## _spn1012 - Introduction

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---

### Overview
- The state of the public finances has worsened substantially in the main advanced economies as a result of the 2008–09 global financial and economic crisis.
- Market pressures and concerns about fiscal solvency in some “peripheral” European countries have been reflected in large default risk premiums and downgrades by rating agencies.
- At the time of writing (late August 2010), credit default swap spreads are about 900 basis points in Greece and 300 basis points in Ireland and Portugal.
- Appendix 1 shows that markets sounded false alarms in the vast majority of episodes when considering sovereign bond spreads over past decades.
- The note reviews macro-fiscal factors underlying government debt dynamics for ten advanced economies: France, Greece, Ireland, Italy, Japan, Netherlands, Portugal, Spain, United Kingdom, and United States.

### Main thesis
- The risk of debt restructuring is currently significantly overestimated.
- The primary challenge for the advanced economies analyzed stems mainly from large primary deficits, not from a high average interest rate on debt.
- Default would not significantly reduce the need for major fiscal adjustment; instead, fiscal adjustment supported by reforms that enhance economic growth is a more effective response.

### Arguments summarized and rebutted
- The note summarizes main arguments by market commentators who argue that default is inevitable and presents a rebuttal for each argument.
- Critics focus on (i) the size of the adjustment needed and (ii) continued market concerns reflected in government bond spreads.
- Core rebuttal: countries that defaulted in recent decades did so primarily because of high debt servicing costs, often amid major external shocks—conditions not analogous to advanced economies today.

### Argument 1: “Default cannot be avoided because the needed fiscal adjustment is just too large.”
- Required fiscal adjustment to stabilize the debt-to-GDP ratio: improve the average cyclically adjusted primary balance from a deficit equivalent to 5.3 percent of GDP in 2010 to a surplus of 1.0 percent of GDP.
- Historical precedent:
  - In the past three decades, there were 14 episodes in advanced economies and 26 in emerging economies when individual countries adjusted their structural primary balance by more than 7 percentage points of GDP.
  - Advanced-economy episodes include Belgium (1998), Canada (1999), Cyprus (2007), Denmark (1986), Finland (2000), Greece (1995), Ireland (1989), Israel (1983), Italy (1993), Japan (1990), Portugal (1985), Sweden (1987; 2000), United Kingdom (2000).
- Experience of defaulters:
  - Defaults are usually partial and often followed by exclusion from borrowing for estimated periods ranging from one to several years.
  - The median primary surplus during the three years after default was about 2 percent of GDP in the sample of economies that defaulted since 1976 (subject to data availability).
  - For countries that defaulted over the past two decades, the median primary deficit amounted to 0.4 percent of GDP, compared with a real interest bill of 3.2 percent of GDP in the two years that preceded default.
- Current advanced economies:
  - Median primary deficit amounts to 7.4 percent of GDP in 2009–10 in the sample, compared with a median real interest bill of 2.3 percent of GDP.
- Quantified effect of a large hypothetical haircut:
  - A 50 percent haircut (exceptionally large by historical standards) would reduce the primary adjustment needed to stabilize the debt-to-GDP ratio by 0.5 percentage point of GDP on average, and 2.7 percentage points for Greece (Table 1).
  - In percent of the adjustment in the absence of haircut, the reduction would be less than one-tenth on average and less than one-fifth in the case of Greece.
- Additional considerations:
  - Debt tolerance is likely to be much lower after a country has defaulted than prior to repayment difficulties.
  - Living with a lower debt ratio as a result of default may not be attractive because default makes it more difficult to persuade investors to hold liabilities.
  - “Investor-friendly” (nonconfrontational or “preemptive” or “voluntary”) restructuring would likely involve a smaller haircut and thus provide limited relief in debt sustainability; combining such an approach with official support would reduce the need for an abrupt primary surplus, but official support is already playing a “smoothing” role (for example, in Greece).

### Argument 2: “Default cannot be avoided because high interest rates make the burden of debt unsustainable.”
- Distinction between marginal and average interest rates:
  - Marginal rates of interest are high for countries experiencing market pressures, but average interest rates on the stock of government debt remain relatively low.
- Debt structure and maturity:
  - Average maturity of government debt for the advanced economies in the sample is seven years (Table 3).
  - Advanced economies have a higher share of long term, nonindexed, domestic currency debt (Appendix 3), making debt structures more resilient to abrupt market perception changes than was the case for emerging economy defaulters.
  - Refinancing needs are not significantly greater in small European peripherals than in the large advanced economies.
  - In Greece, there is essentially no need to go back to the markets for the duration of the program supported by the IMF and the European Union; the European Financial Stability Facility could be activated for other countries if necessary.
- Real interest rates and interest–growth differentials:
  - Median real interest rates (implied by the overall interest bill) projected over the next two years amount to 2.5 percent for the advanced economies in the sample, with a maximum of 4.0 percent for Greece (Table 4).
  - This is lower than for most of the emerging economies in the sample during the two years prior to default (the median for these countries is 5.4 percent).
  - Under current WEO projections, the median interest–growth differential for the ten advanced economies in the sample is forecast at 0.8 percent over 2011–12, with a maximum of 4.4 percent for Greece (in that case, largely on account of weak growth prospects).

