III. Domestic Public Debt and Fiscal Sustainability Issues23
53. This chapter analyzes the sources of the fast increase in the central government domestic debt during 1988–97, describes the structure of the debt, and examines issues related to the sustainability of central government finances.
A. Sources of Debt Growth
54. The central government domestic debt rose from 7.5 percent of GDP in 1988 to 26 percent of GDP in 1997 mainly reflecting a weak primary balance, high real interest rates on domestic debt instruments, and greater reliance on domestic sources of financing. The contribution of each factor to the increase in the domestic debt to GDP ratio has varied over this period.
Primary balance: As part of the political-economic cycles experienced over the last 15 years, the central government primary balance shifted from surpluses of 1.0-1.2 percent of GDP to deficits of about 1 percent of GDP within the four-year cycles. In addition to the pressures from the cycle, the behavior in the primary balance reflected structural weaknesses that have made it difficult to broaden the tax base, reduce expenditure because of earmarking of revenue, cut back employment, and eliminate rigidities in other current outlays.24 Consequently, the primary surplus of the government averaged 0.4 percent of GDP a year over 1988-97 and was not sufficient to offset the adverse effect on the debt of a sharp increase in real interest rates in 1994–97.
Growth-adjusted interest rate: The dynamics of the domestic debt to GDP ratio have been strongly influenced by the behavior of the growth-adjusted real interest rate, as measured by the difference between the average real interest rate on central government debt (external and domestic) and the rate of growth of real GDP. During 1988–93, the real interest rate remained below real output growth, contributing to limit the increase in the domestic debt-output ratio (Table 1). Conversely, as credit conditions tightened and economic activity slowed markedly in 1994–96, the growth-adjusted interest rate shifted from a negative 1.5 percent in 1988–93 to a positive 3.8 percent in 1994–97, resulting in a sharp increase in the domestic debt ratio (Table 2). As a result of these developments, real interest payments on central government debt rose from 1.1 percent of GDP in 1988 to 2.8 percent of GDP in 1997, while the operational deficit is estimated to have widened from 0.9 percent of GDP to 1.8 percent during the same period. The composition of central government expenditure changed significantly over 1988-97 as the share of nominal interest payments in total expenditure rose steadily from 15 percent in 1988 to 26 percent in 1997, while that of noninterest current expenditure declined by about the same magnitude during this period.25 In terms of GDP, nominal interest payments rose from 2.8 percent to 5.3 percent during the same period, while capital expenditure was held at only 2 percent of GDP per year.26
Sources of financing: As external disbursements slowed and amortization increased, the government shifted toward domestic financing through the placement of bonds to support its operations. As a result of the low levels of net external financing (net repayments in most years) and debt relief operations from private and official creditors, the outstanding stock of external debt of the central government declined steadily from about 20 percent of GDP in 1988-91 to 12 percent in 1997 (Figure 1). The switch to domestic bond financing was supported by private capital inflows that were prompted by high interest rates (1992-94) as well as increased liquidity abroad (1995-96).
|Nominal Interest Rate 1/||Real Interest Rate||Growth-adjusted Rate 2/|
|Domestic Debt||External Debt||Domestic Debt 3/||External Debt||Domestic Debt||External Debt||Overall Debt||Real GDP Debt|
|(In percent of GDP, average)|
|Domestic government debt||13.4||13.5||14.2||16.4||18.3||25.0||26.1|
|(In percent of total debt, end of period)|
|Domestic currency bonds||99.4||100.0||100.0||93.3||78.7||68.5||49.6|
|From 8 to 30 days||6.6||7.1||3.3||2.4||1.3||2.5||0.8|
|From 31 to 90 days||28.6||25.5||23.0||27.6||19.3||14.0||8.4|
|From 91 to 180 days||29.0||35.6||28.9||21.8||29.0||31.7||26.7|
|From 181 to 360 days||18.5||17.9||17.2||17.7||19.1||11.5||11.6|
|From 361 to 1,440 days||11.8||9.7||14.1||12.0||8.4||7.2||10.1|
|From 1,441 days to 15 years||5.5||4.3||13.5||18.5||22.8||33.1||42.4|
|Commercial banks 2/||18.0||10.9||7.3||17.4||8.0||7.6||17.7|
|Nonbank financial institutions||15.1||18.0||35.2||16.7||13.6||11.4||10.9|
|Private sector 2/||25.6||26.8||30.9||27.8||41.7||52.8||47.5|
|Rest of nonfinancial|
|Public sector 3/||39.9||43.3||21.9||35.0||28.3||22.5||19.5|Figure 1.Central Government Debt
B. Debt Structure
55. Currently, the government satisfies most of its domestic financing needs with the issue of eight different types of bonds. The bonds are issued with several maturities (ranging from one month to 15 years), various denominations (domestic currency, inflation-indexed, and U.S. dollar-denominated), and lack adequate standardization.27 This situation complicates the management of government debt in a way as to avoid competition among instruments, coordinate placement of government and central bank stabilization bonds, and minimize the cost of domestic debt.
