ABSTRACT
Recent experiences in Argentina and Brazil have brought to the fore the question of the sustainability of external debt. The IMF defines a country's debt to be sustainable if the debt can be serviced without an unrealistically large future correction in the balance of income and expenditure. 1 Although this is a useful working definition, it does not address two key points. First, the question of sustainability only arises after economic conditions change unexpectedly for the worse. When the debt was incurred, both the lender and sovereign borrower must have shared the expectation that the debt would be sustained sans crisis; otherwise, the transaction would not have taken place. Consequently, the IMF should place more emphasis, instead, on assessing the vulnerability of a country's debt before an adverse shock strikes, rather than on the debt's sustainability after the shock's arrival. Second, the critical question to be asked in evaluating the vulnerability of a country's debt level to a potential negative shock is how is the necessary correction in the balance of income and expenditure (net exports) to be obtained to continue debt service? In practice, this correction can be achieved via two well-known channels: import compression or expenditure switching. Traditionally, the IMF focus has been on obtaining the necessary increase in trade balance via import compression, through a reduction in domestic aggregate demand. Economies, however, also endogenously adjust to adverse shocks through a real exchange rate depreciation that causes a shift in domestic and foreign expenditures towards domestically produced goods. Although this adjustment process via a real depreciation will almost always increase net exports, the outstanding question is whether this adjustment will be sufficiently vigorous to allow the country to meet its external debt service obligations and avoid a debt crisis.
