Office of the Chief Economist
Latin America & the Caribbean Region
The World Bank
Living with Sovereign Debt:
Comments to the IPES 2007
Guillermo Perry
XXIV Meeting of the Latin American Network of
Central Banks and Finance Ministries
IADB, October 20, 2006
Structure of Comments
1.
2.
3.
4.
Main Conclusions
Main Policy Implications
Main Implications for IFI’s
Areas in need of further work
Main Conclusions

“It’s Public Debt Structure, Stupid” (more than Public Debt
Levels) that cause LAC proneness to debt crises…or “it’s the
economy, stupid” as economic conditions might largely determine
debt structure?
Policy Agenda must then concentrate on improving public
debt structure (more than, or as much as, reducing its level)
 IFI’ s have a major (so far largely unfulfilled) role in helping
countries improve public debt structure, by modernizing their
own financial instruments and helping solve international market
failures
________________________________________________________

Basically agree, though the report could have explored more the limits
that problems in economic policy (eg, credibility of monetary policy)
or structure (financial dollarization) impose on debt structure
Main Policy Implications:
Reducing Currency Risks


Continuing the Shift towards Domestic Currency Debt
Developing Sound Domestic Currency Debt Markets:
– Prospects brighter than presented given higher credibility of monetary
policies, loss of “fear of floating”, higher awareness of currency risks
by Governments and corporates and higher commitment to develop
debt markets ? Examples: Mexico; Colombia; Chile (success of
Infrastructure Bonds); Brazil (incentives to foreign investors in
domestic debt markets). See attached slide
– Less so in economies with financial dollarization? (is Argentina a
special case? Advances in Peru)

Topics that deserved more discussion:
– Use of Currency Swaps to reduce vulnerabilities associated with
the Stock of foreign currency debt: limits? trade offs?
– Issuing in domestic currencies in international markets:
separating jurisdictional from currency risk for conservative
investors? (is Argentina a special case?)
Recent successes in developing
domestic currency markets
Mexico: Public Debt by Currency composition
70
60
40
30
Mexico: Private Bond Issuance
(in billions)
20
170
22
10
21
0
150
20
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
19
Domestic currency
Indexed to inflation
18
110
17
16
90
15
14
13
External Market
70
Domestic Market
12
97.Q1 98.Q1 99.Q1 00.Q1 01.Q1 02.Q1 03.Q1 04.Q1 05.Q1 06.Q1
50
In 2003 pesos
130
Foreign currency
In US dollars
% of GDP
50
Recent successes in developing
domestic currency markets
Brazil Debt Composition
70
60
Percent
50
40
30
Chile: Infrastructure Project Financing
20
10
0
Jan-00 Sep-00 May-01 Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06 Sep-06
Floating Debt (Selic Linked)
Fixed Int. rate
Inflation Linked
USD Exchange rate linked
27%
73%
Infrastructure Bonds
Bank Loans
Main Policy Implications:
Reducing Liquidity Risks

Use of Inflation Indexed Bonds in order to mitigate
trade offs between currency and roll over risks :
– Message clear in Chapters 12, 13, not so in Chapters 2 ,7
(where all forms of indexation are lumped together).
Clarification: dilution of IPC indexed debt does not require
hyperinflation as stated.

Use of contingent debt instruments: Debt indexed
to GDP growth, commodity prices, terms of trade, EMBI
or Libor (inverse indexation). Which is better, when? Is it
better to index capital or interest?

Sound Reserve Management



Optimal level? Cost of reserves is overstated: higher reserves
reduce costs of issuing debt (and of carrying the stock), as liquidity
risks are reduced.
Regional Pooling? Pros and cons? Rules and institutions?
Investing in assets with negative covariance with country GDP
Main Policy Implications:
Controlling the Flow of Debt
– Political and procedural Reforms; Budgetary
Institutions
– “Good” Fiscal Rules:


A rigid rule augments pro cyclicality, becomes non
enforceable and is thus non credible: it’s just a bad rule
(most FRL’ so far tried in LAC)
Good rules are cyclically (structurally) adjusted -a la Chile.
(more on the pro cyclicality issues latter)
– Commodity Stabilization Funds:


Can be better designed (e.g., Colombia Oil Fund)
But inherent limitation: cover only part of revenues
– Revenue Stabilization Funds are natural
complements to Good (structurally adjusted) Fiscal
Rules
Main Implications for IMF


Contingent Facility to reduce Contagion risks
(and increase counter cyclicality)
Fiscal assessments and programs should not be
based on simple Public Debt Level and Deficit
indexes:



