The sovereign risk associated with high levels of public debt and the significant exposure of banking institutions to these debt instruments have received considerable attention from economic policy makers in recent years (see, for example, World Economic Outlook, September 2003). Reflecting this growing concern, policy makers have focused attention on developing frameworks which can assess the vulnerability of the emerging economies to debt default and mitigate its impact on economic performance and financial stability.

The exposure to exogenous shocks inherent in an open economy such as Jamaica, as well as the high level of indebtedness have raised many questions for policymakers and the general public. For example, at what level does public debt become too high to be sustainable? What can policy makers do to cushion the economy against the risks that high debt presents, and, perhaps most importantly, what policy actions needed to ensure that a debt reduction strategy is sustainable?

According to Goldfajn and Guardia (2003), debt sustainability assessments should focus on medium and long-term scenarios, as well as, the probabilities associated with the evolution of key variables in the debt accumulation process including, among others, GDP growth, interest rates and exchange rates. This paper addresses some of the challenges associated with analyzing the sustainability of public debt in Jamaica by focusing on the role of stochastic factors, including contingent liabilities, on debt dynamics. An assessment of the sustainability of Jamaica’s public debt is conducted by constructing a risk measure which is derived from the likelihood of the debt to GDP ratio exceeding a given threshold over a specific time-horizon.

The analysis explores whether changes in the GDP growth rate, fiscal balance and real interest rate can be used to predict an improvement or deterioration in the debt sustainability dynamics in the medium-term. This risk measure of debt sustainability, to the extent that it can anticipate deteriorations in the debt dynamics, can be used in conjunction with a stress-testing framework to identify the impact of debt-dynamics on the portfolios of the financial sector and thereby signal the necessary policy action, such as an adjustment to capital adequacy allocation. The predictive power of the risk measure on the Euro-denominated GOJ spreads provides strong corroboration that the methodology captures a significant portion of market perception of the default risk in Jamaican sovereign debt and that it can be used effectively in an early warning framework.

The paper has five sections. Section two gives a brief overview of the mainstream approach to analyzing debt-sustainability. Section three discusses the empirical framework used in this paper to assess the debt-dynamics in Jamaica between 1996 and 2004 and conducts a medium-term scenario based analysis. The fourth section discusses the results. The final section summarizes the main findings and conclusions.

Contents

1. Introduction
2. Debt Sustainability: An Overview
3. Risk Management and Debt Sustainability: Methodology and Data
4. Empirical Analysis of Jamaica’s Debt Sustainability Outlook

4.1 Covariance of Reduced-form Residuals
4.2 Impulse responses
4.3 Analysis of Debt Sustainability Prospects in the Absence of Risk
4.4 Risk Based Analysis of Debt Sustainability Monte Carlo Simulations
4.5 Sensitivity Analysis
4.6 Debt Sustainability and Sovereign Spreads

5. Conclusion
Bibliography

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