A quarterly magazine of the IMF

September 2002, Volume 39, Number 3

Debt sustainability

The IMF's Executive Board has approved a framework intended to bring greater consistency and discipline to the IMF's analysis of external and public debt sustainability—an integral part of its crisis prevention initiatives. Judgments about a country's ability to service its debt without increasing its revenues and cutting spending to unrealistic levels are the basis for the IMF's decisions on whether to provide financing (and how much) to the country and whether the country's debt needs to be restructured. These judgments are especially critical in cases where a country is expected to meet its financing needs in international financial markets.

In developing the framework, IMF staff considered whether the assumptions underlying medium-term scenarios for both external and fiscal sustainability were realistic. An IMF report found that staff projections of economic growth erred on the optimistic side in a number of cases, while there were also cases of excessively pessimistic projections. This points to the need for a careful assessment of how much adjustment is realistically feasible and a clear statement of the assumptions underlying projections. The new framework is not meant to replace the articulation of alternative scenarios, which has been, and continues to be, a feature of many IMF staff reports but rather to help place some upper bounds or "standard errors" on the projections of debt dynamics.

Fewer secrets

IMF members' use of side letters has fallen significantly since the IMF introduced procedures governing the use of side letters in 1999—from an annual average of 14 letters during 1997-99 to 5 during September 1999-February 2002—according to an IMF review. When a country applies for an IMF loan, it submits a letter of intent, spelling out its policy intentions. In exceptional cases, a member may submit a confidential side letter containing policy commitments in sensitive areas if publication would cause adverse market reactions or undermine the member's efforts to lay the groundwork for a measure. Side letters typically deal with exchange rate or intervention policies, bank restructuring or closures, contingent fiscal measures, or measures affecting key prices.

The IMF members' willingness to make their policy undertakings public—part of a greater, general commitment to transparency—may have contributed to the decline in side letter use, the IMF review concluded. The drop may also reflect members' efforts to respond to the Executive Board's appeal three years ago to cut back on side letter use. In a few cases, authorities' concerns about confidentiality as side letters were distributed more widely have discouraged their use.

More accurate exchange rate classifications

In a study of the exchange rate regimes of 153 countries going back to 1946, two IMF economists found that the official classification was often radically different from actual country practices. About half of the countries studied by Carmen M. Reinhart and Kenneth S. Rogoff, Deputy Director and Director of the IMF's Research Department, respectively, had dual or multiple parallel exchange rate arrangements. Using an extensive database of parallel market-determined exchange rates, they discovered that in the 1950s, 1960s, and early 1970s, 45 percent of the countries that officially claimed a pegged exchange rate actually had some variant of a float. In the 1980s and 1990s, a new type of misclassification emerged: 53 percent of the official "managed floats" turned out to be de facto pegs or crawling pegs.

These misclassifications may have led to false conclusions about the impact of alternative exchange rate regimes on economic performance. Based on the official classifications for 1970-2001, a freely floating exchange rate appears to be an unwise choice for policymakers—in countries with official floating exchange rates, the average annual inflation rate was 174 percent, the annual per capita growth rate a meager 0.5 percent. But, after Reinhart and Rogoff weeded out countries with de facto pegs or "freely falling" episodes (cases where the 12-month inflation rate was 40 percent or more), they found that countries with true floats actually had annual inflation rates below 10 percent and annual per capita growth of 2.3 percent. They cautioned that these results were uncertain, given the small number of countries—about 5 percent of the sample—that had true floating regimes and the role that other factors played in their economies. The table shows the likelihood of discrepancies between official classifications and the authors' "natural" classifications, which are based on a broader variety of descriptive statistics and chronologies than the traditional three or four categories used in official classifications. According to Reinhart, "what we see on paper seldom turns out to be what we get in practice."

Floating peg or pegged float? What is the probability that the official classification of an exchange rate regime is different from the reality?   (percent) Probability that regime officially classified as peg is dual,    managed, or independently floating 40.2 Probability that regime officially classified as peg is limited    flexibility, managed, or independently floating or freely    falling 44.5 Probability that regime officially classified as managed floating    is peg or limited flexibility 53.2 Probability that regime officially classified as independently    floating is peg or limited flexibility 31.5 Pairwise correlation between official and natural classification 42.0   Source: Reinhart and Rogoff.

The study, "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Paper No. W8963 (Washington: National Bureau of Economic Research, May 2002), is available on the web at http://papers.nber.org/papers/W8963.