Debt: How Much Is Too Much?

• Author: Christina Daseking
• Position: Senior Economist in the IMF's Policy Development and Review Department

As part of the work on vulnerability indicators, economists are looking at what level of debt is sustainable for an economy and how much is too much. Borrowing from abroad can help countries grow faster by financing productive investment, and it can also cushion the impact of economic disruptions. But if a country or government accumulates debt beyond what it is able to service, a debt crisis can erupt with potentially large economic and social costs. For this reason, it is important to gauge how much debt an economy or government can safely handle. This assessment is particularly relevant in emerging market economies that rely heavily on global capital markets to meet their large financing needs.

Assessing debt sustainability

What exactly is debt sustainability? It may be defined as a situation in which a borrower is expected to continue servicing its debts without an unrealistically large future correction to its balance of income and expenditure. Conversely, debt becomes unsustainable when it accumulates at a faster rate than the borrower's capacity to service it. Working out what level of debt is sustainable requires an assessment of how outstanding stocks of liabilities are likely to evolve over time, as well as assumptions about future interest rates, exchange rates, and trends in income. Like any assessment requiring assumptions about the future, this is difficult to get right.

Assessing debt sustainability requires three steps:

* forming a view of how outstanding stocks of liabilities are likely to evolve over time relative to the economy's (or the government's) ability to pay;

* examining how the outlook would change under plausible shocks; and

* assessing whether the results may lead to an unsustainable situation, as defined above.

The first step involves projecting the flows of revenues and expenditures-including those for servicing debt-as well as key macroeconomic variables, such as interest rates, rates of economic growth, and exchange rate changes (given the currency denomination of the debt). To the extent that these variables are influenced by government policies, projections of debt dynamics depend on policy variables as well as on macroeconomic and financial market developments that are intrinsically uncertain.

Given the uncertainties, it is important to explore, in a second step, what the risks are. Among the main ones are higher costs of financing, which may reflect general developments in financial markets-including possible spillover effects from other countries in difficulty-or funding problems specific to the country in question. Similarly, a sharp exchange rate depreciation, possibly-though not necessarily-in the aftermath of the collapse of an exchange rate peg, can drastically increase the...