Abstract

Existing debt structures in emerging market countries seem to rely excessively on risky forms of debt—such as short-term and foreign-currency debt—which may amplify the economic cycle, increase the likelihood of crises, and make crises more difficult to manage. Increases in risky forms of debt may be the result of worsening debt sustainability, but they also reinforce the rise in vulnerability.

Existing debt structures in emerging market countries seem to rely excessively on risky forms of debt—such as short-term and foreign-currency debt—which may amplify the economic cycle, increase the likelihood of crises, and make crises more difficult to manage. Increases in risky forms of debt may be the result of worsening debt sustainability, but they also reinforce the rise in vulnerability.

Problems with the Status Quo

Short-Term Debt

Empirical studies have found short-term debt to be a leading indicator of vulnerability to international financial crises (Bussière and Mulder, 1999; and Rodrik and Velasco, 1999). Theoretical models have put forward two types of mechanisms to explain this empirical association.

First, short-term debt may make governments more vulnerable to debt rollover crises. Indeed, this seems to have been an important factor in triggering the recent crises in Mexico (1994) and Russia (1998). In the extreme case of a pure liquidity crisis, investors stop lending to the government simply because they expect others to do the same. If the average maturity of the debt is low, the government is then at the mercy of self-fulfilling creditor panics that can be triggered by shifts in market sentiment (Sachs, 1984; Alesina, Prati, and Tabellini, 1990; Cole and Kehoe, 2000; and Chamon, 2003). In the less extreme but probably more realistic case where the crisis mixes elements of illiquidity and insolvency, the government would be vulnerable to a piece of bad news, whose real impact would be amplified by creditors’ unwillingness to roll over their claims (Jeanne, 2004; in the corporate context, see Diamond, 1991).

Second, short-term debt can give rise to vicious circles stemming from the two-way interaction between debt levels and interest rates. If the debt has a short maturity or bears a floating interest rate, changes not only in the international interest rates but also in the country’s own creditworthiness will affect the interest bill relatively quickly. A sovereign with a high level of short-term debt may thus find itself trapped in a bad equilibrium in which high interest payments lead to a high probability of default, which in turn increases the default risk premium and the interest rate (Calvo, 1988).

More generally, the relatively short average maturity of debt in emerging markets may also amplify the economic cycle. In emerging market countries, economic downturns are typically associated with increases in interest rates because of increases in the default and devaluation risk premiums, thus reducing the scope for countercyclical fiscal policies.1

Foreign-Currency Debt

The vulnerabilities created by significant levels of debt denominated in (or indexed to) a foreign currency have also been evident in several recent crises, an aspect emphasized, for both private and public debt, in the balance sheet approach to crises (Allen and others, 2002). In fact, the depreciation of the local currency has often led to a sharp increase in government debt as a share of domestic GDP or fiscal receipts (Figure 7). The contribution of this revaluation was especially large in Argentina and Uruguay—two countries where the fraction of debt denominated in foreign currency and the depreciation of the local currency were substantial. By contrast, it was small in Korea, where the government had little foreign-currency debt, and in Turkey, where the real depreciation of the currency was moderate.

Figure 7.
Figure 7.

Recent Crises: Impact of Exchange Rate Depreciation on Public Debt-to-GDP Ratio1

(In percentage points of GDP)

Sources: IMF, Country Reports and International Financial Statistics.1The contribution of exchange rate depreciation is measured as the increase in the precrisis debt-to-GDP ratio that results from setting the precrisis real exchange rate to its postcrisis level.

Not only does foreign-currency debt make crises more severe but it also reduces the scope for domestic policies to alleviate the impact of crises. The revaluation of government debt amplifies the initial fiscal problem and reduces the ability of the government to implement policies that might mitigate the disruption in the private sector (Jeanne and Zettelmeyer, 2002). In addition, monetary policy cannot be used to inflate foreign-currency debt away. The government is faced with the well-known and much-debated dilemma of choosing between raising the interest rate and letting the currency depreciate, with both options having adverse effects on domestic balance sheets.

