Sustainability of the public debt [600723]

Sustainability of the public debt
and the financial crisis

Aura Gabriela SOCOL
The Bucharest University of Economic Studies
[anonimizat]

Abstract. The European Union sovereign-debt crisis brings up
again the problem of current account sustainability, the fiscal policy
sustainability and the public debt sustainability, as well as the interconditionality between them. On the background of the severe
structural problems, the lack of co mpetitiveness has constituted the main
factor resulting in the severe deteri oration of the European public
finances. The external deficits have put additional pressure upon the
fiscal deficits. Practically, they entered a vicious circle, to a great extent
due to the extremely different economic evolutions of the weak economies opposite to the strongly structurally advanced and solid economies. This study makes a risk analysis of the public debt sustainability in Romania for the period 2010-2015, under the ci rcumstances in which it will enter
the Euro zone in the near future.

Keywords: public debt sustainability; primary surplus-generating
capacity; Euro crisis; financial crisis.

JEL Codes: E62, H63.
REL Code: 8K.

Theoretical and Applied Economics
Volume XX (2013), No. 3(580), pp. 7-16

Aura Gabriela Socol
8
1. Introduction

Each financial/economic crisis has its own individual features, but most
of them have a number of common characteristics. This also applies to the current world crisis. Charles Kindleberger's paper “ Manias, Panics and
Crashes” transformed Hyman Minsky's typology into a more modern
expression. The Euro zone experienced, besides the entire world economy, each of the steps described below. Until 2008, the moment when the crisis appeared
in USA, The Euro zone improved well enough. The Euro zone specific problem was that many of the constituent ec onomies could not have finished the
convergence process which had been st arted before 1999. Moreover, some of
them even recorded deviations from the le vels considered as su stainable: first of
all, the competitiveness of the particip ant states was extremely heterogeneous,
this resulting in unsustain able current account defici ts and external debts;
secondly, the public sectors deficits and, consequently, the levels of the public
debt were not sustainable in some of the countries; thirdly, also the private sector deficits proved to be unsustainab le and, consequently, the levels of the
private debts. According to the typology of Minsky/Kindleberger
(1), the crises
have the following evolution:
1. The events start with a “dislocation”, an exoge nous shock outside the
macroeconomic system (a war, adoption, to a large extent, of a new invention, a political event, etc.).
2. The extension of the bank loan resu lts in the increase of the money
supply and it supplies the economic growth. This may result in the creation of new banks, in the develo pment of new loan instruments and
in the unlimited extension of the personal loans until the moment when the phenomenon practically becomes impossible to be controlled.
3. The demand increases, the prices also get increased, new profit opportu-
nities, new companies and investors appear. The revenues increases stimulate the additional investment s, new increases of revenues…
4. The soap bubbles develop. The excess ive trade extends from one country
to another, through arbitr ation for goods a nd internationally traded assets,
the capital flows or, simply, the psycho logical effects of transmission. The
interest rates, the velocity of money an d the prices, all of them continue to
get increased. Some initiates profit an d sell everything.
5. Financial disaster. Everybody start to be aware of devel opment of a rush
for cash – in order to get rid of assets and to obtain cash –, this resulting in
some speculative lenders' incapacity to return thei r loans. As the disaster
persists, the speculators realize that th e market cannot grow more. It is the
moment for them to draw back, and the rush to transf orm the real or
financial assets into cash for a long term turns into panic.

Sustainability of the public debt and the financial crisis

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6. Crisis. The trigger may be the failure of a bank or of a big
company/corporation, the revealing of a cheat or of a defalcation, or a
price decrease of the initial sp eculation object. The prices get
decreased. The bankruptcies get in creased. Closeout is sometimes
required, but this cannot degenerate into panic. The banks cease to grant loans for collateral assets , of which prices get decreased.
When the crisis occurred, the states recording unsustainable positions
from the points of view described above proved to be extremely vulnerable,
with all the risks deriving from here. Wh en the crisis appeared in the whole
world, it shook even the most solid Eur opean economies, and, until the end of
2009, the Euro zone entered the first stage of a severe public debt crisis. On the
background of the severe structural probl ems, the lack of competitiveness has
constituted the main factor resulting in the severe deterioration of the European
public finances. The external deficits have put additional pressure upon the fiscal deficits. Practically, they entered a vicious circle, to a great extent due to
the extremely different economic evoluti ons of the weak economies opposite to
the strongly structurally advanced a nd solid economies. The European Union
sovereign-debt crisis brings up again the problem of the interconditionality
between the current account sustainabilit y, the fiscal policy sustainability and
the public debt sustainability. The recen t crisis has demonstrated, one more
time, the fact that the pro-cyclical fiscal policies, the lack of structural reforms
and the lack of support for pro-increase and competitiveness structural reforms
have generated external imbalances, unsustainable public debts accompanied by high risks of non-payment of the debt service.

