growth performance, benefiting all generations.<sup>8</sup> A debt-financed transition involves maintaining the balance of other taxes and expenditures constant and financing the fiscal losses caused by the second pillar through explicit debt issues. National savings ratios may remain stable, but the explicit public debt increases and the burden of pension imbalances continues to be shifted to future generations.<sup>9</sup>

# **It is essential to have a sound strategy for financing the transition based on solid**

**analytical tools.** Countries should not implement pension reform without a clear evaluation of the fiscal impact of the reform based on solid actuarial projections.  The optimal financing strategy depends on initial conditions, including the overall fiscal balance, the initial and projected financial situation of the PAYG system, the stock of explicit debt and the tax burden.  Governments that are already running large deficits should not initiate a second pillar, especially in cases where there are severe imbalances in the existing PAYG system contributing to the general deficit.  In these situations, the introduction of the second pillar can only be justified when it is part of a broader reform package including strong parametric reforms to the PAYG.

# **Countries should not introduce a second pillar when the explicit government**

**debt is not perceived as sustainable** .  The sustainability of explicit government debt depends on the interest rate-output growth differential, the primary balance and the currency denomination.<sup>10</sup> These variables depend, in turn, on other fundamental factors such as savings and investment ratios, the depth of capital markets, the level and volatility of government revenues, the debt maturity structure, and the initial size of the debt to GDP ratio. Therefore, it is difficult to determine thresholds that would apply to all countries.  For example, the Maastricht agreement for EU countries entails a maximum ratio of government debt to GDP of 60 percent.  However, the evidence suggests that these ceilings are too high for most emerging economies, since half of all government defaults or restructurings since 1970 have taken place in countries with ratios of external debt to GDP below 60 percent.<sup>11</sup> Moody’s (2006) shows that investment grade countries have government debt to GDP ratios around 38 - 43 percent.  This range probably captures more accurately the market perception of debt sustainability for most emerging countries, although the assessment of

> 8 Kotlikoff (1995 and 1996) simulates the impact of different financing strategies on growth and the welfare of different generations.  Kotlikoff, Smetters and Walliser (2001) provide further simulations of the impact of different types of taxes on the welfare of different generations.

> 9 Under certain assumptions, savings ratios and the sum of the implicit pension debt and the explicit debt may remain stable as a share of GDP, but if the pre-reform situation entailed a bias against future generations this bias is maintained.

> 10  IMF (2003) and Celasun, Debrun and Ostry (2006) propose a sustainability condition that depends on the interest rate-output growth differential and a parameter of the government’s reaction function.  For the case of emerging economies, Hausmann (2003) and Hausmann and Velasco (2005) argue that governments’ inability to borrow at long maturities and fixed rates in domestic currency forces them to opt for hard currency or short-term domestic currency debt, which makes debt service sensitive to interest rate and real exchange rate shocks. Consequently, the sustainability of public debt is also affected by its currency denomination.

> 11 Reinhart, Rogoff and Savastano (2003).

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