Transcript L25

Lecture 25: Sovereign Risk
• An additional factor for portfolio investors: risk of default,
– called sovereign risk, in the case of risk of default by governments.
• Defaults and restructuring.
• What determines sovereign spreads?
• Appendix 1: More sovereign spreads
• Appendix 2: The political economy of destabilizing fiscal policy
ITF220 - Prof.J.Frankel
• In the past, sovereign risk
was normally assumed zero for major borrowers
• such as the US, Japan, Euroland.
– So bonds can be identified only by currency of denomination,
• and “risk” is just exchange risk.
• But default risk was always an issue for developing countries.
• Assets are identified not just by currency, but also by the issuer;
• risk also includes default risk, requiring its own risk premium
– “sovereign spreads.”
• Also, recently,
– European countries moved back into that situation,
– especially those with very high debt, like Greece.
ITF220 - Prof.J.Frankel
The international
debt crisis
Spain defaulted the most: 6 times in the 18th century and 7 in the 19th.
Venezuela has defaulted 9 times since independence in 1821.
Nigeria has defaulted 5 times since independence in 1960.
Greece has been in default on its debt half the time since independence in 1829.
Source: Reinhart and Rogoff, This Time is Different: Eight Centuries of Financial Folly, 2011, pp.86-100.
Finding: For some years after a restructuring,
the defaulter is excluded from access to international finance.
Estimated from
67 restructurings,
Cruces &
The Price
of Haircuts,”
AEJ: Macro,
Fig.5, p. 111.
What determines sovereign spreads?
• Global financial environment
– E.g., “risk on” versus “risk off.”
• Country characteristics
– Past history of defaults;
– Level of debt;
– Debt sustainability.
Capital flows to Emerging Markets
and risk-sensitivity as measured by VIX
Private Capital Flows to EMs as % of GDP (left axis)
Volatility Index (right axis)
Source: Kristin Forbes, 2014
VIX peaked
in 2008
Volatilty Index
Capital Flows to EMs as % of GDP
Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets & developing economies.
What determines sovereign spreads?
EMBI is correlated with risk perceptions as measured by VIX
VIX peaked in 2008
risk off
“risk on”
Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011
More importantly, sovereign spreads depend on
country-specific characteristics,
• including: the country’s debt/GDP ratio,
• whether the ratio is expected to come down in the future
(the definition of sustainability),
• whether the country has a past reputation for defaulting
(“debt intolerance”),
• and whether somebody is expected to bail it out
(=> moral hazard).
ITF220 - Prof.J.Frankel
For some years after a restructuring,
the defaulter has to pay higher interest rates,
especially if creditors had to take a big write-down (“haircut”).
especially the 1st 5 years
Cruces & Trebesch, 2013, “Sovereign Defaults: The Price of Haircuts,” Fig.3.
• The spread may rise steeply when Debt/GDP is high.
Stiglitz: it may even bend backwards, due to rising risk of default.
Supply of
funds from
≡ Debt/GDP
Ratio of government debt to GDP among advanced countries
is the highest since the end of World War II.
IMF, April 13, 2016
Vitor Gaspar and Luc Eyraud, “Act Now, Act Together,” IMF Fiscal Monitor
After joining the euro, Greece never got its budget deficit below
the 3% of GDP limit of the Stability & Growth Pact,
nor did the debt ever decline toward the 60% limit
Pro-cyclical (destabilizing) fiscal policy in Greece:
expansion in 2000-08, contraction in 2010-15
IMF, 2011.
I. Diwan,
Oct. 2011
Spreads for Greece, Portugal & other Mediterranean €-members
≈0, 2001-07, perhaps due to moral hazard (bailout expectations)
until they shot up in 2008-11 under fears of sovereign default.
