Chapter

IV Assessing Sovereign Debt Structures

Author(s):
Alfred Schipke, and Dominique Desruelle
Published Date:
June 2007
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Author(s)
André Faria and Guillermo Tolosa 

Since the Asian crises of the late 1990s, researchers and policymakers have put more emphasis on countries’ balance sheets to identify sources of vulnerability. This has led several authors to advocate a “holistic” balance sheet approach as a complement to other surveillance practices to closely monitor these vulnerabilities and sectoral interlinkages.2 A fragile balance sheet of a single sector of the economy might be enough to plunge a country into crisis due to the exposure of other sectors to that single sector. In Central America, assessing the vulnerabilities of the sovereign is of particular importance since the sovereign is the most important external debtor, with implications for the economy as a whole.3 This chapter analyzes Central America’s sovereign debt structures, considers how they evolved over time, and assesses the vulnerabilities implied by them.4

Analysis of Sovereign Debt Structure in the Context of a Balance Sheet Approach5

The balance sheet approach relies on the analysis of an economy’s sectoral balance sheets to identify four types of risks that are typically at the origin of crises: currency, maturity, capital structure mismatches, and solvency risk.6 Currency mismatches occur when assets and liabilities are denominated in different currencies; typically, a vulnerability may be present when assets are denominated in local currency, and liabilities are foreign-currency denominated. Likewise, maturity mismatches occur when assets and liabilities have different maturities: a vulnerability might be present when a sector has long-term assets and short-term liabilities. Capital structure mismatches are present when there is an excessive reliance on debt relative to equity. Solvency risk arises when the value of assets is lower than that of the liabilities. All these vulnerabilities tend to be inter-related.7

The public sector often plays a key role in the development of balance sheet vulnerabilities. Although the private sector was the root cause of several of the balance sheet crises in Asia—with the banking sector being the transmission mechanism for the rest of the economy8—the public sector is an important external debtor in several emerging market and developing countries. In their comprehensive review of sovereign debt, Borensztein and others (2004) show that although sovereign debt stocks (as a percent of GDP) do not differ substantially between advanced economies and emerging market countries, the composition of public debt is strikingly dissimilar. Whereas government debt of advanced economies is typically placed domestically and denominated in local currency and at longer maturities, government debt of emerging market countries is placed internationally and denominated in foreign currency and at shorter maturities.9

A given debt structure is an endogenous outcome of political and institutional constraints and government behavior. For example, the currency composition of sovereign debt may be a reflection of the credibility of monetary policy (Bohn, 1990; Jeanne, 2003), and debt maturity may be a disciplining device to ensure that governments adopt good policies and are accountable to capital markets (Jeanne 2004; Tirole, 2002 and 2003).10 That is, a given debt structure is the outcome of past and current economic policies and institutional circumstances, which in turn determine the level and quality of access to international capital.11 Therefore, sound macroeconomic policies and better debt management, supported by a strengthened institutional framework, are likely to reduce the vulnerability of debt structures.12

Sovereign Debt Across Countries and Over Time

To assess potential vulnerabilities, this section analyzes sovereign debt structure in Central American countries over the past few years. It looks at the level and evolution of debt-to-GDP ratios, the jurisdiction of issue, creditor composition, currency denomination, and maturity structure.

The economies of Central America are very diverse. There are officially dollarized countries (El Salvador and Panama), nondollarized emerging market countries (Costa Rica, Guatemala, and the Dominican Republic), and countries that qualify for the Heavily Indebted Poor Countries (HIPC) Initiative (Honduras and Nicaragua). Keeping this in mind, this chapter highlights similarities and differences across the region.

Total Debt

Over the past few years, the non-HIPC countries have experienced, on average, an increase in sovereign debt as a proportion of GDP (Figure 4.1).13 Guatemala has maintained a relatively low and stable debt-to-GDP ratio, while Panama’s debt has been stable but at a higher level. By contrast, debt ratios have risen in El Salvador and especially in the Dominican Republic. From 2002 to 2003, the debt-to-GDP ratio in the Dominican Republic doubled from 27 percent to 56 percent. This abrupt increase in the level of debt is associated with a severe banking crisis, which resulted both in a bailout of a number of local banks and a sharp devaluation of the local currency.

Figure 4.1.Composition of Sovereign Debt

(In percent of GDP)

Sources: National authorities; and IMF staff calculations.

1 Public sector.

2 Nonfinancial public sector and central bank.

3 Nonfinancial public sector.

4 Central government.

5 Nonfinancial public sector.

6 Public sector and central bank.

7 General government.

As regards the HIPC countries, Honduras experienced a decline in the debt-to-GDP ratio during the period under consideration, while Nicaragua essentially had a similar debt-to-GDP ratio in 2000 and 2004. Both countries qualified for debt relief under the HIPC and Multilateral Debt Relief Initiatives from the IMF, the World Bank, and the Inter-American Development Bank, which are translating into significant debt reductions. In the case of Nicaragua, for example, public external debt levels are expected to fall from 120 percent of GDP in 2004 to about 45 percent of GDP in 2007.14

Creditor Composition

Creditor composition is strongly related to the overall economic performance of a country. In particular, access to international capital markets is an indication of strong economic performance. In addition, it has been found that the quality of policies is a fundamental variable to explain market access above and beyond the impact of those policies on growth (Gelos, Sahay, and Sandleris, 2004).

