Caribbean Renewal: Tackling Fiscal and Debt Challenges by Charles Amo-Yartey Therese Turner-Jones

Author:Charles Amo-Yartey, Therese Turner-Jones
Language: eng
Format: epub
Publisher: International Monetary Fund
Published: 2014-08-15T00:00:00+00:00

Source: Authors’ calculations.

a The abbreviations correspond to the grouping from Table 6.2, which means G1A corresponds to Group 1, Country A, and so on.

An important question surfaces. The analysis of long-term debt benchmarks and natural debt limits for the Caribbean average and different country cases raises one important issue: Why is the actual average debt ratio in the Caribbean two or three times as high as the respective debt benchmark? These discrepancies might be due to factors that the debt sustainability measures are unable to capture but that are specific characteristics of the Caribbean region.

One of these factors might be related to the interest rates on government debt. We have mentioned that it is complicated to measure real interest rates in the Caribbean due to the lack of fully developed debt management and underdeveloped capital markets. This, coupled with further distortions in domestic financial markets, might shelter these governments from real capital costs and allow them to borrow more than the debt benchmarks would suggest. Indeed, the sensitivity analysis hints at the possibility that this issue exists by showing that reducing the real interest rate by 200 basis points would increase the average natural debt limit by 10 percent of GDP.

Underdeveloped capital markets also imply that domestic investors (like banks, nonbank financial institutions, and national insurance schemes) lack viable and profitable investment alternatives and therefore invest heavily in government debt instruments. In addition, foreign investment options are often limited due to capital controls or foreign investment caps. All of this would limit the power of interest rates to work as true indicators for market rates.

While the high domestic investor base might, on the one hand, lead to adverse sovereign–bank interlinkages in cases where the sovereign faces debt distress, on the other hand it might also help to sustain a higher debt ratio. Arslanalp and Tsuda (2012) show that for a set of advanced economies, countries with a high share of domestic investors (domestic banks or central banks) have a low risk of pressures from financial markets. In several Caribbean countries, domestic investors hold a large share of government debt (see Chapter 3).

The issue of low real interest rates also touches upon the previously mentioned “dynamic inefficiency” issue. If a government were sheltered from facing the true interest rate costs, it might not have needed to run fiscal surpluses. But instead, the combination of real interest rates lower than the (albeit low) average growth rates might have lead to a negative discount factor combined with a primary deficit. Normally, market mechanisms would have led over time to rising interest rates; however, distortions might have suspended this mechanism from working correctly. Thus, governments may have been able to borrow above the debt benchmarks based on the measures for real interest rates that we have used in this analysis. Indeed, Escolano, Shabunina, and Woo (2011) find that persistently negative interest rate-growth differentials in non-advanced economies are related to captive financial markets, financial repression, and lack of financial development.

However, even though a negative interest

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