World Economic Outlook - Public Debt in Emerging Markets,
September 2003

Other issues of the World Economic Outlook

Research at the IMF

Transcripts of video presentations on the analytical chapters of the September 2003 World Economic Outlook
by Dalia Hakura, Hali Edison, Nikola Spatafora and Tim Callen

Washington. D.C., September 1, 2003

Hello, my name is Dalia Hakura.

I would like to talk to you about the essay I wrote on How Economic Growth in the Middle East and North Africa Region Can Be Accelerated for the current issue of the World Economic Outlook.

What is the essay about?

Well, over the last two decades, economic growth in the Middle East and North Africa region, or MENA region, has been very weak.

Between 1980 and 2001, real per capita GDP in the MENA region stagnated, compared to average annual growth of 6.3 percent in East Asia and 1.3 percent in all other developing countries over the same period.

The slow growth has been a cause of great concern to policymakers because it worsens the problems of the already high unemployment rates and the relatively strong labor force growth in the region.

The motivation for writing this essay was to try to explain why the region's growth performance was so poor and to provide insights on how its economic growth can be accelerated.

Most importantly, the analysis of the essay takes into account that the challenges faced by the countries in the region are distinctly different from each other.

For instance, the problems faced by an oil-producing country like Oman are different from the issues confronting economic policymakers in Tunisia.

In fact, the essay shows that economic growth has varied considerably across countries in the region.

The overall poor growth of the region mainly reflects the subpar growth performance of the region's oil exporters.

Much like oil exporters in the rest of the world, oil exporters in the MENA region experienced a significant decline in real per capita GDP in the 1980s and very low growth in the 1990s.

In contrast, growth rates in the non-oil exporting countries in the region generally matched those of other developing countries.

However, they were substantially below those achieved in the fast-growing economies of East Asia.

So what are the factors that explain the region's poor growth?

Well, the essay shows that the key impediments to growth varied across subgroups of countries in MENA.

* The countries in East Asia managed to achieve a sustained period of strong growth during the 1980s and 1990s.

Compared to these countries, member countries of the Gulf Cooperation Council, or the GCC have excessively high levels of government consumption averaging more than 25% of GDP compared with an average of about 12% of GDP in East Asia.

The analysis in the essay indicates that the large size of government has held back growth in the GCC countries and reducing the size of government consumption to the average level observed in East Asian countries could be expected to increase average real per capita GDP growth by1 1/4 percentage points per year.

The essay suggests that the high level of government consumption in the GCC reflects the legacy of high oil prices in the 1970s.

This contributed to a major improvement in the standard of living in the 1970s.

However, it also contributed to high levels of public employment.

The latter, in conjunction with rigidities in the labor market, adversely affected economic growth by impeding the diversification of the economies away from oil.

The main policy implication that the essay draws from this finding is that it is important for the GCC countries to reduce the size of government consumption, accompanied by structural reforms to increase labor market flexibility and strengthen the legal and institutional framework for private-sector led growth.

* Compared to the fast-growing countries in East Asia, other oil MENA countries such as Algeria, Iran, and Libya have relatively poor-quality institutions.

The analysis in the essay suggests that this is a key impediment to growth in the other oil MENA countries.

According to the model estimates, if institutional quality is brought to the level in East Asian countries, annual per capita GDP growth could be increased by one percentage point.

This finding underscores the importance of improving institutional quality, especially with regard to the quality of the bureaucracy and the strength of the rule of law for which these countries had low scores relative to other developing country regions.

* The analysis in the essay suggests that poor institutional quality combined with large-sized governments has held back growth in non-oil MENA countries.

The estimations presented in the essay indicate that if these factors are brought to the average levels observed in East Asia, annual per capita GDP growth could increase on average by about 1.5 percentage points.

A key policy implication for non-oil MENA countries is thus to improve institutional quality, especially with regard to the control of corruption, the strength of the rule of law, and the quality of the bureaucracy for which these countries had relatively low scores.

Also, the essay's findings suggest that despite some progress during the last decade, the large size of the government continues to be a drag on growth and should be reduced further in non-oil MENA countries.