The creditor composition of the external debt of Central American countries highlights their heterogeneity (Figure 4.2). The two HIPC countries (Honduras and Nicaragua) have no access to international capital markets, whereas the non-HIPC countries (Costa Rica, El Salvador, Guatemala, Panama, and the Dominican Republic) have a profile similar to emerging market countries.

Figure 4.2.Structure of External Debt, 2001–05

Sources: World Bank, Global Development Finance (2004); and IMF staff calculations.

Note: External debt is public and publicly guaranteed (PPG) debt. PPG debt is an external obligation of a public debtor (including the national government, a political subdivision, or an agency of either, and autonomous public bodies) or of a private debtor that is guaranteed for repayment by a public entity outstanding at year-end that has an original or extended maturity of more than one year. The non-HIPC group consists of Costa Rica, Dominican Republic, El Salvador, Guatemala, and Panama. The group of HIPC countries includes Honduras and Nicaragua.

The non-HIPC countries have roughly half of their debt held by the private sector,15 80 percent of total external debt is nonconcessional, and more than 85 percent of privately held financing takes the form of bonds. By contrast, HIPC countries are almost exclusively financed by the official sector, mostly through concessional loans, and 80 percent of privately held financing is done through the banking sector (and none takes the form of bonds).

Jurisdiction

The ability of the sovereign to place debt in local markets is a sign of economic strength. A larger share of domestic debt reflects a strong contractual environment. It allows the sovereign to reduce exposure to sometimes volatile international capital markets.16

Developed countries have typically financed a large share of their total debt in their mature local markets. Developing countries in general, and Central America in particular, rely to a much larger extent on international markets. In Central America, on average, only 30 percent of sovereign debt is placed domestically. Costa Rica is the only country in Central America for which domestic debt represents more than 50 percent of sovereign debt.

However, in recent years, developing countries have been able to increase their share of debt financed in domestic markets (World Bank, 2005; IDB, 2006). Central America has been no exception to this trend, and every country in the region (with the exception of Panama) has increased the fraction of debt issued domestically. On average, this share increased by 5 percentage points. The country with the most dramatic change was the Dominican Republic. From 2002 to 2003, its share of domestic debt increased by more than 15 percent, reflecting in large part the need to engage in open market operations to offset the massive liquidity injection after the banking crisis.

Currency Denomination

It is now widely accepted that the currency denomination of debt has important macroeconomic consequences. In particular, it plays a critical role in macroeconomic adjustments to external shocks, and it has been a key factor in recent financial crises (Allen and others, 2002; Rosenberg and others, 2006). Currency mismatches not only increase the likelihood of a crisis, but also make it more costly to get out of one (Goldstein and Turner, 2004). Also, currency mismatches can severely constrain monetary and fiscal policies.

Central America has a higher share of foreign currency debt in total debt than other Latin American countries (Figure 4.3).17,18 However, from 2001 to 2005, the region experienced some improvement, in particular in Guatemala and the Dominican Republic.19 A reduction of currency mismatches was also experienced by other Latin America countries, and may be associated with benign worldwide conditions for emerging market countries.

Figure 4.3.Foreign Currency Debt

(In percent of total debt)

Sources: National authorities; and IMF staff calculations.

Note: Sovereign debt coverage differs across countries.

1 Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

Box 4.1.Measures of Currency Mismatch Risk

A currency mismatch in the balance sheet of a sector exists when assets and liabilities are denominated in different currencies. Exchange variations are likely to affect assets and liabilities differently. Therefore, a meaningful measure of currency mismatch risk computes the impact a change in the (real) exchange rate has on the leverage ratio (ratio of liabilities to assets). This box presents the measure this chapter uses to assess currency mismatch risk—elasticity of the ratio of liabilities to assets to real exchange rate movements—and covers in a unified way the different measures proposed in the literature.

Standard Measure

A standard and widely used measure of currency mismatch looks at the ratio of foreign currency debt to total debt:

where B and B* are the sovereign debt in local and foreign currency, and e is the real exchange rate. This measure relates to the “original sin” index created by Eichengreen, Hausmann, and Panizza (2005). However, as it was discussed in detail by Goldstein and Turner (2004), it neglects the asset side of the sovereign (indeed, it implicitly assumes that all assets are in local currency—see below). Moreover, insofar as the tradable component of assets of the sovereign changes over time and across countries, this measure is not adequate for time series and/or cross-country comparisons.

Despite these shortcomings, this measure has been widely used, most of all because of its simplicity. For this same reason and for comparibility with the related literature, this chapter uses this measure for the analysis of the debt structure and its determinants. In the subsection dedicated to debt vulnerabilities, this is one of the three measures used to calculate the currency mismatch.

