFLATION (2) The second method is currency depreciation. . . The owners of small savings suffer quietly, as experience shows, these enormous depredations, when they would have thrown down a Government which had taken from the a fraction of the amount by more deliberate but juster instruments. . . It follows the line of least resistance, and responsibility cannot be brought home to individuals. It is, so to speak, nature’s remedy, which comes into silent operation when the body politic has shrunk from curing itself. The remaining, the scientific, expedient, the capital levy, has never yet been tried on a large scale; and perhaps it never will be. It is the rational, the deliberate method. But it is difficult to explain, and it provokes violent prejudice by coming into conflict with the deep instincts by which the love of money protects itself. . . Once currency depreciation has done its work, I should not advocate the unwise, and probably impracticable, policy of retracing the path with the aid of a capital levy. But if it has become clear that the claims of the bond-holder are more than the taxpayer can support, and if there is still time to choose between the policies of a levy and of further depreciation, the levy must surely be preferred on grounds both of expediency and of justice.

KEYNES ON DEBT AND INFLATION (3) There is a respectable and influential body of opinion which, repudiating with vehemence the adoption of either expedient, fulminates alike against devaluations and levies, on the ground that they infringe the untouchable sacredness of contract; or rather of vested interest. . . Yet such persons, by overlooking one of the greatest of all social principles, namely the fundamental distinction between the right of the individual to repudiate contract and the right of the State to control vested interest, are the worst enemies of what they seek to preserve. For nothing can preserve the integrity of contract between individuals, except a discretionary authority in the State to revise what has become intolerable. The powers of uninterrupted usury are too great. If the accretions of vested interest were to grow without mitigation for many generations, half the population would be no better than slaves to the other half.

KEYNES ON DEBT AND INFLATION (4) These conclusions might be deemed obvious if experience did not show that many conservative bankers regard it as more consonant with their cloth, and also as economising thought, to shift public discussion of financial topics off the logical on to an alleged moral plane, which means a realm of thought where vested interest can be triumphant over the common good without further debate. But it makes them untrustworthy guides in a perilous age of transition. When. . . we enter the realm of State action, everything is to be considered and weighed on its merits. Changes in death duties, income tax, land tenure, licensing, game laws, church establishment, feudal rights, slavery, and so on through all ages, have received the same denunciations from the absolutists of contract, who are the real parents of revolution