2. Public debt sustainability . Effects of a monetary union

The problem of the budget deficit sustainability is as follows: the budget
deficit determines the increase of the public debt, which will have to be paid in the future. If the interest rate to th e public debt exceeds the economic growth
rhythm, the public debt will increase fa ster than the gross domestic product.
Eventually, this dynamics results in unsustainable deficits which require corrective actions. Formally, the dynamics of the debt can be analyzed starting
from the definition of the government budget constraint.
M B Br T G 
YM
YB
YBrtg (1)
2 2YYB
YY B
YB 


  2YY B
YBb 

Aura Gabriela Socol
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YY
YBbYB  (2)
If we introduce equation (1) into equation (2), we will obtain
YM
YY
YBbYBrtg 
Noting, xYY the result will be
 YM
YBx r t g b  (3)
If r < x, then either a budget surplus (g-t) or a money supply will be
necessary. The ratio debt/GDP will become stable when
 ) (gtYM
YBxr  (4)
Equation 4 shows that when the interest rate to th e government debt gets
increased faster than the GDP, the ratio between debt and GDP gets increased
without limits. In other words, the deficit may explode. The increase of the debt
accumulation can be stopped if the primary deficit (expre ssed as a percentage of
the GDP) turns into surplus (g – t) < 0. Thus , if the interest rate exceeds the rate of
economic growth, either the stabilization of a primary surplus (t > g), or the
increase of the money quantity will be nece ssary, which has to be enough so as to
stabilize the ratio between debt and GDP (by Grauwe, 20 03). On the other hand,
relation 4 shows that the st abilization of the public debt at its sustainable level
depends on the foll owing: a national economy's ca pacity to generate primary
surpluses, the interests to which the market s grant loans to the state, according to
the attached risk premium, as well as its own rate of economic growth.
If a country is pa rt of a monetary union, then the effects are the more
important. A country encounte ring problems rela ted to the sustai nability of the
budget/public debt sustaina bility generates negative externalities within that
monetary union. In case a country allows the increa se of the curren t budget deficit
so that the interest rate to the government debt exceeds the rate of economic
growth, then it will be cons trained to appeal more an d more frequently to the
capital markets from the monetary union, thus generating pres sures meaning the
increase of the interest rates. But the increase of the interest rates results in the
increase of the debt burden for the other countries from the m onetary union. If the
governments of these countries decide to stabilize the ratio between debt and GDP,
they will be forced to adopt restrictive fiscal po licies. Consequently, an
unsustainable increase of some countries' budget deficits will force other countries
from the monetary un ion to follow deflatio nary policies and exactly these countries
support the necessity of a control mechan ism which makes the restrictions for the
extent of the budget deficits possible. Another possible negative extern ality of the
unsustainable budge t deficits affect the central bank from the monetary union
(ECB). The countries affected by the in crease of the inte rest rates may put

Sustainability of the public debt and the financial crisis

11
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pressures upon the central bank, meanin g the relaxation of the monetary policy.
Thus, the unsustainable fiscal policies promoted by th e national governments may
come into conflict with the monetary po licy which covers th e entire monetary
union (Grauwe, 2003).

Determining the limit of the sustainabl e public debt and of the insolvency
The sustainability relation describe d above may also be viewed from
another perspective. Thus, th e relation between the term (r-x)  d, which does
not represent but the net financing need, and (pb) – primary surplus, or rather a
country's capacity to gene rate primary surpluses (as it is described in IMF,
2011) determines the sustainable level of a country's public debt. (Figure 1). It
is well known that a higher and higher leve l of the public debt determines a less
and less sustainable fiscal policy and debt . This is because – ceteris paribus – a
higher debt supposes a highe r primary surplus in orde r to support it. Moreover,
higher rates of the debt in the GDP are usually associated with higher interest
rates and, very likely, low rates of economic growth, this creating, again, a
primary surplus which is too high to be able to balance the situation again.
Hypotheses such as the existence of hi gh interest rates or of a low economic
growth, for example, result in a less favor able dynamics of the public debt, thus
requiring an increase of the primary balan ce in order to stabilize the share of the
public debt in the GDP, which could fu rther determine modifications in the
analysis related to the debt sustainability.
The empirical evidences show that th e countries starting from high shares
of the public debts in the GDP are more sensitive to the shocks determined by
the increase of the intere st rate and/or by the decr ease of the economic growth
rate. The higher the initial level of the de bt, the greater is th e impact of a given
increase of the interest rate or of a decrease of the econom ic growth upon the
primary surplus required to maintain the debt stable. Beside certain levels, a
higher level of the public de bt results in a low rate of economic growth on a
long-term (Kumar, Woo, 2010).

