Debt Relief and Fiscal Sustainability for HIPCs *

Transcription

1 Deb Relief and Fiscal Susainabiliy for HIPCs * Craig Burnside and Domenico Fanizza December 24 Absrac The enhanced HIPC iniiaive is disinguished from previous deb relief programs by is condiionaliy ha freed resources mus be used for povery reducion. We argue ha his condiionaliy implies no ne improvemen in he susainabiliy of he governmen's finances. In addiion, we sugges ha a moneary policy dilemma arises when he governmen increases spending. A passive response by he cenral bank o moneary inflows ino he economy causes a shor-run rise and long-run decline in he inflaion rae. On he oher hand, an acive policy o sabilize inflaion implies no long run reducion in he governmen's indebedness. * This paper represens he auhors' views and does no necessarily reflec he views of he Inernaional Moneary Fund. Duke Universiy and NBER. [email protected]. Inernaional Moneary Fund. [email protected].

2 Deb relief under he HIPC iniiaive differs from previous major deb relief iniiaives, such as he Baker and Brady plans, in ha i concerns official raher han commercial deb. I also differs from previous Paris Club deb reducion and rescheduling agreemens in ha i imposes well-defined condiionaliy on governmen spending in he debor counry. In paricular, i requires ha budgeary resources no longer needed for deb service be used for povery reducion purposes. 1 In his paper we argue ha he condiionaliy of HIPC deb relief implies ha i provides no ne relaxaion of he governmen's lifeime budge consrain. To he exen ha he resources freed from deb service are used o increase governmen spending, any iniial budgeary shorfall faced by he governmen remains in place. We also argue ha cenral banks in counries receiving deb relief may face a moneary policy dilemma. An increase in governmen spending on domesic goods, services or ransfers will naurally lead o a moneary injecion ino he economy. If he cenral bank responds passively o his inflow, inflaion will be desabilized, rising during he implemenaion of deb relief and falling during he pos-deb relief period. On he oher hand, if he cenral bank acs o serilize his moneary injecion, inflaion will be sable bu he sock of deb will rise o is pre-deb relief level. In Secion 1 we illusrae he shor-erm impac of deb relief wih HIPC condiionaliy using a simple one period model. We use a sandard specificaion of he governmen budge consrain o esablish ha any shorfall faced by he governmen is invarian o is receiving deb relief wih condiionaliy ha requires i o increasing spending. We hen use sandard exbook T-accouns o illusrae he cenral bank's moneary policy dilemma. We show ha a naural consequence of he governmen's increased spending on povery reducion is a moneary injecion equal in value o he amoun of deb relief he governmen receives. To he exen ha he cenral bank serilizes his injecion i mus sell governmen deb or reduce is foreign reserves by he same amoun. This leaves is deb unchanged relaive o is pre-deb relief level. Thus, deb relief only replaces exising official foreign currency denominaed public deb wih 1 For a simple descripion of he HIPC iniiaive see Van Trosenburg and MacArhur (1999) and he World Bank's HIPC websie: 1

3 eiher domesic deb or new exernal deb. In Secion 2 we exend our analysis o a simple muli-period model of he governmen's budge and money demand. Wihin his framework our resuls are robus. Deb relief wih HIPC condiionaliy provides no ne relaxaion of he governmen's lifeime budge consrain. Absen oher changes in is benchmark fiscal policy, he increase in governmen spending over he lifeime of he iniiaive and implied by is condiionaliy offses he value of he forgiven deb service. To he exen ha he governmen had difficuly saisfying is lifeime budge consrain, i sill does. We also exend our resuls on he moneary policy dilemma using a simple moneary model based on he quaniy heory of money. Wih his model we can fully characerize he equilibrium dynamics of prices, inflaion, deb and seigniorage during and afer he implemenaion of a deb relief iniiaive. We describe he cenral bank as passive if i does no serilize he moneary injecion associaed wih he increase in governmen spending ha follows from HIPC condiionaliy. Passive policy causes a shor-erm increase in inflaion, which is reversed in he pos-deb relief period. An acive cenral bank can sabilize inflaion a is iniial level, bu o do so i mus serilize he moneary injecion. If i does so, we show ha he governmen's ne deb level will be equal o is pre-deb relief level by he erminal dae of he iniiaive. In Secion 3 we provide concluding remarks as well as imporan caveas o our analysis. Imporanly our analysis says nohing abou he welfare implicaions of he HIPC iniiaive. I is clear ha regardless of fiscal susainabiliy issues, he iniiaive represens a resource ransfer from crediors o debors. So, absen sraegic issues, his ransfer should be welfare increasing for he debor counries. An imporan sraegic issue ha we ignore is he possibiliy ha donors will rea deb relief as a subsiue for oher forms of aid. To he exen ha hey do his, of course, he exen o which he HIPC benefis from deb relief is reduced. We also ignore concerns ha deb relief reduces he incenive for HIPC governmens o inroduce economic reforms. Finally, we discuss wheher here are indirec benefis o fiscal susainabiliy semming from HIPC deb relief. If he governmen's increased spending spurs developmen, his may increase governmen revenue. We argue, however, ha he magniude of such effecs is likely o be modes. 2

