## 1. Examples of Debt Ceilings

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### Introduction and motivation
- Buildup of public debt since the global financial crisis has raised concerns about fiscal sustainability and renewed calls for fiscal consolidation.
- The paper (using information up to end-2013) proposes a simple methodology to estimate the level of debt a country should target (the debt benchmark), combining existing debt-ceiling estimation methods and stochastic debt forecasting.
- Key conceptual distinction:
  - Debt ceiling: maximum sustainable debt level consistent with solvency and market access.
  - Debt benchmark: a target for fiscal policy set well below the debt ceiling to provide room to absorb shocks and fiscal risks.
- South Africa selected for application:
  - Debt-to-GDP rose from 27 percent of GDP in 2008 to 43.1 percent of GDP in 2013.
  - Financing so far available, liquid bond market, moderate debt level but high macroeconomic volatility.

### Debt sustainability and determinants of debt tolerance
- IMF definition of debt sustainability: “a situation in which a borrower is expected to be able to continue servicing its debts without an unrealistically large correction to the balance of income and expenditure” (IMF, 2002, p. 5).
- Factors that influence debt tolerance:
  - Debt stock: high government debt-to-GDP ratio can raise borrowing costs and be associated with lower growth.
  - Gross financing requirement: large deficits and rollover needs can imperil borrowing capacity even if debt-to-GDP is low.
  - Composition of debt: high share of foreign-currency debt, short-term debt, or floating-rate debt increases exchange rate, interest rate, and rollover risks.
  - Debt path: rapidly increasing debt-to-GDP can be more problematic than a high but stable/declining ratio.
  - Drivers of new borrowing: borrowing for high-return investment and recurrent human-capital spending is less likely to undermine sustainability.
  - Credibility of fiscal policy: ability to credibly commit to future primary surpluses raises debt tolerance.
  - Long-term fiscal pressures: non-discretionary commitments or declining resource revenues can undermine solvency.
  - Risk appetite: shifts in global risk appetite can quickly change perceived sustainability.
- Empirical and methodological caveats:
  - Cross-country heterogeneity in debt-growth relationships; contested findings such as Reinhart and Rogoff (2010) debated.
  - Several regional groupings and countries set debt ceilings clustered around 60 percent.

### Methods for estimating debt ceilings and debt benchmarks
- Methodological varieties characterized by:
  - Indicator used (risk of crisis, public-sector solvency).
  - Cross-country vs country-specific.
  - Parametric vs non-parametric; econometric vs model-based.
- Approaches described:
  1. Institutional Investor Rating (IIR) club approach (Reinhart et al., 2003):
     - Countries classified into clubs (A, B, C) by IIR; econometric estimation links public debt to default risk with coefficients varying by club.
     - Examples: DiBella (2008) estimated a 30 percent of GDP boundary for Dominican Republic; Topalova and Nyberg (2010) estimated 45-75 percent of GDP for India.
  2. Public sector solvency accounting identity (IMF, 2003):
     - Debt ceiling is the debt-to-GDP consistent with present discounted value of expected future primary surpluses.
     - IMF (2003) median debt ceilings: 75 percent of GDP for industrial economies and 25 percent of GDP for emerging markets.
  3. Mendoza and Oviedo (2009) variant:
     - Computes maximum debt allowing for uncertainty in future revenues and government adjustment ability; uses minimum revenue-to-GDP and non-interest expenditure-to-GDP ratios to define a maximum serviceable debt.
     - Emphasizes that the maximum debt at which government can credibly commit to repay at all times is lower once uncertainty is considered.
  4. Stochastic (fan-chart) debt forecasting with country-specific VAR (Celasun et al., 2006 and IMF, 2013b):
     - Estimate a country-specific VAR of non-fiscal determinants; generate many forecasts by drawing random shock sequences from the estimated shock distribution.
     - Calculate stochastic debt projections using the standard debt accumulation equation and an assumed fiscal reaction function or block.
     - Allows probabilistic assessment of the likelihood that debt remains below a given ceiling under historical shock patterns.
- Main methodological contribution of the paper:
  - Combine econometric and solvency methods to determine a debt ceiling, then use the Mendoza-Oviedo framework and a stochastic VAR to calculate a debt benchmark that keeps stochastic debt projections below the ceiling with high confidence.
  - Three-step approach:
    1. Use Reinhart’s IIR approach and the public-sector solvency approach to determine an appropriate debt ceiling.
    2. Use Mendoza-Oviedo framework and a stochastic VAR to calculate a debt benchmark consistent with the ceiling, manipulating the path of the primary balance so the stochastic “fan chart” stays below the ceiling over the medium term with high confidence.
    3. Calculate the tax or expenditure measures required to achieve the primary balance adjustment necessary to reach the debt benchmark.

