Assessing the Appropriate Size of Relief in Sovereign Debt Restructuring International Monetary Fund SPRDP Seminar Martin Guzman (Columbia-UBA-CIGI) Domenico Lombardi (CIGI) April 27, 2017
Motivation What s the appropriate size of relief in a sovereign debt restructuring process?
Related literature
Related literature: observed haircuts as guide for appropriate haircuts Inter-country comparison of market haircuts (Edwards 2015) 180 restructuring episodes with private creditors from 1970 to 2010 (data from Cruces-Trebesch 2013) Actual haircuts vs. Predicted haircuts H t = 1 PV new bond(r t+ɛ) PV old bond(r t+ɛ ) If actual haircut >> (<<) predicted haircut = too much (too little) haircut But the approach is flawed
The too little syndrome t 3 4 5 6 7 Frequency 0.497 0.525 0.553 0.575 0.6 Frequency: denotes fraction of restructuring with private creditors (bondholders and bank loans) followed by another restructuring or default with the same group within t years This evidence should make us skeptical of papers which use past restructuring episodes as a guide for future debt policy
Related literature Principles for sovereign debt restructuring (Guzman-Stiglitz 2015, 2016) Must ensure proper functioning of sovereign lending markets Ex-ante efficiency Ex-post efficiency The restructuring must restore the conditions for pursuing the sovereign s development goals The ultimate goal of a sovereign restructuring is the restoration of debt sustainability But other principles should be respected as well calls for a broader definition of sustainability
Relation to other literature Empirical literature on fiscal sustainability (Bohn 1995, 2005, 2008, Mendoza-Ostry 2008) IMF DSA; Fan Charts (Abiad-Ostry 2005; Celasun-Debrun-Ostry 2006) Commitment issues and strategic defaults (D Erasmo-Mendoza 2013, 2014; D Erasmo et al. 2015; Eaton-Gersovitz 1981; Aguiar-Gopinath 2006) Excusable defaults (Grossman-Van Huyck 1988; Levy Yeyati-Panizza 2007; Collard et al. 2015) Strategic default is a matter of will. Excusable default is a matter of means Effects of debt relief on economic performance (Reinhart-Trebesch 2016; LDA for West Germany)
The concept of debt sustainability
The concept of debt sustainability Consistency issues (Guzman-Heymann 2015) Any borrowing can be considered sustainable if the lending-borrower transaction is consistent, in the sense that the borrowing cost reflect the actual probability of default As IMF (2013) DSA, we refer to the risk of a country falling into a situation of debt distress
The concept of debt sustainability A general definition: public debt is economically sustainable when its repayment does not rely on a sequence of unbounded future borrowings Caveat 1: Economic sustainability is a necessary but not sufficient condition for principles-based sustainability Caveat 2: the analyst cannot know with certainty what will be the evolution of the state variables that determine the debt repayment capacity Therefore, any statement on debt sustainability is by definition probabilistic
Empirical approach for testing debt sustainability Ad hoc sustainability Notation: s t : fiscal surplus to GDP ratio 1 + r = 1+R 1+γ R: constant nominal interest rate γ: constant growth rate of output d t : outstanding debt payments in period t
Empirical approach for testing debt sustainability Ad hoc sustainability (TC) holds iff (IBC) holds: (IBC): d t = (1 + r) j E t s t+j j=0 (TC): lim j (1 + r) j E t d t+j = 0 Definition 1 Fiscal policy satisfies ad hoc sustainability if (IBC) holds
Empirical approach for testing debt sustainability Model-based sustainability Bohn (1995, 2005, 2008) Arrow-Debreu securities = Lenders use the same pricing kernel u t+j (IBC ): dt (z t ) = E t [u t+j s t+j ] j=0 (TC ): lim j E t [u t+j d t+j ] = 0 Definition 2 Fiscal policy satisfies model-based sustainability if (IBC ) holds
Empirical approach for testing debt sustainability Model-based sustainability = (1 + r) j = β j E t u c (c t+j (z t+j )) u c (c t (z t )) (IBC ) can be rewritten as follows (Mendoza-Ostry 2008): d t (z t ) = [ {(1 + r) j E t s t+j + cov t β j u ]} c(c t+j (z t+j )), s t+j u c (c t (z t )) j=0 Under complete markets, there cannot be excessive borrowing The government trades insurance across possible states of nature Test: regress primary balance on outstanding debt positive (significant) coefficient is sufficient condition for sustainability
Empirical approach for testing debt sustainability What the test informs: assuming the past is a representative guide for the future, would fiscal policy be sustainable? But the course of policies could be reversed Our question: Is there any feasible course of policies consistent with the satisfaction of the transversality condition (plus other conditions) with high probability?
