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Page 1: PART III Use of External Debt Statistics - IMF to external liquidity crises; ... flected by a rising ratio of external debt to GDP). In ... rather than as “snap-

PART III

Use of External Debt Statistics

Page 2: PART III Use of External Debt Statistics - IMF to external liquidity crises; ... flected by a rising ratio of external debt to GDP). In ... rather than as “snap-

Introduction1

15.1 The creation of debt is a natural consequenceof economic activity. At any time, some economicentities have income in excess of their current con-sumption and investment requirements, while otherentities are deficient in this regard. Through the cre-ation of debt, both sets of entities are better able torealize their consumption and output preferences,thus encouraging economic growth.

15.2 The creation of debt is premised on the as-sumption that the debtor will meet the requirementsof the debt contract. But if the income of the debtoris insufficient or there is a lack of sufficient assets tocall upon in the event of income proving insuf-ficient, debt problems ensue; the stock of debt willbe such that the debtor cannot meet its obligations.In such circumstances, or in the expectation of suchcircumstances, the benefits arising from inter-national financial flows—for both creditors anddebtors—may not be fully realized. Hence, the needat the country level for good risk-management pro-cedures and the maintenance of external debt at sus-tainable levels.

15.3 This chapter considers tools for sustainabilityanalysis such as medium-term scenarios and therole of debt indicators in identifying solvency andliquidity problems. This is preceded by a short dis-cussion of the solvency and liquidity aspects ofsustainability.

Solvency

15.4 From a national perspective, solvency can bedefined as the country’s ability to discharge its ex-

ternal obligations on a continuing basis. It is rela-tively easy, but not very helpful, to define a coun-try’s theoretical ability to pay. In theory, assumingdebt can be rolled over (renewed) at maturity, coun-tries are solvent if the present value of net interestpayments does not exceed the present value of othercurrent account inflows (primarily export receipts)net of imports.2 In practice, countries stop servicingtheir debt long before this constraint is reached, atthe point where servicing the debt is perceived tobe too costly in terms of the country’s economicand social objectives. Thus, the relevant constraintis generally the willingness to pay, rather than thetheoretical macroeconomic ability to pay. To estab-lish that a country is solvent and willing to pay isnot easy. Solvency is “very much like honesty: itcan never be fully certified, and proofs are slow tomaterialize.”3

15.5 In analyzing solvency problems, it is neces-sary to take into account the different implicationsof public and private sector debt. If there is a riskthat the public sector will cease to discharge its ex-ternal obligations, this in itself is likely to sharplycurtail financial inflows to all economic sectorsbecause governments can issue moratoria on debtrepayment and impose exchange restrictions. Siz-able public external indebtedness may underminethe government’s commitment to allowing privatesector debt repayment. Also, if private defaults takeplace on a significant scale, this too is likely to leadto a sharp reduction in financial inflows, and gov-ernment intervention may follow—in the form ofexchange restrictions, a general debt moratorium, orbailouts. But problems of individual private sectorborrowers may be contained to the concernedlenders.

15. Debt Sustainability: Medium-TermScenarios and Debt Ratios

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1This chapter draws on IMF (2000b), Debt- and Reserve-Related Indicators of External Vulnerability (Washington: March23, 2000), available on the Internet at http://www.imf.org/external/np/pdr/debtres/index.htm, as well as work at the World Bank.

2In considering imports, it is worth noting that these are endoge-nous and subject to potentially severe compression (reduction).

3Calvo (1996), p. 208.

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External Debt Statistics Guide

Liquidity

15.6 Liquidity problems—that is, when a shortageof liquid assets affects the ability of an economy todischarge its immediate external obligations—almost always emerge in circumstances that give riseto insolvency or unwillingness to pay. But it is alsopossible for a liquidity problem to arise indepen-dently of a solvency problem, following a self-fulfilling “run” on a country’s liquidity as creditorslose confidence and undertake transactions that leadto pressures on the international reserves of theeconomy.4 Liquidity problems can be triggered, forexample, by a sharp drop in export earnings, or anincrease in interest rates (foreign and/or domestic),5

or prices for imports. The currency and interest ratecomposition of debt, the maturity structure of debt,and the availability of assets to pay debts are allimportant determinants of the vulnerability of aneconomy to external liquidity crises; these are allconsidered in the next chapter. Mechanisms—suchas creditor “councils”—by which creditors’ actionscan be coordinated can be useful in preventing orlimiting the impact of liquidity crises by sharing in-formation and coordinating responses.

Medium-Term Debt Scenarios

15.7 External-debt-sustainability analysis is gener-ally conducted in the context of medium-term sce-narios. These scenarios are numerical evaluationsthat take account of expectations of the behavior ofeconomic variables and other factors to determinethe conditions under which debt and other indicatorswould stabilize at reasonable levels, the major risksto the economy, and the need and scope for policyadjustment. Macroeconomic uncertainties, such asthe outlook for the current account, and policyuncertainties, such as for fiscal policy, tend to domi-nate the medium-term outlook and feature promi-nently in the scenarios prepared by the IMF in thecontext of Article IV consultations and the design ofIMF-supported adjustment programs.

15.8 The current account balance is important be-cause, if deficits persist, the country’s external posi-tion may eventually become unsustainable (as re-

flected by a rising ratio of external debt to GDP). Inother words, financing of continually large currentaccount deficits by the issuance of debt instrumentswill lead to an increasing debt burden, perhaps un-dermining solvency and leading to external vulnera-bility from a liquidity perspective, owing to the needto repay large amounts of debt.

