International financial crises

International Macroeconomics Master in International Economic Policy International financial crises Lectures 11-12 Nicolas Coeurdacier nicolas.coeurdacier@sciencespo.fr

Lectures 11 and 12 International financial crises 1. Financial crises and balance sheet effects 2. Sovereign Debt Crises 3. Asset bubbles

Sovereign debt crisis Sovereign - no international enforcement of debt contracts (difficult for creditors to seize assets, no collateral, no bankruptcy court) What is default? Missing any contractual payment: - outright complete default(rare) - repudiation or moratorium - restructuring: renegotiation (with terms less favorable to the lender: haircut) Serial default(long history): a widespread phenomenon

Greece: Central Government (domestic plus external) Debt, Default, Hyperinflation, and Banking Crises, 1848-2009 (debt as a percent of GDP) Restructuring external debt (yellow) Reinhardt and Rogoff, 2010

What is the cost of sovereign default? Gain (wealth transfer) against reputation cost Greece default (1826): no access to international capital markets for 53 years More recently: Uruguay (2003) restructured its debt (stretching maturity dates 5 years). Returned to capital markets a month later. The haircut, or loss to bondholders, was small (13.3%, in net present value) orderly sovereign workouts are possible (not the case of Argentina)

Broader macroeconomic costs Triggers or worsen banking crisis Triggers currency crisis Both together generate large output losses Trade disruption (Rose, 2005): countries in default face very high risk premia to finance simple trade activities; disruption of trade credit

Understanding defaults: some basic theory

From financial crisis to sovereign default Typical stages of financial crises (Reinhart and Rogoff, 2009) 1) private debt surges (domestic banking credit growth + external borrowing) 2) banking crises often precede sovereign debt crises (bail outs + collapsing revenues: government debts rise by about 86% in the 3 years after financial crisis): See Ireland (bail out of banks: public debt increased by 20 % point of GDP) 3)public borrowing accelerates ahead of a sovereign debt crisis ; government often has hidden debts (Greece) 4) On eve of banking and debt crises composition of debt shifts toward short-term maturities

(Source Reinhart and Rogoff)

Cumulative increase in public debt after the financial crisis (selected countries) Source Reinhart and Rogoff

Debt Sustainability? Every period the government runs a deficit its debt increases How can we assess the sustainability of the path of government debt? Hard question but can examine the conditions under which the government can stabilise the debt burden. A useful tool to calculate the size of fiscal adjustment needed to stabilise debt at a current level Or a useful tool to calculate the eventual level of debt that will occur if current deficit is maintained

Sustainable Debt Debt is sustainable if Debt/GDP not changing: (1) Ratio rises because of interest payments r x (Debt/GDP) (2) Ratio falls because of output growth g x (Debt/GDP) (3) Debt increases because of primary deficit (G-T) Putting (1), (2) and (3) together: Change Debt/GDP = (r-g) Debt/GDP + Primary Deficit/GDP Debt sustainability (Change Debt/GDP = 0), implies: (r-g) Debt = Primary Surplus In other words the government needs to run a primary surplus to cover the excess of interest payments over GDP growth.

Sustainable Debt To keep debt levels constant fiscal policy needs to generate primary surplus/gdp = (r-g) Debt/GDP If r>g government has to run a primary surplus in order to control the Debt/GDP ratio If r<g then government can run a deficit (of a certain size) without seeing Debt/GDP ratio increase Shifts in interest rates and growth rates have big impact on government debt dynamics If r increases with Debt/GDP and higher r leads to lower g then countries can rapidly find their public finances deteriorating

2010 Debt Sustainability in the G7 Primary Balance 2010 r-g Debt GDP 2010-0.03-0.02-0.01 0 0.01 0.02 0.03 0.04 Canada -3.4 81.0-2.46-1.64-0.82 0.00 0.82 1.64 2.46 3.28 France -2.9 99.0-2.82-1.88-0.94 0.00 0.94 1.88 2.82 3.77 Germany -1 84.1-2.52-1.68-0.84 0.00 0.84 1.68 2.52 3.36 Italy 2.7 127.3-3.82-2.55-1.27 0.00 1.27 2.55 3.82 5.09 Japan -4.7 199.8-5.99-4.00-2.00 0.00 2.00 4.00 5.99 7.99 United Kingdom -7.1 89.3-2.68-1.79-0.89 0.00 0.89 1.79 2.68 3.57 United States -6.8 97.5-2.93-1.95-0.98 0.00 0.98 1.95 2.93 3.90 Table shows primary surpluses needed (for different values r-g) to stabilise G7 s debt level at 2010 value.

