Finance Sector

Purpose and Perspective

The Finance sector represents a few selected financial indicators that are relevant to a country’s long-term development. More specifically, the sector describes how savings are allocated to investment and how the financing needs of the government are met through domestic and foreign financing. The mechanisms of foreign and domestic public debt accumulation, the stock of gross international reserves and private investment are also represented.

We assumed that the banking system manages the reserves so as to always guarantee a certain number of months of coverage of imports. The level of reserves desired by the banking system represents the level of reserves implicitly targeted by monetary authorities. The desired import coverage is exogenous, and represents the ideal number of years that international reserves should guarantee import coverage. This level of coverage can be modified by the user to reflect different assumptions for future projections. Since the desired level of gross international reserves is established in months of import, as import grows, additional reserves are to be accumulated as reserves. Such an increase in reserves negatively impacts the amount of financial resources available for investment.

Similarly, government domestic financing, by absorbing part of households’ saving, also reduces the volume of private investment. In addition, both domestic and foreign financing lead to growth in the stock of debt, which in turn leads to higher payment of interests.

Model Structure and Major Assumptions

  • The banking system manages the international reserves so as to maintain a given coverage in months of imports [1]

Exogenous Input Variables

  • Domestic debt change from other sources - Units: Lcu/Year

  • Domestic financing share - Units: Dmnl

  • Foreign debt change from other sources - Units: Usd/Year

  • Import coverage ratio - Units: Year

  • Interest rate on domestic debt - Units: Dmnl/Year

  • Interest rate on foreign debt - Units: Dmnl/Year

  • Official exchange rate - Units: Lcu/Usd

Initialization Variables

  • Initial gross international reserves - Units: Usd

  • Initial public domestic debt - Units: Lcu

  • Initial public foreign debt - Units: Usd

  • Initial total import - Units: Lcu/Year

Modeling Details

The accumulation of public debt is often a crucial issue for developing countries. Therefore, the representation of public debt must be accurate enough to capture the fundamental dynamics of debt accumulation and support the analysis of different debt strategies. We separate public debt into domestic and foreign, but not further. Domestic and foreign debts can be divided into several different types of debts, depending, for example, on the type or nationality of the borrowing institution. The level of detail to be used when representing the public debt depends on the particular focus of the analysis and on the extent to which the various types of debt are homogenous and can be meaningfully treated as one entity. Note that when aggregating different types of debt into one variable, it might result that the overall interest rate is negative. This can happen, for example, in case the government has a large credit with the commercial banks but receives little or no interest on it, and at the same time it has a smaller debt with the central bank, on which it pays substantial interests. In this case the net position of the government would be positive, but still it would have to pay interests, resulting in a negative interest rate.

Footnotes and References

[1] Rodrik, D., (2006). The social cost of foreign exchange reserves, International Economic Journal, 20(3).