Chapter

II Evolution of Public Debt and Fiscal Developments

Author(s):
Manmohan Kumar, and Pablo Guidotti
Published Date:
March 1991
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I. Evolution of Public Debt

Since the onset of the external debt crisis in 1982, domestic public debt has become a matter of increasing concern in a number of developing countries. For the G-15 countries, the average ratio of domestic public debt to gross domestic product (GDP) increased to 16 percent in 1987–88 from 10 percent in 1981–82 (Table 1).3 For the four largest debtors among developing countries in the Western Hemisphere, it rose from 12 percent to 18V2 percent over the six-year period.4 This remarkable growth contrasts with relative stability in the domestic debt ratio prior to 1981 (Chart 1). For a majority of the G-15 countries, the domestic debt ratio increased by more than 50 percent between 1981–82 and 1987–88. As a result of these developments, domestic public debt in several of these countries currently is either close to or exceeds 25 percent of GDP. The variability of debt ratios across countries is substantial; it has declined over time, however, with the ratio of the standard deviation to the mean falling between 1981–82 and 1987–88. These developments underscore the need to focus more attention on the evolution and the implications of domestic public debt in developing countries with high levels of external debt.5

Table 1.Fifteen Heavily Indebted Developing Countries: Public Debt, Selected Periods(Percentage of GDP)
1976–771981–821987–88
Domestic public debt1
G-15 countries2
Weighted average36.110.216.1
Median3.23.710.1
Standard deviation6.67.110.5
Four largest debtors4
Weighted average36.312.018.4
Median5.611.917.7
Standard deviation3.04.76.0
External public debt5
G-15 countries2
Weighted average314.722.837.7
Median17.827.552.0
Standard deviation8.317.529.6
Four largest debtors4
Weighted average314.624.233.3
Median12.726.240.9
Standard deviation4.29.014.5
Total public debt6
G-15 countries2
Weighted average320.833.053.8
Median24.135.563.1
Standard deviation10.519.229.9
Four largest debtors4
Weighted average320.936.251.7
Median18.438.160.2
Standard deviation5.44.812.1

Domestic public debt includes gross liabilities of the consolidated public sector and of the monetary authorities with the private sector. Ratios are calculated by dividing the average of the stock of debt at the beginning and the end of the year by GDP in national currency. Domestic public debt data were obtained from national sources; various issues of the International Monetary Fund’s International Financial Statistics and Government Finance Statistics Yearbook; and various unpublished Fund documents. Figures for GDP in national currency were obtained from the Fund’s World Economic Outlook data bank.

The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

Weights are based on the relative shares in U.S. 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. Figures for GDP in U.S. dollars were obtained from the World Economic Outlook data bank.

Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

External public debt includes both public and publicly guaranteed debt. Ratios are calculated by dividing the average of the stock of debt at the beginning and the end of the year by GDP in U.S. dollars.

The total public debt ratio is the ratio of the sum of domestic debt and external debt to GDP.

Domestic public debt includes gross liabilities of the consolidated public sector and of the monetary authorities with the private sector. Ratios are calculated by dividing the average of the stock of debt at the beginning and the end of the year by GDP in national currency. Domestic public debt data were obtained from national sources; various issues of the International Monetary Fund’s International Financial Statistics and Government Finance Statistics Yearbook; and various unpublished Fund documents. Figures for GDP in national currency were obtained from the Fund’s World Economic Outlook data bank.

The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

Weights are based on the relative shares in U.S. 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. Figures for GDP in U.S. dollars were obtained from the World Economic Outlook data bank.

Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

External public debt includes both public and publicly guaranteed debt. Ratios are calculated by dividing the average of the stock of debt at the beginning and the end of the year by GDP in U.S. dollars.

The total public debt ratio is the ratio of the sum of domestic debt and external debt to GDP.

Chart 1.Fifteen Heavily Indebted Developing Countries: Domestic Public Debt, 1976–881

(Percentage of GDP)

1 Weighted averages.

2 Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

3 The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

The growth in domestic public debt occurred at a time when external public debt was also increasing. The average ratio of external public debt to GDP in the G-15 countries increased by 15 percentage points between 1981–82 and 1987–88, while the ratio for the four largest debtors increased by more than 9 percentage points (Table 1 and Chart 2). The processes underlying the growth of domestic debt and external debt were, however, significantly different. While the increase in domestic public debt essentially reflects continued access of governments to funds from the private sector, the increase in external debt largely reflects the extension of public sector guarantees to a large portion of private external debt, as well as the rescheduling of interest and amortization payments, since these countries’ access to international capital markets (based on their perceived creditworthiness) had virtually dried up.6

Chart 2.Fifteen Heavily Indebted Developing Countries: Total Public Debt and External Public Debt, 1976–88

(Percentage of GDP)

1 The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’ Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

2 Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

The sharp increase in both the domestic and external public debts of the G-15 countries led to a corresponding steep rise in their total public debt, which, as a proportion of GDP, increased from 33 percent to 54 percent between 1981–82 and 1987–88. The total public debt of the four largest debtors rose almost as fast during this period, increasing from 36 percent to 52 percent of GDP. In most of the G-15 countries, total debt exceeded 50 percent of GDP by the end of the period.