15.9 One advantage of medium-term scenarios isthat borrowing is viewed within the overall macro-economic framework. However, such an approachcan be very sensitive to projections for variablessuch as economic growth, interest and exchangerates, and, in particular, to the continuation of finan-cial flows, which are potentially subject to suddenreversal.6 Consequently, a range of various alterna-tive scenarios may be prepared. Also, stress tests—“what if” scenarios that assume a major change inone or more variable—can be helpful in analyzingmajor risks stemming from fluctuations of thesevariables or from changes in other assumptionsincluding, for example, changes in prices of importsor exports of oil. Stress tests are useful for liquidityanalysis and provide the basis for developing strate-gies to mitigate the identified risks, such as enhanc-ing the liquidity buffer by increasing internationalreserves, by establishing contingent credit lines withforeign lenders, or both.

Debt Ratios

15.10 Debt ratios have been developed mostly tohelp indicate potential debt-related risks, and thus tosupport sound debt management. Debt indicators inmedium-term scenarios can usefully sum up impor-tant trends. They are used in the context of medium-term debt scenarios, as described above, preferablyfrom a dynamic perspective, rather than as “snap-shot” measures. Debt ratios should be consideredin conjunction with key economic and financialvariables, in particular expected growth and inter-est rates, which determine their trend in medium-term scenarios.7 Another key factor to consider isthe extent to which there is adequate contract

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4For a discussion of self-fulfilling crises, see Krugman (1996)and Obstfeld (1994).

5Such as when domestic rates rise because of an economy’s per-ceived deterioration in creditworthiness.

6An analysis of key indicators, such as the current account ofthe balance of payments, budget deficits, etc., can be particularlyuseful in identifying the possibility of reversals in financial flows.

7If barter trade is significant, and debt payments are in productsthat are not easily marketable, this could affect the interpretationof debt ratios, since the opportunity cost of this form of paymentis different from a purely financial obligation.

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15 • Debt Sustainability: Medium-Term Scenarios and Debt Ratios

enforcement—that is, creditor rights, bankruptcyprocedures, etc.—that will help to ensure that privatedebt is contracted on a sound basis. More generally,the incentive structure within which the private sec-tor operates could affect the soundness of borrowingand lending decisions; for example, whether thereare incentives that favor short-term or foreign cur-rency financing.

15.11 As a result, there are conceptual problems indefining on a general level what are the appropriatebenchmarks for debt ratios; in other words, the scopefor identifying critical ranges for debt indicators israther limited. While an analysis over time, in rela-tion to other macroeconomic variables, might help todevelop a system of early warning signals for a pos-sible debt crisis or debt-service difficulties, compar-ing the absolute value of overall debt ratios acrossheterogeneous countries is not very useful. For in-stance, a high or low debt-to-exports ratio in a par-ticular year may have limited use as an indicator ofexternal vulnerability; rather, it is the movement ofthe debt-to-exports ratio over time that reflects thedebt-related risks.

15.12 For more homogeneous country groupingsand for debt of the public sector, there is more poten-tial to identify ranges for debt-related indicators thatsuggest that debt or debt-service ratios are approach-ing levels that in other countries have resulted in sus-pension or renegotiations of debt-service payments,or have caused official creditors to consider whetherthe debt burden may have reached levels that are toocostly to support. For example, assistance under theHIPC Initiative is determined on the basis of a targetfor the ratio of public debt to exports (150 percent),or the ratio of debt to fiscal revenue (250 percent). Inthese ratios, the present value of debt is used, andonly a subset of external debt is taken into consider-ation, namely medium- and long-term public andpublicly guaranteed debt.8

15.13 Several widely used debt ratios are discussedin somewhat greater detail later. Table 15.1 providesa more comprehensive list. Broadly speaking, thereare two sets of debt indicators: those based on flowvariables (for example, related to exports or GDP)—

these are called flow indicators because the numera-tor or denominator or both are flow variables; andthose based on stock variables—that is, both numer-ator and denominator are stock variables.

Ratio of Debt to Exports and Ratio of Present Value of Debt to Exports

15.14 The debt-to-exports ratio is defined as theratio of total outstanding debt at the end of the yearto the economy’s exports of goods and services forany one year. This ratio can be used as a measure ofsustainability because an increasing debt-to-exportsratio over time, for a given interest rate, implies thattotal debt is growing faster than the economy’s basicsource of external income, indicating that the coun-try may have problems meeting its debt obligationsin the future.

15.15 Indicators that use the stock of debt have sev-eral shortcomings in common. First, countries thatuse external borrowing for productive investmentwith long gestation periods are more likely to exhibithigh debt-to-exports ratios. But as the investmentsbegin to produce goods that can be exported, thecountry’s debt-to-exports ratio may start to decline.So for these countries, the debt-to-exports ratio maynot be too high from an intertemporal perspectiveeven if in any given year it may be perceived aslarge. Therefore, arguably this indicator can bebased on exports after the average gestation lag—that is, using projected exports one or several timeperiods ahead as a denominator.9 More generally,this also highlights the need to monitor debt indica-tors in medium-term scenarios to overcome the limi-tations of a “snapshot.”

15.16 Second, some countries may benefit fromhighly concessional debt terms, while others payhigh interest rates. For such countries, to better cap-ture the implied debt burden—in terms of the oppor-tunity cost of capital—it is useful to report and ana-lyze the average interest rate on debt or to calculatethe present value of debt by discounting the pro-jected stream of future amortization payments in-cluding interest, with a risk-neutral commercial ref-erence rate. As noted above, in analyzing debt

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8See Andrews and others (1999); available on the Internet athttp://www.imf.org/external/pubs/cat/longres.cfm?sk=3448.0.Appendix V discusses the HIPC approach and includes informa-tion on the debt ratios monitored.

9To average out idiosyncratic or irregular swings in export per-formance, multiyear period averages are frequently used, such asthe three-year averages used in the debt-sustainability analysis forHIPCs.

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sustainability for HIPCs, the IMF and World Bankuse such a present value of debt measure—notablypresent value of debt to exports, and to fiscal rev-enue (see below). A high and rising present value ofthe debt-to-exports ratio is considered to be a signthat the country is on an unsustainable debt path.

