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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 9 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 21 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) 25 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