External debt relief but increasing domestic debt

Andrea Presbitero 19 November 2010

a

A

The global crisis and the expansionary government reaction in many countries culminated in fast-growing government debt in the US and some European countries. This has revamped the attention of policymakers and academics on the adverse effects of large public debt. In March 2010, the Bank for International Settlements defined as unsustainable the prospects of public debt in several industrialised countries (Cecchetti et al. 2010). Similarly, in September 2010, the IMF released three position papers on unsustainable debt levels in advanced economies and its director of Fiscal Affairs Department, Carlo Cottarelli, said that "public debt levels among advanced economies have reached levels not seen before in the absence of a major war".

While the focus of political attention and recent academic papers (Reinhart and Rogoff 2010a, Kumar and Woo 2010) has been predominantly on emerging and industrialised countries, in recent years a number of developing countries started substituting external with domestic debt (Panizza 2010), following programs aimed at fostering the development of domestic markets for government securities (IMF and World Bank 2001, UNCTAD 2004, Borensztein et al. 2007). As Figure 1 shows, since 1994 external and domestic public debt in developing countries followed a diverging path, with domestic debt representing about two thirds of total public debt in 2006.

Figure 1. Domestic and external public debt in low- and middle-income countries

The unintended consequence of the Heavily Indebted Poor Countries Initiative

The almost exclusive focus of the development literature on external debt (Cordella et al. 2010) is likely to underestimate the effects of a growing total public debt on growth and poverty reduction in several low-income countries, many of which have benefited from debt relief under the Heavily Indebted Poor Countries (HIPC) and the Multilateral Debt Relief Initiatives (MDRI) launched, respectively, in 1995 and 2006. These programs have brought inflation under control in many HIPC, reducing seigniorage and expanding the budget deficit of the public sector. However, the fiscal adjustment has not been equally successful. Poor access to international capital markets – a condition required by the World Bank and IMF concessional lending programs – and the lack of adequate inflows of concessional lending forced many governments to tap domestic markets to finance their primary deficits. This effect has been aggravated by a loose tax collection capacity and the unfeasibility of tight policies in countries with widespread poverty. Thus, the shift towards domestic securities, and the associated increase in the real cost of financing – already documented by Christensen (2005) in Sub-Saharan Africa –, can be considered an "unintended consequence of the HIPC Initiative" (Arnone and Presbitero 2010).

Over the period 1991-2008, the share of domestic debt in total public debt in a sample of 14 HIPC increased from 11% to 37%, mainly because of a sharp reduction in external debt. Besides, these countries moved from a situation in which external debt service was the largest part of interest payments, to an opposite situation. In 2004 interests on external debt were slightly higher than 1% of GDP, while domestic interests soaked up, on average, more than 2.5% of GDP (Figure 2). Furthermore, the unfavourable evolution of domestic debt could be worsened by a reduction in foreign lending and aid assistance, a likely outcome given the ongoing shift from loans to grants and the shrinking aid budget in response to the global crisis (Frot 2009).

Figure 2. The relevance of domestic debt in 14 Heavily Indebted Poor Countries

Data on the debt structure underline the weaknesses of the domestic debt build-up. Maturities are severely biased towards short-term instruments, which, on average, increased by 10 percentage points and in 2003 reached 69% of the outstanding domestic debt (Table 1). The banking sector remains the main holder of government securities, while the role of non-banking sector is still limited and, in many cases, dominated by state-owned enterprises or other public sector entities, so that a real diversification of the investor base is far from secured (Arnone and Presbitero 2010).

Table 1. Domestic debt’s structure in 14 Heavily Indebted Poor Countries

 
Banking system holding (percent)
Short-term instruments (percent)
Country
1994
2003
1994
2003
Bolivia/1
88.94
32.85
27.63
21.60
Burundi
87.88
67.81
96.97
84.90
Ethiopia
93.29
93.78
9.92
40.29
Gambia/2
29.91
40.95
85.27
94.27
Ghana
67.1
56.3
18.77
59.24
Guyana
59.58
n/a
99.87
99.99
Honduras
82.8
35.07
n/a
n/a
Madagascar
100
65.04
100
100
Malawi
50.06
52.33
54.15
90.55
Rwanda
68.6
63.6
14.22
27.74
Sierra Leone
75.16
61
97.05
100
Tanzania/3
81.95
59.33
12.89
23.00
Uganda
74.29
82.3
99.98
99.99
Zambia/4
70.89
82.71
93.04
32.28

Notes: /1 Refers only to the central bank. /2 The distribution by holder refers to the overall stock of domestic debt. /3 Holders’ classification refers only for stock, bonds and notes, no treasury bills. /4 Only treasury-bills, no data on bonds by holder. Data available from 1995. Source: Arnone and Presbitero (2010).

Opportunities and costs of internal financing

Deficit financing with domestic-currency denominated government securities is likely to reduce the vulnerability of a country to reversal in capital flows and limit the build-up of foreign-currency denominated debt, mitigating the risks of exchange rate devaluations and monetary financing of budget deficits. A liquid and deep market with long-term instruments could help reducing the cost of government financing and mitigate capital flight by providing domestic savers with an alternative to investing abroad. Finally, the shift from external to domestic borrowing could reduce the government's external dependence, promoting political accountability and institutional reforms.