Such amplification mechanisms resulting from high shares of foreign-currency debt create the potential for vicious circles and can thus make countries more vulnerable to crises in the first place. Imbalances in domestic balance sheets would lead investors to attack the local currency; with the resulting depreciation, balance sheets would in turn deteriorate even further (Krugman, 1999; Aghion, Bacchetta, and Banerjee, 2001; and Jeanne and Zettelmeyer, 2002).

Determinants of Government Debt Structure

Why do governments in emerging market countries and their lenders settle on debt that seems to be unduly crisis prone, even though they are the first ones to suffer the costs in a crisis? Lack of credibility of monetary and fiscal policies seems to be an important factor. Other factors may also be at work, including the nature of the domestic investor base and characteristics of domestic financial regulation (in the case of domestic debt), as well as the country’s economic size (in the case of international debt).

Credibility of Monetary and Fiscal Policies

Governments in many emerging market countries cannot borrow on the same terms as advanced economies because of lack of credibility of monetary and fiscal policies. Unsustainable policies lead creditors to anticipate that the government will expropriate them in one way or another—directly through a default or indirectly through inflation if debt is denominated in local currency. Thus, not only do governments face higher and more volatile interest rates, and—from time to time—loss of market access, but they are also under pressure to issue debt instruments that are more prone to crises.

Lack of credibility plays an especially important role in the period leading up to crises, as governments tend to shift the composition of their debt toward shorter maturities and foreign-currency denomination. Notable examples include Mexico’s shift to Tesobonos in 1994 and Brazil’s switch toward short-term, foreign-currency, and floating-rate debt in 1998.2 These examples are consistent with the view that short-term debt is a symptom, rather than a cause, of an impending crisis.3 With a looming crisis, investors would usually prefer to hold short-term debt for two reasons:

  • Dilution. First, investors holding short-term debt may expect the government to repay them before the default actually takes place (Rogoff, 1999). Thus issuing short-term debt dilutes the outstanding long-term debt.4

  • Discipline. Second, investors may expect that if the government deviated from desirable policies, it would soon face higher interest rates or a rollover crisis (Diamond, 1993; Diamond and Rajan, 2001; and Jeanne, 2004). Short-term debt may be the best option when the need for discipline outweighs the expected costs—to both the borrower and its lenders—resulting from the possibility of a rollover crisis.

High-inflation episodes durably change the structure of government debt. Indeed, no country that has experienced hyperinflation has a significant fraction of its government debt in long-term local-currency instruments (Table 3). Furthermore, in an admittedly limited cross section of countries for which data are available, the average inflation rate in 1970–90 is negatively associated with the share of long-term local-currency instruments in government domestic debt in 2001 (Figure 8; Jeanne, 2003).

Figure 8.
Figure 8.

Share of Long-Term Local-Currency Bonds in Total Government Domestic Bonds and Inflation History

Sources: IMF, International Financial Statistics; and JPMorgan.

The persistence of foreign-currency and indexed debt—in some cases long after disinflation or fiscal adjustment have been achieved—may reflect two factors. First, it often takes decades for countries to gain anti-inflationary credibility: some countries may even be trapped in a situation where they cannot prove that they can be trusted with long-term local-currency debt because of creditors’ fears that such debt would be inflated away (Jeanne, 2003). Second, private agents may get used to a certain type of instrument, and impediments to financial innovation may hamper the transition to a different financial structure.

The prevalence of foreign-currency or inflation-indexed debt may be the result of past disinflation and fiscal stabilization efforts. When inflation is high because of an underlying fiscal problem, the authorities may be caught in a vicious circle in which inflationary expectations imply high interest rates on local-currency debt; in turn these make it more difficult to stabilize the fiscal and monetary situation (Calvo, 1988). The government can seek to break such vicious circles by borrowing in foreign currency, or with indexed debt, at lower interest rates. If a lower interest rate is not sufficient to make the debt dynamics sustainable, and a fiscal adjustment is required, foreign-currency debt and inflation-indexed debt can make the government’s commitment to the adjustment more credible, because they cannot be inflated away (Calvo and Guidotti, 1990).

