Working draft – comments requested

UNINTENDED CONSEQUENCES OF EXTERNAL-DEBT REDUCTION Paul Beckerman* March 14, 2015

paul.beckerman@gmail.com

Abstract. Paradoxically, nations that benefit from external-debt reduction may find that their sustainable real growth rates and primary fiscal deficit diminish rather than increase. This is because debt-reduction operations not only reduce debt service; they also limit the new external debt governments can take on following debt reduction. This is intended, of course, to prevent the debt problem from recurring. Nevertheless, imports may have to be reduced to limit new debt inflows, and this could induce reductions in real-GDP growth. In addition, governments may need to reduce primary deficits – that is, to reduce non-interest expenditure or/and increase revenue -- to limit the debt they take on, which could adversely affect government capital formation, real growth and poverty reduction. This paper presents a simplified macroeconomic programming exercise, encompassing the national, external, and fiscal accounts. It applies the model illustratively to a hypothetical but more or less typical developing economy. It compares the results of a “base” scenario with that of a scenario with a reduced government external debt-GDP ratio, to address the question of whether, and by how much, this particular economy would have to reduce its real GDP growth rate and its primary fiscal deficit in order to sustain the reduced external-debt ratio. JEL Classification Codes: C30, E62, F34, H68. *Independent consultant. The writer thanks Sanjida Hossain, Willene Johnson, Raju Kalidindi, and Anh-Nga Tran-Nguyen for comments on earlier versions of this paper. The writer also thanks participants in seminars and conferences in which he presented earlier versions (UNCTAD Conference on External Debt, Buenos Aires, November 2006; Latin American Studies Association, October 2010; University of Illinois, September 2011). The macroeconomic exercise that the paper describes is a revised version of an exercise described in this writer’s book Multiannual Macroeconomic Projection Techniques for Developing Economies. This material is used with permission from World Scientific Publishing Co. Pte. Ltd. (copyright 2010). The writer is solely responsible for views expressed here and for errors of fact and judgment. Views expressed here do not necessarily reflect those of any institutions with which the writer is now or has been associated.

1. Introduction 1. This paper describes a simplified multiannual macroeconomic programming exercise for a developing economy. It then shows how this exercise could be applied to project the consequences of a debt-reduction operation. 2. It is increasingly clear that debt-reduction exercises, particularly those carried out since the 1990s under the Highly Indebted Poorest Countries (HIPC) Initiative and the Multilateral Debt Reduction Initiative (MDRI), have had significant unintended negative consequences. At least in part, these have come about because official creditors who reduced what they were owed also reduced their subsequent lending. They did so, of course, to prevent debt stocks from rising and reviving the original problem. Nevertheless, the reduced flow of new lending meant that the economies in question had to cope with intensified pressures on the fiscal accounts, public investment programs, and the balance of payments. The programming exercise this paper discusses can be used to help understand these consequences, to quantify them, and to determine how they could be, or might have been, mitigated. 3. The programming exercise, which is set out in Section 2 below, is a highly simplified version of the familiar IMF and World Bank macroeconomic programming “models.” As such, it is a “consistency” exercise, in which programming assumptions are used to project the (1) national, (2) external, (3) fiscal and (4) monetary accounts. In each of these account systems, one “gap-filling” account is determined residually, so the national-expenditure, balance-of-payments, and fiscal identities are all satisfied for each projection year. The size of the “gap-filling” account in each projection year serves as an indicator of the financial feasibility of the economic program described by the programming assumptions. 4. Sections 3, 4, and 5 apply the projection exercise to analyze a debt-reduction operation for a hypothetical economy. The macroeconomic “data” are “fudged,” first to make the economy “not untypical” of non-oil developing economies, but also to make the economy simple and ordinary, with no unusual circumstances. The discussion can therefore focus on methodological matters. (It is only fair to add that the numbers are also fudged so that they constitute a good debt-reduction example for the discussion.) The approach could be applied to just about any actual economy, to project the consequences of debt reduction and to determine whether they would be unfavorable. For that matter, any version of the IMF programming model or the World Bank’s RMSM-X could be applied in broadly similar ways, to produce more detailed projection results. 5. Debt reduction, particularly under such programs as the HIPC Initiative and the MDRI, was presumably intended to enable countries to increase non-interest government expenditure and real GDP growth rates. The idea was that reducing public external debt service would free financial resources that could then be applied to foster development and reduce poverty. This was plainly the purpose of the official (multilateral and bilateral) institutions that provided the relief (see van Trotsenburg and MacArthur 1997).

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The debt-reduction operations incorporated conditionality intended to ensure that funds no longer needed for debt service would be redirected appropriately. From this perspective, it would be disappointing, and perhaps paradoxical, if debt reduction tended to reduce real growth and intensify fiscal pressure, particularly if the countries in question responded by reducing government expenditure, raising taxes, importing less, growing more slowly, and borrowing more from non-official and internal sources. Nevertheless, for many countries there is evidence that debt reduction had such consequences. Soon after the first HIPC debt reductions took effect, staff at official development institutions found they needed to reduce their lending programs, especially to the countries that had received the largest debt reductions.1 Once this happened, policy-makers found themselves under pressure to reduce their primary fiscal deficits, or to secure financing from non-official and internal sources. 6. A numerical example shows the character of the problem. Suppose a particular economy’s external-debt stock concludes the year 2015 at 60 per cent of GDP. Suppose this debt is concessional, with an interest rate of 1 per cent and a repayment rate of 2 per cent applied to the preceding year-end debt stock. Suppose GDP is projected to grow 6 per cent in U.S.-dollar terms in 2016. With these assumptions, a straightforward calculation shows that the 2016 debt service would be 1.7 per cent of GDP, comprising interest of 0.6 per cent and repayment of 1.1 per cent of GDP. If the year 2016 is to conclude with the debt stock at the same percentage of GDP at which it stood at the end of 2015, the debt stock would have to grow at the same rate as GDP. Further calculation shows that the 2016 net flow of the debt (disbursement less repayment) would then have to be 3.4 per cent of GDP. This implies that the disbursement flow would be 4.5 per cent of GDP, and the net transfer (disbursement less debt service) would be 2.8 per cent of GDP. 7. If the debt stock were reduced at the end of 2015 by precisely half, all the 2016 percentage-of-GDP figures in the preceding paragraph would be reduced by precisely half. That is, while the debt-service flow would be reduced by half, the disbursement and net-transfer flows would also be reduced by half. This presents a problem: it is unlikely that GDP could still grow 6 per cent with the disbursement and net-transfer flows reduced by half. Moreover, all other things being equal, the diminished net transfer implies that the government would be unable to maintain the same primary deficit that it would have without the debt reduction. 8. The development-economics literature has gradually recognized that debt-reduction exercises may have unintended consequences. Chauvin and Kraay (2005) argued that the HIPC debt relief, at least up to the time their paper was written, had brought about no discernible improvement investment or growth. Johansson (2010) showed that while the debt relief had made a large flow of financial resources for available developmental

1 The design of the HIPC benchmarks meant that countries with relatively low recorded exports received the deepest debt reductions. The World Bank and other official lenders found that they had to reduce its lending particularly sharply to these countries, in order to sustain the deeply reduced debt-export ratios.

