Issues in External Debt Management and Sustainability for the Kyrgyz Republic

1. Issues in External Debt Management and Sustainability for the Kyrgyz Republic Dr HK Pradhan Professor of Finance and Economics XLRI Jamshedpur India 831 001

2. External Debt of the Kyrgyz Rapid accumulation of external debt from a debt-free start in 1991 to reach $1,965.7 million by 2003 With the Debt/GDP ratio at 102.3%, the Debt/Exports ratio at 263.8%, and the Debt service/exports ratio at 22% as of 2003, the country is considered as the most heavily indebted country in the region Global Development Finance 2004(World Bank) classifies the Kyrgyz Rep as severely indebted low income developing country Resort to the Paris Club in 2002 for rescheduling of the bilateral official debt had only reconfirmed the severity of the debt stress facing the country

3. External Debt of the Kyrgyz

4. Kyrgyz Rep has by far the heaviest debt burden within the group of CIS-7(Figures are for 2002)

7. End-2000 Kyrgyz Rep was identified as eligible for the Enhanced HIPC Initiative (after taking into account the Paris Club Rescheduling based on Naples Terms)

8. Why did the Kyrgyz Rep face debt difficulties since 2000? Was there excessive borrowings (over lending)? Did multilateral lenders (WB, IMF) overestimated the prospects for growth, exports, revenue and investment capacity, leading to cash-flow problems since 2000? Was this just a coincidence, that the transition economies faced in general, during the period of their transition? Did the domestic macroeconomic reforms proceeded as planned, facilitating an improved investment climate for sustained growth? Or, was there a bad advice?

9. Kyrgyz Rep: Macroeconomic Trends Since the Debt Problems

10. Debt Unsustainability by 2000 Increasing current account deficits, external borrowings under PIP (lacking domestic savings and resources) Less than anticipated growth of GDP and exports (as forecasted by the donors) Russian financial crisis in 1998 and its impact on exports and the devaluation of the Som and its impact on bilateral exports and debt burden Commodity concentration in exports and imports lacking compressibility Above all, an insufficient legal framework, lack of monitoring and control of debt, lack of risk management practice, underestimation of external factors impacting debt service

11. Debt vulnerability has much to with the nature of capital flows into the economy Debt creating flows Multilateral and bilateral flows Commercial bank loans, bonds Non-debt creating flows Foreign direct investments Hybrid Flows Portfolio investment flows Vulnerable Flows Short term debt Debt with floating interest rates Short term deposits with the banking system

12. Reasons for the rapid accumulation of debt the way the current account deficit is being financed Mostly by debt creating flows FDI had come down from a level of $86.6 million in 1998 to -$ 6.6 million in 2000, -$ 1.1 million in 2001, $ 4.7 million in 2002, and $ 45.5 million in 2003 the way external capital being used for (such as financing investment as opposed to consumption or non-tradable), the enabling environment supporting an investment climate for growth and exports. Most of the external borrowings were not directly related to projects generating exports

14. External Debt of the Kyrgyz Republic

16. Debt Sustainability Analysis (DSA) DSA analysis is traditionally carried out considering two sets of indicators: solvency vs liquidity Solvency: If its level of debt has made its servicing (amortization as well as interest payments) incompatible with the net current inflows. Liquidity: Temporary liquidity problems can trigger debt servicing difficult intense, due to fall in export earnings, increase in international interest rates, appreciation of the contracted currency or increase in prices for imports such as oil. Making DSA analysis is important to decide whether a country needs a debt reduction and major correction in balance of payments as in the case of solvency or rescheduling or restructuring may be just sufficient to make the level of debt sustainable.

