V How Much Debt Is Too Much?
Author: Mr. Christoph A Klingen
Language:
English
Keywords:
OP; debt; foreign currency; bank; debt threshold; debt position; interest rates fluctuation; GNP deflator; Debt sustainability; Debt service; Real interest rates
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Abstract

Turkey has made good progress in reducing its public debt ratio since 2001, but the ratio is still high and remains a key source of vulnerability. A strong fiscal effort and the successful stabilization of the exchange rate reduced gross public debt relative to GNP from a peak of 101 percent in 2001 to 79 percent at end-2003. But this debt stock is still large, especially considering the high debt service ratio it implies (175 percent of revenue) and its sensitivity to exchange rate and interest rate changes.

Turkey has made good progress in reducing its public debt ratio since 2001, but the ratio is still high and remains a key source of vulnerability. A strong fiscal effort and the successful stabilization of the exchange rate reduced gross public debt relative to GNP from a peak of 101 percent in 2001 to 79 percent at end-2003. But this debt stock is still large, especially considering the high debt service ratio it implies (175 percent of revenue) and its sensitivity to exchange rate and interest rate changes.

What debt level should Turkey target in the medium term? Before attempting to answer this question, one needs to examine what would constitute a suitable yardstick against which to measure the sustainability, safety, or advisability of the debt position. This chapter surveys the literature for the different yardsticks for assessing public debt. Particular focus is on studies that relate to emerging market economies, with a view to distilling tentative lessons for Turkey. Following a cursory glance at the main features of Turkey’s debt, the chapter discusses six methods of assessing public debt:

  • Deterministic debt sustainability. This staple of fiscal analysis compares the “debt-stabilizing primary surplus” or the “debt threshold” against the actual primary surplus or debt ratio, respectively, to determine whether public debt relative to GNP explodes over time or remains contained.

  • Stochastic debt sustainability. This approach extends the above deterministic exercise by explicitly recognizing that relevant economic variables like growth, real interest rates, and the exchange rate are subject to shocks. It is therefore necessary to build a safety margin into debt thresholds to ensure that debt remains sustainable should an adverse environment materialize.

  • Fiscal track record approach. This is another variant of the debt sustainability exercise, but rather than basing the calculations on fiscal targets, it uses primary surplus projections guided by past experience. This approach sets a high bar for sustainability, as it rules out fiscal policy breaking with its past.

  • Empirical debt sustainability. This is a purely statistical approach that tries to determine which economic variables best explain the onset of sovereign debt distress or dangerously low investor ratings. External debt and debt service ratios, indicators of macroeconomic instability, and credit history are found to be key.

  • Fiscal dominance of monetary policy. This line of research points to a “default risk channel” in monetary policy. Interest rate policy might have perverse effects in high-debt countries because higher interest rates translate into higher debt service obligations and higher default risk. This triggers capital outflows, currency depreciation, and higher—not lower—inflation. Fiscal dominance is rooted in investors’ concerns about debt sustainability.

  • Real interest rates and financial intermediation. Sustainability considerations aside, high real interest rates and large government claims on the lending capacity of banks are signs in themselves that the government is overborrowing.

Main Features of Turkey’s Public Debt

Turkey’s public debt grew significantly over the past decade. In gross terms, the debt increased from around 50 percent of GNP in the mid-1990s to about 80 percent of GNP in 2003. In the crisis year of 2001, it peaked at just over 100 percent of GNP (Table 5.1). The large upward jump of the debt ratio in that year reflects the recognition of public debt that had been building up over the years outside the official Treasury debt statistics. It also reflects bank restructuring costs in the wake of the financial crisis, and the capital loss on foreign currency-denominated debt in the aftermath of the exchange rate devaluation. Since then, fiscal adjustment together with exchange rate stabilization have improved the debt ratio.

Table 5.1.

Main Features of Turkey’s Debt

(In percent)

article image
Sources: IMF staff calculations based on Central Bank, Treasury, Ministry of Finance, and IMF data.Note: EMBI = Emerging Markets Bond Index.