### Application to South Africa — findings and projections
- Historical context and recent path:
  - Debt-to-GDP has not exceeded 50 percent since 1995.
  - Debt rose from 27 percent of GDP in 2008 to 43.1 percent of GDP in 2013 due to falling revenue and rising expenditure-to-GDP ratios.
  - Fiscal space built up in mid-2000s was eroded by countercyclical fiscal policies in response to the global financial crisis.
  - Volatile macroeconomic environment (reliance on mining, unstable industrial relations) creates significant fiscal risks.
- Estimated debt ceiling and benchmark:
  - Using a wide range of methodologies, the paper estimates a debt ceiling around 60 percent of GDP is consistent with debt sustainability in South Africa.
  - A simple stochastic VAR model suggests a debt benchmark of around 40 percent of GDP would be sufficient to keep debt below the ceiling with a high degree of confidence till 2020, even under large shocks similar to past experience.
- Policy implications and trade-offs:
  - Reaching the benchmark of around 40 percent of GDP would require a significant fiscal effort.
  - Such consolidation, in the absence of growth-enhancing structural reforms, could exert further pressure on an already-weak economy.
- Simulation and forecasting approach:
  - Stochastic simulations (VAR-based) generate a “fan chart” of debt outcomes under historical volatility and the assumed fiscal reaction; the primary balance path is adjusted to achieve the desired confidence that debt remains below the ceiling.
  - Emphasizes the importance of setting fiscal targets below the maximum sustainable debt level to preserve repayment capacity in the face of shocks.

### Introduction of inflation — historical fiscal performance and pre-crisis period
- Inflation-targeting in 2001 ushered in a period of macroeconomic stability, a boom in commodities and robust economic boosted revenue collection, and reforms to broaden and deepen the public debt market lowered interest rates.
- Central government primary surpluses averaging close to 3 percent in 2006-2008 and a positive interest-growth differential brought gross government debt down to a low of 27 percent of GDP in 2008.

### Fiscal response to the global financial crisis and subsequent deterioration
- Between 2009-2012 the central government deficit averaged close to 5 percent of GDP as the weakening economy reduced revenue collection and a rising wage bill increased government spending.
- Government debt-to-GDP increased by 15 percent of GDP since the start of the crisis, reaching 42 percent of GDP at end-2012.
- IMF projections (absent additional policy measures) suggest debt will exceed 50 percent of GDP by the end of this decade.
- The government’s gross domestic financing requirement has more than doubled since 2008 to 11½ percent of GDP in 2012.
- Foreign ownership of domestic government bonds has nearly tripled since 2008, reaching 36 percent at end-2012.
- Sovereign credit rating downgrades occurred in 2012 and 2013.

### Relative position versus peer emerging markets
- South Africa’s relative fiscal position among emerging markets has been deteriorating since 2008.
- South Africa’s debt-to-GDP ratio—which pre-crisis was relatively low—is now slightly above the median in peer emerging market countries.
- Peer emerging market group in this paper consists of: Argentina, Brazil, Chile, China, Colombia, Hungary, India, Indonesia, Korea, Malaysia, Peru, the Philippines, Poland, Romania, Russia, Thailand, Turkey, and Ukraine.