17. Flow Measures: Debt Service Ratio Interest Service Ratio: Interest payments to earning in exports of goods and services indicate the terms of external debt burden. It also indicates how much the current earnings are needed in order that the debtor remains current in servicing debt. Debt-Service Ratio: Debt-service payments to exports of goods and services indicate how much of a country�s export revenue will be used up in servicing its debt In the case of concessional debt, current debt-service ratio may understate the burden of debt as the repayment profiles are typically back-loaded Projections of debt-service ratios are subject to several assumptions associated with making forecasts over long periods, as long as 35-40 years in case of concesional loans.

18. Debt Stocks Based Measures External Debt/GDP: Provides some indication of the potential to service external debt by switching resources from production of domestic goods to the production of exports. External Debt/Exports: Provides an indication of solvency, since an increasing debt to exports ratio indicates that the country may have problems meeting its debt obligations in future External Debt/Central Government Revenue: Measuring the government�s ability to generate fiscal resources, as not all export earnings are in the hands of the public sector.

19. Net Present Value (NPV) Method NPV of External Debt to GDP, Exports or CGR: Present value, as against the face value, is expected to capture the extent of concessionality of outstanding debt Has the limitations when the maturity is very long, relating the present value to existing GDP or Exports or Revenues NPVs are sensitive to the level of the discount rate, which change with market conditions.

20. Indicators of Solvency for the Kyrgyz Republic

21. Liquidity Specific Indicators Reserves/Imports: An important indicator of reserve adequacy Reserves/Short Term Debt: Can be used to assess the vulnerability to liquidity crisis in the event of capital flight on account of short term debt. Interest Payments/Reserves: Measures the interest payments of all debt which could be covered by usable reserves. Short Term Debt/Total Debt: Measures the relative importance of short term debt (all debt with residual maturity of less than a year) in total external financing, measures the extent of vulnerability in the event of liquidity crisis

22. Indicators of liquidity for the Kyrgyz Republic

23. Solvency vs Liquidity There is of course no thumb rule that would determine the thresholds for solvency and liquidity Every insolvent borrower faces liquidity problems Need to measure and assess simultaneously several indicators in a forward looking framework DSA analysis to be supplemented by other indicators such as (i) external debt over total public debt (domestic plus external), (ii) corporate debt/total debt, (iii) share of concessional debt in total debt, (iv) average terms such as interest and maturity Sustainability analysis has to be country specific, considering the debt history, sovereign ratings, the development of capital markets. Well functioning capital market would enable governments to borrow domestically thus avoiding external debt. Country-specific external debt-burden thresholds also depend on the quality of the country�s economic policies and institutions

24. Policy Dependent Debt Threshold Assessment of Institutional Strength and Quality of Polices Poor Medium Strong NPV of debt/GDP 30 45 60 NPV of debt/exports 100 200 300 NPV of debt/revenue 150 200 250 Debt service/exports 15 25 35 Debt service/revenue 20 30 40

25. Sustainability conditions Debt can be serviced for long periods, as long as creditors make positive net transfers Debt sustainability is therefore a difficult concept in countries predominantly depending on the official flows Depends the willingness of official creditors to make positive net transfers Moreover, countries heavily depending on official flows ignore market signals Such as credit assessment, margins on private credits, secondary market spreads, thereby may make compromise with sustainability conditions Sustainability conditions require that creditors and debtors have full information if there is asymmetric information, unrealistic assessment would be the outcome

26. Sustainability conditions Debt dynamics is an outcome between debt sustainability and macro-economic policies. Ukraine refinanced (or rescheduled) $1.8 billion Eurobonds in 2000, when its debt ratios were considered moderate Hungary, with a very high ratio of debt, remained solvent, did not resort to rescheduling, and could manage with pursuing stronger economic growth, tax revenues and exports

27. Sustainability conditions Debt Sustainability is a dynamic concept Relates to the debtor�s ability to generate future debt servings and assessing the evolving economy in an era of globalization Sustainability indicators serve as the early warning signals, and solutions would require undertaking suitable macroeconomic policies correcting imbalances.