4 1. A One Period Model In his secion we ouline a one-period model which allows us o derive our main resuls wihin he simples possible framework. We begin by discussing he implicaions of deb relief wih HIPC condiionaliy for fiscal susainabiliy. Then, wihin a framework familiar o sudens of moneary heory and policy we discuss a possible moneary policy dilemma faced by a recipien governmen. 1.1 Fiscal Susainabiliy in a One Period Model Imagine a model of a single period in which a governmen eners he period wih some ousanding amoun of deb, D. Since he world lass for only a single period, his deb mus be reired a he end of he period. Therefore he governmen's budge consrain is simply: ousanding deb = budge balance + seigniorage (1.1) or D = BB + M, (1.2) where D is he level of ne deb, BB is he budge balance and M is seigniorage revenue. Wihin he budge balance we may disinguish beween ineres on he deb, rd, primary governmen expendiure, G, governmen revenue, T, and foreign aid, A. So (1.2) becomes or D = T + A G rd + M ( 1+ r) D = T + A G + M. (1.3) Since he HIPC iniiaive is argeed a counries ha among heir characerisics have difficuly servicing heir deb, we inerpre hese counries' iniial condiion as one in which D is very large. By very large we mean ha he governmen mus eiher raise an implausibly, or puniively, high level of ax revenue (T ), seek exraordinary amouns of aid ( A ), slash is spending (G ), or prin a large amoun of money ( M ), o avoid defaul. 3

5 To highligh he role of deb relief in deermining he governmen's financial sae, we rearrange (1.3) as follows: ( 1+ r) D A = T G + M. (1.4) Le us imagine ha given he governmen's benchmark budge plans and he likely amouns of aid i will receive, here is a shorfall in is budge. Tha is, suppose ( 1+ r) D A > T G + M, so ha (1.4) does no hold. This would require he governmen o defaul on a porion of is deb wih he same value as he shorfall S = ( 1+ r) D A ( T G + M ). (1.5) We hink of counries ha need deb relief as counries wih large values of S given reasonable benchmarks for heir budgeary plans. Suppose he governmen obains deb cancellaion or, equivalenly, addiional ouside aid wih a value of R. Le A = A + R be he new level of aid being received by he governmen. This implies ha he governmen's budge shorfall is reduced by he amoun of his relief: S = ( 1+ r) D A ( T G + M ) = S R. (1.6) If R S, he governmen will be able o finance is benchmark budge plans wihou defaul. If he governmen sill faces a budge shorfall, here is a sense in which he susainabiliy of is finances has been improved. The amoun by which T G + M would have o adjus upward relaive o he benchmark budge would be smaller. Now suppose ha he governmen receives deb relief, as under he HIPC iniiaive, which commis i o increased expendiures on goods and services equal o he value of he aid i receives. In oher words, relaive o is benchmark level of spending, he governmen mus increase G o he level G = G + R. Now S = ( 1+ r) D A ( T G + M ) = S. (1.7) This simple example illusraes ha aid wih HIPC condiionaliy leaves he governmen in he same fiscal siuaion i was in before. To he exen ha he governmen faced a budge shorfall before, i sill faces one now. There is no change in he susainabiliy of he governmen's budge plans. 2 One cavea o our analysis is ha he 2 Laer, we show ha his resul exends o a muli-period model. In he conex of ha model, deb relief wih HIPC condiionaliy has no impac on he governmen lifeime budge consrain. 4