Figure 1. Limit of the sustainable debt d2with risk
prime ሺr‐gሻd
pb reaction
function
d
debt/PIB primary
surplus
pb, (r-g)d
d*d0d1

Aura Gabriela Socol
12
Point d* is the point in which (r-x)  d is equal to pb and it represents the
sustainable level of the public debt. We can notice that in the first part of the
chart the curve describing the primary su rplus-generating capacity (pb reaction
function) is more elastic than in the s econd part. This means that, starting from
the initial levels of a low debt, then th e necessity to generate a primary surplus
is quite low. In the second part, th e primary surplus-generating capacity
saturates, this meaning that, beside the level d*, any increase of the debt results
in a necessity to generate much higher primary surpluses. As we have previously shown, if the own rate of econo mic growth is lower than the interest
to which the state grants loans, then it is necessary to generate primary surplus
in order to stabilize the debt. An economy's primary surplus-generating capacity
is determined based on an estimation made for the reaction function of the
fiscal policy.

3. Public debt sustainability in Romania. Effects under the terms
of entry into the Euro zone

Under the terms of Romania's proposing to be part of the Euro zone, we
make further a risk analysis for Romani a's public debt sustainability for the
period 2010-2015, after a procedure calibrated according to the public debt sustainability made by World bank expe rts, the resulting toolkit providing
indicators able to identify the risks and vulnerabilities of the debt. This toolkit uses three categories of variables as inputs: macroeconomic, budgetary and related to the debt, making calculations starting from the trajectory of the public
debt in the GDP to the profile of the pub lic debt, making an analysis of the risks
related to re-financing and cash, by usi ng Monte Carlo simulations. Moreover,
we may estimate the risks associated w ith the shocks upon th e public debt as a
result of various hypotheses re lated to the evolution of the rate of exchange, of
inflation and of the real GDP increase ra te, thus generating various stochastic
scenarios.
The inputs necessary to the analysis are divided into three categories:
a) Macroeconomic variables (the real economic growth rate, the initial GDP,
the domestic inflation rate, the foreign in flation rate, the share of the tradable
goods sector in the GDP, the rate of excha nge and the real inte rest rate to the
initial debt and to the new debt – domes tic and foreign); b) Budgetary variables
(the share of the primary budget balance in the GDP and the initial payments
with interests to the public debt) and c) Variables related to the public debt (the
initial weight of the debt in the GDP expressed in national currency, the
maturity profile for the initial debt stoc k expressed in the national currency, the
initial share of the debt in the GDP expr essed in foreign currencies, the maturity
profile for the initial debt stock expressed in foreign currencies, the share of the

Sustainability of the public debt and the financial crisis

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debt in the newly created de bt expressed in foreign cu rrencies and the maturity
profile of the newly created debt).
In the first scenario, we analyzed th e public debt sustainability based on
the official macroeconomic hypotheses of the National Forecast Commission
and the Ministry of Public Finance. Th e share of the tradable goods sector has
been estimated based on the added va lue brought by the out put in the total
added value. The real rate of interest has been calculated based on the data provided by the National Bank of Roma nia. The estimates for the primary
budget balance have been based on the hypotheses provided in the Government
Debt Management Strategy for 2011- 2013. Considering the macroeconomic
data from the official scenario, we have obtained a trajectory for the dynamics
of the public debt, which is presented in Table 1.

Table 1
The dynamics of the public debt – The official scenario
Years Debt to GDP
(%) Total debt dynamics
mld Ron
2010 34.29 180,0
2011 36.74 205,9
2012 38.43 227,9
2013 38.56 242,6
2014 37.87 251,9
2015 37.45 249,6
Source: author's calculations.

We can notice that the share of the public debt in the GDP will increase
from 36.7% in 2011 up to 38.6% in 2013, and then tending to decrease up to 37.9% in 2014, 37.45% in 2015, respectively as a result of the high rates of
economic growth taken into account and of th e decrease of the r eal interest rate.
Moreover, the primary deficit as a shar e in the GDP is improving from 2.7% of
the GDP in 2012 up to 0.5% of the GDP in 2014.
In the second scenario, we have in troduced four hypotheses with a high
realism degree, accounting for the nature of the new macroeconomic European
framework and the new domestic macr oeconomic situation. Thus, we have
considered as follows: the decrease by one percent of the economic growth rate
in each of the years 2012/2015; the increase by one percent of the real interest
rate in each of the y ears 2012/2015; the increase by one percent of the primary
budget deficit in each of the years 2012/2015 and the maintenance of the estimates for the domestic inflation, the foreign inflation and the share of the
tradable goods in the GDP.

