Download Unrewarded good fiscal behavior: The role of debt denomination

The elusive quest for macro
stability:
the role of debt denomination
Ricardo Hausmann
Kennedy School of Government
Harvard University
March 10, 2002
Fortaleza, Brazil
Unrewarded good behavior
Many things have been tried to
achieve macro stability
Most governments have
achieved…
•
•
•
•
•
•
Inflation stabilization
Trade liberalization
Privatization
Social security reform
Improved regulation
Efforts in institutional reform
External public debt ratios have
declined sharply
Evolution of external public debt (%GDP)
1990
Panama
100.10%
Peru
80.50%
Costa Rica 56.50%
Bolivia
89.90%
Chile
42.70%
Venezuela
46.40%
Mexico
32.00%
Uruguay
44.50%
Ecuador
94.80%
Colombia
33.00%
Brazil
22.90%
Average
58.50%
2000
60.20%
43.30%
19.80%
54.20%
7.90%
18.10%
14.70%
28.00%
80.70%
24.90%
15.50%
33.10%
-39.90%
-37.20%
-36.60%
-35.70%
-34.80%
-28.30%
-17.30%
-16.50%
-14.10%
-8.10%
-7.40%
-25.10%
Source: Institute for International Finance
…even faster as a share of
exports
External Public debt (%XGS)
Peru
Ecuador
Brazil
Costa Rica
Mexico
Bolivia
Chile
Panama
Colombia
Venezuela
Uruguay
Average
1990
5.41
3.09
2.61
1.56
1.61
4.32
1.21
2.12
1.71
1.8
1.71
2.47
2000 2000-1990
2.48
-293.0%
1.83
-127.0%
1.36
-125.0%
0.4
-116.0%
0.45
-116.0%
3.31
-101.0%
0.23
-98.0%
1.43
-69.0%
1.23
-48.0%
1.39
-40.0%
1.39
-32.0%
1.48
-99.0%
Source: Institute for International Finance
…based on a significant cut in
fiscal deficits
Public Sector Borrowing Requirements
(5 year averages)
Brazil
Mexico
Peru
Venezuela
Panama
Bolivia
Ecuador
Costa Rica
Chile
Argentina
Uruguay
Colombia
Average
86-90
42.6
10.4
8.0
4.0
4.9
5.3
4.6
1.6
-0.9
1.5
1.4
1.2
7.1
96-00
6.6
0.8
1.6
-1.6
1.0
3.3
3.4
1.6
-0.7
1.9
2.5
3.8
2.0
(4)-(2)
-36.0
-9.5
-6.4
-5.6
-3.9
-2.0
-1.2
0.0
0.2
0.4
1.0
2.5
-5.0
Source: Institute for International Finance
But market access remains a problem
(LEI, Spread over US Treasuries)
1200
Current level
1000
Pre-Argentine Crisis
800
Pre-Russian
Crisis
600
Pre-Asian
Crisis
400
776 pb
Sep-01
May-01
Jan-01
Sep-00
May-00
Jan-00
Sep-99
May-99
Jan-99
Sep-98
May-98
Jan-98
Sep-97
May-97
Jan-97
200
Why do good ratios not get good
ratings?
Start with the popular ratio
D
x1 
Y
Debt to GDP ratios look
modest
Public debt/GDP
Honduras
Panamá
Ecuador
Belice
Bolivia
Perú
Argentina
Chile
Venezuela
T&T
México
Costa Rica
Uruguay
Colombia
El Salvador
Haití
Rep Dom
Guatemala
Paraguay
0
20
40
60
80
100
120
140
…consider the smaller tax base:
the debt to tax ratio
D
x2 
tY
…debt to tax ratios are
comparable
Public debt
(as a share of tax revenues)
NIC
GUY
PER
HND
SUR
BOL
PAN
DOM
ECU
CRI
JAM
SLV
VEN
LA
GTM
ARG
OCDE
BRA
TTO
PRY
URY
MEX
COL
CHL
BLZ
BHS
Nota: NIC and GUY
tienen valores de 26.0 y
12.6 respectivamente.
Promedios regionales
están ponderados por
población.