6 HIPC iniiaive includes a op-up clause hrough which counries can receive addiional deb relief upon reaching he compleion poin. However, as originally envisaged, his op-up would have been rare and relaively small compared o he size of he baseline deb reducion. 1.2 The Moneary Policy Dilemma To illusrae he moneary policy dilemma ha arises wih deb relief and HIPC condiionaliy, we use a simple accouning framework. Imagine a scenario in which he cenral bank and governmen simplified balance shees a he beginning of he period are as described as in Table 1(a). In he absence of deb relief, as above, we assume ha he governmen receives revenue in he form of aid, A, and axes, T. These inflows affec he balance shee in he manner indicaed in Table 1(b). Aid arrives in he form of a gran of addiional foreign exchange reserves, A, which he cenral bank credis o he governmen's deposi accoun. Taxes, T, flow ino he governmen's accoun a he cenral bank eiher in he form of cash or cheques drawn on he banking sysem, so he increase in he governmen's deposis a he cenral bank is mached one for one by a decrease in he moneary base. In Table 1(b) we also see he resul of he governmen's expendiure on goods and services, G. These draw down he governmen's deposis a he cenral bank by G, and a he same ime, increase he sock of base money. 3 A he end of he period, he governmen's deposis a he cenral bank have increased by he amoun A + T G, so he governmen consolidaes is finances a he end of he period by wriing a cheque on is deposi accoun o pay down is deb by he amoun A + T G [see Table 1(c)]. Is deposi accoun a he cenral bank is hus reduced o zero. Noice ha if he period were o end as described by Table 1(c), he public secor's nonmoneary deb would have changed by he amoun ( 2A + T G), while he moneary base would have increased by he amoun A. If we consolidaed moneary and nonmoneary deb his would imply a ne change in deb equal o ( A + T G). We like 3 We are implicily assuming ha he governmen's purchases of goods and services are made in he domesic goods marke. 5

7 o hink of he cenral bank as a deb manager who chooses he allocaion of his change in deb beween moneary and nonmoneary deb. We assume ha he cenral bank conducs open marke sales of foreign exchange (wih a oal value of A ), and open marke purchases of governmen bonds (wih a oal value of M ), so ha he end-ofperiod balance shees appear as in Table 1(d). Noice ha since he change in nonmoneary deb is now ( A + T G + M ), and he change in he moneary base is M, he overall change in deb is sill ( A + T G). Now suppose he governmen obains deb relief wih value R from a foreign donor. In Table 2 we ask how he public secor balance shees change as a resul of his deb relief, relaive o heir sae in Table 1(d). Of course, deb relief direcly reduces he governmen's deb and public secor ne deb by an amoun R, as in Table 2(a). Suppose, however, in order o receive deb relief he governmen mus commi iself o an increase in governmen purchases of domesic goods and services, or ransfers o domesic residens, wih value R. Assuming ha he governmen does no raise new axes or cu oher governmen expendiure in order o finance his increased spending, he cenral bank mus creae money. In fac, his money creaion is he naural resul of he governmen increasing is spending in he absence of any addiional axaion. The public secor accouns end up looking like Table 2(b). The effec on he money supply of he governmen's increased spending can be serilized by he cenral bank. I can sell governmen bonds in an open marke operaion, as in Table 2(c). Noice, however, ha as a resul of he cenral bank's decision, he public secor's ne deb posiion rises back o is pre-deb relief level. 4 Suppose ha raher han increasing domesic purchases or ransfers, as in Table 2(b), he governmen increases is spending on impored goods and services. Then, insead of here being an increase in he moneary base, as in Table 2(b), he cenral bank's foreign exchange reserves are drawn down by he amoun R [see Table 2(d)]. Noice, however, ha he final oucome is equivalen o Table 2(c) in erms of he public secor's ne deb. I is unchanged relaive o he pre-deb relief level. 4 Laer, in a dynamic conex, we obain a similar resul. The governmen can pospone he moneary implicaions of deb relief wih HIPC condiionaliy hrough serilizaion. However, i mus evenually face he realiy of is ineremporal budge consrain: absen cus in fuure spending or rises in fuure axes, he presen value of fuure seigniorage revenue mus rise in order for he level of deb o fall. 6

