Highly favorable terms of trade and external financing conditions have helped Latin America strengthen its fiscal and external fundamentals markedly over the last decade. But, how dependent are these gains on a continuation of such conditions? This chapter assesses debt sustainability under less favorable external scenarios. It finds that, while some countries are well placed to withstand sizeable shocks, many would benefit from a stronger fiscal position to be able to deploy countercyclical policies, especially under tail events. External sustainability, in turn, does not appear to be a source of concern for most countries yet.
Introduction
Over the last decade, and especially during 2003–08, Latin America experienced a remarkable improvement in key macroeconomic fundamentals, reducing public and external debt ratios (Figure 4.1), accumulating foreign assets, strengthening fiscal and external current account balances, and reducing debt structure vulnerabilities (currency denomination and maturity). While, undoubtedly, prudent policies played an important role, these gains reflected to a significant extent a highly favorable external environment—interrupted only temporarily by the 2008–09 financial crisis, and characterized by strong external demand, a commodity price boom, and benign external financing conditions.1 However, with prospects of a less favorable global environment ahead, a key question arises: How vulnerable are the region’s fiscal and external positions to external shocks?
Latin America: Public and External Debt, 2002–121
(Percent of GDP)
Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Blue (white) bars indicate a fall (increase) in the indicator between 2002 and 2012, with the value at bottom (top) of the bar corresponding to 2012 (2002).This chapter sheds light on this question by studying the link between global variables—such as commodity prices, world growth, and global financial market conditions—and a set of key domestic variables (GDP growth, trade balance, real exchange rate, and sovereign spreads) that drive the dynamics of public and external sustainability indicators. To this end, it develops a simple framework that integrates (i) econometric estimates of the effect of exogenous external variables on these key domestic variables with (ii) the IMF’s standard framework for debt-sustainability analysis (DSA). This integrated framework allows us to examine debt dynamics under alternative global scenarios; and consequently assess the vulnerability of current fiscal and external positions for 11 Latin American economies. 2, 3
A Decade of Falling Public and External Debt, 2003–12
Public Debt
Between 2003 and 2008, Latin America witnessed a remarkable decline in public debt-to-GDP ratios (about 30 percentage points of GDP, on average). The downward trend, however, came to a halt in 2009, on account of the effects of the global financial crisis, with no further reductions since then. There are, however, visible differences across countries, especially with respect to the management of rapidly rising revenues (Figure 4.2).
Components of Public Debt Dynamics, 2003–12
Sources: IMF International Financial Statistics; and IMF staff calculations.1 Main factors driving public debt dynamics, as identified in IMF’s standard DSA framework.2 Includes the accumulation of (gross) assets in different types of sovereign wealth funds.3 Includes Brazil, Chile, Colombia, Mexico, Paraguay, Peru, and Uruguay.4 Includes Argentina, Bolivia, Ecuador, and Venezuela.5 Data on commodity-related revenues for Ecuador, Mexico, and Venezuela (Chile) are available from 2000 (2005).6 Expenditure in base year is indexed to the percentage of revenues in that year.7 Based on projected growth for 2015–17.In the LA7 group (Brazil, Chile, Colombia, Mexico, Paraguay, Peru, and Uruguay), a drop of 20 percentage points of GDP in public debt was mainly driven by primary surpluses and rapid real GDP growth, with the former being the result of real public expenditure growing at a slower pace than booming revenues—and generally slower than potential GDP growth. The extraordinary increase in revenues came primarily from the commodity sector, as noncommodity revenues in these economies increased in line with real GDP at rates that, while higher than those observed in the previous decade, were broadly in line with long-term potential.
The rest of Latin America (Argentina, Bolivia, Ecuador, and Venezuela) also experienced a remarkable fall in public indebtedness during this period (averaging about 45 percentage points of GDP), although starting from much higher levels. This decline was largely driven by the direct effect of the economic boom on output (with GDP growth considerably above long-term potential, except in Bolivia) and by negative real interest rates.4 Although primary balances also played an important role in reducing debt ratios, the extent of savings of the booming revenues appears to have been limited. Indeed, real public expenditure grew at a faster pace than potential GDP and even faster than observed output.
External Debt
External debt ratios exhibit similar patterns, falling by more than 30 percentage points, on average, during 2003–08 (Figure 4.3), and being accompanied by a sizable increase in foreign assets (nearly 70 percent of GDP on a cumulative basis).5 Since 2009, external debt ratios have remained broadly stable at about 30 percent of GDP.
