Descriptive Function

As a descriptive measure, external debt indicators reflect the evolution of the terms, structure, and scale of past borrowing. These indicators may be used in cross-country and intertemporal analyses to gauge debt capacity and to assess the development of external debt situations.

Intercountry analysis employing the most commonly utilized indicators ³³ suffers from some general conceptual difficulties. In the long run, and under certain conditions (discussed below), these indicators should reach a constant level, but this theoretical level may vary from country to country depending on underlying economic conditions, including the initial savings gap, productivity of investment, marginal and average savings rates, and loan terms. Comparisons of countries’ external debt situations based on debt ratios require adjustments for differences in these parameters. As developing countries generally have not reached this long-run position, cross-country comparisons also need to be adjusted for the length of time during which external debt has been accumulating, since debtors at different stages of the process have different ratios. A country that has been borrowing for a longer period would have higher debt ratios, and these higher ratios may signify only that fact.

A further complication is introduced by the effect of past changes in the global inflation rate. Inflation, by itself, will alter the commonly used ratios, and the extent to which they are changed is dependent on the proportion of variable interest rate loans in total outstanding external debt, the average maturity for both fixed and variable interest rate loans, and the average interest rate on fixed interest rate loans.

The use of debt indicators for intertemporal analysis also has certain drawbacks. The indicators generally rise in the initial stages of investment and external debt accumulation, with the rate of increase depending on the underlying economic situation. Under stable conditions, however, debt ratios would reach a maximum, which implies that their rate of increase declines, but the rate of deceleration varies from country to country. The proper use of the indicators thus requires knowledge of the debt accumulation path for a country, including the stage the country has reached along that path.

Changing economic conditions, such as changes in the terms of trade or the inflation rate, will alter the external debt accumulation process, thereby affecting both the level of the debt indicators as well as their future path. For example, a deterioration in the current account of the balance of payments, aside from producing higher long-term levels for certain indicators (e.g., external debt to GDP, debt service to export earnings), would result in a more rapid near-term rise in these indicators. The reason for this is that, in its impact on the debt situation, such a change is equivalent to adding new debt flows to the ongoing debt accumulation process.

The conceptual ambiguities cited make intertemporal and intercountry comparisons, utilizing external debt indicators, difficult to interpret. These uncertainties may be reduced by careful study of the individual economic situations. In an appraisal of a country’s current external debt position based on a wide range of economic data and analysis, debt indicators would have important descriptive meaning. Without this comprehensive review, however, it would be difficult to disentangle the various factors influencing an economy and its debt indicators.

Predictive Function

The theoretical difficulties in defining a high value for an indicator also affects the predictive value of these indicators. Moreover, past values of these indicators, particularly debt service, may not accurately reflect future values for a variety of reasons, such as bunching of maturities or changes in market interest rates. Notwithstanding these limitations, external debt indicators have frequently been used to determine whether a country is approaching a possible debt servicing problem. Often, simple criteria, or rules of thumb, for various debt indicators have been used. In addition, sophisticated statistical techniques employing a wide range of indicators have been utilized to predict the probability of debt servicing problems. Even with the refinement of such techniques, however, countries were often misclassified; countries that did not experience default were classified as having done so, and countries that did renegotiate their external debt were not so classified.³⁴ This points out the need to temper assessments based on indicators with judgments gained from a comprehensive study of the economy; and such an evaluation can most appropriately be made in medium-term projections of the entire balance of payments and likely conditions in foreign capital markets.

Data Considerations

The usefulness of external debt indicators is diminished by certain statistical difficulties, including coverage and definitional problems (these shortcomings are discussed in Section II, above, pages 3–4). Data on debt service payments are subject to the same statistical qualifications as external debt data. In addition, debt service payments, as reported by the World Bank and the OECD, represent actual payments rather than scheduled payments; actual payments may be less than scheduled payments (e.g., because of accumulation of arrears related to debt service). In such cases, the cost to the economy of servicing the debt is measured by the actual debt service payments, but the real magnitude of the external debt problem may be understated; in some cases this has been by as much as one third. An external debt problem can also be overstated if a country makes early voluntary repayment of loans. An improved balance of payments position and increased access to international capital markets on relatively favorable terms may enable a country to refinance a portion of its outstanding external debt. This may produce a substantial jump in debt service.

Data limitations also affect the usefulness of debt indicators in their predictive function. Even if detailed statistical information on the terms of individual loans were available, estimating future debt ratios is complicated by the need to predict, possibly over several years, the future course of interest rates in international capital markets, exchange rates, export earnings, or GDP, as well as the level, composition, and terms of future borrowing. This is especially true for predicting debt service ratios, because debtors, in an effort to reduce debt service costs, have borrowed in a variety of currencies and at various interest rates,³⁵ which further compounds the problem.

