Download Sovereign Debt and Debt Crises

Debt and Debt Crises
Ugo Panizza
UNCTAD
There are my own views
The standard view
• Facts
– Countries get into debt problems because of
lax fiscal policies
– Countries have an incentive to default on their
external debt obligations
• Policies
– Debt crises should always be followed by a
fiscal retrenchment
– We need to implement policies that reduce a
country's incentive to default
Background
• U. Panizza, F. Sturzenegger, and J. Zettelmeyer (2009)
"The Economics and Law of Sovereign Debt and
Sovereign Default" Journal of Economic Literature
• B. Eichengreen, R. Hausmann, and U. Panizza (2003)
“The Pain of Original Sin” University of Chicago Press
• E. Borensztein, and U. Panizza (2009)"The Costs of
Sovereign Default" IMF Staff Papers
• E. Levy Yeyati and U. Panizza (2010) "The Elusive Cost
of Sovereign Default," Journal of Development
Economics
• E. Borensztein, E. Levy Yeyati, and U. Panizza (2006)
Living with Debt, Harvard University Press and IDB
• C. Campos, D. Jaimovich, and U. Panizza (2006) “The
Unexplained Part of Public Debt,” Emerging Markets
Review
Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
How Debt Grows?
• The economics 101 debt accumulation equation
states that:
– CHANGE IN DEBT = DEFICIT
• Practitioners use:
– CHANGE IN DEBT = DEFICIT+SF
– SF=Stock-flow reconciliation, or the unexplained part
of public debt
• The stock-flow reconciliation is often considered
a residual entity of small importance
• Is it?
If we estimate: Di ,t   i  d i ,t   i ,t
We expect:  and R2 to be close to 1 and  = 0
R-Squared
0.55
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
All
SSA
Countries
LAC
SAS
EAP
MNA
Source: Campos, Jaimovich and Panizza (2006)
ECA
IND
The Unexplained Part of Public
Debt
Stock-flow reconciliation
% of GDP
7
6
5
4
3
2
1
0
IND
MNA
EAP
ECA
LAC
Source: Campos, Jaimovich and Panizza (2006)
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-toGDP ratio
• If you like math:
Dt 1
Dt 1 SFt
 D  Dt Dt 1 PDt
  


i
 (g   )

Yt
Yt
Yt
Yt
 Y  Yt Yt 1
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
SSA
Source: Campos, Jaimovich and Panizza (2006)
The Unexplained Part of Public
Debt
• What explains the “Unexplained” part of
debt
– Skeletons
• Fiscal policy matters!
• Transparent fiscal accounts are important
– Banking Crises
– Balance Sheet Effects due to debt
composition
Much more about this in a while
The Unexplained Part of Public
Debt
• There are 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
Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
Why is sovereign debt special?
• Creditor rights are not as well defined for
sovereign debt as is the case for private debts.
• If a private firm becomes insolvent, creditors
have a claim on the company’s assets.
• In the case of a sovereign debt, in contrast, the
legal recourse available to creditors has limited
applicability and uncertain effectiveness.
– Sovereign immunity
– Little to attach
• So, why do countries repay and why do lenders
lend?
Theory
The Economic Theory of Sovereign
Debt
• The literature started with (and it's still tied to) an
influential theoretical paper by Eaton and Gersovitz
(Review of Economic Studies, 1981)
• The story of the paper was:
– Countries borrow in bad times (low economic growth) and repay
in good times (high economic growth)
– Since there are no repayments in bad times, there cannot be
defaults either
– As a consequence, defaults can only happen in good times
– Defaults are thus strategic (countries can pay but they decide not
to pay)
– The only reason that prevents countries from defaulting is that
defaults are costly
The Economic Theory of Sovereign
Debt
• So, what are the costs of default?
– The traditional economic literature has
emphasized
– Reputational costs
• Countries that default will no longer be able to
access the international capital market
– Trade costs
• Default will lead to sanctions which, in turn, will
have a negative effect on trade
From the theory to the
data
Do countries borrow in bad
times?
