The Ongoing Financial Crisis: Implications for Debt Sustainability in Developing Countries and the Future of the DSF 1 Carlos A. Primo Braga Director,

The Ongoing Financial Crisis: Implications for Debt

Sustainability in Developing Countries and the Future of

the DSF

1

Carlos A. Primo BragaDirector, PRMED

April 25, 2009

Presentation outline

• The ongoing financial crisis in a nutshell

• Debt sustainability: a summary• Debt sustainability and the crisis• Debt management and the crisis• The ongoing crisis: a protracted

one?• Room for improving the DSF?

2

The crisis in a nutshell

• Antecedents of the crisis:– Boom-bust credit boom, fueled by lax

monetary policy in developed countries– Underestimation (poor assessment) of

risks– Poor corporate governance– Macroeconomic imbalances (low savings

in some developed countries,...) – An asset price bubble and excess

investment in real estate3

Additional considerations

• Financial innovation and increased opaqueness -- Reckless use of colaterized debt obligations relying on mortgages as collateral-- Growing reliance on the originate-to-distribute business model/poorer risk assignment

• Financial integration-- Much larger capital flows /cross-border positions

• Major regulatory and supervision changes-- The repeal of Glass Steagall (1999) to allow US

conglomerates to leverage their balance sheets like EU universal banks; transition to Basel II; SEC ruling on net capital (2004)…

Residential mortgage backed securities versus other securitized assets

Source: Blundell-Wignall and Atkinson (2008), Federal Reserve, Datasteam, OECD.

(% GDP USA)


Three Contagion Channels• Liquidity squeeze and lower risk

appetite higher financial costs

• Lower commodity prices and trade volumes lower export proceeds and government revenues

• Reduction in capital flows and remittances tightened financial sources

6


• Countries reactions to the crisis:– Loose monetary policy– Recapitalization of financial systems– Bail out of household and corporate

sectors– Fiscal stimulus packages – Financial systems regulatory overhaul

• And IFIs are intermediating more funds than ever

7

The crisis in a nutshellImpacts and responses

• Higher financial costs, although benchmark interest rates will remain low for a while;

• New intermediation channels, although financing gaps remain significant;

• Renewed focus on fiscal stimulus: fiscal space considerations.

Bottom line• Full impact depends on countries’ initial

conditions (fundamentals) and exposure to shocks;

• Final outcome depends on the depth and length of the crisis.

8





9

List of Heavily Indebted Poor Countries (as of end March 2009)

24 Post Completion Point Countries

Benin Ethiopia Honduras Mauritania Rwanda Tanzania

Bolivia Ghana Madagascar MozambiqueSão Tomé and

Príncipe Uganda

Burkina Faso Guyana Malawi Nicaragua Senegal Zambia

Cameroon Gambia, The Mali Niger Sierra Leone Burundi

11 Interim Countries

AfghanistanCentral African

Republic

Congo, Dem. Rep. of the

Guinea Haiti Togo

Côte d’Ivoire Chad Congo, Rep. of Guinea-

BissauLiberia

7 Pre-Decision Point Countries

ComorosEritrea Somalia

Sudan Kyrgyz Republic

5

HIPC: Debt burdens have been reduced markedly….

In billions of U.S. dollars, in end-2008 NPV terms

87.373.6

35.6 30.36.8

50.6

40.7

21.421.4

17.1

0

20

40

60

80

100

120

140

160

Before traditionaldebt relief

After traditional debtrelief

After HIPC Initiativedebt relief

After additionalbilateral debt relief

After MDRI

24 Completion-Point Countries 11 Interim Countries

Progress to date (April 2009)• 35 out of 40 eligible countries have

passed the decision point and qualified for HIPC Initiative debt relief

• HIPC Initiative debt relief committed to the 35 post-decision-point HIPCs is US$57.3 bln

• Of the 40 HIPCs, 24 countries have reached the completion point and qualified for irrevocable debt relief under the HIPC Initiative and the MDRI, estimated at a total of US$61.6 bln

• Debt relief is expected to reduce external debt stock in post-CP HIPCs by about 80 percent in end-2008 NPV terms

Post-CP HIPCs are in a better debt situation than other HIPCs.