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expenditure, and had reduced high debt-export ratios from levels that presumably discouraged foreign investors, many economies had found it necessary to borrow more expensively from non-official and internal sources. Amone and Presbitero (2010) compiled comprehensive evidence indicating that HIPC and MDRI debt relief had the effect of intensifying balance-of-payments and fiscal pressures, and that it had led to borrowing from more expensive sources. Borrowing from internal sources appears to have had crowding-out effects in some economies. 9. It is only fair to bear in mind that increasing real growth rates and reducing fiscal pressure were not the only motives for debt-reduction operations. For some economies, creditors and policy-makers were persuaded that pre-emptive, controlled and limited debt reduction was preferable to maintaining high debt ratios that seemed to risk disorderly default. Even if it turned out that this meant that the real growth rates of GDP and government expenditure flows would have to be lower, they seemed more likely to be sustainable. In retrospect, this argument may have been more relevant for “middle-income” economies that owed large amounts of debt to private international banks, with relatively high interest rates and shorter maturities. Relatively fewer “highly indebted poorest” countries genuinely faced high risk of disorderly default, since their concessional debt had lengthy maturities and low interest rates, and because international development agencies were likely to maintain positive transfer flows to “HIPCs.”2 More plausibly, by the 1990s concessional creditors had decided gradually to limit or reduce concessional financing flows to developing economies, and that it would therefore be best to reduce poorer economies’ debt ratios sooner rather than later – again, even if it meant that these economies need to accept lower growth rates and lower primary budget deficits. 10. This paper is organized as follows. Section 2 sets out a simplified version of a standard macroeconomic “consistency model,” with integrated external-, national-, fiscal, and monetary-accounts projections. Section 3 then describes a “base-scenario” projection exercise for a hypothetical developing economy. Section 4 then summarizes the debt-reduction analysis, and Section 5 describes the numerical results of the exercise. Section 6 then discusses the “debt-sustainability” concept implicit in the analysis described in Sections 4 and 5, and contrasts this concept with the conventional HIPC debt-sustainability approach. Finally, Section 7 draws some conclusions and broad policy implications.

2 One sometimes hears the argument that high debt-export ratios discouraged potential foreign investors. Foreign investors were probably sophisticated enough to know when the debt in question was concessional and that international development agencies were likely to maintain positive transfers.

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2. A simplified macroeconomic “consistency model 1. Equations [(1) – (24)] below constitute a simplified multiannual macroeconomic-programming exercise, constructed from base-year data and programming assumptions for a particular (hypothetical) economy. The basic objective is to calculate the external- and fiscal-accounts financing flows that the programming assumptions would require. These financing flows can then be evaluated for feasibility: their feasibility would be the feasibility of the programming assumptions. The exercise is relatively simple, so it reveals the basic concepts and workings of a macroeconomic programming exercise, but also useful for certain practical applications.3 These include showing a debt-reduction operation’s balance-of-payments and fiscal consequences. 2. The exercise sets out from assumptions about the future “state of the world” – that is, assumptions for variables considered to be outside policy-makers’ control. These include the export-volume growth rate (assumed to depend on the growth rates of relevant world markets) and the population growth rate, as well as certain behavioral parameters. The exercise then sets programming assumptions for the future growth rates of such variables as (a) real GDP, (b) government expenditure, and (c) government external debt. Finally, the exercise applies these exogenous and programming assumptions to determine the implied real growth rates of (i) per-capita non-government consumption, (ii) non-government external debt and (iii) government internal debt. To do this, the exercise exploits the accounting identities governing the national-expenditure, balance-of-payments, and fiscal accounts. 3. The analyst (and her readers) could then evaluate the implied real growth rates of per-capita non-government consumption, non-government external debt and government internal debt in terms of their feasibility. Inadequate growth of per-capita non-government consumption, or very rapid growth of non-government external debt or government internal debt, would imply that the analyst would conclude that the assumed growth rates of GDP, government expenditure, and government external debt, taken together, would prove unfeasible.

4. It may seem peculiar to have a projection exercise that assumes, or “programs,” the real-GDP growth rate, and then determines the external-financing flows required to make that growth rate feasible. The point is that the projection exercise’s purpose is to calculate the financing flows that the programming assumptions imply. The feasibility of the financing flows is, by implication, the feasibility of the programming assumptions. That is, rather than assume the financing flows and then determine the real-GDP growth rate that they would permit, the exercise programs the real-GDP growth rate and determines the financing flows that would be required. For many purposes, this “programming” approach is useful and practical for policy planning.

3 For given purposes, of course, it may be helpful to make changes to the equations, or to add additional equations. The version of the exercise presented below may be considered a “core” version.

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5. In this simplified model, the macroeconomic aggregates – i.e., GDP and the various components of expenditure – are all in real terms.4 This version of the exercise therefore abstracts from such important variables as the price level, the exchange rate, and the terms of trade. It does take account, however, of (a) the GDP-capital formation relationship, (b) the national accounts, (c) the general-government accounts, (d) the external accounts, and (e) the monetary accounts. 6. In the formulas following, if “x” is any variable, then x-1 is the value of “x” in the

preceding year, Δx represents x - x-1 and the growth rate of any variable “x” over the

preceding year is given by gx = (x/x-1) – 1, or Δx/x-1. For “stock” variables, those with

a prime (x’) indicate a year-end value and those without a prime indicate a year-average value. 7. To begin, let N represent the year-average population. For any future year, the first equation of the projection system gives the value of N given the programmed growth rate gN ,

(1) N = N-1 (1 + gN).

For this exercise, the value of gN is taken to be a programming assumption. That is, the

analyst carrying out the exercise would be aiming to determine the consequences of setting particular values for future years, along with other programming assumptions. 8. Next, let Y represent real GDP. For any future year,

(2) Y = Y-1 (1 + gY),

where gY is also a programming assumption. The real-GDP growth rate and the per-

capita real GDP growth rates are, of course, the projection exercise’s key programming assumptions. 9. The next equation of the projection system gives total gross fixed capital formation (I) in year t as a function of (i) the programmed growth rate (gY) in the subsequent year,

(ii) the incremental capital-output ratio (k) for capital formation carried out in year t, and (iii) the capital-depreciation rate (d),

(3) I = Y k [gY(+1) + d].

4 If applied in a projection exercise for an actual economy, it may be useful to express them in constant dollars, i.e., dollar values at a base year’s prices and exchange rate.

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This is because, in the familiar Harrod-Domar formulation, GDP growth in year t+1 is given by ΔY+1 = I/k - d K’-1/k’,

where K` represents the year-end capital stock and k’ represents the capital-output ratio K’-1/Y. Dividing both sides of this last expression by Y,

ΔY+1/Y = (I/Y)/k - d (K’-1/Y)/k’,

where K` represents the year-end capital stock and k’ = K’-1/Y. Rearranging this last

formula, gY(+1) = [(I/Y)/k + d],

(since [K’-1/Y] = k’), and this formula can then be rearranged into the formula for I.

10. Next, exports of goods and non-factor services (X) would be given by

(4) X = X-1 [1 + gX] , 5

where gX is their assumed growth rate, and imports of goods and non-factor

services (Q) are given by

(5) Q = Q-1 [(1 + gY)q],

where “q” is the assumed elasticity of Q with respect to Y. That is, the flows of exports and imports of goods and non-factor services follow from the assumptions for gX and q.

