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Inflation and the external debt of developing countries: A reassessment of debt indicators prompted by rising real interest rates

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1981
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G. Russell Kincaid

Over the five years following the first sharp increase in the price of oil in 1973-74, non- oil developing countries were able to adjust their external accounts. A combination of factors played a role in their achievement, including some decline in real petroleum prices, cyclical recovery in the industrial economies, successful domestic economic policies, and the fact that for most of the period these countries were able to raise funds abroad at largely negative real interest rates. Because of inflation these negative rates meant that a real transfer of resources to debtors occurred. As a consequence, their debt burden and various external debt indicators were lower than they would otherwise have been.

In 1979, the external payments imbalances resulting from the second round of oil price increases were comparable in real terms to those stemming from the first oil price increase; however, the adjustment period may be more prolonged and arduous this time, in part because external factors are not likely to be as favorable. The current account surpluses of oil exporting countries are not expected to decline as quickly nor are the growth rates of the industrial countries expected to recover as rapidly as they did after the first oil price increase. In addition, average terms and conditions of the external debt of non-oil developing countries have changed and are no longer as favorable as they were.

There are three main changes in the character of new debt contracted by non-oil developing countries: it is now borrowed primarily from private rather than official lenders; increasingly at market-related (not fixed) interest rates; and these rates are now positive in real terms. At the end of 1972, about two thirds of the outstanding external debt of non-oil developing countries was owed to official lenders; by the end of 1980 private creditors accounted for an estimated one half of the outstanding medium-term and long-term public debt. This shift from official to private sources also produced, as a second factor, a movement toward market-related interest rates, such as London Inter-Bank Offered Rate (Libor), which have risen to positive levels in real terms during this period. For example, Eurodollar interest rates in London—an important index of the price of funds for private financial institutions—rose from about 5½ per cent in 1972 to about 13¾ per cent in 1980, and averaged nearly 17 per cent during the first half of 1981; by contrast, the interest rate on loans from official lenders rose only slightly from about 4¼ per cent to a little over 5 per cent.

Aggregate debt data, however, mask the disparity in exposure to these developments experienced by different oil importing developing countries. For example, net oil exporters and major exporters of manufactures owed almost 50 per cent of their total external debt to financial institutions and thus were more affected by interest rate fluctuations than low-income countries that owed only 10 per cent of their total external debt to these institutions.

This article will consider the impact of inflation and interest rates on nominal debt service burdens and on the debt indicators usually relied on to evaluate the position of developing countries. It will show, first, that nominal debt must be deflated to obtain a realistic assessment, and, second, that to the extent that inflation either outstrips or lags behind the rise in nominal interest rates, then a real transfer of resources will occur—to the debtor in the first case or to the creditor in the second. Finally, the real debt burden will not be altered by inflation if nominal interest rates exactly keep pace with inflation; in that case, however, the effect will be that the real loan will be amortized at a faster rate than the original terms might indicate.

The first two points are well known. But in the last case, when nominal interest rates move with inflation, there are important short-term effects, which are not fully appreciated, even when there is no change in the real interest rate. Obviously, in the long run, if the real interest rate is unaffected by inflation, the sustainability of external debt is unchanged; in that case, the analysis depends only on whether the invested borrowed resources will generate additional output and earnings to cover the associated interest payments—a necessary condition with or without inflation. But in the short run with floating interest rate loans, when nominal interest rates rise in step with greater inflation (so that the real interest rate is unchanged), there is an important short-term effect: the real loan is amortized faster because interest payments have increased. As a result, the usual debt indicators—debt service ratios and ratios of current account and interest payments to gross domestic product (GDP)—will show a misleading weakening in the debtor country’s financial position. This apparent deterioration in creditworthiness will occur, moreover, exactly when the country has an enhanced need to refinance its borrowing as a result of the more rapid actual amortization.

Chart 1Public external debt and debt service for 87 non-oil developing countries, 1972-79

Sources: IMF, World Economic Outlook and World Bank, World Bank Debt Tables.

