IMPACT OF STATE BUDGET DEFICIT ON GOVERNMENT DEBT IN VIETNAM

MINISTRY OF EDUCATION AND TRAINING FOREIGN TRADE UNIVERSITY ---o0o--- DISSERTATION IMPACT OF STATE BUDGET DEFICIT ON GOVERNMENT DEBT IN VIETNAM Major: International Trade and Policy

MINISTRY OF EDUCATION AND TRAINING

FOREIGN TRADE UNIVERSITY

-o0o -

DISSERTATION

IMPACT OF STATE BUDGET DEFICIT ON GOVERNMENT DEBT IN VIETNAM

Major: International Trade and Policy in Vietnam

Full Name: Nguyen Thi Hong Quyen SUPERVISOR: Assoc.prof Dr Hoang Xuan Binh

Ha Noi - 2016

ACKNOWLEDGEMENT

This postgraduate research project could not be accomplished without the strong supports from my supervisor from Foreign Trade University, colleagues at the Department of Debt Management and External Finance, who I have been working with over the last 5 years What I have found during my time working here was the primary inspiration of selecting this very typical topic, along with great encouragements from family and friends Throughout the process of completing this project, I have encountered many difficulties from data collection, analysis and interpretation I would like to take this opportunity to acknowledge such appreciations to my colleagues, who have offered their devotions to assist myself from establishing this research work

First and foremost, I would like to express my greatest gratitude to my supervisor, Associate Professor, Doctor Hoang Xuan Binh, who has been overseen the progress of my entire research project over the last 7 months Sincerely, if this project was not under his guidance, patience, motivation and academic suggestions

on some of my weaknesses, I would not have managed efficiently to finish this study

I greatly cherish the opportunity that my colleagues gave to me, to learn on perfecting

my work professionally It was one of my greatest experiences with supervisors and colleagues throughout five years working in the Debt Management and External Finance, Ministry of Finance

Without any doubt, I would like to thank my family, classmates and colleagues Throughout a long stressful time doing the year-round project, I could not express any greater gratefulness to them, standing by my side and support intellectually

TABLE OF CONTENTS

ACKNOWLEDGEMENT 1

LIST OF FIGURES, GRAPHS AND TABLES 5

LIST OF ABBREVIATIONS 7

CHAPTER I INTRODUCTION 8

1.1 Urgency of subject 8

1.2 Researching overall on budget deficit and government debt 9

1.3 The objectives of research 11

1.4 Scale and subjects of the research 11

1.3 Method of research 12

1.4 Scientific and practical meaning of the research 13

1.5 Structure of the research 13

CHAPTER II: LITERATURE REVIEW 14

2.1 Theories relevant to the research 14

2.1.1 State budget 14

2.1.2 Public debt and government debt 17

2.1.3 Some theoretical research framework 19

2.2.1 Debt burden indicators 33

2.2.2 Debt sustainability 35

2.2.3 Baseline Scenario 38

2.2.4 Standardized stress tests 41

2.2.5 Shocks Analysis in DSF and in DSA 60

CHAPTER III: METHODOLOGY AND DATA SOURCES 63

3.1 Research procedure 63

3.2 Data description 66

3.3 Research assumption 68

3.3.1 Building a model for Vietnam case 68

3.3.2 Domestic Financing Instruments: 70

3.3.3 External Financing Instruments: 71

CHAPTER IV FINDINGS AND DISCUSSION 77

4.1 Alternate scenarios of Primary Deficit 77

4.1.1 Average Primary Balance 77

4.1.2 Revenue-expenditure structure 79

4.1.3 Annual budget deficit reduction schedule 83

4.2 Financing Strategy 87

4.2.1 Financing Sources: Domestic versus External 87

4.2.2 Tenor of new Borrowing 89

4.3 Exchange rate 95

4.4 Interest of domestic and external borrowings 97

4.4.1 Interest of new domestic borrowings 98

4.4.2 Interest of new external borrowings 99

4.5 Notes on Nominal GDP 101

4.6 Summary of findings 101

CHAPTER 5 CONCLUSION AND POLICY RECOMENDATION 104

5.1 Conclusion review and Policy recommendation 104

5.1.1 Effective fiscal deficit control 104

5.1.2 In short-term Vietnam properly forcuses more on controlling effectively expenditures, in middle and long terms, gradually changing expenditure structures under state budget to consolidate fiscal policy 105

5.1.3 Developing domestic capital market should be first and foremost priority 105

5.1.4 A benchmark yield curve of government bond can serve as a strategic management of financing cost 107

5.2 Suggesstions for further research 108

LIST OF REFERENCES 110

LIST OF FIGURES, GRAPHS AND TABLES

Figure 1: Negative shock to real GDP growth (PDSA) - impact on the level of gross financing needs

Figure 10: Negative shock to non-debt creating flows - impact on the level of gross financing needs

Figure 11: Negative combination shock - impact on the level of gross financing needs

Figure 2: Exchange rate depreciation (PDSA) - impact on the level of gross financing needs

Figure 3: Shocks to the Primary Balance (PDSA) - impact on the level of gross financing needs

Figure 4: Negative shock to primary balance and read GDP growth - impact on the level of gross financing needs

Figure 5: Contingent liability shock - impact on the level of gross financing needs

Figure 6: Key variables set to historical averages - impact on the level of gross financing needs

Figure 7: Shocks to financing terms - impact on the level of gross financing needs

Figure 8: Two-year shock to export growth - impact on the level of gross financing needs

Figure 9: Negative shock to the GDP deflator in US dollar terms - impact on the level of gross financing needs

Graph 1: Interest Payment to revenue and Primary Revenue to GDP

Graph 2: Evolution of Annual Gross financing needs in different scenarios Graph 3: Evolution of Interest Service in different scenarios

Graph 4: Evolution of Debt to GDP in different scenarios

Graph 5: Evolution of External Debt to Total Debt in different scenarios

Graph 6: Evolution of Annual Rollover Amount in different scenarios of new borrowings tenor

Graph 7: Evolution of Annual Gross financing needs in different scenarios of Vietnam dong depreciation

Graph 8: Evolution of Annual Gross financing needs in different scenarios of new borrowing cost

Table 1: General Government Net Debt of some countries, 2007- 2021

Table 2: Risk classification and CPIA Score

Table 3: Stress Tests in PDSA and EDSA

Table 4: Summary of Macro-Fiscal Stress Tests

Table 5: Definition of External Instruments

Table 6: Summary of baseline scenario assumptions

Table 7: Debt indicators in Baseline Scenario

Table 8: Baseline scenario – break down of GFN

Table 9: Debt Indicators in scenarios of Average Primary Balance

Table 10: Evolutions of Debt indicators to stabilize debt to GDP ratio

Table 11: Debt Indicators in scenarios of Revenue – Expenditure structure Table 12: Scenario 1 –Annual Primary Deficit remains at 3.4% GDP

Table 13: Scenario 2 – Increasing Annual Primary Deficit / GDP

Table 14: Debt indicators in scenarios of average new domestic tenor

Table 14: Debt indicators in scenarios of domestic financing ratio

Table 16: Debt indicators in scenarios of average new external tenor

Table 17: Debt indicators in scenarios of annual VND depreciation

Table 18: Debt indicators in scenarios of new domestic borrowing cost

Table 19: Debt indicators in scenarios of new external borrowing cost

LIST OF ABBREVIATIONS

ATM Average time to maturity

DSA Debt sustainability analysis

DSF Debt sustainability framework

EDSA External Debt sustainability analysis

EUR official currency of the eurozone

FDI Foreign direct investment

FTA Free-trade agreement

GBP official currency of the United Kingdom

GDP Gross domestic product

GFN Gross financing needs (also gross financing requirements) IDA International Development Association