Exports and imports of goods and non-factor services figure in the national-expenditure and the balance-of-payments accounts. 11. In the fiscal accounts, the non-interest government-expenditure flows are based on the programming assumptions for their growth rates. These flows are government consumption expenditure (G),

5 Exports could be negatively affected by higher real-GDP growth, to the extent it would enable producers to sell more in domestic markets and so would export less. (In general, the growth rate of exports should not be linked positively to real-GDP growth in a programming exercise of this kind.)

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(6) G = G-1 [(1 + gG)],

government expenditure on gross fixed capital formation (J),

(7) J = J-1 [(1 + gJ)],

and government non-consumption current expenditure (internal transfers and subsidies) (H),

(8) H = H-1 [(1 + gH)],

where “gG”, “gJ” and “gH” are the respective growth rates. These growth rates would be

government policy choices.6 The government consumption and gross-fixed-capital-formation flows figure in the national-expenditure accounts. 12. Non-government consumption (C) can then be determined residually using the national-expenditure identity, so it is consistent with the projections of G, I, X and Q,

(9) C = Y - (G + I + X – Q). As a matter of methodology, the objective of the exercise is to determine whether the growth rates gY, gG, gJ, and gH taken together constitute a financially feasible

macroeconomic “program,” given the other assumptions and initial conditions of the economy. One criterion for making this judgment would be whether the growth rate of C/N would be satisfactory, as discussed below.

13. Next, in the fiscal accounts, government revenue (excluding external transfers to the government) (T) would be given by

(10) T = T-1 [(1 + gY)t],

where “t” is a programming assumption. 7 External transfers to the government would be given by

6 For some economies, on first thought, it would make sense to relate the growth rates of government consumption and non-consumption expenditure to population growth. It is important to remember, however, that staff remuneration would form a significant proportion of government consumption. Unit staff remuneration would tend to grow rates similar to those of unit labor costs in the economy generally. Labor costs in the economy generally would tend to grow at rates similar to the growth rate of labor productivity, or the ratio of GDP to the labor force. If the labor force grows at about the same rate as the population, then the growth rate of government consumption would tend to be the same as the growth rate of overall GDP.

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(11) Z = z Y.

14. In the external accounts, “other” current-account flows – that is, current-account flows other than net exports of goods and non-factor services, net interest, and external transfers to government, encompassing non-interest factor-service net exports and all other net unrequited transfers – would be given by

(12) W = w Y. Non-debt capital account flows (including net direct-foreign-investment flows, short-term non-debt financial flows, and errors and omissions) would be given by

(13) V = v Y. 15. A basic “strategic” approach the exercise takes is to program – that is, to assume -- the growth rates of the government external debt (E’) and the central bank’s external liabilities (L’). The net inflow of external debt to the government figures in both the balance-of-payments and the fiscal accounts. The exercise then applies the balance-of-payments and the fiscal accounting identities to calculate (1) the net non-government borrowing that would be required to complete the financing of the balance-of-payments accounts, and (2) the net internal borrowing that would be required to complete the financing of the fiscal accounts. If (1) the required net non-government external borrowing significantly exceeds what sources of finance would be willing and able to provide; if (2) the required net internal borrowing significantly exceeds what internal financial markets would be willing and able to provide; or/and if (3) the growth rates of the net non-government external debt and of the net internal government debt significantly exceed the real-GDP growth rate, then the programming assumptions for macroeconomic policy and government expenditure would be deemed unfeasible. The analyst would then want to adjust some or all of the programming assumptions, until they become financially feasible. 16. For the balance of payments, applying the programming assumptions gE’ and gL’ ,

the flow increases in the government’s external debt (E’) and the central bank’s external debt (L’) would be given by

(14) ΔE’ = gE’ E’-1 and

(15) ΔL’ = gL’ L’-1.

7 In many countries, a significant part of tax revenue depends on merchandise imports, and so it may be useful to have two revenue equations, one for revenue based on merchandise imports and one for revenue based on nominal GDP.

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17. For any year, the balance-of-payments identity is (X – Q + Z + W + V) - [rE E + rU U + rL L - rA A] + ΔE’ + ΔU’ = ΔA’ - ΔL’ ,

where ΔU’ and ΔA’ are the flow increases in the non-government external debt and in the central bank’s external assets, respectively; rE , rU , rL , and rA are the respective

real interest rates, which are programming assumptions; and E = (E’-1 + E’)/2 = E’-1 + (ΔE’/2),

L = (L’-1 + L’)/2 = L’-1 + (ΔL’/2),

U = (U’-1 + U’)/2 = U’-1 + (ΔU’/2),

and A = (A’-1 + A’)/2 = A’-1 + (ΔA’/2) .

That is, the balance-of-payments identity sets the sum of (1) the non-interest current account (X – Q + Z + W), (2) net interest earnings (rA A - rE E - rU U - rL L), (3) the

non-debt financial account (V), and (4) the debt flows (ΔE’ + ΔU’) equal to (5) the increase in the central bank’s net external asset holdings (ΔA’ - ΔL’). (To be sure, according to the IMF’s recommended accounting methodology, the part of Z consisting of project-finance grants would be included in the capital account of the balance of payments, while the remainder of Z would be included in the current account of the balance of payments.) 18. The external-accounts solution procedure determines the flow increases in the non-government external debt, ΔU’, and in the central bank’s external assets, ΔA’, required to satisfy the balance-of-payments identity. For this purpose, ΔU’ and ΔA’ are each taken to have two components, an “unprogrammed” component (ΔU0’, ΔA0’) and a “programmed” component (ΔU1’, ΔA1’): ΔU` = ΔU0` + ΔU1` and ΔA` = ΔA0` + ΔA1` . For each year, the programmed components (ΔU1` and ΔA1`) are based on programming assumptions, while the unprogrammed components (ΔU0` and ΔA0`) are the residuals

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needed to bring the right- and left-hand sides of the balance-of-payments identity into equality. The programmed increase in non-government external debt is given by

(16) ΔU1’ = gU1’ U1’-1 ,

where gU1’ is a programming assumption. The programmed increase in the central

bank’s external asset stock (ΔA1’) is given by

(17) ΔA1’ = [a (Q/12)] - A1’-1 ,

where “a” is a programming assumption (with units of “months of imports of goods and non-factor services”). 19. Applying the assumptions for the interest rates on government, central-bank, and non-government external debt to the year-average debt stocks, and the assumptions for the interest rates on central-bank external assets to the year-average asset stock, the programmed balance-of-payments “financing gap” may be defined as Γ = - (X – Q + Z + W + V)

- [(rA A1) - (rE E) - (rL L) - (rU U1’-1)]

- [ΔE’ - ΔL’ – ΔU1’ + ΔA1’] .

The balance-of-payments solution would then be

(18) ΔU0’ = Γ/[1 – (rU/2)] and A0’ = 0 if γ exceeds zero, and

ΔA0’ = Γ/[1 – (rA/2)] and U0’ = 0 otherwise.

That is, setting ΔU0’ and ΔA0’ to these values would ensure that the balance-of-payments projection satisfies the balance-of-payments identity. 20. While this solution would “work,” in the sense that it would ensure that each year’s balance-of-payments projection satisfies the balance-of-payments identity, it can be improved in one way. If the financing gap Γ exceeds zero in a projection year, but A0`-1is greater than zero, the financing gap could be financed by first drawing down

A0`-1 (on which, moreover, an additional half year’s worth of interest would be earned):

(18)’ ΔU0’ = Γ/[1 – (rU/2)] and ΔA0 = -A0-1 if γ exceeds A0`-1[1 – (rA/2)],

and

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ΔA0’ = Γ/[1 – (rA/2)] - A0-1 and ΔU0’ = 0 otherwise.

