The Ongoing Financial Crisis: Implications for Debt Sustainability in Developing Countries and the Future of the DSF

1. The Ongoing Financial Crisis: Implications for Debt Sustainability in Developing Countries and the Future of the DSF Carlos A. Primo Braga Director, PRMED April 25, 2009

2. 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?

3. 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 estate

4. 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)…

5. Residential mortgage backed securities versus other securitized assets (% GDP USA) Source: Blundell-Wignall and Atkinson (2008), Federal Reserve, Datasteam, OECD.

6. The crisis in a nutshell 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

7. The crisis in a nutshell • 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

8. The crisis in a nutshell Impacts 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.

9. 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?

10. List of Heavily Indebted Poor Countries (as of end March 2009) 5

11. HIPC: Debt burdens have been reduced markedly…. In billions of U.S. dollars, in end-2008 NPV terms

12. Debt Relief and Debt Sustainability 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. As of 2008

13. 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.

14. Risk of Debt Distress IDA-only countries 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)

15. Debt sustainability: a summary • 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.

16. Debt sustainability: a summary • 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.

17. 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?

18. Debt sustainability and the crisis Two scenarios/shocks with different financing conditions

19. Debt sustainability and the crisis

20. Debt sustainability and the crisis

21. Debt sustainability and the crisis

22. Debt sustainability and the crisis

23. 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?

24. Debt management and the crisis • 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?

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

26. 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?

27. The financial crisis will cause a sharp decline in global growth: the largest since the 1930s Growth of Real GDP, Percent Low-income Middle-income World High Income Source: DEC Prospects Group.

28. Economic shocks and the world trading system Trade credit spreads (bp) • 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 • 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 Source: Data collected by WB staff from private sources.

29. All types of private capital flows to emerging economies plunging Source: Institute for International Finance: “Capital Flows to Emerging Market Economies.” 01/27/09.

30. Potential declines inremittances and ODA (USD, % Change) (% of GDP) Remittance Flows to Developing Countries Official Development Assistance Source: World Bank data and staff estimates.

31. Bottom line: outlook for LICs in 2009 has deteriorated sharply

32. 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

33. G20 countries – discretionary fiscal stimulus in 2009 (% of GDP) Source: IMF Staff Note to G20 Deputies Jan. 31, 2009

34. 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.

35. 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?

36. 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)

37. 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).

38. 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…

39. Concluding Remarks • 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).