Ratio of Debt to GDP and Ratio of Present Value of Debt to GDP

15.17 The debt-to-GDP ratio is defined as the ratioof the total outstanding external debt at the end ofthe year to annual GDP. By using GDP as a denomi-

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Table 15.1. Overview of Debt Indicators

Indicator Evaluation/Use

SolvencyInterest service ratio Ratio of average interest payments to export earnings indicates terms of external

indebtedness and thus the debt burdenExternal debt to exports Useful as trend indicator closely related to the repayment capacity of a countryExternal debt over GDP Useful because relates debt to resource base (for the potential of shifting production

to exports so as to enhance repayment capacity)Present value of debt over exports Key sustainability indicator used, for example, in HIPC Initiative assessments

comparing debt burden with repayment capacityPresent value of debt over fiscal revenue Key sustainability indicator used, for example, in HIPC Initiative assessments

comparing debt burden with public resources for repaymentDebt service over exports Hybrid indicator of solvency and liquidity concerns

LiquidityInternational reserves to short-term debt Single most important indicator of reserve adequacy in countries with significant but

uncertain access to capital markets; ratio can be predicted forward to assess future vulnerability to liquidity crises

Ratio of short-term debt to total Indicates relative reliance on short-term financing; together with indicators ofoutstanding debt maturity structure allows monitoring of future repayment risk

Public sector indicatorsPublic sector debt service over exports Useful indicator of willingness to pay and transfer riskPublic debt over GDP or tax revenues Solvency indicator of public sector; can be defined for total debt or for external debtAverage maturity of nonconcessional debt Measure of maturity that is not biased by long repayment terms for concessional

debtForeign currency debt over total debt Foreign currency debt including foreign currency indexed debt; indicator of the

impact of a change in the exchange rate on debt

Financial sector indicatorsOpen foreign exchange position Foreign currency assets minus liabilities plus net long positions in foreign currency

stemming from off-balance-sheet items; indicator for foreign exchange risk, but normally small because of banking regulations

Foreign currency maturity mismatch Foreign currency liabilities minus foreign currency assets as percent of these foreign currency assets at given maturities; indicator for pressure on central bank reservesin case of a cutoff of financial sector from foreign currency funding

Gross foreign currency liabilities Useful to the extent that assets are not usable to offset withdrawals in liquidity

Corporate sector indicatorsLeverage Nominal (book) value of debt over equity (assets minus debt and derivatives

liabilities); key indicator of sound financial structure; high leverage aggravates vulnerability to other risks (for example, low profitability, high ratio of short-termdebt/total debt)

Interest over cash flow Total prospective interest payments over operational cash flow (before interest and taxes); key cash flow indicator for general financial soundness

Short-term debt over total term debt In combination with leverage, indicator of vulnerability to temporary cutoff from (both total and for foreign currency only) financing

Return on assets (before tax and interest) Profit before tax and interest payments over total assets; indicator of general profitability

Net foreign currency cash flow over total Net foreign currency cash flow is defined as prospective cash inflows in foreign cash flow currency minus prospective cash outflows in foreign currency; key indicator for

unhedged foreign currency exposureNet foreign currency debt over equity Net foreign currency debt is defined as the difference between foreign currency debt

liabilities and assets; equity is assets minus debt and net derivatives liabilities;indicator for balance sheet effect of exchange rate changes

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15 • Debt Sustainability: Medium-Term Scenarios and Debt Ratios

nator, the ratio may provide some indication of thepotential to service external debt by switching re-sources from production of domestic goods to theproduction of exports. Indeed, a country might havea large debt-to-exports ratio but a low debt-to-GDPratio if exportables comprise a very small proportionof GDP.

15.18 While the debt-to-GDP ratio is immune fromexport-related criticisms that mainly focus on thediffering degree of value added in exports and pricevolatility of exports, it may be less reliable in thepresence of over- or undervaluations of the real ex-change rate, which could significantly distort theGDP denominator. Also, as with the debt-to-exportsratio, it is important to take account of the country’sstage of development and the mix of concessionaland nonconcessional debt.

15.19 In the context of debt ratios, the numerator inthe present value of debt-to-GDP ratio is again esti-mated using future projections of debt-service pay-ments discounted by market-based interest rates(that is, a risk-neutral commercial reference rate).

Ratio of Present Value of Debt to Fiscal Revenue

15.20 The ratio of the present value of debt to fiscalrevenue is defined as the ratio of future projecteddebt-service payments discounted by market-basedinterest rates (a risk-neutral commercial referencerate) to annual fiscal revenue. This ratio can be usedas a measure of sustainability in those countries witha relatively open economy facing a heavy fiscal bur-den of external debt. In such circumstances, the gov-ernment’s ability to mobilize domestic revenue isrelevant and will not be measured by the debt-to-exports or debt-to-GDP ratios. An increase in thisindicator over time indicates that the country mayhave budgetary problems in servicing its debt.

Ratio of Debt Service to Exports10

15.21 This ratio is defined as the ratio of externaldebt-service payments of principal and interest onlong-term and short-term debt to exports of goods

and services for any one year. The debt-service-to-exports ratio is a possible indicator of debt sustain-ability because it indicates how much of a country’sexport revenue will be used up in servicing its debtand thus, also, how vulnerable the payment of debt-service obligations is to an unexpected fall in exportproceeds. This ratio tends to highlight countries withsignificant short-term external debt. A sustainablelevel is determined by the debt-to-exports ratio andinterest rates, as well as by the term structure of debtobligations. The latter may affect creditworthinessbecause the higher the share of short-term credit is inoverall debt, the larger and more vulnerable is theannual flow of debt-service obligations.

