Transcript L3 - Harvard Kennedy School

Lecture 3: Country Risk
1. The portfolio-balance model with default risk.
2. Default.
3. What determines sovereign spreads?
4. Debt Sustainability Analysis (DSA).
API-119 - Prof.J.Frankel
1. The portfolio balance model
applied to country risk
• One lesson of portfolio diversification theory:
A country that borrows too much drives up the expected rate of
return it must pay. The supply of funds is not infinitely elastic.
-- especially for developing countries.
•
The portfolio-balance model can be very general (menu of assets).
– In Lecture 2, we considered a special case relevant
to rich-country bonds: currency risk is the only risk.
– Some modifications are appropriate for developing-country debt,
starting with the risk of default.
API-119 - Prof.J.Frankel
Demand for assets issued by various countries f:
x i, t = Ai
+ [ρV]i -1
Et (r ft+1 – r dt+1) ;
• Now the expected return Et (r ft+1) subtracts from i ft
the probability of default times loss in event of default.
• Similarly, the variances & covariances
factor in risks of loss through default.
• When perceptions of risk are high [ρV], interest rates
must be high for investors to absorb given supplies of debt
– “risk off” in global financial markets.
API-119 - Prof.J.Frankel
Developing countries:
The view
from
the South
• are usually assumed to be debtors;
• must pay a premium as compensation for default risk.
• Debt to foreigners was usually $-denominated (before 2000).
• Then, expected return = observed spread between interest
rate on the country’s loans or bonds & risk-free $ rate,
minus expected loss through default
-- instead of rp.
• Denominator for Debt:
More relevant than world wealth is
the country’s GDP or X. Why? Earnings determine ability to repay.
•
Supply-of-lending-curve slopes up: when debt is large
investors fear default & build a country risk premium into i.
API-119 - Prof.J.Frankel
2. Default
The international
debt crisis
Asia
crisis
Latin
American
independence
•
•
•
•
Great
Depression
GFC
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.
Spain has defaulted the most: 6 times in the 18th century, and 7 in the 19th.
Source: Reinhart and Rogoff, This Time is Different: Eight Centuries of Financial Folly, 2011, pp.86-100.
Why don’t debtor countries default more often,
given absence of an international enforcement mechanism?
1.
They want to preserve their creditworthiness,
to borrow again in the future.
Kletzer & Wright (2000), Amador (2003), Aguiar & Gopinath (2006), Arellano (2008), Yue (2010).
But: • Some find defaulters don’t seem to bear much of a penalty for long:
Eichengreen (1987), Eichengreen & Portes (2000), Arellano (2009), Panizza, Sturzenegger & Zettelmeyer (2009).
• Not a sustainable repeated-game equilibrium: Bulow-Rogoff (1989).
2.
Best answer (perhaps): Defaulters may lose access
to international banking system, including trade credit.
Loss of credit disrupts production, even for export.
Theory: Eaton & Gersovitz (RES 1981, EER 1986). Evidence: Rose (JDE 2005).
3. Cynical answer: Finance Ministers want to remain members
in good standing of the international elite.
API-119 - Prof.J.Frankel
New finding: For some years after a restructuring, the
defaulter is excluded from access to international finance.
Estimated from
67 restructurings,
1980-2009
Juan
Cruces &
Christoph
Trebesch,
2013,
“Sovereign
Defaults:
The Price
of Haircuts,”
AEJ: Macro,
Fig.5, p. 111.
API-119 - Prof.J.Frankel
3. What determines sovereign spreads?
EMBI is correlated with risk perceptions
risk off
“risk on”
Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011
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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”).
Estimated,
1993-2010
especially the 1st 5 years
Cruces & Trebesch, 2013, “Sovereign Defaults: The Price of Haircuts,” Fig.3.
API-119 - Prof.J.Frankel
Eichengreen & Mody (2000):
Spreads charged by banks on
emerging market loans are
significantly:
• higher if the country has:
•
•
•
•
high total ratio of Debt/GDP,
rescheduled in previous year
high Debt Service / X, or
unstable exports; and
• reduced if it has:
• a good credit rating,
• high growth, or
• high reserves/short-term debt
API-119 - Prof.J.Frankel
• 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
world
investors
i
b
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≡ Debt/GDP
4. Debt dynamics:
• What determines if a country becomes “insolvent”?
• It depends not on the level of debt directly,
• but, rather, on whether the ratio b ≡ debt/GDP is on
an unsustainable path.
API-119 - Prof.J.Frankel
Definition of sustainability: a steady or falling debt/GDP ratio
𝐷𝑒𝑏𝑡
𝑏 ≡
𝑌
𝑑𝑏
𝑑𝑡
=>
𝑑𝑏
𝑑𝑡
=
where Y ≡ nominal GDP.