It is worth noting that the current ratios of total public debt to GDP for the G-15 countries are not very different from those of a number of industrial countries, which currently either exceed or are close to 100 percent. Several other industrial countries have debt ratios of between 40 percent and 60 percent.7 A key question that emerges from this comparison is why these industrial countries are not perceived by international financial markets to be facing the same sort of crisis that besets the developing countries. Section III explores the extent to which this fact can be explained by different current and expected fiscal developments.

One facet of the crisis facing developing countries is the rise in secondary-market discounts on their external debts, particularly since 1985. The discounts began to emerge toward the end of 1983, when many of the G-15 countries were beset with external-debt-servicing problems. By the end of 1988, with the exception of Chile, Colombia, and Uruguay, there was a discount of at least 50 percent on the external debt of G-15 countries. The precipitous fall in secondary-market prices between 1985 and 1988 reflected the continuing sharp rise in external debt ratios because of rescheduling, the lack of significant improvement in the perceived capacity to service debt, as well as the competing demands of domestic debt service.

Secondary-market prices of external debt provide an indication of a country’s ability—as perceived by the market—to service its external debt. The ratio of market value of external debt to GDP, when secondary-market prices are used, shows a decline that is particularly notable between 1984 and 1988.8 (See Chart 3.) From 1981–82 to 1987–88, the average ratio for the G-15 countries declined by nearly 5 percentage points of GDP; while for the four largest debtors, the average decline was even larger. By 1987–88, the market value of the same four countries’ external debt was half its contractual value.

Chart 3.Fifteen Heavily Indebted Developing Countries: Market Value of External Public Debt, 1984–88

(Percentage of GDP)

1 The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’ Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

2 Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

The market value of the combined total of external and domestic debt was almost unchanged between 1981–82 and 1987–88, both for the G-15 countries and the four largest debtors. (See Table 2.)9 The relative stability in the market value of total public debt immediately raises a number of critical questions concerning the dynamics of debt in the externally indebted developing countries. For instance, is there an implicit maximum market value of total debt that a government can incur? Does an increase in domestic debt induce a decline in the market value of external debt? More generally, what is the relationship between domestic and external debt, and to what extent do other factors, such as domestic fiscal developments, affect the market value of public debt? These and other questions about the characteristics of domestic debt and their implications for debt servicing are discussed in Sections III and IV below.

Table 2.Fifteen Heavily Indebted Developing Countries: External and Total Public Debt at Market Prices, Selected Periods(Percentage of GDP)
1976–771981–821987–88
External debt1
G-15 countries2
Weighted average314.722.818.2
Median17.827.524.0
Standard deviation8.317.516.1
Four largest debtors4
Weighted average314.624.216.7
Median12.726.218.1
Standard deviation4.29.09.3
Total debt5
G-15 countries2
Weighted average320.833.034.3
Median24.135.540.4
Standard deviation10.519.221.2
Four largest debtors4
Weighted average320.936.235.0
Median18.438.136.4
Standard deviation5.44.86.9

The external debt ratio at market prices is obtained by multiplying the external debt ratio at contractual value by the secondary-market price of external debt. Data on secondary-market prices for 1985—88 were obtained from Salomon Brothers (New York).

The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

Weights are the same as those used in Table I.

Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

The total public debt ratio is the sum of the domestic debt ratio provided in Table I and the external debt ratio at secondary-market prices provided in this table.

The external debt ratio at market prices is obtained by multiplying the external debt ratio at contractual value by the secondary-market price of external debt. Data on secondary-market prices for 1985—88 were obtained from Salomon Brothers (New York).

The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

Weights are the same as those used in Table I.

Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

The total public debt ratio is the sum of the domestic debt ratio provided in Table I and the external debt ratio at secondary-market prices provided in this table.

