Transcript No Slide Title

The Sovereign CCA Model,
Financial Crises, and Venezuela
Dr. Samuel Malone
Profesor Invitado
IESA
CCA for Sovereigns vis-à-vis CCA for Firms
Market Cap
Firms and Banks
Sovereigns
Number of
shares*price
Base Money plus Govt
local-currency debt *
exchange rate
=Market Cap
Distress Barrier
Senior Debt
Foreign Currency
Debt
CDS Spread
Drivers
Leverage, asset
volatility, and
market price of risk
(correlation and
Sharpe Ratio)
Sovereign leverage,
asset volatility, global
sovereign market
price of risk
(correlation and
“global Sharpe
Ratio”?)
(A proxy for the “global market Sharpe Ratio” is the excess return on global stock
and bond markets per unit of volatility. This is the subject of ongoing research.)
2
Sovereign CCA –
Balance Sheets of Central Bank and Government
Consolidated into Sovereign Balance Sheet
Central Bank BS
Reserves
Credit to
Government
Base
Money
Other
Government BS
PV Primary
Surplus
Credit from CB
Local Currency
DebtLC
Sovereign
(Consolidated) BS
Reserves
Base
PV Primary
Surplus
Money*
- Cont. Liab.
local-currency
debt*LC
Other
Foreign Debt
Value
FX
- Cont. Liab.
Other
Foreign Def-free
Debt FX
*Local Currency Liabilities
are base money plus local
currency debt
3
Sovereign CCA - Calibrate (Unobservable) Sovereign
Asset and Implied Asset Volatility
USING TWO EQUATIONS
WITH TWO UNKNOWNS
INPUTS
Value and
Volatility of Local
Currency
Liabilities*

Foreign Currency
Debt Distress
Barrier Bf (from
Book Value)


LCL$  V$Sov N(d1 )  B f e
 rf T
N(d2 )
V$ Sov $ Sov  LCL$ $ LCL N (d1 )
Gives:
Implied Sovereign Asset
Value
V$ Sov
and
Asset Volatility
Time Horizon
Default Probabilities
Spreads, Risk Indicators
*The value and volatility of local currency debt and part of base money,
measured in foreign currency terms. See Annex 2 for details
4
Robustness of Sovereign Risk Indicators:
There are very high correlations the CCA Risk
Indicators and Credit Default Swap Spreads
(CDS) & EMBI bond spreads on foreign
currency debt.
Highly statistically significant
Note that the Risk Indicators did not use
sovereign bond or CDS spreads as an input!
(See IMF Staff Paper 2008 and IMF Working Paper
05/155 for results and robustness tests)
5
Examples: Risk Indicator vs. Credit Default Swap Spread
TURKEY- Default Indicator vs Market
1-yr Credit Spread
SOUTH AFRICA - Default Indicator vs Market
1-yr Credit Spread
35
1350
14
140
30
1150
12
120
25
950
10
100
20
750
8
80
15
550
6
60
10
350
4
40
5
150
2
20
0
-50
0
0
10
/4
11 /02
/2
9/
0
1/ 2
24
/0
3/ 3
21
/0
5/ 3
16
/0
7/ 3
11
/0
3
9/
5
10 /03
/3
1
12 /0 3
/2
6/
0
2/ 3
20
/0
4
6/
28
/0
8/ 2
23
10 /02
/1
8
12 /0 2
/1
3/
02
2/
7/
03
4/
4/
0
5/ 3
30
/0
7/ 3
25
/0
9/ 3
19
11 /03
/1
4/
03
1/
9/
04
Basis Points
160
16
Basis Points
Default Indicator (Left Scale)
Market 1-yr Credit Spread, CDS (Right Scale)
Default Indicator (Left Scale)
Market 1-yr Credit Spread, CDS (Right Scale)
Correlations are ~ 90 % for 12 countries
KOREA - Default Indicator vs Market 1-yr
Credit Spread
Default Indicator (Left Scale)
Market 1-yr Credit Spread, CDS (Right Scale)
12
110
10
90
8
70
6
50
4
30
0
10
4/
5/
5/ 02
31
/
7/ 02
26
/
9/ 02
20
11 /02
/1
5/
1/ 0 2
10
/0
3/ 3
7/
0
5/ 3
2/
6/ 03
27
/
8/ 03
22
10 /03
/1
7
12 /0 3
/1
2/
0
2/ 3
6/
04
2
Basis Points
130
14
Results from MfRisk model, Sovereign CCA models built for over 20 countries
6
Example of BRAZIL- Implied Sovereign Asset
Value vs Foreign Currency Debt Distress Barrier
Implied Sovereign Asset Value vs Distress
Barrier (External and $-linked Debt)
Sovereign
500
Leverage
Ratio
350
300
was
250
200
150
0.8 in 2002
100
50
and
0.18 in 2006
0
11
/5
/2
00
1
5/
24
/2
00
2
12
/1
0/
20
02
6/
28
/2
00
3
1/
14
/2
00
4
8/
1/
20
04
2/
17
/2
00
5
9/
5/
20
05
3/
24
/2
00
6
Billion US $
450
400
Implied Sovereign Asset
Distress Barrier (FX and $-linked Debt)
7
Rough Estimates of Drivers of Emerging Market (EM)
Sovereigns and (EM) Corporate Credit Spreads
EM Sovereigns
Credit Spreads January
2007
100 -190
Increased Market
Leverage
+10-20
Change in Volatility
+10-20
Mkt Price of Risk
Increase
Credit Spreads January
2008
+50-60?
190 to 290 bps
8
Sovereign, Bank, and Corporate Economywide CCA Sector Interlinked Balance Sheets
Risky Debt = Default-free Value of
Debt minus Expected Losses
Equity
Corporate
Sector
Assets
Default-free
Debt Value
– Put
Option
Money &
Sovereign
Assets
Local
Currency Debt
Expected losses in risky debt are
implicit put options, contingent
liabilities are implicit put
options, equity and junior claims
are implicit call options
Equity
Banking/
Financial
Sector
Assets
Foreign Def-free
Debt Value – Put
Option
Deposits
and Debt
Value –
Put
Option
See Annex
Contingent Liab
Implicit Put Option
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Economy-wide CCA Balance Sheet Models
Capture Non-linear Risk Transmission

