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In a context of highly favorable external conditions, especially for commodity exporters, Latin America's fiscal and external fundamentals improved markedly over the last decade. But, how dependent are these gains on a continuation of such conditions? To address this question, we develop a debt sustainability framework that integrates econometric estimates of the effect of global factors on the main domestic variables that drive debt dynamics, and use it to forecast debt trajectories under less favorable external scenarios.
Over the last decade, and especially during the period 2003-08, Latin America experienced a remarkable improvement in key macroeconomic fundamentals, reducing public and external debt ratios, accumulating foreign assets, strengthening fiscal and external current account balances, and reducing debt structure vulnerabilities. While prudent policies played an important role, a growing view is that much of these gains reflected the effect of a highly favorable external environment, characterized by strong external demand, a commodity price boom, and benign external financing conditions (see Inter-American Development Bank, 2008; Izquierdo and others, 2008; and Osterholm and Zettelmeyer, 2008). Thus, with prospects of a less favorable global environment ahead, the strength of the region’s fundamentals remains an open question. In particular, have countries strengthened their fiscal and external positions enough to guard themselves from a weakening of external conditions? Our recent paper (Adler and Sosa, 2013) sheds light on this issue, by studying how fiscal and external accounts of Latin American countries would be affected by less favorable global conditions.
A decade of falling public debt
Between 2003 and 2008, Latin America experienced a remarkable decline in public debt ratios (Figure 1), averaging 30 percentage points of GDP. And even though this steep trend came to a halt in 2009—as the region felt the effects of the global financial crisis—public debt levels today remain quite low in historical perspective. These improvements were broad-based, but the driving forces varied, and countries can be broadly classified in two groups, based on how they managed their rapidly rising revenues (Figure 2).
In Brazil, Chile, Colombia, Mexico, Paraguay, Peru, and Uruguay (the ‘LA7’ group) the drop in public debt was mainly driven by robust primary surpluses and rapid real GDP growth. The former reflected prudent fiscal policies, with public expenditure growing at a slower pace than booming revenues—which came primarily from the commodity sector—and slower than potential output. This fiscal restraint was relaxed somewhat after 2008.
The rest of Latin America (Argentina, Bolivia, Ecuador, and Venezuela) also experienced a remarkable drop in public indebtedness, although from much higher starting levels. In their case, the decline was largely driven by strong output growth (above long-term potential, except in Bolivia) and negative real interest rates. While primary surpluses also played an important role in reducing debt ratios, the extent of savings of the booming revenues was more limited, as evidenced by a path of public expenditure that largely outpaced output, and even more so potential output.
External debt ratios exhibit similar patterns, falling by more than 30 percentage points of GDP, on average, during 2003–08, and being accompanied by a sizable increase in foreign assets. Since 2009, external debt ratios have remained broadly stable at about 30 percent of GDP.
External factors and debt sustainability
The remarkable drop in Latin America’s debt ratios highlights not only the extent of favorable external conditions but also the region’s sensitivity to those. Precisely because of this, and despite having achieved relatively low debt levels in most countries, whether the region’s fundamentals are strong enough to withstand a deterioration of the global environment remains an open question.
Our paper sheds light on this issue by developing an integrated framework for debt sustainability analysis (DSA) that incorporates (VAR) econometric estimates of the effect of exogenous external variables on key domestic variables that drive public and external debt dynamics (Figure 3). This integrated framework allows us to examine debt dynamics under alternative global scenarios; and consequently assess the strength of current fiscal and external positions. We implement the framework for the 11 Latin American economies mentioned above, estimating each VAR model using quarterly data for the period 1990–2012.
This work entails a methodological contribution to existing DSA frameworks (see IMF 2002, 2005, and 2011), as the latter are not well equipped to assess how changes in external conditions affect debt dynamics, given their lack of linkages between global and domestic variables. It also adds to a growing literature seeking to incorporate the joint stochastic properties of shocks (Celasun et al, 2006; Cherif and Hasanov, 2012; Favero and Giavazzi, 2007 and 2009; Kawakami and Romeu, 2011; and Tanner and Samake, 2008), which has not yet examined the role of external shocks.
A key feature of our framework is that primary balances and debt levels are included in the VAR to allow feedback effects from these variables to the other domestic variables. In our analysis, primary balances are projected by linking fiscal revenues to commodity prices and output growth, as well as evaluating different exogenous expenditure rules.