Before examining these questions, it is natural to inquire why the growth of domestic public debt should be a source of concern. Two main reasons are worth noting. First, the growth of domestic debt has led to a sharp increase in debt-service payments and a further weakening in the public sector’s ability to service its external debt. Increased debt-service requirements, for both domestic and external debts, also put more pressure on public sector investment. Even though investment was curtailed in many cases and the infrastructure subsequently deteriorated in a number of the indebted countries, these developments were not accompanied by the further adjustment required in the public sector’s current expenditures or in the revenue base. Thus, increasing fiscal deficits resulted which, in the absence of new external borrowing, led to further domestic debt accumulation.

A second major reason for concern has been the sharp increase in the rate of inflation that accompanied the increased fiscal deficits and the domestic debt burden from 1982 onward. Several of the heavily indebted developing countries experienced annual inflation rates averaging over 200 percent. As shown in Table 3, the rate of inflation for the four largest debtors increased from an average of 3.9 percent a month during 1975–81 to over 9 percent a month during 1982–88—which are equivalent to yearly rates of 65 percent and 235 percent, respectively. For the G-15 countries, the average inflation rate was more than twice as high during the second period as during the first period. Not only did the average inflation rate increase but also its variability. The deteriorating inflation performance has led to growing uncertainty, which has had further, markedly adverse effects on investment and growth.10 High inflation has also led to increased incentives to economize on holdings of non-interest-bearing assets; this has resulted in rapid demonetization in some economies, with an associated loss in welfare caused by rising transaction costs. In many cases, another major adverse effect of high inflation was a fall in the real value of tax revenues caused by collection lags.

Table 3.Fifteen Heavily Indebted Countries: Monthly Inflation and Real Interest Rates, Selected Periods(In percent)
Monthly Inflation Rates1Monthly Real Interest Rates2
1975–811982–881978–811982–88
G-15 countries3
Weighted average43.26.9–0.6–1.1
Median1.52.7–0.40.3
Standard deviation2.04.71.03.1
Four largest debtors5
Weighted average43.99.1–0.8–1.5
Median2.88.4–0.3–1.5
Standard deviation2.15.71.23.8

Data on inflation were computed from the consumer price index data provided in various issues of International Monetary Fund, International Financial Statistics.

Data extracted from various issues of International Financial Statistics. Nominal interest rates correspond to the deposit rate in all countries, with the exceptions of Brazil and Mexico, for which their treasury bill rates were used. Monthly real interest rates are calculated using the one-month forward inflation rate as given by the consumer price index.

The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

Weights are the same as those applied in Table I.

Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

Data on inflation were computed from the consumer price index data provided in various issues of International Monetary Fund, International Financial Statistics.

Data extracted from various issues of International Financial Statistics. Nominal interest rates correspond to the deposit rate in all countries, with the exceptions of Brazil and Mexico, for which their treasury bill rates were used. Monthly real interest rates are calculated using the one-month forward inflation rate as given by the consumer price index.

The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

Weights are the same as those applied in Table I.

Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

High inflation in several of the sample countries was accompanied by increasingly negative and volatile real interest rates. For several of the G-15 countries, the monthly average ex post real rates were negative and volatile even before the onset of the debt crisis (Table 3).11 After 1982, however, the ex post interest rates became, on average, even more negative, and their variance also increased substantially. The increased volatility was due largely to the fact that a number of countries experienced, on the one hand, episodes of very high positive real interest rates in the midst of stabilization efforts, and, on the other hand, episodes of highly negative real interest rates when adjustment programs were abandoned.

The existence of negative ex post real interest rates in these countries may be considered as something of a puzzle. It is reasonable after all to conjecture that the risks of high and volatile inflation, and of possible default would lead domestic investors to require that significant risk premiums be embodied, ex ante, in domestic interest rates. Given the earlier evidence on the ability of governments to increase their domestic liabilities, it may be thought that the requisite risk premiums would be forthcoming. If this were the case, higher interest rates would be expected to further increase the debt burden. At any given time, investors may underestimate the expected rate of inflation and therefore, ex post, experience negative real returns. But it may be thought that over any length of time, investors’ expectations do not consistently underestimate inflation, and, hence, on average, they obtain positive real returns.

One solution to the puzzle may be found by considering the proposition that domestic public debt may have provided liquidity services to the holder. If that is the case, domestic public debt may be viewed as an interest-bearing component of a broad monetary aggregate. Therefore, real interest rates may be lower, on average, than the international interest rate and may even be negative on account of a liquidity premium. The liquidity premium may be thought of as an important component of the “effective” return on an asset. Thus, the sum of the pecuniary return and the liquidity premium on an asset which provides liquidity services may well be, in equilibrium, no different from the return on an asset which does not provide liquidity services to the holder. This explains why liquid assets—for instance, money—are willingly held even though their pecuniary return, in real terms, is significantly lower than those on other financial assets.

