ECONOMIC CRISES Lecture 5 Sovereign Debt Crises Outline

ECONOMIC CRISES Lecture 5: Sovereign Debt Crises

Outline Ø Facts q How debt grows q When do countries borrow and default Ø Policies q Avoiding debt explosions q What to do during debt crises q How to deal with defaults Ø Lessons of debt crises

The standard view Ø Facts q Countries get into debt problems because of lax fiscal policies q Countries have an incentive to default on their external debt obligations Ø Policies q Debt crises should always be followed by a fiscal retrenchment q We need to implement policies that reduce a country's incentive to default

How Debt Grows? Ø The economics 101 debt accumulation equation states that: q CHANGE IN DEBT = DEFICIT Ø Practitioners use: q CHANGE IN DEBT = DEFICIT+SF q SF=Stock-flow reconciliation, or the unexplained part of public debt Ø The stock-flow reconciliation is often considered a residual entity of small importance Ø Is it?

If we estimate: R-Squared We expect b and R 2 to be close to 1 and a = 0 All Countries SSA LAC SAS EAP Source: Campos, Jaimovich and Panizza (2006) MNA ECA IND

The Unexplained Part of Public Debt 7 Stock-flow 6 reconciliation % of GDP 5 4 3 2 1 0 IND MNA EAP ECA Source: Campos, Jaimovich and Panizza (2006) LAC SSA

The Unexplained Part of Public Debt ■ The growth rate of the debt-to-GDP ratio is equal to: – Primary deficit/GDP + interest payments/GDP+ – GDP growth – inflation ■ The last two variables are multiplied by the debt-to-GDP ratio ■ If you like math:

The Unexplained Part of Public Debt 15 10 5 INFLATION GDP GROWTH UNEXPLAINED PART INTEREST EXPENDITURE PRIMARY DEFICIT 0 -5 -10 -15 IND SAS CAR EAP ECA MNA LAC Source: Campos, Jaimovich and Panizza (2006) SSA

What explains the “Unexplained” part of debt Fiscal policy matters! Transparent fiscal accounts are important Banking Crises Balance Sheet Effects due to debt composition There also things that we can explain but may not have anything to do with fiscal policy Output collapses Sudden jumps in borrowing costs Natural disasters The Unexplaine d Part of Public Debt

Why is sovereign debt special? Ø Creditor rights are not as well defined for sovereign debt as is the case for private debts. Ø If a private firm becomes insolvent, creditors have a claim on the company’s assets. Ø In the case of a sovereign debt, in contrast, the legal recourse available to creditors has limited applicability and uncertain effectiveness. q Sovereign immunity q Little to attach Ø So, why do countries repay and why do lenders lend?

THEORY

The Economic Theory of Sovereign Debt Ø The literature started with (and it's still tied to) an influential theoretical paper by Eaton and Gersovitz Ø The story of the paper was: q Countries borrow in bad times (low economic growth) and repay in good times (high economic growth) q Since there are no repayments in bad times, there cannot be defaults either q As a consequence, defaults can only happen in good times q Defaults are thus strategic (countries can pay but they decide not to pay) q The only reason that prevents countries from defaulting is that defaults are costly

The Economic Theory of Sovereign Debt Ø So, what are the costs of default? q The traditional economic literature has emphasized q Reputational costs ■ Countries that default will no longer be able to access the international capital market q Trade costs ■ Default will lead to sanctions which, in turn, will have a negative effect on trade

FROM THEORY TO THE DATA Or, theory vs. data

DO COUNTRIES BORROW IN BAD TIMES?

What do the data say? 4, 5 4, 0 Net private 3, 5 transfer to the sovereing as a % of GDP 3, 0 2, 5 2, 0 1, 5 1, 0 0, 5 0, 0 -0, 5 -1, 0 -1, 5 -2, 0 -2, 5 -3, 0 -3, 5 -4, 0 -4, 5 Private Flows Official Flows Good times Bad times Total Flows o Government external borrowing is procyclical and not countercyclical (probably because countries borrow when they can) o This confirms the idea that the seeds of debt crises are planted during good times

DO COUNTRIES DEFAULT IN GOOD TIMES?

What do the data say? Ø Default Happen in Waves…. Ø 1824 -1840. 19 events (14 in Latin America: recent independence, civil wars). Long restructuring periods Ø 1840 -1860. 6 events. Credit boom Ø 1861 -1920. 58 events. Much faster restructuring Ø 1921 -1940. 39 events. Great Depression and WWII. Ø 1941 -1970. 6 events (but little lending) Ø 1971 -1981. 15 events. Boom in syndicated bank loans Ø 1982 -1990. 70 events. The “Debt Crisis” Ø 1991 -2004. 40 events. Lending booms and Sudden Stops

…and they are often linked to bad external financial conditions

DO DEFAULTER PAY A HIGH COST?

