Tuesday, May 16, 2006

The Debt Sustainability Analysis (SDL)

Of course the whole SDL debate is based on some very good intentions, like not saddling the countries with excessive debts, and finding adequate means by which to allocate the IDA development resources between loans and grants. Nonetheless, when reading the many papers about “Debt Intolerance,” most of them ridiculously obscured by complex econometrics, I felt that the World Bank was focusing on the issue from a totally wrong perspective.

Instead of analyzing the relevant issues such as the credit-absorption capacity of countries and of how their credits could better contribute to growth and repayment capacity, the WB now seemed to be appearing in the role of any investment bankers, worried about how much of their credit products they could push. In doing so I felt that the WB was, unwittingly and unwillingly, lending force to the belief that a debt was OK, as long as it was sustainable. In my mind, there cannot be a road more conducive to debt turning unsustainable, than to award credits just because they are sustainable.

My potpourri of sometimes somewhat repetitive and not always congruous objections included among others:

SDL analysis is somewhat similar to calculating a sustainable credit line for a compulsive gambler. What politician (anywhere) would resist the multiple temptations of not using an available “allotment” of sustainable credits? Worse, these levels would still be taken only as a minimum, with nothing to stop the rest of the markets pushing even more loans.

The debate on debt sustainability sometimes sounded to me like debating whether you can smoke one, two or three packages of cigarettes a day before smoking kills you. In my case, after not having smoked one single cigarette in more than ten years—and not one single week goes by without being seriously tempted—I am certain that my own “nonsmoking sustainability level” is an absolute zero cigarettes. With respect to public debt, we know there are governments really hooked on public debt and then perhaps their debt sustainability level should be an equally big zero. As it must be very difficult to free someone from a vice with as much addictive power as credits payable by future generations, it might be safer if the Bank and the Fund recommend cutting the habit altogether, cold-turkey, instead of suggesting a life on the border of sustainable (healthy?) levels of debt consumption.

There are cases were SDL calculations are clearly a very valid and needed starting point, as when they are made in relation to the restructuring of debts. Nonetheless, in those cases, attention needs to be focused more on issues such as the amortization profile of the debt, the lowering of interest costs, and the systems put in place to avoid contracting new general nonpurpose debt.

The true purpose of credits
Let us never forget that if credits are correctly awarded and contracted, the whole concept of “debt sustainability” should be a moot issue. New mediocre credits awarded that have small chances to generate repayment capacity, might very well push a country into unsustainability but it is also very possible that new good credits to a country with excessive debt is the only alternative to get it out of unsustainability.

The WB should not be seen as lowering the bar by accepting the concept of unproductive credits as long as they are within certain limits. Instead, the real challenge is to go back to the basics, making effective use of scarce resources, assuring that new credits are productive and, one way or another, generate their own repayment. If this is not so, then the creditor, rightly, even the WB, should also stand to lose as a creditor.

We have been presented a framework for how these debt-sustainable levels are to be determined but in order to mean anything the framework needs to go much further than just determining whether a country can manage public debt of 40, 50, or 60% of its GNP, or of 100, 150, or 200% of its export earnings. Why is there so little analysis about the real causes of its current debt? And why is there so little effort made to ascertain that those causes are truly remedied?

Every dollar of debt that is not used adequately to advance development eats up a dollar of debt-servicing capacity that could be more productively used. In this respect, the use of available space calculated under this framework as a justification for an “increase in poverty-reducing expenditures” or “to meet their Millennium Development Goals” could perversely induce many low-income countries to fill up their credit space without generating the growth they so much need.

The framework, almost as an afterthought, on a case-by-case basis, even when there is no sustainability room left, contains some wording about the importance of accommodating loans designated for specific high-return projects. In fact, the WB should always be looking for those high-return projects that generate poverty-reducing growth.

Moral hazards
One of the yet unsolved mysteries of the world of Public Finance is how politicians can delicately manage the contradiction that arises from declaring all outstanding old public debt to be evil, while simultaneously preaching the virtues of any new credits to their country.

Declaring a debt as “sustainable” (as opposed to self-repayable credit) implies that the debt will be repaid by those coming afterwards. So it would seem that perhaps those in real need of a voice speaking out on their behalf are the future generations.

There is a tough real-world question begging for an answer: What is better: to reach an unsustainable debt level, to have a crisis and get it out of your system, or to condemn yourself and future generations to living forever under the burden of technically correctly calculated sustainable debt levels?

Rewarding countries that have policies that development experts deem to be of poor quality with a higher proportion of concessionality (meaning more grants, fewer loans) screams out the presence of an immense moral hazard. Although reductions in the overall credit volume might in fact mitigate some of the problems caused by excessive debt, the framework has to be crystal clear about what it means, as there are always many parties interested in what it should not mean.

On thresholds
The Bank cares a lot about keeping high standards in procurement, but, out there, in the real world, there are many debt-pushers who just love the addictions they create. Much debt is contracted by nontransparent means, hidden, either in the darkness of smoky-room negotiations or in the technical financial sophistications that make it impossible for any mortal to understand what is going on, especially with so little intelligible data available to their mortal citizens. Odious debt? Yes, there is a lot, but let us not forget that for every penny of odious debt that exists, there is an almost penny by penny match of odious credit. I have written about Odious Debt and about Odious Credits; perhaps it is time for me to write about Odious Thresholds.