15.22 By focusing on payments, the debt-service-to-exports ratio takes into account the mix of conces-sional and nonconcessional debt, while its evolutionover time, especially in medium-term scenarios, canprovide useful information on lumpy repaymentstructures. Moreover, a narrow version of the debt-service ratio, focused on government and govern-ment-guaranteed debt service, can be a useful indi-cator of government debt sustainability and transferrisk (the risk that exchange rate restrictions are im-posed that prevent the repayment of obligations) be-cause it may provide some insight into the politicalcost of servicing debt.11

15.23 The debt-service-to-exports ratio has somelimitations as a measure of external vulnerability, inaddition to the possible variability of debt-servicepayments and export revenues from year to year.First, amortization payments on short-term debt aretypically excluded from debt service,12 and the cov-erage of private sector data can often be limited, ei-ther because the indicator is intentionally focused onthe public sector or because data on private debt ser-vice are not available.

15.24 Second, many economies have liberalizedtheir trade regimes and are now exporting a largerproportion of their output to the rest of the world.But at the same time they are importing more, and

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10This ratio, in addition to the total debt-to-exports and the totaldebt-to-GNP (national output) ratios, is provided for individualcountries in the World Bank’s annual Global DevelopmentFinance publication.

11A version of this indicator that focuses on official debt is used,for instance, in the HIPC Initiative.

12This is the approach taken in the World Bank’s World Devel-opment Report and Global Development Finance, and the IMF’sWorld Economic Outlook. Lack of data, as well as the assumptionthat short-term debt mainly constituted trade credit that was easyto roll over, contributed to this practice. As experience shows, thisassumption is in some cases questionable.

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the import content of exports is rising. Thus, a debt-service-to-exports ratio not corrected for the importintensity of exports is biased downward for econo-mies with a higher propensity to export;13 this argu-ment applies similarly to the debt-to-exports ratio.

15.25 Finally, the concept summarizes both liquid-ity and solvency issues, which may make it analyti-cally less tractable than measures that track only sol-vency (such as the ratio of interest payments toexports) or liquidity (the ratio of reserves to short-term debt).

Ratio of International Reserves to Short-Term Debt

15.26 This ratio is a pure liquidity indicator that isdefined as the ratio of the stock of international re-serves available to the monetary authorities to theshort-term debt stock on a remaining-maturity basis.This could be a particularly useful indicator of re-serve adequacy, especially for countries with signifi-cant, but not fully certain, access to internationalcapital markets.14

15.27 The ratio indicates whether international re-serves exceed scheduled amortization of short-,medium-, and long-term external debt during the fol-lowing year; that is, the extent to which the economyhas the ability to meet all its scheduled amortizationsto nonresidents for the coming year using its own in-ternational reserves. It provides a measure of howquickly a country would be forced to adjust if it werecut off from external borrowing—for example,because of adverse developments in internationalcapital markets. All scheduled debt amortizationpayments on both private and public debt to nonresi-dents over the coming year are covered in such aratio under short-term debt, regardless of the instru-ment or currency denomination. A similar ratio can

be calculated focusing on the foreign currency debtof the government (and banking sector) only. Thismay be especially relevant for economies with veryopen capital markets, and significant public sectorforeign currency debt.

15.28 Interestingly, in most theoretical models thematurity structure of public debt is irrelevant be-cause it is assumed that markets are complete.15 Butmarkets are rarely complete, even in developedcountries. And, as several currency crises in develop-ing and emerging market countries in the mid-to-late1990s have shown, the risk associated with an exces-sive buildup of the stock of short-term debt relativeto international reserves can be quite severe, even incountries that were generally regarded as solvent.One conclusion drawn has been that countries withexcessively large short-term debt in relation to inter-national reserves are more susceptible to liquiditycrisis.16

15.29 However, various factors need to be takeninto account when interpreting the ratio of interna-tional reserves to short-term debt. First, a large stockof short-term debt relative to international reservesdoes not necessarily lead to a crisis. Many advancedeconomies have higher ratios of short-term debt toreserves than many emerging economies, whichhave shown vulnerability to financial crisis. Factorssuch as an incentive structure that is conducive tosound risk management, and a proven track recordof contract enforcement, can help develop credibil-ity, and help to explain this difference. Moreover,macroeconomic fundamentals, in particular the cur-rent account deficit and the real exchange rate, playan important role. Consideration should also begiven to the exchange rate regime. For example, aflexible regime can reduce the likelihood and costsof a crisis. Finally, the ratio assumes that measuredinternational reserves are indeed available and canbe used to meet external obligations; this has not al-ways been true historically.

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13See Kiguel (1999) for more reasons why the ratio of debt ser-vice to exports may not be a highly reliable indicator of the exter-nal vulnerability of a country under special circumstances.

14The potential importance of other residents’ external assets inrelation to debt is highlighted in the table for the net external debtposition presented in Chapter 7 (Table 7.11).

15See Lucas and Stokey (1983) and Calvo and Guidotti (1992).16See Berg and others (1999); Bussière and Mulder (1999); and

Furman and Stiglitz (1998).

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Introduction

16.1 The type of debt ratios discussed in the pre-vious chapter focus primarily on overall externaldebt and external debt service and the potential tomeet debt obligations falling due on an economy-wide basis. However, in assessing the vulnerabilityof the economy to solvency and liquidity risk aris-ing from the external debt position, a more detailedexamination of the composition of the external debtposition and related activity may be required. In thischapter, the relevance of additional data on the com-position of external debt, external income, externalassets, financial derivatives, and on the economy’screditors is explored, drawing particularly on dataseries described in Part I of the Guide. The discus-sion in this chapter, however, is not intended to beexhaustive.

Composition of External Debt

16.2 The relevance for debt analysis of the differentdata series presented in the Guide is set out below. Inparticular this section focuses on the followingissues:• Who is borrowing?• What is the composition of debt by functional

category?• What type of instrument is being used to borrow?• What is the maturity of debt?• What is the currency composition of the debt?• Is there industrial concentration of debt?• What is the profile of debt servicing?