56. For many years, short-term bonds (up to six months) denominated in colones with fixed interest rates had been the main instrument used by the government. With the advent of institutional investors such as the social security agency and other pension funds, the demand for long-term assets increased after 1991, making it possible to lengthen maturities and introduce variable interest rates. The bond portfolio was further diversified with the creation of a consumer price-indexed bond in 1993, which provided a safe asset against variable inflation, and a U.S. dollar-denominated bond, which was used intensively in the face of balance of payments pressures during 1995-96. These two instruments grew in importance recently with their combined share in the stock of domestic debt rising from 6.7 percent of the total at end-1994 to 50 percent by September 1997. At the same time, the pursuit of a yield structure that broadly favored longer-term maturities contributed to lengthen the maturity of domestic debt. The share of 4-year to 15-year bonds rose from 19 percent at end-1994 to 42 percent by November 1997.
57. Government bonds traditionally had been tailored to meet the needs of specific investors and placed over-the-counter (windows) with amounts determined by investor demand at interest rates set by the government. In the first half of the 1990s steps were taken to reduce the number of maturities, set minimum purchase amounts by investor, and make amounts issued a multiple of this minimum. To move to market-determined interest rates and enhance the effectiveness of monetary policy, the system of windows for placement of government and central bank bonds was replaced by an auction mechanism in April 1996, while inflation-indexed and U.S. dollar bonds have been placed through an electronic system in the stock exchange starting in June 1996 (Chapter IV).
58. With the objective of further improving debt management, a new bond with a one-year maturity and sold at discount was introduced in the auction in September 1997 as a step to standardize government bonds and develop a secondary bond market. The bond was designed to set standards at which existing debt instruments will gradually converge. As the market for the new bond develops, existing bond maturities will be further reduced, while an electronic system for operation of paperless bonds will be introduced.
59. The nonfinancial private sector is the main holder of government bonds, with its share in the stock of domestic debt doubling to 48 percent over the period 1991-97. This development resulted from more attractive interest rates on government bonds relative to bank deposit rates and also mirrored a substantial increase in private financial savings in this period. Access of small investors to government bonds was facilitated with the proliferation of small private financial funds, which offered instruments with high liquidity and return based on the intermediation of government bonds.
60. Although the social security agency intensively used government bonds for the management of pension and other workers’ contributions during this period, its share of bonds declined from 20 percent in 1996 to 11 percent in 1997 reflecting the government’s decision to exchange fixed-interest bonds held by the agency with inflation indexed bonds (with one-to five-year maturities). At the same time, the share of commercial banks and nonbank financial institutions declined from 33 percent of the total in 1991 to 29 percent in 1997. The share of bonds held by the central bank had been small but rose to 9 percent in 1995 as government bonds were exchanged for central bank losses that resulted from the liquidation of a large state-owned bank in 1995. Holdings of nonresidents increased from 3 percent of the total in 1994 to 10 percent in 1997.
C. Sustainability Issues
61. Based on a standard budget constraint for the central government finances in which revenue from seignorage are excluded, the dynamics of the debt to output ratio is governed by the following equation:
Where b is the change of the debt to output ratio over time (t), r is the real interest rate, n is real output growth, and s is the primary surplus in terms of GDP. This equation indicates that the debt to output ratio would decline (rise) when the primary surplus exceeds (falls short) growth-adjusted real interest payments, while the debt ratio would be stable when the sustainable primary surplus (s*) is achieved—the surplus that would fully cover growth-adjusted real interest payments, s*= (r-n)b. This equation would also correspond to the definition of the operational balance of the central government if the real output growth argument was omitted.
62. As a measure of fiscal sustainability, the primary surplus gap would indicate the magnitude of the adjustment required to keep the overall debt-output ratio stable over the long term,
63. Several adjustments to the actual stock of domestic debt outstanding are required to measure accurately the central government domestic debt. The adjustments are related to the anticipated issue of government bonds to recapitalize the central bank, settle obligations with the social security agency, and take over debts from CODESA, a state holding company.28 The envisaged recapitalization of the central bank in 1998 is a key step in the strategy to provide greater autonomy to the bank and enhance the effectiveness of monetary policy. This operation requires the issue of government bonds in an amount equivalent to 12 percent of GDP (C 260 billion) to shift to the central government about 80 percent of the quasi-fiscal losses of the central bank, which amount to some 2 percent of GDP a year.
