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Finance & Development
A quarterly magazine of the IMF
December 2002, Volume 39, Number 4

Debt: How Much Is Too Much?
Christina Daseking

As part of the work on vulnerability indicators, economists are looking at what level of debt is sustainable for an economy and how much is too much. Borrowing from abroad can help countries grow faster by financing productive investment, and it can also cushion the impact of economic disruptions. But if a country or government accumulates debt beyond what it is able to service, a debt crisis can erupt with potentially large economic and social costs. For this reason, it is important to gauge how much debt an economy or government can safely handle. This assessment is particularly relevant in emerging market economies that rely heavily on global capital markets to meet their large financing needs.

Assessing debt sustainability

What exactly is debt sustainability? It may be defined as a situation in which a borrower is expected to continue servicing its debts without an unrealistically large future correction to its balance of income and expenditure. Conversely, debt becomes unsustainable when it accumulates at a faster rate than the borrower's capacity to service it. Working out what level of debt is sustainable requires an assessment of how outstanding stocks of liabilities are likely to evolve over time, as well as assumptions about future interest rates, exchange rates, and trends in income. Like any assessment requiring assumptions about the future, this is difficult to get right.

Assessing debt sustainability requires three steps:
  • forming a view of how outstanding stocks of liabilities are likely to evolve over time relative to the economy's (or the government's) ability to pay;
  • examining how the outlook would change under plausible shocks; and
  • assessing whether the results may lead to an unsustainable situation, as defined above.

The first step involves projecting the flows of revenues and expenditures—including those for servicing debt—as well as key macroeconomic variables, such as interest rates, rates of economic growth, and exchange rate changes (given the currency denomination of the debt). To the extent that these variables are influenced by government policies, projections of debt dynamics depend on policy variables as well as on macroeconomic and financial market developments that are intrinsically uncertain.

Given the uncertainties, it is important to explore, in a second step, what the risks are. Among the main ones are higher costs of financing, which may reflect general developments in financial markets—including possible spillover effects from other countries in difficulty—or funding problems specific to the country in question. Similarly, a sharp exchange rate depreciation, possibly—though not necessarily—in the aftermath of the collapse of an exchange rate peg, can drastically increase the burden of foreign-currency-denominated debt. Indeed, as some recent cases have shown, once a crisis erupts, the magnitude of capital outflows can result in exchange rate adjustments far in excess of any initial estimates of overvaluation, as happened, for example, in Indonesia during its 1997-98 crisis.

Another important source of uncertainty surrounding projections of debt and debt service is contingent claims—such as those associated with either explicit or implicit guarantees of debt or bank deposits. Many contingent claims, by their nature, pass unnoticed in normal times but are more likely to be exercised in crises. Such claims have been a key feature in recent emerging market crises, in which defaults in one sector have spilled over to others. But contingent claims are exceedingly difficult to measure in practice, both because amounts subject to such claims are often unknown and because the terms of the claims—the precise circumstances in which they would turn into actual liabilities—are often unknowable.

The third step—and arguably the most difficult in a debt sustainability assessment—is defining a threshold at which debt is deemed to become unsustainable. Such thresholds have been established in certain instances for particular groups of countries. For heavily indebted poor countries, for example, levels above 200 percent for the net present value of debt as a share of export earnings were empirically associated with a significantly higher incidence of debt restructurings. For other nonindustrial countries, there is some evidence that a 40 percent debt-to-GDP ratio is a turning point at which risks of debt exposures start to increase. However, this result reflects the typical conditions in the countries studied, including a relatively low level of foreign assets. More generally, a serious note of caution is required when applying a debt threshold to individual countries. No single threshold can reliably define the turning point at which a country's debt will prove unsustainable, as country-specific factors and circumstances beyond the debt ratio play important roles. For example, higher debt ratios are less worrisome for countries with faster export growth, a larger share of exports to GDP, and a larger share of domestic-currency debt.

Ultimately, assessments of sustainability are probabilistic: one can normally envisage some states of the world in which a country's debt would be sustainable and others in which it would not. There is always an element of judgment involved in assessing whether an individual country's debt exceeds prudent levels.

How the IMF is tracking debt
So, given the critical role of debt in many crises, what is the IMF currently doing to assess debt levels and whether they are risky or sustainable? As part of its monitoring of economies around the world, the IMF staff prepares
  • medium-term projections of the balance of payments and of fiscal developments—a staple of the IMF's work on member countries, particularly as part of an IMF lending program;
  • assessments of medium-term current account and real exchange rate sustainability, which have a bearing on public and external debt sustainability, especially when there is significant foreign-currency-denominated debt; and
  • financial sector stability assessments, a more recent addition to the IMF's toolkit; they help identify the vulnerability of the financial sector to various shocks, with potentially important implications for the contingent liabilities of the government.

Building on these elements, the IMF has recently developed a standardized framework for assessing debt sustainability. The framework explores both fiscal and external debt sustainability and centers on the IMF's baseline medium-term projections for a country's economy. Beyond the baseline projections for public and external debt, the framework incorporates a standard set of sensitivity tests that generate the debt dynamics under alternative assumptions about key variables (including economic growth, interest rates, and the exchange rate). These alternative assumptions are calibrated on the basis of each country's own history, as reflected in averages and volatility of the respective variables in the past.