### Factors supporting South Africa’s debt tolerance
- Long history of sustainable fiscal policies and a deep and liquid debt market contributed to historically low interest rates.
- Favorable debt composition:
  - Strategic benchmarks limit foreign-currency denominated debt to 20 percent of the total.
  - Domestic debt is split 70-30 percent between fixed rate bonds, and inflation-linked bonds and short-term Treasury Bills.
  - In practice, foreign currency debt is around 10 percent of the total.
- Smooth maturity profile with average term-to-maturity of around 10 years contributes to greater debt tolerance.

### A Debt Ceiling for South Africa — approach and key assumptions
- Sustainable debt ceiling calculated as the discounted sum of future primary surpluses; requires specifying the future path of primary surpluses and the appropriate discount rate.
- Assumed path for the primary balance:
  - Convergence from -2.4 percent of GDP in 2012/13 to a long-run equilibrium of 0.6 percent of GDP in 2024/25.
  - This equates to a 2 percent of GDP improvement over the IMF’s projection period (2012/13-2018/19) and an improvement in the primary balance of 0.25 percent of GDP per annum from 2018/19 onwards.
  - Note: South Africa’s primary balance has averaged close to 0.6 percent since 1980.
- Discount rate calculation:
  - Real interest rate proxied by the average yield on US 10-year inflation-linked bonds between 2003-2008 plus South Africa’s average sovereign spread from JP Morgan’s Emerging Market Bond Index Global (EMBIG) over the same period.
  - Excluded more recent data due to sharp movements in US interest rates and EMBIG spreads during the global financial crisis.
  - Resulting real interest rate: 3.8 percent.
  - IMF’s current estimate of long-term growth in South Africa: 3 percent.
  - These yield a discount rate of 0.8, close to the discount rate of 0.9 found by Topalova and Nyberg (2010) for South Africa.

### Box 1. Data Coverage — Coverage of the Public Sector
- Central government debt accounted for around 73 percent of total public sector debt in 2012/13.
- State-owned enterprise debt has increased significantly in recent years, but borrowing has mainly been undertaken by a handful of large commercially-viable companies on the strength of their own balance sheets.
- Provincial governments cannot accumulate debt.
- Local government debt is low and concentrated in a few large metropolitan areas with their own revenue-raising capabilities.
- Due to the above and the absence of reliable data on the indebtedness of the consolidated public sector, central government debt in South Africa is treated as a reasonable proxy for overall public debt and is the measure employed in this paper.
- The analysis should be complemented by an analysis of potential contingent liabilities posed by state-owned enterprise and sub-national borrowing; doing so is beyond the scope of this paper.

### Box 1. Data Coverage — Gross vs. Net Debt
- Between 2004/05 and 2012/13, cash balances increased from 2.1 to 5.7 percent of GDP, largely funded by increased borrowing.
- The gap between gross and net debt has increased considerably as a result of higher cash holdings.
- Only around 65 percent of these cash reserves are readily available for government operations; the remainder is used by the South African Reserve Bank (SARB) to sterilize past foreign exchange purchases and is only available as bridge finance on the understanding that they be replenished.
- The authors argue that net debt underestimates the fiscal risks posed by government borrowing and therefore employ a measure of gross debt in their analysis.
- Any “bias” from using gross rather than net debt likely offsets the use of central government debt to assess fiscal risks posed by the indebtedness of the entire public sector.
- The authors recognize that if cash buffers increase further, incorporating these balances will have a material impact on the assessment of debt sustainability.

*Source: _wp14231 - 1. Examples of Debt Ceilings (PDF chapter/section, content up to end-2013)*

### 1. Examples of Debt Ceilings ...........................................................................................