Factors Driving External Debt Dynamics, 2002–12 1
(Percent of GDP, cumulative contributions since 2002, simple averages)
Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Main factors driving external debt dynamics, as identified in IMF’s standard DSA framework.2 Includes Brazil, Chile, Colombia, Mexico, Paraguay, Peru, and Uruguay.3 Includes Argentina, Bolivia, Ecuador, and Venezuela.4 Includes accumulation of foreign assets by public and private sectors.In the LA7 group, the decline in external indebtedness averaged 25 percentage points of GDP, primarily on account of significant real exchange rate appreciation and external financing in the form of non-debt flows (especially FDI), combined with moderate current account surpluses. The drop for the rest of Latin America was even more remarkable, reaching about 50 percentage points of GDP, although starting from much higher levels. This improvement was mainly explained by large current account surpluses—on account of highly favorable terms of trade—as well as sizable real exchange rate appreciation.6
External factors played a large role in the strengthening of the region’s fundamentals, reflecting the region’s sensitivity to global conditions.7 Precisely because of such sensitivity, whether the region is well placed to withstand a significant deterioration in the external environment remains an open question. This is studied next.
External Factors and Debt Sustainability
Methodological Approach
We develop a framework that maps how shocks to key global variables affect a set of domestic variables that are the primary drivers of public and external debt dynamics. The framework integrates econometric estimates of this relationship with the IMF’s standard DSA framework (Figure 4.4).8 Then, we evaluate debt dynamics under different scenarios, based on conditional forecasts of the endogenous variables of the econometric model, under alternative paths of the exogenous (global) variables.
Integrated Public and External Debt Sustainability Framework
Specifically, our focus is on the effect of global variables on five key domestic variables—GDP growth, trade balance, real exchange rate, and sovereign spreads—derived from the estimation of country-specific VAR models of the following (reduced) form:
where yt is a vector of endogenous variables and zt is a vector of exogenous variables. The vector yt includes real GDP growth (gt), the change in the trade balance in percent of GDP (dTBt), and the (log difference of) the real effective exchange rate (dln(reert)). The vector zt includes global real GDP growth (gw), the S&P 500 Chicago Board Options Exchange Market Volatility Index (vix) as a proxy for international financial conditions, the (log differences of) agriculture, energy, and metal prices (
Scenario Analysis
We study four adverse global scenarios—two of them entailing temporary shocks and two with more persistent shocks (see Annex Table A4.1 for details):
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i. A temporary financial shock, reflected in a spike of the VIX of similar magnitude than the one observed following the Lehman event, and returning to baseline levels in 2014.
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ii. A temporary real shock, entailing a global recession with lower growth and commodity prices during 2013–14, returning to the baseline path afterward.
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iii. A protracted global slowdown, characterized by a relatively high level of uncertainty (VIX), lower commodity prices, and lower global growth (all relative to the baseline).
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iv. A tail event, with an impact on global variables (VIX, global GDP growth, and commodity prices) of magnitudes similar to those observed after the Lehman event, but somewhat more persistent.
Debt trajectories are constructed by adding the estimated impact of these external shocks to the baseline WEO projections.11, 12 A key factor in the dynamics of public debt is the primary balance path, which is determined not only by the behavior of endogenous variables (output and commodity-related revenues) but also by discretionary policies. The former are derived from the conditional VAR forecasts, whereas the latter require some assumptions on fiscal policy responses. We consider two different responses: (i) neutral fiscal policy, with expenditure growing at potential GDP growth rates—thus only allowing for automatic stabilizers to operate; and (ii) countercyclical fiscal policy, with expenditure growing above potential GDP growth by a margin that is proportional to the gap between actual GDP growth and potential GDP growth. Exploring these alternative expenditure rules allows us to assess the extent to which, under each scenario, fiscal buffers are (i) sufficient to respond with fiscal stimulus, (ii) just enough to allow automatic stabilizers to work, or (iii) whether a fiscal tightening is necessary to ensure debt sustainability.13 The overall assessment is based on the relative levels of public debt and primary balance gap reached by 2017.
Results
The results suggest that most countries in the region should be in a position to deploy (expansionary) countercyclical fiscal responses under temporary shocks (scenarios 1 and 2—not shown here), without raising debt sustainability concerns. In case of shocks with more persistent effects (scenarios 3 and 4), countries can be broadly classified into three different groups (Figure 4.5):
Key Fiscal Indicators under Different Scenarios, 2012–171
(Percent of GDP)
Source: IMF staff calculations.1 Series indicate, from left to right, the path of public debt and primary balance from 2012 to 2017 for each country. Solid (dotted) lines denote path under countercyclical (neutral) policies.-
A first group of countries (Venezuela and, to a lesser extent, Argentina) that would need to strengthen their current fiscal position considerably; otherwise they may have to undertake sizable (procyclical) fiscal consolidation in the face of adverse shocks, including moderate ones. This reflects both their sensitivity to external conditions and a relatively weaker initial fiscal position.