IMF International Monetary Fund

LIC DSA Low income country Debt sustainability analysis

MAC DSA Market-accessed country free-trade agreement

MOF Ministry of Finance of Vietnam

PDSA Public Debt sustainability analysis

TPP Trans-Pacific Partnership

USD official currency of the United States

VND official currency of Vietnam

WAL Weighted Average Life

NPV Net present value

LCU Local currency unit

NICA non-interest current account

X exports of goods and services

CHAPTER I INTRODUCTION 1.1 Urgency of subject

Due to the latest report from the Ministry of Finance to the Standing Committee

of National Assembly, public debts of Vietnam stood at 62.2% of GDP in 2015 If GDP of Vietnam grows at 6.5% in 2016, with the inflation bellow 5% (y.o.y), it is expected public debts of Vietnam will be at 64.9% of GDP, just 0.1% of the bellow the symbolic 65% of GDP that was approved by the National Assembly (Ministry of Finance 2016)

Not long before that, after intense debates, National Assembly on 29th July, 2016 approved another record of high budget deficit of 6.33% GDP, much higher than the 5% of GDP targeted for 2014 A major contributing factor to that record high was higher than estimated ODA disbursement in 2014, which was a 26.1 trillion VND add on to the initial estimates

According to Associate Professor, Doctor Hoang Xuan Binh, Public Debt Crisis: From Theory to Practice, public debt of Vietnam stood at only 33.8% in 2007, this number rose significantly through the year and he expected that in 2015, public debts would be between 60- 65% of GDP In fact, as mentioned earlier in 2015, public debt of Vietnam was 62.2% of GDP According the same author, even though public debts of Vietnam has been supported by strong concessional level of ODA financing with a long maturity, the pace of increasing public debt (year on year basis), the inefficient use of public financing through high ICOR, and vulnerability to external shocks that may expose public debts of Vietnam into over all economic stability, such

as inflation raising, private investment and the over all credit rating of the sovereign Never than before, have the issues of public debts and budget deficit become so critical like these days Not only does it become the centre of debates amongst policy makers and scholars, but this topic also receives a lot of attention from different view

in line of economic development

This study is urged on finding new evidence to provide a better understanding,

fill in the absence of research gap in the literature review by examining the impact

of state budget deficit on government debt in Vietnam

1.2 Researching overall on budget deficit and government debt

For a long period of time, there were a lot of discussions on the government should keep running deficits Many respected economists considered deficit in general is very bad for the economy:

● One argues that it will crowd out private investment;

● It redistributes resource and responsibilities to different groups of society, thereby creating disparity in the economy as a whole (which is against the principle

of invisible hand or market self correction principles.)

● Last but not least, it generates burden for the future generations which in the long run indifferent to the effect of raising tax, while the accumulation of public debts arisen from Government’s policies of persistent deficits may lead to the collapse of the economy

While debates amongst policy makers on how much one government should borrow, and amongst many economists on the good and the bad of government borrowing and its implication to state budget, governments all over the world keep borrowing

Table 1: General Government Net Debt of some countries, 2007- 2021

(in percent of GDP)

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

United

States 44.5 50.5 62.0 69.4 75.9 79.4 80.8 80.3 79.8 82.2 82.3 82.1 82.6 83.4 Japan 80.5 95.3 106.2 113.1 127.2 129.0 124.2 126.2 125.3 127.9 130.7 132.6 132.4 132.2

France 57.7 60.3 70.1 73.7 76.4 81.6 84.4 87.4 88.2 89.2 89.8 90.0 89.4 88.0

United

Kingdom 37.1 44.4 57.4 68.5 72.9 76.2 77.6 79.5 80.4 80.5 80.3 80.0 78.1 75.8 Vietnam 37.9 34 42 44.9 39.3 39.4 42.6 46.4 50.3 53.1 53.3 53.3 53.2 52.7 Europe 22.2 22.0 27.8 28.6 26.4 24.1 24.5 23.2 21.8 25.2 25.5 25.6 25.1 24.7

Brazil 44.1 37.1 40.4 38.0 34.5 32.3 30.6 33.1 36.2 45.8 50.4 53.6 56.5 59.6

Peru 16.7 13.0 12.2 10.3 7.2 4.6 3.5 3.6 5.6 7.7 9.1 9.9 10.3 10.5

Source: IMF 2016

At the same time, however, neo classical theory believes that deficit is part of any Nation’s development policies In fact, it is quite hard to find any Nation or Government during the course of current development not running in deficit or causing certain level of public debts When one government revenues is lower than its expected expenditures, it has created budget deficit In order to finance that deficit, the government will have to borrow either externally or domestically to cover that deficit Unlike government deficit that can be changed from this year to next year, thanks to government’s efforts in raising revenues or reducing its expenditures, the level of government debts may not be changed so easy due to its accumulating feature

On the literature point of view, even the schools of debt free economy see the need of identifying the relationship between public debts and budget deficits:

“Persistent budget deficits have increased economist’s interest in theories and

evidence about fiscal policies” (Robert J Barro 1989)

The main argument of debt free scholar was that while public debts created burden of obligations to the future generation, the involvement of the Government during the course of capital mobilization made the economy worse off due to its administrative ineffectiveness in fulfilling the mobilization goals The tendency of over borrowing in any government may boots demand for consumptions, instead of encouraging reserves and provisions That may lead to deepen current account deficit, while credit market is going into further imperfection due to superior role against other market players of the government in the capital market Some even goes further

supporting to this argument The case of Greece was a typical example of over borrowing for Olympic 2002 has knocked an EU member state to a long period of recession and the expected date of recovery is yet unknown The collapse of Greek economy has triggered what has been called debts crises in European continent and others, such as Iceland, Italy, Portugal…To a lessen extent, but not least, however, public debts and government spending have become a heat topic of debates at leading economies such as at the US and Japan Congresses

1.3 The objectives of research

The main focus of this dissertation is to use literature and empirical studies to determine the extent of impact of the level of budget deficit and government debts, and put that into a particular situation of Vietnam Government borrowings, fiscal deficits and policy implications are the key contents of this Paper From the analysis through model building for Vietnam case with assumptions on scenarios of different debt indicators, the paper concludes: i) how state budget deficit impact on government debt; ii) solutions to control budget deficit and government debt; and iii) several recommendations on policy actions on ensuring basic investment needs are met, while public debts can be kept at sustainable level on the basis of the studies is expected to be given under this dissertation

1.4 Scale and subjects of the research

Within scale of the research, the paper only focuses on definitions on fiscal deficit, public debt, government debt and debt indicators from viewpoint of Vietnam

In order to bring out as clear as possible the connection between budget deficit and debt sustainability of Vietnam, the paper has consolidated data from various source

on how much Vietnam government has borrowed and spent and the impacts to the country’s debt positions