A relatively large share of foreign-currency or indexed debt may result from investors’ and borrowers’ attempts to protect themselves from uncertainty in an environment of high and variable inflation (Ize and Parrado, 2002). With long-term domestic-currency debt, the future real burden of debt is very uncertain at the time of issue, and could be unsustainably high if inflation turns out to be much lower than expected. This risk is especially relevant for countries with an imperfectly credible fixed exchange rate peg and high domestic interest rates. Borrowing at a high interest rate in domestic currency effectively involves a bet that the currency will be devalued—a bet that can turn out to be very costly in the event the devaluation does not occur. In such an environment, foreign-currency debt, CPI-indexed debt, or floating-rate debt may be less risky than long-term local-currency debt (Jeanne, 2003).

From the point of view of borrowing countries, the relative desirability of local-currency debt, foreign-currency debt, and CPI-indexed debt can be assessed by looking at the unit in which domestic output is the most stable (Box 1). For most emerging markets, relatively volatile inflation implies that GDP is far more stable when expressed in foreign-currency terms than in local-currency terms. (The opposite holds for the G-7 countries; see also Fontenay, Milesi-Ferretti, and Pill, 1997; and Missale, 1999.) Thus a simple hedging motive may help explain the greater reliance on foreign-currency debt in emerging market countries. Interestingly, for both the G-7 and emerging market countries, the volatility of GDP is smallest when GDP is expressed in terms of CPI-indexed units, suggesting that CPI-indexed bonds may provide substantial advantages to both groups of countries.

Debt Structure and Hedging

In assessing the relative merits of local-currency debt, foreign-currency debt, and inflation-indexed debt, a key criterion is which type of debt results in the lowest probability of the debt-to-GDP ratio exceeding a given threshold. This is equivalent to asking whether the volatility of output is lowest when output is expressed in terms of local currency, dollars, or the consumer price index. In fact, debt commits the borrower to repay a fixed quantity in terms of some unit—the local currency, a foreign currency, or, for inflation-indexed debt, a price index. For example, a 10-year dollar-denominated zero coupon bond issued in 2004 commits the government to repay a certain quantity D$ of dollars in 2014. Assuming that this is the only debt issued by the government, the debt-to-GDP ratio in 2014 is given by D$/Y$, where Y$ is the country’s GDP in 2014 expressed in terms of dollars. Viewed from 2004, the principal debt repayment due is known (with no uncertainty): the likelihood that the debt-to-GDP ratio will exceed a given threshold is therefore entirely determined by the volatility of Y$. More generally, debt denominated in unit A is preferable to debt denominated in unit B if output is less variable when expressed in unit A than in unit B. Thus one way of assessing the relative desirability of local-currency debt, dollar debt, and CPI-indexed debt is simply to compare the volatility of output expressed in terms of local currency, dollars, and the consumer price index. In the exercise conducted below, volatility is defined more precisely as the standard deviation of those changes in the 10-year growth rate of output (in each of the three units, considered in turn) that cannot be predicted on the basis of past output growth. For advanced economies, or G-7 countries, the volatility of output is lower when denominated in local currency than it is when denominated in foreign currency, but for emerging market countries, this is reversed, owing to their higher and more volatile inflation.

uch03fig04

Standard Deviation of Cumulative 10-Year Unexpected Growth

(In percentage points)

Source: IMF, International Financial Statistics.Note: The sample of emerging markets consists of 11 countries. (None experienced annual inflation rates higher than 100 percent in any year during 1955–2000). The result that GDP is more stable when expressed in foreign-currency terms rather than in local-currency terms becomes even more striking when countries that experienced inflation rates above 100 percent are included in the sample. The sample of advanced economies consists of 21 countries. Unexpected output growth is the difference between actual growth and the growth predicted by an autoregressive (AR (1)) process. The sample period is 1965–2000. For a given year, growth is predicted for the subsequent 10 years based on data for the previous 20 years.

