Domestic public debt of externally indebted developing countries increased sharply during the 1980s. How this debt is managed can help or hurt adjustment programs
Ever since the onset of the debt crisis in 1982, a great deal of attention has been focused on the external debt of developing countries—both in terms of the ability of governments to service the debt and the sustainability of economic policies—but domestic public liabilities have gone largely unnoticed.
In the past few years, however, policymakers and academics have begun to shift their interest to the domestic front, troubled by the substantial growth of domestic public debt throughout the 1980s following a period of relative stability. For some countries—particularly those already shouldering heavy external debt loads—domestic debt now is close to, or exceeds, 25 percent of GDP. A few (Argentina and Brazil) have even run into domestic debt-servicing problems since 1988, forcing them to reschedule a significant portion of outstanding domestic debt on a nonmarket basis.
As the situation worsens, it is increasingly clear that how a country manages its domestic—and not just its external—debt may well determine the success or failure of its economic adjustment program, as both have a claim on government resources. Yet, to date, few studies have probed this area. For that reason, we recently undertook a study that explored the extent to which domestic public debt has grown, the reasons behind its sudden growth, how domestic and external debt interact with a country’s current and anticipated fiscal stance, and how domestic debt can be better managed. This article takes a look at the results.
Evolution of public debt
For the 15 developing countries with the heaviest external debt loads—Argentina, Bolivia, Brazil, Chile, Colombia, Côte d’Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia—the 1980s have meant a steady climb in domestic public debt. The average ratio of domestic public debt to GDP for this “group of 15” (or G-15) rose from 10 percent in 1981-82 to 16 percent in 1987-88, while total public debt rose from 33 percent of GDP to 54 percent. Moreover, for the four largest debtors (Argentina, Brazil, Mexico, and Venezuela), average domestic public debt increased to 18½ percent of GDP from 12 percent during the same period (see chart).
This remarkable growth occurred at a time when external public debt was also rising sharply. The average ratio of external public debt to GDP for the G-15 increased by 15 percentage points from 1981-82 to 1987-88, and for the four largest debtors, the rise was more than 9 percentage points.
Although detailed data are available only up to 1988, considerable evidence indicates that the domestic debt situation has deteriorated since then, in contrast to the improvement on the external debt front, reflecting the successes of the external debt strategy. Particularly worrisome is the fact that the growth in domestic debt has not been limited to the G-15. Many other developing countries have also seen their domestic debt burdens rise sharply, especially in the last few years.
How were these increases possible and what was behind the rise? On the domestic side, the bulging liabilities largely reflected continued borrowing from the private sector, while on the external side, they increased because of the assumption by the public sector of a large portion of private external debt, as well as rescheduled interest and amortization payments. At root, however, for the increase in both types of debt was a failure to make an adequate fiscal adjustment when access to new external financing came to a halt. Although a few G-15 countries managed to trim their budget deficits immediately following the onset of the debt crisis, the improvements were only short-lived. With few exceptions, the fiscal situation, on average, remained serious until the late 1980s. In the last two years, wide-ranging fiscal adjustment has taken place in a number of G-15 countries, such as Mexico and Argentina. At the same time, external factors such as the fall in world interest rates have improved the outlook.
One key reason for the seriousness of the fiscal situation had been the low and, in some cases, declining ratio of tax revenues to GDP—partly a result of the external debt problem itself. As policymakers tried to turn current account deficits into surpluses to service external debt, they frequently restrained domestic demand, which, in turn, led to a smaller tax base. Increasing administrative and technical problems in tax assessment and the levying and collection of taxes did not help. In addition, inflation, because of collection lags, led to a reduction in real tax revenues.
Against this fiscal backdrop, the increase in domestic debt with external debts remaining high has given cause for concern on two main counts.
• First, in the absence of a corresponding improvement in the primary fiscal surplus (i.e., the difference between government revenue and noninterest expenditure), and with no new external funds available, growing fiscal deficits led to further domestic debt accumulation.
• Second, the worsening fiscal and domestic debt pictures were accompanied by a sharp increase in the rate of inflation, with some countries experiencing annual rates averaging over 200 percent and many sustaining increasingly negative and volatile real interest rates. This volatility exacerbated the uncertainty surrounding the inflation picture, further harming saving, investment, and growth.
Fiscal policy and public debt
In light of all these interconnections, developments related to external and domestic debt should not be viewed separately from each other or from the underlying fiscal situation, as is often done in medium-term projections. Policymakers must have a way of tracking not only the current evolution of government revenues and expenditures but also the expected values of future magnitudes. What is called for is a “forward-looking” balance sheet of the entire public sector. This would give a measure of the solvency of the public sector, as well as the fiscal adjustment required to fully service the outstanding public debt—thus playing a helpful role in designing and evaluating adjustment programs.
In a simplified balance sheet, government assets would include the current stock of domestic plus foreign assets (the conventional definition), and the estimated present value of anticipated future revenues from tax and nontax sources. Government liabilities would include the current outstanding stock of debt and other current obligations (the conventional definition), and the present value of future expenditures, including subsidies. The difference between the two would be the government’s net worth. Thus, if total assets exceeded total liabilities, net worth would be positive, meaning the government would be solvent (i.e., could meet its current and future obligations). But if net worth were negative, the government would be insolvent and, without an increase in its assets, would not be able to fully service its outstanding debt.
