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Introduction The Model Experiments I Experiments II Conclusions

Borrowing for Growth: Big Pushes and Debt Sustainability in Low-Income Countries

Edward F. Bu¢e (Indiana University) Andrew Berg, Catherine Pattillo, Rafael Portillo, Felipe Zanna (International Monetary Fund)

IGC Workshop on Fiscal and Monetary Policy

November 2-3, 2012

Introduction The Model Experiments I Experiments II Conclusions

Motivation

Many LICs want to—and can—borrow to …nance public investment plans

Needs are great and higher aid will likely not be enough

How much borrowing for investment should countries do, and how much is sustainable?

The IMF-WB DSF provides a framework for thinking about much of this But the linkages are not fully articulated (criticisms by Sachs, 2002, Eaton , 2002, Wyplosz, 2007.....)

Introduction The Model Experiments I Experiments II Conclusions

What We Do

Construct a dynamic model capturing most of the main mechanisms and policy issues for DSAs in LICs

The investment-growth linkages (public capital in production, ine¢ciencies in investment, absorptive capacity constraints) Di¤erent public debt …nancing schemes (concessional, external commercial, and domestic) The …scal policy reactions necessary to ensure debt sustainability

Analyze the macro e¤ects of public investment surges and trade-o¤s and potential risks associated with di¤erent …nancing schemes

Introduction The Model Experiments I Experiments II Conclusions

What We Find

Well-executed high-yielding public investment programs can substantially raise output and consumption and be self-…nancing in the long run Transition problems can be formidable when concessional …nancing does not cover the full cost of the programs Covering the gap with tax increases or spending cuts requires sharp macroeconomic adjustments, crowding out private investment and consumption

Introduction The Model Experiments I Experiments II Conclusions

What We Find

Covering the gap with

Domestic borrowing is not helpful either: higher domestic rates increase the …nancing challenge and private investment and consumption are still crowded out External commercial borrowing can smooth the di¢cult adjustments, but with poor execution, sluggish …scal policy reactions, or persistent negative exogenous shocks, it can easily lead to unsustainable debt

Introduction The Model Experiments I Experiments II Conclusions

Literature

Growth and public investment without public debt dynamics

Endogenous growth: Barro (1990), Sala-i-Martin (1992)....

LIC-speci…c: Chatterjee and Turnovsky (2007), Agenor

(2010)..... Exogenous Growth and LIC-speci…c: Adam and Bevan (2006), Berg et al. (2010).....

Debt sustainability, in advanced and emerging economies:

Bohn (1998), Ghosh et al. (2011), Greiner et al. (2005), and Mendoza and Oviedo (2004).....

Introduction The Model Experiments I Experiments II Conclusions

Outline

Introduction The Model The Policy Experiments

The Long-run Outcome The Medium-run Dynamics Risks

Conclusions and Moving Forward

Introduction The Model Experiments I Experiments II Conclusions

The Model

A real micro-founded dynamic equilibrium model of a small

• pen economy

Perfect foresight Exogenous growth at the rate g 2 sectors: traded and non-traded 3 consumption goods: a traded-domestically-produced good (cx), a traded-foreign good (cm) and a non-traded good (cn)

Introduction The Model Experiments I Experiments II Conclusions

Households

Savers are inter-temporal maximizing agents

∞

∑

t=0

βt (ct)1 1

τ

1 1

τ

where ct = "

∑

i=x,m,n

ρ

1 ǫ

i (ci,t)

ǫ1 ǫ

#

ǫ ǫ1

have access to domestic and foreign bonds (portfolio adjustment costs) Accumulate capital subject to adjustment costs

Non-Savers live check to check

Introduction The Model Experiments I Experiments II Conclusions

Firms in Traded (x) and Non-Traded (n) Sectors

Pro…t-maximizing, operating under perfect competition and ‡exible prices, and using a technology that combines labor (Li,t), private capital (ki,t), and public capital (ze

t )

qi,t = Ai,t (ze

t1)ψ (ki,t1)αi (Li,t)1αi

for i = x, n Other features (externalities), not discussed today

Introduction The Model Experiments I Experiments II Conclusions

The Government

For simplicity in the exposition g = 0 Invests (iz,t) in public capital with some ine¢ciencies (s) (Hulten, 1996, and Pritchett, 2000....) ze

t = (1 δ)ze t1 + siz,t,

with s 2 (0, 1] There are also absorptive capacity constraints (costs

• verruns), not discussed today

Introduction The Model Experiments I Experiments II Conclusions

The Government Budget Constraint (GBC)