21. A similar approach can be taken to projecting the (general) government accounts. The government’s primary surplus would be given by T + Z – (G + H + J) . The fiscal financing accounts would be given by ΔE’ + ΔF’ – ΔD’ , where E’, F’, and D’ represent the year-end stocks of external government debt, (gross) internal government debt, and gross internal government (financial) assets respectively. The overall deficit would be the sum of the primary deficit and the government’s net interest bill, which would be identically equal to the net financing flow: - [T + Z – (G + H + J)] + [(rE E) + (rF F) - (rD D)] = ΔE’ + ΔF’ – ΔD’ ,

where rE , rF , rD represent the respective interest rates, which are programming

assumptions. The values of rE E and ΔE’ would be equal in the balance-of-payments and

the fiscal accounts. For the government’s net internal debt, F’ = F0’ + F1’, where F1’ and F0’ represent programmed and unprogrammed government internal debt respectively, and D’ = D0’ + D1’, where D1’ and D0’ represent programmed and unprogrammed government internal assets (presumably bank deposits) respectively. For the programmed government debt and assets,

(19) ΔF1’ = F1’-1 gF1’

and

(20) ΔD1’ = D1’-1 gD1’ .

As with the balance-of-payments accounts, it is useful to define a programmed government financing gap:

Ψ = - [T + Z – (G + H + J)] + [rF F + rE E + rF F - rD D]

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- (ΔE’ + ΔF1’ - ΔD1’) . The flow increase in unprogrammed government internal debt and the flow increase in unprogrammed government assets would be given then by

(21) ΔF0’ = Ψ/[1 – (rF/2)] if Ψ is greater than zero, and

ΔD0’ = Ψ/[1 – (rF/2)] otherwise.

That is, setting ΔF0’ and ΔD0’ to these values would ensure that the balance-of-payments projection satisfies the balance-of-payments identity. 22. Like the balance-of-payments projection, while these values would ensure that the fiscal-accounts projection satisfies the fiscal-accounts identity, they may be improved in one way. If the financing gap Ψ exceeds zero in a projection year, but D0`-1is greater

than zero, the financing gap could be financed by first drawing down D0`-1 (along with

an additional half year’s interest): (21)’ ΔF0’ = Ψ/[1 – (rF/2)] and ΔD0 = -D0-1 if γ exceeds D0`-1/[1 – (rA/2)],

and ΔD0’ = Ψ/[1 – (rD/2)] - D0-1 and ΔF0’ = 0 otherwise.

23. Finally, three simple equations may be used to project the monetary aggregates. First, the year-end stock of broad money (M2’) is taken to be a given percentage of GDP. Since

(22) M2’ = m Y, the flow increase in the money supply (M2’) is given by ΔM2’ = (mY) - M2’-1 .

The flow increase in the monetary base is given then by

(23) ΔM0’ = ΔM2’/b, and the flow increase in the central bank’s net internal assets is given by

(24) ΔP’ = ΔM0’ + (ΔL’ - ΔA’).

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That is, ΔP’ would be whatever amount is required to ensure that the monetary authority’s flow balance identity is satisfied, with the increase in the net internal assets (ΔP’) and the gross external assets (ΔA’) backing the increase in external liabilities (ΔL’) and monetary base (ΔM0’).8 24. In summary, for each projection year t, the analyst would program various growth rates, in particular, those of (i) real GDP, (ii) the various components of government expenditure, and (iii) (real) government external debt. The equations described above can then be used to solve for the growth rate of per-capita non-government consumption, gC/N = [(C/C-1)/(1 + gN)] – 1;

the year-end non-government external-debt stock as a percentage of GDP, U’/Y = (U’-1 + ΔU’)/Y; and

the year-end government internal-debt stock as a percentage of GDP, F’/Y = (F’-1 + ΔF’)/Y.

25. These projected values could then be examined to determine whether they are sufficiently high, in the case of per-capita non-government consumption, or sufficiently low, in the cases of the debt ratios, to ensure that the programming assumptions, taken together, constitute a financially feasible program.

3. A base-scenario projection exercise for a hypothetical developing economy 1. This section describes a projection exercise carried out for a hypothetical economy, called “Atlántica,” using the equations (1) - (2) to formulate the projections. Table 1 shows the macroeconomy’s main flow and stock variables in the projection base year, taken to be 2015:

8 Note that if an assumption is made for the economy’s marginal currency-deposit ratio, the value of the increase in the banking system’s deposit stock could be determined. For this note only, let C’ represent the currency in circulation (that is, outside the banking system), let R’ represent bank reserves, and let D’ represent the banking system’s deposit stock. Let α represent the marginal currency-deposit ratio. Let M’ represent the broad money supply. Since ∆M’ = ∆C’ + ∆D’, ∆M’ = (α ∆D’) + ∆D’ = (1+ α) ∆D’, it follows that ∆D’ = [1/(1 + α)] ∆M’. If ρ represents the marginal reserve-deposit ratio, the increase in bank reserves would be given by ρ ∆D’, or ρ [1/(1 + α)] ∆M’.

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Table 1. “Atlántica”: Principal macroeconomic indicators, 2015

ATLANTICA:

MACROECONOMIC SUSTAINABILITY EXERCISE Year: 2015 Per cent of GDP:

DATA:Base-year values:

(1) Gross domestic product (GDP) Y 10,000.0 100.0%Non-government consumption expenditure C 7,550.0 75.5%Government consumption expenditure G 1,100.0 11.0%

(2) Total gross fixed capital formation I 2,000.0 20.0%Non-government gross fixed capital formation 2,500.0 15.0%Government gross fixed capital formation J -500.0 5.0%

(3) Exports of goods and non-factor services X 1,550.0 15.5%(4) Imports of goods and non-factor services Q -2,200.0 -22.0%

(5) Year-end capital stock K’ 40,000.0 400.0%(6) Population (millions) N 10.0

(7) Government revenue excl. external transfers T 1,600.0 16.0%(8) External transfers to government Z 100.0 1.0%(9) Government consumption expenditure G -1,100.0 -11.0%

(10) Government domestic transfers and subsidies H -480.0 -4.8%(11) Government gross fixed capital formation J -500.0 -5.0%

Exports of goods and non-factor services X 1,550.0 15.5%Imports of goods and non-factor services Q -2,200.0 -22.0%External transfers to government: Z 100.0 1.0%

(12) External current transfers to government Z0 50.0 0.5%External capital transfers to government Z1 50.0 0.5%

(13) Net current-account inflows excluding net exports, current transfers to govt., net int W 100.0 1.0%(14) Net non-debt financial inflows V 100.0 1.0%

Year-end stocks:(15) Central-bank external assets (-) A’ -733.3 -7.3%(16) Government external debt E’ 3,000.0 30.0%(17) Central-bank external liabilities L’ 100.0 1.0%(18) Non-government external debt U’ 200.0 2.0%

Government internal debt: 400.0 4.0%(19) Government internal debt F’ 500.0 5.0%(20) Government internal assets -D’ -100.0 -1.0%

(21) Broad money supply M2' 3,000.0 30.0%(22) Monetary base M0' 1,000.0 10.0%

These are stylized values intended to be “not untypical” of non-oil developing economies. Note that external debt owed by the government ends the base year (2015) at 60 per cent of GDP, while per-capita GDP for 2010 is US$1000. 2. Table 2 gives the programming assumptions for the basic projection exercise, and Table 3 directly following gives the main projection results. In effect, this projection exercise constitutes a simplified debt-sustainability exercise, intended to determine whether this economy could maintain the assumed real growth rates of GDP and government expenditure indicated in Table 2 while maintaining the initial government debt-GDP ratio of 60 per cent. The basic criteria for making this judgment are the growth rates of (1) the balance-of-payments and (2) fiscal residual accounts, which are the increases in (1) non-government external debt and (2) net internal government debt respectively, calculated using the projection exercise described in Section 2 above.

