# **1 Introduction**

A balloon is elastic and can expand when filled with air. Good latex balloons can contain even more air. One thing is certain however, inject more air than the capacity of that balloon and it will burst. The noise of the pop is loud and the consequences sudden.

A country’s debt is very much like a balloon. There exists a threshold beyond which a country cannot accumulate more debt lest it defaults. The problem for the economist is that each country is a different balloon, and it is up to country officials and multilateral institutions to understand a country’s capacity to accumulate debt in a sustainable manner. Many countries already have inflated balloons or sizable debts. Even though they do not necessarily need to default, it is important to understand their ability to repay debts in the face of unknown events.

Some of these debt sensitivities and vulnerabilities depend on economic fundamentals, political changes, and transparent debt accounting practices. Assuming that debt is transparently communicated and the political environment known, then policymakers can use, as best as possible, available fiscal and economic data to evaluate debt sustainability.

Using the analogy of the balloon, debt vulnerability analysis is further complicated by the environment, which is state and time dependent. First, one needs to understand the structure of debt (i.e. the balloon itself), which includes expected repayments, ownership, debt size, sensitivity to domestic economic environment, and maturity structure. Next, one needs to consider the operator of the balloon (e.g. institutions, policy makers, and politicians). Political statements and the credibility of institutions may change the fiscal policy landscape and hence influence debt sustainability. Finally, one has to consider the external environment in which the balloon floats (e.g. investor perceptions and exchange rates). Unforeseen exogenous shocks do occur and, depending on the debt structure, may have a material impact on debt sustainability. Careful debt vulnerability analysis considers all three aspects.

Reflecting on the structure of debt over the last couple of years, it is evident that public debt in IBRD and IDA countries has been rising significantly. Debt increases have been particularly acute for IBRD countries (Figure 1a) as a result of large issuance of international bonds by middle-income countries (Figure 1b).<sup>1</sup> External sovereign debt carrying variable interest rates has risen markedly in recent years. A few countries have significant and growing non-resident participation in debt. Shifts in debt composition towards foreign reliance leave countries more exposed to various shocks, such as a sharp increase in global interest rates or capital outflows followed by currency depreciation (Panizza et al. (2009)). The increase in debt also limits fiscal space, making it harder for country authorities to conduct counter-cyclical fiscal policy and requiring future resources to be diverted towards repayments.

Changes in debt composition are also followed by a reduction in the average time to maturity and higher average interest rates (Figure 2a). This leaves countries more vulnerable to liquidity shocks and debt rollover risks, although debt increases and composition changes do not necessarily imply an inevitable default. Several emerging market economies (EMEs) have increased their resilience to shocks thanks mainly to prudent policies, the 1LICs = Low Income Countries; LMICs = Lower Middle Income Countries; UMICs = Upper Middle Income Countries; EMDEs = Emerging Market Developing Economies.

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