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1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise

JULY 2010 • Number 23


JUNE 2010 • Number 18

Economic Premise

POVERTYREDUCTION

AND ECONOMICMANAGEMENT

NETWORK (PREM)

THE WORLD BANK

Trade and the Competitiveness AgendaJosé Guilherme Reis and Thomas Farole

Export-Led Growth, the Crisis, and the End of an Era

The dramatic expansion in global trade over recent decadeshas contributed significantly to diversification, growth, andpoverty reduction in many developing countries. This periodof rapid export growth has been enabled by two criticalstructural changes in global trade: (1) the vertical and spatialfragmentation of manufacturing into highly integrated“global production networks,” and (2) the rise of servicestrade and the growth of “offshoring.” Both of these, in turn,were made possible by major technological revolutions; andthey were supported by multilateral trade policy reformsand broad liberalizations in domestic trade and investmentenvironments worldwide.

The global economic crisis came crashing into the middleof this long-running export-led growth party during 2008and 2009. Between the last quarter of 2007 and the secondquarter of 2009, global trade contracted by 36 percent. Butas the recovery started to strengthen in 2010 (at least untilthe clouds began to form over Europe), the longer-term im-

pacts of the crisis on the policy environment regarding tradeand growth were becoming more apparent. Indeed, in addi-tion to raising concerns over the global commitment to tradeliberalization, the crisis has also led to some serious rethink-ing of some of the conventional wisdom regarding thegrowth agenda—the most important result of which is thelikelihood that governments will play a much more activistrole in the coming years. There are three principal reasonswhy governments are likely to be more actively involved inindustrial and trade policy in the coming years.

First, the crisis has undone faith in markets and discred-ited laissez-faire approaches that rely simply on trade policyliberalization. Instead, governments and local markets havebeen “rediscovered.” In this sense, the demand for activistgovernment is likely to go well beyond financial markets andregulation, and it will affect the policy environment in whichtrade and industrial strategies are designed.

Second, the crisis has highlighted the critical importanceof diversification (of sectors, products, and trading partners)in reducing the risks of growth volatility. The recent era ofglobalization contributed to substantial specialization of

The global economic crisis has forced a major rethinking of the respective roles of governments and markets in theprocesses of trade and growth. Indeed, industrial policy seems to be back in fashion—or, at least, talking about it is.But a renewed “activism” by government in the trade and growth agenda need not mean a return to old-stylepolicies of import substitution and “picking winners.” Instead, it may mean a stronger focus on competitiveness byunlocking the constraints to private sector–led growth. This note discusses the renewed role of government in tradeand growth policy from the competitiveness angle, and it suggests some priorities for the new competitiveness agenda.

POVERTY REDUCTION

AND ECONOMIC MANAGEMENT

NETWORK (PREM)

Debt Management: Now the Difficult Part Sudarshan Gooptu and Carlos A. Primo Braga1

The first years of the 21st century were characterized by more prudent macroeconomic policies in the developing world, the positive impact of debt relief on low-income countries (LICs), and positive growth trends for the world economy, despite the puncturing of the high-tech “bubble” in OECD countries. Until the eve of the financial crisis, many emerging economies were able to reduce the vulnerabilities of their debt portfolios and debt management was being carried out under favorable circumstances. Average maturities increased, reflecting increases in the maturities of new debt issuances, and rollover risks declined. Moreover, the increased availability of local currency financing, reflecting the development of domestic capi-tal markets, and the globalization of the corporate sector in emerging economies underscored the changing landscape of development financing.

The current global financial crisis is changing this landscape once again. Since 2007, the world economy has slowed signifi-cantly: global output declined 0.6 percent (a 3.2 percent con-traction in advanced economies) in 2009, and although the global economy is expected to return to a positive growth path in 2010 (4.2 percent), future prospects remain uncertain (World Bank 2010). Moreover, advanced economies are ex-pected to face large public debts, rising real interest rates, and slower growth. The International Monetary Fund (IMF), for example, projects that annual gross domestic product (GDP) potential growth rates in advanced countries will be about a half percentage point less, on average, than precrisis levels if public debt is not lowered (IMF 2010a).

There is broad consensus that many dangers lie ahead in terms of the sustainability of the recovery, including challenges in implementing exit strategies from the massive government interventions that have taken place since 2008 (Primo Braga 2010). Despite the first signs of attenuation of the crisis in the third quarter of 2009, economic indicators still point to signifi-cant levels of unemployment and social distress around the world. This crisis has not yet evolved into a systemic sovereign debt crisis,2 however, the rapid accumulation of public debt and growing fiscal imbalances in many countries, as well as histori-cal precedent, suggest that the possibility cannot be ignored.

