debt sustainability thus requires looking at a host of complex variables, including contingent liabilities, the micro-foundations for sustainable economic growth and the vulnerability to exogenous shocks.

If a country is experiencing public debt sustainability problems, it can safely be assumed that the impact on growth is negative—from the growth perspective, optimal debt levels are likely to be lower than sustainable debt. Moreover, the causality is more likely to flow from unsustainable public debt dynamics to low growth than vice-versa; a country with low growth potential is unlikely to attract market financing to begin with. The channels through which public debt affect growth include uncertainty about future inflation and taxation created by the debt overhang, crowding out and fiscal space problems, whereby high interest payments squeeze out public investment and social spending.

Concerns about fiscal space have led to the argument that countries which cut public infrastructure investments as part of fiscal adjustment could end up hurting the GIBC by reducing long-run growth. This argument raises at least four sets of issues: How do the economic and financial rates of return on infrastructure projects compare with the government’s borrowing cost? Is there scope for reducing wastage in government spending, thereby increasing public saving, and can expenditure composition be better aligned with growth? Can the microeconomic foundation for growth be strengthened through structural reform? What are the market signals on default and devaluation risk?

There are a priori reasons to believe that countries for which the markets are signaling an unsustainable debt situation need to address this first even if the short-run impact on growth is negative. As noted above, overborrowing is more easily explained by political economy than economics; this is reinforced by the debt intolerance argument. Both political economy and debt intolerance lead to similar conclusions: that if fiscal deficits are shaped by politics and weak fiscal and financial institutions, a presumption of wasteful spending and poor public investment project selection would be reasonable. In this case, fiscal and institutional reform would need to precede any expansion of public investment spending.

A puzzling question remains: Why does the market allow overborrowing, especially by debt intolerant countries? To the extent that moral hazard fueled by expectations of an IFI bailout is a possible explanation, this is likely to have diminished after the Russian crisis of 1998 and the Argentine crisis which began in 2001. In the Russian case, only about a fourth of the IFI-led rescue package of $22.6 billion was disbursed before being halted less than a month after being approved, notwithstanding expectations that possession of nuclear weapons implied that Russia could not be allowed to fail. Nonresident investors suffered an estimated 70 percent loss of the face value of their holdings of ruble-denominated treasury bills and bonds as a result of the devaluation and default. And the agreement reached with the London Club in August 2000 involved a 50 percent write-off in present value terms of the $31.8 billion Russia owed. More recently, the conclusion in June 2005 of the Argentine debt restructuring deal at 34 cents on the dollar in present value terms involving $100 billion in bonds defaulted upon in December 2001 has inflicted a loss of $67 billion on the bondholders.<sup>49</sup> If the experience with financial liberalization had been in line with the predictions of neoclassical growth theory, and if the experience with sovereign debt during the 1990s had been

> 49 _Financial Times_ , 3 June 2005, “Argentina closes door on Dollars 100bn debt exchange”, by Adam Thomson.

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