0
1
2
3
4
5
6
…consider higher interest rates:
the debt service to revenue ratio
iD
x3 
tY
Debt service to revenue is much
higher
Interest payments as a share of total government
expenditures 1990-94
30
25
20
15
10
5
0
OECD
LAC
…but where would the higher
interest rates come from?
It must involve some risks
A model of fiscal risk
• Markets are concerned with the solvency of
the government
• But there is uncertainty over future flows
• Reduced form: markets will set a limit to
the share of interest payments in the budget
– Just as mortgage banks do
• What is the likelihood that the country
would hit this limit?
…a graphical representation
Figure 1
~
X
Higher expected value
Prob.
Greater variance
X OECD
X
LA
X
The possibility of multipliers and
multiple equilibria
• High risk causes high interest rates
– Fat tails raise the interest rate
• High interest rates causes high risk
– High interest rates increases the expected value of debt
service
• Fiscal consolidation may be self-reinforcing
– The examples of Italy and Spain
BUT WHAT RISKS ARE WE TALKING ABOUT?
How about revenue volatility?
iD
x3 
tY
Revenue volatility is higher
Fiscal revenue and GDP volatility
(stdev of real rates of growth)
Volatiliy
Revenue
OECD (1970-1994)
LAC (1970-1994)
LAC (1994-2000)
Venezuela
Ecuador
Mexico
Peru
Uruguay
Chile
Colombia
Argentina
Costa Rica
Panama
Bolivia
GDP
5.2
2.2
15.2
4.7
7.9
21.9
17.5
9.9
6.6
6.4
6.4
5.0
4.0
3.0
3.0
3.0
3.4
4.8
3.5
3.7
4.3
3.9
3.7
2.9
5.0
3.0
2.5
1.4
A simulation
Stress test on the debt service capacity: an illustration.
Real Interest rate (local)
Fiscal revenue to GDP
Debt to GDP
Debt to revenue
Debt service to GDP
Debt service to revenue
OECD
LAC
4.0%
10.0%
30.0%
20.0%
40.0%
40.0%
133.3% 200.0%
1.6%
4.0%
5.3%
20.0%
…and it could explain part of the
problem
• Impact of 1 standard deviation shock to
revenues on the the debt service to tax ratio
Shock
Impact
• OECD
-5.0
0.3
• LAC
-8.0
1.7
Its part of the problem, but only a small part.
The original sin hypothesis
• Definition: you cannot borrow long term at
fixed rates in your own currency.
• You are condemned to choose between
short term debt in pesos, or long term debt
in dollars.
• This makes debt service sensitive to the real
exchange rate and the real interest rate
The impact of original sin
Volatility of real interest rates
Volatility of real exchange rates
i D  i D  i eD
x4 
tYt
s
t
s
t 1
l
t 1
l
t 1
*
t 1
Volatility of revenue
*
t 1
Real exchange rates are volatile
and pro-cyclical
Real exchange rates: volatility and cyclical properties
Elasticity of real exchange rate to the import gap in the 1990s
volatility elasticity
t-stat
United States
9.10%
-0.03
-0.9
Latin America
21.40%
0.18
8.9
Peru
28.40%
0.15
3.1
Ecuador
25.70%
0.27
3.7
Venezuela
23.60%
-1.04
-7.7
Argentina
21.10%
0.02
1.2
Colombia
19.30%
0.26
6.2
Brazil
18.80%
0.42
10.4
Mexico
18.30%
0.61
10.7
Chile
16.00%
0.32
4.5
Note: excludes periods in which inflation exceeded 40 percent
…and real interest rates are on a
class by themselves
(monthly data, 1990-1999)
United States
Latin America
Mexico
Venezuela
Brazil
Ecuador
Uruguay
Peru
Colombia
Chile
Costa Rica
Argentina
Panama
Volatility elasticity
0.9
-3.3
10.5
-126.3
23.0
-73.3
17.6
0.1
17.2
-451.6
12.2
-2.4
11.8
2.6
11.2
-151.4
7.8
-16.6
5.4
-8.8
5.0
-19.7
4.0
-221.9
0.6
-0.4
t-stat
-4.1
-10.9
-13.2
0.0
-3.4
-0.5
0.4
-1.7
-2.3
-1.0
-5.0
-10.3
-0.6
They move together in the
“wrong” direction
Real exchange rates and real interest rates
Elasticity of real interest rates vs. RER
(monthly data, 1990-1999)
Country
elasticity
t-stat
United States (1990s)
-4.5
-1.8
Latin America
-153.7
-6.2
Argentina
-174.5
-0.9
Brazil
-1430.5
-7.2
Chile
-66.6
-7.4
Colombia
-4.7
-0.4
Ecuador
-26
-5.2
Mexico
-93.6
-16.2
Peru
-555.3
-3.4
Venezuela
-28.8
-4.3
Note: excludes periods in which inflation
exceeded 40 percent
A simulation
Stress test on the debt service capacity: an illustration.