For the data of Vietnam, even though the empirical findings can provide a clear perception on how debt actually affects growth, given the extent to which this paper

is aiming to explore, other Government policies are not seriously taken into account, which are trade policies, economic policies or FDI policies Changes in these policies

may of course having impacts on fiscal position of the Government, the main objectives of this Paper is to determine the extent of relationship between fiscal deficit and debt sustainable of Vietnam Policy recommendations are therefore, focus mainly

on these two issues For this purpose, data of public debts and fiscal numbers is ranged from 2005 to 2015

For the case of Vietnam, with both public debts and government deficit have or almost have broken threshold, the issue of linkage between state budget deficit and safety level of public debts, more than ever, has become such a big and complicated issue In fact, at the 2nd session of XIV term of National Assembly which is started from October 2016, it is expected that intense discussions on medium term state budget, public debts and public investment plans will be taking place

That fact has led to the subjects of the research is to study about the state budget deficit, government debt and the relationship between state budget deficit and government debt More importantly, what its significance for the economies in transition would be as the case of Vietnam Does budget deficit have adverse influence to debt indicators such as: inflation, interest rate, private investment, and of course public debts (in view of debt sustainability); or does it really support economy and employment, and therefore it will be accommodate public debts in the near future;

or is there just a tiny connection between what the government would spend and its future deficit? Fiscal policies, debt management policies, therefore, are the most important subjects of the researches

1.3 Method of research

The literature review of this research is based on Keynesian theory of public debt It also touches upon monetarist thought, led by Friedman (1968), Ricardian equivalence theorem and Buchanan’s thesis, which will be introduce more detail in the Chapter II of the research

The data is using models Debt Sustainability Framework (DSF) and Debt sustainability analysis (DSA) They are intended to aid technical staff in low-income

countries as well as country teams at the IMF and WB by providing the intuition as well as mechanics of stress testing This should enhance the understanding of the shocks in the DSF and help improve the conduct of debt sustainability exercises in low-income countries

1.4 Scientific and practical meaning of the research

With Vietnam, it is not only the headline growth that matters, but also is the quality of growth that matters more With the level of public debts is stood at alarming level, the concepts of deficit and public debt sustainability are vital By finding the ways to answer most if not all of the questions mentioned hereafter, the research is believed firmly address one of the critical issues that the economy of Vietnam has to face with for the next 5 year period of 2016- 2020 It certainly cannot ambitiously present the comprehensive solutions for sustainability development when refer to public debts and deficit Rather than that, looking into the equation quantifying impacts of public borrowings to Vietnam’s economic growth, and the extent to which budget deficit will have on government debts may help policy makers on deciding when taking into account the trade off between current development opportunity and future debt obligations

1.5 Structure of the research

The research is concluded with 5 chapters which are: 1) Chapter 1: Introduction; 2) Chapter 2: Literature review; 3) Chapter 3: Research model; 4) Chapter 4: Analysis and Findings; and 5) Chapter 5: Conclusion and Policy Implication

CHAPTER II: LITERATURE REVIEW

2.1 Theories relevant to the research

2.1.1 State budget

• According to the Law on State Budget, 2002, the State Budget comprises all revenues and expenditures of the State that have already been decided by the competent State agencies and implemented within one year in order to ensure the implementation of the functions and responsibilities of the State

• State Budget revenues include revenues from taxes, fees and charges; revenues from economic activities of the State; contributions by organizations and individuals; aids; and other revenues as stipulated by law

• The State Budget expenditures include spending on socio-economic development, on ensuring national defense, security, operations of the State apparatus; spending on the payment of State debts; on aid and other spending as stipulated by law

• The State Budget shall be put under unified management on the principle of democratic centralism, transparency, assignment of responsibilities in association with assignment of powers

• The National Assembly shall decide the draft State Budget and allocations of the central State Budget, and ratify the State Budget accounts

• The State Budget shall comprise the central budget and local budgets Local budgets shall comprise budgets of the local administration at various levels that have People’s Councils and People’s Committees

• Decentralization of sources of revenue and spending tasks, and the relations between budgets of various levels shall be established on the following principles:

- The central budget and the budget of each level of local administration shall

be decentralized in terms of concrete sources of revenue and spending tasks;

- The central budget shall play a key role, ensuring implementation of strategic tasks of national importance, and support localities that have not been able to balance their budget revenue and expenditures;

- Sources of revenue shall be decentralized to local budgets in order that local administration will perform assigned tasks proactively, and resources of commune budget will be strengthened People’s Councils of provinces and cities under the central Government (hereinafter collectively called

“provincial”) shall decide decentralization of sources of revenue and spending tasks among budgets of local administration of various levels in line with decentralized socio-economic management, national defense and security, and management competencies of each level in the locality concerned;

- The budget of each level shall handle assigned spending tasks Promulgation and execution of new policy and regime, which entails an increase in budget spending, must be supported by a financing solution appropriate with balancing capability of the budget concerned;

- In case an upper-level State management agency authorizes a lower-level State management agency to carry out a spending task that comes under the formers' responsibility, funds must be transferred from the upper-level budget

to the lower-level budget for performing such a task;

- The revenue sharing by a percentage (%) ratio among the budgets of various levels shall be implemented, and additional allocation from the upper-level budget to the lower-level budget shall be made to ensure equality, balanced development among the regions and localities The percentage ratio for revenue sharing and the additional allocation of revenue from the upper-level budget to the lower-level budget shall be maintained stable from three to five years The additional revenue allocated from the upper-level budget to the lower-level budget shall be the latter’s revenue;

- During a period of stable budget, localities may utilize annual increased revenue to which they are entitled for local socio-economic development After each period of stable budget, the localities must improve their capabilities of budget self-balancing, increase the local budget, reduce additional allocation from the upper-lever budget or increase the percentage ratio of revenue sharing with the upper-level budget; and

- Except for the supplementary allocations to the revenue source and the authorized spending as stipulated in Clauses e and f of this Article, the budget

of one level shall not be used to pay for spending that comes under the task of another level, except in special cases as stipulated by the Government

• The State Budget shall be balanced in accordance with the principle that the total revenue from taxes, fees and charges must be bigger than the total regular spending and help to accumulate more and more for spending on development investment; in case of over-spending, the over-spent amount must be smaller than the amount spent on development investment and a balance between revenue and expenditure of the budget must be achieved eventually

• Budget deficit shall be financed by domestic and foreign borrowings The borrowing to make up for the State Budget deficit must abide by the following principle: they must not be used for consumption, but only for development purposes; and a budget must arranged to proactively repay the debts when they are due

• The local budgets shall be balanced on the principle that the total expenditure shall not exceed the total revenue; in case a province or city directly under the central Government needs an investment in infrastructure construction which comes under the scope of the provincial budget, or which is on the list of investment in the five-year plan approved by the People’s Council, but which is beyond its balancing ability, such a province or city shall be allowed to mobilize domestic investment capital and balance its own provincial budget in order to be able to repay all debts when they are due Total outstanding borrowing shall not exceed 30% of total annual domestic capital investment of the provincial budget

State budget deficit: A budget deficit is an indicator of financial health in

which expenditures exceed revenue The term budget deficit is most commonly used

to refer to government spending rather than business or individual spending, but can

be applied to all of these entities When referring to accrued federal government deficits, the deficits are referred to as the national debt

2.1.2 Public debt and government debt

According to Law on Public debt management, 2009, Debt means a loan to be repaid, including the principal, interests, charges and other related expenses at a point

of time, which arises from the borrowing by a borrower that is permitted to take loans under the law of Vietnam

