Multilateral organizations have joined efforts to deal with high debt levels. But debt intolerance affecting countries with a history of high inflation and serial default, mainly developing countries, leads to a situation in which binding constraints have “teeth” at relatively low levels of debt. The debt threshold might be much lower than previously thought, according to recent analysis of debt intolerance.
“External debt thresholds are uncomfortably low,” said University of Maryland economist Carmen M. Reinhart, who highlighted current trends on debt intolerance. Reinhart recently spoke at IDB headquarters in Washington, D.C, and pointed out that more emerging market debt defaults loom on the horizon. Serial default, in any case, has been pervasive throughout history because countries rarely grow out of their debts—default is the most common way out, she remarked. “Governments suffer from intolerance to repayment, not to borrowing.”
Reinhart presented a paper on debt defaults that she wrote with Harvard University economist Kenneth S. Rogoff and International Monetary Fund economist Miguel A. Savastano. Reinhart argued that the safe ratio of external debt-to-GNP is “surprisingly” lower in emerging market countries than in industrial countries. The analysis suggests that for developing countries as a whole, a 35 percent external debt-to-GNP threshold is reasonable, but for some countries with a poor credit and inflation track record, the threshold is much lower, perhaps as low as 15 percent in some cases. “Debt intolerance manifests itself in the extreme duress many emerging markets experience at debt levels that would seem manageable by advanced country standards,” according to the authors.
The study shows that debt-to-GNP thresholds depend on a country's default and inflation history. Less than 17 percent of all defaults or restructurings in middle-income countries since 1970 occurred at levels of external debt-to-output above 100 percent, and about half at levels below 60 percent. This highlights the irrelevance of using debt-to-output ratios from advanced economies as benchmarks for comparison with emerging markets.
Reinhart, Rogoff, and Savastano find that external debt is being replaced by “internal” debt linked to the dollar, and that external investors are purchasing the debt, compounding the external debt problem. Reinhart warned that countries should keep an eye on domestic debt intolerance, which might be the new problem going forward. Debt is a way of avoiding tough budgetary and fiscal decisions and to a large extent debt has replaced the inflation tax, which is also a form of default, noted IDB Chief Economist Guillermo A. Calvo.
According to the study, understanding and measuring debt intolerance is fundamental to assess the problems of debt sustainability, debt restructuring, and capital market integration, and the scope for international lending to ameliorate crises.