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A new scenario tool applied to Latin America

A new scenario tool applied to Latin AmericaIn this paper we introduce a new scenario framework for public debt sustainability which explicitly models the structure of debt. The debt structure can be as important as the debt level for sovereign credit risks as it determines how vulnerable public balance sheets are to adverse shocks such as higher interest rates, currency fluctuations and/or capital flow reversals.

Applying the new framework to Latin America we first observe that several of the largest economies in the region have significantly improved their public debt structures. For instance, the region’s overall reliance on FCY public debt as well as on external funding has decreased considerably since the beginning of the last decade. Nevertheless, most of the so-called LatAm-7 countries still have a relatively large proportion of their debt in foreign currencies as well as at short maturities and/or floating interest rates, which poses risks to public debt dynamics.

In our baseline scenario the LatAm-7 public-debt-to-GDP ratio is predicted to fall significantly over the outlook period 2010-20. As regards individual countries, public-debt-to-GDP ratios are expected to decline in Argentina, Brazil, Chile, Mexico and Peru, to remain broadly unchanged in Colombia and to more than double in Venezuela.

Under various adverse shock scenarios, public debt ratios in 2020 could still be lower than at present in Argentina, Brazil, Chile and Peru. In the case of Mexico, a scenario involving lower-than-expected growth would leave debt unchanged. In Colombia, not only lower growth but also a potential materialisation of contingent liabilities from the banking sector would lead to higher debt ratios. In Venezuela, public debt would increase in all scenarios, with the scenario involving a worse-than-expected primary balance having the largest negative impact. The unfavourable trajectory expected for Venezuela?s debt and its vulnerability to shocks could at least in part explain why the country’s sovereign CDS spreads are the widest in the region despite having the second lowest public debt level.