64. A decree promulgated in June 1997 provides for the issue of government bonds (2 percent of GDP) to the social security agency to pay overdue contributions by the government as employer and to transfer contributions made by teachers that are expected to shift from the pension regime run by the government to that of the social security agency. Also, an additional government bond issue (1 percent of GDP) to the central bank is envisaged to assume the old debts of CODESA that remained after its liquidation.
65. With these adjustments, the estimated stock of domestic debt in 1997 would amount to 41 percent of GDP and, including outstanding external debt, the overall government debt would be 53 percent of GDP. The primary surplus gap is estimated under two scenarios: (a) on the basis of the past fiscal stance (past policy scenario); and (b) on the projected fiscal stance over the medium term (projected policy scenario) presented in the staff report.29 The past policy scenario utilizes averages of the primary surplus, real interest rate, and real output growth over the period 1993–97, while the projected policy scenario utilizes averages of the same variables for the period 1998–2002.
66. Under the past policy scenario, the sustainable primary surplus is 1.6 percent of GDP compared with an average primary surplus of only 0.6 percent of GDP a year (Box 1). Thus, the primary surplus would be insufficient to cover growth-adjusted real interest payments, resulting in increasing debt to GDP ratios to finance the fiscal gap. The pursuit of the past fiscal stance in the future would place the central government in an unsustainable path over the medium term (i.e., the overall debt ratio and real interest payments would rise without bound). To achieve fiscal sustainability, the central government would need to adopt measures to raise the primary surplus by about 1 percent of GDP.
67. Under the projected policy scenario, a strengthening of the finances of the central government is envisaged to result in a primary surplus of 1.1 percent of GDP a year. On the basis of stronger macroeconomic policies, the medium-term projection envisages higher output expansion and lower real interest rates than those observed in the period 1993-97. Under these assumptions, the growth-adjusted real interest rate would be 0.5 percent compared with 3 percent under the past policy scenario, which in turn implies that a primary surplus of only 0.2 percent of GDP a year would be sufficient to cover the growth-adjusted interest bill and keep the overall debt to GDP ratio stable in the medium term. Consequently, the central government primary surplus envisaged under this scenario would allow for a gradual decline in the overall debt to GDP ratio from 53 percent of GDP in 1997 to 49 percent in 2002.
Box 1.Sustainability of the Central Government Finances
(In percent of GDP, unless otherwise noted)
|I. Past policy scenario 1/|
|Primary surplus gap 2/||1.0|
|Sustainable primary surplus||1.6|
|Growth-adjusted real interest rate 3/||3.0|
|Real interest rate||6.0|
|Real growth rate||3.0|
|Operational balance (deficit -) 4/||-1.6|
|II. Projected policy scenario 5/|
|Primary surplus gap 2/||-0.9|
|Sustainable primary surplus||0.2|
|Projected primary surplus||1.1|
|Growth-adjusted real interest rate 3/||0.5|
|Real interest rate||4.3|
|Real growth rate||3.8|
|Operational balance (deficit -) 4/||-2.0|
|Stock of overall debt||52.7|
68. These results are quite sensitive to the underlying assumptions. A rise of 200 basis points in the real interest rate (or a decline of similar magnitude in output growth) would raise the growth-adjusted interest payments by 1.2 percent of GDP. Sustainability of the central government finances would then require a primary surplus of 1.4 percent of GDP a year.
D. Policy Implications
69. A comprehensive strategy to reduce the burden of the central government debt should be based on a combination of various actions, including the expected increase in the primary surplus and a faster implementation of structural reforms to improve prospects for higher sustainable output growth. This strategy should also include the use of privatization proceeds to repay government debt and an improved debt management to reduce the cost of domestic debt.
70. The fiscal stance envisaged in the medium-term projection is anticipated to reduce the debt to output ratio by some 0.9 percentage point of GDP a year. The projected reduction in the debt ratio would make the central government finances less vulnerable to changes in long-term trends for interest rates and output growth. In addition to sustainability considerations, a reduction in the debt ratio would place the government in a better position to gradually change the composition of expenditure in favor of capital spending and to deal with the risk of maintaining a large portion of the domestic debt in short-term maturities.
71. Privatization plans envisage the sale of two state commercial banks with a possible value of US$400 million. The use of these proceeds to repay debt would reduce the stock of debt by about 4 percent of GDP and would result in savings on interest payments of 0.1–0.2 percent of GDP a year. Additional interest savings may arise from improvements in debt management (i.e., a 100 basis point reduction in the interest rate would reduce interest payments by 0.6 percent of GDP a year). Steps initiated in 1997 to standardize bond instruments and develop a government bond market should be intensified so as to ultimately reduce the cost of domestic debt and contribute to lengthen the average maturity of debt.