Interestingly enough, for the first time in over 40 years, con-cerns about debt sustainability seem to be concentrated in high-income economies. It is true that developing economies entered this crisis in a much stronger financial position, reflect-ing better macroeconomic policies, improved debt manage-ment practices, and, in the case of heavily indebted poor coun-tries, debt relief. Still, the severity of the crisis and the growing tensions in public debt markets in Organisation for Economic Co-operation and Development (OECD) countries emphasize that there is no room for complacency. This note documents evolving debt and fiscal trends and identifies some of the emerg-ing challenges faced by debt managers in developing markets.

Emerging Issues

Figure 1 captures debt and fiscal variables for selected advanced and emerging countries in 2007, immediately before the onset of the current financial crisis. As illustrated by the location of a large number of economies in the right quadrant of the graph—with fiscal surpluses and debt-to-GDP ratios below 60 percent—many countries were able to respond to the crisis from a posi-tion of strength. Figure 2 shows that by the end of 2009, the picture had changed significantly, with many countries now dis-playing fiscal deficits of more than 5 percent and debt-to-GDP

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ratios well above 60 percent. In other words, the scope for fur-ther expansionary interventions, be it on the monetary or on the fiscal fronts, is now much more limited. The situation is par-ticularly complex in some of the countries in the eurozone,

Source: Authors’ calculations based on IMF 2010a.Note: Debt measures for República Bolivariana de Venezuela are external debt (all other countries are measured in general government gross debt).

Figure 1. General Government Balance and General Government Gross Debt, 2007 (% of GDP)

where existing social entitlements and low productivity growth prospects make debt-to-GDP reduction exercises quite difficult.

Confidence in the strength of the recovery of advanced economies remains a question and the process of delever-aging of the private sector in many OECD countries is on-going. Accordingly, although the debate about the proper timing to unwind public interventions remains fierce (see, for example, Hannoun [2009]); it was clear by May 2010 that developments in European markets had increased the need for credible plans for fiscal consolidation.

Given the growing levels of debt, several questions emerge, including: What if the fiscal stimulus programs were to continue for two to four years more than currently projected? What will happen to public debt if there is no adjustment to the primary fiscal balances in the medium term? What is the degree of fiscal adjustment necessary for countries to either reduce their public debt stock to his-torical average levels or stabilize it around a certain fiscally sustainable target? If the adjustment is deemed too large to be feasible from a political economy standpoint, what will be the effect of a more gradual adjustment on debt sustain-ability? While this paper does not aim to answer these im-portant questions, some preliminary findings have already started to appear in the literature. A recent study conduct-ed on a sample of 20 middle-income countries (MICs), for

example, shows that the fiscal policy responses in 2008 and 2009 and the related external financing packages have contrib-uted to higher public and external debts in several countries (figure 3; Van Doorn, Suri, and Gooptu forthcoming).

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Source: Authors’ calculations based on IMF 2010a.Note: Debt measures for República Bolivariana de Venezuela are external debt (all other countries are measured in general government gross debt).

Figure 2. General Government Balance and General Government Gross Debt, 2009 (% of GDP)

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Hypothetical scenarios that were examined in this study—to assess the staying power of the fiscal stimulus programs in the sample countries—suggest that if a growth recovery is not sustained in advanced countries and the global outlook re-mains fragile, the primary balances that most of these coun-tries will need to run in the medium term will be significantly higher than what they have carried in the recent past. More-over, if the prolonged downturn leads to even more debt accu-mulation, if rising international interest rates, foreign exchange risk, and a continuous repricing of risk of sovereign credits characterize the new postcrisis reality, it will become more dif-ficult for several countries to reach their respective debt targets (figure 4).

In the case of LICs, the global financial crisis has also impact-ed their debt positions and associated vulnerabilities. This group of countries is likely to face tighter external financing—dwindling foreign direct investment, commercial lending, and (potentially) smaller aid flows—and contractions in export in-come. Several of the LICs have increased their reliance on do-mestic debt to close their widening fiscal financing needs. A recent joint World Bank and IMF study reviewed debt sustain-ability analyses (DSAs) for 32 LICs for which pre-and postcrisis DSAs were available. Like the MICs, the external and fiscal fi-nancing requirements of LICs also increased after the global crisis (World Bank and IMF 2010). In addition, their future lev-els of GDP, exports, and fiscal revenues are expected to be per-manently lower as a result of this global shock. The World Bank and IMF (2010) conclude that, on average, LIC debt ratios are also expected to deteriorate in the near term, particularly for public debt.