A methodology for assessing the appropriate size of relief in sovereign debt restructuring
A criterion for assessing the appropriate size of debt relief A preview of the methodology 1 Define restructuring principles and translate them into economic terms 2 Describe the model that represents the economy under analysis 3 For each possible economic scenario, find the trajectory of fixed points {s t } t that satisfies IBC 4 Classify each fixed point according to its economic and political feasibility 5 If there is a sufficiently large mass of feasible trajectories of fixed points, then the state variable dt satisfies sustainability with high probability 6 Otherwise, there is need for a debt write off large enough as to achieve a sufficiently large mass of trajectories of fixed points
A criterion for assessing the appropriate size of debt relief Suppose (IBC) is the appropriate IBC d t = (1 + r) j E t s t+j j=0 Suppose: s t = s(γ t, R t, X s t, ɛ s t) γ t = γ(s t, X γ t, ɛ γ t ) = R t = R(s t, X R t, ɛ R t ) s t = s [ ] γ(s t, Xt γ, ɛ γ t ), R(s t, Xt R, ɛ R t ), Xt s, ɛ s t = T (s t ) st
A criterion for assessing the appropriate size of debt relief Definition 3 The set of economically feasible s t is defined as J E = {s t : γ(s t, X γ t, ɛ γ t ) > 1 R(s t, X R t, ɛ R t ) > γ(s t, X γ t, ɛ γ t )} Definition 4 s t is an economically feasible fixed point if s t J E
A criterion for assessing the appropriate size of debt relief Definition 5 The set of economically feasible s t is defined as J P Definition 6 s t is a politically feasible fixed point if s t J P Definition 7 s t is a feasible fixed point if s t J F = J E J P
A criterion for assessing the appropriate size of debt relief Definition 8 d t 1,t is x-sustainable if given the probability distributions for ɛ i t (i = s, γ, R), there are {s t } t J F s.t. IBC holds with probability mass not smaller than x Definition 9 Suppose IBC holds with probability x < x for dt. Then, the appropriate level of debt relief,, must satisfy = dt dt, where dt is the maximum value of d that satisfies x-sustainability
A methodology for assessing the appropriate size of relief in sovereign debt restructuring: An illustration of how to apply it
A criterion for assessing the appropriate size of debt relief An illustration: The case of constant fiscal surplus to GDP ratio Commonly invoked object in practical episodes of restructuring: the debt-stabilizing constant fiscal surplus to GDP ratio Suppose (IBC) is the relevant IBC Suppose γ t = γ, R t,t+1 = R, both r.v. ex-ante Let γ n and R n be any possible realization of γ and R = ( R n γ n ) s n = d t 1 + γ n
A criterion for assessing the appropriate size of debt relief An illustration: The case of constant fiscal surplus to GDP ratio Suppose γ n = α 0 α 1 s n R n = β 0 β 1 s n α i and β i have discrete uniform distributions: α 0 unif (0.02, 0.07) with pmf = 1/6; α 1 unif (0, 1) with pmf = 1/11; β 0 unif (0.03, 0.07) with pmf = 0.2; β 1 unif (0, 101) with pmf = 1/101
A criterion for assessing the appropriate size of debt relief An illustration: The case of constant fiscal surplus to GDP ratio Under our distributional assumptions, N = 33, 330 combination of states Compute s n for each n, for d t [0.01, 1.8] Multiple fixed points
A criterion for assessing the appropriate size of debt relief An illustration: The case of constant fiscal surplus to GDP ratio 1 Eliminate dynamically inefficient combinations 2 Count scenarios where there is at least one economically feasible fixed point 3 Political feasibility: suppose J P = {s t ( 1, 1) : γ(s t, X γ t, ɛ γ t ) 0.01} 4 Count scenarios where there is at least one politically feasible fixed point 5 Compute ratio of relevant scenarios with feasible fixed point
A criterion for assessing the appropriate size of debt relief An illustration: The case of constant fiscal surplus to GDP ratio x-sustainability: Fraction of states with feasible fixed points 1.2 1 0.8 0.6 0.4 0.2 0 0.01 0.05 0.09 0.13 0.17 0.21 0.25 0.29 0.33 0.37 0.41 0.45 0.49 0.53 0.57 0.61 0.65 0.69 0.73 0.77 0.81 0.85 0.89 0.93 0.97 1.01 1.05 1.09 1.13 1.17 1.21 1.25 1.29 1.33 1.37 1.41 1.45 1.49 1.53 1.57 1.61 1.65 1.69 1.73 1.77 Initial debt to GDP ratio
A criterion for assessing the appropriate size of debt relief An illustration: The case of constant fiscal surplus to GDP ratio Appropriate relief, x = 0.95 1.4 Appropriate debt relief for x=0.95 1.2 1 0.8 0.6 0.4 0.2 0 0.01 0.05 0.09 0.13 0.17 0.21 0.25 0.29 0.33 0.37 0.41 0.45 0.49 0.53 0.57 0.61 0.65 0.69 0.73 0.77 0.81 0.85 0.89 0.93 0.97 1.01 1.05 1.09 1.13 1.17 1.21 1.25 1.29 1.33 1.37 1.41 1.45 1.49 1.53 1.57 1.61 1.65 1.69 1.73 1.77 Initial debt to GDP ratio
A criterion for assessing the appropriate size of debt relief Discussion Computing the appropriate non-contingent relief requires knowledge on the distribution of fiscal multipliers Anomalies such as counterfactual multipliers are ruled out before subsequent analysis is undertaken Framework is complementary of Fan Chart Approach Fan Chart analysis especially useful when it s hard to identify distributions of multipliers Helps to rule out via stress tests unusual predictions regarding variables over which uncertainty is high
A criterion for assessing the appropriate size of debt relief Discussion Framework can be used for identifying the optimal fiscal plan from the perspective of debt relief Framework can be used for designing GDP linked exchange bonds
Conclusions Need for clarifying what s a sensible framework for assessing how appropriate is a debt discount Evidence that suggests presence of too little syndrome in sovereign debt restructuring Broad definition of concept of sustainability Possible guide for practitioners Framework could be the basis to codify the UN sustainability principle