Note that if asset volatility in CCA sector
balance sheets is set to zero:
– Implicit put options go to zero,
– Macroeconomic accounting balance sheets and
traditional flow-of-funds are the result
– Measurement of (non-linear) risk transmission is not
possible using macroeconomic flow or accounting
frameworks

Interlinked implicit options result in
compound options that exhibit highly nonlinear risk transmission, as seen a variety
of financial crises
10
Now let’s relate these concepts to…
Petrodollars, Inflation, and Country
Risk in Venezuela
11
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
USD per Barrel
The Price of Oil During the Past Decade
Cushing, OK WTI Spot Price FOB
100
80
60
40
20
0
12
The Bull Market for Commodities Over the Past 2.5
Years
Source: see IMF GFSR 2008
13
External Environment: Increase in Volatility and Risk
Aversion in International Markets
Source: see IMF GFSR 2008
14
External Environment: A Rise in EMBI Spreads across
Geographical Areas
Source: see IMF GFSR 2008
15
The Venezuelan Environment: A Volatile Fiscal
Surplus/Deficit
Fiscal Surplus/Deficit Measures
60%
Fiscal Surplus as % of
M1
20%
0%
Fiscal Surplus as % of
GDP
-20%
-40%
2007
2006
2005
2004
2003
2002
2001
2000
1999
-60%
1998
Percentage
40%
Year
Source: Banco Central de Venezuela
16
A High Rate of Money Growth From January 2003 Onward
Money Growth
100.000.000
80.000.000
Base Money
60.000.000
Deposits
40.000.000
M1
20.000.000
Source: Banco Central de Venezuela
Ene-07
Ene-05
Ene-03
Ene-01
Ene-99
0
Ene-97
Millions of VZB
120.000.000
17
Consequences of Monetary Expansion and Fiscal Volatility
18
High Rates of Consumer Price Inflation
Monthly CPI, Base Year 2007
120,00
100,00
80,00
60,00
40,00
20,00
Source: Banco Central de Venezuela
Ene-08
Ene-07
Ene-06
Ene-05
Ene-04
Ene-03
Ene-02
Ene-01
Ene-00
Ene-99
Ene-98
Ene-97
0,00
19
Source: Banco Central de Venezuela and author’s calculations
Ene-08
Ene-07
Ene-06
Ene-05
Ene-04
Ene-03
Ene-02
Ene-01
Ene-00
Ene-99
Ene-98
6,00
5,00
4,00
3,00
2,00
1,00
0,00
-1,00
-2,00
Ene-97
% per month
Monthly CPI Inflation
20
Annualized Monthy Inflation Rate
100,00
60,00
40,00
20,00
0,00
Source: Banco Central de Venezuela and author’s calculations
Ene-08
Ene-07
Ene-06
Ene-05
Ene-04
Ene-03
Ene-02
Ene-01
Ene-00
Ene-99
Ene-98
-20,00
Ene-97
% peryear
80,00
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Negative Real Interest Rates
60,00
40,00
20,00
0,00
-20,00
-40,00
-60,00
-80,00
Real Lending Rate
Ene-07
Ene-05
Ene-03
Ene-01
Ene-99
Real Deposit Rate
Ene-97
Annual Yield (%)
Expected Real Interest Rates
Source: Banco Central de Venezuela and author’s calculations
22
Depreciation of the Parallel Exchange Rate
Ene-08
Ene-07
Ene-06
Ene-05
Ene-04
Ene-03
Ene-02
Ene-01
Ene-00
Ene-99
Ene-98
8000
7000
6000
5000
4000
3000
2000
1000
0
Ene-97
VZB / USD
"Market" Exchange Rate VS. Official Rate
23
Spending of Petrodollars Causes Expansion of Real Output…
Source: Banco Central de Venezuela
Abr-07
Abr-06
Abr-05
Abr-04
Abr-03
Abr-02
Abr-01
Abr-00
Abr-99
18000000
16000000
14000000
12000000
10000000
8000000
6000000
4000000
2000000
0
Abr-98
Millions of 1997 Bolivares
Real GDP
24
…While Monetary Expansion Coupled with an Overvalued Exchange
Rate Causes Import Boom
Importaciones
1950-2007
Representarían casi
el 75% de las
Export. Petroleras
50025
45,463
45025
40025
62,555
35025
30025
23,693
25025
20025
15025
32,226
45,463
17,021
Importaciones
Export. Petroleras
10.483
10025
5025
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
25
En
En elel 2007
2007 tuvimos
tuvimos un
un ¨boom¨
¨boom¨ de
de US$
US$ 45.463
45.463 millones
millones (mas
(mas de
de cuatro
cuatro veces
veces
superiores
a
las
del
2003…)...
superiores a las del 2003…)...

