Debt Dynamics in Low-Income Countries
This appendix derives the equations for the NPV of debt-to-exports and the NPV of debt-to-revenue ratios, discussed in Box 4 of the main text.
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The HIPC Initiative reduces a qualifying country’s net present value (NPV) of external public debt to 150 percent of exports or 250 percent of government revenues.
The definition of low-income countries is typically based on per capita income (the current threshold used by the World Bank, for example, is $875 in 2001 per capita gross national income). This generally determines also eligibility for concessional loans from multilateral institutions and official bilateral creditors. In the assessment of debt sustainability, other factors shared by many low-income countries, aside from their income level, are important. For this reason, this paper leaves open the precise definition of low-income countries, to allow for the inclusion (exclusion) of countries that share many (few) of the features typical for this group.
Workshops are scheduled to take place in Paris and Berlin (May) and Washington (September), the latter being organized by the Fund and the Bank.
For the group as a whole, the ratio of aggregate net transfers to aggregate GDP (i.e., the GDP-weighed average) was 7 percent, reflecting proportionately smaller flows to the larger economies in the group.
The Paris Club provided its first concessional stock-of-debt operation in 1995 to Uganda. For a brief history of debt relief to low-income countries, see Daseking and Powell (1999).
For a discussion of the historical role and objectives of export credit agencies, see Stephens (1999).
For a discussion of these factors and the specific experience often low-income countries, see Brooks and others (1998).
See Chalk and Hemming (2000), for a discussion of different concepts of sustainability. For countries, net worth would be equivalent to the present value of non-interest current account surpluses minus the present value of external debt-service obligations, with the future current account surpluses (i.e., the excess of savings over investment) generated by the profits from the (external debt-financed) investment.
Indeed, in perfect world capital markets, a simple two-country neoclassical model would suggest that all investment take place in the low-capital country, reflecting its higher rates of return. See Lucas (1990).
The literature on this topic, which was originally focused on middle-income countries but has increasingly been applied also to low-income countries, is vast. For a few prominent examples, see Cohen and Sachs (1986); Krugman (1988); Sachs (1989); Cline (1995); Agénor and Montiel (1996); and Servén (1997). For a brief summary of the literature see Pattillo and others (2002) or Loko and others (2003).
This argument is often made with reference to a debt “Laffer” curve: in countries being on the “wrong side” of the curve, the debt overhang has such a large negative effect on their capacity to repay that debt forgiveness would actually benefit the creditors.
Indeed, the expectation that debt service will be growing faster than the country’s capacity to pay, further discourages domestic investment, as it implies that foreign creditors would receive an increasing share of returns.
While empirical evidence of a debt overhang is mixed, a recent study by Pattillo and others (2002) finds a non-linear relationship between debt and growth in a sample of 93 developing countries that is indicative of a debt overhang. Their analysis suggests, on average, a negative impact of external debt on per capita growth for NPV of debt levels above 160-170 percent of exports and 35^10 percent of GDP.
The safety margin was introduced with the enhancement of the HIPC Initiative, when the threshold for the NPV of debt-to-exports ratio was lowered to 150 percent from an original range of 200-250 percent.
See Claessens and others (1997). Of course, the opposite incentives could be created by allocating additional aid to countries that reduce their debt burden.
Indeed, the observation that capital inflows are lower than suggested by a simple neoclassical model is not confined to low-income countries—even though the factors that account for this are likely to differ for more advanced economies. For a discussion of this issue applied to transition economies, see Lipschitz, Lane, and Mourmouras (2002).
Calls for additional debt relief are sometimes supported by the notion of so-called “odious debts,” e.g., debts that were contracted by illegitimate governments and should arguably be forgiven. The term dates back to the days of the Spanish-American War, where the United States argued that Cuba’s debt was odious, as it (i) was incurred without the consent of the people; and (ii) did not benefit the people. In the recent debate, examples for debts that have been argued to be odious include those incurred under the apartheid regime in South Africa, under Mobutu in former Zaire (now Democratic Republic of Congo), and under Marcos in the Philippines (see Kremer and Jayachandran (2002)).
This argument is very similar to the “tapering-in” proposal for aid flows, as discussed in Bulir and Lane (2002).
In this context, a compelling moral case can be made that funds provided for humanitarian purposes and unlikely to enhance long-term growth should be in the form of grants rather than loans.
For most low-income countries rollover risk is less of a concern, as much of their debt is owed to multilateral creditors which do not tend to withhold financing in times of uncertainty or crisis and which provide such financing on fixed (concessional) rates.
It should be noted that the NPV of a concessional loan changes over time (even with fixed terms and a constant discount rate), reflecting both amortization payments and the loan’s remaining maturity. For example, the NPV rises throughout the grace period even though the face value of the loan remains constant.
CIRRs are determined monthly by the OECD, typically on the basis of the secondary market yield on government bonds with a residual maturity of five years. For PRGF-related debt ceilings, 10-year historical averages of discount rates are used for loans with maturities longer than 16 years. Under the HIPC Initiative and for PRGF-related debt ceilings for loans with less than 15-year maturities, 6-month historical averages are used. Currency-specific CIRRs are used to try to capture market expectations about exchange rate movements without the need for explicit assumptions on the exchange rate path. See www.oecd.org for more details on CIRRs.
In this case, prospective cross-currency movements (suggested, for example, by interest-parity conditions) could be modeled explicitly for an applicable period, rather than using historical interest differentials implicitly for the entire maturity period. In the HIPC Initiative, this pragmatic approach would have created problems, as it would have added an element of subjectivity that is inconsistent with the HIPC principles.
Under the HIPC Initiative framework, debt of public enterprises—defined as at least 50 percent owned by the government—is included in the definition of public debt, regardless of whether the debt is formally publicly guaranteed.
Of course, even in middle-income countries, there are limits to the country’s ability to channel GDP into debt service—as exemplified by the relatively low debt-to-GDP ratios and high debt-to-export ratios in the run-up to Argentina’s 2001 debt crisis.
In addition to these variables, movements in cross-currency exchange rates can also affect countries’ debt dynamics to the extent that the debt stock consists of loans of various currencies.
As discussed earlier, for more advanced low-income countries with access to private financing and little constraints on obtaining foreign exchange, GDP could be a more relevant denominator than exports or revenue. If the debt ratio were expressed in relation to GDP, the endogenous debt-dynamics would be driven by the difference between the interest rate and GDP growth (rather than export or revenue growth), and the multiplier would only capture the grant element without scaling it by the exports-to-GDP or revenue-to-GDP ratio.
A note that provides further guidance on the technical aspects of debt sustainability assessments and appropriate stress testing in low-income countries is currently being prepared jointly by Fund staff in FAD and PDR.
The simulations do not include a stress test for lower GDP growth, because this (isolated) shock has no impact on the NPV of debt and debt service ratios relative to exports, unless assumptions are made about the link between GDP and other variables. A growth shock would obviously have an impact on the debt-to-GDP ratio.
As indicated earlier, these levels find empirical support in a recent study by Pattillo and others (2002).
In principle, this is similar to the usage under the HIPC Initiative of three-year averages of exports when determining the amount of debt relief.
If the NPV dynamics were assessed relative to GDP, equation (6) would become:
This assumption has no qualitative impact on the results.