Scenarios and policy responses
We focus on four—two temporary and two persistent—adverse global scenarios, defined as deviations of the key global variables from the IMF’s WEO baseline projections:
i. A temporary financial shock, with a spike of the VIX similar to the one observed following the Lehman event.
ii. A temporary real shock, entailing lower global growth and commodity prices.
iii. A protracted global slowdown, with lower global growth and commodity prices, and a higher level of uncertainty.
iv. A tail event, with an impact on all global variables of magnitudes similar to those observed after the Lehman event, but somewhat more persistent.
Debt trajectories under the different scenarios are constructed by adding the estimated impact of these external shocks to the baseline projections. In this regard, it is worth noting that WEO baseline projections entail a further, but slight, decline in public and external debt ratios through 2017, as external conditions are expected to remain relatively favorable.
A key driver of public debt dynamics is the primary balance, which is determined not only by the behavior of endogenous variables (output and commodity-related revenues) but also by discretionary policies. We consider two different policy responses: (i) neutral fiscal policy, with expenditure growing at the pace of potential GDP—thus only allowing for automatic stabilizers to operate; and (ii) countercyclical fiscal policy, with expenditure outpacing potential GDP by a margin that is proportional to the gap between actual and potential GDP growth. Exploring these alternative expenditure rules allows us to assess the extent to which, under each scenario, fiscal buffers are (i) appropriate to respond with fiscal stimulus, without jeopardizing debt sustainability, (ii) just enough to allow automatic stabilizers to work, or (iii) whether a fiscal tightening is necessary to ensure debt sustainability.
The results suggest that most countries in Latin America should be in a position to deploy (expansionary) countercyclical fiscal responses under temporary shocks (not shown here), without raising debt sustainability concerns. On the other hand, fiscal space to deal with more persistent shocks appears to be more limited, and countries can be broadly classified into three groups, based on their relative levels of public debt and primary balance gaps reached by 2017 (Figure 4):
On the external front, we find that even under the more severe scenarios, countries in the region (except Venezuela) appear to be in a position to maintain external debt sustainability (not shown here).
In sum, the application of our integrated DSA framework to Latin America provides valuable insights about the region´s vulnerability to external shocks. The results indicate that, while external sustainability does not appear to be, at this point, a source of concern, fiscal space may still be limited in several countries. These would benefit from building further fiscal space while favorable conditions last, to be in a position to actively use fiscal policy should the external environment deteriorate markedly.
Adler, G., and S. Sosa, 2013, “External Conditions and Debt Sustainability in Latin America,” IMF Working Paper 13/27 (Washington: International Monetary Fund).
Celasun, O., X. Debrun, and J.D. Ostry, 2006, “Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A ‘Fan-Chart’ Approach,” IMF Working Paper 06/67 (Washington: International Monetary Fund).
Cherif, R., and F. Hasanov, 2012, “Public Debt Dynamics: The Effects of Austerity, Inflation, and Growth Shocks,” IMF Working Paper 12/230 (Washington: International Monetary Fund).
Favero, C., and F. Giavazzi, 2007, “Debt and the Effects of Fiscal Policy,” NBER Working Paper No. 12822 (Cambridge, Massachusetts: National Bureau of Economic Research).
______, 2009, “How Large are the Effects of Tax Changes?,” NBER Working Papers No. 15303 (Cambridge, Massachusetts: National Bureau of Economic Research).
Inter-American Development Bank, 2008, “All that Glitters May Not be Gold. Assessing Latin America`s Recent Macroeconomic Performance,” Annual Report.
International Monetary Fund, 2002, Assessing Sustainability (Washington: International Monetary Fund). Available at: www.imf.org/external/np/pdr/sus/2002/eng/052802.pdf
______, 2005, Information Note on Modifications to the Fund’s Debt Sustainability Assessment Framework for Market Access Countries (Washington: International Monetary Fund). Available at: www.imf.org/external/np/pp/eng/2005/070105.pdf
______, 2011, Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis (Washington: International Monetary Fund). Available at: www.imf.org/external/np/pp/eng/2011/080511.pdf
Izquierdo, A., R. Romero, and E. Talvi, 2007, “Booms and Busts in Latin America: The Role of External Factors,” IADB, Research Department Working Paper No. 631 (Washington: Inter-American Development Bank).
Kawakami, K., and R. Romeu, 2011, “Identifying Fiscal Policy Transmission in Stochastic Debt Forecasts,” IMF Working Paper 11/107 (Washington: International Monetary Fund).
Osterholm, P.,and J. Zettelmeyer, 2008, “The Effect of External Conditions on Growth in Latin America,” IMF Staff Papers, Vol. 55, Number 4.
Tanner, E., and I. Samake, 2008, “Probabilistic Sustainability of Public Debt: A Vector Autoregression Approach for Brazil, Mexico, and Turkey,” IMF Staff Papers Vol. 55, No. 1.
* The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.