28. DSA QuadrantsMaking analysis of economic and financial shocks to which the country is potentially exposed Domestic real GDP Exports Energy consumption Natural disasters Foreign Real Export growth Terms of trade current account deficit Real Exchange rate Oil price shocks

29. Use other analytical techniques duration sensitivity/scenario analysis stress test, currency risk analysis Value at risk analysis (for reserves) cash flows forecasting, etc

30. Policy Issues in External Debt Management Macroeconomic policies Monitoring domestic debt Monitoring contingent liabilities Debt market development Reserve management Exchange rate policy Risk management Institutional framework

31. Macroeconomic stability is the key to external debt management

32. External Debt and National Accounts Y = E Y = C + S + T E= C+ I + G + X- M C + S + T = C + I + G + X � M (S- I) + (T-G) = (X- M) = � D

33. Monitor the level of domestic debt Debt management should include external as well as domestic debt Servicing of the external debt and the domestic debt have implications on the fiscal sustainability Domestic debt has been limited(8.6% of GDP in 2003) due to the small size of the financial sector, low savings rate, and limited growth of pension and insurance funds Domestic debt issues were considered merely as part of the budgetary exercises

34. Creating Domestic Bond Markets Gradual introduction of local currency debt instruments by deepening domestic debt markets help reducing external debt burden Creating domestic markets for local currency bond issuance is difficult due to: Small size of the financial system (with bank assets 7 per cent of GDP and non-bank assets another 2.5 per cent of GDP) Lack of government bond markets beyond short term sector Investment institutions such as insurance, and pension sectors are all equally small

35. Necessary preconditions for domestic bond market initiation Create benchmark bonds Establishment of yield curve Establish realistic interest rates Strengthening institutions and intermediaries Create investor confidence Stable inflation, sustainable fiscal parameters Improve trading and settlement infrastructure Improve financial information for the private sector borrowers Adequate investor protection Rationalization of regulatory framework

36. Contingent Liabilities Explicit or implicit government guarantees affect the future increases in government debt obligations Explicit contingent liabilities arise from any contractual arrangement protecting the risk of another party, such as a line of credit, exchange rate and interest rate risk guarantees, sovereign guarantee of corporate external borrowings, and commercial guarantees of projects Implicit contingent liabilities can arise due contractual or legal obligation conditional upon certain events such as ensuring systemic solvency of the banking system, deposit insurance, etc. Implicit contingent liabilities are more difficult to assess than explicit ones, due to the potential moral hazard issues Contingent liabilities are difficult to measure in the presence of poor governance and non-transparent regimes

37. Monitor the level of private sector debt Need to gradually also consider the debt positions of the private sector Private sector debt include corporate debt (domestic and international) as well as liabilities of the financial intermediaries (banks, DFIs, NBFCs) Claims on the private sector as a whole accounted for about 4.8 per cent of GDP in 2003 Have the potential of creating moral hazard or disrupting the functioning of financial market conditions in the event of macroeconomic crisis Excessive build up of the private sector debt created severe non-performing loan (NPL) problems in post crisis Asia, needing bank failures and bail outs, with the implications of huge fiscal costs

38. Foreign Exchange Reserves Holding of adequate level of reserves is an important element of debt management Good policy of maintaining reserves on the face of debt service difficulties potential debt servicing essential imports at times of shortages Reserves are for liquidity reasons, rather than investment reasons foreign exchange market interventions other short term liquidity management

39. Foreign Exchange Reserves Reserve to import ratio serves as good indicator, if the reserves are primarily held for the purpose of trade For this purpose 3-6 months of imports are considered adequate India assesses reserve adequacy in relation to the stock of short-term debt and portfolio flows apart from the traditional import cover. Another concept is called the �Guidotti rule�: usable foreign exchange reserves, including any available contingent credit lines, should be sufficient to meet all repayments and interest on foreign debt falling due over the next year thus �being able to live without new foreign borrowing for up to one year� (assuming balanced current accounts).

