Effect of Financial System Soundness on Debt Sustainability

Debt sustainability refers to the ability of a borrower to service a given stock of debt, given the anticipated payments of interest and principal. Debt servicing ability depends on the stream of income accruing to the borrower, the stock and residual maturity profile of the borrowers’ assets, the stock of debt outstanding, and the agreed terms—chiefly, the inter­est rate, currency, and time profile.22

Developments in financial system soundness can have a significant effect on debt sus­tainability of households, corporations, and governments; debt sustainability problems in different sectors are mutually reinforcing. The resulting financial instability can impose massive restructuring costs on an economy and can lower overall growth rates, thus undermining the debt servicing capacity of the economy and potentially causing a sov­ereign default. Debt servicing difficulties in any one sector could arise because of market risk, rollover risk, or liquidity risk—or more fundamentally because of unsustainable debt levels and insolvency risk—and difficulties can spread throughout the system.

Even when sovereign debt is initially at a sustainable level, the realization of contin­gent liabilities in the event of a crisis can result in deterioration of the government’s bal­ance sheet and unsustainable debt ratios. Debt sustainability problems in the nonfinancial sectors can further weaken the financial system by affecting the value of loans and secu­rities held by the financial sector. Sovereign defaults, in particular, have a severe effect on the financial system because of the key role that government securities often play in financial institutions’ balance sheets as a risk-free asset, as a store of collateral, and as a liquid asset. In general, doubts about the debt servicing capacity of any large borrower or group of borrowers can cause a loss of confidence by depositors and other holders of secu­rities, thereby prompting a flight to quality or a more widespread run on banks and other institutions. The economic dislocation caused by debt defaults or by a loss of confidence can be magnified by the effect on financial prices as interest rates typically rise and as credit becomes less readily available—unless the monetary authorities take concerted and credible actions. The exchange rate may also come under pressure if domestic assets as a whole become less attractive relative to foreign assets. The effect on financial markets can thus magnify the effect of debt sustainability problems on the macroeconomy.

Assessing debt sustainability and monitoring the two-way linkages between financial system soundness and financial soundness of nonfinancial sectors are key to fostering financial stability. Although it is difficult to specify a precise level at which a given stock of debt becomes “unsustainable,” it is possible to detect warning signs of excessive debt accumulation by examining a few key indicators and ratios. At the most simple level, growth rates of the stock of debt provide an indicator of potential problems if the growth rates exceed reasonable estimates of the growth rate of productive capacity, which ulti­mately determine the ability to repay. The evolution of financial soundness indicators of

nonfinancial sectors—including the relative size of the debt stock (e. g., debt-to-GDP or debt-to-equity ratios; see section 3.3.1) and its key determinants—provides some useful information on prospective developments in debt ratios or in debt service capacity. For example, a common rule of thumb for public sector debt sustainability is to relate primary fiscal balance to the real interest rates and real growth rates. Similarly, an analysis of the determinants of corporate debt-to-equity ratios (real interest rates, rate of profit, and real return on equity are likely to be among the determinants) could provide an indication of the dynamics of this ratio.

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