The structure of the debt entails substantial exchange rate and interest rate risk. Including its external debt, 46 percent of the government’s total debt is denominated in, or indexed to, foreign currency (as of end-2003). Consequently, any (real) devaluation of the domestic currency directly translates into a sizable increase in the debt ratio. Moreover, about half of the debt stock is floating interest rate instruments (in Turkish lira and foreign currency). Interest rates fluctuations, which can be quite pronounced for emerging markets, thus feed without delay into debt servicing costs. Only about one-quarter of the debt is linked to neither the exchange rate nor to current interest rates. But even that part is not immune to interest rate shocks, given that the average maturity of domestic debt is only about one year (Table 5.1).

High real interest rates and short maturities have saddled Turkey with enormous debt servicing costs. Over the past five years, the real interest rate on treasury bills was 16.5 percent on average and the spread on its eurobonds around 650 basis points. This makes for a very large interest bill—16.4 percent of GNP in 2003. Total debt service in 2003 was a staggering 49 percent of GNP or 175 percent of central government revenue.

The size of Turkey’s public debt approximates the emerging market average, but this is little consolation. Public debt increased across emerging markets to reach an average of 72 percent of GNP in 2002 (IMF, 2003)—a ratio not dissimilar to that of Turkey. However, as further discussed below, there are good reasons to believe that emerging markets as a group might have overborrowed. Their debt ratios now exceed those of the advanced economies, which have debt ratios of around 65 (IMF, 2003).

Deterministic Debt Sustainability Exercise

According to this approach, public debt is deemed sustainable if the debt-to-GNP ratio remains constant or declines over time. This requirement can be expressed as a simple relationship between the primary surplus ratio (PS/GDP), the debt ratio (D/GDP), the real interest rate (r), and the rate of economic growth (g):

P⁢S/G⁢D⁢P≥(r−g)*D/G⁢D⁢P(1)

or equivalently

D/G⁢D⁢P≤(P⁢S/G⁢D⁢P)/(r−g)⁢.(2)

The critical value of the primary surplus ratio that fulfills (1) with equality is known as the “debt-stabilizing primary surplus.” For smaller primary surpluses, the debt ratio explodes over time and hence is unsustainable. Equivalently, one can think of the critical value of the debt ratio that fulfills (2) with equality as a “debt threshold.” For initial values of the debt ratio below the threshold, the debt position is sustainable.

Making this approach operational requires making assumptions about the real growth and interest rates that will likely prevail in the future. The primary surplus is largely a policy variable that can be set by the government. The debt ratio is an observable variable, which, incidentally, depends on the exchange rate if a sizable share of the debt is denominated in, or indexed to, foreign currency.

Turkey’s public finances pass the deterministic debt sustainability test. It would appear reasonable for Turkey to put the real interest rate in the vicinity of 12 percent and the real growth rate at around 5 percent. The debt ratio is currently at around 70 percent of GNP. This implies a debt-stabilizing primary surplus of 4.9 percent of GNP. As this is less than the primary surplus that the government is implementing (6.5 percent of GNP), public finances pass this debt sustainability test.

Stochastic Debt Sustainability Exercise

This approach extends the above exercise by explicitly recognizing that the underlying economic variables are stochastic. The deterministic exercise tries to simply assign the underlying economic variables their expected values. However, the future evolution of interest rates, exchange rates, and economic growth is inherently uncertain. In order to have some margin for comfort, debt should remain sustainable even under adverse circumstances. Obviously, this additional requirement raises the bar on the primary surplus, or the debt threshold, that is needed.

Exactly how resilient to adverse circumstances the debt position should be is open to debate. On the one hand, it must be recognized that the debt position of almost any country becomes unsustainable under unduly adverse circumstances. On the other, allowing for only minor deviations from the most likely scenario is risky. With this in mind, the IMF (2003) has developed some guidelines that are now routinely being applied to all member countries. The resilience of a country’s debt position is tested against (i) shocks to individual variables on the order of one or two standard deviations, (ii) alternative scenarios that fix variables at their historical averages or use forecasts produced outside the IMF, and (iii) tailored tests that combine shocks to individual variables in a manner deemed relevant for the country at hand.