Sovereign debt crisis in Argentina (2001-2002) Context: The Convertibility Plan - 1989, President Carlos Menem takes office. Monthly inflation > 200%. Output plummeting April 1991, Finance Minister Domingo Cavallo implements the Convertibility Plan, including the policy of a Currency Board: Fixed Exchange Rate of 1 Peso / $1 People free to buy and sell Dollars. Implication: Central Bank no longer controls monetary policy. gradual loss of competitiveness as no longer possible to depreciate the currency and inflation still high

(HYPER)INFLATION Argentinean Inflation (% ) 3500 3000 2500 2000 1500 1000 500 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

In 2000 Argentina does not stand out as hopeless

Indicators of Fiscal Sustainability Argentina s crisis caused not by high debt (around 50% GDP) buthighrandfallingg! (source: Perry & Serven, WB03)

Sustainable Debt - Argentina To stabilize the debt to GDP ratio, one needs: (r-g)d/y=pdf/y. D(dec 2001) = 140 bn. Pesos Y(2001) = 269 bn Pesos g(1999-2001) = -2.9 % (2001: -4.4%; 2000: -0.8, 1999: -3.5) r = 8.7 % (high but including risk premium) Required primary surplus = (140/269)*(11.6) = 6%! (actual primary surplus in 2000 = 0.3%) If negative growth is seen as persistent, this is unsustainable. Unless fiscal policy is adjusted, debt will rise continuously.

Sustainable Debt - Argentina Simple calculations but firm implications: (a) Although debt was not extraordinarily high, the low growth quickly makes the debt burden unsustainable (b) If growth prospects turn around, no major problems, but that requires reforms (c) Default is only a temporary relief, unless growth picks up and fiscal policy changes Problem partly due to sovereign debt -the non-existence of a chapter 11 for sovereign nations -who decides when and if a country is bankrupt?

Currency Mismatch and Balance Sheets Effects

The Unravelling recession exacerbated government s fiscal position investor fears that currency board would be abandoned fear of devaluation pushed up yield spreads dramatically increasing fiscal burden from interest payments, banking system increasingly based around dollars peso devaluation even more expensive with election focused on economic policy, capital inflows dried up. In December 2000, IMF offered $40bn subject to fiscal conditions Very costly debt exchange in mid-2001, then Argentina convinced US to get IMF to offer a further $8bn But by December 2001, the conditions had not been met, IMF pulled the plug, and government introduced outright default on public debt and exchange controls, abandoned peg, let currency float. Forced pesificationof dollar bank deposits at 1.40 Peso to $, dollar loans converted at 1-1, banks foreign exchange reserves confiscated huge balance sheet blow to the banks

Run on Banks and Capital Outflows $US billion $US billion 100 2 90 0 80 70-2 -4-6 60-8 50 IVQ 2000 IQ 2001 IIQ 2001 IIIQ 2001 IVQ 2001-10 IVQ 2000 IQ 2001 IIQ 2001 IIIQ 2001 IVQ 2001 Bank Deposits Balance of Payments-Non Financial Private Sector Capital Account Source: Argentine Central Bank and Ministry of Economy

2002:1 2003:1 2004:1 2001:1 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 Exchange Rate: Peso / $ (inverted scale) 1995:1 1996:1 1997:1 1998:1 1999:1 2000:1 1994:1 1993:1 1992:1 1991:1

The Hair Cut March4,2005NYTimes It took more than three years of stop-and-go negotiations, threats, political maneuvers and court battles, but the largest government debt default in history ended here Thursday, as the Argentine government announced that 76 percent of its creditors had accepted a proposal that will pay them at most 30 cents. This was the biggest haircut or loss on principal, for investors of any sovereign bond restructuring in modern times.

