External debt, fiscal policy, and sustainable growth in Turkey

7k71 o~~~o= r f-:; By ! O Wog wJa.L~J~J~J 1!!~~ 9PHXS Y9PY' 1!! Xxt 4x v-i! 1!!~~~c m4A WSB My 'I   -z 10 X  I:  _______ External Debt, Fiscal Policy, and Sustainable Growth in Turkey   External Debt, Fiscal Policy, and Sustainable Growth in Turkey Sweder van Wijnbergen, Ritu Anand, Ajay Chhibber, and Roberto Rocha Published for the World Bank The Johns Hopkins University Press Baltimore and London  Copyright C) 1992 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing March 1992 The Johns Hopkins University Press Baltimore, Maryland 21211-2190, U.S.A. The findings, interpretations, and conclusions expressed in this book are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to its Board of Executive Directors or the countries they represent. Library of Congress Cataloging in Publication Data External debt, fiscal policy, and sustainable growth in Turkey / Sweder van Wijnbergen . . . [et al.]. p. cm. "Published for the World Bank." Includes bibliographical references and index. ISBN 0-8018-4327-8 1. Debts, External-Turkey. 2. Fiscal policy-Turkey. 3. Saving and investment-Turkey. I. Wijnbergen, Sweder van, 1951- . HJ8770.7.E98 1992 91-40358 338.9561-dc20 CIP  Contents Introduction 1 A Historical Overview: Debt, Output Growth, and the Real Exchange Rate 3 Toward Formulating an External Debt Strategy 5 Organization of the Book 9 Part 1. The Analytical Framework 13 Introduction 14 1 Solvency, Creditworthiness, and Sustainable External Borrowing 16 The Dynamics of Debt, Output Growth, and the Current Account 16 Solvency and Creditworthiness 18 Empirical Preliminaries 22 Appendix: Exchange Rate Fluctuations and External Debt 24 2 Inflation, External Debt, and Financial Sector Reform: Toward Consistent Fiscal Policy Design 26 Fiscal Deficits, Money Creation, and Debt 29 Revenue from Monetization and the Structure of the Financial System 34 The Design of Consistent Fiscal Policy 35 Empirical Preliminaries 37 3 External Debt, Investment, and the Public Sector 40 Structure of the Model 40 How the Model Works 41 Econometric Results 43 Appendix: Data and Equations Used in the Model 48 v  vi CONTENTS Part 2. The Framework Applied 55 4 External Adjustment, Exchange Rate Policy, and Output Growth 57 External Debt, Exchange Rates, and Output Growth 60 The Dynamics of External Debt 66 Financing the External Transfer: The Contribution of the Public and Private Sectors 71 5 Internal Adjustment: The Size and Financing of the Fiscal Deficit 76 Sources of Financing 76 Foreign Exchange Financing of Public Sector Deficits 78 Money Financing and Financial Sector Reform 80 Domestic Debt Finance 95 The High Cost of Debt: Implications of Current Trends 96 Macroeconomic Consistency, Financial Sector Reform, and Financing the Government Deficits 108 Summary and Conclusions 113 6 Internal Adjustment: Fiscal Policy, Private Savings and Investment, and Growth 115 Real Interest Rates and Private Savings and Investment Behavior: The Role of Fiscal Deficits 119 Private Sector Response to Fiscal Policy 123 Fiscal Deficits, Interest Rates, and Growth 131 The Composition of Investment: A Warning Sign? 133 7 Can Output Growth and External Balance Be Reconciled? 135 Exports, Output Growth, and External Borrowing 135 Macroeconomic Consistency, Foreign Borrowing, and the Public Sector Deficit 140 Fiscal Adjustment, Output Growth, and External Debt 145 8 Summary and Conclusions 149 The Strategy So Far: Achievements and Concerns 149 Options for the Future 156 General Conclusions 160 Notes 161 References 170 Index 173  Introduction THE RECESSION in the United States in the early 1980s and the ensuing rise of interest rates and collapse of commodity prices triggered the debt crisis that has dominated macroeconomics in the developing countries ever since. Despite the overriding emphasis on Latin Amer- ica, other regions have not escaped the problems caused by these adverse shifts in the world economy. A strategy to deal with external debt and the formulation of internal policies that allow sustainable output growth within the limits of creditworthiness and macroeco- nomic stability are at the forefront of policymaking in most developing countries. These concerns are also the subject of this book. A brief overview of external debt since 1980 contrasts developments in Turkey with those in other high-debt countries. This overview high- lights the choices that need to be made and the tradeoffs involved in formulating an external debt strategy. At issue is whether to pursue policies that restrict expenditure to improve current account perfor- mance. To what extent will such policies sacrifice future output growth and thus undermine the benefits of the debt reduction that does take place? Do the alternatives allow satisfactory output growth within the limits set by creditworthiness? What role does exchange rate policy play in all this? The social costs and benefits of any external debt strategy, and in fact its sustainability, depend to a large extent on the internal policies that form the counterpart of any external adjustment undertaken. Ex- ternal adjustment requires that a transfer be made to foreigners (or an adjustment made to a lower transfer received from them); internal adjustment brings about a matching internal surplus of savings over investment. The role the public sector can play in these adjustments is one of the main issues dealt with in this book. The central question is how to create a surplus of savings over investment and still maintain enough investment to sustain output growth.  