Conventional measures

Deflating the nominal outstanding external debt and the annual debt service payments is a first step toward a more accurate picture of a country’s external debt situation. For example, debt service payments can be adjusted by export unit prices to obtain their cost in terms of real domestic resources; they can also be adjusted by import unit prices to provide an indicator of the approximate cost of these resources in terms of forgone real imports. Chart 1 shows clearly how nominal values overstated real developments during 1972-79, both when export unit prices and import unit prices were employed as deflators. Nominal outstanding public debt of non-oil developing countries expanded nearly fourfold in nominal terms between 1972 and 1979 but by only 56 per cent in real terms.

A better indicator of the implications of the enlarged external indebtedness is obtained by comparing it to the growth in domestic real resources; hence, the widespread use of debt indicators as ratios to GDP or to exports of goods and services which incorporate the effects of both output and price changes. The average annual rate of increase of real public debt in these countries between 1972 and 1979 was 6.6 per cent, larger than the average growth rate of real GDP for non-oil developing countries (at 5.2 per cent) but lower than the expansion in their export volume (at 7.3 per cent); thus, the growth in external debt was not substantially out of line with the growth of real resources. On the other hand, debt service payments rose much faster than export earnings. The ratio of debt service to export earnings grew by one third over the period, reflecting the proportionally larger borrowing at commercial market rates. The average interest rate was still negative at this time, however, and served to hold down debt indicators below the level they would have otherwise been and thus also slow their rise. The average interest rate on all outstanding public external debt was about 5 per cent during this period as compared to a less than 11 per cent average inflation rate for export unit values.

Inflation and amortization

Inflation has far-reaching consequences on the evaluation of a country’s external debt position, which cannot be identified with such deflators or indicators. General price increases affect the amortization schedule of the real loan; in this way, inflation distorts standard statistical measures of creditworthiness—the ratios of the current account of the balance of payments (BOP), interest payments, and the annual debt service to GDP. These consequences of inflation have only recently received attention.

As is well known, unanticipated inflation—that is, price increases that are not fully reflected in higher nominal interest rates—reduces the real debt burden of the borrower by eroding the real value of interest and amortization payments. The magnitude of the resulting transfer of real resources from the creditor to the debtor depends on the inflation rate, the maturity of the loan, and the extent that nominal interest rates lag behind inflation developments. One result of the transfer is that standard debt indicators exhibit a decline and a country’s unused borrowing capacity is expanded. Both these effects applied to debt contracted by developing countries after the first oil price increase.

Central to this analysis is the behavior of interest rates. Traditionally these rates were fixed for the maturity of the loan and therefore were not changed by inflation. However, in the 1970s, commercial bank syndicated credits or loans with variable interest rates became an increasingly important form of lending to developing countries. Interest rates on these loans are adjusted periodically (usually every six months) based on the movement of a standard market interest rate such as Libor. These interest rates are sensitive to the credit policies of major industrial countries; the important point is that they broadly move in response to inflation rates. In this situation, as the higher interest payments tend to compensate the lender for any decline in the real value of the loan, inflation may not result in any real transfer of resources from the creditor to the debtor and the real interest rate is maintained.

Because actual interest payments include a component to compensate the lender for the erosion in the future value of the debt, they effectively cause the real loan to be amortized at a faster rate, though, it must be repeated, they do not change the total real repayment of the principal. (For an example of how this compensatory adjustment works, see box.) Charts 2-4 show that the longer the average maturity of outstanding loans and the more rapid the rise in inflation, the faster is the increase in amortization rate. For a given maturity, higher inflation rates produce progressively greater real debt service obligations in the near term and corresponding reductions in the more distant future. With a loan of 20-year maturity and an interest rate fully incorporating inflation (and with no grace period), the average time period that the real loan is outstanding declines from 10.5 years with no inflation, to 7.5 years with 5 per cent inflation, and to 4.6 years if the inflation rate is 15 per cent—a reduction of over 50 per cent. A comparison of Charts 2-4 shows that the amortization rate is quickened as the calendar maturity of the loan is lengthened. An increase in inflation from zero to 15 per cent more than doubles the initial debt service for the 20-year loan in Chart 2 but causes only a 42 per cent increase for the five-year loan in Chart 4. (It follows, of course, that the situation would be reversed in cases where inflation and interest rates decline over the life of the loan.)

