BASELINE PROJECTIONS AND RISKS IN KEY POLICY AREAS: FISCAL, MONETARY AND EXTERNALS SECTORS

Joint UNCTAD, IMF and World Bank MTDS WorkshopGeneva, October 1 – 5, 2018

OUTLINE

1. What are the links between macroeconomic policy and the formulation of debt management strategy?

2. How do these links operate in practice?• Baseline projections• Risks• Structural factors

3. Feedback from MTDS and macroeconomic policy• Risk mitigation• DM Strategy can improve the functioning of the financial system

WHY LOOKING AT LINKS BETWEEN MTDS AND MACRO FRAMEWORK: THREE COUNTRY EXAMPLES

Mexico 1994/5:• Sudden devaluation of the peso led to capital flight and a run on reserves of the Central Bank and government debt crisis exacerbated by a large stock of short-term debt and high level of dollar denominated debt =>IMF bailout to resolve liquidity

Argentina 2001/2:• External current account deficit (5% of GDP) high in terms of exports (100%) and currency peg meant overvaluation of the peso and costly government FX debt=>200% depreciation/debt restructuring.

Greece 2010:• Mainly primary deficit problem but non transparent fiscal/debt accounting and significant reliance on short-term and variable rate funding aggravated situation

LINKAGES BETWEEN MTDS AND THE MACRO-ECONOMIC FRAMEWORK

MACROECONOMIC FRAMEWORK AND THE MTDS1. The primary fiscal balance drives future borrowing volumes. The primary balance in turn depend

on the broader macro outlook (i.e., tax revenues, expenditures, etc.)

2. High GDP growth and real appreciation may reduce the burden of debt

3. Monetary and exchange rate policies influence the types and costs of available sources of financing, i.e. poor credibility of the monetary policy effects the inflation risk premium and increase debt roll-over risk

4. Balance of payments gaps may require external financing

CONCRETE LINKS TO MACROECONOMIC FRAMEWORK

Use Medium Term Budget Framework for baseline projections of macro variables. • Projections need to be part of a consistent macro framework.• Source: usually fiscal or macroeconomic policy unit, sometimes Ministry of Planning.• The DSA will contain these variables, but these may not be the latest update.

For strategy analysis it is vital to use a realistic baseline for market variables.• Exchange rate outlook can often be not realistic, politically influenced

RELATION TO DEBT SUSTAINABILITY ANALYSIS (DSA)

DSA role is to gauge the level of the debt. Does the level of debt lead to future debt servicing difficulties (over indebtedness)? • Derive advice on the (maximum) primary fiscal balance based on DSA

MTDS role is to derive and shape the composition of debt• Debt structure, and interest rate structure often crudely modeled in DSA. This is the role of MTDS

If new MTDS leads to a revision in debt strategy, this should be fed back into MTBF/DSA.

MTDS: HOW DO THESE LINKAGES OPERATE IN PRACTICE?

BASELINE PROJECTIONSRISKSLONG-TERM STRUCTURAL FACTORS

BASELINE PROJECTIONS: 4 SECTORSKEY MACRO AND MARKET VARIABLES

Real Sector

Fiscal policy

External sector

Monetary policy

GDP: denominator in cost /risk indicators and affects financing needs (if deficit projections is ratio to GDP);

Primary balance = Revenues –Non-interest Expenditure

•exchange rate•Balance of Payments•Reserves accumulation (roll-over risk)

•Interest rates inflation variation

SCHEMATIC DIAGRAM*

Fiscal MTDS

DSA

BOP

Monetary

1

1

2

3

5

4

12345

Primary balanceInterest payments

Total debt service, new financing source & its termsExternal debt serviceGovernment debt holdings by financial system

* Abstracts from other linkages.

MTDS TO FISCAL

2016 2017 2018 2019

Gross financing requirementPrimary BalanceInterest Payments

existing debtnew debt

Principal Repaymentexisting debtnew debt

Financing sources

MultilateralBilateralCommercialDomestic

Financing gap

MTDS TO BOP

2016 2017 2018 2019

Overall balanceCurrent Account BalanceTrade balanceService and income (net)

o/w interest paymentnew debt

Capital account balanceFinancial account balance

FDIPortfolio investment (Eurobond & nonresidents)Other investment (Loans)

Financing sources

Gross official reservesMultilateral creditBilateral credit

Financing gap

MTDS TO MONETARY

2016 2017 2018 2019

Central BankNet foreign assetsNet domestic assets

Credit to the public sector (net)Capital and other asset (net0

Base money

Commercial Banks

MTDS TO DSA

2016 2017 2018 2019

Public Debt StockDomestic debt

For LIC DSA _ existing and new debtFor MAC DSA _ existing debt

External debtFor LIC & MAC DSA – existing debt

Debt ServiceExternal principal and interest payment

For LIC & MAC DSA – existing debtDomestic principal and interest repayment

For LIC DSA – existing and new debtFor MAC DSA – existing debt

Consistent new debt assumptions

MACRO VS MARKET VARIABLES

Macro variables do not directly affect the relative performance of debt liabilities / instruments

Fiscal performanceGrowth

Shocks that affect the relative performance of debt liabilities / instruments(critical for MTDS)“Market” variablesoExchange rateoInterest rate

FISCAL BASELINE PROJECTIONS

Debt management should be clear aboutExpected path of Primary BalanceGross Financing Needs: Government Deficit (Primary Balance + Interest) + Debt RepaymentsFor LICs: grants depend on donor policies and economic prospects; a declining source of revenues as countries develop (a structural factor to consider)

From DSA whether there is considerable risk in terms of sustainability=>composition policy should help to reduce riskUnsustainable debt cannot be mitigated with a better debt portfolio structure

MONETARY BASELINE PROJECTIONS

Short-term interest rates driven by monetary policy. For dollarized economies monetary policy is mainly pass through.