* Finally, the essay shows that the MENA countries had a higher incidence of internal and external political tensions and conflicts than other regions, and that an improvement in the actual and perceived security situation, particularly in other MENA oil and non-oil countries, would be important to revive growth.

A more comprehensive discussion of these and other findings related to the MENA region's growth performance are provided in the WEO essay.

I hope you will enjoy reading it!

Hello, my name is Hali Edison

and I would like to describe the essay I wrote for the latest issue of the World Economic Outlook. The essay is entitled "Are Foreign Reserves in Asia too High?"

What is this essay about?

This essay is about the rapid increase in foreign reserves over the past decade.

This buildup has been accelerating over time with the bulk of the increase occurring in emerging market countries.

In particular, foreign reserves in the main emerging Asian economies increased by $170 billion in 2002 and reserve accumulation has accelerated further in 2003, with reserves in China alone jumping by $60 billion in the first half of the year.

In addition, over this same period, exchange rates in emerging Asia have generally remained stable against the U.S. dollar, even though the dollar has depreciated against most industrial country currencies.

Given this backdrop, this essay attempts to:

1. Explain trends in reserve accumulation, by examining closely the experience of emerging markets.

2. Investigate whether we can explain this reserve buildup, using a variety of approaches including a simple econometric model.

3. Consider the policy implications of the reserve buildup by exploring whether it is time for emerging Asia to consider slowing the pace of reserve accumulation.

The main findings of the essay are:

First, the reserve buildup in emerging Asia is large not only in absolute terms, but also once reserves are scaled by imports or short-term external debt.

Second, the reserve buildup in emerging Asia has been similar across exchange rate regimes.

Both economies with limited exchange rate flexibility and those with managed floating exchange rates have experienced large increases in reserves.

Finally, the reserve buildup in emerging Asia between 1997 and 2001 was broadly in line with the empirical model, whereas the surge in 2002 has been in excess of that warranted by fundamentals.

What are the policy implications?

In deciding how much to increase reserves, policymakers in emerging Asia need to weigh the costs and benefits of holding a high level of reserves:

On crisis prevention there is considerable evidence that higher reserves reduce both the likelihood of a crisis and the depth of a crisis, should one occur.

However, there are limits to the level of reserves needed to prevent financial crisis.

One useful rule-of-thumb suggests that a ratio of reserves to short-term external debt above one marks an important reduction in crisis vulnerability, as long as the current account is not out of line and the exchange rate is not misaligned.

On domestic costs, the cost of holding reserves is the difference between the interest paid on the country's public debt and the interest earned on reserves.

In addition, rapid reserve accumulation may reflect an undervalued exchange rate, which can have potentially harmful effects on growth and welfare.

On multilateral concerns, the current account surpluses in emerging Asia have been the largest counterpart to the U.S. current account deficit in 2002.

Thus, an eventual narrowing of the US current account deficit from its present unsustainable level, will likely require emerging Asia to share in that adjustment, to prevent an undue burden of adjustment on other countries.

What conclusions do I draw in this study?

The rapid buildup of foreign reserves in emerging Asia is understandable from a number of perspectives, but may now be approaching the point where some slowdown in the rate of accumulation may be desirable.

It may be desirable from both domestic and multilateral perspectives, that growth in emerging Asia become more reliant on domestic demand, which is accompanied by a steady reduction in current account surpluses over the medium term.

While such a strategy involves many elements, it includes further progress on structural reforms.

Clearly, one key aspect will be to allow greater exchange rate flexibility.

It would be especially helpful for countries with managed floats to intervene less in the foreign exchange market and for some countries with limited exchange rate flexibility-such as China- to gradually move toward greater flexibility.

This concludes my summary.

A more comprehensive discussion of this is provided in this issue of the World Economic Outlook.

Hello, my name is Nikola Spatafora..

I want to talk to you about an essay which I wrote for this World Economic Outlook, titled "How Concerned Should Developing Countries Be About G-3 Exchange Rate Volatility?"

This essay examines the potential spillover effects on developing countries of volatility across the three major currencies: the dollar, the euro, and the yen.