### Examples of Debt Ceilings

### Introduction and motivation
- The buildup of public debt since the global financial crisis has raised concerns about fiscal sustainability and renewed calls for fiscal consolidation.
- The paper (using information up to end-2013) proposes a simple methodology to estimate the level of debt a country should target (the debt benchmark), combining existing debt-ceiling estimation methods and stochastic debt forecasting.
- Key conceptual distinction:
  - Debt ceiling: maximum sustainable debt level consistent with solvency and market access.
  - Debt benchmark: a target for fiscal policy set well below the debt ceiling to provide room to absorb shocks and fiscal risks.
- South Africa chosen as an application: debt-to-GDP rose from 27 percent of GDP in 2008 to 43.1 percent of GDP in 2013; financing so far available, liquid bond market, moderate debt level but high macroeconomic volatility.

### Debt sustainability and determinants of debt tolerance
- IMF definition of debt sustainability: “a situation in which a borrower is expected to be able to continue servicing its debts without an unrealistically large correction to the balance of income and expenditure” (IMF, 2002, p. 5).
- Factors that influence debt tolerance:
  - Debt stock: high government debt-to-GDP ratio can raise borrowing costs and be associated with lower growth.
  - Gross financing requirement: large deficits and rollover needs can imperil borrowing capacity even if debt-to-GDP is low.
  - Composition of debt: high share of foreign-currency debt, short-term debt, or floating-rate debt increases exchange rate, interest rate, and rollover risks.
  - Debt path: rapidly increasing debt-to-GDP can be more problematic than a high but stable/declining ratio.
  - Drivers of new borrowing: borrowing for high-return investment and recurrent human-capital spending is less likely to undermine sustainability.
  - Credibility of fiscal policy: ability to credibly commit to future primary surpluses raises debt tolerance.
  - Long-term fiscal pressures: non-discretionary commitments or declining resource revenues can undermine solvency.
  - Risk appetite: shifts in global risk appetite can quickly change perceived sustainability.
- Empirical and methodological caveats:
  - Cross-country heterogeneity in debt-growth relationships; contested findings such as Reinhart and Rogoff (2010) debated.
  - Several regional groupings and countries set debt ceilings clustered around 60 percent.

### Methods for estimating debt ceilings and debt benchmarks
- Overview of methodological varieties:
  - Indicator used (risk of crisis, public-sector solvency).
  - Cross-country vs country-specific.
  - Parametric vs non-parametric; econometric vs model-based.
- Approaches described in the paper:
  1. Institutional Investor Rating (IIR) club approach (Reinhart et al., 2003):
     - Countries classified into clubs (A, B, C) by IIR; econometric estimation links public debt to default risk with coefficients varying by club.
     - Examples: DiBella (2008) estimated a 30 percent of GDP boundary for Dominican Republic; Topalova and Nyberg (2010) estimated 45-75 percent of GDP for India.
  2. Public sector solvency accounting identity (IMF, 2003):
     - Debt ceiling is the debt-to-GDP consistent with present discounted value of expected future primary surpluses.
     - IMF (2003) median debt ceilings: 75 percent of GDP for industrial economies and 25 percent of GDP for emerging markets.
  3. Mendoza and Oviedo (2009) variant:
     - Computes maximum debt allowing for uncertainty in future revenues and government adjustment ability; uses minimum revenue-to-GDP and non-interest expenditure-to-GDP ratios to define a maximum serviceable debt.
     - Emphasizes that the maximum debt at which government can credibly commit to repay at all times is lower once uncertainty is considered.
  4. Stochastic (fan-chart) debt forecasting with country-specific VAR (Celasun et al., 2006 and IMF, 2013b):
     - Estimate a country-specific VAR of non-fiscal determinants; generate many forecasts by drawing random shock sequences from the estimated shock distribution.
     - Calculate stochastic debt projections using the standard debt accumulation equation and an assumed fiscal reaction function or block.
     - Allows probabilistic assessment of the likelihood that debt remains below a given ceiling under historical shock patterns.
- Main methodological contribution of the paper:
  - Combine econometric and solvency methods to determine a debt ceiling, then use the Mendoza-Oviedo framework and a stochastic VAR to calculate a debt benchmark that keeps stochastic debt projections below the ceiling with high confidence.
  - Three-step approach:
    1. Use Reinhart’s IIR approach and the public-sector solvency approach to determine an appropriate debt ceiling.
    2. Use Mendoza-Oviedo framework and a stochastic VAR to calculate a debt benchmark consistent with the ceiling, manipulating the path of the primary balance so the stochastic “fan chart” stays below the ceiling over the medium term with high confidence.
    3. Calculate the tax or expenditure measures required to achieve the primary balance adjustment necessary to reach the debt benchmark.

