Living in a New World of Heightened Sovereign RisksOpening Remarks by Murilo Portugal, Deputy Managing Director, IMF
At the 10th IMF Forum on Policy and Operational Issues Facing Public Debt Management, Managing Sovereign Balance Sheet Risks in Turbulent Times
Stockholm, Sweden, July 1-2, 2010
Good morning. It is my great pleasure to be here. Let me start by expressing my thanks to the Swedish authorities for hosting the Forum, and in particular to Minister Borg, Director General Lundgren and his colleagues for all the excellent work in organizing this meeting.
Over the last decade the IMF Debt Forum has emerged as a significant multilateral consultative event for debt managers, central bankers, and other government officials, as well as representatives of the private sector. It has evolved from focusing predominantly on emerging markets to also include advanced market economies. This evolution largely reflects the importance that public debt, sovereign risk, and sovereign debt management have assumed. It also reflects changes over the last decade in debt capital markets and the investor base.
It seems appropriate that, on this 10th occasion of the Forum, we are gathered in a country that not only has one of the oldest debt offices, dating back to 1789, but which has set a stellar example in formulating and adopting best practices in public debt and sovereign balance sheet management. If ever there was a time that good debt and sovereign balance sheet management practices were needed it surely this time is now.
B. The aftermath of the crisis, high public debt and elevated sovereign risk
This Debt Forum comes indeed at a critical juncture. The crisis is leaving a legacy of high public debt and sharply elevated sovereign risk. Both will need to be managed well in order to avoid the global financial crisis morphing into a sovereign debt crisis and undermining financial stability and the prospects for recovery. The role of debt managers, along with policy makers in charge of fiscal consolidation, will be crucial in helping contain this risk.
High public debt
At present, one of the key priorities for policy makers, especially in advanced economies, should be to reduce sovereign vulnerabilities. In these countries, public debt is expected to reach 120 percent of GDP by 2015—about 40 percentage points above pre-crisis levels. Most of this comes from the recession itself, from falling revenues and the play of automatic stabilizers, and not from discretionary fiscal stimulus.
By contrast, in emerging economies, debt-to-GDP ratios are projected to resume a gradual decline in 2011. This is predicated on sustained growth and relatively low interest rates, as country-risk premiums and bond yields have fallen rapidly compared with the spike in risk aversion early in the crisis. Indeed, yields are projected to remain below the growth rate of GDP, while primary balances are expected to be in a small deficit. Weak primary balances are an element of vulnerability should the gap between interest rate and growth turn out to be less favorable than expected, particularly given that in many emerging economies debt ratios have increased as a result of the crisis. Similarly, in low-income economies, debt levels are also projected to begin declining by 2011–12. Low-income countries debt fell to 36 percent of GDP, on average, prior to the crisis, reflecting both debt relief initiatives and sustained economic performance. Debt is mostly owed to external creditors with a high degree of concessionality. The debt-to-GDP ratio for low income countries is projected to be about 4 percentage points higher in 2010 than before the crisis reflecting increased use of domestic sources to finance larger deficits. However, this deterioration is expected to taper off as growth resumes and budgetary conditions improve both in oil and non-oil producing countries.
Elevated sovereign risks
But concerns about fiscal and debt sustainability in advanced economies if left untreated can undermine the economic recovery and jeopardize global financial stability. The high debt and fiscal vulnerabilities in these countries are being priced in market assessments of sovereign risk. We have seen further major sovereign credit downgrades, increased volatility in sovereign debt markets, uncertain outcomes in sovereign funding efforts and a questioning of government debt as a risk free asset. Initially, sovereign credit risk premia increased substantially in the economies directly most hit by the crisis. More recently, spreads have increased more widely in some highly indebted advanced economies with underlying fiscal vulnerabilities.
Sovereign risks have been transformed also in a number of important ways as a direct consequence of the crisis. As the public sector intervened to support financial institutions, distinctions between sovereign and private liabilities have been blurred and public exposure to private risks has increased. Contagion channels of transmission among weaker advanced countries sovereigns, particularly in the euro zone, have been revealed. Sovereign credit risk concerns have spread to other countries perceived to be afflicted by similar fiscal vulnerabilities, raising sovereign funding costs, and inducing market volatility and short-term financing strains. The unfolding of all these uncertainties may also bring new risks to those countries not fully affected thus far. Due to the close linkages between the public sector and domestic banks, deteriorating sovereign credit risk has quickly spread to the financial sector.