Finally, governments may borrow in foreign currency to reduce nominal interest payments (which are high in local-currency terms owing to the inflation premium) and thus the headline fiscal deficit (Blejer and Cheasty, 1991). Typical measures of the public deficit take into account the flow of interest payments but not the changes in the real value of the principal due to currency depreciation or inflation.5

Domestic Investor Base, Financial Regulation, and Pension Systems

A large base of domestic investors may be expected to make it easier for a country to absorb shocks to capital flows and, more specifically, for the government to issue debt domestically and in local currency, if this is not precluded by a history of high inflation (IMF, 2003e). Indeed, countries with a larger domestic investor base—as proxied by the ratio of bank deposits to GDP—are found to have a smaller share of foreign-currency bonds in total (private and public) bonds (Claessens, Klingebiel, and Schmukler, 2003). The type of pension system has important consequences for the size of the domestic investor base, and thus the development of the domestic government debt market. Prefunded pension systems are likely to induce significant domestic savings available for investment in government domestic debt, though in practice the relationship between pension systems and the share of domestic debt is not straightforward, probably because of the presence of other determinants of debt structure.

Governments may also create a captive market for their debt—including long-term debt—through financial regulation, moral suasion, or direct control of financial institutions. Many countries have regulations that prevent domestic pension funds from investing more than a fraction of their portfolios in foreign assets: such regulations can be quite constraining, even in the case of OECD countries (Fischer and Reisen, 1994). Moreover, in financially repressed countries, the government may induce domestic banks to buy its debt, especially where the government controls a large share of the banking system. Finally, the presence of capital controls has been found to be associated with the share of local-currency borrowing in the domestic credit market (Hausmann and Panizza, 2002).

Indeed, the share of long-term local-currency instruments in total government domestic debt is high not only in financially liberalized countries with relatively strong policy credibility, such as many advanced economies, but also in countries with lower degrees of financial liberalization (Figure 9). This may be tentatively interpreted in terms of three stages in the development of domestic government debt markets. In a first stage, in some developing countries, financial repression forces residents to hold long-term nominal local-currency debt. As countries develop and move to a second stage, however, they often ease restrictions even before establishing strong credibility: investors thus may shift to other forms of debt. In a third stage, countries attain credibility while refraining from restrictions, and investors hold long-term local-currency debt voluntarily, as in advanced economies.

Figure 9.
Figure 9.

Share of Long-Term Local-Currency Bonds and Financial Liberalization

Sources: Abiad and Mody (2003); IMF, International Financial Statistics; and JPMorgan.Note: The financial liberalization index refers to 1996: the latest available from Abiad and Mody (2003). Although the quadratic term in the regression corresponding to the figure is statistically significant, the small number of observations suggests the U-Shape shown above should be interpreted as merely suggestive.

Political Economy Determinants

The determinants of government domestic debt structures are rooted in the domestic political economy. Explanations under the heading of “lack of policy credibility” are ultimately related to different ways in which the government can reduce the burden of its obligations to creditors. The risk of non-payment is in turn determined by the stability of the government and the weight that creditors carry in the political arena. Great Britain in the seventeenth century is an especially interesting example, because it was the first country to develop a government debt market comparable in size to those observed now in advanced economies. It has been argued that this was made possible by the new system of checks and balances set up after the Glorious Revolution, which gave creditors more control over the government (North and Weingast, 1989). A domestic creditor constituency may also help ensure that the government will respect creditor rights.

Political economy considerations have some implications for the link between financial repression and the development of the domestic debt market. Even if long-term nominal debt were the result of financial repression, this would not necessarily imply that the government would seek to expropriate its creditors. Defaulting on a debt that is held by domestic banks would likely generate a financial meltdown. Thus, the government’s incentives to avoid a default are likely greater if domestic banks hold the public debt.

