Ken Ofori Atta, Minister of Finance
Ken Ofori Atta, Minister of Finance

What is sovereign debt sustainability and capacity to pay?

In recent years developing countries have racked up a lot of debt which has made policy and financial analysts, financial sector regulators and other stakeholders worry about their ability to keep up with these levels of debt because of its negative effect on the financial sector and the economy as a whole.

But what does it mean for the government’s debt to be unsustainable?


It is said that a country's public debt is "sustainable" if the government can pay all of its current and future bills without getting extra money or going into default.

This is what the solvency part of debt sustainability is all about. Insolvency, on the other hand, happens when the debtor can't make enough revenue over time to meet its financial obligations. If a country's overall debt load, as measured by the ratio of debt to GDP, stays the same or goes down over time, this is a good sign that it meets the solvency condition.

When the debt-to-Gross Domestic Product (GDP) ratio is already high, it is harder to reduce the debt burden because the interest payments on the debt will also be high.

This leaves less room in the government budget to cut spending and bring down fiscal deficits and debt. Liquidity is also a part of debt sustainability. Even if the solvency condition is met, a government can have a liquidity problem if it cannot pay its bills when they come due at a certain time.

In other words, a debtor is illiquid when it cannot pay its debts when they are due or when it cannot roll over or convert those debts into new debt. On its own, a liquidity problem might not make it impossible for a government to pay its debts. But sudden changes in market access at home or abroad can make it harder for the government to roll over its existing debts, which could cause a problem with its ability to pay. So, the debt may not be able to be paid off if it needs to be rolled-over overtime.

Capacity to carry debt and factors that affect it

The IMF and other international organisations use well established frameworks to figure out how much debt a country can handle before it becomes too much to handle, or before it becomes a concern that it would not be able to pay its debts.

Debt stress episodes in the past have shown that a country's debt carrying capacity depends on its own economic structure, institutions and history.

Among the structural factors, a country that gets a lot of its money from natural resources (like oil or mining) could be hit by terms-of-trade shocks that affect economic activity and the ability to pay off debt (think of the effects of a decline in oil prices on the fiscal revenues of countries like Angola or Nigeria).

So, we would expect sustainable debt levels in resource-rich countries like Ghana to be lower than in countries with a wide range of sources of revenue like cocoa, oil etc. This is why oil producers who use best practices in fiscal management put some of their annual oil income into extra-budgetary savings funds (like sovereign wealth funds) to be better prepared for terms-of-trade shocks and to be able to handle higher levels of debt.

Countries that are expected to grow quickly are able to take on more debt relative to their GDP than countries that struggle to grow. For some rapidly growing economies, these prospects may be based on clear demographic advantages, like a strong education system or a thriving tourism sector.

Having developed domestic financial markets is another structural factor that makes it possible for countries to have more debt. When financial systems are better able to use savings from businesses and households, they create a larger pool of domestic savings from which both the private and public sectors can borrow at lower risk and lower cost. So, you can see why the capital market masterplan is so important.

When local markets are small, expensive, and unstable, governments have to find money elsewhere. Most of the money borrowed from these sources is in foreign currency, which makes it riskier because exchange rates can change in ways that are detrimental. Governance is important as well.

For example, in the same way, it will be hard to get investors to buy public debt in the first place if they think they will "pay the bill" through haircuts (reductions in principal amounts, reductions in coupon rates, or longer terms) or inflation-driven erosion of their claims. Institutional and governance problems have been found to cause debt intolerance, which is a syndrome that keeps some countries from being able to handle levels of debt that other, better-run economies could handle.

Indicators of debt sustainability

Debt metrics and market indicators are used to figure out how likely it is that debt will be paid back. Debt metrics are used to measure the burden of debt now and in the future. Most debt indicators measure the amount of debt based on GDP, government revenue, or exports when only looking at external debt. The debt-to-GDP ratio shows how much debt a country has in comparison to how big its economy is.

The debt-to-government-revenue ratio compares a government's debt to the taxes and other direct sources of money it has to pay it back. The external debt to exports ratio, on the other hand, shows how well a country can pay back its foreign debts, since exports bring in the foreign currency needed to do so. There are a number of other ways to measure a country's sovereign debt. Among them are:

Interest costs as a percentage of public income (or budget spending):

This indicator measures how flexible fiscal policy is. For example, if the ratio of interest costs to revenue (or total spending) is high, there may not be enough money to spend on things like social services and infrastructure.

Ratio of interest on external debt to exports:

This indicator shows how much a country's foreign currency income is enough to pay its foreign debt. When countries also get a lot of money from other countries in the form of remittances or tourism, these can be added to exports in the ratio to get a better idea of how heavy the burden is.

Gross financing needs of the government as a percentage of GDP: Gross financing needs, also called gross borrowing requirements, is the amount of debt that the government needs to issue in a given period to pay off all debt that is coming due and cover the fiscal deficit for that period.


Proportions of parts: To figure out how debt is set up, different indicators are made. In addition to the usual breakdown of debt by creditor group (multilateral, bilateral, commercial loans, and bonds), important metrics include the ratio of debt denominated in foreign currency to total debt, the share of concessional debt to total debt, and the average debt maturity. For countries that issue bonds, both domestically and internationally, it is important to know who holds these bonds.

One useful metric is the share of bonds held by non-residents, since these bonds can be more volatile when global liquidity conditions change.

The sovereign risk premium: Market indicators can also tell you about the risk of not being able to pay back debt. The sovereign risk premium that is built into the prices of international bonds is a key metric. Risk premiums are calculated by comparing the yield (the return to the investor) of a country's bond to the yield of a bond from the safest advanced economy.

If the bonds are issued in euro, their yields are compared to those of Germany bonds (US, if bonds are dollar-denominated, and Japan if denominated in yen).


To figure out the risk premium, you need to compare bonds with similar maturities. This is because yields tend to go up as bonds get older, making it hard to separate the risk factor. Usually, high premium mean that market participants think the risk is higher. In fact, risk premium is usually linked to the creditworthiness of the issuer, as measured by international credit rating agencies.

The writer is an Economic Policy Analyst

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