Aura Gabriela Socol
14
Table 2
The dynamics of the public de bt – The pessimistic scenario
Years Debt to GDP
(%) Total debt dynamics
mld Ron
2010 34.29 180,0
2011 36.74 205,9
2012 39.95 236,2
2013 39.64 249,4
2014 41.26 274,5
2015 41.98 280,7
Source: author's calculations.

The sensitivity analysis for the public debt in the hypothes is of the
pessimistic scenario shows a share of the public debt in the GDP of 39.95%, this
representing an increase by 1.5 percents of the GDP compared to the estimate
made in 2012 for the same y ear. The major difference for the public debt dynamics
in the two estimates is given by the fact that, in the pessimistic scenario, the share
of the public debt marginally decrease s in 2013, up to 39.64% of the GDP, and
then it increases in 2014 up to 41.26% of the GDP (in th e optimistic scenario, the
share of the public debt in the GDP was getting marginally increased in 2013
compared to 2012, fro m 38.43% of the GDP up to 38.56% of th e GDP, after which
it was getting decreas ed in 2014 up to 37.8 7% of the GDP).
Moreover, the result of the calculations made was that the constant
primary surplus necessary to stabilize the public debt to the level from 2011,
considered sustainable for the Romanian economy (namely 37% of the GDP), is
0.3% of the GDP (the hypothesis of the official scenario) and 0.8% of the GDP
(the hypothesis of the pessimistic scenario). As solutions for improvement of the debt sustainability and/or risk management, we may propose: the annual
review of the government public debt ma nagement strategy or, whenever the
market conditions and/or the financi ng needs require it; maintainance under
control of the refina ncing risk through bond exchange instruments (conversion
of the medium-term securities into long-term securities) and buyback (rebuying
securities in advance) – these instruments being specific to the secondary
securities market; extension of the secu rities due time by issuing a significant
proportion from the financing need w ith medium and long-term due times,
obtaining loan contracts from internationa l financial institutions with medium
and long-term due times, the developm ent of a financial buffer in foreign
currency which could cover the financing need of the deficit and the refinancing of the public debt for approximately four months; the active management of the
cash by placing fixed-term deposits at the Romanian financ ial institutions,
collateralized with securities; the pe rformance of repo and reverse repo
operations (buying securities with the se ller's obligation to rebuy them at a
higher price within the term agreed in the convention) ; conventions agreed with

Sustainability of the public debt and the financial crisis

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the pension funds from pylon 2 so that they could rebuy the securities on a
medium and long term; the analysis of th e opportunity to rebuy, in advance, for
certain loans previously agreed upon at very high interests, mutually agreed
with the financing institutions; the issuan ce of inflation indexed securities on
the domestic market (especially for the population and for the banks, in order to
diversify the risk); the decrease of the foreign exchange risk by increasing the
share of the government public debt denominated in lei in the total debt; the active management of the foreign exch ange risk by using foreign exchange
swap instruments; the active management of the interest rate by using the
interest rate swap instruments; the incr ease of the share of the public debt with
fixed interest; the development of th e occurring opportunitie s related to the
financing on the foreign markets; the c onstant going out on the foreign markets
in order to increase the investors' confidence.

Conclusions
When the crisis appeared in the whole world, it s hook even the most solid
European economies, an d, until the end of 2009, the Euro zone entered the first
stage of a severe public debt crisis. On the background of the severe structural
problems, the lack of competitiveness has constituted the main factor resulting in
the severe deterioration of th e European public finances. The external deficits have
put additional pressure upon the fiscal deficits. Prac tically, they entered a vicious
circle. One of the main lesso ns of the current crisis for a country, and much more
for a country which is part of a monetary union or wh ich prepares itself to enter a
monetary union, is that the public debt sustainabili ty becomes an essential
condition. The public debt stabilization to its sustainable level depends on the following: a national economy' s capacity to generate primary surpluses, the interest
to which the markets grant loans to the state, according to the attached risk
premium, as well as its own rate of economic growth. This means that the idea of
debt sustainability must be thought of in individual term s, as long as it depends on
its own economic co nditions. As for Romania, the risks related to the above-
mentioned estimates – both scenarios – may be consid ered to be of medium
intensity. The risks are rather related to the necessity to generate primary surplus in order to stabilize the debt at its sustainable level.

Aknowledgements

This article represents the dissemi nation of research financed by Social
European Fund, contract no. POSDRU /89/1.5/S/59184 Postdoctoral research
performance and excellence in economic sciences in Romania, the Bucharest
University of Economic Studies.

Aura Gabriela Socol
16

Note

(1) Adapted from Llewellyn and P. Westaway, 2011.

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