New Measure

In addition to the standard measure of currency mismatch, this chapter proposes a new measure of currency mismatch risk that looks at the composition of assets and liabilities. Assuming for now, for the sake of comparability with some standard measures, that GDP is a good proxy for the assets of the sovereign, an alternative currency mismatch measure is:

where Y and Y* are the nontradable and tradable components of GDP, and B and B* are the sovereign debt in local and foreign currency. If the ratio equals 1, the composition of liabilities and assets are perfectly matched. In the case in which the sovereign issues all its debt in foreign currency, the ratio is equal to the inverse of the share of tradables in the economy (therefore, larger than 1). If all sovereign debt is issued in local currency, γ is equal to zero. This ratio relates closely to the measure used throughout the chapter, ξ, which has a meaningful interpretation:

In this case, ξ is a measure of currency mismatch risk: this elasticity gives the percentage change in the debt-to-GDP ratio as a consequence of a 1 percent increase in the real exchange rate. The standard measure, σ, equals ξ in the case in which the tradable component of GDP, Y*, is zero. This assumption is obviously extreme, so S is an upper bound to the effective change in the debt-to-GDP ratio as a result of a 1 percent increase.

To assume that the GDP is a proxy for the sovereign’s assets is an extreme assumption, as the sovereign is not able to fully appropriate GDP without substantially reducing it (among other reasons, owing to incentive problems and the inalienability of human capital; see Hart and Moore, 1994). Government primary surpluses are a more reasonable proxy for the sovereign’s assets; however, the division of the government accounts in tradable and nontradable components is nontrivial. An alternative measure that looks at the government’s budget more seriously incorporates the net present value of government’s expenditures on the liability side and the present value of government’s revenues on the asset side. (Burnside, Eichenbaum, and Rebelo, 2006, show that for some countries the effect of currency devaluation in government accounts, or “implicit fiscal reforms,” can be considerably large.)

This approach divides current government expenditures into two components: tradable and nontradable. Assuming the composition of government expenditures and the total share of government expenditure in GDP remain unchanged, it computes the net present value of local and foreign-currency-denominated government expenditures. These components are added to debt components and the totals are assumed to represent the totality of the sovereign’s liabilities. For the asset side, the net present value of revenues is added to reserves to form total assets. The share of the tradable component of revenues is then assumed to be equal to the share of tradables in the economy (exports to GDP). Using this ratio, the net present value of the tradable component of revenues is computed. Foreign-currency-denominated assets are the net present value of the tradable component of revenues and reserves. The computation of the elasticity of the leverage ratio is then straightforward.

As discussed in the main text, elasticities alone may not provide meaningful information in terms of debt-sustainability analysis. Multiplying the elasticity by the initial debt-to-GDP ratio would allow the policymaker to fully realize the impact of changes of the real exchange rate on that ratio.

Other Measures

The new measure of currency mismatch proposed in this chapter, ξ, relates to other measures developed in the literature, namely those created by Goldstein and Turner (2004) and Calvo, Izquierdo, and Talvi (2003).

Rescaling γ by the ratio of (net) foreign currency debt to GDP delivers a sovereign debt equivalent of the aggregate effective currency mismatch measure proposed by Goldstein and Turner (2004).

The measure γ also relates to the one proposed by Calvo, Izquierdo, and Talvi (2003):

The scale of this measure is inverted when compared with γ: the closer to zero, the larger the currency mismatch risk; the larger the number, the smaller the currency mismatch. Its relation with γ is given by

When γ equals zero (no currency mismatch), τ is infinite; τ is zero when γ equals the inverse share of tradables in GDP, that is, when all sovereign debt is in foreign currency; when both economies are fully hedged both measures are equal to 1. The drawback of the measure proposed by Calvo, Izquierdo and Talvi (2004), τ, comes from the fact that it delivers the maximum currency mismatch risk when a country has no domestic debt, regardless of the openness of the economy.

To illustrate the difference between τ and γ, consider two economies, A and B, that borrow exclusively in foreign currency but which have different levels of openness: economy A has an ε share of its GDP in tradables, and economy B has an ε share of its GDP in nontradables, where ε is an arbitrarily small number different from zero. The measure proposed by Calvo, Izquierdo, and Talvi (2003) delivers the larger currency mismatch for both economies, τ=0.

However, γ distinguishes clearly between both cases: for A, γ=1ε, that is, very large (large currency mismatch) and for B, γ=11ε, that is, very close to 1 (perfect hedging). The main advantage of τ is its invariance to the real exchange rate. In net terms, γ and especially ξ are more meaningful measures of currency mismatch risk.

Maturity Structure

A high percentage of short-term debt can expose the sovereign to rollover risk. The sovereign’s main assets are essentially illiquid and long term while its liabilities can be short term, leaving it exposed to a maturity mismatch that can potentially lead to a liquidity crisis.20 In spite of the risks involved, it might still be optimal for governments to borrow short term under certain conditions, for instance because of investor risk aversion or of underlying fragilities that provide incentives to investors to avoid longer-term lending.21

The presence of short-term debt in market access countries in Central America is highest in Costa Rica and the Dominican Republic (Figure 4.4). Panama, Guatemala and El Salvador have minimal levels of short-term debt (indeed, Guatemala has no short-term debt at all). Overall, the region compares relatively well with other Latin American countries.22

Figure 4.4.Short-Term Debt

(In percent of total debt)

Sources: National authorities; and IMF staff calculations.

Note: Sovereign debt coverage differs across countries.