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A second group (Brazil, Ecuador, Mexico, and Uruguay) that could manage moderate shocks but would benefit from building additional fiscal space to be in a position to deploy countercyclical policies (and even neutral policies in some cases) under more adverse scenarios, without reaching debt and/or primary balance levels that could raise concerns about fiscal sustainability.14
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A third group (Bolivia, Chile, Paraguay, Peru, and to a lesser extent Colombia) with a relatively solid fiscal position to withstand sizable external shocks—even responding with expansionary policies—without putting fiscal solvency at risk.
On the external front, even under the more extreme scenarios (3 and 4), countries in the region appear to be in a position to maintain external debt sustainability (Figure 4.6).15, 16 A key factor driving this result is that current accounts tend to improve in the face of large negative external shocks (especially financial ones). Although this macroeconomic response does not appear to have negative implications for debt sustainability, it may still have adverse welfare implications, but this issue is beyond the scope of this study.
External Indicators under Different Scenarios, 2012–171
(Percent of GDP)
Source: IMF staff calculations.1 Series indicate, from left to right, the path of external debt and non-interest current account balance gap from 2012 to 2017 for each country. Solid (dotted) lines denote path under countercyclical (neutral) policies.Conclusions
Latin America experienced a remarkable improvement in key macroeconomic fundamentals over the last decade, on the back of a highly favorable external environment. With prospects of less benign global conditions ahead, however, the region’s fundamentals could change drastically. This chapter examined how important these changes could be, thus informing the discussion on whether current levels of policy buffers (especially fiscal) are adequate to withstand a deterioration of the global environment.
The results indicate that, while external sustainability does not appear to be, at this point, a source of concern, fiscal space may still be limited in several countries. These results suggest that the region would benefit from building further fiscal space, while favorable conditions last, to be in a position to actively use fiscal policy should the external environment deteriorate markedly.
Annex 4.1
Global Variables under Alternative Scenarios
Temporary financial shock affecting 2013 only. Financial variables return to projected path under the baseline in 2014.
Temporary real shock (commodity prices and world growth) in 2013–14. Variables return to projected path under the baseline in 2015.
Global slowdown over the whole forecast horizon.
Lehman-like event in 2013–14, with protracted impact on global growth, commodity prices, and the VIX.
Relative to 2012 level.
As projected by country desks for each country.
Reported gap vis-à-vis baseline is reached by end-2013. Prices recover gradually afterwards to reach baseline by end-2014.
Reported gap vis-à-vis baseline is reached by 2013:Q2. Prices recover gradually afterwards to reach new path by end-2014.
Global Variables under Alternative Scenarios
| Scenarios | ||||||
|---|---|---|---|---|---|---|
| Baseline (BL) | 1 | 2 | 3 | 4 | ||
| Global Variables | 2013–17 avg. | Financial Shock 1 |
Global Recession2 |
Protracted Global Slowdown3 |
Tail Event4 |
|
| World GDP growth (Percent) | 3.6 | BL | 2013: BL-1.5% 2014: BL-0.5% 2015–17: BL |
BL-1% | 2013: Lehman-like 2014–17: BL-1% |
|
|
VIX
(Points) |
17 | 2013: Lehman-like 2014–17: = BL |
BL | BL + 4 pts | 2013: Lehman-like 2014–17: BL+2pts |
|
| 10-year U.S. Treasury interest rate (Basis points) | 300 | 2013: BL-100bps 2014–17: BL |
√ | BL-50bps | 2013–14: BL-100bps 2015–17: BL-50bps |
|
| Commodity prices | Food | −105 | BL | 2013: BL-10%7 2014–17: BL |
BL-7% | 2013: BL-15% 82014–17: BL-5% |
| Energy | −85 | √ | 2013: BL-25%7 2014–17: BL |
BL-15% | 2013: BL-45% 82014–17: BL-10% | |
| Metals | −85 | √ | 2013: BL-20%7 2014–17: BL |
BL-15% | 2013: BL-35% 82014–17: BL-10% | |
| Non debt flows | by country6 | √ | BL | BL* 0.7 | 2013: BL+2008–09 change2014 –17: BL*0.8 |
|
Temporary financial shock affecting 2013 only. Financial variables return to projected path under the baseline in 2014.
Temporary real shock (commodity prices and world growth) in 2013–14. Variables return to projected path under the baseline in 2015.