### Argument 3: “Once primary balance has been attained, it makes sense to default.”
- Variant claim: highly indebted countries will default as soon as they have attained primary balance because default would eliminate the interest bill without further adjustment.
- Counterpoints and evidence:
  - Short of full default, countries must continue to run primary surpluses even after a debt restructuring.
  - Historical record: countries usually make great efforts to avoid defaulting; having achieved primary balance, they do not typically choose to default absent refinancing crises.
  - Sample of advanced economies with government debts above 60 percent that reduced primary deficits to zero during the past twenty years (eight countries: Austria, 1997; Belgium, 1984; Greece, 1994; Ireland, 1984; Italy, 1991; Japan, 1981; Portugal, 1986; Sweden, 1996) shows no instance of default; all improved the primary balance further to considerable surpluses (Figure 2).
  - Wider sample including emerging markets: practically all defaults occur against the background of debt sustainability issues but are triggered by refinancing problems, often accompanied by large external shocks.

### Argument 4: “Default cannot be avoided in the countries with an overvalued exchange rate because the needed real depreciation would further raise the public debt ratio, making it even less sustainable”
- Context:
  - Real exchange rate overvaluation noted for Greece (20–30 percent), Portugal and, to a lesser extent, Spain.
  - For members of currency areas, reversal of overvaluation requires internal deflation rather than nominal exchange rate depreciation.
- Implications:
  - Emerging economy defaulters experienced major increases in the debt ratio due to nominal depreciations; euro area countries would not see as abrupt or as large a real depreciation because the process lacks overshooting typical of nominal exchange rate depreciations.
  - Internal devaluation implies some increase in the debt-to-GDP ratio, but the real depreciation would be less abrupt than in emerging market crises.
- Additional notes:
  - A hypothetical exit from the euro area would cause abrupt devaluation and a consequent jump in the debt-to-GDP ratio; even then, default would not obviate the need for major fiscal adjustment.
  - Structural reforms of factor, product, and service markets can contribute to downward flexibility of prices and wages to assist real exchange rate adjustment.
  - Spain has made significant progress; Ireland’s experience suggests possible restoration of competitiveness and growth relatively quickly despite a deep recession—real effective exchange rate viewed broadly in line with medium-term fundamentals (IMF Country Reports 09/195 and 10/209).

### Argument 5: “Politically it is easier to default than to adjust, because it is easier to ‘soak’ the rich and the foreigners than to face demonstrations by the lower and middle classes.”
- Observations:
  - Share of government debt held by domestic residents is typically higher in advanced economies than in emerging economies, though variation exists across advanced economies.
  - For some smaller European peripherals, share held by nonresidents has risen significantly; in Greece a sizable share is held by banks from other euro area countries.
- Counterpoints:
  - Debt holdings are also widespread among the middle and lower-middle class, and domestic banks.
  - High degree of financial integration means default affecting foreign banks would reverberate back to the domestic banking system and domestic economy.
  - Domestic political and economic costs of a default could be greater than those from fiscal adjustment.
- Policy implication:
  - In designing fiscal adjustment, it is crucial to protect the vulnerable to preserve the political sustainability of the process.

### Argument 6: “Default cannot be avoided because fiscal adjustment will depress growth.”
- Points:
  - Required fiscal consolidation may impose a drag on growth, but default will not lessen the pain because the needed adjustment would not be substantially smaller.
  - IMF staff argument: A fiscal adjustment of about 1 percentage point per year on average for the advanced economies balances adjustment needs with recovery concerns; support by appropriate structural reforms is crucial (Blanchard and Cottarelli, 2010).
  - In highly indebted countries with large risk premiums, speed and extent of fiscal adjustment is greater and growth prospects are weaker; concerns about deflationary spirals exist.
  - A potential debt restructuring now would not undo large and rapid fiscal contraction already undertaken in some countries (notably, Greece).
  - Fiscal adjustment in countries with higher perceived sovereign default risk tends to be less contractionary (though still contractionary).
- Additional effects:
  - Fiscal consolidation reduces likelihood of crisis scenarios; diminished uncertainty and lower risk premiums on private borrowing reduce incentives to postpone investment and consumption.
  - Restructuring debt in today’s advanced economies would be detrimental to economic growth and would not address fundamental causes of weak growth.
  - Near-term effects of hypothetical debt restructuring on sectors (particularly banking) would have severe consequences for growth.
  - Restructuring would be no substitute for, and would probably distract from, fiscal and structural reforms needed for durable growth.