2 INTRODUCTION An important part of any program of internal adjustment is the extent to which the public sector contributes directly to improving the savings surplus. This will typically require reducing the fiscal deficit. The remaining deficit will then be financed by issuing domestic or foreign debt or by creating revenue from monetization. But macro- economic targets for, say, inflation and output growth, in addition to the constraints implicit in remaining creditworthy and solvent, restrict each financing method. Hence fiscal consistency must be considered. Do these targets and constraints allow the government to raise enough financing to cover the deficit that is part of its internal adjustment program? The lack of fiscal consistency forebodes future changes in policy and thus undermines the credibility of the fiscal program envis- aged. Thus we discuss the interaction of fiscal deficits and the macroe- conomic variables that influence fiscal consistency. Empirical work on Turkey shows the tradeoff that exists between fiscal policy adjustment and sustainable inflation. We discuss in particular how this tradeoff is affected by financial sector reform, economic growth, and real.ex- change rate policies as well as by interest rates on foreign and domestic debt. Further, we analyze situations in which postponing adjustment adversely affects the terms of the tradeoff. Turkey has, in many ways, fared better than most highly indebted countries. An important question is whether this success can be attrib- uted to factors specific to Turkey. If so, Turkey's experience would be of only limited interest to other countries. If, however, Turkey's relatively successful performance between 1980 and 1987 can be traced to consciously designed policies, the lessons would be of substantial interest to other debtor countries. The thesis of this book is that Tur- key's experience is pertinent to other countries. Sustained growth within the limits set by creditworthiness is possible, and an analysis of Turkey's performance over this period can show us how. Income distribution significantly affects adjustment and creditwor- thiness. Changes in real exchange rates, other relative prices, and public expenditure programs affect the distribution of income, real wages, and employment growth. The austerity that typically accom- panies an adjustment program is often criticized for having an adverse impact on the poor. Of course, the relevant comparison is not between how the poor fare before and after a crisis; in Turkey the events of 1978 to 1980 clearly show that the policies implemented at that time were not sus- tainable. Instead, the central issue is how the poor would have fared in the absence of an adjustment program. Important as this issue is, the lack of data and, for that matter, the state of economic theory do not allow us to go deeper than journalistic generalities. We therefore do not address this issue further.  Introduction 3 A Historical Overview: Debt, Output Growth, and the Real Exchange Rate Turkey experienced a debt crisis in 1978 and rescheduled a large amount of its debt between 1978 and 1980. Since then, the ratio of its gross external debt to its output increased from 28 percent in 1980 to 56 percent at the end of 1986. This ratio puts the country's debt burden well within the range of Latin America's. The 1986 value of Turkey's debt was actually higher than the average for the group of highly indebted countries listed in the International Monetary Fund's (IMF's) World Economic Outlook.1 Thus by international standards, Turkey's external debt is high. Such measures should, however, be seen in perspective. Countries such as the United States and the United Kingdom also relied exten- sively on external borrowing during earlier periods in their economic history. In the nineteenth century Britain financed much of its indus- trial revolution with money borrowed from cash-rich Holland. As the century progressed, Britain itself became a lender and financed much of the economic expansion of the United States and Argentina, which was at that time a dynamic economic power. The United States' move- ment toward the West and Argentina's extension of its railroad system were financed with money borrowed from abroad. The United States became a net lender only toward the middle of this century, a position that ended with the deficit of the past few years. The historical examples show that extensive debt accumulation has occurred before; they also demonstrate that the borrower-lender cy- cles, which are part of this process, often last many decades. Major borrowers often take decades to become lenders. Thus short-term solutions to what has become known as the debt crisis may be unwar- ranted. An essential feature of the two or three examples of successful exter- nal debt accumulation is that the high rate of foreign borrowing fueled substantial investment and thus output growth. The high output growth and accompanying increase in productivity enabled these countries to engage in lending rather than borrowing as time pro- gressed and their investment needs declined. This element is perhaps the most worrisome aspect of the current debt situation: in almost all debtor countries output growth has fallen to a postwar low. The fif- teen heavily indebted countries listed in the IMF'S World Economic Out- look saw their annual growth in output fall from more than 5 percent in the 1970s to only 1 percent in the 1980s. The importance of high output growth is underscored by Turkey's performance since its series of debt reschedulings in the late 1970s. The increase in the ratio of Turkey's gross debt to its output between  4 INTRODUCTlON 1980 and 1986 is in line with the average for the fifteen highly indebted countries (see table 4-1). It is surprising that Turkey's debt-output ratio did not rise more rapidly: as a percentage of gross national prod- uct (GNP), Turkey had a much lower surplus on its noninterest current account than the highly indebted countries had after their respective debt crises. This apparent inconsistency is explained by the much higher rate of output growth that Turkey managed to sustain. Tur- key's debt-output ratio followed a path similar to that of the highly indebted countries, not because the surpluses on its noninterest cur- rent account were large, but because its output growth was high. This is where Turkey differs most from the highly indebted coun- tries. Figure 1 shows Turkey's growth rate from 1980 to 1986 compared with that of the highly indebted countries. Turkey's real growth rate exceeded that of the other countries by four to five percentage points almost every year. This was achieved in a world economy that became distinctly unfavorable after 1980. Even in Turkey, where output grew much faster than in most highly indebted countries, real interest rates on foreign debt are no longer below the real growth rate of the economy. Figure 1. Real Output Growth in Turkey and the Heavily Indebted Countries, 1980-86 Percent 8 7 6 5 -1 -2 , , ".,. 