The effects of this exchange rate volatility on advanced economies have generally been found to be empirically small.

However, developing countries could be particularly vulnerable to exchange rate spillovers.

The reason is that the less developed nature of their financial markets, and their limited ability to borrow in their own currencies, hamper adjustment to external disturbances.

For instance, it has been argued that the Asian and Argentinean crises partly reflected inflexibilities, including formal or informal dollar pegs.

These made it difficult to adjust to G-3 exchange rate shocks, and in particular to the misalignments associated with the appreciation of the dollar in the late 1990s.

Such concerns are particularly relevant at the current juncture, since there still seem to be major misalignments among the major currencies, and the chance of significant exchange rate volatility is therefore very high.

The main findings of the study are as follows.

First, industrial-country exchange rate volatility does have negative effects on developing-country economic performance.

In particular, it depresses developing-country trade volumes and capital inflows, and it raises the likelihood of exchange rate crises.

Second, these effects come mainly through indirect channels.

G-3 exchange rate volatility increases the instability of developing countries' own effective exchange rate, and the chance that they will experience exchange rate misalignments and overvaluations.

In this process, the countries' own exchange rate regime plays an important role.

That said, the magnitude of the estimated effects is quite limited.

On average, even if all volatility in G-3 real exchange rates were eliminated, developing-country exports and imports would rise by a modest 1 percent, capital inflows to emerging markets would increase by 3 1/2 percent, and the probability of developing-country exchange rate crises would decline by over 1 percentage point.

Such relatively weak effects could reflect the fact that G-3 exchange rate volatility is only one of many factors behind volatility and misalignment in developing countries' exchange rates.

In general, the impact of G-3 exchange rate volatility is greater in those countries which peg to a specific industrial-country currency.

It is also relatively larger in those countries where external debt is high, and where there is a substantial mismatch between the currency composition of debt and the geographical orientation of trade.

For instance, the impact of G-3 exchange rate volatility on the likelihood of exchange rate crises is twice as large in those developing countries on an exchange rate peg.

This suggests that, in many cases, more flexible exchange rate regimes and the use of various hedging instruments may help reduce vulnerabilities.

Overall, simulations using the IMF's new Global Economy Model suggest that developing countries would not benefit significantly from attempts to stabilize G-3 exchange rates.

Reductions in G-3 exchange rate volatility would come at the cost of increased fluctuations in G-3 interest rates and output, with little net effect on developing countries as a group.

Finding that industrial-country exchange rate volatility has limited effects is in a sense quite comforting, given the current conjuncture.

Still, the analysis does not provide grounds for complacency.

While G-3 exchange rate volatility might have small effects on average, it poses more significant threats to certain types of developing countries.

For instance, as mentioned, policy-makers should be particularly concerned about the impact of industrial-country exchange rate volatility when their country is pegged to a specific industrial-country currency.

In addition, developing countries are likely to be especially vulnerable to G-3 exchange rate volatility when their external debt is relatively high, or when their external trade and external debt are mismatched, so that a peg which stabilizes trade competitiveness may be associated with volatile debt service.

That's it!

I do hope you will enjoy reading this essay!

Hello, my name is Tim Callen.

In the latest edition of the World Economic Outlook there is a chapter that looks at the question of whether public debt in emerging market economies is too high.

The chapter was prepared by a team comprising Marco Terrones, Xavier Debrun, James Daniel, Celine Allard, Enrique Mendoza, and myself.

In this short presentation I will explain why the chapter concludes that the current high level of public debt in many emerging market economies is a cause for concern, and what can be done to reduce these high debt levels.

Let me first begin by providing some background.

In recent years, a number of high profile debt defaults or distressed debt restructurings in emerging market economies such as Argentina, Ecuador, Pakistan, Russia, Ukraine, and Uruguay have received considerable attention, and have resulted in significant economic costs for the countries involved.

But, more generally, public debt has risen quite sharply across a broad range of emerging market economies, and it is now at a high level.

At the end of last year, the average public debt ratio in emerging market economies was about 70 percent of GDP, some 15 percent of GDP higher than five years earlier.