(source: Malone and Puente, forthcoming)
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Domestic Debt has Increased in Absolute Terms…
Total Gross Internal Debt
40.000
35.000
Millones de Bs.F.
30.000
25.000
20.000
15.000
10.000
5.000
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007/a
Año
But has not grown dramatically as a % of nominal GDP
26
External Public Debt (including PDVSA) Increased
Substantially in the Past Year
45.000
40.000
35.000
30.000
25.000
20.000
15.000
10.000
5.000
0
Deuda Pública (con
empresas públicas)
Deuda Pública (sin
empresas públicas)
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
Millones de USD
Deuda Pública Externa
Año
Higher leverage contributes to higher spreads.
Source: Banco Central de Venezuela and author’s calculations
27
After Falling Sharply in mid-2007, International Reserves Have
Recovered Recently Due to the Recent Spike in Oil Prices
8
En
e0
7
e0
6
En
En
e0
5
En
e0
4
e0
3
En
En
e0
2
e0
1
En
En
e0
0
En
e0
9
e9
En
e9
En
e9
En
8
40.000
35.000
30.000
25.000
20.000
15.000
10.000
5.000
0
7
Millions of USD
International Reserves
But high reserve volatility contributes to a high
sovereign asset volatility…and that also
contributes to higher spreads.
28
Country Risk (EMBI+)
Venezuelan spreads have risen much
more dramatically during the past
15 months than EMBI+ spreads as
a whole.
29
An apparent paradox: rising oil prices and rising external
spreads for VZ
Because of the increase in the oil price during the past year, we
should expect the EMBI spread for VZ to decrease…yet we
observe precisely the opposite trend: rising oil prices coupled
with a rising EMBI spread.
This effect cannot be explained solely by recent turmoil in the
international markets, because the VZ spread has increased
much more than the Latam or EM spread averages.
Higher leverage, in the form of higher debt burdens, has a
positive effect on country risk. So does higher sovereign
asset volatility.
The markedly increased borrowing needs of PDVSA during the
past year have contributed to the level of foreign
indebtedness and this appears to have played a role in
increasing the cost of borrowing for VZ in international
markets.
30
FDI: Negative and Trending Downward
Source: Banco Central de Venezuela and author’s calculations
20
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
5,000
4,000
3,000
2,000
1,000
0
-1,000
-2,000
-3,000
-4,000
19
98
Millions of USD
Foreign Direct Investment
31
Recent Policy Dilemmas
Money creation causes inflation.
However, the government has committed to a wide
variety of transfer programs and spending initiatives
that keep the rent income flowing into the economy.
The increase in the money supply, coupled with a fixed
exchange rate, creates a high level of demand for
imports of traded goods and services.
This high import demand creates a drain on the
government’s international reserves, especially as
seen during 2007.
The government has used a series of debt issues to drain
liquidity from the domestic market. This has worked
to lower the parallel market rate and, if the situation
persists, should effectively lower the drain on foreign
reserves.
32
Recent Policy Dilemmas
Nonetheless: the increased rate of debt issuance raises the
degree of leverage of the government. This will translate