8 2. A Muli-Period Analysis In his secion we exend he resuls we obained wih he one-period model o a dynamic model. Once again, we show ha deb relief wih HIPC condiionaliy has no impac on a governmen's fiscal susainabiliy. In he dynamic model his means ha here is no relaxaion of he governmen's lifeime budge consrain implied by deb relief. Similarly, we show ha he cenral bank faces a moneary policy dilemma. The naural consequence of he governmen's increased spending for povery reducion is a moneary injecion ha occurs over he life of he deb relief iniiaive. To he exen ha he cenral bank serilizes his injecion, inflaion can be sabilized, bu his implies no long-run reducion in he governmen's level of deb. 2.1 The Governmen's Ineremporal Budge Consrain We now presen a sandard model of he governmen's ineremporal budge consrain in coninuous ime. In our simple model, here is only one good, whose price is P. The governmen issues only one ype of deb, D, whose value is indexed in erms of ha good. We assume, for simpliciy, ha he ne real ineres rae on governmen deb is some consan r. The governmen finances is ineres paymens, on goods, services and ransfers, issuance of base money, rd, and is spending G, in four ways: by raising ax revenue, T, hrough he M, by receiving aid, A, or hrough he issuance of new deb. The governmen raises funds by issuing base money via seigniorage revenue, M & / P, where P is he price level and governmen's flow budge consrain is given by M & is he ime derivaive of he money sock. 5 / Hence, he D & = rd + G T A M& P, (2.1) where all variables are measured in unis of he single good. The soluion o he differenial equaion (2.1) is D r r( s) = e D ( Ts Gs + As + M& s / Ps ) e ds. (2.2) 5 We generically indicae ime derivaives, Z /, as Z &. 7

9 If we ake he limi as and impose he no-ponzi scheme condiion ha we obain r lim e D = r D = ( T G + A + M& / P ) e d. (2.3) Our inerpreaion of a highly indebed governmen a ime is as follows: given he likely pahs of { T } [, ), { G } [, ), { A } [, ) and { M & / P } [, ), he governmen's lifeime budge consrain, (2.3), is violaed. In oher words, wihou (i) fiscal reforms ha would increase fuure values of T or decrease fuure values of increased in anicipaed aid inflows, G, (ii) a subsanial A, or (iii) higher raes of money growh and seigniorage revenue, he governmen will be unable o service is deb while avoiding defaul. The lifeime budge consrain only holds if a governmen does no defaul. To measure he degree o which a highly indebed governmen has a fiscal susainabiliy problem we define: r V ( T G + A + M& / P ) e d. (2.4) Here V represens he presen value of he governmen's fuure primary surpluses and seigniorage revenue given benchmark values for is fuure revenue, spending, aid and seigniorage flows. The governmen's lifeime budge shorfall is given by S = D V, he difference beween he value of he governmen's iniial deb, and he exen o which i will be able o service i based on is benchmark budge. The design of he HIPC deb relief program can be inerpreed as follows. A counry ha receives deb forgiveness under he program is one ha finds is deb level a dae reduced o D = ( 1 θ ) D, wih < θ < 1. Formally, he iniiaive reduces deb by forgiving a subsanial porion of fuure deb service paymens. Here θd represens he presen value of hese forgiven paymens. Clearly if deb relief were given uncondiionally his would reduce he governmen's budge shorfall since we would have S = D V = S θd. Deb relief under he HIPC iniiaive, on he oher hand, comes wih condiionaliy aached. This condiionaliy is equivalen o a simulaneous increase in he presen value of he fuure 8