The sustainability of Turkey’s debt position is reasonably robust to shocks, but risks remain. Adverse shocks of reasonable magnitude to individual variables can mostly be absorbed, especially if they are temporary in nature. However, unfavorable developments on several fronts at the same time could undermine sustainability. To illustrate this point, consider the following shocks relative to the quantifications in the previous section:

  • If growth were permanently lower—say, 3.5 instead of 5 percent—the debt threshold would decline to 76 percent of GNP. According to formula (2), this is still above the actual level and thus satisfies the sustainability criterion. This is even more true when the growth reduction is only transitory.

  • If the real effective exchange rate depreciated by, say, 10 percent, the actual debt level would rise from 70 to 73.5 percent, as about half of Turkey’s debt is effectively denominated in foreign currency. Actual debt would remain safely below the threshold of 93 percent of GNP. Debt sustainability would be maintained.

  • A combination of the above growth deceleration and depreciation in conjunction with a rise of real interest rates by 1 percentage point, however, would push Turkey’s public debt into unsustainability; the debt threshold would fall to 68 percent of GNP and thus exceed actual debt of 73.5 percent of GNP.

Fiscal Track Record Approach

So far, the primary surplus has been treated as if it were a policy variable, but in reality it is subject to political and technical constraints that limit the scope for fiscal adjustment. Governments often miss their fiscal targets for a variety of reasons. Budgets might be based on assumptions that involve some degree of wishful thinking, sufficient political support for fully implementing the underpinning measures might be lacking, expenditure cuts might run into legal constraints, the revenue yield from taxes has technical limits, etc.

Using an approach based on the fiscal track record yields quite low debt thresholds for emerging market economies. The IMF (2003) operationalizes this idea in two ways. The first method simply fixes the primary surplus, as well as growth and interest rates, at the average value during recent history. The debt threshold for the average emerging market economy then calculates as low as 25 percent of GNP, some two-and-a-half times less than actual levels of indebtedness. The second method allows for uncertainty in the evolution of revenue and places limits on the primary expenditure response to revenue shortfalls. The idea is to determine a safe level of debt—a level that is sustainable even if revenue falls two standard deviations short of its historical average offset by the maximum realistic primary expenditure cut (defined as the largest two-year reduction in recent history).

If the fiscal track record approach is used as a yardstick, Turkey appears to have heavily overborrowed. Applying the first method gives debt thresholds of 61, 46, and 30 percent of GNP, depending on whether three, five, or 10-year historical averages are used. According to the second method, levels of debt up to 52 percent of GNP can be considered as safe. In all cases, current levels of gross debt of around 80 percent of GNP substantially exceed thresholds.

While this approach may seem unduly pessimistic for Turkey, it is a useful reminder to remain cautious when assessing the sustainability of its debt. On the one hand, the approach is very rigid because, by construction, it forces future fiscal policy to be the same as the one pursued in the past. There is thus no room for cases where fiscal policy breaks decisively with the past—which is precisely the kind of situation one hopes is taking hold in Turkey. On the other hand, the approach is a reminder that debt levels must be low enough to also accommodate situations where fiscal targets are not always met and budgetary policies may suffer temporary setbacks at some point in the future.

Empirical Debt Sustainability

In practice, sovereign debt distress often arises at rather moderate levels of indebtedness. The history of sovereign defaults over the last three decades reveals that 55 percent of the recorded events took place when public debt was less than 60 percent of GNP. And in 35 percent of the default cases, debt was not even 40 percent of GNP (IMF, 2003). These are debt levels that advanced economies can easily support—some of them, such as Japan, Italy, and Belgium, have been living with debt ratios far in excess of 100 percent of GNP. A different yardstick seems to apply to emerging market economies and developing countries. Reinhart, Rogoff, and Savastano (2003) have coined the term “debt intolerance” for this phenomenon.