### CONCLUSION
- Key considerations:
  - The needed fiscal adjustment is difficult, but has been attained before.
  - Default would not reduce the need for adjustment by much, because primary deficits, not the interest bill, are the problem in advanced economies today.
  - Although marginal interest rates are now high for Greece and, to a lesser extent, other European peripherals, average interest rates remain relatively low, giving time for fiscal adjustment to convince markets.
  - Countries do not strategically decide to default but do so in the midst of refinancing crises: in the past, advanced economies that reduced primary deficits and reached primary balance or a small primary surplus subsequently persevered with the adjustment.
  - The political and economic costs stemming from a hypothetical default would not be lower than those incurred under a strategy based solely on fiscal adjustment.
  - Reforms are needed to improve potential growth and external competitiveness, thereby easing the fiscal adjustment process.

### Appendix 1: How Often Are High Sovereign Bond Spreads Episodes Followed by Defaults? The Experience of Emerging Markets
- Method and data:
  - Uses EMBIG sovereign bond spreads for 31 emerging markets (various start dates beginning with first Brady deals in 1991–92).
  - Threshold: spreads above 1,000 basis points; if threshold crossed repeatedly during a two year period, only first instance recorded.
- Findings:
  - 36 instances in which a country’s spreads rose above 1,000 basis points (Table 5).
  - Of those 36 instances, seven eventually resulted in default; the remaining 29 cases saw spreads stay high for a few months and eventually fall back well below 1,000 basis points with no default.
  - Several instances associated with contagion from Mexican (1994–95), Asian (1997–98), Russian (1998), Argentine (2002) and Lehman (2008) crises.
- Interpretation:
  - Absence of default does not always mean smooth sailing: many of the countries with high spreads required support from the international community, including large-scale IMF-supported programs.
  - Default was avoided in the majority of instances initially identified by markets as warranting spreads in excess of 1,000 basis points.
- Examples of averted defaults:
  - Mexico (1994–95), Korea (1997), Brazil (1998–99 and 2002), Turkey (2000–01).
  - Brazil in 2002: spreads surpassed 2,000 basis points in summer/fall 2002; with fiscal effort, help from international financial institutions, and a new policy track record, spreads fell below 500 basis points by late 2003 and declined further later.

### Appendix 2. Derivation of Real Interest Bill (key definitions and reported terms)
- Key definitions and notation (selected):
  - St ≡ Units of local currency per 1 US$ (spot exchange rate at end of period)
  - St / St−1 ≡ 1 + st ; therefore, st is rate of nominal depreciation
  - Dt ≡ Dtd + St Dtf (sum of domestic and foreign currency debt, all expressed in local currency terms together)
  - Pt: primary balance
  - Lt: (nominal) interest bill
  - dt ≡ Dt / Yt ; pt ≡ Pt / Yt
  - dtd = (1−α) dt ; dtf = α dt
  - Yt = Yt−1 (1 + πt) (1 + gt)
  - 1 + δt ≡ (1 + πt) (1 + gt) ; δt is nominal growth in domestic currency
  - 1 + itd ≡ (1 + πt) (1 + rtd) ; itd is nominal, rtd real interest rate on domestic currency debt
  - 1 + itf ≡ (1 + πt$) (1 + rtf) ; itf is nominal, rtf real interest rate on foreign currency debt
- Nominal decomposition (expressed as share of GDP):
  - dt − dt−1 = −pt − δt / (1 + δt) * dt−1 + lt + α dt−1 st / (1 + δt)
  - where lt ≡ [ itd / (1 + δt) * (1−α) + itf (1 + st) / (1 + δt) * α ] dt−1
- Real decomposition (expressed as share of GDP):
  - dt − dt−1 = −pt − gt / (1 + gt) * dt−1 − πt / (1 + δt) * dt−1 + α dt−1 st / (1 + δt) + lt
- Terms reported in Table 2 (expressed as share of GDP):
  1. The primary balance: pt
  2. The nominal interest bill: lt
  3. The capital loss from the nominal depreciation: (α dt−1 st / (1 + δt))
  4. The inflation correction: (πt / (1 + δt) * dt−1)
  5. The real interest bill: (2)+(3)-(4)
  6. The real growth contribution: (gt / (1 + gt) * dt−1)
- Terms reported in Table 4 (expressed in percentage points):
  1. The nominal interest rate: [ itd / (1 + δt) * (1−α) + itf (1 + st) / (1 + δt) * α ]
  2. The capital loss rate: (α st / (1 + δt))
  3. The inflation correction rate: (πt / (1 + δt))
  4. The real interest rate: (1)+(2)-(3)
  5. The real interest rate minus the real growth rate: (1)+(2)-(3) − (gt / (1 + gt))