1 Guatemala reported no short-term debt for either 2001 or 2005.

2 Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay, and Venezuela.

The average remaining maturity of emerging markets’ sovereign debt has increased considerably in recent years (IMF, 2006), and, over 2001–05, the short-term exposure of Latin American countries was reduced, albeit moderately. These broad movements across emerging markets reflect a cyclical reduction in the risk aversion of investors, a global decrease in long-term rates, and improved creditworthiness because of stronger economic conditions. In Central America, El Salvador reduced its short-term exposure while Panama’s and Costa Rica’s exposure remained broadly unchanged. In contrast, that of the Dominican Republic increased significantly.

Determinants of Debt Structure

Analyses of the determinants of debt structures have long been hampered by the paucity of data. Partly as a result, no consensus has yet emerged on optimal policies to make debt structures safer. Lately, new important data sets have been developed that have provided important insights.23 This section aims to confirm some of the results obtained in the literature by using a sample of 27 market access countries to gain some additional perspective on the relative situation of the Central American countries.24

Domestic Debt

The literature finds that reliance on debt issued domestically depends importantly on contract enforcement, market size, and investor base. These results were confirmed in our sample by running a cross-country regression using as proxies, respectively, the rule of law indicator (obtained from Kaufmann, Kraay, and Mastruzzi, 2005), total GDP, and M2/GDP. These variables are all statistically significant at standard levels.25 Countries with weaker contract enforcement give less protection to investors against confiscation risk and the severity of loss in case of default, creating more incentives for them to rely on debt issued in foreign jurisdictions. While foreign jurisdictions have not delivered much in terms of recovery of assets, they have been effective in excluding countries from debt markets, and thus create a credible threat that indirectly provides greater protection to investors.26

Differences in domestic issuance across non-HIPC Central American countries can largely be explained by these factors as well. Figure 4.5 and Table 4.1 show that they can account for the fact that Costa Rica relies more heavily on the domestic market than economies with smaller size and weaker performance on the rule of law indicator. Other less conventional factors, such as the exchange rate regime, could explain the remaining differences. The full dollarization of Panama may explain why it relies so little on the domestic market, as the perfect substitutability of local and foreign currencies may make it more attractive to place debt in international markets.

Figure 4.5.Domestic Debt: Predicted and Actual

(Based on regression with financial development, total GDP, and rule of law as independent variables)
Table 4.1.Domestic Debt Share Determinants
Rule of LawGDPM2/GDP
Costa Rica0.5718.5337.62
Dominican Rep.–0.5418.4438.17
Panama–0.0414.2074.65
Guatemala–0.9625.9630.53
El Salvador–0.3415.824.74
Sample average–0.114.7450.11
Sources: Kaufmann, Kraay, and Mastruzzi (2005); and IMF, International Financial Statistics.
Sources: Kaufmann, Kraay, and Mastruzzi (2005); and IMF, International Financial Statistics.

The determinants of debt jurisdiction in HIPC countries (Honduras and Nicaragua) are significantly different. Given that most external debt is official, which typically does not entail rollover risks, and is granted at concessional rates, this type of debt is generally a more attractive option from a vulnerability perspective. The share of external debt in total debt is thus mainly constrained by the availability of official financing.

Foreign Currency Debt

For non-HIPC countries, the ability to issue debt domestically is critical to be able to issue debt in domestic currency (Figure 4.6a). Relying on a foreign jurisdiction for contracting debt with private creditors almost inevitably implies reliance on foreign currency debt.27 In Central America, Costa Rica has been the most successful in issuing a high share of debt in domestic currency, while Guatemala has been least successful given its more limited ability to tap domestic markets. The Dominican Republic has stood in the middle of these two extreme cases.28

Figure 4.6a.Domestic Debt and Foreign Currency Debt Share

Countries may also be unable to issue domestic currency debt because of poor credibility of monetary policy.29 Limited monetary policy credibility can in turn be related to a history of high inflation, which can potentially sharply reduce the ability of the sovereign to issue long-term debt in domestic currency (Figure 4.6b), or be associated with poor institutions or a weak policy framework (see Chapter VI).30 While inflation has come down in Central America in line with other emerging markets, the fall in inflation does not immediately translate into improved debt structures, which tend to show significant persistence.

Figure 4.6b.Inflation History and Foreign Currency Debt

Foreign currency debt could also be a consequence of an unconstrained optimization of the debt portfolio, given the evolution of expected return and variance of portfolios. For example, it is the optimal hedging strategy when the volatility of inflation is considerably higher than the volatility of the real exchange rate.31 Another key dimension in the optimality of this type of debt is the correlation of the exchange rate with public revenue. A way to capture these elements is to consider the relative volatility of public revenue in terms of foreign currency, domestic currency, and indexed domestic currency. Ideally, debt should be denominated in those units in which public revenue exhibits the lowest volatility. Only Costa Rica seems to have a clear hedging argument to become indebted in dollars, which might be a possible reason why it seems to be issuing more foreign-currency-denominated debt than expected based on its capacity to issue domestically and its inflation history. In the case of Guatemala, there is no clear case for hedging, thus raising questions about the desirability of such a high share of foreign currency borrowing.