A troublesome growth of domestic public debt
Domestic Public debt 1
(In percent of GDP)
Citation: 29, 3; 10.5089/9781451952094.022.A003
Sources: National sources; various issues of the IMF’s International Financial Statistics and Government Finance Statistics Yearbook, and various unpublished IMF documents.
1 Domestic public debt includes gross liabilities of the consolidated public sector and of the monetary authorities with the private sector. Weights are based on the relative shares in US dollar GDP in 1981-82 of the G-15 countries and of the four largest debtors among them (all of which are in the Western Hemisphere), respectively.
2 Among the G-15, the four developing countries with the largest external debts are: Argentina, Brazil, Mexico, and Venezuela.
3 The G-15 countries include: Argengtina, Bolivia, Brazil, Chile, Colombia, Côte d’Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.
For a more detailed discussion, see “Domestic Public Debt of Externally Indebted Countries,” by the authors, IMF Occasional Paper No. 80, June 1991, $10 ($7.50 for academic orders) available from IMF Publication Services, Washington, DC 20431, USA.
This approach is similar to that used to evaluate the solvency of a private firm. However, two key differences should be kept in mind. First, in the private sector, given the relatively limited activities in which a firm is engaged, it is usually possible to estimate with reasonable accuracy the present value—that is, the value in terms of today’s dollars—of major future flows of expenditures and revenues. By contrast, in the public sector, given the broad mandate, it may be hard to obtain good estimates of the present value of the expected future stream of revenues and expenditures.
Second, this definition of solvency appears to be somewhat simplistic for governments, because not all assets (e.g., government buildings and embassies) can be used to service liabilities. For our balance sheet, therefore, we will focus only on the assets most likely to be available—foreign exchange reserves and government revenues from taxes and other sources (privatization is turning out to be a major source of extraordinary revenue for many countries, but for the sake of simplicity, it is not included here).
So constructed, the balance sheet approach highlights several aspects of the fiscal situation:
• For a given net worth to be maintained, any increase in debt has to be matched by (1) an increase in government revenues or current assets and/or (2) a decrease in expenditures.
• Domestic and external debt appear to enter the balance sheet on an equal footing—that is, both types of debt have an equal claim on government resources.
• The present value of the anticipated future stream of government expenditure and subsidies, to the extent that the stream is perceived as a “permanent” obligation, is also a form of government debt. Similarly, the stream of future taxes can be seen as a form of government asset. For this reason, “solving” the debt problem may involve a cut in subsidies or an increase in tax revenues.
Government net worth. How would this balance sheet work? The table presents four cases, which although hypothetical, illustrate situations that are not atypical of several of the G-15 countries. They enable us to calculate a country’s net worth, or solvency.
The first step is to estimate the primary fiscal balance expected to prevail in the future—in Cases A and B, we have surpluses, and in C and D, deficits. These figures are then discounted to the present—using an illustrative discount rate of 5 percent a year (this would be consistent with a growth rate of, say, 3 percent and a real interest rate of 8 percent). In Case A, the present value of a primary surplus of 1.5 percent of GDP is equivalent to a current asset of 30 percent of GDP, whereas in Case D, a primary deficit of 2.5 percent of GDP is equivalent to a debt of 50 percent of GDP. Finally, the present value must be added to the ratios of foreign exchange reserves to GDP to obtain total gross assets and subtracted from the total (domestic plus external) public debt to GDP ratio to obtain the net worth of the government.
What we end up with is only one solvent government, Case A, meaning that its expected primary surplus would be adequate to meet its outstanding government liabilities. In the other three cases, government net worth is negative, reflecting the impact of a high level of public debt and/or a high primary fiscal deficit. It is interesting to note that Case D, while having the lowest public debt to GDP ratio (similar to Case A), shows a significantly negative net worth (similar to Case C), because of inadequate fiscal adjustment. Case B shows how a country with a primary surplus and positive foreign exchange reserves can still have a negative net worth, because of a large public debt load.
Required adjustment. But if government net worth is negative, how much of a primary fiscal adjustment (as a percent of GDP) would be needed to re-establish solvency? Or to put it another way, how much of a permanent primary surplus would be required to service the current levels of public debt, thereby preventing government net worth from being negative? The last two columns in the table give the answers for these four cases.
Using the 5 percent discount rate, we see that the primary surplus needed is quite sizable, especially in Cases B and C—where it exceeds 3 percent of GDP. Moreover, with the exception of Case A, substantial permanent fiscal adjustments are being called for, compared with current expected performance. And while some of these numbers may appear manageable, they represent a significant adjustment given that the improvement has to be maintained into the future. But if the growth rate was higher—say, 5 percent instead of 3 percent—and real interest rates remained at 8 percent, giving a discount rate of 3 percent, the required fiscal surpluses could fall markedly. But even then, substantial permanent fiscal adjustment would be in order.
