# **3.  FACTORS UNDERLYING CHANGES IN MAC DEBT LEVELS**

We now discuss factors explaining movements in the public debt-to-GDP ratios of prominent MACs before answering the three questions posed at the outset. This section is based on case studies for 15 “Big MACs” for which data were available (see Budina, Fiess and others, 2004).<sup>25</sup> These case studies document trends in domestic and external public debt; decompose the changes in debt-to-GDP ratios into components attributable to GDP growth, fiscal effort, exchange rate and interest rate fluctuations, and other factors (recognition of contingent liabilities, privatization, debt restructuring, etc); correlate debt dynamics with key economic policy changes; and extract lessons. Of particular interest are episodes during which debt ratios increased or decreased by large amounts. Table 3 provides a summary of decompositions for ten episodes of **reductions** in the public debt-to-GDP ratio ranging between 15 and 60 percentage points. The numbers in bold italics identify the main factors reducing the debt-to-GDP ratio. We see that:

- All episodes involve GDP growth as one of the main contributing factors

- 80 percent of the episodes involve significant primary surpluses; in only one episode, Lebanon 1991-93, were debt ratios reduced while running significant primary deficits

- 60 percent of the episodes involve real exchange rate appreciation.

While a real appreciation of the currency helps reduce the debt-to-GDP ratio especially when the share of foreign currency-denominated debt is high, this may not last if the real exchange rate becomes overvalued. Russia between mid-1995 and the meltdown of 1998 is an example. The debt-to-GDP ratio stayed roughly constant in spite of large primary deficits, zero or negative growth and high real interest rates on ruble debt. The reason was the high initial share of dollardenominated debt plus the real appreciation of the ruble during the stabilization program, which relied on fixing the nominal exchange rate. The real exchange rate became overvalued, and when it collapsed following the August 1998 crisis, the public debt-to-GDP ratio rose by a large amount (KPU (2001)). Real appreciation was also a factor in the debt-to-GDP reduction over 2000-2003; but in this case, it was an equilibrium movement as it coincided with high oil prices, rapid growth and fiscal and institutional reform.

Table 4 summarizes thirteen episodes of **increases** in the public debt-to-GDP ratios ranging between 20 and 130 percentage points. The numbers in bold italics identify the main factors raising the debt-to-GDP ratio. We see that:

- All episodes involve real interest or exchange rate changes or both as significant factors; more than 75 percent of the episodes involve interest rate increases, and more than 50 percent involve real exchange rate devaluations

- Over 75 percent of the episodes involve contingent liabilities or "other factors" such as financial sector bailouts, a major factor during the East Asian crisis of 1997-98<sup>26</sup>

- In more than half the cases, the countries ran primary _surpluses_ during these debt run-ups; only in three cases (India, Lebanon and Korea) did countries run primary deficits

- An important finding is that economic growth collapses did not play an important part in the debt-to-GDP increase episodes.<sup>27</sup>

> 25 Argentina, Brazil, Chile, México, and Jamaica in LAC, Lebanon in MNA, India and Pakistan in SAR, Poland, Russia, and Turkey in ECA, and Indonesia, Korea, Malaysia and Philippines in EAP. 26 In Table 4, “contingent liabilities” refers to those identified as such in the data.  “Other factors” also includes the impact of contingent liabilities, such as bank bailouts.  In Brazil and Mexico, “debt indexation” of local currency debt to the exchange rate, inflation or short-run interest rates also played a role. 27 In India, Lebanon, Pakistan and Philippines, GDP growth was a significant factor dampening the increase in the debt-to-GDP ratio.

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