Pt∆bt+∆dc,t + ∆dt | {z }

Borrowing

= rt1Ptbt1+rddt1+rdc,t1dc,t1 | {z }

Interest Payments

+ Pz,tiz,t | {z }

Investment

+ Tt |{z}

Transfers

htPtct | {z }

Taxes

f

• δze

t1

• |

{z }

User fees

∆dt concessional; ∆dc,t external commercial; ∆bt domestic rdc,t = rf |{z}

free-risk world rate

+ F(dt/yt + dc,t/yt | {z })

risk premium

rt = 1/β [(1 + ht+1)/(1 + ht)] [cs

t+1/cs t ]1/τ 1

Introduction The Model Experiments I Experiments II Conclusions

Fiscal Adjustment and Reaction Functions

Concessional borrowing ∆dt is exogenous Today, the …scal burden falls exclusively on h (i.e., Tt = To) Today, 2 types of …nancing schemes

Free tax adjustment: ht adjusts to satisfy GBC and not need to borrow ∆dc,t= 0 and ∆bt = 0 Constrained tax adjustment supplementing with external commercial borrowing. Cap on ht and ∆bt = 0

Introduction The Model Experiments I Experiments II Conclusions

Constrained Tax Adjustment with Commercial Borrowing

In the long run taxes adjust to cover the gap In the short/medium run

Taxes ht = Min n hrule

t

, ceilingt

• hrule

t

= ht1 + λ1(htarget

t

ht1) + λ2 (dc,t1 dtarget

c

) yt with λ1, λ2 > 0 and htarget

t

is the VAT that would be required to satisfy the GBC when ∆dc,t = 0 When ht hits the ceiling then the government is "forced" to borrow ∆dc,t

Why can debt be explosive?

Introduction The Model Experiments I Experiments II Conclusions

Experiments: Calibration to an "average" LIC

E¢ciency s = 0.6 (Pritchett, 2000) Return on public capital R = MPz(s, ψ, ...) δ = 0.25 (Dalgaard and Hansen, 2005, Foster and Briceño-Garmendia, 2010) User fees recoup 50% of recurrent costs f = 0.5 (Briceño-Garmendia et al., 2008) VAT ho = 0.15 (IMF, 2011) A front-loaded surge which in the long run reaches 3% of GDP and only 50% of it is covered by concessional loans

Introduction The Model Experiments I Experiments II Conclusions

Experiments: The Long Run Outcome

Public Investment scaling-ups may be self-…nancing in the long run, depending on structural conditions Long-run E¤ects of ∆iz of 3% of GDPo

Base Case Optimistic Troublesome

R = 0.25 R = 0.35 R = 0.1 f= 0.5 f= 1 f= 0.2 s= 0.6 s= 1 s= 0.2

Taxes (%) 16.29 12.81 18.73 Public Capital 50.00 83.33 16.67 Private Capital 13.23 27.98 2.49 Real GDP 13.45 28.50 2.48 Real Wages 13.53 28.76

• 1.24

Consumption 9.29 23.73

• 3.33

Experiments: The Medium-Run Dynamics

2 types of experiments

Free tax adjustment Constrained tax adjustment supplementing with external commercial borrowing

Free Tax Adjustment

Challenging transition even if these are good projects

5 10 15 20 25 30 10 20

Investment and Borrowing (% of GDP)

Public Investment Concessional Loans 5 10 15 20 25 30 20 40 60

Public Capital

5 10 15 20 25 30

• 5

5 10

Private Capital

5 10 15 20 25 30

• 5

5 10

Wages

5 10 15 20 25 30 1 2 3 4

Real GDP Growth (%)

5 10 15 20 25 30 40 60 80 100

Public Debt (% of GDP)

Total Concessional

Free Tax Adjustment

Challenging transition even if these are good projects

5 10 15 20 25 30 10 20

Investment and Borrowing (% of GDP)

Public Investment Concessional Loans 5 10 15 20 25 30 20 40 60

Public Capital

5 10 15 20 25 30

• 5

5 10

Private Capital

5 10 15 20 25 30

• 5

5 10

Wages

5 10 15 20 25 30 1 2 3 4

Real GDP Growth (%)

5 10 15 20 25 30 40 60 80 100

Public Debt (% of GDP)

Total Concessional 5 10 15 20 25 30 16 18 20 22

VAT Rate (%)