Net private transfer to the
sovereing as a % of GDP
What do the data say?
4.5
4.0
3.5
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
Good times
Bad times
Private
Official
Total
Flows
Flows
Flows
• Government external borrowing is procyclical and not countercyclical
(probably because countries borrow when they can)
• 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?
•
•
•
•
•
•
•
•
Default Happen in Waves….
1824-1840. 19 events (14 in Latin America: recent
independence, civil wars). Long restructuring periods
1840-1860. 6 events. Credit boom
1861-1920. 58 events. Much faster restructuring
1921-1940. 39 events. Great Depression and WWII.
1941-1970. 6 events (but little lending)
1971-1981. 15 events. Boom in syndicated bank loans
1982-1990. 70 events. The “Debt Crisis”
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?
Sovereing Spread
(basis points)
700
600
500
400
300
200
100
0
-100
1
2
3
4
Years after the default episode
• 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?
• There is some evidence that defaults have
a negative effect on trade
• But this is still controversial and the
channel is not clear
– No evidence that defaults have a direct
impact on trade credit
– No evidence (at least in recent years) of
explicit sanctions
What do the data say?
• Anyway, who cares?
– 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
• But do we really know what we think we know?
– Are default episodes bad for growth or is it low growth
that causes default?
– That is, do defaults happen in bad times?
What do the data say?
• Causality is always very hard to assess
• But, if we look at high frequency data, we
find that:
– Growth collapses anticipate defaults
– Default episodes are often followed by a rapid
rebound of the economy
What do the data say?
115
110
105
100
95
90
85
-12
-8
-4
0
Event time
4
8
12
Do countries default too early or
too late?
• Hell, the last thing I should be doing is tell a
country we should give up our claims. But there
comes a time when you have to face reality.
– Unnamed financial industry official. Both are taken
(Source: Bluestein, 2005, p 163)
• The problem historically has not been that
countries have been too eager to renege on
their financial obligations, but often too reluctant.
– Memo prepared by the Central Banks of England and
Canada (Source: Bluestein, 2005, p 102)
Political costs of default
• There is a (small) literature of political costs of currency
devaluations (Cooper 1971).
• 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”
– Mickey Mouse model (Borensztein and Panizza, 2009)
Summing up: Theory versus Reality
• Theory
– Countries get into trouble because of lax fiscal policy
– Countries borrow in bad times
– If ever, countries default in good times (strategic defaults)
• So, if anything, they default too much
– Defaults are very bad for the economy, with long lasting negative
consequences
• Reality
– Many debt explosions have nothing to do with fiscal policy
– Countries borrow in good times
– Countries default in bad times (justified defaults)
• And sometimes too late
– Defaults do not seem to have long lasting negative
consequences
Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
Prudent Fiscal Policy
• Control the flow of debt
– Only borrow when the social return is higher than
the opportunity cost of funds
– This requires strengthening fiscal policies and
institutions
• Fiscal rules
• Budget institutions
– Hierarchical rules
– Transparency Rules
– Like motherhood and apple pie, this is always
good, but it may not be enough
Avoid disasters in the banking
sector
• It is mostly about preventing lending
booms (Borio, Reinhart, Rogoff)
But low debt can’t buy
you love
Low debt is not enough
Standard & Poor's Sovereign Rating
Public Debt and Sovereign Rating (1995-2005)
Germany
Switzerland
Norway
AAA
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.
BahrainBahamas Malaysia
Estonia
Latvia
Thailand
China
Poland
Oman
A-
Israel
Qatar
Barbados
Egypt, Arab Rep.
Panama
India
Brazil
Russian Federation
Benin
Bolivia
Papua New Guinea
Grenada
Venezuela, RB
Turkey
B-
Morocco
Philippines
Bulgaria
BBUkraine Belize
Paraguay
Investment grade
Hungary
Tunisia
and Tobago
Africa
Slovak Republic TrinidadSouth
Lithuania
Mexico El Salvador
Croatia
Colombia
Kazakhstan
PeruUruguay
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)
A tale of two countries
The importance of debt structure
• Debt denominated in foreign currency or
short-maturity debt is associated with:
– 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
Why do we need official
intervention?