40. Exchange Rate Policy Policy of managed float with limited intervention Exchange rate has appreciated in nominal terms, and in real terms too So far, previously under valuation has been correcting Need to have real exchange rate targets Appreciation, though reduces debt servicing costs, but affects exports Should balance between two goals: avoid falling price competitiveness of exports and prevent a rise in the cost of external debt servicing

41. Currency Risk Management Cross currency risk due to the appreciation of Japanese yen against US dollar in recent times Cross currency risk due to mismatch between earnings in exports and debt repayments

42. Currency Risk: An Example Effect of exchange rate movements between $/� on a borrower�s net income, when � appreciates from $1.03/� to $1.12/� during the year

43. Risk Management Instruments Financial derivative contracts such as currency forwards, swaps and futures help managing currency and interest rate risks of external borrowings Since there is virtually no market for financial derivatives, authorities could, on a case-by-case basis after very careful a scrutiny, allow domestic entities to access such instruments from the overseas markets, and to this end, necessary regulations and control mechanisms need to be put in place. Development of derivative markets domestically will take very long time, depending on the strength of the banking system

44. Integrated Approach to Asset-Liability Management Currency risk management could be an important element of debt management Working towards avoiding mismatch between existing assets (which include commodity exports and capital inflows, including borrowings) and liabilities (which include commodity imports and debt servicing) Use financial derivatives (such as swaps and forwards) with extreme caution

45. A comprehensive framework of debt management should include.. Assess the vulnerabilities of the public sector as a whole Consider a comprehensive measure of liabilities such as external debt, domestic debt, private sector debt, contingent liabilities, liabilities of the banking sector Work towards enhancing the foreign currency earning capacity of the economy: improvement in exports, increase in FDI, private capital inflows into capacity generating sectors Requires an acceleration of structural reforms and promoting investment climate, to enhance the long-term productive capacity of the economy.

46. Debt management framework� Continue (strengthen) with present macroeconomic policies keeping key targets: fiscal deficits and current account deficits (key prices are inflation, interest rate, and exchange rates) Accelerate financial sector reforms by strengthening banking sectors, prudential supervision, gradually building domestic debt markets, stock markets and listing of stocks, strengthen legal and institutional environment Improve further the reserve levels and manage reserves appropriately Risk and liquidity management practices in other sectors of the economy, particularly the financial sector needs assessment

47. Debt management framework� Debt maturities should be decided avoiding bunching of repayment obligations, avoiding potentially unmanageable concentrations of refinancing risk Private sector borrowing requirements be within the overall ceiling, which can be decided keeping in view the future debt servicing Assessing exposure to the risk of not being able to refinance maturing liabilities, or of being able to do so only at higher interest rates To the extent, borrowings can be matched with the cash flow structure of projects (structuring grants, grace periods, costs (IRR), and maturity project cash flows

48. Debt management framework� Use the world�s best practices such as debt conversion schemes (debt-for-equity swaps, debt-for-environment, debt repayment against export deliveries, debt-for-investment scheme (in specific projects) An arrangement on converting $50 million of Russian debt into environmental protection projects was achieved in July 2001 with Finland, for example

49. Eventually prepare the private sector access to global capital markets Preparing grounds for commercial borrowings from global capital markets, mainly by the private sector entities, for investments in infrastructure Facilitate good public as well as private sector external commercial borrowings without government guarantee Well within strict legal framework and country ceiling for such borrowings Strictly monitor their end-use and repayments

50. Institutional Capacity in Debt Management Strengthen institutional capacity in debt management Clearly defining the boundary of operations of MOF and NBKR Coordination between various agencies involved Coordination between fiscal, monetary, exchange rate policies and public debt management Efficient debt recording and data analysis Enhance the skill levels of operating staff

51. Successful debt management depends on good policy Effective debt management depends to a large extent on the country�s own policy and economy Would depend on the judgment of policy makers and planners Technical advice and models cannot substitute for good policy making Howsoever full proof and consistent the models are?