A second solution may be found by considering the proposition that in a period of high and volatile inflation, investors’ horizons are considerably shortened. Therefore what is relevant is not average real rates over a period of several years, but rather average real rates over a period of months. If the real returns are examined on, say, a year-to-year basis over time, then for most of the high-inflation countries, the annual average real return would be expected to be either close to zero or positive. An analysis of the returns in individual countries suggests that when shorter horizons are considered, returns do not significantly differ from zero in a number of cases. In some cases, however, ex post real interest rates are significantly below zero even when shorter horizons are examined.12

2. Fiscal Developments

In most of the countries with large external debts, the increase in the domestic public debt ratios largely reflects inadequate fiscal adjustment in the face of a virtual cessation of private external financing and, in several countries, a deterioration in the terms of trade. While fiscal deficits in some countries decreased immediately following the onset of the external debt crisis, after a short time they again increased. On average, for the 15 indebted countries, the fiscal situation remained serious (Table 4 and Chart 4).

Table 4.Fifteen Heavily Indebted Developing Countries: Fiscal Accounts of the Consolidated Public Sector, Selected Periods1(Percentage of GDP)
1979–821983–851986–88
Revenue
G-15 countries223.322.122.7
Four largest debtors318.518.117.6
Expenditure
G-15 countries227.425.326.9
Four largest debtors323.921.623.7
Surplus or deficit (-)
G-15 countries2–42–3.3–42
Four largest debtors3–5.4–3.5–6.1
Interest payments
G-15 countries43.56.27.1
Four largest debtors3.15.87.0
Primary surplus or deficit (-)
G-15 countries4,5–2.32.00.8
Four largest debtors–2.32.30.9

Data were obtained from recent unpublished papers written by various International Monetary Fund staff members. They are drawn from the accounts of the nonfinancial public sector for all G-15 countries, except in the following cases: data for Brazil are for the consolidated general government; data for Colombia and Ecuador are for the consolidated public sector; data for Nigeria are for the federal government; and data for the Philippines are for the national government. Weights are the same as those used in Table I.

The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

Estimate was based on nine countries for which data were available: Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, the Philippines, and Venezuela.

Data are not comparable with those provided for the G-15 overall surplus or deficit.

Data were obtained from recent unpublished papers written by various International Monetary Fund staff members. They are drawn from the accounts of the nonfinancial public sector for all G-15 countries, except in the following cases: data for Brazil are for the consolidated general government; data for Colombia and Ecuador are for the consolidated public sector; data for Nigeria are for the federal government; and data for the Philippines are for the national government. Weights are the same as those used in Table I.

The Group of Fifteen countries include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

Among the G-15, the four developing countries with the largest external debts are Argentina, Brazil, Mexico, and Venezuela.

Estimate was based on nine countries for which data were available: Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, the Philippines, and Venezuela.

Data are not comparable with those provided for the G-15 overall surplus or deficit.

Chart 4.Fifteen Heavily Indebted Developing Countries: Summary of Fiscal Accounts, 1978–881

(Percentage of GDP)

1 Weighted average of the Group of Fifteen countries which include Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’ Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.

One of the important reasons for the heavily indebted developing countries’ precarious fiscal situation has been the low and, in some cases, declining, ratio of tax revenues to GDP.13 The inadequate revenues are due in part to the consequences of the external debt problem itself. In order to obtain current account surpluses with which to service external debt, domestic demand was frequently restrained. This restraint led, in turn, to lower wages, profits, and per capita incomes, as well as to lower imports, thus eroding the tax base. In part, lower revenues have been due to the increasing administrative and technical problems involved in tax assessment, as well as in the levying and collection of taxes. The decline in the tax base could have been offset to some extent by an increase in tax rates. But increasing tax rates would also have entailed other direct economic and political costs which the authorities may not have been willing to bear. In several countries, tax rates were, in fact, increased, but the increases often proved to be unproductive or even counterproductive.14

Seigniorage owing to price inflation contributed to restraining the increase in debt ratios but, at the same time, led to a reduction in normal tax revenues. Unlike the experience in industrial countries, in which the “bracket-creep” from inflation-induced income growth leads to increased tax revenues, the experience in indebted developing countries has been that their collection lags lead to considerable losses in real tax revenues.15

In the face of a sharp increase in debt-service requirements and declining or unchanging real revenues, the percentage share of public noninterest expenditure in GDP has been reduced in most of the G-15 countries, with some of the sharpest declines occurring in Mexico and Venezuela. For Mexico, the ratio of non-interest expenditure to GDP fell by more than 10 percentage points between 1982 and 1987. The drop was due for the most part to a large reduction in investment, as well as to real wage cuts in the public sector, and to a lesser degree, to cuts in subsidies. For Venezuela, non-interest expenditure was reduced primarily by cutting investment in the oil industry. Wideranging expenditure reductions also took place in the Philippines during this period, with public investment again bearing the brunt of the cuts.