### Appendix 3. Government Debt Structures—Advanced versus Emerging Economies
- Debt-structure differences (main findings):
  - Advanced economies’ debt is almost entirely denominated in domestic currency.
  - The share of government debt denominated in or indexed to foreign currency stands at 42 percent in the emerging economies.
  - The share of government debt denominated in or indexed to foreign currency amounted to 63 percent the year prior to default in the emerging economies that defaulted over the past couple of decades.
  - Within domestic-currency debt, advanced economies have a lower share of floating-rate or indexed debt than emerging economies.
  - The share of domestic currency, long-term, nonindexed, fixed-rate debt is larger in advanced economies than in emerging economies, implying slower pass-through from increases in marginal rates to average borrowing costs.
- Empirical context and selected statistics:
  - Average gross debt (Advanced Economies sample, Table 1): 101.2
  - Japan gross debt (Table 1): 227.1
  - Emerging-economy share of government debt in foreign currency: 42 percent.
  - Share of government debt denominated in or indexed to foreign currency the year prior to default (default cases): 63 percent.
  - Advanced-economy median primary balance (Table 2): -7.4
  - Advanced-economy median nominal interest-related components (Table 4): Median nominal interest rate 4.2; capital loss rate -1.4; inflation correction rate 2.5; implying a median real interest rate 0.8.
  - Emerging-economy medians (two years prior to default, Table 4): Median nominal interest rate 7.2; median capital loss rate 7.2; median inflation correction rate -11.5; median real interest minus real growth 7.3.
  - Gross financing needs, 2010–2011 (selected averages, Table 3): Average Maturity 7.1 years; Maturing Debt (2010) 18.0 (percent of GDP); Maturing Debt (2011) 10.2 (percent of GDP); Gross Financing Needs 2010 26.8 (percent of GDP); Gross Financing Needs 2011 19.8 (percent of GDP).
- Policy-relevant implications:
  - A higher prevalence of domestic-currency, long-term, fixed-rate, nonindexed debt in advanced economies implies a slower pass-through from increases in marginal rates to average borrowing costs.
  - High shares of foreign-currency and indexed/floating-rate debt amplify exchange-rate and rollover vulnerabilities in emerging economies, increasing the speed at which market perception shocks translate into higher debt-servicing burdens.
  - Large increases in sovereign spreads (EMBI > 1,000 basis points) have historically signaled elevated default risk in many emerging economies, though outcomes vary by country and episode.

*Source: _spn1012 - Introduction (IMF PDF content provided).*

### Introduction ...........................................................................................................

### _spn1012 - Introduction

### Overview
- The state of the public finances has worsened substantially in the main advanced economies as a result of the 2008–09 global financial and economic crisis.
- Market pressures and concerns about fiscal solvency in some “peripheral” European countries have been reflected in large default risk premiums and downgrades by rating agencies.
- At the time of writing (late August 2010), credit default swap spreads are about 900 basis points in Greece and 300 basis points in Ireland and Portugal.
- Market overreaction occurs from time to time; Appendix 1 shows that markets sounded false alarms in the vast majority of episodes when considering sovereign bond spreads over past decades.
- The note reviews macro-fiscal factors underlying government debt dynamics for ten advanced economies: France, Greece, Ireland, Italy, Japan, Netherlands, Portugal, Spain, United Kingdom, and United States.

### Main thesis
- The risk of debt restructuring is currently significantly overestimated.
- The primary challenge for the advanced economies analyzed stems mainly from large primary deficits, not from a high average interest rate on debt.
- Default would not significantly reduce the need for major fiscal adjustment; instead, fiscal adjustment supported by reforms that enhance economic growth is a more effective response.

### Arguments summarized and rebutted
- The note summarizes main arguments by market commentators who argue that default is inevitable and presents a rebuttal for each argument.
- Critics focus on (i) the size of the adjustment needed and (ii) continued market concerns reflected in government bond spreads.
- Rebuttal core: countries that defaulted in recent decades did so primarily because of high debt servicing costs, often amid major external shocks—conditions not analogous to advanced economies today.