1980 1981 1982 1983 1984 1985 1986 - Turkey -....Heavily indebted countries  Introduction 5 In debtor countries throughout the world, the ratio of debt to ex- ports rose after 1980 in line with the ratio of debt to output. By this measure, Turkey has been much more successful than the highly in- debted countries. Turkey was the only debtor country whose debt- export ratio fell after 1980-by one-third initially-and it rose only slightly afterward. The empirical analysis presented in this book shows that the depreciation of the real exchange rate after 1980 was a major factor contributing to the success of Turkey's export drive. The counterpart to this real depreciation, however, was a substan- tial capital loss on Turkey's external debt. This loss contributed signifi- cantly to the increase in the debt-output ratio: between 1980 and 1986 it accounted for more than half of the increase in the ratio. Empirical results show, however, that the debt-export ratio will improve after a real devaluation: the volume of exports will increase enough to offset the decrease in price. Clearly, the debt-export ratio would have been more unfavorable if the depreciation had not taken place. A real deval- uation causes a capital loss on foreign debt and thus reduces national wealth. Higher exports cannot undo this, but increased export orienta- tion eases access to foreign capital markets. Turkey probably would not have had the access to external markets that it had if the reform program implemented since 1980 had not generated successful export performance. The real depreciation of the exchange rate was an essen- tial component of that program. Toward Formulating an External Debt Strategy This brief survey suggests that three factors are essential to analyz- ing external adjustment. First, the noninterest current account is the fundamental measure of the net transfer of resources between a bor- rowing country and the rest of the world. Second, real interest rates paid on external debt interact with the growth rate of the economy and set the pace at which the dynamics of debt and output growth unfold over time. Third, exchange rate developments occur both be- tween the borrower and its trading partners (the real exchange rate) and between the country's trading partners and the creditors them- selves (the cross-currency exchange rates). An increase in the debt- output ratio can in fact be traced to these three factors (see chapter 1). The noninterest current account deficit of the balance of payments is the fundamental measure of a country's external (im)balance: it equals the difference between total expenditure (net of interest pay- ments on foreign debt) and nationally generated income. Its counter- part is the net transfer of resources from foreigners: that is, the in- crease in debt minus the interest payments made. If the noninterest current account is zero, the increase in debt will equal the interest  6 INTRODUCTION payments; in this case, the debt grows at the rate of interest. As long as there is a surplus on the noninterest current account, foreign bor- rowing will be less than the interest paid to foreigners; to put it an- other way, the growth in foreign borrowing will be less than the rate of interest, and a net transfer of resources to the rest of the world will occur. The opposite will happen when there is a deficit on the noninterest current account: in that case the debt will grow faster than the rate of interest, which will eventually lead to insolvency. The second factor captures what might be called an autonomous effect inherent in the mechanics of debt, real interest rates, and output growth. If the noninterest current account is zero, the numerator of the debt-output ratio will grow at the rate of interest, and the denomi- nator will grow at the (real) growth rate of the economy. Therefore, if the real interest rate exceeds (falls short of) the real growth rate of the economy, the debt-output ratio will rise (fall) if the noninterest current account is zero. This term therefore measures the dynamics inherent in the interplay between real interest rates and real output growth, referred to as the debt dynamics component. If real interest rates exceed the real growth rate by a substantial margin, the dynam- ics component will contribute significantly to increases in the debt- output ratio; the room for a noninterest current account deficit will be limited accordingly. The final factor measures the capital loss a country incurs on its external debt when the exchange rate depreciates in real terms. The debt-output ratio measures the debt in terms of home goods; if the relative value of home goods falls, as it does after a real depreciation, the debt-output ratio will rise. Against that must be set the favorable impact of the real devaluation on exports, an important determinant of creditworthiness. These three factors play a role in external debt strategies. Under current economic conditions, an external debt strategy involves mak- ing choices in two areas: how to achieve a sustainable ratio of external debt to GNP and the role of the real exchange rate. The first choice is between two ways of restraining the debt-GNP ratio: I. Transfer net resources to creditors through sufficiently large sur- pluses on the noninterest current account. 2. Pursue a policy of high growth of output; high growth slows the extent to which external debt feeds on itself through escalating debt service costs. The first option has been pursued by most Latin American and Eastern European debtor countries since 1981-82. The problem with this approach is vividly demonstrated by their experience. The only reliable and practical way to create a surplus on the noninterest cur-  Introduction 7 rent account is to cut expenditure substantially. This may, however, cause substantial loss of output. First of all, the short-run effect of cutbacks in expenditure may be recessionary. A more fundamental cause of output losses is cutbacks that come out of investment and thus slow output growth. This opens up the possibility that gains made through improve- ments in the noninterest current account will be offset by wide differ- ences between the rates of real interest and real output growth. Effec- tively, what the numerator gains is at least partially lost again because the rate of increase in the denominator of the debt-output ratio slows down. This happened in most of the heavily indebted countries. De- spite a substantial external adjustment, Turkey did not transfer re- sources to creditors through large surpluses on its noninterest current account. It thus avoided the destabilizing spiral in which most other heavily indebted countries seem to be trapped. It must be asked whether the Latin American countries took this route by design or because no other option was available to them. Clearly, countries such as Brazil and Mexico would have liked to bor- row more than they did after 1982. In that sense they were perhaps forced into the