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Table 2. “Atlántica”: Programming assumptions, 2016-2030

ATLANTICA: Average:MACROECONOMIC SUSTAINABILITY EXERCISE Year: 2016 - 2030 2030

ASSUMPTIONS:Assumptions for parameters, exogenous variables:

Real growth rates:(1) Exports of goods and non-factor services gX 6.0% 6.0%(2) Population (millions) gN 2.0% 2.0%

Ratio:Incremental capital-output ratio (ICOR) [I/Y]/gY 3.3 3.3

(3) ICOR net of depreciation k 2.0 2.0Per cent:

(4) Depreciation rate of the capital stock d 4.0% 4.0%Per cent of GDP:

(5) Net current-account inflows excluding net exports, current transfers to govt., net in w 1.0% 1.0%(6) Net non-debt financial inflows v 1.0% 1.0%

Elasticities with respect to real GDP:(7) Government revenue excl. external transfers t 1.0 1.0(8) Imports of goods and non-factor services q 1.0 1.0

Year-end stock/GDP:(9) Broad money supply m = M2'/Y 30.0% 30.0%

Ratio:(10) Marginal money multiplier b 3.0 3.0

Real interest rates on...(11) Government external debt rE 3.0% 3.0%(12) Central-bank external liabilities rL 2.0% 2.0%(13) Central-bank external assets rA 1.0% 1.0%(14) Non-government external debt rU 4.0% 4.0%(15) Government internal debt rF

(16) Government internal assets rD 5.0% 5.0%

Programming assumptions:Real growth rates:

(17) Gross domestic product (GDP) gY 6.0% 6.0%(18) Government external debt gE' 6.0% 6.0%(19) Programmed non-government external debt gU1' 6.0% 6.0%(20) Central-bank external liabilities (+) gL' 6.0% 6.0%(21) Government consumption expenditure gG 6.0% 6.0%(22) Government domestic transfers and subsidies gH 6.0% 6.0%(23) Government gross fixed capital formation gJ 6.0% 6.0%(24) Programmed government internal debt gF1' 6.0% 6.0%(25) Programmed government internal assets gD1' 6.0% 6.0%

Per cent of GDP:(26) External transfers to government z = Z/Y 1.0% 1.0%(27) External current transfers to government z0 = Z0/Y 0.5% 0.5%

External capital transfers to government z1 = z - z0 0.5% 0.5%Months of imports of goods and non-factor services:

(28) Central-bank external assets (-) a 4.0 4.0

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Table 3. “Atlántica”: Base-scenario projection results for 2016-2030

ATLANTICA: Average:MACROECONOMIC SUSTAINABILITY EXERCISE Year: 2015 2016 - 2030 2030

Key programming assumptions (real growth rates):Gross domestic product (GDP) 6.0% 6.0%Exports of goods and non-factor services 6.0% 6.0%Government consumption expenditure 6.0% 6.0%Government external debt 6.0% 6.0%Population (millions) 2.0% 2.0%

Gross domestic product (US$ million at 2015 prices and exchange rate) Y $10,000.0 $16,448.4 $23,965.6Population (millions) N 10.0 11.8 13.5

National-expenditure accounts (per cent of GDP):Y/Y 100.0% 100.0% 100.0%

Total consumption: (C+G)/Y 86.5% 86.5% 86.5%Non-government consumption expenditure C/Y 75.5% 75.5% 75.5%Government consumption expenditure G/Y 11.0% 11.0% 11.0%

Total gross fixed capital formation: I/Y 20.0% 20.0% 20.0%Non-government gross fixed capital formation (I-J)/Y 15.0% 15.0% 15.0%Government gross fixed capital formation J/Y 5.0% 5.0% 5.0%

Net exports of goods and non-factor services: (X+Q)/Y -6.5% -6.5% -6.5%Exports of goods and non-factor services X/Y 15.5% 15.5% 15.5%Imports of goods and non-factor services Q/Y -22.0% -22.0% -22.0%

Total saving: 20.0% 20.0% 20.0%Current-account deficit: 6.5% 6.2% 7.4%

Net imports of goods and non-factor services 6.5% 6.5% 6.5%Other current-account deficit 0.0% -0.3% 0.9%

National saving: 13.5% 13.8% 12.6%Internal saving 13.5% 13.5% 13.5%National saving less internal saving 0.0% 0.3% -0.9%

Government saving 5.0% 0.2% -0.8%Non-government saving 8.5% 13.6% 13.4%

Per capita non-government consumption expenditure (2016 = 100) 96.2 132.7 171.3Growth rates 0.0% 3.9% 3.9%

Capital stock K’/Y 400.0% 305.1% 254.5%

External accounts (per cent of GDP):Current account of the balance of payments: -6.5% -6.2% -7.4%

Net exports of goods and non-factor services: (X-Q)/Y -6.5% -6.5% -6.5%Exports of goods and non-factor services X/Y 15.5% 15.5% 15.5%Imports of goods and non-factor services Q/Y -22.0% -22.0% -22.0%

Interest due on central-bank external assets: rA A 0.1% 0.1%Interest due on... -1.3% -2.4%

Government external debt rE E -0.5% -1.0%Non-government external debt rU U -0.8% -1.4%Central-bank external liabilities rA A 0.0% 0.0%

External current transfers to government Z0/Y 0.5% 0.5%Net current-account inflows excluding net exports, current transfers to govt., net inte W/Y 1.0% 1.0%

Capital and financial accounts 6.6% 7.7%Net increase in central-bank net external assets (-): -0.4% -0.4%

External and government assets and liabilities:Central-bank external assets A’/Y -7.3% -7.3% -7.3%Government external debt E’/Y 30.0% 30.0% 30.0%Central-bank external liabilities L’/Y 1.0% 1.0% 1.0%Non-government external debt U’/Y 2.0% 20.5% 37.6%

(continues)

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Table 3. “Atlántica”: Base-scenario projection results for 2016-2030 (concluded)

ATLANTICA: Average:MACROECONOMIC SUSTAINABILITY EXERCISE Year: 2015 2016 - 2030 2030

Government accounts (per cent of GDP):Government surplus: -4.8% -5.8%

Primary surplus: -4.3% -3.3% -3.1%Government revenue excl. external transfers T/Y 16.0% 16.5% 16.7%External transfers to government: Z/Y 0.5% 1.0% 1.0%Government consumption expenditure G/Y -11.0% -11.0% -11.0%Government domestic transfers and subsidies H/Y -4.8% -4.8% -4.8%Government gross fixed capital formation J/Y -5.0% -5.0% -5.0%