In several countries, the non-interest deficits of public sector enterprises declined after 1982, but these deficits remain an important component of the overall deficit and have contributed to the growth of public sector debt. The deficits of public enterprises were due in part to inappropriate pricing policies, which had been adopted out of the authorities’ concern about income distribution and price stability; the policies, however, often led to prices being set below long-run marginal costs. In the wake of the fiscal adjustment required to enable a country to service its public debt, it was rarely possible to avoid raising public sector prices. Such price increases, however, have often generated general discontent, and, over time, the public sector prices have barely kept pace with increased costs.

Domestic public debt figures include gross liabilities of the consolidated public sector, and of the monetary authorities, with the domestic private sector. Since these are consolidated data, government liabilities held by the monetary authorities are excluded.

The average debt ratio for the G-15 countries is a weighted average in which each country’s weight is given by the proportion of its GDP (in U.S. dollars) in the group’s combined total GDP in 1981–82. The reason for using weighted averages is to make these data comparable with those used in existing studies of external debt. Results are qualitatively unchanged when unweighted averages are used.

Among the G-15, the four largest debtors, all of which are in the Western Hemisphere, are Argentina, Brazil, Mexico, and Venezuela.

It is worth noting that diverse institutional arrangements for domestic debt exist among the G-15 countries. In some countries, much government borrowing is financed directly by the public through the competitive placement of securities in relatively well-developed capital markets, while in other countries, government borrowing involves central bank intermediation.

In two cases, Cote d’Ivoire and Peru, the government had run into domestic arrears during the review period. These arrears represent a form of domestic public debt that is not voluntary. For Cote d’Ivoire, the domestic public debt data used in this paper include part of these arrears, which constitute a small portion of the total. For Peru, domestic arrears are not included in the data presented because information was not available.

Table 10 in Appendix II reports the public debt ratios of the majority of the Organization for Economic Cooperation and Development (OECD) countries. As it indicates, the average ratio for these countries increased to 59 percent of GDP in 1988 from 48 percent of GDP in 1982.

It is worth pointing out that for Chile, Colombia, and the Philippines, there was an increase in the market value of external debt, perhaps reflecting some market optimism about their debt-servicing ability.

Estimates provided in Table 2 are calculated by multiplying the secondary market price of the syndicated bank debt by the total public external debt. This is done for expositional purposes only. It might, in fact, be argued that the claims of the official bilateral creditors and of the international financial institutions should not be discounted at the same rate as syndicated commercial bank debt.

The market value of external debt is calculated using secondary-market prices. Since, during the review period, domestic debt had been serviced regularly, there were no discounts on domestic debt comparable with those attached to external debt. It may be argued that one reason why domestic debt has been serviced regularly is that governments always have the option of issuing currency to do so. Thus, in nominal terms, a government may never need to resort to outright default on its domestic debt. In real terms, however, if governments issue domestic currency to service their domestic debts, an effective “default” would result through an increase in inflation, to the extent that such an increase was not anticipated and, hence, was not included in nominal interest rates. The interaction between government policy regarding inflation and public expectations will be discussed in detail in Section IV.

See, for instance, the discussion in Owen Evans, “National Savings and Targets for the Federal Budget Balance in the United States,” Chapter III of Staff Studies for the World Economic Outlook (Washington: International Monetary Fund, September 1990), pp. 35–52. Kormendi and Meguire (1985), De Gregorio (1991 b), and Fischer (1991) provide empirical evidence suggesting a negative relationship between inflation and long-run growth in Latin American countries.

Interest rates reported in Table 3 are based on countries’ short-term deposit rates, with the exceptions of Brazil and Mexico, for which the interest rates on their treasury bills were used.

A number of characteristics of the financial markets in some of these countries may also have a bearing on this issue. These include, for example, interest rate controls, restrictions on capital flows, and portfolio requirements imposed on depository institutions.

The fall in the real value of tax revenue caused by inflation has been analyzed, most notably, by Olivera (1967) and Tanzi (1977).

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