Domestic public debt management
The above numbers show that fiscal adjustment is critical for countries facing a domestic debt crisis. But there are other steps policymakers can take to enhance the chances of success of their stabilization programs—notably, better management of domestic public debt. This holds particularly true for the G-15, which have had to contend with sharp increases in inflation over the past decade.
|Case||deficit (-)||(r=0.05) 1/||reserves||debt||worth 2/||(r=0.05)||(r=.03)|
Nominal debt and indexation. In most countries, domestic public debt is issued in nominal terms—that is, it is denominated in domestic currency and not indexed to reflect changes in the general price level. But since its real value is affected by changes in the price level, the presence of nominal debt itself has several implications for macroeconomic policymaking in general, and the fiscal picture in particular.
Perhaps the most important implication is the potential to tolerate or encourage inflation, because, at least superficially, rising prices hold the promise of reducing the debt burden in real terms. But such a reduction can occur only if the increase takes the public by surprise. For if inflation was anticipated, government bond holders would require a sufficient return to compensate for the expected loss due to a fall in the real value of the bonds, meaning nominal interest rates would have to rise. If policymakers believe that inflation may be unanticipated, however, they may be tempted to tolerate the adverse effects of inflation. For this reason, a large stock of nominal public debt may be destabilizing, especially when the government is having trouble enforcing a credible stabilization program. The higher rates will boost the government’s issuing and servicing costs, thereby increasing the debt burden even further. This, in turn, will make inflation appear even more “attractive” to the policymaker.
One possible way of eliminating, or reducing, the temptation for inflation, would be to index the debt—that is, tie the domestic currency value of the principal to, for example, the consumer price index, the exchange rate, or both. This would serve to maintain the real value of the principal, in effect breaking the link between inflation and government debt. Expectations of inflation would be lowered, and the government would be forced to make a policy pre-commitment (namely, the indexation formula itself). But debt indexation should be used with caution, because (1) any device that promises to moderate the adverse consequences of inflation is likely to weaken the resolve to reduce it, and (2) debt indexation may be ineffective, or even counterproductive, if fiscal adjustment is inadequate.
As for how debt indexation fared in the G-15 countries from 1982-88, the verdict is unclear. It appears, however, that in three of the countries (Brazil, Chile, and Uruguay), most (on average more than 75 percent) of the domestic public debt was indexed, and in four countries (Argentina, Colombia, Mexico, and Morocco), very little (less than 25 percent) was indexed. Among those with high indexation, Brazil experienced extremely high rates of inflation, largely as a result of inadequate fiscal adjustment, whereas Chile and Uruguay had substantially lower average rates of inflation, with no hyper-inflationary experiences. Among those with low indexation, Mexico and Argentina sustained high inflation episodes, while a number of other countries showed substantially lower average inflation rates.
Maturity structure. Another possible tool in debt management is adjusting the maturity structure—that is, the period over which the outstanding stock of debt will be redeemed by the government. The average maturity matters because it can play a crucial role in preventing “confidence crises.” This is because longer maturities reduce the need to refinance on a frequent basis. For the G-15, the proportion of short-term debt (with a maturity of less than one year) to total debt for 1983-88 tended to be very high in countries such as Brazil, Mexico, and Argentina, and to a significantly lesser extent in Chile and Uruguay. Adjusting the average maturity also holds the potential—if used in conjunction with indexation—to help stabilize inflation.
To understand how this would work, it is important to first consider the relationship between inflation and debt maturity; in particular, how the real value of debt (nominal debt adjusted by the price level) would decline with an increase in the inflation rate. In general terms, by lengthening the average debt maturity, that is, increasing the time period after which the debt stock will be redeemed, governments can reduce dramatically the yearly rate of inflation needed to decrease the real value of debt by a given amount.
For example, compare two countries, both with a nominal debt equivalent to 25 percent of GDP. In the first country, all the debt matures in one year, while in the second country, the debt matures in 30 years. Reducing the real value of debt by the same amount in the two countries would require an inflation rate of over 20 percent in the first case, but only around 1 percent a year in the second case. This is because with longer maturities, very low rates of inflation have a cumulative effect that is as significant as high rates of inflation over a very short period.
What this means for policymakers is that maturity structures can be lengthened or shortened to help control expectations about inflation. But the decision on the maturity structure should be linked to whether the country also chooses to index the debt, as both actions affect the impact of inflation on the real value of debt.
If debt indexation is used, longer maturities would be called for. This is because under indexation, inflation has no effect on reducing the real value of debt. Thus, a long maturity would mean that over a long period of time there would be no temptation for the government to tolerate inflation just to reduce the real value of debt. If debt indexation is not used, however, shorter maturities would be in order; in fact, longer maturities may even exacerbate expectations of high inflation. This is because with a longer maturity, inflation would appear more attractive, as the government might rationalize that it was only a little amount each year for many years. By having a shorter maturity, the government would put itself in the position of needing a sharp burst of inflation to achieve a given reduction in real debt. This would naturally increase the cost associated with any given debt reduction, making the inflationary route less acceptable.