How inflation affects a loan

Inflation may either accelerate the real effective amortization schedule for a loan (but not the total real repayments) or decelerate that schedule to such an extent that a portion of the real repayment is canceled. Which of these two extremes occurs depends on whether the nominal interest rate—the real interest rate plus an inflation premium—fully incorporates the actual inflation experienced. When market interest rates rise in response to inflation, the erosion in the real value of the outstanding loan caused by inflation is offset. The creditor receives as interest payments what in a less inflationary environment would be repaid as amortization. This equivalence of inflation-induced amortization payments effected by nominal interest rates along with the standard process of amortization is illustrated in the table.

An appropriate benchmark for comparisons of the effect of inflation is to set an inflation-free scenario against one with inflation—in this example, 10 per cent. Interest payments on fixed interest loans (assumed for simplicity to be zero), made prior to the sudden increase in inflation, are unchanged; thus, in every time period the real value of amortization payments is less than originally anticipated. As a result, the real value of total amortization payments is less than the initial real value of the loan. A variable interest rate loan, on the other hand, would increase interest payments by 10 per cent (the inflation rate) under the assumption that the nominal interest rate fully incorporates actual inflation. As can be seen from the table, although the total real debt service repaid over the life of the loan is the same as the value of the loan, initially the real debt service is higher than under fixed interest rates and then falls below that level. The new amortization schedule given by the total debt service payments only reflects a more rapid rate of amortization since the total repayments have not been altered. This more rapid amortization of the real loan also implies that the average period the loan is outstanding is shortened. Inflation, which is fully incorporated in the nominal interest rate, results in an acceleration of the real amortization schedule; if it is not fully reflected in the nominal interest rate, then some debt repayments are effectively canceled. Higher inflation rates and longer maturity loans make these effects more pronounced.

Effect of inflation on a loan1
Time periods
12345
No inflation2
Loan outstanding at beginning of period1,000800600400200
Amortization schedule200200200200200
Interest payments
Debt service (sum = 1,000)200200200200200
Average period real loan is outstanding—3 periods3
Inflation (10 per cent)
Fixed interest rate loan
Loan outstanding at beginning of period1.000800600400200
Amortization schedule200200200200200
Interest payments
Debt service200200200200200
Real debt service (sum = 758.2)181.8165 3150.3136.6124.2
Variable Interest rate loan”
Loan outstanding at beginning of period1,000800600400200
Amortization schedule200200200200200
“Interest” payments due to erosion
of outstanding principal410080604020
Debt service300280260240220
Real debt service (sum = 1,000)272.7231.4195.4163.91366
Average period real loan is outstanding—2 66 periods5
Price index1.11.211.3311.4641.611

Loan is assumed equal to 1,000. Maturity is in five periods with equal amortization payments. The real interest rate is assumed zero.

Or indexed bond case.

A five-year loan may be considered as five separate loans for different periods; hence the average period is the sum of these loans weighted by the period during which each is outstanding, that is. (.2)(1) + (.2)(2)(.2|(3) + (.2)(4) + (.2)(5) = 3.

The nominal interest rate equals the constant inflation rate.

The method in footnote 3 applied to this case would yield (.2727)(1) + (.2314)(2)+(.1954)(3) + (.1639)(4) + (.1366)(5) = 2.66

Loan is assumed equal to 1,000. Maturity is in five periods with equal amortization payments. The real interest rate is assumed zero.

Or indexed bond case.

A five-year loan may be considered as five separate loans for different periods; hence the average period is the sum of these loans weighted by the period during which each is outstanding, that is. (.2)(1) + (.2)(2)(.2|(3) + (.2)(4) + (.2)(5) = 3.

The nominal interest rate equals the constant inflation rate.

