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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