Meanwhile, the surge in gross borrowing needs of advanced economies—from US$9 trillion in 2007 to roughly US$16 tril-lion in 2009, with an expected similar level for 2010—is add-ing to the financial stress under which public debt is being managed (Blommestein and Gok 2009). If general govern-ment debt ratios in advanced economies are to be brought back to the precrisis average of 60 percent of GDP by 2030, it will require an 8 percent swing in the fiscal balance from an average deficit of 4 percent in 2010 to a fiscal surplus of 4 per-cent by 2020 and then maintenance of this surplus for the en-suing decade (Lipsky 2010). The growing level of public debt suggests that the spread between long-term and short-term in-terest rates is likely to increase over time, even though quantita-tive easing may delay such a trend. For developing countries, this is likely to imply higher borrowing costs and shortening maturities on new borrowings. Developing countries will be impacted by these developments not only through the cost of capital and reduced global economic dynamism, but also be-cause the massive public interventions of the last two years—in the absence of an orderly unwinding—will foster asset bubbles and speculative waves. Exchange rate misalignments can also contribute to the tensions in the financial system. Speculative attacks against currencies in highly leveraged economies can add to risks by further contributing to the deterioration of pri-vate sector balance sheets and may evolve into sovereign debt crises. All of these risks need to be managed on a continuous basis, and risk management should be accompanied by credi-ble, medium-term debt management practices and financing strategies to support the fiscal spending and postcrisis recovery efforts.

Figure 3. Increased External and Public Debt Levels in MICs (% of GDP)

Sources: Van Doorn, Suri, and Gooptu forthcoming; IMF 2010b.

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Adopting a Sovereign Balance Sheet Approach

This review of debt and fiscal paths underscores the impor-tance of refocusing on sovereign debt management. The tradi-tional, external DSAs will continue to be an important ingredi-ent of the analytical toolkit, but they need to be complemented by a closer examination of public debt (encompassing both do-mestic and external debt) and medium-term fiscal sustainabil-ity analyses by the respective authorities on a regular basis. Spe-cial attention will now need to be given to managing not only the composition of sovereign debt portfolios, but also the ex-panding array of contingent liabilities incurred by government responses to the crisis.

Conventional DSAs for low- and middle-income countries highlight country-specific characteristics, focusing on the na-ture and size of shocks that affect a country’s debt and debt service profile, and the potential for fiscal response to these shocks, given fiscal space at any point in time. However, the les-sons from the East Asian financial crisis of the late 1990s and the current global financial crisis emphasize the need for DSAs to consider the wider liabilities of the public sector. Countries with high sovereign debt ratios, large fiscal deficits, and growing contingent liabilities are especially at risk of contagion because heightened market uncertainties in international capital mar-kets lead to a flight to quality. Investors are wary of rising inter-est rates across countries and the prospect of stringent fiscal consolidation that lies ahead.

The ability of governments to make payments on their debt obligations (domestic and external) and minimize future risks to their public finances can be enhanced by implementing a credible, medium-term debt management strategy and creat-ing an institutional capability to monitor and manage contin-gent liabilities. To this end, a sovereign balance sheet approach to debt management will be useful in managing the financial and credit risks associated with carrying out regulatory and macroeconomic functions. This approach focuses on the risk characteristics of the assets and obligations that the govern-ment manages, and the types of financial flows associated with them. In practice, this entails an examination of the cash flows generated by the key assets (or asset classes) of the government and monetary authorities to see how sensitive they are to changes in real interest rates, currency movements, and shifts in terms of trade (Wheeler 2004, chapter 4).

Conclusion

The coordination of exit policies from the massive fiscal inter-ventions of the last few years will pose major challenges for gov-ernments around the world. While simultaneous fiscal expan-sion helped thwart the global economic slowdown of 2008–9, the story is more complicated when it comes to unwinding these fiscal programs and moving toward a path of fiscal con-solidation. Simultaneous fiscal consolidation is likely to con-strain the dimensions of economic recovery, at least in the ini-tial stages of fiscal retrenchment. If the fiscal consolidation is

Sources: Van Doorn, Suri, and Gooptu forthcoming; IMF 2010b.Note: Assumptions: debt target is 40 percent of GDP by 2020 if the country’s gross public debt was above 40 percent of GDP at end-2009, or to stabilize debt at its end-2009 level if debt was below 40 percent of GDP at end-2009. Adjustment is the difference between the required primary balance to reach the debt target under the two hypothetical scenarios and the country-specific historical primary balance (that is, average of 1996–2001 for countries marked with an asterisk; average of 2002–07 for all other countries). For Chile, Indonesia, South Africa and Nigeria the historical primary balance is larger than the required primary balance, so, in principle, no unprecedented fiscal adjustment will be needed in these countries.