72. This appendix summarizes the main features of the eight types of central government bonds. An income tax rate of 8 percent is levied on the interest earnings of government bonds, with the exception of earnings on U.S. dollar bonds.
73. The fixed-interest rate bond has been issued for many years. The bond is issued with maturities of 28, 84, and 168 days and with a minimum value of C 250,000 (US$10,000) and in September 1997 represented 19.3 percent of the total outstanding bonds. The 28-day bond is issued at discount, while remaining maturities carry an interest coupon redeemable every 84 days.
74. The variable-interest rate bond was created in November 1990. It is issued with maturities of 270 days, 1, 2, 3, 4, 5, 10, and 15 years, with a minimum value of C 1 million, and six-month interest coupons, with a share of 30 percent of the total bonds outstanding in September 1997. The interest rate is the basic interest rate of the central bank (a weighted average of interest rates in the weekly auction and six-month bank deposits) plus a spread set by the government at the time of issue. The interest rate is adjusted every six-months and was in the range of 19.5 to 21.8 percent depending on maturity at end-1997. Another variable-interest rate bond, TIAB, was created in May 1990. Its share in the stock of domestic debt peaked at 8.3 percent in 1993 but has remained below 1.0 percent thereafter.
75. The inflation-indexed bond, título de unidad de desarrollo, was created in May 1993. It is issued with maturities of 1, 2, 3, 4, 5, 10, and 15 years, with a minimum value of US$10,000, and six-month interest coupons. The bond principal is expressed in a special unit of account, unidad de desarrollo, with its value fully indexed to the consumer price index (as calculated by the ministry of commerce and industry) and adjusted monthly by the stock exchange commission. The real interest rate is set by the government on the basis of its financing needs and was in the range of 4.5 to 6.5 percent depending on maturity during 1997. This bond is mostly held by institutional investors such as pension funds and its share in the stock of domestic debt rose from 6 percent at end-1994 to 18 percent in September 1997.
76. The U.S. dollar-denominated bond, DOLEC, was created in December 1993 but its share in the stock of domestic debt has remained very small (below 2 percent). The bond is issued with maturities of 180 and 270 days, 1, 2, 3, 5, and 15 years, with a minimum value of US$5,000, and six-month interest coupons. The bond is purchased with colones at the central bank at the buying exchange rate of the day and redeemed in colones by the central bank at the selling exchange rate of the day, and is offered with fixed or variable interest rate. The variable interest rate is the six-month LIBOR deposit rate plus a spread set by the government for each maturity at the time of issue. Other bond instrument with minor importance is the U.S. dollar indexed bond, INDEX, which was created in July 1991 and discontinued in 1995.
77. The U.S. dollar bond was created in March 1995. It is issued with maturities of 90 and 180 days, 1, 2, 3, 5, and 15 years, with a minimum value of US$5,000, three-month interest coupons, and is negotiated fully in U.S. dollars. The interest rate is the six-month LIBOR rate plus a spread set by the government for each maturity. Its share in the stock of domestic debt amounted to 20 percent in September 1997.
78. A new inflation-indexed bond, bono de renta real, was created in February 1997 to provide an alternative investment instrument to the social security agency, the state insurance and electricity companies, and other public agencies under the control of the budgetary authority. The bond is issued with maturities of 28, 56, 84, 168, 252, and 336 days, with a minimum value of C 1 million, and 84-day interest coupons. The interest rate is linked to the change in the value of the unidad de desarrollo plus a spread to account for a real return. The real rate of return is set by the government and was in the range of 2-4 percent depending on maturity during 1997. The share of this instrument in the stock of domestic debt amounted to 11 percent in September 1997.
79. A new fixed-interest rate bond denominated in colones was created in September 1997 with the objective to move to standardized and paperless bond instruments that could be operated electronically. The bond is issued at discount with one-year maturity and auctioned every month.
Prepared by Marco Rossi.
See Chapter II for a discussion of the structural imbalances in the public sector during this period and actions that have been adopted to address them.
When the revaluation of principal related to changes in consumer prices and the exchange rate is added to the interest paid on inflation-indexed and dollar-denominated bonds, interest payments account for one-third of total expenditure during this period.
Adding principal revaluation of inflation-indexed and dollar-denominated bonds, interest payments rose from 5.4 percent of GDP in 1988 to 7.8 percent of GDP in 1997.
Appendix I summarizes the main features of current debt instruments.
CODESA was a holding company for a number of state-owned agricultural, industrial, and mining firms. A program to sell and liquidate its 43 firms started in 1985 and after the program was virtually completed, the company was shut down in 1993.
See SM/98/63 (3/3/98).