5 10 15 20 25 30

• 2

2 4 6

Consumption

5 10 15 20 25 30 5 10

Private Investment

Constrained Tax Adjustment

Supplementing with external commercial borrowing can smooth the transition

5 10 15 20 25 30 16 18 20

VAT Rate (%)

Free Tax Adjustment 5 10 15 20 25 30 40 60 80

Total External Public Debt (% of GDP)

5 10 15 20 25 30

• 2

2 4 6

Consumption

5 10 15 20 25 30 1 2 3 4

Real GDP Growth (%)

5 10 15 20 25 30 5 10

Private Investment

Constrained Tax Adjustment

Supplementing with external commercial borrowing can smooth the transition

5 10 15 20 25 30 16 18 20

VAT Rate (%)

Free Tax Adjustment Constrained VAT with Commercial Borrowing 5 10 15 20 25 30 5 10 15

Commercial Public Debt (% of GDP)

5 10 15 20 25 30 40 60 80

Total External Public Debt (% of GDP)

5 10 15 20 25 30

• 2

2 4 6

Consumption

5 10 15 20 25 30 1 2 3 4

Real GDP Growth (%)

5 10 15 20 25 30 5 10

Private Investment

Constrained Tax Adjustment

Supplementing with external commercial borrowing can smooth the transition

5 10 15 20 25 30 16 18 20

VAT Rate (%)

Free Tax Adjustment Constrained VAT with Commercial Borrowing 5 10 15 20 25 30 5 10 15

Commercial Public Debt (% of GDP)

5 10 15 20 25 30 40 60 80

Total External Public Debt (% of GDP)

5 10 15 20 25 30

• 2

2 4 6

Consumption

5 10 15 20 25 30 1 2 3 4

Real GDP Growth (%)

5 10 15 20 25 30 5 10

Private Investment

Introduction The Model Experiments I Experiments II Conclusions

Across the Financing Schemes

When concessional …nancing does not cover the full cost of the investment program, covering the gap with external commercial borrowing can smooth the di¢cult private sector adjustments, while reconciling the scaling ups with constraints

• n feasible increases in tax rates

Risks

...But it maybe risky if e¢ciency is lower

10 20 30 10 20 30 40 50

Public Capital (% dev from SS)

10 20 30 10 20 30 40 50

Commercial Public Debt (% of GDP)

Base Case Efficiency 10 20 30 70 80 90 100 110

Total Public Debt (% of GDP)

Risks

...But it maybe risky if e¢ciency is lower

10 20 30 10 20 30 40 50

Public Capital (% dev from SS)

10 20 30 10 20 30 40 50

Commercial Public Debt (% of GDP)

Base Case Efficiency Lower Efficiency 10 20 30 70 80 90 100 110

Total Public Debt (% of GDP)

Risks

...But it maybe risky if e¢ciency is lower

10 20 30 10 20 30 40 50

Public Capital (% dev from SS)

10 20 30 10 20 30 40 50

Commercial Public Debt (% of GDP)

Base Case Efficiency Lower Efficiency 10 20 30 70 80 90 100 110

Total Public Debt (% of GDP)

Risks

...But it maybe risky if e¢ciency is lower

10 20 30 10 20 30 40 50

Public Capital (% dev from SS)

10 20 30 10 20 30 40 50

Commercial Public Debt (% of GDP)

Base Case Efficiency Lower Efficiency 10 20 30 70 80 90 100 110

Total Public Debt (% of GDP)

Risks

...But it maybe risky if …scal adjustment is delayed

10 20 30 15 16 17 18 19 20 21

VAT Rate (%)

10 20 30 10 20 30 40 50

Commercial Public Debt (% of GDP)

Quick Tax Adjustment 10 20 30 70 80 90 100 110

Total Public Debt (% of GDP)

Risks

...But it maybe risky if …scal adjustment is delayed

10 20 30 15 16 17 18 19 20 21

VAT Rate (%)

10 20 30 10 20 30 40 50

Commercial Public Debt (% of GDP)

Quick Tax Adjustment Delayed Tax Adjustment 10 20 30 70 80 90 100 110

Total Public Debt (% of GDP)

Risks

...But it maybe risky if …scal adjustment is delayed

10 20 30 15 16 17 18 19 20 21

VAT Rate (%)

10 20 30 10 20 30 40 50

Commercial Public Debt (% of GDP)