Measures of political stability and rule of law are positively correlated with the domestic public debt as a share of GDP (Figure 10). This is consistent with previous findings of a significant correlation between the size of the domestic local-currency bond market (including both private and public debt) and political economy variables, such as rule of law and democracy (Burger and Warnock, 2003; and Claessens, Klingebiel, and Schmukler, 2003).

Figure 10.
Figure 10.

Institutional Quality and Domestically Issued Long-Term Local-Currency Debt

(Component orthogonal to per capita GDP)

Sources: JPMorgan, Guide to Emerging Markets (2001); and Kaufmann, Kraay, and Mastruzzi (2003).Note: The scatter plot shows the association between an indicator of governance and the size of the local-currency debt market, taking into account that both these variables are associated with GDP per capita. The horizontal axis reports the residuals of a regression of long-term local-currency debt on GDP per capita. The vertical axis reports the residuals of a regression of an institutional index on GDP per capita. The correlation is significant at the 5 percent level. The correlation between governance and the share of long-term local-currency is highly significant when not controlling for GDP per capita.

Finally, historical accidents may contribute to explaining the development of domestic debt markets in local currency: changes in financial structure that occurred because of a transitory event often persist long after the event. For example, Canada and Australia developed their domestic long-term local-currency debt market during World War I because the government had large financing needs that could no longer be fulfilled by borrowing on London’s financial markets (Bordo, Meissner, and Reddish, 2003).

International Debt Market

It has been argued that many countries, both emerging and advanced, are unable to issue in their own currency on international markets at reasonable cost, owing to an unwillingness of international investors to bear exchange rate risk. In existing empirical studies, issuance of bonds in local currency is not found to be closely related to countries’ policies or institutions (Hausmann and Panizza, 2002). Nor do these variables seem to help explain the (admittedly limited) variation across countries in the structure of sovereign debt issued on international markets. However, countries’ economic size seems to be associated with whether they issue bonds in their own currency on international markets. This is suggested by both systematic cross-country regressions on modern data (Eichengreen, Hausmann, and Panizza, 2002) and historical evidence. In the nineteenth century, for example, local-currency debt issued by a few “emerging markets” of the time, such as Russia, was actively traded on the secondary market in London (Flandreau and Sussman, 2002). By contrast, the local-currency debt of countries judged to have better creditworthiness, such as the Nordic countries, was not traded in London. The role of the ruble as a vehicle currency for a large number of international trade and finance transactions may help explain this difference.

Policy Implications

Domestic Debt Markets

To make public debt structures less crisis prone, a key long-term policy objective is to develop a deep domestic market for government debt, especially for long-term local-currency instruments. Issuing long-term local-currency debt requires monetary and fiscal credibility. In part, this can be gained through a combination of policy success—such as stabilizing from high inflation and reducing public debt levels—and institutional reforms that create an expectation that stabilization gains will be sustained. The latter include medium-term fiscal and monetary policy frameworks that constrain future policy choices, such as longer-term fiscal and inflation targets, and central bank independence. In the long run, such institutions may be a better foundation for policy credibility than the discipline that comes from risky forms of debt (Falcetti and Missale, 2002).

Creating Domestic Markets for Long-Term Domestic-Currency Bonds: Country Experiences

A number of emerging markets—including Colombia, India, Singapore, South Africa, Taiwan Province of China, and Thailand—have traditionally issued long-term domestic debt in local currency. This reflects long histories of low or moderate inflation, in some cases combined with financial repression. Recently, however, some countries have begun to issue long-term, nonindexed local-currency debt, in spite of having experienced high inflation during the 1970s or 1980s, and liberalizing their capital markets.

Chile last experienced high inflation in the 1970s and inflation has remained moderate since the early 1980s. Until recently, more than half of the public debt was inflation indexed, reflecting a desire to promote indexation as a way of avoiding dollarization, and to conduct monetary policy in terms of “real” policy rates and a “real” term structure of interest rates. As part of that strategy, indexed bonds of 8–20-year maturity were issued in the early 1990s. With inflation in the low single-digit levels (since 1999) and the adoption of a formal inflation targeting regime, the policy interest rate switched to nominal targets (August 2001). Subsequently, the central bank issued two-year and five-year nonindexed peso bonds.

