Lecture 3: Country Risk

Transcription

1 Lecture 3: Country Risk 1. The portfolio-balance model with default risk. 2. Default. 3. What determines sovereign spreads? 4. Debt Sustainability Analysis (DSA).

2 1. The portfolio balance model applied to country risk One lesson of portfolio diversification theory: A country that borrows too much drives up the expected rate of return it must pay. The supply of funds is not infinitely elastic. -- especially for developing countries. The portfolio-balance model can be very general (menu of assets). In Lecture 2, we considered a special case relevant to rich-country bonds: currency risk is the only risk. Some modifications are appropriate for developing-country debt, starting with the risk of default.

3 Demand for assets issued by various countries f: x i, t = A i + [ρv] i -1 E t (r f t+1 r d t+1) ; Now the expected return E t (r f t+1) subtracts from i f t the probability of default times loss in event of default. Similarly, the variances & covariances factor in risks of loss through default. When perceptions of risk are high [ρv], interest rates must be high for investors to absorb given supplies of debt risk off in global financial markets.

4 Developing countries: The view from the South are usually assumed to be debtors; must pay a premium as compensation for default risk. Debt to foreigners was usually $-denominated (before 2000). Then, expected return = observed spread between interest rate on the country s loans or bonds & risk-free $ rate, minus expected loss through default -- instead of rp. Denominator for Debt : More relevant than world wealth is the country s GDP or X. Why? Earnings determine ability to repay. Supply-of-lending-curve slopes up: when debt is large investors fear default & build a country risk premium into i.

5 2. Default The international debt crisis Latin American independence Great Depression Asia crisis GFC Venezuela has defaulted 9 times since independence in Nigeria has defaulted 5 times since independence in Greece has been in default on its debt half the time since independence in Spain has defaulted the most: 6 times in the 18th century, and 7 in the 19 th. Source: Reinhart and Rogoff, This Time is Different: Eight Centuries of Financial Folly, 2011, pp

6 Why don t debtor countries default more often, given absence of an international enforcement mechanism? 1. They want to preserve their creditworthiness, to borrow again in the future. Kletzer & Wright (2000), Amador (2003), Aguiar & Gopinath (2006), Arellano (2008), Yue (2010). But: Some find defaulters don t seem to bear much of a penalty for long: Eichengreen (1987), Eichengreen & Portes (2000), Arellano (2009), Panizza, Sturzenegger & Zettelmeyer (2009). Not a sustainable repeated-game equilibrium: Bulow-Rogoff (1989). 2. Best answer (perhaps): Defaulters may lose access to international banking system, including trade credit. Loss of credit disrupts production, even for export. Theory: Eaton & Gersovitz (RES 1981, EER 1986). Evidence: Rose (JDE 2005). 3. Cynical answer: Finance Ministers want to remain members in good standing of the international elite.

7 New finding: For some years after a restructuring, the defaulter is excluded from access to international finance. Estimated from 67 restructurings, Juan Cruces & Christoph Trebesch, 2013, Sovereign Defaults: The Price of Haircuts, AEJ: Macro, Fig.5, p. 111.

8 3. What determines sovereign spreads? EMBI is correlated with risk perceptions risk on risk off Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011

9 For some years after a restructuring, the defaulter has to pay higher interest rates, especially if creditors had to take a big write-down ( haircut ). Estimated, especially the 1 st 5 years Cruces & Trebesch, 2013, Sovereign Defaults: The Price of Haircuts, Fig.3.

10 Eichengreen & Mody (2000): Spreads charged by banks on emerging market loans are significantly: higher if the country has: high total ratio of Debt/GDP, rescheduled in previous year high Debt Service / X, or unstable exports; and reduced if it has: a good credit rating, high growth, or high reserves/short-term debt

11 The spread may rise steeply when Debt/GDP is high. Stiglitz: it may even bend backwards, due to rising risk of default. i Supply of funds from world investors b Debt/GDP

12 4. Debt dynamics: What determines if a country becomes insolvent? It depends not on the level of debt directly, but, rather, on whether the ratio b debt/gdp is on an unsustainable path.

13 Definition of sustainability: a steady or falling debt/gdp ratio b Debt Y db dt = d Debt/dt Y where Y nominal GDP. Debt Y 2 dy dt => db dt = = Total Fiscal Deficit Y Primary Deficit + (i Debt) Y Debt Y dy/dt Y bn where n nominal growth rate. = d + i b bn where d Primary Deficit / Y. = d + i n b. => Debt ratio explodes if d > 0 and i > n (or r > real growth rate).

14 db dt = d + (i - n) b. where b Debt Y n nominal growth rate, and d primary deficit / Y. Debt dynamics line shows the relationship between b and (i-n), for db/dt = 0. i db/dt=0 Even with a primary surplus (d<0), if i is high (relative to n), then b is on explosive path. range of explosive debt range of declining Debt/GDP ratio n 1 0 i us b

15 Debt dynamics, continued It is best to keep b low to begin with, especially for debt-intolerant countries. Otherwise, it may be hard to stay on the stable path if i rises suddenly, due to either a rise in world i* (e.g., 1982, 2016), or an increase in risk concerns (e.g., 2008); or n exogenously slows down. Now add the upward-sloping supply of funds curve. i includes a default premium, which probably depends in turn on db/dt. => It may be difficult or impossible to escape the unstable path without default, write-down, or restructuring of the debt, or else inflating it away, if you are lucky enough to have borrowed in your own currency.

16 Debt dynamics, with inelastic supply of funds i Greece 2012 range of explosive debt range of declining Debt/GDP Ireland 2012 n 1 0 i us b

17 explosive debt path Professor Jeffrey Frankel, Kennedy School, Harvard University

18 Appendix 1: Debt dynamics graph, with possible unstable equilibrium i Supply of funds line Initial debt dynamics line sovereign { spread i US b Debt Y

19 (1) Good times. Growth is strong. db/dt = 0, or if > 0 nobody minds. Default premium is small. (2) Adverse shift. Say growth n slows down. Debt dynamics line shifts down, so the country suddenly falls in the range db/dt>0. => gradually moving rightward along the supply-of-lending curve. (3) Adjustment. The government responds by a fiscal contraction, turning budget into a surplus (d<0). This shifts the debt dynamics line back up. If the shift is big enough, then once again db/dt=0. (4) Repeat. What if there is a further adverse shift? E.g., a further growth slowdown (n ) in response to the higher i & budget surplus. => b starts to climb again. But by now we are into steep part of the supply-of-lending curve. There is now substantial fear of default => i rises sharply. The system could be unstable.

20 Appendix 2: Recent history of sovereign spreads EM sovereign spreads, The blurring of lines between debt of advanced countries and developing countries, Since the crisis of the euro periphery began in Greece, we have become aware that advanced countries also have sovereign default risk.

21 Sovereign spreads Bpblogspot.com Spreads shot up in 1990s crises, and fell to low levels in next decade. Spreads rose again in Sept. 2008, esp. on $-denominated debt & in E.Europe. WesternAsset.com World Bank

22 Spreads for Italy, Greece, & other Mediterranean members of were near zero, from 2001 until 2008 and then shot up in 2010 Market Nighshift Nov. 16, 2011

23 Turkey is able to borrow in local currency (lira), but has to pay a high currency premium to do so. { Total premium on Turkey s lira debt over US treasuries Pure default risk premium on lira debt { Schreger & Du, Local Currency Sovereign Risk, HU, 2013, Fig. 5