What do the data say? Sovereign Spread (basis points) 700 600 500 400 300 200 100 0 -100 1 2 3 Years after the default episode 4 • 3 years after the resolution of a default episode, there is no statistically significant difference between the spreads paid by defaulters and non defaulters • We find similar results if we look at access • Global factors (risk aversion and US interest rate) appear to be more important than default history

What do the data say? Ø There is some evidence that defaults have a negative effect on trade Ø But this is still controversial, and the channel is not clear q No evidence that defaults have a direct impact on trade credit q No evidence (at least in recent years) of explicit sanctions Ø Is that important? q We do know that defaults are bad because they lead to deep recessions ■ Econometric estimates found that, on average, default episodes are associated with a 2 percentage points drop in GDP growth Ø But do we really know what we think we know? q Are default episodes bad for growth or is it low

What do the data say? Ø Causality is always very hard to assess Ø But, if we look at high frequency data, we find that: q Growth collapses anticipate defaults q Default episodes are often followed by a rapid rebound of the economy

What do the data say?

Do countries default too early or too late? The last thing one should be doing is tell a country we should give up our claims. But there comes a time when you have to face reality. The problem historically has not been that countries have been too eager to default on their financial obligations, but often too reluctant.

There is a (small) literature of political costs of currency devaluations (Cooper 1971). Politica l costs of default Frankel (2005) finds that a devaluation increases turnover of finance ministers from 36 to 58 percent. • Applying Frankel’s approach, bond defaults increase minister turnover from 19 to 40 percent. But bank defaults increase it only to 24 percent. • Governments lose votes after defaults The high political cost of default may affect the timing of the decision by the government. It could cause “gambles for redemption”

Summing up: Theory versus Reality Ø Theory q Countries get into trouble because of lax fiscal policy q Countries borrow in bad times q If ever, countries default in good times (strategic defaults) ■ So, if anything, they default too much q Defaults are very bad for the economy, with long lasting negative consequences Ø Reality q Many debt explosions have nothing to do with fiscal policy q Countries borrow in good times q Countries default in bad times (justified defaults) ■ And sometimes too late q Defaults do not seem to have long lasting negative consequences

POLICIES

Prudent Fiscal Policy Ø Control the flow of debt q Only borrow when the social return is higher than the opportunity cost of funds q This requires strengthening fiscal policies and institutions ■ Fiscal rules ■ Budget institutions – – Hierarchical rules Transparency Rules q Like motherhood and apple pie, this is always good, but it may not be enough Ø Avoid disasters in the banking sector q It is mostly about preventing lending booms

BUT CAN LOW DEBT “BUY YOU LOVE” ?

Low debt is not enough Standard & Poor's Sovereign Rating Public Debt and Sovereign Rating (1995 -2005) AAA Germany Switzerland Norway Australia Luxembourg New Zealand United Kingdom France Austria Denmark Canada United States Spain Finland Ireland Sweden Netherlands AA- Iceland Belgium Portugal Italy Cyprus Saudi Arabia Malta Botswana Slovenia Chile Czech Republic Korea, Rep. Bahrain. Bahamas Malaysia Estonia Latvia Thailand China Poland Oman A- Israel Qatar BB- Egypt, Arab Rep. India Morocco Philippines Bulgaria Bolivia Papua New Guinea Grenada Venezuela, RB Turkey Investment grade Panama Brazil Russian Federation Benin Ukraine Belize Paraguay B- Barbados Hungary Tunisia and Tobago Africa Slovak Republic Trinidad. South Lithuania Mexico El Salvador Croatia Colombia Kazakhstan Peru. Uruguay Costa Rica Guatemala BBB- Japan Jordan Senegal Mongolia Indonesia Argentina Ghana Jamaica Pakistan Ecuador 0 10 20 30 40 50 60 70 Public Debt as Percent of GDP Source : Jaimovich and Panizza (2006) and Standard and Poor's 80 90 100 110

Low debt is not enough Source: De Grauwe (2011)

Low debt is not enough Source: De Grauwe (2011)

Debt denominated in foreign currency or shortmaturity debt is associated with: The importanc e of debt structure • • Lower Credit Ratings Sudden Stops Higher volatility Limited ability of conducting monetary policy • Contractionary devaluations An appropriate debt structure can reduce risk

How to make debt safer New and safer instruments • Local currency • Contingent debt instruments • GDP index bonds • Commodity linked bonds • Catastrophe bonds Dedollarize official lending