What is particularly strikingly is that after being well below industrial country levels during the 1990s, the average public debt to GDP ratio in emerging market economies is now higher than in industrial countries.

Is the current high level of public debt in many emerging market economies a cause for concern? The analysis in the chapter suggests that it is.

This is because public debt in many emerging market economies is not sustainable in the sense that a continuation of the fiscal policies that have been followed in the past will not be sufficient to enable these debts to be repaid in the future.

The following points support this conclusion.

First, just to stabilize the public debt to GDP ratio, the average emerging market economy will have to run a primary budget surplus-that is the budget surplus after interest payments are excluded-that is 11/2 percent of GDP higher than what has been achieved in the recent past.

Second, based on their past fiscal performance, the sustainable public debt level for the typical emerging market economy may be quite low (although it does vary considerably between countries).

Calculations in the chapter suggest that the sustainable public debt level for a typical emerging market economy may only be about 25 percent of GDP, compared to around 75 percent of GDP for a typical industrial country.

Third, fiscal policy in many emerging market economies in the past has not responded in a manner that is consistent with ensuring the sustainability of public debt once this debt has exceeded a threshold of 50 percent of GDP.

This stands in contrast to the behavior in most industrial countries where fiscal policy has responded strongly to ensure the sustainability of public debt when it is at a high level.

This raises the question of why sustainable public debt levels are often quite low in emerging market economies? The answer is importantly related to the characteristics of the fiscal systems in these countries which mean that governments often have difficulty in achieving the budget surpluses needed to ensure the sustainability of public debt.

There are weaknesses on both the revenue and expenditure sides of the budget.

Government revenues in emerging market economies are usually quite low reflecting a large informal sector and significant tax exemptions.

For example, effective direct tax rates in emerging market economies outside of eastern Europe are often only around 10 percent, compared to 30 percent or more in industrial countries.

This is despite the fact that statutory tax rates are often not that different between these two groups of countries.

Revenues are also volatile-often at least twice as volatile as in industrial countries-because of the volatility of the economy and the high reliance on revenues from commodity exports.

Governments in emerging market economies also have difficulty controlling their expenditures, particularly during economic upswings when spending tends to expand at the same pace as the overall economy.

This is in contrast to industrial countries where government spending declines as a share of the economy during upswings reflecting the role of the large social security systems in these countries.

If high public debt levels in many emerging market economies are a cause for concern, how can they be reduced? The historic experience presented in the chapter suggests that large reductions in public debt ratios are possible.

While in the past they have often occurred in conjunction with a debt restructuring, there have been cases where a combination of strong growth and fiscal consolidation have successfully brought about a large reduction in public debt without recourse to a debt restructuring.

Indeed, debt restructuring alone is not a panacea for public debt difficulties as it does not always result in sustainably lower debt unless supported by other policy reforms.

One of the key messages in the chapter is that the past does not necessarily condition the future-policies and institutions do change.

But to successfully reduce public debt, a broad and sustained package of policy and institutional reforms is required.

Tax and expenditure reforms are needed to strengthen the fiscal position.

The tax base needs to be broadened and tax administration improved to ensure higher and more stable government revenues.

Steps are also required to ensure the effective control of expenditures, particularly during economic upswings.

The strengthening of fiscal institutions is likely to have an important role to play in this regard.

Structural reforms are required to improve growth prospects.

It is difficult to reduce public debt ratios without robust economic growth, and consequently a broad-based structural reform agenda that boosts growth is a crucial complement to fiscal reforms.

Measures are also needed to reduce the fiscal risks facing governments to ensure that efforts to reduce public debt are not derailed by unanticipated events.

For example, many emerging market countries have considerable external public debt, and therefore face exchange rate risks.

Policies to promote more open economies would reduce these risks as exchange rate depreciations would then provide more of a boost to activity and government revenues to help mitigate the budgetary impact of higher debt servicing costs.

Steps are also needed to minimize the risks from contingent and implicit liabilities.

Improving financial sector supervision is an important step toward this goal.

That concludes my discussion of the chapter.

I hope you enjoy reading it.