16.3 Traditionally in debt analysis, the focus hasbeen on official sector borrowing, not least in theform of loans from banks or official sources. But the1990s saw a tremendous expansion in capital marketborrowing by the private sector. This has had signifi-cant implications for debt analysis, including the

need to gather and analyze external debt data by theborrowing sector.

16.4 If there is a risk that the public sector willcease to discharge its external obligations, this islikely in itself to lead to a sharp curtailment of finan-cial inflows to the economy as a whole, in part be-cause it also casts severe doubt on the government’scommitment to an economic environment that al-lows private sector debt repayment. Thus, informa-tion on public sector total, and short-term, externaldebt is important. Especially in the absence of capi-tal controls or captive markets, information on short-term domestic debt of the government is important,since capital flight and pressure on international re-serves can result from a perceived weak financialposition of the public sector.

16.5 Also, beyond its own borrowing policies, thegovernment has a special role to play in ensuringthat it creates or maintains conditions for sound riskmanagement in other sectors; for instance, avoidingpolicies that create a bias toward short-term foreigncurrency borrowing.

16.6 Most of the financial sector, notably banks, isby nature highly leveraged—that is, most assetsare financed by debt liabilities. Banks may take onliabilities to nonresidents by taking depositsand short-term interbank loans. These positionscan build up quickly and, depending also on thenature of the deposits and depositors, be run downquickly. How well banks intermediate these fundshas implications for the ability to withstand large-scale withdrawals. More generally, informationon the composition of assets and liabilities is impor-tant for banks (and nonbank financial cor-porations)—notably information on the maturitystructure and maturity mismatch (including inforeign currency)—because it provides insightabout their vulnerability to such withdrawals and

16. External Debt Analysis: FurtherConsiderations

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their sensitivity to changing exchange and interestrates.1

16.7 As mentioned in Chapter 15, large-scale defaultsby nonfinancial corporations that borrow fromabroad, depending on their importance to the econ-omy, could result in financially expensive governmentintervention, an impact on the credit risk of the finan-cial sector, and an undermining of asset prices in theeconomy. In any case, the debt-service needs of cor-porations will affect the economy’s liquidity situation.As with banks, the regulatory regime and incentivestructure within which the corporate sector operates isimportant. For instance, overborrowing in foreigncurrency, particularly short-term, in relation to for-eign currency assets or hedges (be they natural hedgesin the form of foreign currency cash flow or throughderivatives products such as forwards), exposes thecorporate sector to cash-flow (liquidity) problems incase of large exchange rate movements. Overborrow-ing in foreign currency in relation to foreign currencyassets could potentially expose corporations to sol-vency problems in the event of a depreciation of thedomestic exchange rate. Ensuing corporate failures,in the event of sharp exchange rate depreciation, canreduce external financing flows and depress domesticactivity, especially if contract enforcement is poor orthe procedures are overwhelmed.

16.8 The provision of guarantees can influence eco-nomic behavior. Invariably, the government providesimplicit and explicit guarantees, such as deposit insur-ance, and sometimes also guarantees on private sectorexternal borrowing (classified as publicly guaranteedprivate sector debt in the Guide). Also, domestic cor-porations may use offshore enterprises to borrow, andprovide guarantees to them, or have debt paymentsguaranteed by domestic banks. Similarly foreign cor-porations may guarantee part of domestic debt. Wherepossible, direct and explicit guarantees should bemonitored because they affect risk assessment.

16.9 The functional classification of debt instru-ments is a balance of payments concept, grouping

instruments into four categories: direct investment,portfolio investment, financial derivatives, and otherinvestment. Direct investment takes place betweenan investor in one country and its affiliate in anothercountry and is generally based on a long-term rela-tionship. Recent crises have tended to support theview that this category of investment is less likely tobe affected in a crisis than other functional types.2

Portfolio investment, by definition, includes tradabledebt instruments; other investment, by definition, in-cludes all other debt instruments. The relevance offinancial derivatives instruments for external debtanalysis is discussed below.

16.10 The type of instrument that a debtor willissue depends on what creditors are willing to pur-chase as well as the debtor’s preferences. Borrowingin the form of loans concentrates debt issuance in thehands of banks, whereas securities are more likely tobe owned by a wider range of investors. Trade creditis typically of a short-term maturity. Although equityissues are not regarded as debt instruments, declareddividends on equity are included in debt servicing,and so it remains necessary to monitor activity inthese instruments. At the least, sudden sales of eq-uity by nonresidents or residents can have importantramifications for an economy and its ability to raiseand service debt.3

16.11 The maturity composition of debt is impor-tant because it can have a profound impact on liquid-ity. Concentration of high levels of short-term exter-nal debt is seen to make an economy particularlyvulnerable to unexpected downturns in financialfortune.4 For instance, an economy with high levelsof short-term external debt may be vulnerable to asudden change in investor sentiment. Interbank linesare particularly sensitive to changes in risk per-ception, and early warning signals of changes ininvestor sentiment towards the economy might be

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1Banks are subject to moral hazard risk through explicit or im-plicit deposit insurance and limited liability. The potential moralhazard risk arising from deposit insurance schemes is that by “pro-tecting” from loss an element of their deposit base, banks might beprovided with an incentive to hold portfolios incorporating morerisk, but potentially higher returns, than they otherwise would.Monitoring the risks taken by banks is a central element of bankingsupervision, a subject beyond the scope of the Guide.

2However, direct investment enterprises may place additionalpressure on the exchange rate in a crisis situation through thehedging of domestic currency assets. Moreover, foreign investorscan repatriate rather than reinvest profits, thereby effectively in-creasing the domestically (debt) funded part of their investments.

3In analyzing the securities transactions, both debt and equity,changes in prices (rather than in quantities) may equilibrate themarket.