### Argument 1: “Default cannot be avoided because the needed fiscal adjustment is just too large.”
- Required fiscal adjustment to stabilize the debt-to-GDP ratio: improve the average cyclically adjusted primary balance from a deficit equivalent to 5.3 percent of GDP in 2010 to a surplus of 1.0 percent of GDP.
- Historical precedent:
  - In the past three decades, there were 14 episodes in advanced economies and 26 in emerging economies when individual countries adjusted their structural primary balance by more than 7 percentage points of GDP.
  - The advanced-economy list includes (end date in parentheses): Belgium (1998), Canada (1999), Cyprus (2007), Denmark (1986), Finland (2000), Greece (1995), Ireland (1989), Israel (1983), Italy (1993), Japan (1990), Portugal (1985), Sweden (1987; 2000), United Kingdom (2000).
- Experience of defaulters:
  - Defaults are usually partial and often followed by exclusion from borrowing for estimated periods ranging from one to several years.
  - The median primary surplus during the three years after default was about 2 percent of GDP in the sample of economies that defaulted since 1976 (subject to data availability).
  - For countries that defaulted over the past two decades, the median primary deficit amounted to 0.4 percent of GDP, compared with a real interest bill of 3.2 percent of GDP in the two years that preceded default.
- Current advanced economies:
  - Median primary deficit amounts to 7.4 percent of GDP in 2009–10 in the sample, compared with a median real interest bill of 2.3 percent of GDP.
- Quantified effect of a large hypothetical haircut:
  - A 50 percent haircut (exceptionally large by historical standards) would reduce the primary adjustment needed to stabilize the debt-to-GDP ratio by 0.5 percentage point of GDP on average, and 2.7 percentage points for Greece (Table 1).
  - In percent of the adjustment in the absence of haircut, the reduction would be less than one-tenth on average and less than one-fifth in the case of Greece.
- Additional considerations:
  - Debt tolerance is likely to be much lower after a country has defaulted than prior to repayment difficulties.
  - Living with a lower debt ratio as a result of default may not be attractive because default makes it more difficult to persuade investors to hold liabilities.
  - “Investor-friendly” (nonconfrontational or “preemptive” or “voluntary”) restructuring would likely involve a smaller haircut and thus provide limited relief in debt sustainability; combining such an approach with official support would reduce the need for an abrupt primary surplus, but official support is already playing a “smoothing” role (for example, in Greece).

### Argument 2: “Default cannot be avoided because high interest rates make the burden of debt unsustainable.”
- Distinction between marginal and average interest rates:
  - Marginal rates of interest are high for countries experiencing market pressures, but average interest rates on the stock of government debt remain relatively low.
- Debt structure and maturity:
  - Average maturity of government debt for the advanced economies in the sample is seven years (Table 3).
  - Advanced economies have a higher share of long term, nonindexed, domestic currency debt (Appendix 3), making debt structures more resilient to abrupt market perception changes than was the case for emerging economy defaulters.
  - Refinancing needs are not significantly greater in small European peripherals than in the large advanced economies.
  - In Greece, there is essentially no need to go back to the markets for the duration of the program supported by the IMF and the European Union; the European Financial Stability Facility could be activated for other countries if necessary.
- Real interest rates and interest–growth differentials:
  - Median real interest rates (implied by the overall interest bill) projected over the next two years amount to 2.5 percent for the advanced economies in the sample, with a maximum of 4.0 percent for Greece (Table 4).
  - This is lower than for most of the emerging economies in the sample during the two years prior to default (the median for these countries is 5.4 percent).
  - The projected interest–growth differential is substantially lower for the advanced economies today than it was for the economies that defaulted over the past two decades.
  - Under current WEO projections, the median interest–growth differential for the ten advanced economies in the sample is forecast at 0.8 percent over 2011–12, with a maximum of
  (text ends mid-sentence in the source).

*Source: _spn1012 - Introduction (IMF PDF content provided).*

### 4.4 percent for Greece (in that case, largely on account of weak growth prospects—see

### 4.4 percent for Greece (in that case, largely on account of weak growth prospects—see

### Argument 3. “Once primary balance has been attained, it makes sense to default.”
- Variant claim: highly indebted countries will default as soon as they have attained primary balance because default would eliminate the interest bill without further adjustment.
- Counterpoints and evidence:
  - Short of full default, countries must continue to run primary surpluses even after a debt restructuring.
  - Historical record: countries usually make great efforts to avoid defaulting; having achieved primary balance, they do not typically choose to default absent refinancing crises.
  - Sample of advanced economies with government debts above 60 percent that reduced primary deficits to zero during the past twenty years (eight countries: Austria, 1997; Belgium, 1984; Greece, 1994; Ireland, 1984; Italy, 1991; Japan, 1981; Portugal, 1986; Sweden, 1996) shows no instance of default; all improved the primary balance further to considerable surpluses (Figure 2).
  - Wider sample including emerging markets: practically all defaults occur against the background of debt sustainability issues but are triggered by refinancing problems, often accompanied by large external shocks.