high-surplus, low-growth situation. Comparing them with Turkey shows, however, that this answer may be too superficial. Much of the increase in Turkey's external debt was funded by private sources. Internal policies clearly made repatriating past and current earnings attractive for Turkish citizens working abroad, as shown in the chapters that follow. In Latin America, however, the opposite occurred: the outflow of private capital was substantial (this is the capital flight problem). Internal policies gave the private sector little incentive to fund either private capital accumulation or public sector debt.2 Although the external constraints eventually imposed on these countries were clearly not of their choosing, the internal policies that contributed to capital flight were. External constraints without capital flight would have required much less restraint of expenditures than with it. Thus Latin American countries may have had much more choice than is often asserted. The second option relies on a policy of encouraging high output growth, which is intended to slow the dynamic process in which debt feeds on itself as debt service costs as a share of GNP escalate. The main problem with this strategy of low trade surplus and high growth is that the government needs to ensure that the extra expenditure allowed by the lower trade surplus is channeled into productive, trade-oriented capital accumulation. Even if this is done, through in- creased public sector investment, incentives for private investment, or both, the strategy could fail because it clashes with the export drive.  8 INTRODUCTION We argue that an export drive should also be part of a successful external debt strategy. Higher investment expenditure increases aggregate demand for home goods and pushes up the real exchange rate. The growth strat- egy then crowds out exports and jeopardizes creditworthiness by di- verting production away from traded goods. The only way out is to create room for exports by restraining public and private consump- tion. This also alleviates the pressure on imports and the trade balance that could result if consumption is not restrained as investment ex- penditure is increased. All of these points concern problems of inter- nal adjustment, which are central to much of the discussion in this book. The options are, in practice, mutually exclusive. Running high sur- pluses on the noninterest current account typically leads to slower growth as investment falls. As a consequence the debt dynamics com- ponent increases as the growth rate falls below the real interest rate on external debt. Conversely, higher growth and the resulting invest- ment expenditure require continued net transfers of resources from abroad. The second choice determining an external debt strategy concerns the role of the real exchange rate. A real depreciation raises the debt- output ratio but lowers the ratio of debt to exports. Should a country opt for real depreciation and export orientation and accept the associ- ated losses on its external debt? Does an alternative set of policies involve less exchange rate depreciation? A real appreciation lowers the ratio of external debt to output by lowering the price of foreign goods (in which the foreign debt is ex- pressed) in relation to home goods (the GNP). A steady real apprecia- tion implies, however, a steady increase in the relative price of home goods. In the absence of policy changes, such an increase would in- duce an increasing, excess supply of home goods. The only way to avoid this is to raise government expenditure, the one component of demand for home goods that is likely to be relatively less price sensi- tive and under the control of policymakers. Such a strategy would induce government expenditure to rise and exports to fall over time. In addition, domestic consumers would increasingly shift from buying more expensive home goods to buying less expensive foreign ones. Because this strategy often leads to a deteriorating trade balance, it would eventually have to be abandoned. The anticipation of such events underlies the exchange rate crises that have characterized many Latin American 'countries over the past few years. Turkey adopted the opposite strategy over the period considered: with its concerted export drive, Turkey was committed to an exchange rate strategy designed to maintain or steadily improve its external  Introduction 9 competitiveness. This required real depreciation of the exchange rate, which is essential to maintain creditworthiness. Commercial credit ratings invariably put a great deal of emphasis on the degree of export orientation in the economy. The conclusion seems clear: an export orientation based on the exchange rate is essential to an external debt strategy, notwithstanding the associated capital losses on external debt. The purpose of this book is to assess the option taken by Turkey in the past and its leeway to continue with that choice in the future. A great deal of effort is devoted to establishing, with quantitative meth- ods, the link between specific outcomes and the policy measures taken. This is important because the degree to which Turkey's perfor- mance since its debt crisis was policy induced will determine the ex- tent to which Turkey's experience is of interest to other countries. If well-designed policies are behind Turkey's performance to date, other debtor countries might fare likewise by implementing similar mea- sures. We conclude that much of Turkey's experience can in fact be repeated if other countries orient their economic policy the way Tur- key did between 1980 and 1986. The questions of sustainability also exist in Turkey, however, particularly in the matter of fiscal policy; these questions are addressed in chapters 7 and 8. Organization of the Book The central question this book addresses is whether sustainable external borrowing, coupled with a fiscal policy consistent with other macroeconomic targets, permits enough investment for satisfactory output growth to be achieved. Can external balance and output growth be reconciled, or are they inherently opposed? The analysis of these issues focuses on the answers to three groups of questions: 1. How much external borrowing is consistent with sustained credit- worthiness? 