𝑑 𝐷𝑒𝑏𝑡/𝑑𝑡
𝑌
−
𝐷𝑒𝑏𝑡 𝑑𝑌
𝑌2 𝑑𝑡
=
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑠𝑐𝑎𝑙 𝐷𝑒𝑓𝑖𝑐𝑖𝑡
𝑌
=
𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝐷𝑒𝑓𝑖𝑐𝑖𝑡 + (𝑖 𝐷𝑒𝑏𝑡)
𝑌
−
𝐷𝑒𝑏𝑡 𝑑𝑌/𝑑𝑡
𝑌
𝑌
= 𝑑 +
𝑖 𝑏 − 𝑏𝑛
= 𝑑 +
𝑖 − 𝑛 𝑏.
− 𝑏𝑛
where n 
nominal growth rate.
where d  Primary Deficit / Y.
=> Debt ratio explodes if d > 0 and i > n (or r > real growth rate).
API-119 - Prof.J.Frankel
db
= d + (i - n) b.
dt
where
Debt
b
Y
n  nominal growth rate, and d  primary deficit / Y .
Debt dynamics line
shows the relationship between b and (i-n), for db/dt = 0.
Even with a primary surplus (d<0),
if i is high (relative to n), then b is on explosive path.
i
db/dt=0
range of explosive debt
range of
declining Debt/GDP ratio
n1
0
ius
b
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Debt dynamics, continued
• It is best to keep b low to begin with,
especially for “debt-intolerant countries.”
• Otherwise, it may be hard to stay on the stable path
• if
– i rises suddenly,
• due to either a rise in world i* (e.g., 1982, 2016), or
• an increase in risk concerns (e.g., 2008);
– or n exogenously slows down.
• Now add the upward-sloping supply of funds curve.
• i includes a default premium,
which probably depends in turn on db/dt.
• => It may be difficult or impossible to escape the unstable path
– without default, write-down, or restructuring of the debt,
– or else inflating it away,
• if you are lucky enough to have borrowed in your own currency.
API-119 - Prof.J.Frankel
Debt dynamics, with inelastic supply of funds
i
Greece
2012
range of explosive debt
range of
declining Debt/GDP
Ireland
2012
n1
ius
0
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b
explosive debt path
API-119 - Prof.J.Frankel
Professor Jeffrey Frankel, Kennedy School, Harvard University
Appendix 1: Debt dynamics graph,
with possible unstable equilibrium
Supply of
funds line
i
Initial debt
dynamics line
{
sovereign
spread
iUS
Debt
b
Y
API-119 - Prof.J.Frankel
(1) Good times.
Growth is strong.
db/dt = 0, or if > 0 nobody minds. Default premium is small.
(2) Adverse shift. Say growth n slows down. Debt dynamics
line shifts down, so the country suddenly falls in the range db/dt>0.
=> gradually moving rightward along the supply-of-lending curve.
(3) Adjustment. The government responds by a fiscal
contraction, turning budget into a surplus (d<0). This shifts the
debt dynamics line back up. If the shift is big enough, then once
again db/dt=0.
(4) Repeat. What if there is a further adverse shift?
E.g., a further growth slowdown (n↓) in response to the higher i & budget
surplus. => b starts to climb again.
But by now we are into steep part of the supply-of-lending curve.
There is now substantial fear of default => i rises sharply.
The system could be unstable….
API-119 - Prof.J.Frankel
Appendix 2:
Recent history of sovereign spreads
• EM sovereign spreads, 1994-2008
• The blurring of lines between debt of advanced
countries and developing countries, 2009-.
– Since the crisis of the euro periphery began in Greece,
we have become aware that “advanced” countries also
have sovereign default risk.
API-119 - Prof.J.Frankel
Sovereign spreads
Bpblogspot.com
↑ Spreads shot up in 1990s crises,
• and fell to low levels in next decade.↓
Spreads rose again in Sept.2008 ↑ ,
• esp. on $-denominated debt
• & in E.Europe. ↓
WesternAsset.com
World Bank
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Spreads for Italy, Greece, & other Mediterranean members
of € were near zero, from 2001 until 2008
and then shot up in 2010
Market Nighshift Nov. 16, 2011
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Turkey is able to borrow in local currency (lira),
but has to pay a high currency premium to do so.
{
Total premium on
Turkey’s lira debt
over US treasuries
Pure default risk premium on lira debt
Schreger & Du, “Local Currency Sovereign Risk,” HU, 2013, Fig. 5
API-119 - Prof.J.Frankel
{