Debt sustainability in Greece r-g Primary Balance 2010 Debt GDP 2010-0.12-0.08-0.04 0-14.80-9.86-4.93 0.00 Greece -9.8 123.3 0.04 0.08 0.12 0.16 4.93 9.86 14.80 19.73 Source: OECD Economic Outlook, 2010 Table shows primary surpluses needed (for different values r-g) to stabilise Greece s debt level at 2010 value. Note, today s Greek debt is 139% of GDP 10 year interest rate Greek T-Bill (securities issued) Source: ecb

Greece Fiscal Adjustment

Balance sheet effects and the euro crisis? Greece out? Danger of self-fulfilling expectations on euro crisis? expect euro zone to break-up existng euro debt seen as foreign currency debt debt/gdp rato explodes (debt legally in euro ; GDP in «drachma» that depreciates) country becomes (even more) insolvent because of change in expectations (same with interest rate and risk premium)

Portugal - In 2010, another Greece? -Public Debt expected to be roughly 80% of GDP. -Fiscal deficit was 9.4% of GDP in 2009, 7.3% in 2010. Austerity plan: In 2011, we are going to reduce the deficit to 4.6 percent (Prime Minister Socrates) -Growth slowdown quite pronounced but not as bad as Ireland (-1% in 2009, 1% in 2010 and 1% in 2011) Interest rates on Portuguese 10-year T Bonds (securities issued). Source: ecb -ECB actions and fiscal adjustment have calmed down market expectations.

Ireland In 2010, circular causality with self-fulfilling expectations? Expect Ireland to default risk premium on Irish public debt cost of refinancing debt Irish public debt could become unsustainable Interest rates on debt issued Irish, 10-year T Bonds In 2010, more fundamentals based view of crisis was also put forward: even with low interest rate public debt burdened with banks debt would not be sustainable?

Ten years interest rates in big 4 Debt issued. Source: ecb

Key distinction, key current debate Liquidity crisis: Circular causality with self-fulfilling expectatons remedy: European Financial Stability Facility (EFSF) = financial safety net : objective break the expectations Solvency crisis: some countries will not be able to repay (whatever markets reactons) remedy: restructure sovereign debt. When? How much?

Run on public debt and multiple equilibria -Back to financial crisis with self fulfilling expectations crises and multiple equilibria -an investor has choice between German Treasury bond (zero probability of default) and I. Treasury bond (probability p of default); (10 year bonds ) Return on German T. bond: 1+r G Return on I. T bond : but probability pof default with hthe haircut (% of present value of debt not reimbursed) Expected return: (1-p) (1+r I ) + p(1-h) if no default if default If I. bonds are held must be that : 1+r G = (1-p) (1+r I ) + p(1-h) So (1+r I ) = 1+r G -p(1-h) note if p = 0; r G = r I no spread (1-p) More generally r I and spread increase with p and h: I. must compensate for risk and size of default

Run on public debt and multiple equilibria -A numerical example (too simple): 1+r G = 1.02 ; h= 0.5 (50% haircut) ; p = 10% (1+r I ) = 1+r G -p(1-h) = 1.08 or 8% interest rate (spread 600 basis points with G) (1-p) First relation (rr) : r I increases withp -How does p (the probability of default) change with r I? D t D t-1 = r D t-1 + T G For given primary balance: an increase in r increases future D t increases p Second relation (pp): p increases withr I

r I The case of low level of debt D 1 equilibrium no crisis pp almost vertical: p does not increase with r and is low No crisis : p close to 0, r I close to r G rr : r increases with p r G 1 0 p (proba of default)

r I The case of higher level of debt 3 equilibrium crisis, low interest rate and low probability of crisis versus high interest rates and high probability of crisis (the stable one with infinite interest rates and p=1) pp: p increases a lot with r and is high rr : r increases with p r G 0 1 p (proba of default)