The new framework may be useful in three different situations. For countries that have moderately high indebtedness but are not facing an imminent crisis, the framework can help identify vulnerabilities—that is, how the country might eventually stray into "insolvency territory." For countries that are on the brink, or in the midst, of a crisis, experiencing severe stress characterized by high borrowing costs or lack of market access, the framework can be used to examine the plausibility of the debt-stabilizing dynamics articulated in the program projections. Finally, in the aftermath of a default, the framework can be used to explore the debt dynamics following a potential restructuring.

How would the IMF's analytical framework have performed in a real case?

Taking Turkey in 1999 as an example, would the new framework have helped in highlighting vulnerabilities? The answer is yes. Even though projections at the time did not appear excessively optimistic relative to past experience, the framework would have raised flags about Turkey's external debt situation in the event of adverse shocks.

To find out whether the framework would have been useful, IMF economists ran sensitivity tests of Turkey's external vulnerability as it would have been viewed at the time of the approval of the 1999 IMF arrangement. Under the IMF-supported program, the external debt ratio was projected to increase by 10 percent of GNP, though much of this corresponded to an increase in central bank reserves, so that net external debt was to remain roughly constant (in fact, to decline by about 2 percent of GNP between 1998 and 2001). However, the debt ratio actually rose by almost 30 percent of GNP. How did the IMF staff miss the mark by such a large margin? The main source of error was the trade deficit, which, during 1999-2000, was some 6 percent of GNP greater than projected. This reflected, in part, the steep rise in oil prices, but also underestimation of the responsiveness of imports to higher income. In addition, Turkey's unexpected exit from the exchange rate peg in early 2001 raised debt levels substantially.

What would the framework have predicted? Using five-year averages for the key parameters, it would have projected that net debt would increase by 6 percent of GNP, rather than the 2 percent of GNP decline projected under the program. More important, the sensitivity tests would have highlighted the risks to the projection. In particular, the outcome of a 7 percent of GNP increase in the debt ratio between 1998 and 2000 (prior to the devaluation) was within the two-standard deviation shocks (this range captures most of the risks to the scenario) to either the interest rate, the real GDP growth rate, or the noninterest current account deficit. Moreover, the two devaluation scenarios—either the two-standard deviation shock to the U.S. dollar deflator growth rate, or the standard 30 percent devaluation shock—would have generated an eventual outcome in excess of the 30 percent increase in the net debt ratio observed between end-1998 and end-2001.

Application of the framework is still new but will be progressively expanded to a wide range of countries, both for surveillance purposes and to inform decisions about IMF financial support of programs, with appropriate modifications in light of initial experience. Although the purpose is to provide greater uniformity and discipline for sustainability assessments, it is not intended that the framework be applied in a completely mechanical and rigid fashion: depending on country circumstances, there may be good reasons for deviating from it to some extent. At the same time, the basic logic of undertaking baseline sustainability analyses and calibrated sensitivity tests should apply across countries. Finally, in interpreting the results generated by the framework, additional factors need to be considered, such as the structure of the debt (in terms of its maturity composition, whether it is contracted on fixed or floating rates, whether it is indexed, and by whom it is held) as well as various other vulnerability indicators. Information provided by markets, including expectations of interest rates and spreads embedded in the position and shape of yield curves, access to new borrowing, and whether there have been interruptions in such access or difficulties in issuing long-term debt, will also put the figures in perspective.

This article is based on "Assessing Sustainability," a paper prepared by the IMF's Policy Development and Review Department, May 28, 2002.

Finding out more

David O. Beim and Charles W. Calomiris, 2001, Emerging Financial Markets (Boston: McGraw-Hill).

Enrica Detragiache and Antonio Spilimbergo, 2001, "Crises and Liquidity: Evidence and Interpretation," IMF Working Paper 01/2 (Washington).

Jeffrey Frankel and Andrew Rose, 1996, "Currency Crashes in Emerging Markets: An Empirical Treatment,"Journal of International Economics, Vol. 41 (November), pp. 351-66.

Morris Goldstein, Graciela Kaminsky, and Carmen Reinhart, 2000, Assessing Financial Vulnerability: An Early Warning System for Emerging Markets (Washington: Institute for International Economics).

Graciela Kaminsky, A. Lizondo, and Carmen Reinhart, 1998, "Leading Indicators of Currency Crises,"IMF Staff Papers Vol. 45 (March), pp. 1-48.

Graciela Kaminsky and Carmen Reinhart, 1999, "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, Vol. 89 (June), pp. 473-501.

Carmen Reinhart, 2002, "Default, Currency Crises and Sovereign Credit Ratings," NBER Working Paper No. 8738 (Cambridge, Massachusetts: National Bureau for Economic Research).

John Underwood, 1990, "The Sustainability of International Debt," (unpublished; Washington: World Bank, International Finance Division).

Christina Daseking is a Senior Economist in the IMF's Policy Development and Review Department.