Israel stabilized from high inflation in 1985. Inflation initially fell to moderate levels (10–20 percent) and later—after 1995—to single digits. In 1985, about 40 percent of public sector debt was in foreign currency, while the rest was inflation-indexed local-currency debt. By 2002, foreign-currency debt had disappeared, the share of inflation-indexed debt was less than 40 percent, and nonindexed local-currency debt made up the remaining debt stock. This transformation took place in two stages. First, foreign-currency debt was reduced and substituted by inflation-indexed debt, which peaked at 80 percent in the 1990s. Second, inflation-indexed debt was gradually substituted by nonindexed local-currency debt. A two-year nonindexed bond was first introduced in 1995. Subsequently, the maturities of local-currency bonds were gradually lengthened: 5-year, 7-year, and 10-year bonds were introduced in 1998, 2000, and 2001, respectively. Average maturity in 2002 stood at about six years.

Mexico had its last high inflation episode in 1987–88. Inflation fell to single-digit levels by 1993–94, rose to moderate levels after the 1994–95 crisis, and fell again to single-digit levels by 2000. In the decade between 1989 and 1999, domestic debt consisted mainly of short-term local-currency debt and floating-rate debt—except for the well-known sharp increase in short-term foreign-currency debt leading up to the 1994 crisis—with inflation-indexed debt generally taking a third place. This began to change in 2000, when the Mexican government issued 3-year and 5-year nonindexed bonds, followed by 7-year and 10-year bonds in 2002, and, finally, a 20-year bond in 2003.

Poland stabilized from near-hyperinflationary levels in 1991. Inflation hovered at about 30 percent until 1996, then dropped to 10–20 percent and finally (in 1999) to single-digit levels. Until 1992, all of Poland’s local-currency debt, which was small relative to its foreign-currency debt, consisted of short-term treasury bills. In 1992, Poland introduced an inflation-indexed one-year bond and a three-year floating-rate bond. In 1994—with inflation still at around 30 percent—2-year and 5-year nonindexed local-currency bonds were introduced, followed by a 10-year floating-rate bond in 1995, and a 10-year nonindexed bond in 1999. The share of foreign-currency debt in domestic debt fell from about 20 percent in 1994 to essentially zero in 2002.

These experiences share a common pattern. Nonindexed bonds of more than five-year maturity were issued almost immediately after fiscal stabilization, the decline of inflation to low single-digit levels, and the adoption of formal inflation-targeting regimes (Israel in 1991; Chile, Poland, and Mexico in 1999) and formal central bank independence (Chile in 1989; Mexico in 1994; Poland in 1998). Moreover, all countries undertook major pension reforms in the direction of fully funded systems. This suggests that the development of a long-term local-currency bond market requires substantial and credible reforms but is feasible without a long period of credibility building.

Sources: Galindo and Leiderman (2003); Herrera and Valdés (2003); Werner (2003); IMF Country Reports; and national statistical sources.

It has been argued that, even with stabilization and institutional reforms, acquiring sufficient credibility to issue long-term local-currency debt may take several years or even decades (Caballero, Cowan, and Kearns, 2003, based on a comparison between Australia and Chile). However, a number of countries have recently been able to issue nonindexed long-term debt almost immediately after stabilizing at low levels of inflation and reforming their monetary policy frameworks (Box 2). In addition, governments that are unable to issue nonindexed long-term debt can become less reliant on risky debt forms by issuing inflation-indexed debt.

The main advantage of inflation-indexed debt is that it breaks the automatic link between government solvency and large exchange rate swings that may result from external shocks or losses in investor confidence. Indeed, inflation-indexed debt exposes the borrower to less uncertainty than does foreign-currency debt (Box 1). Moreover, CPI-indexed debt provides as much policy discipline and investor protection as do short-term debt and foreign-currency debt.