Debt Service Ratio

This ratio is defined as debt service payments—interest and principal—divided by GDP or export earnings of goods and services. Private transfers, such as workers’ remittances, should also be included, since these receipts are an important source of foreign exchange in some countries. The ratio to export earnings is more frequently used and, consequently, the discussion focuses on it. The debt service ratio can be interpreted as indicating the proportion of a country’s annual exports of goods and services that would be absorbed by debt service payments and thus is a measure of the debt burden. The indicator also provides a liquidity measure analogous to cash flow indicators for a firm. According to this interpretation, a debtor’s ability to cover debt servicing obligations declines as the ratio increases.

A country rarely must service its external debt obligations wholly from current export earnings; rather, in normal circumstances, when creditor confidence is maintained, a large part of scheduled principal payments is “rolled over” by new gross foreign borrowing. The principal value of this indicator is as an index of short-run rigidity in a country’s balance of payments; the higher the ratio, the greater the external adjustment required to compensate for adverse balance of payments developments. A rule of thumb in use is that a debt service ratio below 10 per cent is acceptable whereas a ratio above 20 per cent is potentially dangerous. Generally, it is cautioned that this ratio must be analyzed in conjunction with other factors, such as growth and composition of exports and imports; otherwise, the results may be misleading. The crucial importance of this caveat is apparent when one notes that many countries have had ratios of between 20 per cent and 70 per cent at various times without encountering serious debt servicing problems, while other countries had ratios well below 20 per cent when they had to renegotiate their external debt.

To make meaningful judgments about a country’s debt position, additional data must be considered: (1) the extent to which a country obtains its export earnings from a few commodities or small number of sources; (2) the historical and prospective trends of export prices and volumes; (3) the variability in export prices and volumes around their trends, which is related to (1); (4) the level of international reserves and secondary reserves in relation to imports; and (5) the degree to which demand management can, in the short run, adjust the balance of payments without unacceptable effects on the domestic economy, which is, inter alia, related to the degree to which nonessential imports can be compressed.

Ratio of Amortization Payments to Disbursements

The ratio of amortization payments to loan disbursements provides a measure of the extent to which a country’s external debt is “rolled over.” ³⁶ Under normal circumstances, the amortization component of debt service payments may be expected to be largely refinanced or rolled over from year to year and thus does not represent an immediate burden on the economy of the debtor country.³⁷ A value of unity for the ratio implies that disbursements are just covering amortization payments and outstanding external debt is not growing. As external debt accumulates, this ratio is less than one and is generally smallest in the initial stages of borrowing. It rises to a constant value, which is less than one, as the long-run ratio of external debt to GDP is reached ³⁸ and, like the debt service ratio, varies from country to country, since the underlying economic parameters differ and also can change for a given debtor over time. As a consequence, comparisons utilizing this measure are difficult. While this ratio is expected to rise over time, sharp increases may indicate either bunching of maturities or a less favorable access to international capital markets.

Ratio of Interest Payments to GDP or Export Earnings

The ratio of annual interest payments to GDP (or export earnings) can be a useful index of the relative magnitude of the burden of external debt. In theory, a high level or rapid increase in this measure would indicate the emergence of excessive consumption and/or problems with the productivity or efficiency of investment. Foreign resources may have been directed to consumption rather than investment, and/or the contribution to expanded GDP and exports of a country’s investment program may be low relative to the cost of foreign financing. However, such a conclusion cannot be drawn without additional information concerning the stage of growth and characteristics of the growth path of a country, since the external debt accumulation process predicts that this ratio will rise. The speed at which it rises and its ultimate level varies from country to country, depending on the proportion of foreign financing of investment, the incremental output/ capital ratio, the cost of foreign financing, and the extent to which the marginal savings rate exceeds the average savings rate in the debtor country. Inflation can compound the difficulties of evaluation, when floating interest rate loans are part of the external debt portfolio, by effectively assimilating some amortization payments in interest payments and distorting the statistical measure of interest payments. The extent to which the data capture this effect is dependent on the inflation rate, the proportion of floating interest rate debt, and the maturity structure. Deflating these payments by nominal GDP or export earnings does not eliminate this distortion.