10 pah of { G } [, ) equal in value o θ D. This is because he forgiven deb service paymens are argeed owards increased spending on povery reducion iniiaives. So he presen value of fuure governmen spending will rise by an equivalen amoun o he presen value of he forgiven deb service absen some independen fiscal reform. Hence he presen value of he governmen's fuure primary surpluses plus seigniorage revenue falls by he amoun θ D : V = V θd. There is no change in he size of he governmen's lifeime budge shorfall which equals S = D V = S. Thus, in a welldefined sense, he design of he deb relief iniiaive does no make he governmen's deb posiion more susainable. 2.2 A Simple Moneary Framework In his secion we examine a simple model of price deerminaion. Togeher wih he governmen budge consrain, his model allows us o discuss he dynamic inflaionary implicaions of differen policy responses o deb relief. We assume ha money demand akes he form implied by he quaniy heory of money: M d 1 = v PY (2.5) where v > is some consan, Y represens he level of oupu, and P coninues o denoe he price level. Alhough some of he specific implicaions of he quaniy heory do no hold for more general money demand specificaions, our qualiaive resuls are robus o differen models of money demand. 6 We will assume ha he level of oupu is consan, and we will normalize i o equal 1. Hence, in money marke equilibrium, our soluion for he price level is jus where P = vm, (2.6) µ = &, his means M is he supply of money. If he money growh rae is M / M 6 In Burnside and Fanizza (24) we use a Cagan money demand framework. When money demand is ineres elasic, fuure values of he quaniy of money influence he curren price level, whereas under he quaniy heory, all ha is relevan is he curren quaniy. Wih ineres elasic money demand, his means ha he precise iming of inflaion may be differen han under he quaniy heory. 9

11 ha seigniorage revenue is 1 M & / P = v µ. (2.7) To analyze he impac of deb relief on he price level, we will siuae he economy in an iniial seady sae a ime. Since, in his secion, we wish o absrac from issues of defaul, and since we have shown ha he iniiaive has no ne impac on long-run susainabiliy, we assume ha wih or wihou deb relief he governmen will, wih difficuly, adjus is benchmark fiscal plans so ha is lifeime budge consrain, (2.3), holds. In he iniial pre-deb relief seady sae we assume ha G, T, A, and µ are given by consan values G, T, A and µ. Using hese assumpions, he governmen's lifeime budge consrain, (2.3), can be rewrien as 1 rd = T G + A + v. (2.8) µ The governmen mus se is fiscal plans so ha is primary balance plus seigniorage is equal o is flow of deb service. Furhermore, from he flow budge consrain, (2.1), we ge he implicaion ha he governmen's deb sock is consan a he level D. Given ha money grows a a consan rae, he inflaion rae is simply π = µ for all. To make our example as simple as possible we will assume ha he governmen issues deb in he form of perpeuiies. So, in he iniial seady sae, he governmen has a sock of perpeuiies which will pay ou ineres equal o rd in each period ino he infinie fuure. The HIPC iniiaive ypically forgives some fracion of a counry's exising deb service obligaions ou o some finie horizon in he fuure. To capure his aspec of he iniiaive, we will assume ha a ime he holders of he governmen's perpeuiies announce ha beween dae and dae hey will forgive some fracion ψ of he ineres paymens on he exising sock of perpeuiies. For his o amoun o a reducion of he governmen's deb by he amoun θ D, we can see ha he parameer ψ mus be r r such ha θ D = ψrde d = ψ ( 1 e ) D. Hence ψ = θ /(1 e r ). Our inerpreaion of he HIPC iniiaive is ha a ime he counry receives previously unanicipaed deb relief of he form described above. We inerpre he 1