Net interest due on... -1.5% -2.7%Government external debt rE E -0.5% -1.0%Net government domestic debt -1.0% -1.7%

Government external debt E’/Y 30.0% 30.0% 30.0%Government internal debt F’/Y 5.0% 19.8% 33.3%

Monetary accounts (per cent of GDP):Broad money supply M'/Y 30.0% 30.0% 30.0%Monetary base B'/Y 10.0% 10.0% 10.0%

Per-capita:Non-government consumption C/N $1,041.3 $1,344.4

Real growth rate 3.9% 3.9%Total government expenditure G/N $286.9 $370.4

Real growth rate 3.9% 3.9%

3. On the basis of the programming assumptions given in Table 2, Table 3 shows that per-capita real non-government consumption would grow at an average annual rate of 3.9 per cent from 2016 through 2030; the year-end non-government external-debt stock would rise from 2.0 per cent of GDP in 2015 to 10 per cent of GDP in 2030; and the year-end government internal-debt stock would decline from 5 to 3.8 per cent of GDP in 2030. (Note that if per-capita real non-government consumption – “living standards,” roughly speaking -- grows at an annual average rate of 3.9 per cent, living standards would double in just over 18 years, which some countries’ policy-makers might consider too slow.) Suppose for now that the government’s policy-makers consider these results acceptable, and would maintain the programming assumptions listed in Table 2 – including the 6-per cent real-GDP growth rate -- as their longer-term macroeconomic program. All the same, the premise is that they would like to consider the consequences of a debt-reduction operation at the end of 2015.

4. The debt-reduction analysis procedure 1. The analysis of the debt-reduction operation proceeds as follows. The first step would be to carry out a projection exercise that is the same as the base-scenario exercise, using the programming assumptions given in Table 2, but with the single exception that the initial year-end government external debt stock is reduced (say) by half, from 60 to 30 per cent of GDP. This reduced ratio is then maintained throughout the projection

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period (by linking the assumed growth rate of the government external debt stock to the assumed real-GDP growth rate). 2. With this single change, (1) the interest bill on government external debt is reduced from its base-projection value, both on the balance of payments and the fiscal accounts. To this extent, of course, the required flows of non-government external debt and government internal debt would diminish. However, (2) the net inflow of external debt to the government would also be reduced, in order to hold the government external debt-GDP ratio at its reduced value. To this extent, the required flows of non-government external debt and net government internal debt would have to increase. 3. For countries that participated in the HIPC and MDRI debt-reduction programs, the second effect is likely, in general, to be stronger than the first. That is, following debt reduction, the net inflow of external debt to the government would diminish by more than the interest on the debt. The relative sizes of the two effects would be determined by the specific quantitative circumstances. For a country eligible for the HIPC or the MDRI, however, since the debt-GDP ratio would presumably be relatively high while the interest bill would be relatively small, since it is largely concessional, it is likely that the second effect would predominate. 4. If the required flows of non-government external debt and net government internal debt with debt reduction would be larger following debt reduction than they would be in the base scenario, it is possible that their feasibility could come into question. This sets up the approach to evaluating the debt-reduction consequences. It consists of carrying out several calculations, with the reduced external debt-GDP ratio and all the other assumptions listed in Table 2, as follows:

1- A reduction in the assumed real-GDP growth rate is calculated that would, through its effect on imports of goods and non-factor services, reduce the final non-government external debt-GDP ratio to its value in the base projection exercise. The reduction in the real-GDP growth rate required for this may be regarded as a benchmark indicator of the pressure that debt reduction brings about to diminish the economy’s real growth.

2- The real-GDP growth rate is restored to its base-scenario value. With the reduced external debt-GDP ratio, a reduction in the assumed government-expenditure flow is calculated that would bring the final net internal debt-GDP ratio down to its value in the base projection exercise. (To simplify the results, it is assumed that only the growth rate of the “government-consumption” account is reduced. In real circumstances, such an adjustment would more likely be carried out through a combination of reductions in the growth rates of all categories of government expenditure and increases in tax revenue.)

3- The government-expenditure flows are restored to their base-scenario value.

With the reduced external debt-GDP ratio, a new value is calculated for the flow of external transfers (grants) to the government, such that the non-government

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external debt stock concludes at the same value as in the base scenario, with the real-GDP and government-expenditure flows as in the base scenario.

4- Finally, with the reduced external debt-GDP ratio, a new value is calculated for the flow of external transfers to the government, such that the non-government external debt stock concludes at the same value as in the base scenario, again with the real-GDP and government-expenditure flows as in the base scenario.

5. The results of these calculations may be regarded as benchmark indicators of the policy “tightening” that debt reduction would require: (1) the reduced real-GDP growth rate required to hold the 2030 non-government external debt stock the same as in the base scenario; (2) the reduced government expenditure flow required to hold the 2030 government internal debt stock the same as in the base scenario; (3) the increase in the flow of external transfers to the government as a percentage of GDP required to hold the real-GDP growth rate and the 2030 non-government external debt stock the same as in the base scenario; and (4) the increase in the flow of external transfers to the government as a percentage of GDP required to hold the government expenditure flow and the 2030 government internal debt stock the same as in the base scenario.

5. Debt-reduction analysis 1. The analysis follows the outline discussed in Section 4 above. A single change is made in the base-year values: the figure given for government external debt at the end of 2015 and for all periods is reduced from 60 to 30 per cent of GDP, as might take place in a debt-reduction operation. This change, while maintaining all other projection assumptions given in, while maintaining all other projection assumptions given in Table 2, produces a new set of projection results. In the base scenario, non-government external debt would rise to 10 per cent of GDP and net government internal debt would decline to 3.8 per cent of GDP in 2030 (see Table 4):

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Table 4. “Atlántica”: Summary projection results for 2016-2030 with government external debt maintained at 60 per cent of GDP

Average:Year: 2015 2016 - 2030 2030

RESULTS:Year-end stock/GDP:

Non-government external debt U'/Y 2.0% 6.1% 10.0%Central-bank net external liabilities (L' - A')/Y 8.3% 7.6% 7.2%Net government internal debt (F' - D')/Y 5.0% 4.7% 3.8%

Growth rates:Per-capita non-government consumption g(C/N) 3.9% 3.9%

Year-end stock/GDP:Government external debt E'/Y 60.0% 60.0% 60.0%Central-bank external liabilities L'/Y 1.0% 1.0% 1.0%Capital stock K'/Y 400.0% 305.1% 254.5%Broad money supply M2'/Y 30.0% 30.0% 30.0%Monetary base M0'/Y 10.0% 10.0% 10.0%Central-bank net domestic assets P'/Y -18.3% -17.6% -17.2%

Real values:Per-capita gross domestic product Y/N 1,000.0 1,379.2 1,780.7Per-capita non-government consumption C/N 755.0 1,041.3 1,344.4Per-capita government consumption G/N 110.0 151.7 195.9Per-capita government capital formation J/N 50.0 69.0 89.0

Increase as a per cent of GDP:Government external debt ΔE'/Y 3.4% 3.4%Central-bank external liabilities ΔL'/Y 0.1% 0.1%Central-bank external assets -ΔA'/Y -0.4% -0.4%