• Government debt: a debt arising from a domestic or foreign loan, which is

signed or issued in the name of the State or the Government, or a loan signed or issued

by or under the authorization of the Ministry of Finance under law Government debts

do not include debts issued by the State Bank of Vietnam to implement monetary policies in each period

• Government-guaranteed debt: a domestic or foreign loan borrowed by an enterprise or financial or credit institution under the Government's guarantee

• Debt of local administration means a debt signed or issued by or under the authorization of the People's Committee of a province or centrally run city (below referred to as provincial-level People's Committee)

• National foreign debts means the total of foreign debts of the Government, government- guaranteed debts and debts borrowed and paid by enterprises and other organizations themselves under the law of Vietnam

• Borrowing means the process of creating the debt payment liability through the conclusion and performance of a loan treaty, contract or agreement (below referred to as loan agreement

• Borrower means the borrowing party in a loan agreement or the issuance of debt instruments that is liable for repaying the principal to the lender according to the conditions and terms of the loan agreement or the issuance

• Borrower of government loan (below referred to as sub-sub-borrower) means

an enterprise, financial or credit institution, or provincial-level People’s Committee, which signs an on-lending agreement land, acknowledges debts with the on-lending agency to use the Government's loan under the on-lending mechanism

• Guaranteed borrower means a borrower who is guaranteed by the Government Guaranteed borrowers include those receiving the lawful transfer from borrowers under the guarantor’s approval

• Short-term loan means a loan with a term of less than one year

• Medium- or long-term loan means a loan with a term of one year or more

• Foreign loan means a short, medium or long-term loan with or without interest borrowed by the State or Government or an enterprise or organization of Vietnam from a foreign government, territory, organization or individual or an international financial organization

• Official Development Assistance (ODA) loan means a loan borrowed in the name of the Vietnamese State or Government from a donor being a foreign government, bilateral donor organization, transnational organization or inter-governmental organization with non-refundable funds (preferential component) accounting for at least 35% for a binding loan, and 25% for a non-binding loan

• Concessional loan means a loan which is provided under conditions more preferential than those for a commercial loan, but its preferential component does not reach the level set for ODA loans

• Commercial loan means a loan provided under market conditions

• Debt instrument means a bill, draft, bond, public bond or other instrument which gives rise to a debt payment liability

• Government bond means a bond issued by the Ministry of Finance to raise funds for the state budget or a specific work or investment project

• Government-guaranteed bond means a bond with a term of one year or more which is issued by an enterprise to raise funds for an investment project under the Prime Minister's designation and guaranteed by the Government

• Bond of local administration means a bond with a term of one year or more, which is issued by or under the authorization of a provincial-level People's Committee to raise funds for local works and investment projects

• Debt payment means the payment of a due debt, including the principal, interests, charges and other related expenses arising from the borrowing

• Debt refinancing means new borrowing to pay one or many existing debts

• Debt restructuring means the performance of operations in order to change the conditions and terms of an existing debt without creating a new debt payment liability

• Debt portfolio restructuring means the performance of operations in order to restructure each debt in a debt portfolio, including debt refinancing, debt transfer and sale, currency swap, interest rate and other operations to mitigate debt payment liabilities and restrict risks

• Debt settlement means taking measures to handle a debt in case of insufficient solvency or insolvency

• On-lending agency means the Ministry of Finance or a financial or credit institution authorized by the Ministry of Finance to re-lend the Government's foreign loans

• Government guarantee means the Government's commitment with the lender

to fulfill the debt payment liability in case a borrower fails to fulfill or fully fulfill the debt payment liability for a debt due

• Projected debt liability means a debt obligation which has not arisen but is likely to arise when occurs at least one of specified conditions

• Borrowing limit means the maximum net annual loan (actually received after subtracting principal payments)

• Debt limit against the gross domestic product (GDP) means the maximum ratio of outstanding debts to GDP in each period

2.1.3 Some theoretical research framework

Functional finance appeared to work well for a while For at least twenty-five years after the World War II, there was an economic boom that dipped rather mildly only occasionally As a result, unemployment was on the average lower than at any time in the previous some one hundred years However, by late 1960s, unemployment and inflation rose simultaneously, challenging the certainties associated with the Phillips curve and symbolizing the failure of Keynesian policies The time was ripe for the resurgence of classical liberalism In particular,

monetarism, led by Milton Friedman (1962, 1963, 1977) rapidly asserted itself as

a major pole of the opposition to Keynesianism Diverse other liberal currents also appeared Among these, supply-side economics focussed on offering advice for economies in difficulty and public choice applied the postulates of rational choice

to political processes

Two threads of the monetarist thought are of special interest to our research topic First, there is the argument that an increase in the money supply at a rate equal

to its demand at current prices is non-inflationary It generates zero costs In contrast,

an increase in money supply at a rate greater than its demand (at current prices) is inflationary It leaves in the hands of the public excess cash balances The public’s bid to reduce these balances restores a new supply and- demand equilibrium wherein both current and expected prices rise in proportion to the change in the quantity of money Monetising the deficit, therefore, inflicts an ‘inflation tax’ on the holders of money balances The value of this tax equals the proportional rate of change of the high-powered nominal money stock times the real stock of money balances It is paid

by the holders of money balances to the issuers of money in the form of surrendering command over real resources (Lewis & Mizen 2000)

It is not surprising therefore that Musgrave and Musgrave consider inflation tax among the least equitable of all taxes The arbitrariness of inflation tax incidence only reinforces this inequitable character

The second important contribution of monetarist thought, again led by Friedman (1968), has been an emphasis on the ‘natural rate of unemployment’ that an economy tends to have in a state of equilibrium This rate depends on the ‘real economic forces’

at play i.e structural characteristics of the economy such as market imperfections, institutional arrangements (unemployment-insurance schemes), trade unions and the preferences of its members etc., and it has important implications for economic management In brief, fiscal and monetary policies aimed at reducing the unemployment rate below the natural rate are ineffective in the long run They generate an accelerating inflation Thus there is no trade-off between inflation and unemployment; the so-called, Phillips curve on which the Keynesians hinge their

economic policy recipes is vertical in the long run; the relationship disappears because agents adapt to the inflation rate, which they notice in the economy

The new classical analysis of public borrowing has elucidated many channels through which it can adversely influence macroeconomic variables For instance, when governments issue domestic bonds to finance deficits, they compete with private institutions and persons to borrow money likely pushing interest rates higher Orr, Edey and Kenedy (1995) estimate that an increase in budget deficit by 1% of GDP could raise real interest rates by around 1/6% when funded through internal debt and by approximately 1/3% when funded through external debt that worsens current account deficit High real interest rates, in turn, discourage, displace, reduce or

‘crowd out’ private investment (Friedman and Friedman 1980) Thus in the long run budget deficits result in either reduced private investment and/or (depending on the monetary policy accompanying budget deficits and its impact on exchange rates) an increased current account deficit Alternatively, given current account deficit reflects national dissaving, government can reduce such dissaving by 10 tightening fiscal policy assuming the gap between private saving and private investment remains stable over time This link between current account deficit and budget deficit is known as the twin deficit hypothesis (Fischer and Easterly1990)

