Issues in External Debt Management and Sustainability for the Kyrgyz Republic

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Issues in External Debt Management and
Sustainability for the Kyrgyz Republic
Presentation at the National Workshop on
External Debt Management in an Era of Rapid
Globalization on October 28, 2004

• Dr HK Pradhan
• Professor of Finance and Economics
• XLRI Jamshedpur
• India 831 001

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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

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External Debt of the Kyrgyz
Source Global Development Finance, 2004, and
NBKR for 2003
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Kyrgyz Rep has by far the heaviest debt burden
within the group of CIS-7(Figures are for 2002)
Source Global Development Finance 2004
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External Debt Ratios of Selected Countries (,
averages for 200002)
Source Global Development Finance, 2004
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• 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)

• HIPC debt sustainability thresholds are
• NPV of debt-to-export ratio exceeded 150
• NPV of debt-to-fiscal revenue ratio exceeded 250

Source IMF and World Bank, Poverty reduction,
Growth and Debt Sustainability in Low Income CIS
Countries, February 4, 2002
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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?

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• Kyrgyz Rep Macroeconomic Trends Since the Debt
  Problems

Source ADB, Economist, and National Sources
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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

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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

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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

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External Debt Outstanding of Kyrgyz Republic
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External Debt of the Kyrgyz Republic
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Terms of New Commitments to Kyrgyz Republic All
Creditors (Average of the year)
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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.

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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 countrys 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.

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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 governments ability to generate
  fiscal resources, as not all export earnings are
  in the hands of the public sector.

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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.

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Indicators of Solvency for the Kyrgyz Republic
Debt Service/Exports
Interest Service Ratio
External Debt/Exports
External Debt/GDP
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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

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Indicators of liquidity for the Kyrgyz Republic
Reserves/Imports (months)
Reserves/Short Term Debt
Short term Debt/Total Debt
Interest Payments/Reserves
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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 countrys
  economic policies and institutions

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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

Source Debt Sustainability in Low-Income
CountriesProposal for an Operational Framework
and Policy Implications, the IMF and the World
Bank, February 3, 2004
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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

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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

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Sustainability conditions

• Debt Sustainability is a dynamic concept
• Relates to the debtors 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.

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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

• Foreign Financial
• Interest rates
• Exchange rates
• Currency crisis
• Commodity prices
• Capital flows

• Domestic Financial
• Budget deficit
• Savings-Investments
• revenue generation, spending, tax policy
• Money supply, Inflation

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Use other analytical techniques

• duration
• sensitivity/scenario analysis
• stress test,
• currency risk analysis
• Value at risk analysis (for reserves)
• cash flows forecasting, etc

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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

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Macroeconomic stability is the key to external
debt management
Maintain macro economic stability on a
sustainable basis Ensure monetary, fiscal and
exchange rate policy consistency. Pay careful
attention to the growing fiscal deficits of the
public sector Current account deficit must be
sustainable
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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) ß D

BOP
Govt
Debt
Private
External debt acts as a balancing act in meeting
one or all of the THREE GAPS, depending on the
country's monetary, fiscal, trade, exchange rate
and investment regimes
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Monitor the level of domestic debt
ETD/GDP DD/GDP

• 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

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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

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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

Selected interest rates in Kyrgyz Rep
1999 2000 2001 2002 2003 Interest
Rate T bill rate 47.2 32.3 19.1
10.2 7.2 Deposit rate 35.6 18.4 12.5
5.9 5.0 Lending rate 60.9 51.9 37.3
24.8 21.7 Lombard rate 51.6 32.8 10.7
6.8 4.0 Inflation Rate 35.9 18.7 6.9
2.1 3.0 Source IMF, IFS
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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

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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

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Foreign Exchange Reserves
International Reserves minus gold

• 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

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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).

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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

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Currency Risk Management

• Foreign currency debts are exposed to exchange
  rate and interest rate risks.
• Commodity price fluctuations add further risk by
  affecting the ability to service the debt.

• 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

• In view if the market risks associated with the
  foreign currency borrowings there is a need to
  adopt appropriate risk management techniques

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Currency Risk An Example

• Effect of exchange rate movements between / on
  a borrowers net income, when appreciates from
  1.03/ to 1.12/ during the year

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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

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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

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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.

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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

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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

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Debt management framework

• Use the worlds 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

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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

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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

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Successful debt management depends on good policy

• Effective debt management depends to a large
  extent on the countrys 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?

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"National Debt is like a toothache it is best
not to have one, but if you have got one, it is
next best to get rid of it as soon as you
can".E.H. Young, The System of National
Finance,1915
Thank You