External debt

and
sustainability

Mihai Copaciu

Outline

External debt External debt and sustainability

CA/debt
sustainability
Definition
Determinants
Main indicators Mihai Copaciu
IMF
methodology -
in detail

Materials
December 15, 2010
External debt
and
sustainability

Mihai Copaciu 1 External debt

Outline

External debt 2 CA/debt sustainability

CA/debt
sustainability
Definition
Definition
Determinants
Determinants
Main indicators Main indicators
IMF
methodology -
in detail

Materials
3 IMF methodology - in detail

4 Materials
 Definition

External debt
and
sustainability

Mihai Copaciu

Outline
Gross External Debt, at any given time, is the outstanding
External debt
amount of those actual current, and not contingent, liabilities
CA/debt that require payment(s) of principal and/or interest by the
sustainability
Definition
debtor at some point(s) in the future and that are owed to
Determinants
Main indicators
nonresidents by residents of an economy.
IMF
methodology - VIP!!!: You will see references also to Total Gross External
in detail
Debt.
Materials
Total Gross External Debt = Gross external debt + Direct
investment intercompany lending.
 More on definition

External debt
and
sustainability Gross debt is defined in terms of liabilities. A concept of net
Mihai Copaciu debt can be derived by subtracting the stock of external assets
Outline
from gross liabilities. Although such a notion might be useful
in countries that are both debtors and creditors (ex. Russia),
External debt
there are a number of practical difficulties in defining net debt:
CA/debt
sustainability
Definition
it is unclear which assets should offset liabilities for example,
Determinants
Main indicators
should only official assets be used, or should bank and nonbank
IMF
assets also be included;
methodology -
in detail a net debt total would mask important differences in the
Materials maturity structure, currency composition, and risk features of
liabilities and assets;
linking debt servicing to net debt may disguise the seriousness
of a country’s debt problem if assets broadly offset liabilities.
External debt
and
sustainability
Dt = Dt-1 + Bt - At, where:
Mihai Copaciu
Dt: Stock of the outstanding debt at the end of a given period;
Outline Dt-1: Stock of the outstanding debt at the end of the previuos
External debt period;
CA/debt Bt: Disbursements of new loans (the placing of financial resources at
sustainability
Definition the disposal of a borrower) during time period t;
Determinants
Main indicators At: Amortization of debt (repayment of principal) during period t.
IMF
methodology -
in detail Basically this law of motion provides the connection between the gross
external debt and the debt creating flows from the capital and financial
Materials
accounts from the BOP. Please take into account that the interest
component is found in the current account (under Incomes balance,
debits).
 Why the earlier formula is just an approximation

External debt
and
sustainability

Mihai Copaciu

debt stocks are subject to valuation adjustments owing to

Outline

External debt
the fact that debt is contracted in various currencies. The
CA/debt
stock of debt, measured (for example) in euros, may
sustainability change because the value of debt denominated in another
Definition
Determinants
Main indicators
currency (such as dollars), changes in euro terms when the
IMF euro depreciates or appreciates against that currency;
methodology -
in detail Interest is sometimes capitalized, adding to the stock of
Materials debt any unpaid interest obligations (interest arrears);
Outstanding debt is sometimes canceled or written off.
 Look at:

External debt
and
sustainability
maturity structure
Mihai Copaciu short term: original maturity of less than 1 year;
medium term: original maturity between 1-5 years;
Outline
long term: original maturity greater than 5 years;
External debt

CA/debt
sectors
sustainability public: general government, monetary authority and
Definition
Determinants eventually public owned commercial banks;
Main indicators
private: private banks and non-banking sectors;
IMF
methodology -
in detail
types of instruments: loans, currency and deposits, bonds,
Materials trade credits, etc.
original versus residual maturity;
publicly guaranteed or not;
foreign and domestic currencies;
interest rate type, etc.
 What is meant by intertemporal solvency, liquidity
and sustainability?
External debt
and
sustainability
Intertemporal solvency
Mihai Copaciu
Implies that the present discounted value of future primary current account
balances (=current account excluding interest payments) is sufficient to
Outline
repay the accumulated debt (strong condition) or maintain debt-to-GDP
External debt ratio constant (weak condition);
CA/debt if a country is a net debtor it must run primary current account surpluses
sustainability (in case of strong condition);
Definition
Determinants
requires forecasting of future current account balances and assumptions
Main indicators about future policies.
IMF
methodology -
in detail
Liquidity
Materials
ability to meet or roll over the maturing obligations;
Sustainability

solvency+liquidity+no expectation of unrealistically large

adjustment.
 Main determinants affecting CA/debt sustainability

External debt
and
sustainability

Mihai Copaciu Economic growth

Outline Is GDP growth rate above the world interest rate?
External debt Investment-Saving gap
CA/debt
sustainability Is CA deficit caused mainly by lower savings or higher
Definition
Determinants investment?
Main indicators