Non-government external debt ΔU'/Y 0.8% 1.1%Net government internal debt (ΔF'-ΔD')/Y 0.5% 0.4%

Growth rates:Non-government external debt ΔU'/U'(-1) 18.1% 12.5%Government internal debt ΔD'/D'(-1) 4.0% 2.9%Broad money supply ΔM'/M'(-1) 6.0% 6.0%Monetary base ΔB'/B'(-1) 6.0% 6.0%Central-bank external assets ΔV'/V'(-1) 5.5% 5.7%

Per cent of GDP:Government interest due -0.5% -0.6%Overall government surplus -3.8% -3.7%Current-account surplus -4.5% -4.2%

Per cent of exports of goods and non-factor services:Government external debt E'/X 387.1% 387.1% 387.1%Interest on government external debt r(E) E(-1)/X -1.4% -2.0%

With the reduction in the government external debt stock, non-government external debt would rise to 37.6 per cent of GDP and net government internal debt would rise to 33.3 per cent of GDP in 2030 (see Table 5):

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Table 5. “Atlántica”: Summary projection results for 2016-2030 with government external debt reduced to 30 per cent of GDP

Average:Year: 2015 2016 - 2030 2030

RESULTS:Year-end stock/GDP:

Non-government external debt U'/Y 2.0% 20.5% 37.6%Central-bank net external liabilities (L' - A')/Y 8.3% 7.6% 7.2%Net government internal debt (F' - D')/Y 5.0% 19.8% 33.3%

Growth rates:Per-capita non-government consumption g(C/N) 3.9% 3.9%

Year-end stock/GDP:Government external debt E'/Y 30.0% 30.0% 30.0%Central-bank external liabilities L'/Y 1.0% 1.0% 1.0%Capital stock K'/Y 400.0% 305.1% 254.5%Broad money supply M2'/Y 30.0% 30.0% 30.0%Monetary base M0'/Y 10.0% 10.0% 10.0%Central-bank net domestic assets P'/Y -18.3% -17.6% -17.2%

Real values:Per-capita gross domestic product Y/N 1,000.0 1,379.2 1,780.7Per-capita non-government consumption C/N 755.0 1,041.3 1,344.4Per-capita government consumption G/N 110.0 151.7 195.9Per-capita government capital formation J/N 50.0 69.0 89.0

Increase as a per cent of GDP:Government external debt ΔE'/Y 1.7% 1.7%Central-bank external liabilities ΔL'/Y 0.1% 0.1%Central-bank external assets -ΔA'/Y -0.4% -0.4%

Non-government external debt ΔU'/Y 3.4% 4.5%Net government internal debt (ΔF'-ΔD')/Y 3.2% 4.2%

Growth rates:Non-government external debt ΔU'/U'(-1) 31.1% 13.7%Government internal debt ΔD'/D'(-1) 20.6% 13.2%Broad money supply ΔM'/M'(-1) 6.0% 6.0%Monetary base ΔB'/B'(-1) 6.0% 6.0%Central-bank external assets ΔV'/V'(-1) 5.5% 5.7%

Per cent of GDP:Government interest due -1.5% -2.7%Overall government surplus -4.8% -5.8%Current-account surplus -3.6% -2.5%

Per cent of exports of goods and non-factor services:Government external debt E'/X 193.5% 193.5% 193.5%Interest on government external debt r(E) E(-1)/X -3.5% -6.6%

2. The analysis turns then to the four indicative calculations listed at the end of Section 4 above, all using iterative calculations (“goal-seek” in Excel):

1- The non-government external debt stock would be reduced back to 10 per cent of GDP if the programmed annual real-GDP growth rate were reduced from 6 to 3.6 per cent.

2- The net government internal debt stock would be reduced back to 3.8 per cent of GDP if the programmed growth rate of government consumption expenditure were reduced from 6 to 0.9 per cent.

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3- The non-government external debt stock would be reduced back to 10 per cent of

GDP if the flow of net transfers to the government were increased from 1 to 2.7 per cent of GDP.

4- The net government internal debt stock would be reduced back to 5.5 per cent of GDP if the flow of net transfers to the government were increased from 1 to 2.7 per cent of GDP. This would be the same percentage that would restore the non-government external debt stock to its base scenario value (as it should be).

3. These results constitute indicators of the “unintended consequences” of a debt-reduction operation. To be sure, after a debt-reduction operation, policy-makers might not actually want to reduce the future non-government external debt stock and government internal debt stock as far as they would have been in the base scenario, and they could use the programming exercise to tailor a program with a combination of adjustments. It is clear, however, that unless they can secure additional grants, or allow government external debt to rise somewhat as a percentage of GDP, they would have to adjust to the reduction in disbursements to the government. 6. “Debt sustainability 1. The analysis described thus far takes a different approach to “debt sustainability” from what has now become conventional. Since the HIPC exercise beginning in the late 1990s, economists and policy-makers have come to define debt “sustainability” in terms of benchmark debt-export and debt service-export ratios. Public external debt stocks (recalculated as the net present values of future debt service) have been deemed “sustainable” if and only if they were within or below the range of 150 to 200 per cent of exports of goods and non-factor services. Debt service-export ratios have been deemed sustainable if and only if they were within or below the range of 20 to 30 per cent of exports of goods and non-factor services. These benchmarks were presumably grounded in experience, since they have no obvious theoretical underpinning.9 At least part of their purpose was to serve the practical purposes of the HIPC operation: they could be applied more or less uniformly to different countries, implying that debt reduction was being allocated fairly among them.

9 An argument can be made that the HIPC objectives ought to have been set from the outset as ratios to GDP rather than exports. (To grasp the essential point, it may help to think not of ratios of debt to GDP, but rather of ratios of per-capita debt to per-capita GDP.) Ratios to GDP would have been more relevant indicators of the economy’s overall debt burden than ratios to exports, especially if the objective was to enable the government to maintain adequate developmental expenditure. In any case, apart from differing policy approaches regarding export incentives, differing circumstances of geography and economic structure imply differences in economies’ export-GDP ratios: all other things being the same, small, open economies naturally tend to have higher export flows than larger economies.

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2. The analysis discussed in Sections 4 and 5 above is based implicitly on an alternative sustainability criterion, which may be summarized as follows: A developing economy’s public external debt may be considered prospectively “sustainable” if, with realistic “state-of-the-world” assumptions, the economy, and in particular the government, could maintain the projected debt-service payments while (i) real GDP and living standards grow at minimum acceptable rates or better; (ii) the government maintains or exceeds minimum (per-capita real) expenditure on basic services and developmental objectives; and (iii) non-government external debt and of internal government debt remain the same or diminish as percentages of GDP. That is, the public external debt should be considered sustainable if (and only if) a projection analysis shows that the government could service it while also maintaining adequate expenditure on basic services, economic development, and poverty reduction, and while real GDP and living standards grow adequately. 3. Several points may be noted about this alternative approach. First, it focuses on the debt-service flows, not the debt stock. The debt-service flow, after all, is the “burden” of any debt for a borrower. Rather than convert future debt-service flows into a current stock through a net-present-value calculation, it focuses on the evolution of the future flows, and asks whether – and, if so, when -- they would eventually become higher than the government could reasonably be expected to pay.10 4. This way of characterizing debt sustainability not only requires a realistic projection of all relevant state-of-the-world variables; it is for a particular state-of-the-world projection. As a moment’s thought should make clear, it stands to reason that the sustainability of any given debt stock or service flow can be meaningful only within the context of the borrowing country’s prospective income and expenditure commitments. To be relevant, any debt-sustainability definition must take account of the full range of the borrower’s likely future earnings and expenditure commitments, and so of the “state-of-the-world” variables that determine those earnings and commitments.11 In contrast with the HIPC sustainability benchmarks, the debt-sustainability concept described here makes a point of doing this. The basic HIPC sustainability benchmarks do take account of the country’s current or recent export flows, but of no other aspect of the country’s economic context. 5. It may be, of course, that the projected debt-service flow would be sustainable for one future state of the world but not for different ones that may nevertheless be plausible. In this case, one could deem the debt stock sustainable in what might be called the “base”