Begging for humility
Most of the documents coming out from the Debt Sustainability Analysis (DSA) correctly state that the conclusions should at best serve as rough guidance and indicative guideposts. Nonetheless by including so many references to strong empirical evidence, robustness, and strong analytical underpinnings, they end up anyhow overstating its validity.

The case for more humility and lower expectations with respect to the reliability of the DSA is laid out with crude clarity by the United States General Accounting Office (GAO) in its study of the IMF’s capacity to predict crisis, published in June 2003 (SecM2003-0306). In it, GAO states, among other things, that of 134 recessions occurring between 1991 and 2001, IMF was able to forecast correctly only 11 percent of them, and that it was similarly bad in forecasting current accounts results. Moreover, when using their Early Warning Systems Models (EWS), in 80 percent of the cases where a crisis over the next 24 months was predicted by IMF no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.

Domestic debt
Frequently, just because of the lack of adequate data, there are proposals to disconnect the DSA from the analysis of the domestic debt, an idea which is just plain crazy. There is no way on earth that you can argue, or justify, that a debt-sustainability framework can be developed exclusively for the external public debt of a country, ignoring the domestic.

I guess the above is another prime example of what can happen when we allow the econometrists an excessive influence. Oh we cannot get data? Do not let that stop us! In their desperation, I even heard some of the number-masseurs put forward the weird argument that the assessment of, and the response to, domestic debt in low-income countries, although critical, did not lend itself to a threshold approach. Weird, because they did not seem to notice that, if true, this should cast doubts over the whole DSA framework itself.

Crowding out the private sector
Considering the importance given by the WB to the private sector as a development agent, I was always upset to find so few and sparse references in the DSA to the issue of how public debt crowds out of the private sector from the credit markets. From my point of view, one of the main determinants when calculating debt sustainability should be this factor and indeed if the DSA decrees as untenable any public credit that raises the cost of private debt more than x number of basis points, I might have reacted quite differently to the debate.

Currently defining a country’s debt sustainability in terms of how much public debt it can have before risking default sounds to me like setting the bar unbearably high, since long before that happens, the private sector is probably already long gone.

As a sort of consolation I read somewhere that we Directors had agreed that private external debt was potentially less troublesome than public debt, but this is of course a far cry from declaring as an absolute development need that the private sector should have competitive access to external debt.

Of course there are traders and investors who do have a particular interest in the probability of sovereign risk defaults but, in fact, most ordinary citizens and entrepreneurs are much more interested in making sure that the public debt does not crowd out their own opportunities of accessing credits on reasonable terms and costs. Of course, the Bank and the Fund must know with whom they should team up.

Public debt could sometimes be described as financial emphysema inasmuch as it makes it harder for the private economy to breathe properly. In some cases the secondary hazards produced by public-sector debts, might be so large that they should perhaps be entirely prohibited.

Credit Ratings?
Some of the data and conclusions coming out from the DSA are supposed to be made transparently public, as they indeed should be—to all the market. We have also been told that this information will not develop into a sort of credit-rating system but it is hard to understand why this would not happen. In this respect, the Bank needs to understand better the reactions of the market, because it might very well happen that when the Bank proposes more concessions in response to a low-debt sustainability, other market players might respond by asking for higher interest or shorter repayment terms, so as to make up for the higher risks announced by the Knowledge Bank.

Why consensus?
While we appreciate the worth of a diversity of opinions, I cannot understand how at the same time we give such great importance to having a consensus of opinion between the Bank and the Fund. For instance, on the issue of banking regulations, I have frequently warned that the mentality of a Central Bank regulator who pursues with zealous fervor the avoidance of a crisis, at any cost may lead to the exclusion of other key objectives of a financial system, such as generating growth and distributing income. In this respect, we might on the contrary need the Bank to differ outspokenly from the Fund.

Costs and efforts
Currently there is a lot of frantic activity analyzing debt sustainability, mainly in the Fund. If we add up all the resources used, we might come up with quite an impressive figure, and it would be a shame if all those efforts came to naught just because of a lack of focus. Whatever you do, please rein in all those econometricians who with little or no ideas about debt are having the time of their life, having been given a license to regress on whatever variable they can imagine.

Grants or loans? Neither! Just more open markets, let us trade, in all services as well, and let us do business.

A word of caution about Financial Leverage
If a project is expected to produce 10% in returns and an investor can borrow half of the funds needed at 8% then, on his own investments, he will make 12%. That’s why financial leverage is considered a good thing. Of course if the project then only makes 6% for the investor, as he still has to pay all the interest on the loans, he will see his return drop to 4% and that’s is why financial leverage has risks.

Mixing your capital and debts in such a way as to extract the highest possible profit for a certain level of risk is basically what finance is all about. As good and useful as financial leverage can be for the private sector, its application for the public sector though is far from that straightforward.

The main problem with financial leverage in the public sector is that there is a gap too wide between the immediate beneficiaries and the final payers of the risk. If a private investor does badly he will normally pay for it himself shortly, sometimes even before the investment has taken place, as there are stock markets that evaluate his investment decisions in a flash. However, if it is the public sector, the payee of any loss is an anonymous next generation of citizens or, at the earliest, the next government. When you can reap all the goodies today and have someone else pay for them tomorrow we must know that the stage is set for committing huge mistakes.

That is why I get so angry when financial professionals so haphazardly extol the virtues of debt and believe them applicable across the board.