2. The answer to the first question sets the limits on external deficits. Internal adjustment to those external deficits requires a matching surplus of savings over investment. The second question is, how much of the matching internal adjustment should be brought about directly by the public sector? In other words, what should the fiscal deficit be? 3. The answers to the first two questions define the amount of surplus private savings over investment that is necessary to reconcile the external balance target from the first question with the fiscal deficit from the second. The third question, then, is, which policies are needed to induce the private sector to run this matching surplus without sacrificing output growth?  10 INTRODUCTION Although each question is well defined in its own right, the separa- tion is more apparent than real. The answer to each question has implications for the others; the sequential presentation does an injus- tice to the relations that exist among them. The approach of this book does, however, take the interactions fully into account. The first part of this book develops analytical models, which are then used in part 2 to analyze Turkey's performance from 1980 to 1986 and to assess its prospects for the future. Part 1 consists of three chapters, each corresponding to one of the questions raised. Chapter 1 deals with solvency, creditworthiness, and the limits on issuing foreign debt. First, however, this chapter provides a simple decomposition method that traces increases in the debt-output ratio to its various driving factors: the noninterest current account deficit, the interplay between real interest rates and real out- put growth, and, finally, the exchange rate. It then analyzes solvency and creditworthiness and presents a simple method, designed by Cohen (1985, 1988), to assess quantitatively the limits on external bor- rowing implied by creditworthiness constraints. Chapter 2 turns to the internal adjustment problem and examines what constitutes an appropriate fiscal deficit. Rather than attempting to assess optimal government borrowing policies (derived from, for example, the cost of future compared with current taxation), we sug- gest a more modest approach with less forbidding requirements for information. We present a simple quantitative method for assessing whether fiscal deficits are consistent with macroeconomic targets in other areas, such as inflation, output growth, and the real exchange rate. This method explores the effect of various factors-such as finan- cial structure, foreign and domestic real interest rates, and the require- ments imposed by sustainability of debt issue-on consistency. In chapter 3, a methodology is developed to assess the impact of real interest rates, fiscal deficits, and various fiscal policy instruments on private saving, investment, and aggregate output growth. This methodology is used later, both to assess the factors contributing to Turkey's success in the past and to explore Turkey's options for the future. The second part of the book applies the discussion in part 1. The first subject is external adjustment. To what extent are the past increases in debt caused by one-time capital losses due to, for example, an exoge- nous realignment of the major world currencies and to what extent by developments in Turkey's current account? Is Turkey's current account deficit in line with the sustainability requirements derived from creditworthiness constraints? What is the role of exchange rate policy? Since a real devaluation raises the cost of external debt but encourages exports, which effect dominates? What, in the end, consti-  Introduction 11 tutes an acceptable level of foreign borrowing given creditworthiness constraints? These issues are covered in the first part of chapter 4. Policy regarding internal adjustment to external targets is the focus of the second group of issues. To effect a transfer of resources abroad, the government needs to induce a matching surplus of domestic sav- ings over investment. To assess the sustainability of the external im- provement, it is important to analyze how this internal surplus is brought about. The government can increase its own surplus by cut- ting its (noninterest) deficit, rely on the inflation tax to extract re- sources from the private sector, or sell interest-bearing debt at real interest rates high enough to induce the private sector to increase its surplus of savings over investment. The extent of each factor's contribution is documented in the second part of chapter 4. Chapter 5 analyzes in detail how the public sector contributed to the increase of savings over investment. In financing the fiscal deficits, did the government rely excessively on the inflation tax? Are the cur- rent level and financing of fiscal deficits consistent with the limits imposed by the government's macroeconomic targets? What do the past and proposed reforms of the financial sector imply for these ques- tions? As a substitute for monetization, does issuing increased domes- tic debt postpone or resolve the problem of having fiscal deficits that are inconsistent with inflation targets? This book goes beyond the issues of consistency and budgetary implications, however, and uses quantitative methods to capture the interactions among fiscal policy, private savings, investment, and output growth. First, even for given real interest rates, consistency must be consid- ered: is fiscal policy compatible with the targets for inflation and out- put and the need to maintain external creditworthiness? Second, we assess quantitatively the effect of fiscal deficits on real interest rates by investigating the link between fiscal deficits and pri- vate savings and investment. Given fiscal deficits, the government must choose between increased external borrowing, which would jeopardize creditworthiness, and higher domestic real interest rates, which would allow the deficits to be financed from domestic sources. We then assess the extent to which reduced fiscal deficits can reconcile this conflict by allowing output growth based on private investment without jeopardizing external balance. The high real interest rates that characterized this period were essential to bringing about the net surplus of private savings needed to reconcile external balance targets with fiscal deficits. In addition, fiscal policy influences the economy through other channels. fIence discussing the size of fiscal deficits alone cannot de- termine the balance between private and public sector policies that will guarantee an acceptable accumulation of external debt and output  12 INTRODUCnON growth. Therefore chapter 6 discusses the macroeconomic importance of public sector investment and its interaction with private investment and output growth. A final issue explored is