Quick Tax Adjustment Delayed Tax Adjustment 10 20 30 70 80 90 100 110

Total Public Debt (% of GDP)

Risks

...But it maybe risky if …scal adjustment is delayed

10 20 30 15 16 17 18 19 20 21

VAT Rate (%)

10 20 30 10 20 30 40 50

Commercial Public Debt (% of GDP)

Quick Tax Adjustment Delayed Tax Adjustment 10 20 30 70 80 90 100 110

Total Public Debt (% of GDP)

Risks

...But it maybe risky if there are shocks, especially if persistent

10 20 30 85 90 95 100 105

Terms of Trade (Base = 100)

10 20 30 20 40 60

Commercial Public Debt (% of GDP)

No Shock 10 20 30 70 80 90 100 110 120 130

Total Public Debt (% of GDP)

Risks

...But it maybe risky if there are shocks, especially if persistent

10 20 30 85 90 95 100 105

Terms of Trade (Base = 100)

10 20 30 20 40 60

Commercial Public Debt (% of GDP)

No Shock Temporary TOT Shock 10 20 30 70 80 90 100 110 120 130

Total Public Debt (% of GDP)

Risks

...But it maybe risky if there are shocks, especially if persistent

10 20 30 85 90 95 100 105

Terms of Trade (Base = 100)

10 20 30 20 40 60

Commercial Public Debt (% of GDP)

No Shock Temporary TOT Shock Permanent TOT Shock 10 20 30 70 80 90 100 110 120 130

Total Public Debt (% of GDP)

Risks

With persistent shocks, additional concessional …nancing, instead of commercial borrowing, may help ensure debt sustainability

10 20 30 85 90 95 100 105

Terms of Trade (Base = 100)

10 20 30 20 40 60

Supplement (stock) (% of GDP)

Commercial Borrowing 10 20 30 70 80 90 100 110 120 130

Total Public Debt (% of GDP)

Risks

With persistent shocks, additional concessional …nancing, instead of commercial borrowing, may help ensure debt sustainability

10 20 30 85 90 95 100 105

Terms of Trade (Base = 100)

10 20 30 20 40 60

Supplement (stock) (% of GDP)

Commercial Borrowing Additional Concessional Borrowing 10 20 30 70 80 90 100 110 120 130

Total Public Debt (% of GDP)

Introduction The Model Experiments I Experiments II Conclusions

Other Structural Conditions and Shocks

Under external commercial borrowing, similar higher debt sustainability risks are associated with

• ther weak structural conditions (e.g., low return to public

capital, low capacity to collect user fees, high absorptive capacity constraints, etc.)

• ther persistent negative shocks (e.g., TFP shocks, risk

premium shocks, etc.)

Introduction The Model Experiments I Experiments II Conclusions

Conclusions

We develop a fully-articulated, dynamic macromodel that while capturing several pervasive features in LICs shows the trade-o¤s and potential risks associated with di¤erent borrowing …nancing schemes of public investment scaling ups Applications: Afghanistan, Burkina Faso, Cote d’Ivoire, Cape Verde, Ethiopia, Ghana, Liberia, Rwanda, Senegal, and Togo

Introduction The Model Experiments I Experiments II Conclusions

Moving Forward

Incorporate uncertainty (shocks and parameters) more systematically while maintaining the non-linear structure, to construct con…dence bands around debt trajectories. Enrich the model with other features (human capital, habits persistence, maturity structure, etc.) and shocks (in trends, growth, preferences), to improve how to take the model to the data Apply to one historical case—…nd a clear event (a boom in public investment), conduct a quantitative exercise aimed at replicating the key features in the data, and perform counterfactual policy analysis

Constrained Tax Adjustment

Supplementing with domestic borrowing does not help smooth the transition

5 10 15 20 25 30 14 16 18 20 22

VAT Rate (%)

Commercial Borrowing 5 10 15 20 25 30 10 20 30

Public Debt (% of GDP)

External Commercial

5 10 15 20 25 30 2 4

Consumption

5 10 15 20 25 30 5 10

Private Investment

Constrained Tax Adjustment

Supplementing with domestic borrowing does not help smooth the transition

5 10 15 20 25 30 14 16 18 20 22

VAT Rate (%)

Commercial Borrowing Domestic Borrowing 5 10 15 20 25 30 10 20 30

Public Debt (% of GDP)

External Commercial Domestic

5 10 15 20 25 30 2 4

Consumption

5 10 15 20 25 30 5 10

Private Investment