Global slowdown over the whole forecast horizon.
Lehman-like event in 2013–14, with protracted impact on global growth, commodity prices, and the VIX.
Relative to 2012 level.
As projected by country desks for each country.
Reported gap vis-à-vis baseline is reached by end-2013. Prices recover gradually afterwards to reach baseline by end-2014.
Reported gap vis-à-vis baseline is reached by 2013:Q2. Prices recover gradually afterwards to reach new path by end-2014.
Global Variables under Alternative Scenarios
| Scenarios | ||||||
|---|---|---|---|---|---|---|
| Baseline (BL) | 1 | 2 | 3 | 4 | ||
| Global Variables | 2013–17 avg. | Financial Shock 1 |
Global Recession2 |
Protracted Global Slowdown3 |
Tail Event4 |
|
| World GDP growth (Percent) | 3.6 | BL | 2013: BL-1.5% 2014: BL-0.5% 2015–17: BL |
BL-1% | 2013: Lehman-like 2014–17: BL-1% |
|
|
VIX
(Points) |
17 | 2013: Lehman-like 2014–17: = BL |
BL | BL + 4 pts | 2013: Lehman-like 2014–17: BL+2pts |
|
| 10-year U.S. Treasury interest rate (Basis points) | 300 | 2013: BL-100bps 2014–17: BL |
√ | BL-50bps | 2013–14: BL-100bps 2015–17: BL-50bps |
|
| Commodity prices | Food | −105 | BL | 2013: BL-10%7 2014–17: BL |
BL-7% | 2013: BL-15% 82014–17: BL-5% |
| Energy | −85 | √ | 2013: BL-25%7 2014–17: BL |
BL-15% | 2013: BL-45% 82014–17: BL-10% | |
| Metals | −85 | √ | 2013: BL-20%7 2014–17: BL |
BL-15% | 2013: BL-35% 82014–17: BL-10% | |
| Non debt flows | by country6 | √ | BL | BL* 0.7 | 2013: BL+2008–09 change2014 –17: BL*0.8 |
|
Temporary financial shock affecting 2013 only. Financial variables return to projected path under the baseline in 2014.
Temporary real shock (commodity prices and world growth) in 2013–14. Variables return to projected path under the baseline in 2015.
Global slowdown over the whole forecast horizon.
Lehman-like event in 2013–14, with protracted impact on global growth, commodity prices, and the VIX.
Relative to 2012 level.
As projected by country desks for each country.
Reported gap vis-à-vis baseline is reached by end-2013. Prices recover gradually afterwards to reach baseline by end-2014.
Reported gap vis-à-vis baseline is reached by 2013:Q2. Prices recover gradually afterwards to reach new path by end-2014.
Latin America: Factors Driving Public and External Debt Dynamics under Alternative Global Scenarios, 2003–171
(Contributions to change in debt-to-GDP ratio, in percent of GDP, simple average)
Sources: IMF, Internatonal Financial Statistics; and IMF staff calculations.1 Simple average for Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, Uruguay, and Venezuela.2 Country desk projections (based on WEO baseline assumptions).3 Based on differential between VAR forecasts and VAR baseline. Bars denote contributions of different factors to the deviation of the debt ratios from the baseline.4 Deviation in percent of baseline.Optimal Sovereign Debt Levels: The Information in Sovereign Spreads
Although there is growing consensus about the desirability of low sovereign debt levels—to weather external and domestic shocks and allow for countercyclical fiscal policy—there is still significant debate about what the “optimal” levels of sovereign debt should be. This issue has become increasingly important for much of Latin America, as most countries have witnessed significant reductions in their public debt (and spreads) over the last decade (Figure A), and questions have been raised on whether further consolidation efforts are warranted. Our analysis suggests that such consolidations are optimal (maximize welfare), and that countries still facing significant sovereign risk would benefit from further consolidation. The analysis complements work by Adler and Sosa (2013), who assess the desirability of consolidation from the perspective of preventing adverse debt dynamics under scenarios of large external shocks.
Latin America: Evolution of Sovereign Debt and Spreads, 2000–12
We use a structural model to assess welfare under government’s commitment to different (future) levels of sovereign debt, where sovereign spreads in turn depend on the expected future debt levels. The model is calibrated to capture the historical relationship between the levels of aggregate income, sovereign debt, and spreads in emerging economies. Thus, model predictions match the average levels of sovereign debt and spread, the countercyclicality of spreads, and the implied procyclicality of sovereign borrowing in emerging economies.