More emphasis on structure of debt and vulnerability
analysis (against multivariate shocks)
Use cyclically (structurally) adjusted indexes and goals.
Otherwise assessments will be misleading and programs will
augment pro cyclicality
More emphasis on net worth and inter temporal fiscal
solvency analysis
Main Implications for MDB’s



Borrow and lend in Domestic
Currencies –in addition to currency
Swap offerings- (specially important in
de facto dollarized economies)
Provide menu of Contingent Loans
Help solve market failures in
catastrophic risk insurance
Areas in need of further work:
Debt and Fiscal Sustainability

Need to develop better methods to assess
fiscal/debt vulnerabilities to shocks. Craig
Burnside (2005)

Need to better integrate the analysis of public
debt in the context of overall fiscal solvency:
– Implicit versus explicit liabilities (e.g., with respect to
pension fund assets)
– Net worth and inter temporal effects: critical
difference of an increase in debt to finance
productive infrastructure and public consumption;
projects that can be financed by tariffs or tolls
versus others; etc. Easterly, Serven and Irwin (2006)
Areas in need of further work:
Debt and Pro cyclicality of fiscal policies




Pro cyclical biases lead to anti investment and
deficit biases.
Other estimates controlling for endogeneity
suggest strong pro cyclicality of policies in LAC
(eg, Fatás and Mihov (2004), Suescún (2005)). In
any case, what matters most is the pro
cyclicality of fiscal “results”.
Need of fiscal rules that at least permit (or
amplify) the effect of automatic stabilizers
Need to increase the size and effectiveness of
automatic stabilizers in LAC. Suescun (2005)


Improving tax elasticities
Incorporating some automatic countercyclical programs
Discretionary Fiscal Policy Response to
Cyclical Conditions
(structural budget balance)
Developed Countries
LAC
1.0
-0.6
-0.8
-1.0
-0.4
-0.6
-0.8
-1.2
-1.4
-1.4


Ecuador
Dominican Republic
Brazil
Mexico
Venezuela
Costa Rica
El Salvador
Guatemala
Uruguay
Panama
Chile
Colombia
Peru
-1.0
-1.2
5% significance
Paraguay
-0.2
-0.4
Netherlands
-0.2
Germany
United Kingdom
0.0
Belgium
Turkey
Luxembourg
0.0
New Zealand
0.2
United States
0.2
Canada
Denmark
0.4
Australia
Sweden
Norway
Japan
0.4
Argentina
0.6
Nicaragua
0.6
0.8
Bolovia
0.8
Ireland
Finland
Greece
France
Iceland
Portugal
Italy
Austria
Spain
1.0
10% significance
Not significant
The present figures report IV country-by-country estimates of the sensitivity of the structural budget
balance (as a ratio of potential output) to changes in the output gap. Positive coefficient estimates
denotes a counter-cyclical response in fiscal policy.
Source: Suescún (2005)
The Stabilizing Role of Government Size
LAC
Developed Countries
0.08
0.05
0.07
STD cyclical GDP
STD cyclical GDP
0.04
0.06
0.05
0.04
0.03
0.02
0.03
0.02
0.01
0.01
0.00
0.00
0.00
0.10
0.20
Government size
0.30
0.40
0.50
0.00
0.10
0.20
0.30
Government size
0.40
0.50
Pro cyclicality and public
investment


Countries with more pro-cyclical fiscal policies
tend to show a higher anti-investment bias:
where:
i
i= 80 countries, p-values are in reported parenthesis
is the trend component of public investment to
GDP ratio (proxy of investment bias)
–  i represents the pro-cyclicality of current public
expenditure
–
Areas in need of further work:
Dealing with Vulnerabilities in Fully
Dollarized Economies



Dollarized economies can get into debt
deflation problems when facing adverse shocks
(either to the current or capital account)
Should (can) they develop debt indexed to non
tradable sectors prices? Or just use more debt
indexed to GDP, commodity prices, terms of
trade, EMBI or Libor (inverse)?
Do they need countercyclical fiscal rules more
potent than other countries?
Areas in need of further work:
Catastrophic Risk Insurance



Market failures: premiums sky rocket and
markets virtually disappear in the wake of
major disasters
Need for wide pooling of risks: a coordination
problem?
Role of IFI’s: recent initiatives
– Caribbean fund to cover Sovereign liquidity
risks
– Mexican proposal to create a multilateral
agency for wide risk pooling
– Dealing with moral hasard problems