### Argument 4. “Default cannot be avoided in the countries with an overvalued exchange rate because the needed real depreciation would further raise the public debt ratio, making it even less sustainable”
- Context:
  - Real exchange rate overvaluation noted for Greece (20–30 percent), Portugal and, to a lesser extent, Spain.
  - For members of currency areas, reversal of overvaluation requires internal deflation rather than nominal exchange rate depreciation.
- Implications:
  - Emerging economy defaulters experienced major increases in the debt ratio due to nominal depreciations; euro area countries would not see as abrupt or as large a real depreciation because the process lacks overshooting typical of nominal exchange rate depreciations.
  - Internal devaluation implies some increase in the debt-to-GDP ratio, but the real depreciation would be less abrupt than in emerging market crises.
- Additional notes:
  - A hypothetical exit from the euro area would cause abrupt devaluation and a consequent jump in the debt-to-GDP ratio; even then, default would not obviate the need for major fiscal adjustment.
  - Structural reforms of factor, product, and service markets can contribute to downward flexibility of prices and wages to assist real exchange rate adjustment.
  - Spain has made significant progress; Ireland’s experience suggests possible restoration of competitiveness and growth relatively quickly despite a deep recession—real effective exchange rate viewed broadly in line with medium-term fundamentals (IMF Country Reports 09/195 and 10/209).

### Argument 5. “Politically it is easier to default than to adjust, because it is easier to ‘soak’ the rich and the foreigners than to face demonstrations by the lower and middle classes.”
- Observations:
  - Share of government debt held by domestic residents is typically higher in advanced economies than in emerging economies, though variation exists across advanced economies.
  - For some smaller European peripherals, share held by nonresidents has risen significantly; in Greece a sizable share is held by banks from other euro area countries.
- Counterpoints:
  - Debt holdings are also widespread among the middle and lower-middle class, and domestic banks.
  - High degree of financial integration means default affecting foreign banks would reverberate back to the domestic banking system and domestic economy.
  - Domestic political and economic costs of a default could be greater than those from fiscal adjustment.
- Policy implication:
  - In designing fiscal adjustment, it is crucial to protect the vulnerable to preserve the political sustainability of the process.

### Argument 6. “Default cannot be avoided because fiscal adjustment will depress growth.”
- Points:
  - Required fiscal consolidation may impose a drag on growth, but default will not lessen the pain because the needed adjustment would not be substantially smaller.
  - IMF staff argument: A fiscal adjustment of about 1 percentage point per year on average for the advanced economies balances adjustment needs with recovery concerns; support by appropriate structural reforms is crucial (Blanchard and Cottarelli, 2010).
  - In highly indebted countries with large risk premiums, speed and extent of fiscal adjustment is greater and growth prospects are weaker; concerns about deflationary spirals exist.
  - A potential debt restructuring now would not undo large and rapid fiscal contraction already undertaken in some countries (notably, Greece).
  - Fiscal adjustment in countries with higher perceived sovereign default risk tends to be less contractionary (though still contractionary).
- Additional effects:
  - Fiscal consolidation reduces likelihood of crisis scenarios; diminished uncertainty and lower risk premiums on private borrowing reduce incentives to postpone investment and consumption.
  - Restructuring debt in today’s advanced economies would be detrimental to economic growth and would not address fundamental causes of weak growth.
  - Near-term effects of hypothetical debt restructuring on sectors (particularly banking) would have severe consequences for growth.
  - Restructuring would be no substitute for, and would probably distract from, fiscal and structural reforms needed for durable growth.

### CONCLUSION
- Key considerations:
  - The needed fiscal adjustment is difficult, but has been attained before.
  - Default would not reduce the need for adjustment by much, because primary deficits, not the interest bill, are the problem in advanced economies today.
  - Although marginal interest rates are now high for Greece and, to a lesser extent, other European peripherals, average interest rates remain relatively low, giving time for fiscal adjustment to convince markets.
  - Countries do not strategically decide to default but do so in the midst of refinancing crises: in the past, advanced economies that reduced primary deficits and reached primary balance or a small primary surplus subsequently persevered with the adjustment.
  - The political and economic costs stemming from a hypothetical default would not be lower than those incurred under a strategy based solely on fiscal adjustment.
  - Reforms are needed to improve potential growth and external competitiveness, thereby easing the fiscal adjustment process.