the method of financing the deficit, its implications for inflation, and its impact on the sus- tainability of the policies chosen. Chapter 7 looks forward. First, it explores the targets of sustainable external debt accumulation. Second, it analyzes the fiscal deficit neces- sary to achieve an internal adjustment compatible with sustained out- put growth, external balance, and lower inflation. Finally, it investi- gates sustainable ways of financing the public sector deficit. The third part of chapter 7 addresses the major issue covered in this book. Reducing the fiscal deficit to what can be financed given the macroeconomic targets for inflation, output growth, and external bal- ance ensures that the fiscal policy is at least sustainable. Taking this measure does not, however, guarantee that those macroeconomic tar- gets can or will be achieved, only that they are not inconsistent with the fiscal deficit. Whether the targets can in fact be achieved is dis- cussed at the end. Can external balance and output growth be recon- ciled, or is the conflict between these two objectives inherent? The last section of chapter 7 answers this question with projections generated with the models developed in chapters 2 and 3. In addition, it explores cases in which external financing may not be forthcoming. Chapter 8 summarizes the findings of the previous chapters.  The Analytical l'AI -I Framework  Introduction to Part 1 THE NEXT THREE CHAPTERS build the framework used in part 2 to analyze Turkey's recovery from the debt crisis. The framework is designed to show the choices Turkey made as part of its external debt strategy and how its policies contributed to the final outcome. After analyzing the past, we turn toward the future and use the framework to assess the feasibility of continued growth within the limits set by creditworthi- ness constraints. We also trace the likely consequences of several alter- natives: what would happen to output growth and interest rates if Turkey lost its access to external capital markets? What would happen if no fiscal adjustment took place in such a situation? Chapter 1 begins by presenting a simple method for decomposing the increase in the debt-output ratio. This method is used in part 2 to highlight why the debt-output ratio in Turkey increased in the late 1980s. The decomposition highlights the role played by the noninter- est current account, the interplay between real interest rates and real output growth, and the effect of real exchange rate developments. These factors also enter into the formulation of an external debt strat- egy, which we address next. In the introduction we argued that to formulate an external debt strategy requires that choices be made in three areas. Each area is covered in turn in the following three chap- ters. First, how much external debt accumulation is advisable? The answer to this question defines the minimum transfer of resources that must be made to the rest of the world (or the maximum transfer that should be received). An analytical model to deal with this issue is presented in chapter 1, which discusses the concepts of solvency and creditworthiness and their implications for the limits on external deficits. The remaining two choices concern the internal counterpart to this external transfer. A surplus in the current account should be matched by a corresponding surplus of income over expenditure, of savings over investment. The first choice, then, is to decide how much 14  Introduction 15 the public sector should contribute to this surplus. An approach to this problem is presented in chapter 2. Finally, once a target for the fiscal surplus (which could, of course, be negative; that is, a deficit) is set, how is that target to be reconciled with the target for the current account derived in chapter 1? What policies should the government adopt to ensure that the private sector does indeed generate the re- quired matching surplus of savings over investment? How can the government avoid achieving this surplus at low rather than high in- vestment levels, which would jeopardize output growth? The model presented in chapter 3 is designed to shed light on these issues.  Solvency, Creditworthiness, and Sustainable External Borrowing THE RAno of net external debt to gross national product (GNP) can increase for three reasons: increased resource transfers from the rest of the world to the borrowing country, interest payments on past debt at a real rate higher than the real growth rate of the economy, or capital losses incurred on outstanding debt as a result of depreciation of the real exchange rate. This chapter presents a decomposition method designed to highlight the extent to which each of these factors contributed to the changes in the debt-output ratio in Turkey. The Dynamics of Debt, Output Growth, and the Current Account Decomposition begins with the identity that the current account as a share of GNP equals the change in the value of net external debt, excluding capital losses arising from depreciation of the real effective exchange rate (that is, the weighted average of real bilateral exchange rates). Changes in the real effective exchange rate can, in turn, be broken down between changes in the real exchange rate of the do- mestic currency against the dominant foreign currency (such as the dollar) and cross-currency effects (such as changes in the value of the dollar vis-a-vis the deutsche mark). The analysis that follows is simplified by assuming only one foreign currency. The effects of cross- currency fluctuations are examined in the appendix to this chapter. The analysis is simplified further by assuming initially the gross and net external debt to be equal. Under these assumptions, the following holds: (1-1) eb* = cad, where e = EP*IP is the real exchange rate of the Turkish lira against 16  Solvency, Creditworthiness, and Sustainable External Borrowing 17 the dollar, defined as the nominal exchange rate, E, times foreign prices, P*, divided by the domestic price, P; b* is the real value of the external debt in terms of foreign goods, defined as b* = B*IP*, where B* is the nominal value of the debt in terms of foreign goods; and cad is the current account deficit in real terms (that is, the local currency value of the current account deficit deflated by P). In addition, cad includes only real interest payments, r*b*e; the inflation component in foreign nominal interest rates, p*b*, is included in the capital ac- count, as it is in the discussion of domestic debt in chapter 2. The increase