The relationship between sovereign debt and spread levels varies widely across countries, reflecting idiosyncratic country characteristics (Figure A). This indicates that optimal debt levels can vary widely across countries. That said, we find that optimal debt levels are always associated with low sovereign spreads (around 100 basis points, Figure B). This implies that countries with sovereign spreads much higher than this threshold could benefit from further fiscal consolidation, independently from their debt level.
When sovereign spreads are high, reducing debt increases welfare. This would be especially so if sovereigns can commit to lower future debt levels through a gradual and smooth consolidation path, as the expectation of lower future debt levels allows the government to pay a lower spread today.1 Our findings suggest that credible fiscal rules can produce sizable welfare gains. For instance, announcing a fiscal rule that would reduce public debt by 18 points of aggregate income over 9 years could deliver a drop in sovereign spreads of 690 basis points (Figure C) and a welfare gain equivalent to up to a 0.3 percent permanent increase in consumption. Much of this debt reduction arises automatically from the lower spreads.
Note: This box was prepared by Juan Carlos Hatchondo (Indiana University and Richmond Fed), Leonardo Martinez, and Francisco Roch (both IMF) and based on Hatchondo and others (2012).
1 Our analysis is silent on how this commitment can be achieved. Institutions that improve commitment to fiscal rules (Schaechter and others, 2012) and floating rate sovereign debt instruments (Hatchondo and others, 2011) may help committing to sovereign debt levels that produce a low sovereign premium.See Chapter 5 and Adler and Magud (2013) for a discussion on the magnitude of the terms-of-trade income windfall.
The sample includes South America and Mexico, representing about 95 percent of Latin America’s GDP. The study entails a methodological contribution to the existing IMF’s DSA framework, as the latter is not equipped to assess how changes in external conditions affect debt dynamics. Unlike traditional DSA, our framework also takes into account the correlation among shocks and their joint dynamic responses. For details on IMF’s DSA framework, see IMF (2002, 2003, 2005, 2011, and 2012a).
See Box 4.1 for a discussion on a complementary approach to assess the adequacy of public debt levels.
Argentina’s debt restructuring in 2005 was a major factor driving debt ratios down. Bolivia also benefitted from a debt relief program, of roughly 25 percent of GDP, in 2006.
This reflected both public policies oriented to the accumulation of international reserves and assets under sovereign funds as well as private sector foreign savings (e.g., pension funds accumulating assets abroad).
These economies also accumulated large amounts of foreign assets (mostly by the public sector in Bolivia and Ecuador, and by the private sector in Argentina and Venezuela).
See, for example, Inter-American Development Bank (2008); Izquierdo and others (2008); and Osterholm and Zettelmeyer (2008).
As in standard debt sustainability analysis, the focus of our analysis is the dynamics of gross debt and primary balance. Risks related to financing needs as well as the composition of creditors are beyond the scope of our work.
The VAR model (together with the spread equation) and the debt motion equations capture the key linkages between domestic and external variables. To fully determine the dynamics of debt ratios, however, a few assumptions are necessary. See details in Adler and Sosa (2013).
A key feature of our framework is that primary balances and debt levels are included in the VAR to allow feedback effects from these variables to the other domestic variables that determine debt dynamics. Our approach, however, does not entail estimating a fiscal reaction function, as our objective is not to obtain debt paths under fiscal responses that mirror those of the past—which may have been constrained (or sub-optimal)—but rather under broadly unconstrained policies. Primary balances are projected by linking fiscal revenues to commodity prices and output growth, as well as evaluating different exogenous expenditure rules.
Baseline projections correspond to the Fall 2012 WEO, and entail slight declines in public and external debt ratios (less than 2 percentage points of GDP) through 2017. Scenarios are constructed as:
where the first term on the right-hand-side denotes debt projections under the WEO baseline, and the second term captures the effect of the external shocks, estimated as the difference between a VAR conditional forecast with scenario i assumptions and one conditioning on baseline assumptions.
See Annex Figure A4.1 for an illustration of the effect of the different scenarios on the average debt dynamics for the region (assuming unchanged policies vis-à-vis the baseline).
For countries with well-established fiscal rules, the reported dynamics should be interpreted as an illustration of how fiscal variables would behave in the event of deviations from such rules and of the magnitude of the fiscal adjustment required to return to the targets under the corresponding rule.
In countries with well-established fiscal rules, adherence to the rule after a temporary deviation would ensure that public debt remains on a sustainable path. In some cases, however, returning to the rule’s fiscal targets could entail significant fiscal effort.
An exception is Venezuela, where external sustainability concerns could arise in case of a tail event.
Under both scenarios (and even assuming active policy responses), debt levels would remain moderate and current account balance gaps would be either closed or positive.