IMF
Openess and trade pattern
methodology -
in detail large size and diversification of exports sector strenghten
Materials sustainability;
outward-oriented trade policy and a well diversified export
sector can deal easier with external shocks;
 Main determinants affecting CA/debt sustainability

External debt
and
Size and composition of external liabilities
sustainability
Maturity structure and currency composition of external
Mihai Copaciu
liabilities are relevant to the risk of suffering a liquidity
Outline crisis;
External debt
Financial structure
CA/debt
sustainability Financial sector weaknesses undermine sustainability (e.g.
Definition
Determinants Asian crisis, current crisis);
Main indicators

IMF missmatch between assets and liabilities denominated in

methodology -
in detail foreign currency increase vulnerability to external shocks;
Materials Other factors
political instability and uncertainty;
policy credibility;
market expectations;
contagion;
 Main determinants affecting CA/debt sustainability

External debt
and
sustainability

Mihai Copaciu

Outline
Exchange rate and monetary policy
External debt

CA/debt
Fiscal policy
sustainability
Definition countercyclical policy is recommended;
Determinants
Main indicators Capital flows
IMF
methodology - excessive capital inflows, resulting in excess domestic
in detail
demand, inflation in nontradables, loss of monetary
Materials
control and real exchange rate appreciation;
 Main indicators to assess vulnerability/sustainability

External debt
and
sustainability

Mihai Copaciu

Outline

External debt
CA/GDP;
CA/debt FDI/GDP and FDI/CA;
sustainability
Definition REER;
Determinants
Main indicators GDP growth;
IMF
methodology -
public deficit;
in detail
CDS spreads (credit default swaps spreads);
Materials
 Main indicators to assess vulnerability/sustainability

External debt
and
sustainability

Mihai Copaciu
external debt/GDP (NPV and current);
Outline external debt/exports (NPV and current);
External debt
short term debt (remaining maturity)/reserves;
CA/debt
sustainability interest payments/GDP, interest payment/exports;
Definition
Determinants external debt service payment/reserves;
Main indicators

IMF
external debt service payment/exports;
methodology -
in detail reserves/imports, reserves in months of imports;
Materials reserves/short term debt by remaining maturity;
maturity structure of liabilities, public versus private, guaranteed
versus not guaranteed;
 What are CDS?

External debt
and
sustainability

Mihai Copaciu A credit default swap (CDS) is a swap contract in which the buyer of the
CDS makes a series of payments to the seller and, in exchange, receives a
Outline payoff if a credit instrument (typically a bond or loan) goes into default
External debt (fails to pay).
CA/debt
sustainability
The (premium) spread of a CDS is the annual amount the protection buyer
Definition must pay the protection seller over the length of the contract, expressed as
Determinants
Main indicators
a percentage of the notional amount.
IMF
methodology - For example, if the CDS spread of Romania is 50 basis points, or 0.5% (1
in detail
basis point = 0.01%), then an investor buying 10 millions USD worth of
Materials
protection from AAA-Bank must pay the bank 50,000 USD per year.
These payments continue until either the CDS contract expires or Romania
defaults (adapted from http://en.wikipedia.org/wiki/Credit default swap).
 More on CDS spreads

External debt
and
sustainability

Mihai Copaciu CDS spreads depends on the expected default risk of the respective
country and thus are an indicator of the market’s current perception
Outline
of sovereign risk.
External debt
CDS spreads also depend on the global financial environment like
CA/debt
sustainability global risk appetite.
Definition
Determinants Spreads derived from the CDS market are more reliable during
Main indicators
sovereign debt crises since, while the bond market liquidity decreases
IMF
methodology -
during a crisis, the demand for insurance against the default risk
in detail increases for the troubled countries.
Materials
Very interesting paper: Euro-area sovereign risk during the crisis, Silvia
Sgherri, Edda Zoli.
Summary available at: http://www.voxeu.org/index.php?q=node/4217
 More on CDS spreads

External debt
and
sustainability

Mihai Copaciu

Outline

External debt

CA/debt
sustainability
Definition
Determinants
Main indicators

IMF
methodology -
in detail

Materials

Source: Bloomberg
 Which values are considered dangerous?

External debt
and
sustainability

Mihai Copaciu

One way: take some benchmark values used by others/implied

Outline

External debt
by the ratio itself.Some examples:
CA/debt
sustainability
CA/GDP ≥ 5%;
Definition
Determinants
short term debt(remaining maturity) / reserves≥ 1;
Main indicators

IMF
reserves in months of imports≤ 3;
methodology -
in detail

Materials Give special attention to the dynamics and to the direction of

change.
 Which values are considered dangerous?