ITF220 - Prof.J.Frankel
Market Nighshift Nov. 16, 2011
• Appendix 1: More sovereign spreads
• Appendix 2: The political economy
of pro-cyclical (destabilizing) fiscal policy
Appendix 1: More
sovereign spreads
Spreads rose again in Sept.2008 ↑ ,
• esp. on $-denominated debt
• & in E.Europe. ↓
↑ Spreads shot up in 1990s crises,
• and fell to low levels in next decade.↓
World Bank
API-119 - Prof.J.Frankel
The eurozone financial situation improved after Nov. 2011,
when Mario Draghi became ECB President.
Spreads came back down.
-- Dec.2011 & Feb.2012
“Within our
mandate, the
ECB is ready
to do whatever
it takes to
preserve the
And believe me,
it will be
enough.” –
July 2012
Data source: Datastream
Measures of financial market volatility rose in 2015.
Source: Bloomberg, L.P.
G-20 Finance Ministers and Central Bank Governors’ Meetings, Feb. 26–27, 2016 , Shanghai, China
Brazil & South Africa in 2016 have to pay
higher interest rates than a year ago.
Source: Bloomberg, L.P.
G-20 Finance Ministers and Central Bank Governors’ Meetings, February 26–27, 2016 , Shanghai, China
When the global oil price started falling sharply in June 2015,
the sovereign spreads of oil-exporting developing countries rose.
Oil exporters' global bond spreads
(Average JP Morgan EMBIG Sovereign Spread Index)
Note: Oil exporters comprise Angola, Bolivia, Colombia, Ecuador, Gabon, Iran, Kazakhstan,
Nigeria, Russia, Trinidad & Tobago and Venezuela.
M.Obstfeld, R.Arezki, & GM Milesi-Ferretti, 13 April 2016, VoxEU,
“Oil prices and the global economy: It’s complicated.” Data source: Bloomberg, LP and IMF staff calculations.
Appendix 2: The political economy of
destabilizing fiscal policy
• In the textbook approach, benevolent governments
are supposed use discretionary fiscal (& monetary)
policy to dampen cyclical fluctuations.
• expanding at times of excess supply, and
• contracting at times of excess demand.
• In practice, policy has often been pro-cyclical,
i.e., destabilizing, in developing countries.
ITF220 - Prof.J.Frankel
Destabilizing fiscal policy: Political economy explanations
• #1 : Political Budget Cycles
– Politicians expand just before elections, so that
rapid growth will buy votes; the cost comes later
(debt, inflation, reserve loss, devaluation)
– Example: The Mexican sexenio (until 2000)
– Do politicians really fool voters this way? Yes, for awhile.
• #2: Procyclical government spending
– Due, e.g., to commodity cycle
• Dutch Disease in commodity booms,
• and the need to retrench in downturns.
– Bias toward optimism in official forecasts.
ITF220 - Prf.J.Frankel
Historic role reversal in the cyclicality of fiscal
policy in industrialized vs. developing countries
Previously, fiscal policy was procyclical
in developing countries:
• Governments would raise spending in booms;
• and then be forced to cut back in downturns.
• Especially Latin American commodity-producers.
ITF220 - Prof.J.Frankel
The procyclicality of fiscal policy, cont.
• An important development -some developing countries, were able to break
the historic pattern in the most recent decade:
– taking advantage of the boom of 2002-2008
• to run budget surpluses & build up reserves,
– thereby earning the ability to expand
fiscally in the 2008-09 global recession.
ITF220 - Prof.J.Frankel
What determines countries’ fiscal performance?
– Fundamentally: Quality of institutions.
– This does not mean “tough” rules, if they lack enforceability –
like SGP, debt ceiling or Balanced Budget Amendment.
– Better would be structural budget targets (Swiss)
with forecasts from independent experts (Chile).
– After 2000, while some developing countries graduated
from pro-cyclical spending to countercyclical,
– some US, UK & euro politicians have seemingly forgotten
how to run countercyclical fiscal policy.
• They instead enact higher spending & tax cuts
in the expansion & contraction after the recession hits.
ITF220 - Prof.J.Frankel