As we saw above, a very important related question formulated by Ricardo and contested by the functional finance theorists had been that of the burden of public debt on future generations i.e the interdependence between public borrowing and taxes Here, Buchanan (1958) has made a key contribution He argues that Keynesian dismissal of private-public debt analogy owes to an illusion created by focussing only

on one side of the balance sheet: in case of private debt, on the liability side and in case of the public debt, on the asset side If both the asset and liability sides were taken together, it all boiled down to whether debtfunded investment yielded, at minimum, enough returns to service and amortise the debt And in this respect, there was no difference between the internal and external debt, or, the public and the private debt On the burden of public debt, Buchanan draws on Adam Smith’s insight that investors in government paper do not incur any sacrifice since they purchase it

voluntarily He takes the position that this insight when transposed into the choice framework means that members of say, Generation I who purchase government bonds on their own volition, move to a higher indifference curve since the purchase increases their utility compared to investing in any other available alternative This is quite opposite to what happens to the utility of the members of Generation II who inherit the burden to service this liability by paying taxes While purchasing of government bonds is voluntary, paying part of income in taxes to service government debt previously contracted is compulsory Since Generation II participates neither in the decision to issue debt nor in decisions as to what projects the proceeds are applied, by all means its members incur a sacrifice in servicing such debt They are bonded into these tax payments without consent Naturally, their utility decreases

utility-As Shoup (1962) argues Buchanan’s thesis leaves mercantilist and functional finance position on debt burden in an embarrassing situation For, the argument that the choice to issue debt rather than to tax Generation I is made through political representatives, offers no escape unless we assume that Generation I has the authority

to act on behalf of Generation II This suggestion in turn leads to the question, what

if among the factors that influence the utility / welfare of Generation I, is a lively interest in the welfare of Generation II? To Buchanan, this question leaves his argument essentially intact The only change he expects is that Generation I will purchase government bonds by cutting down on consumption rather than savings Even assuming to the contrary would make no difference to his thesis since the welfare of a generation in his framework depends on free choice Barro (1974), however, attempts to undermine this stance by arguing that because future generations are the children and the grandchildren of the present generation, the latter behave altruistically toward them i.e., the utility of the current generation depends not only on its own consumption but also on the consumption of future generations This extends the consumption-savings decision making horizon for the members of Generation I practically to the infinite lives of their families (continuing in future) rather than to the finite life of their own The extension occurs through a series of

bequests that each generation leaves for their immediate successors The implications are that if a debt funded tax cut raises income over an individual’s lifetime but keeps family’s permanent income unchanged, then the individual will save rather than consume the incremental amount and leave it as a bequest for his descendants Thus government bonds enter in an individual’s portfolio, construed not as ‘net wealth’ but together with the corresponding (fully anticipated) tax liability in future From this perspective then, when a government runs deficits by cutting taxes and keeping spending constant, individuals will not increase their spending because their permanent family income will not have changed Similarly, when a government increases its spending financed by deficit, individuals correspondingly reduce their spending making no effect on aggregate spending There is no difference therefore between issuing public debt and raising taxes And there is no burden of public debt

on future generations whatsoever

Barro’s formulation, known as Barro-Ricardo or Ricardian equivalence theorem, is based on an amalgamation of permanent income hypothesis and Ricardo’s insights on the theoretical equivalence of public debt and future taxes mentioned above We saw above that the Keynesian theory assumes that private demand depends almost exclusively on contemporaneous income receipts This view explained well the inter-war behaviour of private consumption in the US However, it did not shed light on the long term behaviour of consumption-and-savings This issue attracted theoretical attention in the post-war period Two theories were advanced, first, the permanent income hypothesis by Friedman (1957), and second, the life-cycle hypothesis advanced by Modigliani and Brumberg (1954) and Ando and Modigliani (1963) The essence of these hypotheses is that it is not the contemporaneous increase

in income that determines households’ disposable income but rather average expected income over a longer term horizon (e.g., a lifetime) That is why consumption is less variable over time than income and savings This formulation brings the focus on

‘expectations’ that current government financial policies generate about future real after-tax incomes If tax reductions are viewed as temporary by private households, they have far less influence on consumption than those taken as permanent cuts

Notably, Buchanan (1958) pre-empts and discards it Elmendorf and Mankiw (1998), Brennan and Buchanan (1987), and Buiter (1990) also deal at length with the tenuous nature of the assumptions underlying Barro’s framework The empirical evidence in favour of Ricardian equivalence is also inconclusive albeit, it has not been possible

to categorically reject the hypothesis because it simultaneously rejects the impact of some forms of fiscal policy (temporary cuts in taxes financed by debt) while admitting others (such as anticipated permanent cut in government purchases) Overall, evidence from the United States suggests that tax cuts do increase aggregate demand (given accommodative monetary policy) although expectations about the permanence of such cuts play some role in determining the extent to which increased income flows into consumption (Fischer and Easterly 1990)

In contrast to the subdued support for Ricardian equivalence theorem, Buchanan’s thesis on the shifting of debt burden to future generations receives support from the occurrence of intergenerational redistribution in the basic overlapping-generations models such as that formulated by Diamond (1965) When

a government (beginning with balanced budget) lowers taxes without corresponding cuts in expenditure, its inter-temporal budget constraint (see the arithmetic of budget deficits and solvency above) requires that taxes be increased in future Such an increase, however, may fall on those who are younger or not yet living enabling the living / older to consume more at the cost of the young This prospect raises two issues First, the implications of present fiscal policies for future tax rates Generational accounting, as this research program is called, although based on partial accounts and a number of simplified assumptions about the future, indicates that net life-time tax rates for future generations will be substantially higher than at present (for details, see (Auerbach, Gokhale and Kotlikoff 1991), (Auerbach and Gokhale 1993), and (Haveman 1994) At the second level, there is this question of the conditions under which public loans become feasible In this larger context, there is

an emphasis on distinguishing between loans for consumption and those for investment in capital goods, and there is an associated support for capital budgeting

and / or more comprehensive public sector balance sheet (Wolfson 1979; Buiter 2001)

Mankiw (2000) argues that both the Diamond-Samuelson model of overlapping generations and the Barro-Ramsey model of infinitely-lived families contradict one

or more of the following empirical findings: (a), actual consumer spending follows more closely the current incomes of households, (b), many households do not have sufficient financial means required to enable them to do inter-temporal consumption smoothing, and (c), the vast majority of aggregate US capital formation stems from intergenerational transfers Thus bequest motive is active although for only small part

of the population that owns most wealth (top 5% hold some 60% of economic and 72% of financial wealth) Mankiw argues that these findings speak for developing a third alternative - the savers-spenders model of fiscal policy – that 13 acknowledges the great heterogeneity in consumer behaviour that is reflected in the data In this model, economy is populated by savers whose behaviour confirms with Barro-Ramsey model of infinite horizons (smoothing not only across one’s own life but also across descendants) and spenders who live from paycheck-to-paycheck consuming their entire income in every period This model yields the following theoretical results: -

● Temporary tax changes have large effects on the demand for goods and services

● Government debt increases steady-state inequality in income and consumption; and

● Substantial long-run crowding-out can occur if taxes are distortionary If, however, taxes are lump sum or levied entirely on inelastically supplied labour, then government debt need not crowd out capital in the long run

This theory retains the scope of fiscal policy in the short run but ties up its long run effects to the nature of taxation regime Insofar as the burden of public debt is concerned, there is no escape from the result that the distribution of income and consumption are influenced for the worse i.e., against the spenders and in favour of savers

If public borrowing implies postponing taxes, this raises the question of how the problem will be dealt with in future since only a portion of future national income can be taxed to service public debt while maintaining primary public expenditure consisting of (producing, purchasing, providing of) public goods and services, and transfers to households and businesses (e.g through income support and subsidies)

To the extent the total (primary and interest) expenditure in a single year exceeds tax revenues and seigniorage, it must be met by issuing new debt This gives us our first identity of the one period public borrowing requirement:

New borrowing = Primary expenditure + Interest expense - Tax - Seigniorage

For simplicity, let us club seigneiorage (inflation tax) together with tax Also, let D be the outstanding stock of debt (that is all of short maturity) and i the nominal interest rate on it Then the above equation can be re-written as:

New borrowing = Primary expenditure + i*D - Tax (1)

Note, however, that an increase in debt in one period has implications for government’s budgetary policy in the subsequent periods In particular, to service the debt, either government spending must reduce in the future or taxes must increase But public expenditure cannot be reduced to zero and taxes cannot rise forever By implication, there is a prudent limit on the level of debt in relation to the productive capacity of the economy What is that limit?