Short-Term Debt

The determinants of issuing debt at shorter maturities are less well understood, partly reflecting the limited empirical work in this area. Much of the literature deals with the common factors behind risky debt structures in general,32 and while some authors do focus on the maturity profile of debt, they generally consider economy-wide debt as opposed to sovereign debt. However, one possible cause of this vulnerability is the presence of high total debt (Rodrik and Velasco, 1999; Missale, 1999). The higher the level of debt, the bigger the incentive to default could be, and thus the shorter the maturity at which investors are willing to lend.33 Past defaults may also have important consequences on present investor willingness to lend longer term (Reinhart, Rogoff, and Savastano, 2003).

An empirical analysis based on our sample suggests that the level of total debt is the only significant variable to explain the share of short-term debt. The rule of law variable does not show a strong association in this case, and neither does M2/GDP, the size of the economy, or past inflation, casting doubt on the view of common underlying factors for both currency and maturity vulnerabilities. Nor did default history and income (proxied by GDP per capita), as indicators of institutional strength, turn up to be important determinants of the level of short-term debt in our small sample.34 Finally, foreign currency debt was not significant either. Two contrasting channels may be at play here: the exogenous presence of foreign currency debt increases financial fragilities that translate into high short-term debt (Bussière, Fratzcher, and Koeniger, 2004);35 and, in contrast, for a given level of institutional and policy weaknesses, short-term debt is an alternative risk-coping mechanism to foreign currency risk.

For Central American countries, the share of short-term debt can only be partially explained by the total level of debt, the only significant variable mentioned above. Costa Rica and the Dominican Republic show relatively more short-term debt than expected, Guatemala is near the predicted value, and Panama and El Salvador have considerably less short-term debt share than expected (Figure 4.7). These differences suggest that official dollarization might be playing a role in allowing countries to issue debt at longer maturities.

Figure 4.7.Short-Term Share and Total Debt

Closer Look at Vulnerabilities

Currency Mismatch

The first measure, shown in Table 4.2, computes for non-dollarized countries the elasticity of total debt to GDP with respect to the real exchange rate—the percentage change in the total-debt-to-GDP ratio following a 1 percent change in the real exchange rate. This measure assumes that the only effect of a real exchange rate change on GDP is a valuation effect.36 This elasticity is computed by taking the difference between the share of foreign currency debt in total debt and the share of tradable goods (and services) in the economy. An elasticity of zero means that the economy is fully hedged, i.e., a change in the real exchange rate does not affect the debt-to-GDP ratio. An elasticity larger (smaller) than zero means that a devaluation worsens (improves) the debt-to-GDP ratio. Based on this measure, all Central American countries with the exception of Nicaragua reduced their currency mismatch between 2001 and 2004. Costa Rica even managed to fully hedge its position in 2004. In 2004, Nicaragua was the country with the largest currency mismatch.37

Table 4.2.Elasticity of Ratio of Debt to GDP vis-à-vis the Real Exchange Rate
20012004
Costa Rica0.13–0.01
Dominican Republic0.430.16
Honduras0.570.57
Nicaragua0.760.78
Guatemala0.670.61
Sources: National authorities; World Bank, World Development Indicators (2005); and IMF staff calculations.Note: Foreign currency to total debt minus share of tradables in the economy. A value equal to zero implies perfect hedging. A value larger than zero worsens the debt-to-GDP ratio.
Sources: National authorities; World Bank, World Development Indicators (2005); and IMF staff calculations.Note: Foreign currency to total debt minus share of tradables in the economy. A value equal to zero implies perfect hedging. A value larger than zero worsens the debt-to-GDP ratio.

The elasticity of total debt to GDP with respect to the real exchange rate as a measure of currency mismatch is informative but, nevertheless, incomplete. This measure alone is unsuitable for a meaningful debt sustainability analysis because the initial ratios of debt are also important inputs. Rescaling such elasticity by the initial debt-to-GDP ratio would allow for a more meaningful stress test exercise.38 In 2004, Guatemala had an elasticity larger than that of Costa Rica and the Dominican Republic. Despite this, Guatemala’s debt-toGDP ratio after a 30 percent devaluation would remain substantially lower than those of these other countries (Figure 4.8).39

Figure 4.8.Sovereign Debt

(In percent of GDP)

Sources: National authorities; and IMF staff calculations.

Note: Sovereign debt coverage differs across countries.

As has been traditional in debt sustainability analyses and in the macroeconomic literature, the previous measures of currency mismatch risk for the sovereign assumed GDP as a proxy for the sovereign’s assets. This is an extreme assumption, as the sovereign is not able to fully appropriate GDP. Government primary surpluses are likely to be a more reasonable proxy for the sovereign’s assets. However, the division of the primary surplus in tradable and nontradable components is nontrivial. We develop a measure that looks at the government budget to compute the net present value of government revenue and expenditure. (See Box 4.1 for a more complete discussion of the methodology and related literature.)

