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Commodity Prices and Debt Sustainability

Objectives, Instruments and Scope

The structure of any intervention scheme is determined by its objectives, the instrument(s) used to attain these objectives, and its scope.

Objectives

Concessional debt service typically shows relatively little cyclical variation over time. Export earnings are highly variable and, because commodity prices are at least to some extent mean reverting this variation is in part cyclical – see Cashin and McDermott (2002), Gilbert (2003) and Dehn et al. (2004). Because schemes to smooth export earnings have, in general, proved unattractive, unsuccessful or not financially viable 7, this involves unsmoothing concessional debt service. The debt sustainability literature has typically focused on the debt service to export ratio.

This measure has the merit of direct comparability across countries – see, for example, World Bank and IMF (2001), and Edwards (2001, 2003). In what follows we consider a variant of this measure – the free foreign exchange resources that a country has available after meeting debt obligations (“free forex”). This gives a more immediate measure of the impact of debt service payments and has the additional benefit of treating commodity export and import revenues symmetrically. We define the objective as that of reducing the variability (specifically, the ex ante variance) of free forex8. In practice, we will scale this relative to a (moving average) trend of commodity export earnings.

Instruments

The fundamental issue here is whether to gauge countries’ ability to pay in relation to their export revenues or to the world prices of the commodities they export, noting that prices are clearly a major driving force of revenues. There are issues of hedge quality, timeliness, offsetting and implementability.

· Hedge quality: Linking repayments to export revenues will directly align debt service payments with debtor countries’ ability to pay. A price link will fail to insure borrowers against quantity shocks, and will give to “basis risk” if the country’s export price moves differently from the world price.

· Timeliness: Export revenues are only known with a one or two-year lag while prices are observed immediately. Schemes, such as the EU’s Stabex scheme, which have operated in terms of export revenues, have been slow to disburse and this lack of timeliness has resulted in disbursements becoming pro- and not counter-cyclical (Collier et al., 1999; Brun et al., 2001). See also Hewitt (1983, 1987, 1993) and Aiello (1999). Basing the scheme on prices would increase timeliness.

· Offsetting: We show below that a scheme based on world prices can be structured as an overlay of floating for fixed commodity swaps. This structure would allow creditor institutions to offset their risk on financial markets if they so choose. Offsetting would be much less straightforward in a scheme operating in terms of export revenues.

· Implementability: Basing the scheme on export revenues could result in governments being rewarded for falls in the quantum of exports for which they may be directly or indirectly responsible (for example, in the case of a civil war). It may also give rise to incentives to manipulate reported trade statistics. Concerns about moral hazard revenue-based compensation schemes have typically forced lenders to impose conditionality clauses on borrowers, and these conditionalities have considerably reduced the attractiveness of the schemes to commodity exporting countries9. A scheme based on world prices will not give rise to significant moral hazard problems so long as the country has only a small share of the world market (a reasonable assumption for HIPCs).

The choice between these two instrumentalities will depend on the balance between the perceived benefits of timeliness and offsetting from a price-based scheme, and the potential extent of moral hazard problems arising in a revenue-based scheme on the one hand, and the loss of hedge quality through quantity and basis risk on the other. Our focus is on schemes which condition debt service on world prices.

Scope

Historically, indebted countries have typically borrowed from a range of official and nonofficial lenders. Some official loans are completely concessional, others are non-concessional and the majority are part concessional and part non-concessional.

This latter group can be split into concessional and non-concessional components. So long as we focus on highly indebted countries, it is reasonable to suppose that, in the future, debt service will come to predominantly reflect concessional lending as non-official lending has ceased to be available to these countries – see Sachs (2002). For this reason, and because our concern is to devise a scheme which may be implemented in a simple and straightforward way, we consider only concessional lending.

 

7 There are two routes to smoothing export revenues – price stabilization and compensatory finance. International commodity agreements, which set out to stabilize prices, are reviewed in Gilbert (1987, 1996). These have all either lapsed, broken down or been abandoned, although Robbins (2003) has recently argued that these arrangements should be resurrected, initially for coffee but then more generally. Compensatory finance schemes are discussed below.

8 We have posed these objectives in terms of variabilities, but it is arguable that what is important is avoidance of bad outcomes, whether in the form of high debt service to export ratios or low residual foreign exchange availability. In practice, these two objectives are likely to be similar if it is also required that reduced debt service in poor times is matched by increased debt service in good times.

9 It is widely judged that the IMF’s Compensatory Finance Facility (CFF) has been too subject to conditionalities to prove attractive to borrowers. See Finger and DeRosa (1980), Goreux (1980), Lim (1987, 1991) and IMF (2003b); and, for a comparison with Stabex, Brun et al. (2001).

 

By Prof. Christopher L. Gilbert, Prof. Alexandra Tabova

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