in foreign debt does not, however, measure the net transfer of resources received from foreigners: the interest payments made on the debt must be taken into account. If interest payments are subtracted from both sides of equation (1-1) to obtain the net resource transfer, it becomes clear that this transfer equals the noninterest cur- rent account deficit (nicad) rather than the current account deficit it- self. This is a more fundamental concept of external balance: (1-2) e(b* r*b*) = cad - r*b*e = nicad. Using the symbol - to indicate variables scaled by real GNP, y, and expressing equation (1-2) in terms of GNP yields: (1-3) e (b- r*b*) = nicad, where nicad = nicad/y and b* = eb*ly. Finally, straight differentiation for the change in the debt-output ratio b* yields: (14) b* = b*ely - nb* + e*, where n is the growth rate of real output and e is the rate of change of the real exchange rate e. Using equation (1-4) to substitute out b* from equation (1-3) gives the decomposition formula underlying much of the analysis in chapter 4: (1-5) b* = nicad + (r* - n)b* + eb*. Equation (1-5) isolates three components underlying an increase in the debt-output ratio: the deficit on the noninterest current account or the net transfer of resources received from abroad; the debt dynam- ics term measuring the extent to which interest payments offset the tendency of real output growth to reduce the debt-output ratio; and the capital losses on foreign debt arising from depreciation of the real exchange rate. The analysis presented in chapter 4 proceeds in- two stages. The first is to determine the extent to which the increase in Turkey's debt- output ratio can be traced to changes in the real exchange rate of  18 - THE ANALYTICAL FRAMEWORK the Turkish lira vis-a-vis the dollar and to cross-currency effects. The second is to define a debt measure that eliminates all exchange rate effects by evaluating Turkey's debt-output ratio at. constant 1980 ex- change rates. The increase in the ratio of this corrected debt measure is decomposed into the contributions made by the noninterest current account and by the remaining component, the excess of the real inter- est rate over the real growth rate of the economy. The appendix to this chapter describes how exchange rate losses are separated out. The decomposition of equation (1-5) leads naturally to the concepts of solvency and creditworthiness, which are discussed next. Consider the decomposition of the debt-output ratio corrected for fluctuations in the exchange rate. By setting e = 0 and e = 1 by choice of units, equation (1-5) becomes: (1-6) b* = nicad + (r* - n)b*. Defining the minimum noninterest current account deficit that will hold the debt-output ratio constant as nicad yields (1-7) nicad= -(r* - n)b*. Clearly, if r* ! n, then nicad g 0. If the interest rate exceeds the growth rate of the economy, only a surplus on the noninterest current account is compatible with a con- stant debt to output ratio. A noninterest current account deficit, and in fact any surplus less than (r* - n)b*, will lead to escalating debt growth and interest payments that rise faster than the gross domestic product (GDP). This will eventually cause insolvency. Solvency and Creditworthiness It is important to distinguish between the concepts of solvency and creditworthiness. Solvency involves the ability to pay; creditworthi- ness involves both the ability and the willingness to pay. Solvency A country does not need to reduce the balance of its debt to remain solvent. Strictly speaking, solvency requires the debt to grow more slowly than the rate of interest, a very weak condition indeed. This condition is the same as the requirement that the discounted value of current and future consumption not exceed the discounted value of current and future output net of investment and minus the initial debt. An equivalent condition is that the discounted value of current and future surpluses on the noninterest current account be at least as large as the initial debt.  Solvency, Creditworthiness, and Sustainable External Borrowing 19 In other words, a country should devote at least some of its re- sources to servicing its debt, so that the increase in its debt does not exceed its interest payments. Otherwise the country ends up involved in a Ponzi scheme. Solvency requires that the discounted value of total (public and private) consumption, C, not exceed the discounted value of output minus investment (public and private), yt - I, minus the initial debt, bo :i (1-8) f exp(-r*t)[(yt - It)Ietldt - MOi f exp(-r*t)(CtIe,)dt, 0 where exp(-r*t) is the discount factor to correct for the time differ- ence between 0 and t. The noninterest current account equals nation- ally generated output, including remittances, minus expenditure, ex- cluding interest payments on the external debt: (1-9) nicadt = - (ye - I, - C,). Hence we can rewrite equation (1-8) as: (1-10) f ~exp(- r'~t) (nicad,/et)dt bo*-b 0 Equation (1-10) shows that solvency requires the current and dis- counted value of the surplus on the noninterest current account (or minus the current account deficit) to equal at least the initial value of the debt. Using the definition of the noninterest current account given in equation (1-2) allows equation (1-10) to be rewritten as: (1-11) f exp(- r-t)(bh - r*b*)dt = -0bo 0 Integrating equation (1-11) yields: (1-12) lim b*t exp(-r*t) - bo = Mo or (1-13) lim b*t exp(-r*t) = 0. Equation (1-13) implies that for the country to remain solvent the debt will eventually need to grow slower than the rate of interest. Creditworthiness The distinction between creditworthiness and solvency is unique to the subject of external debt. In the case of internal debt (for example, a debt owed by a corporation), a firm's assets can be seized through the legal system if the firm does not meet its debt-service obligations.  