Debt Relief and Debt Sustainability

As of 2008

Debt sustainability: a summary

• Debt is sustainable as long as it can be serviced without resorting to exceptional financing and/or major corrections in the balance of income and expenditures.

• Analyses focuses on indicators such as:– PV of Debt in percent of: (i) Exports, (ii)

GDP, and (iii) Government Revenues;– Debt Service in percent of (i) Exports,

(ii) Government revenues.

13

IDA-only countries

Risk of Debt Distress

HIPCs

In the case of IDA, the graph reflects only countries for which a DSA is available. The graph for HIPCs includes: Bolivia and Honduras (both Blend countries) and Somalia (for which a DSA is not available)


• Debt sustainability indicators will deteriorate due to the fall in exports and government revenues, and the increase in debt service.

• For some countries rollover and accelerated repayment may be an issue.

• Debt sustainability indicators may deteriorate even further as governments implement fiscal stimulus packages.

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• A critical issue is how long the crisis will last.

• A short lived crisis will have a small effect on debt sustainability as relevant indicators are of a long term nature (forward looking, 20 yrs).

• In contrast, a protracted crisis will have a more lasting effect on debt sustainability.

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Debt sustainability and the crisis

18

YEAR

1 2 3 4 5 6 7

(A) Exports: % deviation with respect to baseline

30 25 20 15 10 5 0

20 10 0 0 0 0 0

(B) Conditions of additional financing incurred to maintain consumption and expenditures constant

(i) IDA terms: 40 yrs; 10 yrs grace period; 0.75% interest

(ii) Commercial: 10 yrs.; no grace period; 5% interest

Two scenarios/shocks with different financing conditions


19


20


21


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Debt management and the crisis

24

While a debt sustainability analysis focuses on the long-term sustainability of debt, which is influenced by both its level and composition, a debt management framework focuses on how the composition of debt is managed.

The crisis creates particular challenges for debt managers:

• How to close an increasing financing gap and finance a country’s development needs at low cost with a prudent degree of risk, especially at a time when conditions in financial markets are severely constrained?

• Given limited external financing options, how can potential benefits from developing domestic markets be exploited at a low cost and prudent degree of risk?

• Given the efforts by many governments to strengthen their balance sheets over the past decade, how can these sounder public debt structures be protected?

• Since the crisis implies substantial macroeconomic adjustments, how should debt management strategy reflect the new reality?

• Systematic application of the Debt Management Performance Assessment (DeMPA);

• Country-led design of medium-term debt management strategies (MTDS) jointly with the IMF;

• Design of reform programs;

• Training events;

• Research and development of knowledge products;

• Peer learning initiatives, such as a the Debt Management Practitioners’ Program and the Debt Managers Network.

The Debt Management Facility as part of the solution, leveraging existing TA providers





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2011-6

-4-202468

1012141618202224

The financial crisis will cause a sharp decline in global growth: the largest since the 1930s

World

Low-income

Source: DEC Prospects Group.

Growth of Real GDP, Percent

Middle-income

High Income

Economic shocks and the world trading system

• The food and fuel price surges led to disorderly and sometimes harmful trade policy responses

• Financial crisis has led to a trade credit crunch and sharp increases in credit spreads

0

50

100

150

200

250

2003 2004 2005 2006 2007 2008 est

Trade credit spreads (bp)

Brazil Indonesia

Korea China

India Russia

Turkey

Trade credit spreads (bp)

Source: Data collected by WB staff from private sources.

• Contraction in trade finance was also fostered by loss of critical market participants

• Secondary market drying up, reducing ability of banks to sell trade finance positions

• Concerns about protectionist measures rising

• World trade volume (goods and services) is likely to contract by 6% to 10% in 2009

All types of private capital flows to emerging economies plunging

U.S. dollars, billions, net 2006 2007 2008 2009

Private Flows 565 929 466 165

• Equity investment 222 296 174 195

• Direct 171 304 263 198

• Portfolio 52 -8 -89 -3

• Private Creditors 343 632 292 -30

• Commercial Banks 212 410 167 -61

• Nonbanks 131 222 125 31

Official Flows, net -58 11 41 29

• IFIs -30 3 17 31

• Bilateral -27 9 24 -2

Source: Institute for International Finance: “Capital Flows to Emerging Market Economies.” 01/27/09.