As Buiter (2001) contends, the prudent level of the public debt-to-GNP ratio depends on many structural features of the economy, its international environment, and its history or the inherited initial conditions Among the structural features are private saving propensity, the degree of financial development of the economy, growth rate of productivity, government’s ability to expand tax base, raise tax rates and compress public spending, and demographic developments This means that there

is no one-size-fits-all figure In fact, if history provides any guidance, in Britain, to-GNP ratio reached as high as 282% in 1821 (after Napoleonic wars) and 272% after World War II These, however, were extraordinary times Under normal circumstances, the recent Maastricht Treaty offers a model that calls for a ceiling on

debt-deficit of 3% of GDP and on net public debt of 60% of GDP for member countries Importantly, the debt here is not just the debt exclusive to the national government, but the combined debt of all levels of government in the nation including national, state and local authorities Of course, given the complexity of the problem, it is possible to argue that this number is not sacrosanct but rather quite arbitrary from an economic standpoint Once it is realised that based on economics, there is no single prudent debt-to-GNP level equally suitable for all nations, then the focus shifts to the conditions under which a given debt-to- GNP ratio can be stabilised This problem is rather easier to approximate In a growing economy, stabilising debt-to-GNP would mean that the level of deficit to be financed by issuing new debt in each period should equal the existing stock of debt (D) multiplied by the rate of growth of nominal GNP (say, ‘z’) This gives us our second identity: -

New borrowing = z * D (2)

Combining (1) and (2) above, we get the long-run budget constraint as follows

z * D = Primary Expenditure - Tax + i*D

or

(i - z) * D = Tax - Primary Expenditure (3)

or

(r - g) * D = Tax - Primary Expenditure (4) (Note that equation 4 replace (i-z)

in equation 3 with (r-g) since i = r + inflation and z = g + inflation)

or

Change in d = primary deficit/GNP + (r-g) * D/GNP (5)

where d denotes the debt-to-GNP ratio, r and g represent real interest and economic growth rates, and primary deficit equals excess of primary expenditure over tax revenue

Equations (1), (3), (4), and (5) provide useful guidance on whether the current level of taxes and expenditure can be sustained in future with a certain upper level

constraint on the debt-to- GNP ratio In particular, the following points are worthy of note: -

● the change in the outstanding public debt is the sum of two components: borrowing to finance primary deficit and borrowing to finance nominal interest on the outstanding debt

● if the economic growth rate exceeds real interest rate i.e z>i or g>r, then taxes can be lowered relative to primary expenditure or existing debt can be refinanced with more debt (without the need for raising taxes) or up to a certain level, primary deficits can be sustained, all without impairing the debt-to-GNP ratio;

● If, however, the real interest rate is greater than the rate of the real GNP growth i.e i>z or r>g, then taxes have to rise relative to primary expenditure Alternatively, the debt ratio will increase even if the issuance of new debt was required only to service the outstanding debt stock Thus primary surpluses will be required (i.e taxes will have to rise relative to primary expenditure) to service the debt and stabilise the ratio Otherwise, risk premia may increase and at some point it may become impossible for the government to sell more debt

The above analysis shifts our focus to the conditions under which the level of real interest rates could remain below the rate of economic growth On this issue, Fischer and Easterly (1990) contend that it is believed that the real interest rate should normally be below the growth rate, and that this eventual return to normality will provide an escape from the debt crisis But this an economist’s instinct is not possible Real interest rates can be temporarily below the growth rate and could be below the growth rate for a long time in rapidly growing economy- this is part of the virtuous circle of growth But market forces tend to prevent the real interest rate from remaining below the real growth rate permanently As more debt piles up, the pressure on bond markets drives up the interest rate and growth declines If a rapidly growing economy attempts to exploit the apparently favorable debt dynamics by borrowing excessively, the growth rate will eventually fall below the real interest rate

At the level of the word economy, the normal situation should be thought of as one

in which the real interest rate exceeds the growth rate Meanwhile, Macklem

(1994/95) states that it is clear that periods in which growth has exceeded the real interest rate are the exception There is an economic argument for the real interest rate to exceed the growth rate of real output in the long run If the real interest rate were below the growth rate of the economy, then firms and households could borrow, pay the interest on their debt with the additions to output stemming from growth, and still have a surplus left over In such circumstances, everyone would want to borrow,

in which case the demand for loans would exceed the supply, putting upward pressure

on the real interest rate The rise in real interest rate would encourage individuals to save while discouraging borrowing, thereby balancing the demand and supply of loans Market forces will tend to push the real interest rate above the growth rate of real GDP if households prefer current consumption to future consumption on average, since lenders will have to be compensated for deferring their consumption to the future These considerations suggest that a prudent assumption on which to base fiscal policy is that the real interest rate will exceed the real growth rate over the long term

We believe the message from the above economists is very clear There are risks that interest based financing of government activities may ultimately turn out sour,

as there is real danger that interest costs in the long run may exceed the economic growth rate resulting from additional investment

One way to contest the above suggestions has been to point out that in the US, for example, the average real cost of government borrowing (risk-free rate) has been lower than the real rate of economic growth Elmendorf and Mankiw (1998) point to research explaining this phenomenon In brief, the rationale advanced is that risk characteristics of government debt are different from that of economic growth A comparison of average risk free rate directly with the growth rate therefore may at times be misleading We believe there are additional reasons US stands out among industrialised countries being considered as a safe haven for capital Also, its currency

is used as a reserve currency by many countries And there are political pressures on many developing countries to maintain this status Some political analysts, for example, believe that among the reasons of US attack on Iraq was its decision to switch its oil exports to European curren Real rates on US Dollar therefore do not

necessarily get influenced by the same set of factors that impinge upon the rates on the currencies of developing countries

This brings us to an important related issue There is an empirical observation that governments can borrow at less than diversified private institutions (from a general equilibrium perspective, at a rate less than the marginal productivity of capital (r)) Does this represent a genuine social saving? Wagner (1987) scrutinises this question and concludes that it all boils down to if government enterprises in which the borrowed funds are invested can surpass the economic constraints - the inherent uncertainty in investment - that apply to other private firms in an economy Given public sector does not incorporate the same incentive structure as does the private sector (see the theory of public choice below), it is not misleading to suggest that government is a rather more costlier and riskier enterprise Thus the perception that lower government borrowing rate represents opportunities for social gain is ruled out Instead, the rationale for a spread between the private and public borrowing rates is found in the limited liability of the former while that of the unlimited liability of government This unlimited liability finds realisation in covering up higher cost and riskiness through present and future taxation