The method in footnote 3 applied to this case would yield (.2727)(1) + (.2314)(2)+(.1954)(3) + (.1639)(4) + (.1366)(5) = 2.66

Debt indicators

In the long run, the capacity of a country to sustain debt always depends on whether the productivity of the borrowed resources is at least equal to the interest charges associated with that debt (when the interest cost excludes the amortization effect discussed earlier). But when a large share of a country’s external debt portfolio is linked to inflation through floating interest rate arrangements, the analysis of the short- term position becomes more complicated. Near-term prospects are altered and new debt-management problems may arise. As interest rates adjust to inflation, debt service is higher in the near term—having the effect of a more rapid amortization of the real loan. This increases the debtor’s need to refinance or “rollover” its maturing obligations and, therefore, makes the country vulnerable to disruptions in capital markets or short-run fluctuations in export earnings. Consequently, the confidence of creditors in the country’s creditworthiness becomes even more important than in less inflationary conditions.

Chart 2Impact of inflation upon real debt burden of a 20-year maturity loan1

1 Assumes a variable interest rate. Amortization payments are equally divided and the real interest rate is 5 per cent. The nominal interest rate fully incorporates the inflation.

Chart 3.Impact of inflation upon real debt burden of a 10-year maturity loan1

1 Assumes a variable interest rate. Amortization payments are equally divided and the real interest rate is 5 per cent. The nominal interest rate fully incorporates the inflation.

Chart 4.Impact of inflation upon real debt burden of a 5-year maturity loan1

1 Assumes a variable interest rate. Amortization payments are equally divided and the real interest rate is 5 per cent. The nominal interest rate fully incorporates the inflation.

Chart 5.Impact on debt service ratios of inflation

In these circumstances, certain measures commonly used to evaluate a country’s creditworthiness—the ratio of the current account deficit to GDP, annual interest payments to GDP, or annual debt service to GDP—are biased upward by these higher inflation-induced interest rates. While the rise in the debt service ratio accurately measures the accelerated amortization rate, the other indicators may show an altogether misleading deterioration in the debtor’s economic situation. For example, the current account of the BOP is distorted because interest payments have the effect of transferring some amortization payments from the capital account to the current account, which implies that the current account position would record a deterioration solely due to this phenomenon. This apparent weakening of the debtor’s economic position may adversely influence decisions by commercial banks to extend more loans.

The impact of inflation on each of the various ratios—in this case the debt service ratio—is complex and depends on the movement of nominal interest rates in relation to higher inflation. Chart 5 shows how price rises affect the debt service ratio. Inflation increases the near-term ratio over the level it would have otherwise been, but the extent of this change is sensitive to developments in the real interest rate. A decline in the real interest rate limits, perhaps even reverses, the rise in the debt indicators stemming from inflation and results in a lower debt service ratio than otherwise would be the case. Conversely, the nominal interest rate may rise more than is needed to compensate for inflation, perhaps because of a tightening of credit policies in an industrial country. This action would produce a higher real interest rate and thus compound the effect of inflation and force the debt service burden even higher. In addition, the movement from a negative to a positive real interest rate implies a jump from a longer debt service time profile to a shorter one. For countries with external debt linked to market interest rates, the above describes some of the consequences of the high positive real interest rates that have been recorded since 1979.

The precise impact of inflation on amortization rates and debt indicators is dependent, of course, on inflation itself, on whether foreign borrowing is subject to fixed or floating interest rates, and on average maturities—a combination of factors that cannot easily be summarized in simple statistical measures. The complex effects of inflation on debt term structure and debt indicators make assessments of the debt situation less straightforward than in a noninflationary environment. Only careful and detailed analysis of a country’s economic situation can begin to disentangle these factors and permit an accurate and comprehensive review of the external debt position of any single borrowing country. Thus, lenders are confronted with greater uncertainty in determining a country’s creditworthiness while, simultaneously, the country’s need for external financing may have increased due to inflation. An attempt by lenders to understand the effects of inflation on real debt amortization and to interpret debt indicators in the light of inflation is essential to realistic assessments of creditworthiness under current conditions in the world economy.

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