Market failures Why do we need official intervention ? • Critical mass • Standards • Instruments cannot be patented Political economy • Shortsighted politicians may underinsure

Fiscal consolidation? Ø The instinctive response to a debt crisis is (almost) always: we need a fiscal adjustment Ø This does not make much sense if the debt crisis is not rooted in fiscal problems Ø In fact, it may hurt. Ø Not only in the short-run, but also in the long-run: q Recessions lead to a permanent output loss q The adjustment variable is public investment

The adjustment variable is public investment Source: Martner and Tromben (2005)

…and this is very bad for growth, and for the fiscal adjustment When growth-promoting spending is cut so much that the present value of future government revenues falls by more than the immediate improvement in the cash deficit, fiscal adjustment becomes like walking up the down escalator. (Easterly, Irwin, Serven, 2008)

What can the internation al community do? Don’t ask Think about Don’t ask for fiscal contractions if fiscal profligacy was not the problem • If a fiscal contractions is needed, don’t frontload it Think about fiscal targets that protect investment • Also think about the quality of public investment

Think about the math • • • When is a fiscal contractio n needed?

Just to remind you……. . Ø Theory q Countries borrow in bad times q If ever, countries default in good times (strategic defaults) ■ So, if anything, they default too much q Defaults are very bad for the economy, with long lasting negative consequences Ø Reality q Countries borrow in good times q Countries default in bad times (justified defaults) ■ And sometimes too late q Defaults do not seem to have long lasting negative consequences

Countries should not ne encouraged to default more often To default or not to default? But why is there this disconnect between theory and reality? • The theory might be wrong? • Or, there may be a problem with the international financial structure? Most likely, this is due to a mix of political failure and a lousy international financial architecture

Is the financial structure wrong? Ø In a well working system, countries should be able to borrow when they need funds (i. e. , in bad times) q But during bad times, the international capital markets are not willing to provide credit at a reasonable interest rate q Therefore, countries borrow in good times because this is when they have access to credit ■ Same reason why Willie Sutton robbed banks q Unfortunately, sometimes they borrow too much in good times and this behavior sows the seeds of future crises ■ We need to fix the political economy of debt – The real reason why Willie Sutton robbed banks

Strategic or justified? Ø Most of the defaults we observe are justified (or unavoidable, at least ex-post) episodes Ø Strategic defaults are very rare q So, we cannot use econometric methods to assess the cost of these very rare events q What we are actually assessing is the cost of non-strategic defaults Ø But why are they rare? Ø Probably because they are costly Ø But what is the cost?

The current system is inefficient: It brings some pain… Length of Debt-Restructuring Delays 10 9 8 7 6 Years 5 4 3 2 1 0 Low income (n=26) Source: Wright (2010) Low middle income (n=31) Upper middle income (n=31)

…but little gain Change in Indebtedness to Private Creditors following Debt Restructuring 1, 8 1, 6 1, 4 1, 2 Ratio of Debt/GNI Post-Default to Pre-Default 1 0, 8 0, 6 0, 4 0, 2 0 Source: Wright (2010) Low income (n=20) Low middle income (n=26) Upper middle income (n=31)

Is this inefficient system efficient? Ø Some pain and no gain might be inefficient ex-post, but could be efficient ex-ante Ø High costs of defaults are necessary to create willingness to pay, establish credibility, and lower borrowing cost q Therefore countries sub optimally delay default q This is why some borrowing countries are opposed to the creation of a mechanism that may eliminate these inefficiencies

From second best to first best Ø An alternative story q The international community and financial markets implicitly forgive countries that default out of necessity but would impose a harsh punishment on countries that default strategically q If this is the case, policymakers need to signal that the default is indeed unavoidable and not strategic q A way of doing this is to go through considerable pain in order to delay the default as long as possible Ø Also second best, but in this case, there is a solution Ø Solution: q The first best could be achieved with the creation of a body with the ability to assess whether a default was indeed unavoidable ■ A bankruptcy court for sovereigns ■ By increasing potential recovery rates, it could be efficient both ex-ante and ex-post

Lessons of Debt Crises 1. Fixing the exchange rate has risks: governments desire to fix exchange rates to provide stability in the export and import sectors, but the price to pay may be high interest rates or high unemployment. 2. Weak enforcement of financial regulations can lead to risky investments and a banking crisis when a currency crisis erupts or when a fall in output, income and employment occurs. 3. Liberalizing financial capital flows without implementing sound financial regulations can lead to financial capital flight when risky loans or other risky assets lose value during a recession. 4. The importance of expectations: even healthy economies are vulnerable to crises when expectations change. q Expectations about an economy often change when other economies suffer from adverse events. q International crises may result from contagion: an adverse event in one country leads to a similar event in