Pulling the threads together, the set of equations derived in this section provides useful insights on the long run (steady state) dynamics of public debt and its relationship with economic growth, taxes, and expenditure on the one hand and government’s cost of borrowing on the other hand Overall, we reach the conclusion that it appears doubtful that governments, through fixed interest borrowing and investment, can boost economic growth on a sustained basis Somewhere, the limit is reached as real interest rates rise beyond the real growth rates and taxes have to rise relative to public expenditure to finance public debt

An important dimension of the new classical research program has been an extension in the application of the economic model of self interested rational choice

to the sphere of politics The theory of public choice, as it is called, uses the tools of microeconomics to study the behaviour of public servants and politicians engaged in government decision-making, producing recommendations for optimal institutional

structure and constitutional rules (Downs 1957); Buchanan and Tullock (1962), Buchanan (1967)) Such analysis adds a unique dimension to understanding the problems of budget deficit and public debt in a democratic political institutional framework that has inherent tendencies to expand the role of government over time

In essence, the theory of public choice views politicians as representing an electoral constituency, aligning closely with its economic interests, and working through democratic decision making process to secure these interests so that their own chances of re-election are improved When this understanding of political behaviour is brought to bear on the public expenditure decision making process, then three asymmetries emerge First, democracies tend to favour decisions that deliver benefits to small groups (special interest groups) whereas the costs are spread over a large number of taxpayers The converse of this rule is that since the cost of cutting government spending falls on a small number of beneficiaries while the society as a whole benefits, it is the former who have the incentive to form pressure groups and deter cost cutting Second, democracies tend to favour decisions entailing visible benefits and invisible costs The former coalesces the beneficiaries while the latter neutralises the opponents Third, there is a tendency to favour decisions involving immediate gains whose cost is paid in the distant future Budget deficits and public debt provide opportunity for the realisation of all these tendencies Deficits spread costs over large number of taxpayers, hide these costs from those who bear it, and create an impression of producing immediate benefits at the expense of higher consequences (rising taxes, lower private capital formation, increased trade deficits)

in the future It is not surprising therefore that as Bennett and DiLorenzo (1984) argue, 'Debt is a politician's delight’ It provides opportunity to redistribute income from future (possibly unborn) generations to the current electorate

To summarise then, the new classical view may be considered as consisting of

a range of opinions as regards the nature and burden of public debt and the scope to use deficits and debt as an instrument of fiscal policy The view most popular among policy economists is that in the backdrop of self adjusting, full employment, classical economy, deficit financing comes at a long run cost: prices may rise (inflation),

savings may fall, private investment may be crowded out, imbalances in external accounts may result, and capital formation may be impaired As regards the nature and burden of debt, it is agreed that public debt shifts the burden of public expenditure that it funds, forward in time; that future taxes cause additional distortion of incentives; that there is little conceptual difference between internal and external debt; and that the analogy between private and public debt holds good in most essential respects In contrast to this majority view, a minority believe that individuals foresee the impact of all government fiscal policy and offset it in advance by taking measures opposite to that of the government This means, debt and taxes as alternative means of financing government expenditure are essentially similar and have no differential impact on aggregate demand Also, there is no burden of public debt on future generations

All the above researches share one point in common is that they did not focus intensively quantifying impact level of the major factors including state budget deficit, borrowing conditions, capacity of mobilizing financing resources…on public debt, government debt but only focus on each factor regarding to theory aspect

2.2 Quantitative models recommended by international organizations

In this context, this research’s main objective is to study the impact of budget deficit on government debt in Vietnam Government debt is an important stimulator and an inevitable financial obligation of economic growth and an approach to balance the government budget, partly to offset the budget deficit This paper contributes to the debate by presenting new empirical evidences, based on analyzing the time series data of Vietnam financial statistics from 2011 to 2015 The development of this study begins from estimating the correlations between independent variables, including budget deficit, with government debt in order to verify the level of impact as a whole Furthermore, not only running the regression of budget deficit to real evolution of government debt, real GDP growth, change in nominal interest rate and change in price and exchange rate are also chosen as explanatory variables to inspect further on the impact macro-economic variables on government deb The study exercises

diagnose tests, such as debt sustainability analysis (DSA) to identify serial correlation and causality relationship between state budget and real government debt

The objective of the joint Fund-Bank debt sustainability framework (DSF) for low-income countries (LICs) is to support LICs’ efforts to achieve their development goals without creating future debt problems The DFS is built on three pillars: (i) a standardized forward-looking analysis of debt and debt-service dynamics under a baseline scenario, alternative scenarios, and standardized stress test scenarios; (ii) a debt sustainability assessment based on indicative country-specific debt-burden thresholds that depend on the quality of policies and institutions in the country; and (iii) recommendations on a borrowing (and lending) strategy to limit the risk of debt distress, while maximizing the resource envelope to achieve the Millennium Development Goals The DSF is operationalized through the joint Bank-Fund debt sustainability analysis (DSA) which is epitomized by the LIC DSA template

To adequately inform borrowing and lending decisions, DSAs need to be based

on realistic macroeconomic baseline scenarios The principal mechanism for promoting realism in DSAs is to scrutinize baseline projections by (i) subjecting them

to reality checks and (ii) making use of precautionary features of the DSF The reality checks and precautionary features are intended to provide safeguards against excessive borrowing and a return to debt distress, without constraining justified optimism about the effective use of external resources to promote growth, reduce poverty, and achieve the country’s development goals The LIC DSA template contains 16 standardize shocks The standardized shocks are deterministic with simplified feedback effects to ensure cross-country comparability To understand the underlying dynamics of the DSF, it is imperative to comprehend the propagation of individual shocks through the economy

2.2.1 Debt burden indicators

Debt sustainability is assessed by undertaking a forward-looking analysis of the evolution of debt burden indicators under a baseline scenario, alternative scenarios,

and standardized stress test scenarios Debt burden indicators compare a measure of indebted ness to a measure of capacity to repay:

Debt burden indicator =

Measure of Indebtedness Measure of capacity to repay Different measures of indebtedness are used to identify solvency and liquidity risks Liquidity problems arise when a country has short-term difficulties meeting its financial obligations as they come due although its ability to pay is not affected under normal circumstances Solvency problems, on the other hand, arise when a country’s repayment difficulties are permanent or protracted Put differently, insolvency is associated with policies that lead to ever-increasing debt levels in relative terms, which necessitate a shift in policies such as an increase in taxes, cuts in spending, resource to monetization, or even repudiation Indicators based on debt stocks are used to identify possible solvency problems For LICs, a debt stock measure based

on the present value (PV) of debt is more informative than the nominal of debt, reflecting the typical concessionality of loans contracted by LICs (equation 2) Concessional loans are characterized by below-market interest rates, a grace period, and a long maturity period Clearly, the debt burden associated with an obligation to repay US$100 million in 5 years at an interest rate of 7 percent is more onerous compared to the obligation to repay the same US$100 million in 40 years, with a 10-year grace period and an interest rate of 0.75% By discounting the debt service (principal and interest) using an appropriate discount rate, the PV captures the effective debt burden