### Appendix 1: How Often Are High Sovereign Bond Spreads Episodes Followed by Defaults? The Experience of Emerging Markets
- Method and data:
  - Uses EMBIG sovereign bond spreads for 31 emerging markets (various start dates beginning with first Brady deals in 1991–92).
  - Threshold: spreads above 1,000 basis points; if threshold crossed repeatedly during a two year period, only first instance recorded.
- Findings:
  - 36 instances in which a country’s spreads rose above 1,000 basis points (Table 5).
  - Of those 36 instances, seven eventually resulted in default; the remaining 29 cases saw spreads stay high for a few months and eventually fall back well below 1,000 basis points with no default.
  - Several instances associated with contagion from Mexican (1994–95), Asian (1997–98), Russian (1998), Argentine (2002) and Lehman (2008) crises (Figure 3).
- Interpretation:
  - Absence of default does not always mean smooth sailing: many of the countries with high spreads required support from the international community, including large-scale IMF-supported programs.
  - Default was avoided in the majority of instances initially identified by markets as warranting spreads in excess of 1,000 basis points.
- Examples of averted defaults:
  - Mexico (1994–95), Korea (1997), Brazil (1998–99 and 2002), Turkey (2000–01).
  - Brazil in 2002: spreads surpassed 2,000 basis points in summer/fall 2002; with fiscal effort, help from international financial institutions, and a new policy track record, spreads fell below 500 basis points by late 2003 and declined further later.

### Appendix 2. Derivation of Real Interest Bill
- Purpose:
  - Recalls two ways of accounting for change in debt-to-GDP ratio (nominal and real) and shows conversion of nominal interest bill into real interest bill as reported in the text and Tables 2 and 4.
- Key definitions and notation (as reported):
  - St ≡ Units of local currency per 1 US$ (spot exchange rate at end of period)
  - St / St−1 ≡ 1 + st ; therefore, st is rate of nominal depreciation
  - Dt ≡ Dtd + St Dtf (sum of domestic and foreign currency debt, all expressed in local currency terms together)
  - Pt: primary balance
  - Lt: (nominal) interest bill
  - dt ≡ Dt / Yt ; pt ≡ Pt / Yt
  - dtf ≡ Dtf St / Yt ; dtd ≡ Dtd / Yt ; lt ≡ Lt / Yt
  - Yt = Yt−1 (1 + πt) (1 + gt)
  - πt: domestic inflation
  - gt: real growth (domestic currency terms)
  - 1 + δt ≡ (1 + πt) (1 + gt) ; δt is nominal growth in domestic currency
  - 1 + itd ≡ (1 + πt) (1 + rtd) ; itd is nominal, rtd real interest rate on domestic currency debt
  - 1 + itf ≡ (1 + πt$) (1 + rtf) ; itf is nominal, rtf real interest rate on foreign currency debt
  - α: share of foreign currency debt in total debt: dtd = (1−α) dt ; dtf = α dt
  - Dt = −Pt + Dt−1d + Dt−1f * St + Lt
  - Lt = itd Dt−1d + itf * Dt−1f * St
- Nominal decomposition (closest to standard accounts):
  - dt − dt−1 = −pt − δt / (1 + δt) * dt−1 + lt + α dt−1 st / (1 + δt)
  - where lt ≡ [ itd / (1 + δt) * (1−α) + itf (1 + st) / (1 + δt) * α ] dt−1
- Real decomposition (using δt / (1 + δt) = gt / (1 + gt) + πt / (1 + δt)):
  - dt − dt−1 = −pt − gt / (1 + gt) * dt−1 − πt / (1 + δt) * dt−1 + α dt−1 st / (1 + δt) + lt
- Terms reported in Table 2 (expressed as share of GDP):
  1. The primary balance: pt
  2. The nominal interest bill: lt
  3. The capital loss from the nominal depreciation: (α dt−1 st / (1 + δt))
  4. The inflation correction: (πt / (1 + δt) * dt−1)
  5. The real interest bill: (2)+(3)-(4)
  6. The real growth contribution: (gt / (1 + gt) * dt−1)
- Terms reported in Table 4 (expressed in percentage points):
  1. The nominal interest rate: [ itd / (1 + δt) * (1−α) + itf (1 + st) / (1 + δt) * α ]
  2. The capital loss rate: (α st / (1 + δt))
  3. The inflation correction rate: (πt / (1 + δt))
  4. The real interest rate: (1)+(2)-(3)
  5. The real interest rate minus the real growth rate: (1)+(2)-(3) − (gt / (1 + gt))