The second alternative measure of currency mismatch, shown in Table 4.3, computes the elasticity of the sovereign’s leverage ratio—total liabilities to total assets—with respect to the real exchange rate. This elasticity is simply the difference between the share of foreign currency liabilities in total liabilities and the share of foreign currency assets in total assets. As described above, this elasticity takes into account the composition of government expenditures and revenue by decomposing each of them in tradables and nontradables. Assuming the composition of government expenditure and the total share of government expenditure in GDP remain unchanged, it computes the net present value of local and foreign-currency-denominated government expenditure. These components are added to debt components and the totals are assumed to represent the totality of the sovereign’s liabilities. For the asset side, the net present value of revenue is added to reserves to form total assets. The share of the tradable component of revenues is then assumed to be equal to the share of tradables in the economy (exports to GDP). Using this ratio, the net present value of the tradable component of revenue is computed. Foreign-currency-denominated assets are the net present value of the tradable component of revenues and reserves. Given that a large fraction of government expenditure is nontradable, the currency mismatch measure is significantly lower than the previous one for all countries. As with the previous measures, in 2004, Nicaragua was the country with the largest currency mismatch.

Table 4.3.Elasticity of the Sovereign’s Leverage Ratio vis-à-vis the Real Exchange Rate
20012004
Costa Rica–0.15–0.20
Dominican Republic–0.09–0.21
Honduras–0.05–0.03
Nicaragua0.300.24
Guatemala0.070.07
Sources: National authorities; World Bank, World Development Indicators (2005); and IMF staff calculations.Note: Foreign currency liabilities to total liabilities minus foreign currency assets to total assets. A value equal to zero implies perfect hedging. A value larger than zero worsens the leverage ratio.
Sources: National authorities; World Bank, World Development Indicators (2005); and IMF staff calculations.Note: Foreign currency liabilities to total liabilities minus foreign currency assets to total assets. A value equal to zero implies perfect hedging. A value larger than zero worsens the leverage ratio.

Maturity Mismatch

The level of international reserves is an important indicator to assess the vulnerabilities associated with short-term debt.40 As indicated earlier, the Dominican Republic and Costa Rica are the only countries with a significant short-term exposure. However, once reserves are considered, both countries exhibit a ratio of short-term debt to reserves larger than 1 (Table 4.4).41

Table 4.4.Ratio of Short-Term Debt to Reserves
20012005
Costa Rica1.460.83
Dominican Republic0.151.69

Short-term debt is risky not only because of the rollover risk but also because it entails risk in terms of exposure to variation in interest rates. This interest rate risk also applies to debt of longer maturities issued at a variable interest rate. In Central America, variable interest rate debt is relatively common (Figure 4.9). El Salvador appears to be the most exposed to interest rate variations in this case. In this sense, El Salvador seems to be trading off the option of having higher short-term debt with having more debt at a variable interest rate. At the other extreme, Guatemala and Panama exhibit the lowest level of debt indexed to the interest rate, reflecting an overall safer profile of debt. Costa Rica and especially the Dominican Republic are more exposed. Given their high levels of short-term debt, their overall exposure to interest rate movements is considerably greater.

Figure 4.9.Debt with Variable Interest Rate, 2005

(In percent of total debt)

Sources: National authorities; and IMF staff calculations.

Note: Sovereign debt coverage differs across countries.

Capital Structure Mismatch

An often neglected risk concerns the typically non-contingent nature of debt, i.e., the fact that debt obligations are independent of the level of GDP or fiscal revenue.42 This noncontingent nature could possibly be overcome if expenditure were flexible enough to adjust to the performance of revenue. However, this is seldom the case. Therefore, countries with a higher volatility of revenue tend to have higher financing needs at specific moments in time. Indeed, volatility of revenue has been proved to be an important determinant of “safe” thresholds of debt (IMF, 2003; Mendoza and Oviedo, 2004). This risk is likely to be exacerbated if countries have large maturity mismatches and/or high interest rate risk.

Nicaragua appears as the most risky country in Central America along this dimension (Figure 4.10), probably associated with a less diversified productive base. Revenue volatility also seems relatively high in the Dominican Republic, Panama and Guatemala. In contrast, public revenue in El Salvador and Costa Rica have been remarkable stable.

Figure 4.10.Volatility of Revenue Growth, 1990–2005

(In percent)

Sources: IMF, International Financial Statistics and World Economic Outlook; and authors’ calculations.

Conclusions

Central America has made important strides toward safer debt structures. Over the years, in line with broader developments in emerging markets, the Central American countries have reduced their reliance on riskier types of debt. In particular, the region has been able to increase its share of debt financed in domestic markets (with the exception of Panama) and has reduced its reliance on foreign currency, albeit modestly

Nevertheless, the main vulnerability in Central America remains its relatively high level of foreign currency debt. The region, with the exception of Costa Rica, has a high share of foreign currency debt in total debt when compared with the rest of the Latin American countries. This exposure may be partially hedged in some countries (especially in the Dominican Republic, Panama, and Honduras), given their high degree of openness to trade and a higher bias in government spending than in revenue stream toward nontradable sectors.

Beyond this, other relevant vulnerabilities tend to differ across countries of the region. A key issue for Honduras and Nicaragua seems to be the limited diversification of the creditor base. In Panama and Guatemala, high volatility of revenue is a particular concern. Costa Rica and the Dominican Republic exhibit relatively high levels of short-term debt. El Salvador is particularly exposed to movements in interest rates given its high share of variable interest rate.