### Application to South Africa — findings and projections
- Historical context:
  - South Africa’s debt-to-GDP ratio has not exceeded 50 percent since 1995.
  - Debt rose from 27 percent of GDP in 2008 to 43.1 percent of GDP in 2013 due to falling revenue and rising expenditure-to-GDP ratios.
  - Fiscal space built up in mid-2000s was eroded by countercyclical fiscal policies in response to the global financial crisis.
  - Volatile macroeconomic environment (reliance on mining, unstable industrial relations) creates significant fiscal risks.
- Estimated debt ceiling and benchmark:
  - Using a wide range of methodologies, the paper estimates a debt ceiling around 60 percent of GDP is consistent with debt sustainability in South Africa.
  - A simple stochastic VAR model suggests a debt benchmark of around 40 percent of GDP would be sufficient to keep debt below the ceiling with a high degree of confidence till 2020, even under large shocks similar to past experience.
- Policy implications and trade-offs:
  - Reaching the benchmark of around 40 percent of GDP would require a significant fiscal effort.
  - Such consolidation, in the absence of growth-enhancing structural reforms, could exert further pressure on an already-weak economy.
- Simulation and forecasting approach:
  - Stochastic simulations (VAR-based) generate a “fan chart” of debt outcomes under historical volatility and the assumed fiscal reaction; the primary balance path is adjusted to achieve the desired confidence that debt remains below the ceiling.
  - The analysis emphasizes the importance of setting fiscal targets below the maximum sustainable debt level to preserve repayment capacity in the face of shocks.

*Source: _wp14231 - 1. Examples of Debt Ceilings (PDF chapter/section, content up to end-2013)*

### introduction of inflation

### introduction of inflation

### Historical fiscal performance and pre-crisis period
- Inflation-targeting in 2001 ushered in a period of macroeconomic stability, a boom in commodities and robust economic boosted revenue collection, and reforms to broaden and deepen the public debt market lowered interest rates.
- Central government primary surpluses averaging close to 3 percent in 2006-2008 and a positive interest-growth differential brought gross government debt down to a low of 27 percent of GDP in 2008.

### Fiscal response to the global financial crisis and subsequent deterioration
- Between 2009-2012 the central government deficit averaged close to 5 percent of GDP as the weakening economy reduced revenue collection and a rising wage bill increased government spending.
- Government debt-to-GDP increased by 15 percent of GDP since the start of the crisis, reaching 42 percent of GDP at end-2012.
- IMF projections (absent additional policy measures) suggest debt will exceed 50 percent of GDP by the end of this decade.
- The government’s gross domestic financing requirement has more than doubled since 2008 to 11½ percent of GDP in 2012.
- Foreign ownership of domestic government bonds has nearly tripled since 2008, reaching 36 percent at end-2012.
- Sovereign credit rating downgrades occurred in 2012 and 2013.