4The compilation of average maturity data might disguiseimportant differences in the sectoral composition of debt and in thedispersion of maturities. However, data on average maturity bysector and by debt instrument might alert policymakers and marketparticipants to maturity structures that are potentially problematic.

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16 • External Debt Analysis: Further Considerations

detected through the monitoring of the refinancing(“rollover”) rate.5

16.12 Debt analysis needs to make a distinctionbetween short-term debt on an original maturitybasis—that is, debt issued with a maturity of oneyear or less—and on a remaining-maturity basis—that is, debt obligations that fall due in one year orless. Data on an original maturity basis providesinformation on the typical terms of debt and the debtstructure, and monitoring changes in these termsprovides useful information on the preferences ofcreditors and the sectoral distribution of debtors.Data on a remaining (residual) maturity basis pro-vides the analyst and policymaker with informationon the repayment obligations (that is, the liquiditystructure). For the policymaker, to ensure sufficientliquidity, such as indicated by an appropriate ratio ofinternational reserves to short-term debt, requiresavoiding a bunching of debt payments.

16.13 The debtor will be interested in the nominalvalue of its debt because at any moment in time it isthe amount that the debtor owes to the creditor at thatmoment. Also, the debtor is well advised to monitorthe market value of its debt. The market value andthe spreads over interest rates on “risk-free” instru-ments provide an indication to the borrower of themarket view on its ability to meet debt obligations aswell as current market sentiment toward it.6 This isimportant information because it might influence fu-ture borrowing plans: whether it is advantageous toborrow again while terms seem good, or whetherthere are early warning signs of possible increasedcosts of borrowing, or even refinancing difficulties.However, for those countries with debt that has a verylow valuation or is traded in markets with low liquid-ity (or both), a sudden swing in sentiment might causea very sharp change in the market value of externaldebt, which might also be reversed suddenly. Becauseit would be unaffected by such swings, informationon the nominal value of external debt would be ofparticular analytical value in such circumstances.

16.14 The currency composition of external debt isalso important. There is a significant difference be-tween having external debt payable in domestic cur-

rency and having external debt payable in foreigncurrency. In the event of a sudden depreciation of thedomestic currency, foreign currency external debt(including foreign-currency-linked debt) has poten-tially important wealth and cash-flow effects for theeconomy. For instance, when public debt is payablein foreign currency, a devaluation of the domesticcurrency could aggravate the financial position of thepublic sector, so creating an incentive for the govern-ment to avoid a necessary exchange rate adjustment.Information on the currency composition of debt atthe sectoral level, including resident and nonresidentclaims in foreign currency, is particularly importantbecause the wealth effects also depend on foreigncurrency relations between residents.

16.15 But any analysis of the foreign currency com-position of external debt needs to take account of thesize and composition of foreign currency assets, andincome, together with foreign-currency-linked finan-cial derivatives positions. The latter instruments canbe used to change the exposure from foreign to do-mestic currency or to a different foreign currency.

16.16 The interest rate composition of externaldebt, both short- and long-term, may also have signifi-cant implications. Sharp increases in short-term inter-est rates, such as those experienced in the early 1980s,can have profound implications for the real cost ofdebt, especially if a significant share of debt paysinterest that is linked to a floating rate such as LIBOR.As with the foreign currency position, it is necessaryto take account of financial derivatives positions, sincethese may significantly change the effective interestcomposition of debt. For instance, interest-rate-basedfinancial derivatives can be used to swap variable-rateobligations into fixed-rate liabilities, and vice versa.The relevance of financial derivatives in analyzing ex-ternal debt is considered in more detail below.

16.17 The industrial concentration of debt shouldalso be monitored. If debt is concentrated in a partic-ular industry or industries, economic shocks such asa downturn in worldwide demand for certain prod-ucts could increase the risk of a disruption in debt-service payments by that economy.7

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5This type of monitoring is discussed in more detail in Chapter7, Box 7.1.

6Increasingly, information from credit derivatives, such as de-fault swaps and spread options, also provides market informationon an entity’s credit standing.

7While the Guide does not explicitly include guidance for themeasurement of the industrial composition of external debt, thesedata can be compiled using the concepts set out in the Guide to-gether with the International Standard Industrial Classification(1993 SNA, pp. 594–96) as the “sector” classification.

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16.18 To monitor debt service, the amounts to bepaid are important, rather than the market value ofthe debt. Debt servicing involves both the ongoingmeeting of obligations—that is, payments of interestand principal—and the final payment of principal atmaturity. However, it is most unlikely that the debt-service schedule will be known with certainty at anygiven time. Estimates of the amounts to be paid canvary over time because of variable interest and for-eign currency rates, and the repayment dates for debtcontaining embedded put (right to sell) or call (rightto buy) options that can be triggered under certainconditions add further uncertainty. So, in presentingdata on the debt-service payment schedule, it is im-portant that the assumptions used to estimate futurepayments on external debt liabilities be presented ina transparent manner along with the data.

16.19 One indication of an economy that is begin-ning to have difficulty servicing its external debt iswhen the level of arrears is on a rising trend both inrelation to the external debt position and to theamount of debt service falling due. In such circum-stances, detailed data by institutional sector and bytype of instrument might help to identify the sourcesof the difficulty.

The Role of Income

16.20 In analyzing debt, the future trend of incomeis clearly relevant because it affects the ability of thedebtor to service debt. Traditionally, the focus hasbeen on earnings from exports of goods and ser-vices. To what extent is debt, or are debt-servicepayments, “covered” by earnings from the export ofgoods and services? Diversification of products andmarkets is positive because it limits exposure toshocks, in turn limiting the possibility that the pri-vate sector as a whole will get into difficulties, andthat the public sector will lose revenues, thus affect-ing the willingness to pay. The currency compositionof export earnings may also be of relevance.