The key to improving debt structures is sound monetary and fiscal policies and strengthened institutions. Sound fiscal policy has an obvious direct impact on debt. Strong fiscal and monetary policies also have other important beneficial effects for debt structures, as they limit volatility, enhance resilience to shocks, and strengthen confidence in the domestic currency. Credible monetary policy, for example, is likely to have a positive impact on the currency composition of sovereign debt. A stronger institutional framework makes it easier for the government to issue debt in its own jurisdiction and currency. In this respect, the rule of law and strong contract enforcement play a particularly important role by reducing confiscation risk and the severity of loss in the case of default. The development of a domestic investor base, for which pension funds can be a catalyst (see Chapter III), can also bring important results. The more financially developed a country is, the lower the shares of foreign currency and short-term to total debt.

References

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1We would like to thank Eduardo Borensztein, Marcos Chamon, Alfred Schipke, and Jeromin Zettelmeyer for helpful conversations and insightful comments to previous drafts. We also thank Luis Cubeddu, Mario Dehesa, Odd Hansen, Ivanna Vladkova Hollar, Koji Nakamura, and Jordi Prat for their help in gathering and cross-checking the data.
2Krugman (1999) was among the first economists to call attention to the importance of balance sheets in understanding the Asian crisis. For a review of the balance sheet approach, see Allen and others (2002) and Rosenberg and others (2005).
3For operational issues related to public debt management, see IMF and World Bank (2001).
4This chapter builds on previous work by the International Monetary Fund on sovereign structure and balance sheet vulnerabilities. The only Central American countries covered in this study are Costa Rica and Panama (Borensztein and others, 2004).
5The term “sovereign debt” is used to denominate the broadest possible category of public debt, including the central government (the sovereign) and subsovereign entities such as municipalities and nonfinancial sector public firms. Due to data limitations, coverage is not uniform across countries. Cowan and others (2006) and IDB (2006) collect data that are comparable across countries; however, in their dataset, composition of debt by currency or maturity is not available for several Central American countries.
6The sectors generally considered are the government, the financial sector (banks and other financial institutions), the nonfinancial private sector (corporations and households), and the rest of the world. This list follows the approach proposed by Allen and others (2002). They recognize, however, that there are several other risks or alternative categorizations. But the classification they adopt has “the advantage of highlighting the underlying mismatches that create sources of vulnerability from a debtor’s perspective” (p. 15). As more data become available, a full balance sheet analysis for all Central American countries might be warranted.
7Rosenberg and others (2005) exemplify this approach by looking at countries that experienced balance sheet crises (Argentina, Turkey, and Uruguay) and at countries that avoided these crises (Brazil, Lebanon, and Peru). Lima and others (2006), in their study of sectoral balance sheet mismatches and macroeconomic vulnerabilities in Colombia, undertake probably the most complete country balance sheet analysis to date, especially focused on the private sector.
8For theoretical models on the vulnerabilities of private sector balance sheets as sources of currency crises, see Aghion, Bacchetta, and Banerjee (2000, 2001) and Krugman (1999). Burnside, Eichenbaum, and Rebelo (2001) and Schneider and Tornell (2004) develop models in which weak balance sheets of the private sector and banks subject to government bailout guarantees deliver “twin” currency and banking crises. Jeanne and Zettelmeyer (2002) survey this literature and study the role of international crisis lending in the context of models with currency and maturity mismatches that produce bank runs (for example, Burnside, Eichenbaum, and Rebelo, 2001), and in the context of models with currency (but no maturity) mismatches that result in credit crunches (Aghion, Bacchetta, and Banerjee, 2000 and 2001; Krugman, 1999; and Schneider and Tornell, 2004).
9This argument is developed extensively in IDB (2006) and Borensztein and others (2004).
10Other authors study the determinants of private sector debt composition and find that some of the factors that affect sovereign debt composition (credibility of monetary policy, risk of expropriation) also affect private sector debt composition (Arellano and Heathcote, 2004; Chamon, 2003; Jeanne, 2003; Tirole, 2002).
11Albuquerque (2003) and Tirole (2003) develop theoretical features that capture the financial, institutional, and political constraints that determine a country’s access to international capital and the composition of its balance sheet. Faria and Mauro (2004) and Wei (2001) present evidence that good institutions tilt the balance sheet in favor of equity-like liabilities and increase the stock of foreign direct investment and portfolio equity (in percent of GDP).
12Sturzenegger and Zettelmeyer (2006) discuss institutional improvements that may make the debt structure less vulnerable.
13Comparisons are only indicative because the level of coverage varies across countries. This chapter only presents gross debt; net debt indicators could be significantly different. In addition, the level of implicit liabilities is also dramatically different given varying pension systems across the countries.
14This, however assumes full delivery of HIPC debt relief from non-Paris Club members and commercial creditors.
15This average also disguises important heterogeneity among the group of emerging market countries. From 2001 to 2004, Panama was the only country whose creditors were mostly private (80 percent). Costa Rica and the Dominican Republic saw an increase in the percentage of debt held by private creditors toward the end of the period. In 2004, both countries had more than 50 percent of their debt held by private creditors.
