Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government,

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Lecture 25: COUNTRY RISK

The portfolio-balance model can be very general (menu of assets).

• In Lecture 24, we considered a special case relevant especially to rich-country bonds: exchange risk is the only risk.

• What modifications are appropriate for developing country debt?

One lesson of portfolio diversification theory: A country borrowing 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 view from the South:



WesternAsset.com

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.

World Bank



What determines spreads?

AmChamGuat

EMBI is correlated with risk perceptions:

The portfolio balance model can be applied to country risk

Demand for assets issued by various countries f:

x i, t = Ai + [ρV]i -1 Et (r ft+1 – r d

t+1) ;

Now the expected return Et (r ft+1) subtracts from i ft

the probability of default times loss in event of default.

Similarly, the variances & covariances factor in risks of loss through default.



In developing countries:

• Domestic country is usually assumed to be a debtor, not a creditor.

• Debt to foreigners is often $-denominated => no exchange risk .

• Then, expected return = observed “spread” between

interest rate on the country’s loans or bonds and 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 because when debt is large investors fear default & build a country risk premium into i.

• Default risk is a major part of the premium it must pay.



• The spread may rise steeply when Debt/GDP is high.

Stiglitz: it may even bend backwards, due to rising risk of default.

b

iSupply of funds from

world investors



Eichengreen & Mody (2000):

Spreads charged by banks on emerging market loans are significantly:

• reduced if the borrower generates more business for the bank, but

• increased 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



Why don’t debtor countries default more often, given absence of an international enforcement mechanism?

1. Common answer: They want to preserve their creditworthiness, to borrow again in the future.Not a sustainable repeated-game equilibrium: Bulow-Rogoff (AER, 1989).

2. Cynical answer: Finance Ministers want to remain members in good standing of the international elite.

3. Best answer (probably): 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 86). Evidence: Rose (JDE, 2005).

Debt dynamics

Y

Debtb

dtdYY

Debt

Y

dtdDebt

dt

db/

/2

Y

dtdY

Y

Debt

Y

lDeficitTotalFisca /

bnY

iDebtitimaryDefic

Pr

where n nominal economic growth rate and d primary deficit / Y .

= d + i b - bn = d + (i - n) b. dt

db

=> Debt ratio explodes if d > 0 and i > n (≡ r > real growth rate) .

where Y ≡ nominal GDP


dt

db

Y

Debtb

Debt dynamics line shows the relationship between b and (i-n), for db/dt = 0. It slopes down.

= d + (i - n) b. where ,

n nominal growth rate, and d primary deficit / Y .

n1

ius

i

b

range of explosive debt

range of declining Debt/GDP ratio

0

Db/dt=0

Debt dynamics, with inelastic supply of funds

n1

ius

i

b0

Greece2011

Ireland2011

range of explosive debt

range of declining Debt/GDP



Debt dynamics, continued

• It is best to keep b low to begin with,especially for “debt-intolerant countries.”

• Otherwise, it may be hard to keep db/dt < 0, if– i rises some time,

• due to either a rise in world i*, or• an increase in risk concerns;

– or n exogenously slows down.

• Now add the upward-sloping supply of funds curve.

• i includes a default premium, which depends in turn on db/dt.

Appendix: Debt dynamics graph, with possible unstable equilibrium

Y

Debtb

{

sovereignspread

Initial debt dynamics line

Supply of funds line

iUS

i

(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….



explosive debt path

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Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government,