20 THE ANALYTICAL FRAMEWORK If the value of the assets is high enough, the firm will be forced to pay. If the value of the assets falls short of the outstanding debt, the firm will be bankrupt. Where domestic debt is concerned, creditwor- thiness and solvency are not different concepts. Foreigners will not, however, be able to seize domestic assets on a significant scale, especially if those assets belong to the debtor govern- ment. For this reason, the cost of defaulting on external debt is gener- ally less than the value of the debtor's assets. This implies that a country can fail to be creditworthy (that is, it can seriously consider defaulting) even before it becomes insolvent. To assess a country's creditworthiness therefore requires gauging whether the cost to the country of defaulting is less than the cost of its debt. A practical problem is that the cost of defaulting cannot be assessed reliably. A country that has not yet defaulted, however, clearly perceives that the burden of its debt falls short of the cost of defaulting. Otherwise it would have defaulted already. Creditworthi- ness can thus be maintained by preventing the burden of the debt from increasing further (Cohen 1988). A prudent debt strategy would be not to raise the debt burden above its current value. This may sound tautologically true, but it has important implications. For exam- ple, the trade surpluses that many Latin American countries were obliged to-run after 1982 were in fact not prudent under this approach. Clearly, being forced to run trade surpluses of about 8 percent of GNP raises the burden of the external debt and might trigger default. This approach to creditworthiness thus requires that the debt bur- den not increase. A second problem is how the debt burden is defined. Repayment requires not only a sufficiently high value of wealth, but also a surplus in traded goods of production over consumption (net exports). This is likely to be much more burdensome for a country whose resources are largely in the nontraded sectors of the economy than for one whose economy is oriented abroad. If the debt is more burdensome, a country might be more tempted not to repay, even if solvency requirements are met. Hence debt-export ratios are impor- tant for assessing creditworthiness, even though they overestimate the ratio of a country's debt to its output of tradable goods. Some traded goods that are produced domestically are likely to be sold at home. On the other hand, the debt-output ratio underestimates the debt burden, since GNP incorporates nontraded goods. Therefore a weighted average of the debt-output ratio and the debt-export ratio is used: (1-14) R = YX* + (1 - )Y*, with X* (Y*), the value of exports (home output), expressed in foreign goods as X* = Xle (Y* = yle).  Solvency, Creditworthiness, and Sustainable External Borrowing 21 For the choice of the weights we follow an approach suggested by Cohen (1988). Cohen suggests weights constructed so that no incen- tive remains to drive a wedge between actual anid social costs of for- eign exchange, at least for assessing creditworthiness. The measure of resources, R*, should thus be set up so that any improvement in the debt-output ratio as a consequence of an appreciation of the real exchange rate will be offset by the negative effect of the real apprecia- tion on the debt-export ratio. The question is how to choose -y. Choos- ing y so that R* does not depend on the real exchange rate implies that at the optimal choice of Ay, small changes in e leave R* unaffected: dR* dX* G dY* (1-15) de ="Y de + (1 -de dede This leads to the following expression for y: _,Y* (1-16) 'Y X* Y ex (eWY) is the elasticity of X*(Y*) for the real exchange rate e. A feasible external debt strategy that maintains creditworthiness at least at current levels consists of a time path for foreign borrowing that will not lead to a rise in b*IR*. For later convenience we define the growth rate of R*, nR, as: (1-17) nR= x (1 - y)ny 7[vJxy +( Y)] [xy + (1_)] R* has been constructed to be insensitive to real exchange rate depre- ciation; nx* (ny*) is the growth rate of exports (GNP), both expressed for foreign goods; and nx can in turn be linked to output growth, n*, in the countries Turkey is exporting to: (1-18) nx f = Eyln Here Exy is the elasticity of X*, Turkey's exports in constant dollars, for output in the countries purchasing Turkey's exports. By this definition, the following must hold to have a constant real debt burden: (1-19) - R , with a " " indicating the percentage change. Also, the rate of increase in foreign debt equals: (1-20) b* = nicadl(eb*) + r* from equation (1-2). Combining equations (1-19) and (1-20) yields the  22 THE ANALYTICAL FRAMEWORK restriction on the noninterest current account required by this consid- eration of creditworthiness: (1-21) nicad = r*- n)b*e. Equation (1-21) implies that creditworthiness requires a noninterest current account surplus equal to the debt times the excess of the real interest rate over the real output growth rate. Thus as long as the growth rate of real output is positive, a deficit on the current account, including interest payments, is in fact compatible with the constraints imposed by creditworthiness: (1-22) nicad - (r* - n)eb* < 0 -- cad = nicad + r*eb* = neb* > 0. Expressing variables as a share of GNP produces the following expression of feasible external debt accumulation as a percentage of GNP, eb*/y: (1-23) eb*ly= (eb*ly)nR. Applying this approach empirically requires the various elasticities to be estimated. Empirical Preliminaries The export elasticities of price and income are needed to derive the resource base measure R* used in quantifying the creditworthiness limits to foreign borrowing. Estimating elasticities of demand for Turk- ish exports is difficult because the composition of Turkish exports has changed a great deal over the past few years. While total exports rose at an annual rate of 25 percent in real terms between 1980 and 1985, exports to the Gulf countries increased 42 percent in real terms over the same period. As a result, the share of exports going to the Gulf countries went from 21.5 percent in 1980 to 40.8 percent in 1985. We therefore estimate separate demand equations for exports to the Mid- dle East and for exports to other countries. The next problem is specification, which involves more than techni- calities. At issue is whether Turkey competes with local producers in an export market or with other countries exporting to the same mar- ket. In the first case, the relevant price variable is a measure of Turkish export prices relative to a weighted average of, say, wholesale price indexes (translated into a common currency) in the export markets covered by the equation. In the second case, comparing price indexes for imports into Turkey's export markets is more appropriate. Arslan  Solvency, Creditworthiness, and Sustainable External Borrowing 23 and van Wijnbergen (1990) show that the second assumption has strong empirical support. Only those results are reported here. Consider first the results for exports to the Gulf countries, XO': log(Xto') = -3.43 + 4.45 log(CMPRO) + 0.57 log(RMOIL) (1.62) (2.40) (1.75) (1-24) + 0.59 log(Xt