Developing International Markets for Bonds in Emerging Market Currencies

A considerable share of the relatively rare international bonds denominated in emerging market currencies have not been issued by sovereigns, but rather by international organizations or multinational corporations that were able to reduce their borrowing costs by issuing in those emerging market currencies and, when they did not have a natural hedge, engaging in currency swaps. This process began in the mid-1980s with the currencies of countries such as Italy, Portugal, and Spain and in recent years has involved the currencies of emerging market countries such as Brazil, Chile, the Czech Republic, Hungary, Mexico, Poland, the Slovak Republic, and South Africa. Such opportunities for savings may be the result of the ability to tap an investor base that seeks to hold bonds denominated in an emerging market currency but are essentially default free. Regulation or differences in tax treatment occasionally have also played a role.

Beginning in 2001, the World Bank has allowed its borrowers to request a local-currency swap. That request is considered on a case-by-case basis, depending on whether current market conditions allow for a mutually advantageous outcome to be achieved. Following such a swap, the World Bank would face net liabilities in hard currency (as it normally does) while the emerging market that engaged in the swap would face net liabilities in its own currency. While there has been some interest in these local-currency swaps, no transactions have taken place to date, perhaps owing to initial learning barriers.

Recent proposals have sought to generalize this type of approach so as to fully exploit its benefits for emerging market countries. Levy-Yeyati (2003) argues that the role of the IFIs in issuing debt denominated in emerging market currencies could be expanded. He points out that a number of emerging market residents move their money abroad for a number of reasons, including a desire to decrease their vulnerability to possible government default. While those residents are unwilling to hold the credit risk of their own country, they may be willing to hold its currency risk because much of their consumption basket is in their local currency. The IFIs could issue risk-free local-currency debt, perhaps making it more attractive by indexing it to local inflation. The IFIs could then lend to the country without creating any currency mismatches in their balance sheets. The crowding-out effect on domestic credit markets may not be large, as some of those funds would have fled the country anyway.

Eichengreen, Hausmann, and Panizza (2002) suggest that the IFIs could issue in a basket of local-currency units indexed to the CPI of a number of emerging market countries. The pooling of currencies would help that market achieve a critical mass. The IFIs could simultaneously arrange a series of swaps with emerging market countries that had issued hard currency debt. However, if the swaps were arranged directly with emerging market country governments, the IFIs would face a default risk. If the swaps were arranged through an intermediary (which would then absorb, but also charge for, the default risk), the transactions costs could be large, partly because the swap markets between emerging market currencies and the world’s major currencies are not very liquid. For a comprehensive critique of these proposals, see Goldstein and Turner (2004).

A potential objection to issuing inflation-indexed debt is that it may lead to an economy-wide culture of sweeping CPI indexation, up to and including wage contracts. This would reduce real wage flexibility and weaken the effectiveness of stabilization policies. The example of Chile has often been mentioned in this context, but in that case a broader use of CPI indexation seems to have been specifically encouraged (Herrera and Valdés, 2003). In general, there is no automatic link between the currency of denomination of public and private liabilities and the denomination of other contracts in the economy. Another potential problem in some cases is the need for timely and reliable measurement of the CPI.

An alternative form of indexation that requires less statistical capacity is indexation to a market-determined domestic interest rate, that is, floating-rate debt. However, floating-rate debt implies higher debt repayments during bad times, whereas inflation-indexed debt is usually either acyclical or provides a slight hedge. From the perspective of decoupling government solvency from shifts in confidence and external shocks, floating-rate debt shares many of the disadvantages of foreign-currency debt.