Other nominal rates driven by inflation expectations.

Unstable monetary regime and inflation will lead to high inflation risk premiums for medium-long-term fixed rate instruments

Inflation indexed debt requires trusted index not subject to political “intervention”

BASELINE PROJECTIONS: EXTERNAL SECTOR

Balance of Payment defines the external financing needs (BoP gap) in the short-term (for given exchange rate/reserves target)

Current account drives the path of the exchange rate which is a key variable in cost-risk of external versus domestic funding

Reserves are key for roll-over risk especially under a fixed exchange rate regime where authorities will defend a predefined level

MACROECONOMIC FRAMEWORK: MAIN RISKS?Having established the baseline we need to ask what are the most likely risks (deviations from the realistic baseline)

RISK SOURCE IMPACT ON DEBT-RELATED RISK

GDP decline Taxes and revenues Weak debt repayment capacity

Deterioration fiscal position Primary balance High financing needs

Current Account Deficit & FDI reduction Balance of Payments Need for external financing (loans /market)

Inflation and credit rating DX interest rates High DX debt service

Currency depreciation Exchange rate High FX debt service

Sudden stop of inflows (or reversal) Balance of PaymentsExchange rate

Limits the choice of financing sourcesHigh FX debt service

Terms of Trade Commodities pricesExchange rate High FX debt service

EXCHANGE RATE SHOCK IMPACT

LONGER-TERM STRUCTURAL FACTORS

Examples of structural factors:structural changes in monetary policy (inflation targeting), in the long term reduce borrowing costdevelopment of domestic debt markets (reforms)changing trends in prices of commoditiesLong term trends in exchange rates due to productivity improvements

Long-term structural factors influence the debt strategy through their effects on the baseline macro scenario and on the mix of available instruments

FEEDBACK FROM MTDS AND MACROECONOMIC POLICY

THE CHALLENGE

Public debt management should be an integral part of a country’s comprehensive policy agenda (often not the case), including among others:

prudent fiscal policy measuresappropriate policy mix, with a consistent monetary policy frameworkadequately regulated and supervised financial system, in particular the banking sector

Public debt management should be an additional policy tool, consistent with the general macroeconomic policy framework.

MITIGATING FISCAL VULNERABILITIES

Choice of strategy can reduce liquidity risk and therefore, reduce the likelihood of crisis

Longer debt maturity helps reduce fiscal vulnerabilities: reduces roll-over risk and slows the pass through of increasing spreads / interest rates

More domestic funding reduces foreign exchange rate risk exposure

Similarly, reducing variable rate debt can reduce budgetary uncertainty and exposure to shifts in market’s assessment of credit risk (credit risk impacts the interest rates)

MITIGATING DIFFICULTIES IN THE IMPLEMENTATION OF MONETARY POLICY

Longer domestic debt maturities may help reduce the conflict between monetary and debt management objectivesCentral bank can more freely set the appropriate level of nominal short-term interest rates to achieve monetary objectives

Public debt management can help develop efficient money marketsFacilitates move to indirect instruments of monetary policy (open market operations)Enhancing the liquidity of government bonds can facilitate short term money market instruments such as repo and securities lending, which are important for monetary policy transmission mechanism.

MITIGATING BALANCE OF PAYMENTS VULNERABILITIES

Lengthening external debt maturities reduces roll-over and potential drain on reserves/ pressure on the balance of payments through capital flight.

Switching to domestic can reduce pressure on the BoP, though this may lead to private sector credit crowding out. However, the latter can be mitigating by developing the savings market.

Maximizing concessional borrowing, if available, reduces pressure to borrow for BoPsupport.

LINK TO FINANCIAL SYSTEM

More generally, public debt management can effectively support the development of more robust financial markets, improving the functioning of the financial system

Facilitating corporate debt marketsoProviding a benchmark for the private sector

Facilitate repo market developmentoImproving liquidity of banks’ balance sheets (provide collateral)

Facilitate development of derivatives marketsoAllowing for more effective risk management within the economy

CONCLUSIONS

The overall aim of public debt management is to minimize costs to the budget, taking account of potential vulnerabilitiesComposition of debt stock can help mitigate vulnerability of budget to shocks thus enhancing macroeconomic stabilityReducing rollover risk is an important mitigating factor to address broad range of vulnerabilities

To achieve its intended objectives, public debt management should be performed in close coordination with the rest of the macroeconomic policy

Despite public debt management’s policy impact on macroeconomic stability, financial stress and crisis may still occur, but amplitude of such events will not be exacerbated.