Debt Capacity

One function of external borrowing, commonly utilized by developing countries, is to supplement national savings to reach a desired level of investment and GNP growth. To focus on this major purpose of foreign borrowing, other functions (e.g., maintenance of international reserves) have been omitted, as have other forms of foreign savings—direct investment—which stimulate economic development. As a result of these constraints, the difference between investment and domestic savings—the current account deficit of the balance of payments—is financed by borrowing. Over time, and with GNP growth, larger absolute amounts of foreign savings are required to support development efforts. The ability to service this expanding external debt depends on the growth of GNP and exports of goods and services, which also determines, along with other factors such as the interest rate and changes in the terms of trade, the equilibrium level and sustainable rate of growth of external debt. Eventually, with sufficient GNP growth, the gap between national savings and investment may close, and the level of external debt could decline.

The analytics of debt capacity can be described by utilizing a simple model.⁴⁶ In this model, all external debt is assumed to finance the gap between investment and domestic savings, with GDP growth progressing at a rate determined by investment and the fixed incremental capital/ output ratio.⁴⁷ The external debt acquired is a bond with a fixed maturity and interest rate. If inflation exists it is constant and correctly anticipated and, thus, fully incorporated in the nominal interest rate. Relative prices, the terms of trade, and the real exchange rate are assumed fixed, but inflation is permitted. Consequently, the rate of debt accumulation is determined by the savings gap, interest charges on the expanding debt, and GDP growth.

Formally, the model consists of the following equations:

where

I = investment

S = domestic savings

k = fixed incremental capital/output ratio

s = domestic savings/GDP

g = growth rate of real or nominal GDP

D = external debt

i = real or nominal interest rate on debt

The ratio of external debt to GDP will reach an upper limit in the future if the interest rate on external debt is less than the growth rate of output. Mathematically, this condition is

Thus, the external debt/GDP ratio rises to an asymptotic limit, given a constant savings gap relative to GDP and a growth rate of GDP that exceeds the cost of foreign borrowing. The growth of the external debt/GDP ratio decelerates over time (Chart 5). If the external debt/ GDP ratio reaches a long-run constant, then the debt service/GDP ratio will also reach a constant, but lower, level.⁴⁸ The difference between these two ratios is determined by the terms of the loans. Interest payments are a constant fraction of outstanding debt and, thus, developments in the interest payments/GDP ratio mirror, but at a lower level, those of the outstanding debt/GDP ratio. However, the ratio of amortization payments to GDP follows a more complex path. In the initial stages of debt accumulation, amortization payments are below their long-run value, since external debt grows more rapidly than amortization payments because of the grace period, even if that period is only one year. After the first loan has matured, the unpaid balances of past loans represent a stable structure much like the age structure of a population growing at a constant rate. As a result, in the short run, the amortization payments/outstanding external debt ratio rises while, simultaneously, the outstanding external debt/GDP ratio is increasing and, thus, the amortization payments/GDP ratio must at first rise at a faster rate than the external debt/GDP ratio. After the first loan has matured and a stable structure of outstanding external debt is established, the debt service and external debt ratios will rise at the same rate (see Chart 5). In the long run, the rate of growth of external debt, debt service payments, and GDP will all be equal.⁴⁹

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Model of External Debt Accumulation

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If this long-run solution were disturbed by a once-for-all deterioration in the terms of trade so that the savings gap was expanded, a new round of external debt accumulation would be launched. However, as long as the rate of GDP growth exceeds the interest rate on external debt, the process is still stable but at a new, higher external debt/GDP ratio. A shortening of the loan maturity would gradually increase the debt service ratio because of the weight of previously made longer-term loans. Only as these longer-term loans mature and are replaced will the debt service ratio begin to approach its new, higher level. A shorter average maturity structure of outstanding loans causes a debtor to seek refinancing sooner but does not change the underlying parameters of the model or, thus, the long-run external debt/GDP ratio. This is not true if the real interest rate increases, since this would reduce the sustainable external debt/GDP ratio. An increase in the nominal interest rate, assuming no change in relative prices, would be matched by a corresponding greater growth rate of nominal GDP, leaving the long-run situation unchanged. Whether the short-run situation is altered depends on whether fixed interest rate or variable interest rate bonds are assumed.⁵⁰

The above has assumed that the marginal savings rate is equal to the average savings rate, and thus the domestic savings/GDP ratio remained constant even though the economy experienced greater real income. When the marginal savings rate is greater than the average savings rate,⁵¹ national savings rise and the current account/GNP ratio declines. With a large enough marginal savings ratio, external debt will decline and the debtor will become a net creditor.

The principal implication of the foregoing is that, to avoid debt difficulties in the longer term, the productivity of borrowed resources must at least equal the interest charges associated with that debt when interest cost excludes the amortization effect discussed in Appendix II, above. Investing the proceeds from foreign borrowing at less than their opportunity cost leads to an erosion of the debtor’s resource base, because relatively more income is absorbed by debt service payments.