12 condiionaliy of he HIPC iniiaive as requiring ha governmen expendiure increase by as much as he aid flow unil dae : G + ψrd for < G = G for. We assume ha axes and aid remain unchanged so ha (2.9) T = T and A = A for all. Togeher hese assumpions imply ha he presen value of he governmen's primary surpluses goes down by he amoun θ D, which is precisely he same as he reducion in he value of he governmen's deb a ime. So far we have said nohing abou he pah of he money supply under he deb relief iniiaive. We will now explore moneary policy, by considering wo alernaive pahs for he money supply is he pos-deb relief world. Noice ha under he HIPC iniiaive, as described in he previous secion, he governmen increases is primary expendiure by he amoun ψ rd for <. As we saw in he simple T-accoun examples, increased governmen spending requires an insananeous injecion of money ino he domesic economy. In response o his moneary injecion he cenral bank could be passive, in he sense ha i could ake no acion. Alernaively, he cenral bank could serilize he moneary injecion hrough an offseing sale of domesic governmen deb or foreign reserves. In wha follows, we explore hese wo possibiliies, keeping in mind, of course, ha here are many ohers. Passive Moneary Policy We firs describe a passive cenral bank which does no respond o he injecion of liquidiy creaed by he governmen's increased spending. The real value of governmen spending is higher by he amoun ψrd in he period <. So if he cenral bank acs passively he real value of seigniorage revenue, M & / P = v 1 µ, 1 will be higher by he same amoun. Hence M& / P v v 1 = µ = µ + ψrd. Hence he money growh rae (and he inflaion rae) will rise o he level µ = µ = µ + vψrd for. (2.1) To ge some sense of he quaniaive magniudes implied, imagine ha he counry's iniial deb level is 7 percen of GDP ( D =. 7 ), he real ineres rae is 2 11

13 percen ( r =. 2 ), he moneary base is 1 percen of GDP ( v 1 =. 1), 5 percen of he deb is forgiven ( θ =. 5) and he life of he iniiaive is 2 years ( = 2 ). Togeher hese assumpions imply ha ψ = and µ µ =. 21, i.e. he inflaion rae would rise by roughly 21 percenage poins. An ineresing consequence of passive policy is ha he governmen's deb level is reduced by he erminal dae of he iniiaive, despie our resul ha here is no ne relaxaion of he governmen's lifeime budge consrain a ime. From (2.2) we can see ha D = e r = (1 θe (1 θ ) D r ) D. 1 r( s) ( T G + A + v µ ) e ds (2.11) The firs line follows from he fac ha G = G + ψrd, while seigniorage revenue is 1 v µ + ψrd. The second line follows from (2.8). The reason ha he deb level is permanenly reduced is ha wih passive policy, he increased governmen spending is financed by seigniorage revenue, and deb relief provides addiional financing. Given he previous resul, noice ha he governmen would saisfy is lifeime budge consrain a dae if, for >, i se M & / P consisen wih 1 + ) r( ( T G + A) ( M / P ) e d. D = & (2.12) r If he governmen ses he money growh rae equal o a consan µ for >, (2.11) combined wih (2.12) and (2.8) implies µ µ = vrθe r D. So he long-run inflaion rae, µ, is lower han he iniial inflaion rae. In our numerical example above, we would have µ µ =. 1 ; i.e. he inflaion rae is lower in he long run by 1 percenage poins. Acive Moneary Policy By an acive cenral bank we mean one ha serilizes he moneary injecion associaed wih he governmen increased spending in he period <. As money flows ino he economy, he cenral bank buys in back from he privae secor hrough an offseing sale of domesic governmen deb or foreign reserves. 12

14 Under his policy, he money supply coninues o grow a he rae µ, and he inflaion rae says he same as in he pre-deb relief seady sae. From (2.2) we can see ha D = e r = D. (1 θ ) D 1 ( T G ψrd + A + v µ ) e r ( s) ds (2.13) By he ime he erminal dae of he iniiaive is reached, he counry's deb level is once again equal o is iniial deb level. This is he cumulaive resul of he cenral bank's policy of serilizaion. Of course, once he iniiaive is over, he governmen's deb level remains a D, and money growh and inflaion coninue a he rae µ. Discussion We summarize our findings as follows. Under acive moneary policy (i) he governmen's deb level is no permanenly reduced bu (ii) inflaion is sable. Under passive moneary policy (i) he governmen's deb level is permanenly reduced bu (ii) inflaion is unsable, rising during he period of increased governmen spending and falling afer he iniiaive ends. We should noe ha under eiher ype of policy we kep T = T and A = A for all. The pah of governmen purchases was described by (2.9) in boh cases. Since he iniial deb level was ( 1 θ ) D in boh cases, i is clear ha he presen value of seigniorage revenue is idenical across he wo examples. The disincion beween he wo is ha he iming of seigniorage revenue is differen. Under passive policy bigger moneary injecions during he life of he iniiaive are followed by smaller ones in he pos-iniiaive period. Under acive policy, moneary financing is sable over ime Caveas and Conclusions We conclude by firs poining ou several imporan caveas o our analysis. Mos imporanly, we wan o poin ou ha our analysis is no a negaive saemen abou he 7 Our resuls are he mirror image of Sargen and Wallace's (1981) unpleasan monearis arihmeic: wihou a change in he primary surplus, low inflaion now means more inflaion laer. In our case, lower inflaion in he fuure means higher inflaion now. 13