16.21 While the willingness to pay is an importantfactor in determining whether debt-service paymentsare made, the use of external borrowing will affectthe future income from which those payments aremade.8 If debt is used to fund unproductive activity,

future income is more likely to fall short of thatrequired to service the debt. The question to addressis not so much the specific use of the borrowedcapital but rather the efficiency of total investment inthe economy, considered in the context of indicatorsfor the economy as a whole, such as the growth ratesof output and exports, and total factor productivity—all data series potentially derivable from nationalaccounts data. From another perspective, if an econ-omy is unwilling to service its debts, and defaults,production losses might ensue as the economyceases to be integrated with international capitalmarkets.

The Role of Assets

16.22 As indicated above, the external debt positionneeds to be considered in the context of external as-sets because these help to meet debt-servicing re-quirements—assets generate income and can be soldto meet liquidity demands. In the IIP, the differencebetween external assets and external liabilities is thenet asset (or liability) position of an economy.

16.23 For all economies, international reserveassets are, by definition, composed of externalassets that are readily available to and controlled bythe monetary authorities for direct financing of pay-ments imbalances, for indirectly regulating themagnitude of such imbalances through interventionin exchange markets to affect the currency exchangerate, and for other purposes. Because of this role, inMarch 1999, the IMF’s Executive Board, drawingon the work of the IMF and the Committee onGlobal Financial Systems of the G-10 central banks,strengthened the Special Data Dissemination Stan-dard requirements for the dissemination of data oninternational reserves, and foreign currency liquid-ity. A data template on international reserves andforeign currency liquidity was introduced that pro-vides a considerably greater degree of transparencyin international reserves data than was hithertoavailable.9

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8Dragoslav Avramovic and others (1964, p. 67) noted that whilethe debt-service ratio “does serve as a convenient yardstick for

passing short-term creditworthiness judgments, that is to say,judgments of the risk that default may be provoked by liquiditycrises,” in fact “the only important factor, from the long-run pointof view, is the rate of growth of production.” Indeed, “it is only inthe interest of the borrowers as well as of the lenders that outputand savings be maximized, since they are the only real sourcefrom which debt service is paid.”

9See Kester (2001).

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16 • External Debt Analysis: Further Considerations

16.24 But as private entities in an economy becomeincreasingly active in international markets, theyare likely to acquire external assets as well as lia-bilities. The diverse nature of private sector externalassets suggests that they are of a different naturethan reserve assets. For instance, private sectorexternal assets may not be distributed among sec-tors and individual enterprises in such a way thatthey can be used to absorb private sector liquidityneeds. But the presence of such assets needs to betaken into account in individual country analysis ofthe external debt position. One approach is to pre-sent the net external debt position for each institu-tional sector, thus comparing the institutional attri-bution and concentration of external assets in theform of debt instruments with external debt (seeChapter 7).

16.25 But in comparing assets with debt, it is neces-sary to also consider the liquidity and quality of as-sets, their riskiness, and the functional and instru-ment composition of assets.

16.26 Most important, assets should be capable ofgenerating income or be liquid so that they could besold if need be, or both. The functional compo-sition of assets provides important informationin this regard. For instance, direct investment assetsmay generate income but are often less liquid,especially if they take the form of fully owned non-traded investments in companies or subsidiaries.Typically, direct investment assets are either illiquidin the short term (such as plant and equipment) or,if they are potentially marketable, the direct in-vestor needs to take into account the implicationson direct investment enterprises of withdrawingassets. The latter will be a countervailing factor toany selling pressures. Nonetheless, some directinvestment assets may be closer to portfolio invest-ments and relatively tradable—such as nonmajorityshares in companies in countries with deep equitymarkets.

16.27 Portfolio investment is by definition tradable.Investments—such as loans and trade credit—whilegenerating income can be less liquid than portfolioinvestment, but the maturity of these investmentsmay be important because the value of short-termassets can be realized early. Increasingly, loans canbe packaged into a single debt instrument andtraded. Trade credit may be difficult to withdrawwithout harming export earnings, a very impor-

tant source of income during situations of externalstress.

16.28 In assessing assets in the context of debtanalysis, the quality of assets is a key factor. In prin-ciple the quality of the assets is reflected in the priceof the assets. Some knowledge of the issuer and thecountry of residence may provide a further idea ofthe quality of the asset and its availability in times ofa crisis; availability is often correlated with locationor type of country. Knowledge of the geographicspread of assets can help one to understand the vul-nerability of the domestic economy to financial diffi-culties in other economies.

16.29 The currency composition of assets, to-gether with that of debt instruments, provides anidea of the impact on the economy of changes in thevarious exchange rates; notably, it provides informa-tion on the wealth effect of cross exchange ratemovements (such as changes in the dollar-yenexchange rate for euro-area countries). The BISInternational Banking Statistics (see next chapter),and the IMF’s Coordinated Portfolio InvestmentSurvey (see Chapter 13), at the least, encourage thecollection of data on the country of residence of thenonresident debtor, and the currency composition ofassets.

Relevance of Financial Derivatives andRepurchase Agreements (Repos)

16.30 The growth in financial derivatives marketshas implications for debt management and analysis.They are used for a number of purposes includingrisk management, hedging, arbitrage between mar-kets, and speculation.

16.31 From the viewpoint of managing the risksarising from debt instruments, derivatives can beboth cheaper and more efficient than other tools.This is because they can be used to directly tradeaway the specific risk to be managed. For instance, aforeign currency borrowing can be hedged through aforeign-currency-linked derivative and so eliminatepart or all of the foreign currency risk. Thus, aggre-gate information on the notional position in foreigncurrency derivatives is important in determining thewealth and cash-flow effects of changing exchangerates. Similarly, the cash-flow uncertainties involvedin borrowing in variable interest rates can be reduced

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by swapping into “fixed-rate” payments with an in-terest rate swap.10 In both instances the derivativescontract will involve the borrower in additionalcounterparty credit risk, but it facilitates good risk-management practices.