The optimal debt structure should take into account the trade-off in terms of risks, costs and externalities between external and internal borrowing (Panizza 2010, Abbas and Christensen 2010). The domestic-bond maturity mismatch could substitute for the currency mismatch of foreign debt, given that many developing countries are unable to issue long-term government securities at a reasonable interest rate. Especially in countries where a large share of domestic debt is non-indexed, the strong incentive to monetise government deficit may cause hyper-inflation episodes and trigger external debt crisis. Moreover, government borrowing could crowd out lending to the private sector, especially to small and medium enterprises and rural borrowers, which have to rely on domestic savings and bank credit. This problem is intensified when banks and institutional investors are “forced” by the government to absorb “too much” domestic debt (Hanson 2007).

The balance between benefits and costs of domestic debt depends on the presence of prerequisites, such as a stable macroeconomic environment, an efficient money market, a broad investor participation and the presence of a sound legal, regulatory and supervisory framework (Guscina 2008, Kose et al. 2009), which in many HIPC are often not satisfied, making domestic debt a particular source of concern which should be addressed (Arnone and Presbitero 2010).

Domestic debt as part of debt relief policies

The IMF and the World Bank did not recognise in full the importance of internal borrowing until 2005 when they started including domestic debt into the new Debt Sustainability Framework. An improved framework to deal with total public debt is now required, since debt sustainability ratios are still based on external debt and the adverse effect of domestic interest payments are not taken into account (IMF and the World Bank 2009).

In particular, debt relief policies should shift from external debt to a more comprehensive approach based on total public debt and on the evaluation of stock and flows effects. The interest bill on domestic debt absorbs a large share of government revenues and reduces pro-poor and social expenditures, undermining the achievement of the Millennium Development Goals. The switch from foreign to domestic borrowing and the resulting interest rates can jeopardise overall debt sustainability (Arnone and Presbitero 2010). Finally, the increasing importance of domestic debt (Figures 1 and 2) requires an evaluation of the effects of total public debt (and not only external debt) on economic growth. Recent evidence on a sample of developing countries show that, contrary to what holds in industrialised countries (Reinhart and Rogoff 2010a, 2010b), the basic relationship between total public debt and economic growth is monotonic and negative up to a threshold corresponding to a level of total public debt over GDP approximately equal to 90%, and irrelevant thereafter, when increasing total public debt goes hand in hand with worsening macroeconomic policies and output and policy volatility, whose negative consequences are likely to overshadow the adverse effect of debt on economic growth (Presbitero 2010).

References

Abbas, S.M.A. and Christensen J.E. 2010. The Role of Domestic Debt Markets in Economic Growth: An Empirical Investigation for Low-income Countries and Emerging Markets, IMF Staff Papers, 57(1): 209-55.

Arnone, M. and Presbitero, A.F. 2010. Debt Relief Initiatives: Policy Design and Outcomes, (Foreword by Nancy Birdsall), Global Finance Series, Farnham: Ashgate

Borensztein, E., Levy Yeyati, E. and Panizza, U. 2006. Living with Debt – How to Limit The Risks of Sovereign Finance. Cambridge, MA: Harvard University Press.

Cecchetti, S., Mohanty, M and Zampolli, F. 2010. The Future of Public Debt: Prospects and Implications, BIS Working Paper 300.

Christensen, J. 2005. Special Data Section Domestic Debt Markets in Sub-Saharan Africa, IMF Staff Papers, 52(3): 518-38.

Cordella, T., Ricci, L.A. and Ruiz-Arranz, M. 2010. Debt Overhang or Debt Irrelevance? IMF Staff Papers, 57(1): 1-24.

Frot, E. 2009. Aid and the Financial Crisis: Shall We Expect Development Aid to Fall? , VoxEU.org, 13 May.

Guscina, A. 2008. Impact of Macroeconomic, Political, and Institutional Factors on the Structure of Government Debt in Emerging Market Countries, IMF Working Paper, No. 08/205.

Hanson, J.A. 2007. The Growth in Government Domestic Debt: Changing Burdens and Risks, Policy Research Working Paper 4348, The World Bank.

IMF and the World Bank. 2001. Developing Government Bond Markets: A Handbook. Washington, DC: The World Bank and International Monetary Fund.

IMF and the World Bank. 2009. A Review of Some Aspects of the Low-Income Country Debt Sustainability Framework, August 5, 2009.

Kose, M.A., Prasad, E.S., Rogoff, K. and Wei, S. 2009. Financial Globalization: A Reappraisal, IMF Staff Papers, 56(1): 8-62.

Kumar, M.S. and Woo, J. 2010. Public Debt and Growth, IMF Working Paper 10/174.

Panizza, U. 2008. Domestic and External Public Debt in Developing Countries, UNCTAD Discussion Paper, No. 188.

Panizza, U. 2010. Is Domestic Debt the Answer to Debt Crisis?, in B. Herman, J.A. Ocampo and S. Spiegel (eds.) Overcoming Developing Country Debt Crisis, Oxford: Oxford University Press.

Presbitero, A.F. 2010. Total Public Debt and Economic Growth in Developing Countries, MoFiR working paper, No. 44.

Reinhart, C.M. and Rogoff, K.S. 2009. This Time is Different. Princeton, New Jersey: Princeton University Press.

Reinhart, C.M. and Rogoff, K.S. 2010a. Growth in a Time of Debt, American Economic Review, 100(2): 573–78.

Reinhart, C.M. and Rogoff, K.S. 2010b. Debt and Growth revisited, VoxEU.org, 11 August.

UNCTAD, 2004, Debt Sustainability: Oasis or Mirage?. Geneva: United Nations.

a

A

Topics:  Development Global governance

Tags:  IMF, debt relief, World Bank, public debt

Economist, IMF; Assistant Professor (on leave), Università Politecnica delle Marche

Events

CEPR Policy Research