15 welfare implicaions of he HIPC iniiaive. Alhough we argue ha fiscal susainabiliy is no enhanced, i is clear ha he iniiaive represens a resource ransfer from credior counries o debor counries. Therefore, oher hings equal i is welfare enhancing o he debor counries. 8 We absrac from he possibiliy, raised by Cohen (21), ha donors will decrease heir non-deb relief aid once he HIPC iniiaive is under way. Of course, any decline in oher forms of aid would offse he value of he deb relief provided by he donors, and would imply a ne worsening of he governmen's fiscal posiion. We have also ignored incenives effecs ha sem from aid and deb relief. 9 For example, we do no ake ino accoun he possibiliy ha wih preferences unchanged, HIPC governmens may undo he effecs of deb relief (see Easerly 22 and Burnside and Fanizza 24). Undoubedly here may be some indirec benefis o fiscal susainabiliy semming from he impac of HIPC deb relief on domesic income. We explore he likely magniude of hese effecs in Burnside and Fanizza (24), and conclude ha hey are relaively modes, perhaps amouning o a mos abou one quarer of he counry's iniial deb sock under generous assumpions abou he reurns o foreign aid. 1 Our main focus has been on wo simple poins. Firs, deb relief condiioned on increased governmen spending does no relax he governmen's lifeime budge consrain. Second, moneary policy makers face a policy dilemma. If hey ac passively in he face of moneary inflows semming from increased governmen spending, his can have a desabilizing effec on inflaion. On he oher hand, if hey acive serilize hese inflows he governmen sock of deb reurns o is pre-deb relief level. 8 Our analysis has also omied he possible welfare consequences of desabilized inflaion under passive moneary policy. 9 See, for example, Corden (1989), Bulow and Rogoff (199), Casella and Eichengreen (1996), and Svensson (2). 1 The resuls in Burnside and Fanizza (24) are based on he assumpion ha he reurns o foreign aid are quie high, of a magniude consisen wih wha Burnside and Dollar (2) sugges is consisen wih a good policy counry. Implici in he analysis is he noion ha governmen invesmen in capial leads o growh. Easerly and Levine (21), and Devarajan, Easerly, and Pack (23) provide independen evidence ha here is good reason o hink ha our assumpions are, if anyhing, overly generous. 14

16 References Bulow, Jeremy and Kenneh Rogoff (199) Cleaning Up Third World Deb Wihou Geing Taken o he Cleaners, Journal of Economic Perspecives, 4, Burnside, Craig and David Dollar (2) Aid, Policies, and Growh, American Economic Review, 9, Burnside, Craig and Domenico Fanizza (24) Hiccups for HIPCs? NBER Working Paper No Casella, Alessandra and Barry Eichengreen (1996) Can Foreign Aid Accelerae Sabilizaion? Economic Journal, 16, Cohen, Daniel (21) The HIPC Iniiaive: True and False Promises, Inernaional Finance, 4, Corden, W. Max (1989) Deb Relief and Adjusmen Incenives, in Frenkel, Jacob A., Michael P. Dooley and Peer Wickham eds. Analyical Issues in Deb, Washingon, DC: Inernaional Moneary Fund. Devarajan, Shana, William Easerly and Howard Pack (23) Low Invesmen is no he Consrain on African Developmen, Economic Developmen and Culural Change, 51, Easerly, William (22) How did he Heavily Indebed Poor Counries Become Heavily Indebed? Reviewing 2 Decades of Deb Relief, World Developmen, 3, Easerly, William and Ross Levine (21) Wha Have We Learned from a Decade of Empirical Research on Growh? I's No Facor Accumulaion: Sylized Facs and Growh Models, World Bank Economic Review, 15, Sargen, Thomas, and Wallace, Neil. (1981) Some Unpleasan Monearis Arihmeic, Federal Reserve Bank of Minneapolis Quarerly Review, 5 (Fall): Svensson, Jakob (2) Foreign Aid and Ren-Seeking, Journal of Inernaional Economics, 51, Van Trosenburg, Axel and Alan MacArhur (1999) The HIPC Iniiaive: Delivering Deb Relief o Poor Counries. Washingon, D.C.: Inernaional Moneary Fund and World Bank. 15