### Relative position versus peer emerging markets
- South Africa’s relative fiscal position among emerging markets has been deteriorating since 2008.
- South Africa’s debt-to-GDP ratio—which pre-crisis was relatively low—is now slightly above the median in peer emerging market countries.
- Peer emerging market group in this paper consists of: Argentina, Brazil, Chile, China, Colombia, Hungary, India, Indonesia, Korea, Malaysia, Peru, the Philippines, Poland, Romania, Russia, Thailand, Turkey, and Ukraine.

### Factors supporting South Africa’s debt tolerance
- Long history of sustainable fiscal policies and a deep and liquid debt market contributed to historically low interest rates.
- Favorable debt composition:
  - Strategic benchmarks limit foreign-currency denominated debt to 20 percent of the total.
  - Domestic debt is split 70-30 percent between fixed rate bonds, and inflation-linked bonds and short-term Treasury Bills.
  - In practice, foreign currency debt is around 10 percent of the total.
- Smooth maturity profile with average term-to-maturity of around 10 years contributes to greater debt tolerance.

### A Debt Ceiling for South Africa — approach and key assumptions
- The sustainable debt ceiling is calculated as the discounted sum of future primary surpluses; this requires specifying the future path of primary surpluses and the appropriate discount rate.
- Assumed path for the primary balance:
  - Convergence from -2.4 percent of GDP in 2012/13 to a long-run equilibrium of 0.6 percent of GDP in 2024/25.
  - This equates to a 2 percent of GDP improvement over the IMF’s projection period (2012/13-2018/19) and an improvement in the primary balance of 0.25 percent of GDP per annum from 2018/19 onwards.
  - Note: South Africa’s primary balance has averaged close to 0.6 percent since 1980.
- Discount rate calculation:
  - Real interest rate proxied by the average yield on US 10-year inflation-linked bonds between 2003-2008 plus South Africa’s average sovereign spread from JP Morgan’s Emerging Market Bond Index Global (EMBIG) over the same period.
  - Excluded more recent data due to sharp movements in US interest rates and EMBIG spreads during the global financial crisis.
  - Resulting real interest rate: 3.8 percent.
  - IMF’s current estimate of long-term growth in South Africa: 3 percent.
  - These yield a discount rate of 0.8, close to the discount rate of 0.9 found by Topalova and Nyberg (2010) for South Africa.

*Source: _wp14231 - introduction of inflation*

### Box 1. Data Coverage

### Box 1. Data Coverage

### Coverage of the Public Sector
- Central government debt accounted for around 73 percent of total public sector debt in 2012/13.
- State-owned enterprise debt has increased significantly in recent years, but borrowing has mainly been undertaken by a handful of large commercially-viable companies on the strength of their own balance sheets.
- Provincial governments cannot accumulate debt.
- Local government debt is low and concentrated in a few large metropolitan areas with their own revenue-raising capabilities.
- Due to the above and the absence of reliable data on the indebtedness of the consolidated public sector, central government debt in South Africa is treated as a reasonable proxy for overall public debt and is the measure employed in this paper.
- The analysis should be complemented by an analysis of potential contingent liabilities posed by state-owned enterprise and sub-national borrowing; doing so is beyond the scope of this paper.

### Gross vs. Net Debt
- Between 2004/05 and 2012/13, cash balances increased from 2.1 to 5.7 percent of GDP, largely funded by increased borrowing.
- The gap between gross and net debt has increased considerably as a result of higher cash holdings.
- Only around 65 percent of these cash reserves are readily available for government operations; the remainder is used by the South African Reserve Bank (SARB) to sterilize past foreign exchange purchases and is only available as bridge finance on the understanding that they be replenished.
- The authors argue that net debt underestimates the fiscal risks posed by government borrowing and therefore employ a measure of gross debt in their analysis.
- Any “bias” from using gross rather than net debt likely offsets the use of central government debt to assess fiscal risks posed by the indebtedness of the entire public sector.
- The authors recognize that if cash buffers increase further, incorporating these balances will have a material impact on the assessment of debt sustainability.

*Source: Box 1. Data Coverage, provided content.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14231.pdf_