𝑃𝑉𝑡 =𝐷𝑒𝑏𝑡𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑡+1

𝐷𝑒𝑏𝑡𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑡+2(1 + 𝑟)2 + ⋯ +𝐷𝑒𝑏𝑡𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑡+𝑛

(1 + 𝑟)𝑛

Indicators based on debt service (interest payments and amortization) are used

to assess liquidity problems They represent the share of a country’s resources used

to repay its debt (and therefore resources not used for other public purpose) However, with the repayment of concessional loans usually increasing as a loan matures, debt service indicators are likely to be limited for predicting future debt servicing

problems Long projection periods can mitigate this problem, but the reliability of the projection tends to diminish with its length

Measures of capacity to repay include GDP, exports, and government revenues Nominal GDP captures the amount of overall resources of the economy, while exports provide information on the capacity to produce foreign exchange Finally, government revenues measure the government’s ability to generate fiscal resource

In some specific cases, remittances may be added to GDP and exports to assess external debt sustainability

By default, DSAs are done on gross debt For countries with significant assets,

a net concept may be applied in the public debt framework; liquid asset accumulation

is not taken into account in the external template

To appropriately identify solvency and liquidity problems, the LIC DSA focuses on different debt burden indicators depending on the coverage of PPG debt For public and publicly guaranteed external debt, the debt burden indicators include ratios to exports and are as follows:

debt burden indicators Based on empirical findings, the DSF assumes that external PPG debt levels that LICs can sustain are determined by the quality of their policies and institutions A country with relatively good (weak) policies and institutions is more (less) likely to allocate resources effectively and is, therefore, better placed to manage a higher (lower) level of external PPG debt

Policy performance and institutional quality is measured by the three-year moving average Country Policy and Institutional Assessment (CPIA) index, compiled annually by the World Bank The three-year average is used to prevent volatility in threshold level, and, thus, excess volatility in the risk of debt distress, which in turn determines the country’s financing terms from IDA (and possibly from other donors)

The DSF divides countries into three policy performance categories: strong, medium, and weak Table 1 depicts the associated external debt-burden thresholds The risk classification depends, among other factors, on the indicative thresholds and therefore on the CPIA score

Table 2: Risk classification and CPIA Score

Quality of policies and institutions

Low risk All debt indicators are well below relevant country-specific

debt-burden thresholds Stress testing and country-specific alternative scenarios do not result in indicators significantly breaching thresholds In cases where only one indicator is above its benchmark, judgement is needed to determine whether there is

a debt sustainability problem or some other issue, for example, a data problem

Moderate risk While the baseline scenario does not indicate a breach of

thresholds, alternative scenarios or stress tests result in a significant rise in service indicators over the projection period (nearing thresholds) or breach of debt or debt-service thresholds

High risk The baseline scenario indicates a protracted breach of debt or

debt-service thresholds but the country does not currently face any payment difficulties This is exacerbated by the alternative scenarios or stress tests

In debt distress Current debt and debt-service ratios are in significant or

sustained breach of thresholds The existence of arrears would generally suggest that

a country is in debt distress, unless there are other reasons than debt-service burden for not servicing its debt

(forward-The evolution of government debt (Debtgov) can be characterized in terms of the primary deficit trajectory Government debt is expressed in local currency units and its evolution takes into account: outstanding (Debtt-1gov), budget deficit (PD), net borrowing for lending and residual The residual captures exceptional financing, e.g debt relief and arrears, as well as changes in gross foreign assets, non-debt creating net capital flows which are not FDI, numerical approximations and valuation changes

in cross-exchange rates

Debt t gov = Debt t-1 gov + PD+ residual

Due to the Law on State Budget, the State budget deficit includes deficit of the central government budget and deficit of provincial budgets Central government budget deficit is the positive difference between total central government budget expenditure (not including principal repayment) and total central government budget revenue Provincial budget deficit is total deficit of budget of each province, which

is the positive difference between total budget expenditure (not including principal repayment) and total budget revenue of every province

Government debt is a debt arising from a domestic or foreign loan which is signed or issued in the name of the State or the Government or loan signed or issued

by or under the authorization of the Ministry of Finance under law Government debts

do not include debts issued by the State Bank of Vietnam to implement monetary policies in each period

This technical note describes in detail the propagation of standardized stress tests in the LIC DSA template using an analytical and graphical approach It is intended to aid technical staff in low-income countries as well as country teams at the IMF and WB by providing the intuition as well as mechanics of stress testing This should enhance the understanding of the shocks in the DSF and help improve the conduct of debt sustainability exercises in a low-income country such as Vietnam The debt sustainability analysis (DSA) framework for market access countries

is used to assess Vietnam’s debt sustainability and other risks related to its funding and debt structure The framework uses a risk-based approach and expands upon the basic DSA to include: (i) an assessment of the realism of baseline assumptions and projected fiscal adjustment; (ii) an analysis of risks associated with the debt profile; (iii) macro-fiscal risks; (iv) a stochastic debt projection taking into account past macro-fiscal volatility; and (v) a standardized summary of risks in a heat map This DSA also examines the implications of implementation risks by considering a no-adjustment scenario

In the LIC DSA template, the expression for the change in public debt will include terms describing the endogenous or automatic debt dynamics, such as the contribution from changes in the interest rate, real GDP growth, and prices and exchange rate changes These contributions are calculated automatically in the template

The usefulness of fiscal indicators depends on the coverage of the public sector and the quality of the debt data If the public sector is defined too narrowly (central government, rather than general government including public companies), then public sector debt may be understated and its capacity to repay may be in adequately

measured The accuracy of the sustainability assessment may also be impeded by data deficiencies such as incomplete domestic debt data or inappropriately measured cost

of financing

Similar to the public debt template, the evolution of external debt can be characterized by the path of the non-interest current account deficit (NICA) together with non-debt creating flows The basic equation for the evolution of external debt (Debtexternal) takes into account a country’s source of foreign exchange includes exports of goods and services (X), net transfer (NT), and net income (NI) (Note that for simplicity, net transfers and net income are assumed to be sources of foreign exchanges but shits may not be the case in reality) A country’s use of foreign exchange, meanwhile, includes imports of goods and services (M) These components (X, M, NT, NI) form the current account (CA) in the balance of payments and can be rearranged into the current account deficit excluding interest payments (NICA) and interest payments (INT) The evolution of the stock of external debt takes also into account non-debt creating sources of financing from the balance of payments In particular, the LIC DSA template accounts for the non-debt creating component of foreign direct investment (net FDI) (In addition to its equity and portfolio part, FDI also has a debt creating component, intercompany loans, which should be added to private external debt) Other factors (residual) contributing to the evolution of the external stock of debt include debt relief (exceptional financing) drawdown of foreign exchange reserves, and errors and omissions Another source

of non-debt creating flows is capital grants, which are not explicitly taken into account in the LIC DSA template As such, capital grants are captured by the residual

Debt t external = Debt t-1 external + M t – X t – NT t – NI t – net FDI t + OTHER t + residual t Debt t external = Debt t-1 external + NICA t + INT t – netFDI t + OTHER t + residual t Debt t external – Debt t-1 external = NICA t + INT t - netFDI t + OTHER t + residual t ΔDebt t external = NICA t + INT t – netFDI t + OTHER t + residual t

If a country spends more than it earns (current account deficit), then foreigners accumulate net claims on residents- the country borrows externally This assumes