A growing empirical literature tries to identify the factors that render some countries more debt intolerant than others. Rather than analyzing country-specific debt dynamics, this literature focuses on finding those variables that explain the observed pattern of sovereign debt distress best in a statistical sense. This type of approach typically works with large sets of panel data that cover many countries and years. A plethora of potential variables is tested for its explanatory power in order to eventually arrive at a parsimonious specification that fits the data well. Identification of the key explanatory variables helps solve the puzzle of why some countries are more debt intolerant than others.

External debt relative to servicing capacity and economic volatility are consistently found to be closely associated with the emergence of sovereign debt distress. Manasse, Roubini, and Schimmelpfennig (2003) find that the likelihood of a sovereign debt crisis rises significantly with the external debt ratio, short-term external debt, and external debt service scaled by reserves. Domestic economic conditions are also significant, with unfavorable economic growth and high and volatile inflation contributing further. External developments play a role in that higher interest rates in the United States and a larger current account deficit make crises more likely. Kruger and Messmacher (2004) construct a single variable with all the information content of external debt variables: the so-called proportion of new financing needs, the ratio of external debt service and imports to the sum of exports, net external transfers, and reserves. Reinhart, Rogoff, and Savastano (2003) try to explain countries’ perceived creditworthiness, as measured by the Institutional Investor Rating, and confirm the significance of the external debt ratio. In addition, a country’s credit history as well as its inflation rate play an important role.

This literature holds some lessons about what can be considered a reasonably safe level of external debt in the emerging market context. Reinhart, Rogoff, and Savastano (2003) conclude that emerging markets that have not graduated to the club of countries with a very high Institutional Investor Rating, and that do not have a track record of low inflation, should not risk external debt-to-GNP ratios over 35 percent. The IMF (2003) finds external debt thresholds of 40 percent of GNP for the average nonadvanced economy, and 26 to 58 percent of GNP for low-income countries, depending on the quality of a country’s policies and institutions.

Although these studies do not explicitly report results for Turkey, their general conclusions are applicable. While the studies focus on identifying the key risk factors for debt distress in emerging markets or developing countries as a group, a casual glance at the data suggests that Turkey is unlikely to score above the emerging market average in the relevant risk factors. Hence, the above stringent external debt thresholds also apply to Turkey and are currently exceeded by wide margins (Table 5.1).

Fiscal Dominance of Monetary Policy

The implications for the effectiveness of monetary policy are yet another, though related, consideration when thinking about safe levels of public indebtedness. Here the concern is that the effectiveness of the central bank’s tools may be compromised once public debt reaches a certain level. The critical debt level depends on country specifics, especially the currency and maturity composition of debt, and is subject to uncertainty. As fiscal dominance is ultimately rooted in investors’ concerns about public debt sustainability, one would expect that the debt thresholds derived here are not very different from those calculated in the previous sections. However, the emphasis is more on investors’ perception of debt sustainability than debt sustainability per se.

Fiscal dominance implies that monetary tightening has a perverse effect on inflation, because higher interest rates raise default concerns and weaken the exchange rate. Under normal circumstances, interest rate hikes by the central bank give rise to capital inflows and an appreciation of the exchange rate. This reduces inflationary pressure together with the effects working through the standard interest and credit channels. The central bank thus has an effective tool in hand to steer inflation. A strand of literature (Giavazzi, 2003; and Blanchard, 2004) points out that this might not be the case if the government has a large outstanding debt: higher interest rates also mean higher debt servicing costs and, in the case of highly indebted countries, a higher risk of default. Capital therefore flows out of the country, the exchange rate weakens, and interest rate spreads widen. Incidentally, there are also second-round effects on debt service from the exchange rate and spreads to the extent that public debt is denominated in foreign currency or a floating rate, respectively. At any rate, the effect through this default risk channel can be powerful enough to swamp the capital flow, interest rate, and credit channels. As a result, the central bank’s interest rate policy has perverse effects: a tighter interest policy causes inflation to accelerate.