External debt
and
Another way: look at some values for leading indicators in
sustainability different time periods and get info on the current stance.
Mihai Copaciu Let’s see an example from Manasse and Roubini (2005).
Outline

External debt

CA/debt
sustainability
Definition
Determinants
Main indicators

IMF
methodology -
in detail

Materials
 Let’s look at the IMF methodology

External debt
and
sustainability
CABt+1 + KABt+1 + FABt+1 + NEOt+1 = 0
Mihai Copaciu
You can rewrite this (why?) as:
Outline
CABt+1 + NDCFt+1 + NNDCFt+1 + ∆Rt+1 + NEOt+1 = 0
External debt
∗
CA/debt CABt+1 − rt+1 × Dt + NDCFt+1 + NNDCFt+1 + ∆Rt+1 + NEOt+1 = 0
sustainability ∗
Definition NDCFt+1 = −CABt+1 + rt+1 × Dt − NNDCFt+1 − ∆Rt+1 − NEOt+1
Determinants ∗
Main indicators NDCFt+1 = −CABt+1 + rt+1 × Dt − NNDCFt+1 + RESt+1
IMF
methodology - where:
in detail CAB - current account balance; KAB - capital account balance;FAB - financial account balance;
Materials NEO - net errors and ommisions;
r - nominal effective interest rate on external debt;
D - stock of external debt;
NDCF - net debt creating flows;
NNDCF - net non-debt creating flows;
NEO - net errors and omissions;
∆R − change in the foreign reserve assets and other assets held by residents abroad;
RES = -∆R − NEO;
 Let’s look at the IMF methodology

External debt
and
sustainability

Mihai Copaciu
We assume that all variables are in USD. The debt accumulation equation
Outline you had earlier in the slides can be written as:
External debt
Dt+1 − Dt = Bt+1 − At+1 = NDCFt+1
CA/debt
sustainability
Definition Now, replace the expression for NDCFt+1 with the one derived on the
Determinants
Main indicators
previous slide:
IMF ∗
methodology - Dt+1 − Dt = −CABt+1 + rt+1 × Dt − NNDCFt+1 + RESt+1
in detail
Now, divide everything with nominal GDPt+1:
Materials
∗
Dt+1 Dt CABt+1 NNDCFt+1 RESt+1
= (1 + rt+1 ) × − − +
GDPt+1 GDPt+1 GDPt+1 GDPt+1 GDPt+1
 Let’s look at the IMF methodology

External debt
and
sustainability

Mihai Copaciu
You can rewrite the last equation as (lower case shows ratios in GDP):
Outline
(1 + rt+1 ) ∗
External debt dt+1 = × dt − cabt+1 − nndcft+1 + rest+1
(1 + gt+1 ) × (1 + ρt+1 )
CA/debt
sustainability
Definition
The change in debt debt is:
Determinants  
Main indicators (1 + rt+1 ) ∗
dt+1 − dt = − 1 × dt − cabt+1 − nndcft+1 + rest+1
IMF (1 + gt+1 ) × (1 + ρt+1 )
methodology -
in detail
where:
Materials
g - real GDP growth rate;
ρ − change in domestic GDP deflator in USD terms
 A note on the nominal effective interest rate

External debt
and
sustainability
Let’s assume that:
Mihai Copaciu you still want to have your debt expressed in USD terms;
you have foreign debt issued on dollars and national currency.
Outline
Then, the nominal effective interest rate for the USD denominated debt is:
External debt
domestic foreign
CA/debt 1 + rt+1 = α × (1 + rt+1 ) × (1 + ∆et+1 ) + (1 − α) × (1 + rt+1 )
sustainability
Definition where:
Determinants
Main indicators
∆e − change in the nominal exchange rate . + shows an
IMF
methodology - appreciation of the domestic currency against the dollar ;
in detail
e ×D domestic
Materials
α = t Dt t − share of foreign debt issued in domestic currency
(and expressed in dollars) in total external debt (in USD );
foreign
D
1-α = tDt − share of foreign debt issued in USD
in total external debt (in USD);
rforeign , r domestic − interest rates on foreing and domestic denominated
foreign debt .
 Now, let us analyse this. You have it also on the
Yahoo group/email (IMF aggrement)
External debt
and
sustainability

Mihai Copaciu

Outline

External debt

CA/debt
sustainability
Definition
Determinants
Main indicators

IMF
methodology -
in detail

Materials
 NBR-Debt data: www.bnro.ro - BNR - Comunicate
de presă - Tipuri de comunicate - Balanţa de Plăţi
External debt
and
sustainability

Mihai Copaciu

Outline

External debt

CA/debt
sustainability
Definition
Determinants
Main indicators

IMF
methodology -
in detail

Materials
 Materials

External debt
and
sustainability

Mihai Copaciu

Outline

External debt

CA/debt On the Yahoo group/email you have:

sustainability
Definition This presentation;
Determinants
Main indicators
The first(sept. 2009) and the last (sept. 2010) reviews of
IMF
the IMF Stand-By Agreement with Romania;
methodology -
in detail

Materials