into higher spreads on both domestic and foreign debt.
These higher borrowing costs will be passed on the domestic
firms and individuals, and will act as a disincentive for
undertaking much needed investment.
As we learn from the sovereign CCA model: the volatility of
sovereign assets has a major effect on spreads as well.
Thus volatile reserves and exchange rates (including the
parallel market rate) contribute to high spreads.
Also, volatile oil prices contribute to volatile base money,
which implies a volatile sovereign asset.
33
Conclusion
The government’s desire to maintain a fixed exchange rate and
capital controls is unsustainable in the medium term.
We learned all of this years ago from e.g. Krugman, but the
situation in Venezuela has the added interest of being a
Dutch Disease economy combined with an unsustainable
exchange rate regime.
In addition to the above, the element of indebtedness and
sovereign risk creates the possibility for Venezuela’s “slow
motion” crisis of high inflation, low investment, and falling
productive capacity in the non-oil traded sector to become a
“fast motion” crisis of increasing probabilities of default.
There is still room left to correct these imbalances…but the
room to maneuver will decrease dramatically if there is a
sustained fall in the oil price.
34
Linking the economy-wide CCA models to
macroeconomic models
Ideally, we would like to link the sector
CCA models to macro models in order to
form an integrated model for the
economy.
Leonardo will discuss this in detail for
Chile.
I will just highlight the issue in two slides.
35
Linking CCA Balance Sheets and Risk Indicators to
Simple Macro Monetary Policy Models
Monetary Policy Model (GDP gap, inflation, exchange rate,
policy rate set by Taylor Rule)

Include aggregate credit risk indicator (CRI) in GDP gap
equation

ygap  f ( ygapt 1, r   , CRI )
Include capital adequacy “Taylor-type rule” for the banking
sector using CCA with macro variables

Incorporates feedback between interest rates and financial
system credit risk

See (i) Macrofinancial Risk Analysis by Gray, Malone (2008) and (ii)
Framework for Integrating Macroeconomics and Financial Sector
Analysis by Gray, Karam, Malone, N’Diaye (forthcoming)
36
Unified Macrofinance Framework
(Targets: GDP, Inflation, Financial System Credit Risk,
Sovereign Credit Risk)
Policies:
Domestic and
International
Factors
Sovereign
CCA Model
• Fiscal Policy
• Debt Management
• Reserves / SWF
Interest Rate
Term Structure
Model
Monetary
Policy Model
Financial CCA
(Merton-STV)
Model (s)
Economic Capital
Adequacy
• Policy Rate
CRI
• Economic Capital
Adequacy
• Bank and Financial
Sector Regulations
37
Thank you, for more information see:
Papers by D. Gray, Robert C. Merton, Zvi Bodie:

NBER 12637 (2006)

NBER 13607 (2007)

Sovereign Credit Risk, JOIM v. 5, no. 4, Dec 2007
IMF Global Financial Stability Report (GFSR)
IMF Working Papers: WP 05/155, 04/121, 07/233, Indonesia SIP
(2006), Gray and Walsh (WP 08/89), Gray, Lim, Loukoianova,
Malone (WP/08), IMF Staff Papers Gapen et. al v 55 #1 2008;
Framework for Integrating Macroeconomics and Financial Sector
Analysis by Gray, Karam, Malone, N’Diaye (forthcoming)
Macrofinancial Risk Analysis, Gray and Malone
book Foreword by Robert Merton)
(Wiley Finance
[email protected]
38