The size of the public debt, conditional on its composition and other country specifics, distinguishes a monetary dominance regime from a fiscal dominance regime. At low levels of debt, default risk is not an issue and this channel simply does not apply; monetary policy operates normally. At high levels of debt, however, the default risk channel might dominate and the fiscal dominance regime applies. At what threshold of debt fiscal dominance kicks in depends on the following: (i) the higher the primary surplus, the higher the threshold, as the surplus alleviates default concerns; (ii) the higher the share of floating rate instruments or rollover rates, the lower the threshold, as these higher rates mean that monetary policy feeds more immediately into debt service costs; (iii) the higher the share of foreign and foreign currency-denominated instruments, the lower the threshold, as this share strengthens the second-round effects associated with capital outflows; and (iv) the higher the spread, the lower the threshold, as this increases debt servicing costs.

The results of some empirical studies carried out for other emerging market countries seem to indicate that fiscal dominance could also be a concern for Turkey. Blanchard (2004) and Favero and Giavazzi (2004) point to possible fiscal dominance effects in Brazil during 2002 and 2003, when markets showed concerns about the change of government. While its key variables are not identical, Turkey is generally viewed by international investors to fall into the same category as Brazil, such that their reactions to potential interest rate increases could be similar. Moreover, even if a country does not suffer from outright fiscal dominance, the conduct of its monetary policy can nonetheless be complicated by high debt.

Other Considerations

A comprehensive assessment of a country’s debt position goes beyond narrow concerns about sustainability and fiscal dominance. In many ways, it is a minimum requirement that the debt position be safely bounded away from a level where shocks could make it spiral out of control or monetary policy could lose traction. But even safe debt levels might entail unduly high real interest rates or absorb a disproportionate share of bank lending.

One important additional consideration is real interest rates. The size of public debt and government borrowing requirements warrant an assessment against the depth of domestic and international capital markets available to a country. If this depth is lacking, real interest rates end up very high. This might not only imperil debt sustainability and thus further reduce the depth of the available international capital market, but it also means that the government’s intertemporal consumption and investment allocation is likely far from optimal. In other words, the price for bringing government consumption and investment forward in time through borrowing might simply be too high to make it worthwhile. Turkey is indeed saddled with very high real interest rates (Table 5.1), which is tentative evidence that the country’s borrowing is not commensurate with the depth of the capital markets available to it.

A second, and related, consideration is the crowding out of private sector credit from the banking system. Turkey’s financial sector is relatively small to begin with. Total assets of deposit money banks amount to only about 60 percent of GNP (Table 5.1). Against this backdrop, it appears particularly problematic that claims on the government make up more than 40 percent of all bank assets. Since this leaves few resources for the private sector, it is likely holding back investment and growth.

Conclusions

How much debt is too much for Turkey? While it is not possible to be precise about a particular safe debt level, the above analysis indicates that, despite recent progress in reducing the public debt ratio, that ratio still remains too high. However, Turkey’s aspirations for accession to the European Union notwithstanding, the Maastricht threshold for public debt of 60 percent of GNP is not an appropriate target, given the much more unfavorable composition of Turkey’s debt compared to the average EU member country. Instead, the average public debt level of the recent EU accession countries—40 percent of GNP—might provide a sensible yardstick. That figure falls in the range of recommended thresholds found in the literature presented in this chapter. Still, this is an ambitious target for Turkey, even for the medium term.

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Cover Turkey at the Crossroads
Turkey at the Crossroads
From Crisis Resolution to EU Accession
Author: Mr. Donal McGettigan, Mr. Xavier Debrun, Mr. Mark E Griffiths, Mr. Reza Moghadam, Mr. Ernesto Ramirez Rigo, Mr. Martin Schindler, Mr. Mats A Josefsson, Cheng Hoon Lim, Mr. Christian Keller, Mr. Christoph A Klingen, Mr. Chris Lane, Oya Celasun, Mr. Ashoka Mody, Mr. Dewitt D Marston, and Mathew A. Verghis
ISBN:
9781589063860
ISSN:
0251-6365
Publication Date:
19 Sep 2005
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589063860.084
Pages:
84

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