Potential declines inremittances and ODA

2005 2006 2007 2008 2009 2010

-10

-5

0

5

10

15

20

25

Baseline Low Case

Source: World Bank data and staff estimates.

Remittance Flows to Developing Countries

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

0

1

2

3

4

5

6

7

8

9

Low Income Middle Income

Official Development Assistance

(% of GDP)(USD, % Change)

Bottom line: outlook for LICs in 2009 has deteriorated sharply

31

Source: IMF Staff. Latest projections correspond to April 2009.

GDP Growth(In percent)

0

2

4

6

8

10

All LICs Sub-Saharan

Africa

Asia Middle Eastand Europe

LatinAmerica

WEO Spring 2008

Latest projections

Current Account Deficit(In percent of GDP)

0

2

4

6

8

10

12

14

16

18

20

All LICs Sub-Saharan

Africa

Asia Middle Eastand Europe

LatinAmerica

WEO Spring 2008

Latest projections

A protracted crisis?• Short-term responses/effects

– Fiscal stimulus packages substitute for the fall in aggregate demand

– Government’s and IFI’s lending replace banks and other financial intermediaries

– Recapitalization/lending to banks allow them to stay in business

32

G20 countries – discretionary fiscal stimulus in 2009 (% of GDP)

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5

ArgentinaBrazilChinaIndia

IndonesiaKorea

MexicoRussia

Saudi ArabiaSouth Africa

Turkey

AustraliaCanadaFrance

GermanyItaly

JapanSpain

U.K.U.S.A

Advanced Economies - Simple average = 1.2% of GDP

Emerging Economies - Simple average = 1.3% of GDP

33Source: IMF Staff Note to G20 Deputies Jan. 31, 2009

A protracted crisis?• Long-term issues:

– Global imbalance: large deficits and accumulation of debt in some countries (and reserve accumulation in others) needs to be reversed, a costly and difficult adjustment.

– Further balance sheet effects may result from this adjustment as some currencies appreciate/depreciate.

– Allocation of losses among stake holders: a complex economic and political process.

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Room for improving the DSF?

• Broadly speaking the DSF comprises two aspects:– Country assessments: CPIA, DSA

(“medical check up”)– Policy on borrowing, including non

concessional (“treatment”)– Currently the treatment allows for

flexibility (the IMF is revising its own policy to make it more flexible and the Bank does a case by case analysis)

36

Room for improving the DSF?

• Bottom line:– Developing countries need growth and

trade to resume quickly (the sooner the better)

– Need cheap financing to muddle through (the more and cheaper the better)

• What relaxing the DSF and related policies would accomplish?– It would allow countries greater access to

borrowing, but that is not necessarily the remedy under the current conditions (non-concessional borrowing implications).

37

Room for improving DSF?• Is there room for improving the tests run

on the “patient”? YES, ongoing efforts• Is there room for more flexible

treatments? YES, but this needs to be integrated with broader reviews of concessionality policies

• Analysis of the “tests” and the “treatments” should not be confused

• LICs should be particularly careful about the implications of non-concessional borrowing…

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• Financial crisis: scale of policy responses is country specific, but, given the procyclicality of the financial system, it is important to coordinate financial sector reform and to synchronize macroeconomic responses;

• The deepening of the downturn suggests the need for an increase in high-impact fiscal expenditures. But embedding stimulus packages in a credible medium-term strategy, that safeguards fiscal sustainability, is key;

• Debt sustainability implications for LICs: a function of the crisis duration. Implications of non-concessional borrowing need to be carefully evaluated;

• Debt management: the crisis underscores the importance of debt management practices and makes the Debt Management Facility even more relevant;

• WBG response: increase in IBRD lending (mix of Development Policy Loans (budget financing/fast disbursing: financial sector restructuring; contingent source of liquidity...) and Investment Loans (preserving infrastructure spending; support for clean technology; social safety nets...)); fast-tracking IDA funds; Vulnerability Financing Facility; INFRA (support for infrastructure); expansion of guarantees (MIGA); new IFC facilities (support for trade; recapitalization of banks; refinancing of microcredit institutions).

Concluding Remarks

Documents

The Ongoing Financial Crisis: Implications for Debt Sustainability in Developing Countries and the Future of the DSF 1 Carlos A. Primo Braga Director,