Real Interest rate ($)
Real Interest rate (local)
Real exchange rate
Fiscal revenue to GDP
GDP
Debt to GDP
-foreign currency
- domestic long term
-domestic short term
Debt to revenue
Debt service to GDP
Debt service to revenue
OECD
LAC
4.0%
10.0%
4.0%
10.0%
100.0% 100.0%
30.0%
20.0%
100.0% 100.0%
40.0%
40.0%
0.0%
20.0%
30.0%
0.0%
10.0%
20.0%
133.3% 200.0%
1.6%
4.0%
5.3%
20.0%
Vive la petite difference
SHOCK
Real Interest rate (local)
Real exchange rate
Fiscal revenue to GDP
GDP
IMPACT
Debt to GDP
-foreign currency
- domestic long term
-domestic short term
Debt to revenue
Debt service to GDP
Debt service to revenue
OECD
LAC
1.0%
-9.0%
-5.0%
-2.0%
10.0%
-21.0%
-8.0%
-4.0%
0.8%
0.0%
0.6%
0.2%
9.9%
0.1%
0.7%
6.0%
5.2%
0.0%
0.8%
50.2%
2.7%
16.3%
Conclusions
• Why do Latin American countries borrow in
dollars?
– Because it is safer than borrowing short-term in
pesos. Not because of moral hazard.
– Because they want to preserve the
independence of their monetary policy
Conclusion
• Why do countries float the way they float?
– Because they borrow the way they borrow
– Since they borrow in dollars, the central bank prefers to
stabilize the exchange rate and concentrate the volatility
on the interest rate
• Why do countries borrow the way they borrow?
– Because they float the way they float
– You would borrow in whatever is more stable. If it is
the exchange rate, then you want to borrow in dollars
Countries with OS keep their
volatility in the interest rate
Relative Volatilities: Exchange Rate and Reserves
std(dev)/std(res/m2)
20
17.559
15
10
5.074
5
2.626
1.760
0
G3
Other Developed
Emerging
0.820
1.123
Other Developing
LA Emerging
East Asia
Conclusion
• Why has good fiscal behavior remained
largely unrewarded?
• Because debt structure (original sin) makes
real exchange rates and real interest rates
matter for debt service
• And these are very volatile and have the
“wrong” cyclical properties, making debt
service much riskier
Conclusions
• Why is Latin America trapped in a procyclical fiscal response in bad times?
• Because in bad times they need to finance
not just the decline in tax revenues but also
the jump in debt service
Implications
• Reduction of the debt to GDP ratio may not be the
most efficient way to achieve fiscal consolidation
– We already tried that
• Working on debt denomination may be more
effective
– It would lower the “value at risk”
– …which would lower the interest rate
– …which would allow fiscal consolidation
Implications
• Governments should target a risk-weighted
debt level
– Risk weights should depend on the volatility
and cyclicality of its determinants
– In the previous examples, short term domestic
currency debt should get the highest weight.
Followed by foreign currency debt
Conclusions
• A risk-weighted debt target should create
incentives for countries to optimize the trade-off
between cheaper and safer debt
– A deficit target favors cheap, risky debt
• Long-term fixed-rate domestic-currency debt is
best but it is hard to develop
– Bravo Mexico
• Inflation-indexed, long-term, fixed-rate domestic
debt are second best and are easier to develop
– Chile dixit
Conclusions
• International financial institutions are now
part of the problem
– They borrow and lend only in foreign currency
• They could be part of the solution
– They need to help develop the international
market for long-term fixed-rate bonds by
issuing their own obligations and on-lend to
borrowers