WPS3674

# PUBLIC DEBT IN DEVELOPING COUNTRIES: HAS THE MARKET-BASED MODEL WORKED?

## Indermit Gill and Brian Pinto

### _Abstract_

Over the past 25 years, significant levels of public debt and external finance are more likely to have enhanced macroeconomic vulnerability than economic growth in developing countries. This conclusion applies not just to countries with a history of high inflation and past default, but also to those in East Asia, with a long tradition of prudent macroeconomic policies and rapid growth. We examine why with the help of a conceptual framework drawn from the growth, capital flows and crisis literature for developing countries with access to the international capital markets ('market access countries' or MACs). We find that, while the chances of another generalized debt crisis have receded since the turbulence of the late 1990s, sovereign debt is indeed constraining growth in MACs, especially those with debt sustainability problems. Several prominent MACs have sought to address the debt and external finance problem by generating large primary fiscal surpluses, switching to flexible exchange rates and reforming fiscal and financial institutions. Such country-led initiatives completely dominate attempts to overhaul the international financial architecture or launch new lending instruments, which have so far met with little success. While the initial results of the countries’ initiatives have been encouraging, serious questions remain about the viability of the model of market-based external development finance. Beyond crisis resolution, which has received attention in the form of the proposed sovereign debt restructuring mechanism, the international financial institutions may need to ramp up their role as providers of stable long-run development finance to MACs instead of exiting from them.

### World Bank Policy Research Working Paper 3674, August 2005

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._ Both authors are at the World Bank. This paper is drawn from a larger work program on sovereign debt and development in the Economic Policy and Debt Department, Poverty Reduction and Economic Management Anchor, of the World Bank. An abridged version will be appearing in a volume dedicated to an April 2005 conference on “The Financial Sector Post-Crisis: Challenges and Vulnerabilities”, organized jointly by the World Bank and The Brookings Institution. We thank Joshua Aizenman, Amar Bhattacharya, Nina Budina, Craig Burnside, Christophe Chamley, Ajay Chhibber, Gautam Datta, Norbert Fiess, Jim Hanson, Olivier Jeanne, Himmat Kalsi, Homi Kharas, Gobind Nankani, Vikram Nehru, Anand Rajaram, Luis Serven, John Williamson, Holger Wolf, and many others for useful comments or contributions.

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