*Italic line: Source: IMF staff paper content provided in the supplied text.*

### Appendix 3. Government Debt Structures—Advanced versus Emerging Economies

### Appendix 3. Government Debt Structures—Advanced versus Emerging Economies

### Debt-structure differences (main findings)
- Currency composition
  - Advanced economies’ debt is almost entirely denominated in domestic currency.
  - The share of government debt denominated in or indexed to foreign currency stands at 42 percent in the emerging economies.
  - The share of government debt denominated in or indexed to foreign currency amounted to 63 percent the year prior to default in the emerging economies that defaulted over the past couple of decades.
- Floating-rate and indexed debt
  - Within domestic-currency debt, advanced economies have a lower share of floating-rate or indexed debt than emerging economies.
  - Other things equal, a lower share of floating-rate or indexed debt tends to slow the transmission of increases in marginal rates to average borrowing costs.
- Maturity structure
  - Emerging economies have fairly long average maturity on their foreign-currency-denominated debt (some of which is from official creditors, often on concessional terms).
  - Even the maturity of fixed-rate, domestic-currency debt in emerging economies is only slightly shorter than for advanced economies.
  - Vulnerabilities arise from the combination of high weights of foreign-currency, floating-rate, and indexed debt together with these maturity patterns.
- Net implication
  - The share of domestic currency, long-term, nonindexed, fixed-rate debt is larger in advanced economies than in emerging economies.
  - Consequently, it takes longer for increases in marginal interest rates to feed through to average borrowing costs in advanced economies.
  - Risks from changes in the exchange rate and rollover risks are also lower for advanced economies than for emerging economies.

### Empirical context and selected statistics from the chapter
- Cross-sample summary (from prose and tables)
  - Average gross debt (Advanced Economies sample, Table 1): 101.2
  - Japan gross debt (Table 1): 227.1
  - Emerging-economy share of government debt in foreign currency: 42 percent.
  - Share of government debt denominated in or indexed to foreign currency the year prior to default (default cases): 63 percent.
- Debt dynamics decomposition (selected medians and examples, Table 2 and Table 4)
  - Advanced-economy median primary balance (Table 2): -7.4
  - Advanced-economy median nominal interest-related components (Table 4): Median nominal interest rate 4.2; capital loss rate -1.4; inflation correction rate 2.5; implying a median real interest rate 0.8.
  - Emerging-economy medians (two years prior to default, Table 4): Median nominal interest rate 7.2; median capital loss rate 7.2; median inflation correction rate -11.5; median real interest minus real growth 7.3.
- Gross financing needs, 2010–2011 (selected averages, Table 3)
  - Average: Average Maturity 7.1 years; Maturing Debt (2010) 18.0 (percent of GDP); Maturing Debt (2011) 10.2 (percent of GDP); Gross Financing Needs 2010 26.8 (percent of GDP); Gross Financing Needs 2011 19.8 (percent of GDP).

### Dynamics of market stress and defaults (empirical patterns)
- Sovereign bond spreads and default linkage (Table 5 and figures)
  - EMBI spread episodes above 1,000 basis points occurred for many emerging economies; outcomes varied:
    - Some episodes saw spreads decline and stabilize (e.g., Algeria (2000) — “Declined. Went down below 300 in 2003.”).
    - Some episodes were followed by default (e.g., Argentina (2001) — “Remained High. Defaulted in 2002. Y”; Cote d'Ivoire (1999) — “Remained High. Defaulted in 2001. Y”).
  - Repeated crossings of the 1,000-basis-point threshold within two-year windows were not uncommon; in such cases only the first instance is recorded.
- Primary balance behavior around default (Figure 1)
  - The sample consists of all default episodes since 1976 (subject to data availability); the figure reports median, 25th, and 75th percentiles of primary balances from t-2 to t+5, where t = year of default.

### Policy-relevant implications (drawn from analysis in the appendix)
- Reduced pass-through in advanced economies
  - A higher prevalence of domestic-currency, long-term, fixed-rate, nonindexed debt in advanced economies implies a slower pass-through from increases in marginal rates to average borrowing costs.
- Vulnerability focus in emerging economies
  - High shares of foreign-currency and indexed/floating-rate debt amplify exchange-rate and rollover vulnerabilities in emerging economies, increasing the speed at which market perception shocks translate into higher debt-servicing burdens.
- Crisis signaling and market spreads
  - Large increases in sovereign spreads (EMBI > 1,000 basis points) have historically signaled elevated default risk in many emerging economies, though outcomes vary by country and episode.

*Source: Appendix 3. Government Debt Structures—Advanced versus Emerging Economies (excerpts and tables reproduced from the supplied chapter content).*

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