16This chapter uses the terms domestic debt as debt issued in a domestic jurisdiction. Domestic debt is thus different from domestic currency debt.
17This basic indicator is used for comparability. See the section in this chapter on currency mismatch and Box 4.1 for a more complete discussion of measures of currency mismatches and their use in assessing sovereign debt vulnerabilities in Central America.
18We exclude from the analysis officially dollarized countries. While the real exchange rate could still move in these countries, they are unlikely to be subject to major shocks and, as emphasized by Mussa (1986), they are generally much less volatile under fixed exchange rate regimes (of which full dollarization is an extreme example) than under floating exchange rate regimes.
19Within Latin America, the ratio went up slightly for Mexico and Uruguay, and decreased significantly for Argentina and, especially, Brazil.
20Detragiache and Spilimbergo (2001) show that the share of short-term debt is important in explaining liquidity crisis.
21See Calvo (1988), Missale and Blanchard (1994), and Jeanne (2004) on moral hazard problems; see Broner, Lorenzoni, and Schmukler (2005) on investor risk aversion; and see Bussière, Fratzcher, and Koeniger (2004) on underlying fragilities.
22The classification of short-term debt throughout the chapter is on the basis of original maturity.
24The data correspond to 2004. The main advantage of the data set collected from IMF country desks is that it provides data on currency denomination and maturity structure for a large set of countries. The main disadvantage is the inconsistency of debt definitions across countries, making an outright cross-country comparison vulnerable to criticisms.
25Variables are significant at the 95 percent level. Other variables, including GDP per capita were not significant. These results are consistent overall with other research on the determinants of domestic debt share. Claessens, Klingebiel, and Schmukler (2003) find poor enforcement of creditor rights and a narrow local investor base to be important. Also, Cowan and others (2006) find market size (measured by GDP) and level of development to be important.
26See Sturzenegger and Zettelmeyer (2006). The usual caveat applies in that it is also possible that the rule of law is correlated with other variables not included in the analysis.
27For some hypothesis related to this fact, see Hausmann and Panizza (2003). For some notable country exceptions see IDB (2006, Chapter 2).
28Dollarized countries still face real exchange rate variations that can make debt service more burdensome in bad times, but they avoid the abrupt and sizable changes that typically come with currency crisis.
29This phenomenon has been dubbed as the domestic dimension of the “original sin.”
31See Ize and Levy-Yeyati (2003) for the theoretical argument; and IMF (2006) for an application for sovereign debt. We did not test this result on our sample given that restrictions referred to in the previous paragraphs are most likely be binding for many of the countries in the sample.
33Total debt may be capturing the likelihood of future defaults. Our results thus suggest markets are forward-looking and have a short-term memory.
34Investor composition may also be an important factor as potential creditors aim to match duration of assets and liabilities.
35de la Torre and Schmukler (2004) explicitly make this argument, calling it, as suggested by Ricardo Caballero, the “conservation principle.” Hausmann and Panizza (2003) and Mehl and Renaud (2005) implicitly assume that the determinants of maturity and currency denomination are the same by considering determinants of the amount of long-term debt in domestic currency, or what they call the liberation of “original sin.”
36Despite the fact that this measure represents an improvement on traditional currency mismatch measures, it is not exempt from important caveats. It neglects three other effects besides the valuation effect: endogenous changes to the GDP structure (most notably, elasticity of exports); changes to GDP due to currency mismatches in the private sector—a currency mismatch on the private sector side might trigger a crisis with real effects (for example, a banking crisis), thus lowering GDP measured in local currency by more than the real exchange rate effect; and changes in debt due to currency mismatches in the private sector—the sovereign might be tempted to bail out the private sector, thus issuing more debt to finance it, further deteriorating the debt-to-GDP ratio.
37A transformation of this measure to include reserves on the sovereign’s asset side does not change the elasticities significantly. For 2001, the largest change was a reduction in the elasticity of 1 percent in the case of Nicaragua; for 2004, the largest change was a reduction in the elasticity of 0.9 percent in the case of Honduras. Smallest changes were on the order of 0.1 percent for Panama (2001 and 2004) and the Dominican Republic (2004).
38A rescaling in this spirit was also proposed by Goldstein and Turner (2004).
39In fact, such an exercise is biased against more open economies. As shown by Calvo, Izquierdo, and Talvi (2003), a more open economy is less likely to experience a devaluation. Therefore, for the same share of foreign currency debt in total debt, more open economies are less exposed to a crisis because the currency mismatch is smaller and the likelihood of devaluation is also lower.
40A longstanding rule of thumb, the “Guidotti-Greenspan rule,” indicates that international reserves should be at least equal to short-term debt and amortization coming due.
41Rodrik and Velasco (1999) document that during the Asian crisis, Indonesia, the Philippines, South Korea, and Thailand all had a ratio larger than 1. Malaysia was the only country of the group surveyed that had a ratio smaller than 1. By the end of 1997, the ratio of Korea exceeded 3.
42Rogoff (1999) called attention to this fact and highlighted the benefits of the creation of equity-like instruments. Borensztein and Mauro (2004) went on to propose the creation of GDP-indexed bonds.

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