10 Conversion of a debt-service burden into a stock value through the net-present-value calculation substitutes a single number for a series of figures, and analysts have found this useful in many contexts. It may be less practically useful in the debt-reduction context, however, precisely because it is useful to compare the time profile of a country’s debt-servicing burden with the time profile of the determinants of the ability to meet that burden – i.e., the growth rates of exports, GDP, and private consumption. 11 By way of analogy, evaluation a homeowner’s mortgage application ought to take account of the the full range of the prospective borrower’s income prospects and other expenditure commitments.

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scenario for the future state of the world, but vulnerable – i.e., sensitive -- to changes in the state-of-the-world assumptions. The fundamental point remains, though, that the sustainability of a given debt stock can only be meaningful in terms of a specified set of relevant assumptions regarding the future. 6. In one sense, the most important shortcoming of the HIPC-MDRI approach is that it takes account of future debt service arising from existing debt, but not from new debt the country might need to take on in the future. It does not distinguish, in effect, between governments with large and small prospective external-borrowing needs. A government running a substantial fiscal deficit, or a country with a substantial current-account deficit, would presumably need to borrow in the future. For a relevant sustainability analysis, debt service on that new borrowing should be included in the net-present-value calculation. Either that, or the sustainability analysis should focus on the future year-by-year flow projections, determining whether the country and the government would be able to meet the debt-service obligations while meeting other commitments in each projection year. 7. To be sure, while a country may seem able to maintain adequate real-GDP growth and government expenditure while maintaining its debt stock high relative to exports or to GDP, its creditors may be reluctant to go along. All other things being equal, the higher the debt-export or debt-GDP ratio the country aims to maintain, the less likely it will be that its creditors would be willing to lend sufficiently lending to maintain that ratio. One might suppose that if a country’s debt-export or debt-GDP ratio is sustainable according to the definition proposed here, then creditors should be inclined to provide enough new lending to maintain it. Creditors may be under pressure themselves, however: official lenders, for example, may be under direction by governments to reduce lending to all or to particular economies, and private lenders may be under pressure from regulators, or from their own depositors and creditors, to reduce lending. 8. This last point notwithstanding, it is nevertheless useful to carry out what may be characterized as a debt-sustainability analysis focused on the country’s prospects. In keeping with the “sustainability” definition used here, the exercise would determine whether the projected external debt-service flows would be feasible for the country given its fiscal and external context of earnings and expenditure commitments, without taking account of whether external creditors would be likely to find it comfortable to maintain the projected lending flows. If the debt would be feasible at this level – that is, if the projection indicates that this sustainability criterion could be satisfied for realistic future states of the world -- then the next step would be to complete the analysis by determining whether foreign creditors would be likely to lend as the projection assumes.

7. Conclusions 1. This paper’s basic purpose has been to show how a simplified macroeconomic programming exercise could be used to help project and evaluate the consequences of a

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debt-reduction operation. While debt reduction does of course reduce debt-service burdens, maintenance of the reduced debt-export or debt-GDP ratio requires that future loan disbursements also be reduced. If the economy still has significant external and fiscal borrowing requirements following debt reduction, it will need to adjust to the reduced availability of external financing, which could negatively affect growth and poverty reduction. The negative consequences of the adjustment to reduced loan disbursements could outweigh the benefits of reduced debt-service burdens. 2. Policy-makers who formulate or carry out debt-reduction exercises and those advising them should be aware of this possibility. For debt-reduction exercises still in the planning stage, it is important to try to determine whether and how the negative consequences could be mitigated. If a debt-reduction exercise has already been carried out, it is important for all concerned to recognize that it may turn out – or may already have turned out -- less favorable for growth and development than hoped.12 Multiannual projection exercises like the one described here may be helpful to determine the likely consequences of specific debt-reduction operations, to help ensure that the operation considered as a whole is sufficiently favorable (or minimally unfavorable) to growth and poverty reduction. 3. A meaningful debt-sustainability analysis must ask whether a country and its government can sustain a reduced debt-GDP ratio, given minimum real GDP-growth and government-expenditure aspirations. In particular, it is important to tie debt-sustainability calculations to growth and poverty-reduction objectives. The standard debt-sustainability benchmark ratios of debt and debt service to exports have no direct analytical relationship with these objectives. 4. For some post-HIPC economies, one realistic approach to ensure both adequate developmental expenditure and stable external-debt ratios may be to maintain a relatively high and steady flow of external grants. It is important to remember, however, that external grants tend not to be freely available funds. They may come with restrictive conditionality, and are often earmarked to quite specific uses.13 If external grants are likely to remain limited, however, or available for different purposes than the particular economy requires, it may then be reasonable enough for the economy to allow the debt-GDP and debt-export ratios to rise somewhat following debt reduction. This may be “less bad” than raising taxes or borrowing internally, if the higher debt-GDP ratio can be sustained under reasonable assumptions about the future. For many poorer economies,

12 Policy-makers in economies that received debt reduction often believed that they now had a “dividend” in the form of debt service that they no longer need to pay, and sometimes found it politically convenient to commit themselves to allocate it in certain ways. Such “dividends” were often illusory, and commitments to spend them in particular ways only served to intensify the fiscal pressure. 13 Grants are more likely than loans to be provided in the form of training and technical assistance and less in forms leading to physical capital formation. In particular, all other things being equal, to the extent an economy receives grants rather than loans, it may find it harder to finance physical capital formation.

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the alternatives – higher taxation and internal borrowing – may be more damaging for longer-term growth. 5. It is important to bear in mind that in recent decades world public opinion has come to regard government indebtedness as “mostly bad.” This is understandable, of course: in the 1970s and 1980s, excessive external-debt accumulation, and the ensuing stabilization programs, interrupted economic growth. This was particularly so for Latin America, where the bulk of the external debt was at commercial (and, more precisely, floating) rates. It is difficult to doubt that Latin American living standards have been significantly lower since the early 1980s than they would have been if there had been no debt crisis. For more recent years, it is at least open to question whether it was best for all of the world’s poorest economies to reduce the debt owed to official creditors and then to try to keep them reduced, especially since the debt reduced was highly concessional in terms of interest rates and maturity. It is by no means clear that debt reduction left the countries in question better placed to develop faster; it is at least possible that it left them worse off.14

14 In the years preceding the HIPC debt reduction, a number of African countries benefited from arrangements under which certain OECD economies subsidized their debt service to official creditors. These arrangements effectively brought about debt reduction’s “good” debt service-reduction effect, while avoiding debt reduction’s “bad” disbursement-reduction effect.

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