16.32 Derivatives are also used as speculative andarbitrage instruments.11 They are a tool for undertak-ing leveraged transactions, in that for relatively littlecapital advanced up front, significant exposures torisk can be achieved, and differences in the implicitprice of risk across instruments issued by the sameissuer, or very similar issuers, can be arbitraged.12

However, if used inappropriately, financial deriva-tives can cause significant losses and so enhance thevulnerability of an economy. Derivatives can also beused to circumvent regulations, and so place unex-pected pressure on markets. For instance, a ban onholding securities can be circumvented by foreigninstitutions through a total-return swap.13

16.33 Derivatives positions can become very valu-able or costly depending on the underlying pricemovements. The value of the positions is measuredby the market value of the positions. For all theabove reasons, there is interest in market values,gross assets and liabilities, and notional (or nominal)values of financial derivatives positions.14

16.34 Risk-enhancing or -mitigating features thatare similar to financial derivatives may also be em-bedded in other instruments such as bonds and notes.Structured bonds are an example of such enhancedinstruments. These instruments could, for example,

be issued in dollars, with the repayment value de-pendent on a multiple of the Mexican peso–U.S. dol-lar exchange rate. Borrowers may also include aput—right to sell—option in the bond contract thatmight lower the coupon rate but increase the likeli-hood of an early redemption of the bond, not leastwhen the borrower runs into problems. Also, forexample, credit-linked bonds may be issued thatinclude a credit derivative, which links payments ofinterest and principal to the credit standing of an-other borrower. The inclusion of these derivativescan improve the terms that the borrower would oth-erwise have received, but at the cost of taking onadditional risk. Uncertainty over the repaymentterms or the repayment schedule is a consequence,so there is analytical interest in information on thesestructured bond issues.

16.35 Repurchase agreements (repos) also facili-tate improved risk management and arbitrage. Arepo allows an investor to purchase a financial in-strument, and then largely finance this purchase byon-selling the security under a repo agreement. Byselling the security under a repo, the investor retainsexposure to the price movements of the security,while requiring only modest cash outlays. In this ex-ample, the investor is taking a “long” or positive po-sition. On the other hand, through a security loan, aspeculator or arbitrageur can take a “short” or nega-tive position in an instrument by selling a securitythey do not own and then meeting their settlementneeds by borrowing the security (security loan) fromanother investor.

16.36 While in normal times all these activities addliquidity to markets and allow the efficient taking ofpositions, when sentiment changes volatility may in-crease as leveraged positions may need to be un-wound, such as the need to meet margin require-ments. Position data on securities issued by residentsand involved in repurchase and security lendingtransactions between residents and nonresidents helpin understanding and anticipating market pressures.These data can also help in understanding the debt-service schedule data. For example, if a nonresidentsold a security under a repo transaction to a residentwho then sold it outright to another nonresident, thedebt-service schedule would record two sets of pay-ments to nonresidents by the issuer for the same se-curity, although there would be one set of paymentsfor the one security. In volatile times, when large po-sitions develop in one direction, this might result in

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10The risk might not be completely eliminated if at the reset ofthe floating rate the credit risk premium of the borrower changes.The interest rate swap will eliminate the risk of changes in themarket rate of interest.

11Speculation and arbitrage activity can help add liquidity tomarkets and facilitate hedging. Also, when used for arbitrage pur-poses, derivatives may reduce any inefficient pricing differentialsbetween markets and/or instruments.

12Leverage, as a financial term, describes having the full bene-fits arising from holding a position in a financial asset withouthaving had to fund the purchase with own funds. Financial deriva-tives are instruments that can be used by international investors toleverage investments, as are repos.

13A total-return swap is a credit derivative that swaps the totalreturn on a financial instrument for a guaranteed interest rate, suchas an interbank rate, plus a margin.

14While the Guide explicitly presents data only on the notional(or nominal) value for foreign-currency- and interest-rate-linkedfinancial derivatives, information on the notional value of finan-cial derivatives, for all types of risk category, by type and in aggre-gate, can be of analytical value.

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apparent very significant debt-service payments onsecurities; the position data on resident securities in-volved in cross-border reverse transactions could in-dicate that reverse transactions are a factor.

Information on the Creditor

16.37 In any debt analysis an understanding of thecreditor is relevant because different creditors havedifferent motivations and influences upon them.

16.38 The sector and country of lender are impor-tant factors in debt analysis. Debt analysis has tradi-tionally focused on sectors—in particular, on the splitbetween the official sector, banking, and other,mostly private, sectors. The importance of this sec-toral breakdown lies in the different degrees of diffi-culty for reaching an orderly workout in the event ofpayment difficulties. For instance, negotiations ofdebt relief will differ, depending on the status of thecreditor. The official sector and the banks constitute arelatively small and self-contained group of creditorsthat can meet and negotiate with the debtor through

such forums as the Paris Club (official sector), andLondon Club (banks). By contrast, other private cred-itors are typically more numerous and diverse.

16.39 Also, the public sector may be a guarantorof debts owed to the foreign private sector. Often thisis the case with export credit, under which the creditagency pays the foreign private sector participant inthe event of nonpayment by the debtor, and so takeson the role of creditor. These arrangements are in-tended to stimulate trade activity, and premiums arepaid by the private sector. In case of default, the ulti-mate creditor is the public sector, if the credit agencyis indeed in the public sector. The country of credi-tor is important for debt analysis because overcon-centration of the geographic spread of creditors hasthe potential for contagion of adverse financial activ-ity. For instance, if one or two countries are maincreditors, then a problem in their own economies orwith their own external debt position could causethem to withdraw finance from the debtor country.Indeed, concentration by country and sector, such asbanks, could make an economy highly dependent onconditions in that sector and economy.

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