17 TABLE 1 (a) INITIAL BALANCE SHEETS OF THE PUBLIC SECTOR Cenral Bank Governmen Asses Liabiliies Asses Liabiliies FX reserves Moneary base Governmen deposis Gross deb Governmen bonds Governmen deposis Ne nonmoneary deb of he public secor: Gross deb governmen bonds held by he cenral bank FX reserves (b) CHANGES IN BALANCE SHEETS AFTER REVENUE INFLOWS AND EXPENDITURE OUTFLOWS Cenral Bank Governmen Asses Liabiliies Asses Liabiliies FX reserves +A Moneary base +(G T) Governmen deposis +(A+T G) Gross deb n.c. Governmen bonds n.c. Governmen deposis +(A+T G) Ne nonmoneary deb of he public secor: A (c) CHANGES IN BALANCE SHEETS AFTER GOVERNMENT PAYS OFF DEBT Cenral Bank Governmen Asses Liabiliies Asses Liabiliies FX reserves +A Moneary base +A Gov deposis n.c. Gross deb (A+T G) Governmen bonds n.c. Gov deposis n.c. Ne nonmoneary deb of he public secor: (2A+T G) (d) CHANGES IN BALANCE SHEETS AFTER CENTRAL BANK MANAGES THE PUBLIC SECTOR DEBT Cenral Bank Governmen Asses Liabiliies Asses Liabiliies FX reserves n.c. Moneary base + M Gov deposis n.c. Gross Deb (A+T G) Governmen bonds + M Gov deposis n.c. Ne nonmoneary deb of he public secor: (A+T G+ M) n.c. Indicaes no change 16

18 TABLE 2 (a) CHANGES IN BALANCE SHEETS AFTER DEBT RELIEF IS PROVIDED Cenral Bank Governmen Asses Liabiliies Asses Liabiliies FX reserves n.c. Moneary base n.c. Governmen deposis n.c. Gross deb R Governmen bonds n.c. Governmen deposis n.c. Ne nonmoneary deb of he public secor: R (b) CHANGES IN BALANCE SHEETS AFTER HIPC CONDITIONALITY IS IMPOSED Cenral Bank Governmen Asses Liabiliies Asses Liabiliies FX reserves n.c. Moneary base +R Gov deposis R Gross deb R Governmen bonds n.c. Gov deposis R Ne nonmoneary deb of he public secor: R (c) CHANGES IN BALANCE SHEETS AFTER CENTRAL BANK STERILIZES THE MONETARY INJECTION Cenral Bank Governmen Asses Liabiliies Asses Liabiliies FX reserves n.c. Moneary base n.c. Gov deposis R Gross Deb R Governmen bonds R Gov deposis R Ne nonmoneary deb of he public secor: n.c. (d) CHANGES IN BALANCE SHEETS AFTER INCREASED GOVERNMENT PURCHASES ARE DIRECTED TOWARDS IMPORTED GOODS Cenral Bank Governmen Asses Liabiliies Asses Liabiliies FX reserves R Moneary base n.c. Gov deposis R Gross Deb R Governmen bonds Gov deposis R Ne nonmoneary deb of he public secor: n.c. n.c. Indicaes no change 17