<mark>We look at the one year of history provided, namely, 2021 (Exhibit A contains the DSA). 1. Change in d during 2021 was -3.3 percentage points of GDP, that is, d − d</mark> −1<sup><mark>= -3.3, so with d in 2021</mark></sup> <mark>at 255.4, d in 2020 was 255.4 + 3.3 = 258.7.</mark> tt tt <mark>2. pd for 2021 = 5.6.</mark> <mark>3. ADD (effect of interest rates, growth rates and exchange rates) = -3.3.</mark> <mark>4. Other identified flows = 0.0.</mark> <mark>5. Residual = 1 – (2+3+4) = -3.3 – (5.6 – 3-3 + 0) =-5.6 (the actual change in d was 5.6 percentage points of GDP less than that predicted by the components).</mark> <mark>The underlying debt dynamics are driven by 2 and 3 above, namely, pd and ADD. We now look at ADD. According to Exhibit A, the “real interest rate and relative inflation” contribution was 2.1, the “real growth rate” contribution was -5.4 and the “real exchange rate” contribution was zero. We take each in turn:</mark> (i) Real interest rate contribution = −1<sup>. The “Memo” in the DSA tells us that the “effective interest</sup> (1 ) rr <mark>rate” (nominal interest rate) was 0.6% in 2021 and inflation was -0.2%, so that 1+r = (1+0.006)/0.998, or</mark> +gg ddtt <mark>rate” (nominal interest rate) was 0.6% in 2021 and inflation was -0.2%, so that 1+r = (1+0.006)/0.998, or r=0.8%. With g=2.1% and d in 2020 (t-1) at 258.7, this puts the “real interest rate” contribution at 2.03, which roughly equals the “real interest rate and relative inflation” contribution of 2.1 shown in Exhibit A, implying the relative inflation contribution was zero.</mark> <mark>Notice also that the “real exchange rate” contribution was also zero for 2021. This is not surprising: recall from Note 4 that the relative inflation and real exchange rate contributions apply only when there is borrowing in foreign currency.</mark> **<mark>The Japanese government, in common with governments in most, if not all, AEs, borrows only in the local (home) currency. This crucial difference between AEs and EMs raises the question of whether a common DSF for both sets of countries makes sense, a topic we return to below.</mark>** (ii) Real growth contribution = −g −1<sup>. The “Memo” in the DSA tells us g = 2.2% for 2021, so that the</sup> (1 ) <mark>real growth contribution was (-0.021/1.021) X 258.7 = -5.32, compared to -5.4 in Exhibit A.</mark> +gg ddtt <mark>Another crucial difference between AEs and EMs pertains to the vulnerability to sovereign debt crises. For an EM to have a government debt-to-GDP ratio of 255%, as in Japan, is virtually unthinkable. However, Japan has been able to avoid a crisis or even a major selloff in its Japanese Government Bonds (JGBs) in spite of repeated predictions of crisis, leading to the shorting of JGBs being described by Wall Street traders as a ‘widow-maker trade’, that is, a trade that could result in a catastrophic wipeout.</mark><sup>5</sup> <mark>An important reason the short sale may fail is the central bank, Bank of Japan in this case, acts to prop up the price of the security either by buying it or through other means, such as taxes on short sales.</mark> <mark>While there are many factors that could explain the resilience of Japan to a sovereign debt crisis (including high levels of foreign exchange reserves and net foreign assets) compared to an EM with the same debt levels—a topic beyond the scope of this note—the mantra that it is unwise to bet against a central bank in a major AE would not apply to EMs in general. This calls for a different set of yardsticks in gauging the vulnerability of an EM to a debt crisis compared to an AE: an EM is likely to have much less monetary policy space than an AE.</mark>

> 5 Short-selling, or shorting, typically involves borrowing a security that is considered to be overvalued with the agreement to return it plus interest to the owner after a certain period. The short-seller sells the borrowed security and banks the proceeds until the time to return the borrowed security, hoping to buy it back at a lower price and thereby make a profit.

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