There are several channels through which this occurs. On the liability side, banks’ wholesale funding costs rise generally in tandem with sovereign spreads; as a consequence, sovereign contagion risks have amplified the volatility of funding conditions for the banking sector. On the asset side, a sharp decline in sovereign debt prices generates losses for banks holding large portfolios of government bonds. In addition, the perceived value of government guarantees to the banking sector diminishes when the sovereign comes under stress, thus further raising funding costs. Excessive levels of debt and large sovereign funding needs also threaten to raise interest rates, crowd out private sector credit, undermine confidence and growth, and reduce flexibility to respond to shocks. The considerable heightening of sovereign risk and its contagion spread across borders and to banking systems could thus jeopardize both regional and global financial stability and growth prospects.
C. Policy Implications
Let me turn to some measures that policy makers can take to tackle high public debt and heightened sovereign risks. Reassuring markets about fiscal sustainability is critical to preserve the recovery and contain volatility in sovereign debt markets. Deteriorating fiscal fundamentals need to be credibly addressed; governments urgently need to communicate fiscal consolidation strategies specifying the measures and the timetable for implementing them. The strategic goal should be to reverse the rise in debt, not just to stabilize it at post-crisis level. Lowering debt will take years and involve difficult measures, but history tells us it can be done, for example, here in Sweden in the 1990s.
The risk of stifling the recovery through premature fiscal tightening must be balanced against the risk of killing it through a fiscal and debt crisis. The timing of the fiscal consolidation depends on country circumstances, particularly the pace of recovery and the risk of a loss of fiscal credibility.
• From a near-term perspective, most advanced economies do not need to tighten fiscal policy this year, as doing so could undermine the recovery, but they should not add further stimulus and should specify now what they are going to do in the medium term. Although specifics will vary by country, current fiscal consolidation plans for the advanced G20 for 2011—which envisage, on average, an adjustment of about 1¼ percentage points of GDP in the cyclically adjusted balance—are broadly appropriate. What is important is not just targets but the measures that will enable the targets to be reached.
• Countries facing severe market pressure have already embarked on immediate fiscal consolidation and this is appropriate. Strong signals through politically difficult, upfront measures are necessary. Countries that are unable to credibly commit to medium-term consolidation may find that adverse market sentiment will likely compel them to undertake a significantly more front-loaded fiscal adjustment.
• Fast growing emerging and advanced economies can start tightening now. For some countries, using fiscal policy to contain demand pressures is preferable if tighter monetary conditions would risk exacerbating pressures from capital inflows. However, in some countries where debt levels are relatively low, monetary tightening and exchange rate adjustment would be more appropriate than fiscal tightening.
Debt management policy
High public debt limits the scope for governments to absorb additional risks in their balance sheets. In this regard, managing debt portfolio vulnerabilities becomes even more significant and debt managers would require a robust framework for doing this effectively. This framework must facilitate the comprehensive assessment of sovereign balance sheets risks, including those related to contingent debt. It must also foster the formulation and implementation of medium-term debt strategies that are supportive of long-term debt sustainability and financial stability. Debt managers must choose strategies that diversify the structure of the debt portfolio in terms of the types of debt instruments, the maturity profile, and the investor base. Countries with much larger post-crisis debt will need to control for larger refinancing risk by lengthening its maturity. Poorly structured redemption profiles could intensify funding risks in the context of heightened volatility in sovereign debt markets. Understanding and controlling contingent liabilities and working to minimize the impact of their realization on government balance sheets is also important. Similar to fiscal consolidation plans, the communication and implementation of credible medium-term debt strategies would contribute to reassuring markets.
In light of the challenge of issuing increased amounts of debt into less liquid and more volatile markets, debt managers should consider adapting their primary market operations to minimize execution risk and deploying a range of liability management operations to help improve price discovery, reduce market volatility, and support secondary market liquidity. But changes to operational procedures should not undermine the prerequisite of transparency and predictability.
This Forum offers us a good opportunity to discuss in depth these and other issues pertaining to the challenges of managing high public debt and elevated sovereign risk in a volatile market environment. It also affords us a chance to discuss concrete ideas on cross-country cooperation and developing an integrated framework for managing sovereign debt and balance sheet and associated risks. Having sound principles to anchor this framework is of important and hopefully a broad consensus is built around these principles in the final session of Day 2.
I am confident that this Forum will play a critical role in developing a common understanding about the challenges from high levels of debt and heightened sovereign balance sheet risks and help in building consensus for moving towards a broad acceptance of debt management principles to deal with these challenges.