• Market failures
– Critical mass
– Standards
– Instruments cannot be patented
• Political economy
– Shortsighted politicians may underinsure
Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
Fiscal consolidation?
• The instinctive response to a debt crisis is
(almost) always: we need a fiscal adjustment
• This does not make much sense if the debt crisis
is not rooted in fiscal problems
• In fact, it may hurt.
• Not only in the short-run, but also in the longrun:
– Recessions lead to a permanent output loss (Cerra
and Saxena, 2008)
– The adjustment variable is public investment
(Easterly, Irwin, Serven, 2008; Martner and Tromben,
2005)
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 international
community do?
• Don’t ask for fiscal contractions if fiscal
profligacy was not the problem
• If a fiscal contractions is needed, don’t frontload it
(Blanchard and Cottarelli, 2010)
• Think about fiscal targets that protect
investment (Blanchard and Giavazzi,
2004, Buiter, 198?)
• Also think about the quality of public investment
(Pritchett, 2000, Dabla-Norris et al., 2011,)
When is a fiscal contraction
needed?
• Think hard about the math
d=-ps+(i-g)d
– Multiple equilibria (high i and low i)
– The international community can help
(especially when the global i is very low)
– Don’t lend at punitive interest rates
• Bagehot was right for banking crises, but he might
be wrong for sovereign debt crises
– Moral hazard is often overstated (Meltzer versus
Krugman)
Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
From earlier this morning
• Theory
– Countries borrow in bad times
– If ever, countries default in good times (strategic
defaults)
• So, if anything, they default too much
– Defaults are very bad for the economy, with long
lasting negative consequences
• Reality
– Countries borrow in good times
– Countries default in bad times (justified defaults)
• And sometimes too late
– Defaults do not seem to have long lasting negative
consequences
To default or not to default?
• Let me start by saying that I am not (I repeat
NOT) suggesting that countries should default
more often
• But I want to ask, why is there this disconnect
between theory and reality?
• The theory might be wrong
• Or, they may be a problem with the world
• My hunch is that this is due to a mix of political
failure and a lousy international financial
architecture
Is the world wrong?
• In a well working system, countries should be
able to borrow when they need funds (i.e., in
bad times)
– But during bad times, the international capital markets
are not willing to provide credit at a reasonable
interest rate
– Therefore, countries borrow in good times because
this is when they have access to credit
• Same reason why Willie Sutton robbed banks
– 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?
• Most of the defaults we observe are
justified (or unavoidable, at least ex-post)
episodes
• Strategic defaults are very very very rare
– So, we cannot use econometric methods to
assess the cost of these very rare events
– What we are actually assessing is the cost of
non-strategic defaults
• But why are they rare?
• Probably because they are costly
• But what is the cost?
The current system is inefficient:
It brings some pain…
Length of Debt-Restructuring Delays
10
8
6
Years
4
2
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
2
1.5
Ratio of
Debt/GNI
Post-Default to
Pre-Default
1
0.5
0
Source: Wright (2010)
Low income
(n=20)
Low middle income
(n=26)
Upper middle
income (n=31)
Is this inefficient system efficient?
• Some pain and no gain might be inefficient expost, but could be efficient ex-ante
• High costs of defaults are necessary to create
willingness to pay, establish credibility, and lower
borrowing cost
– Dooley (2000), Shleifer (2003)
• This is why countries suboptimally delay default
• 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
• This is clearly a second best solution
– Countries suffer
– They destroy value and decrease recovery
rates
From second best to first best
• An alternative story
– 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 (Grossman and van Huyk,
AER 1988)
– If this is the case, policymakers need to signal that the
default is indeed unavoidable and not strategic
– A way of doing this is to go through considerable pain
in order to delay the default as long as possible
• Also second best, but in this case there is a
solution
From second best to first best
• Solution:
– 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
• Everybody (lenders and borrowers) is better off
Debt and Debt Crises
Ugo Panizza
UNCTAD
There are my own views