Figure 4. Required Postcrisis Primary Balances Diverge Significantly from Historical Levels (% of GDP)

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focused on stabilizing entitlement spending–to-GDP ratios (a must for countries facing demographic pressures) and letting discretionary interventions expire, the required adjustment can be achieved. However, the difficulties of dealing with enti-tlement reforms (for example, pension and health reforms) and the temptation to postpone adjustment because of contin-ued weaknesses in the private sector (reflecting the ongoing deleveraging process) exacerbate the challenges of fiscal con-solidation.

Markets will be closely monitoring the evolution of fiscal po-sitions around the world, and economies that are not able to implement consolidation plans will face increasing difficulties in financing their debts. In this context, international coordina-tion (and monitoring) can play a positive role in helping en-hance the credibility of national strategies and by giving “am-munition” to financial authorities to resist short-term pressures associated with political cycles.

Finally, because of the increasing importance of public infra-structure spending in renewing the growth process through the issuance of sovereign guarantees and/or by the reliance on pub-lic-private partnerships, the role of contingent liabilities re-quires renewed attention. Contingent liabilities may pose sub-stantial balance sheet risks for governments, as demonstrated by the East Asian financial crisis in 1997. When contingent li-abilities are realized, they become a potential source of future call on tax revenues and can be a major factor in the build-up of public sector debt. Experience shows that contingent liabilities associated with capital injections into the banking system or in the recapitalization of public sector enterprises are particularly important (Wheeler 2004, chapter 6). The rapid build-up of public debt that has occurred in advanced countries, and is now occurring in MICs, is highly correlated with these “hidden deficits.”

Experiences of many countries, such as Colombia, Hunga-ry, New Zealand, South Africa, and Sweden, suggest that a gov-ernment’s exposure to contingent liabilities can be substantial-ly reduced through better, more complete monitoring and reporting; better risk-sharing arrangements; improved gover-nance and regulatory regimes; and sound economic policies that minimize the possibility of these contingent liabilities from being realized in the first place. Debt managers around the world will have to pay close attention to the evolution of contingent liabilities and their impact on public debt to avoid surprises.

Notes

1. This paper relies extensively on Primo Braga (2010) and Van Doorn, Suri, and Gooptu (forthcoming). 2. There is extensive literature on the correlation between banking crises and sovereign debt crises. See, for example, Rein-hart and Rogoff (2009).

About the Authors

Sudarshan Gooptu is acting director and sector manager in the Economic Policy and Debt Department and Carlos Alberto Primo Braga is acting vice president and corporate secretary of the World Bank Group, Washington, D.C.

References

Blanchard, Olivier, Giovanni Dell’Ariccia, and Paolo Mauro. 2010. “Rethinking Macroeconomic Policy.” International Monetary Fund Staff Position Note, SPN/10/03, Washington, DC

Blommestein, Hans J., and Arzu Gok. 2009. “The Surge in Borrowing Needs of OECD Governments: Revised Estimates for 2009 and 2010 Outlook.” OECD Journal: Financial Market Trends (2).

Hannoun, Hervé. 2009. “Unwinding Public Interventions after the Crisis.” Speech delivered at the IMF High Level Conference, “Unwinding Public Interventions—Preconditions and Practical Considerations,” December 3, Washington, DC.

Horton, Mark, Manmohan Kumar, and Paolo Mauro. 2009. “The State of Pub-lic Finances: A Cross-Country Fiscal Monitor.” International Monetary Fund Staff Position Note, SPN/09/21, Washington, DC.

IMF (International Monetary Fund). 2010a. Fiscal Monitor: Navigating the Challenges Ahead. Fiscal Affairs Department.

———. 2010b. World Economic Outlook. April, Washington, DC.Lipsky, John P. 2010. “Fiscal Policy Challenges in the Post-Crisis World.”

Speech delivered at the China Development Forum, March 21, Council on Foreign Relations publication, www.cfr.org/publication/21712/imf.html.

Primo Braga, Carlos A. 2010. “The Great Recession and International Policy Coordination.” Paper prepared for the First International Research Con-ference of the Reserve Bank of India, “Challenges to Central Banking in the Context of Financial Crisis,” Mumbai, February 12–13.

Reinhart, Carmen M., and Kenneth S. Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press.

Van Doorn, Ralph, Vivek Suri, and Sudarshan Gooptu. Forthcoming. “Do Middle-Income Countries Continue to Have the Ability to Deal with the Global Financial Crisis?” World Bank Staff Policy Research Working Paper.

Wheeler, Graeme. 2004. Sound Practice in Government Debt Management. Washington, DC: World Bank.

World Bank. 2010. Global Monitoring Report: The MDGs after the Crisis. Wash-ington, DC.

World Bank, and IMF (International Monetary Fund). 2010. “Preserving Debt Sustainability in Low-Income Countries in the Wake of the Global Crisis.” Washington, DC, http://www.imf.org/external/np/pp/eng/2010/04011 0.pdf.

The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise.

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