Pension reforms and financial regulation often have important implications for the development of the domestic debt markets. A shift toward a fully funded pension system is often especially significant, because pension funds have a natural interest in debt securities carrying a relatively low default risk, and denominated in CPI units or local currency. Regulation that induces pension funds to invest a significant portion of assets locally may further enhance that interest. Of course, regulation that forces investors to hold long-term local-currency debt may also generate a temptation to reduce the debt burden through inflation or depreciation, and makes it easier for governments to overborrow. This temptation is somewhat mitigated by a large constituency of local-currency debt holders, who may pressure the government to follow sound fiscal and monetary policies. Moreover, if domestic banks hold large amounts of public debt, the government may be reluctant to provoke a crisis in which sovereign default would turn into a banking crisis. While the costs of financial repression will typically exceed its benefits, a greater share of long-term local-currency debt may be a welcome by-product.

While governments are seeking to establish credibility and develop domestic debt markets, they can undertake steps that help insulate the economy from external and confidence shocks, even in the presence of substantial shares of short-term debt or foreign-currency debt. Three such steps are mentioned briefly here. First, countries can avoid a bunching of repayment obligations, maintain adequate reserve levels, and manage reserves appropriately.6 Second, there is a trade-off between low debt levels and a less crisis-prone debt structure: with low debt levels, the public sector would remain solvent even after a depreciation; this reduces the urgency to move away from foreign-currency-denominated debt. Third, the importance of public sector vulnerabilities for the economy as a whole depends on conditions in other sectors, especially mismatches in the private financial sector and the flexibility of exports in responding to a depreciation.

Debt Issued on International Markets

Over the past two decades, some international financial institutions (IFIs) may have helped foster the creation of a market for internationally issued bonds in emerging market currencies. The IFIs have often been among the first parties to issue bonds denominated in emerging market currencies that had not previously been used in international bonds (Box 3, p. 21). The IFIs’ main motivation for issuing bonds denominated in emerging market currencies, typically in combination with exchange rate swaps, has been to reduce their borrowing costs. At the same time, however, many residents of emerging markets may have borrowed internationally in their own currency as the counterparts in such swaps.

Note: The authors of this section are Marcos Chamon and Olivier Jeanne.

1

GDP growth is negatively correlated with the spread on foreign-currency bonds issued internationally by emerging market countries (Eichengreen and Mody, 1998). This effect is likely augmented, for domestic currency borrowing, by the expected depreciation premium.

2

In the period leading up to Mexico’s 1994 crisis, both the stock of Tesobonos and the interest rate differential between the peso-denominated Cetes and the dollar-linked Tesobonos rose sharply (IMF, 1995, pp. 53–69, Figures I–6 and I–7).

3

Indeed, systematic panel regressions show that, while higher shares of short-term debt are associated with greater likelihood of debt crises, that association is no longer significant when taking into account that greater use of short-term debt is itself influenced by other factors, including low credibility (Detragiache and Spilimbergo, 2001).

4

Anticipating dilution, investors could be reluctant to lend on a long-term basis or be willing to do so only at high interest rates (Bolton and Jeanne, 2004). In fact, the government could use short-term debt to postpone the necessary adjustment at the expense of long-term creditors. However, such dilution might turn out to be desirable, even for long-term creditors, if it bought time to permit the necessary adjustment and avoided a default.

5

Several countries where inflation is an important consideration report an “operational” fiscal balance that includes the effect of inflation on the debt principal.

6

International Monetary Fund and World Bank (2001); and IMF (2000a).

  • View in gallery

    Recent Crises: Impact of Exchange Rate Depreciation on Public Debt-to-GDP Ratio1

    (In percentage points of GDP)

  • View in gallery

    Share of Long-Term Local-Currency Bonds in Total Government Domestic Bonds and Inflation History

  • View in gallery

    Standard Deviation of Cumulative 10-Year Unexpected Growth

    (In percentage points)

  • View in gallery

    Share of Long-Term Local-Currency Bonds and Financial Liberalization

  • View in gallery

    Institutional Quality and Domestically Issued Long-Term Local-Currency Debt

    (Component orthogonal to per capita GDP)

  • Abiad, Abdul and Ashoka Mody, 2003, “Financial Reform: What Shakes It? What Shapes It?IMF Working Paper 03/70 (Washington: International Monetary Fund).

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