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Fiscal Policy, Bond Prices, Credit Ratings and Original Sin. Problems with fiscal policy. Precarious creditworthiness Pro-cyclical outcomes Electoral budget cycles Today, the first two. Market access is a problem for most EMs (LEI, Spread over US Treasuries). 1200. Current level. 1000. - PowerPoint PPT Presentation
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Precarious creditworthiness Pro-cyclical outcomes Electoral budget cycles Today, the first two
200
400
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800
1000
1200
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-97
May
-97
Se
p-9
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Jan
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May
-98
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Jan
-99
May
-99
Se
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Jan
-00
May
-00
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Jan
-01
May
-01
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776 pb
Market access is a problem for most EMs(LEI, Spread over US Treasuries)
Pre-Asian Crisis
Pre-Russian Crisis
Pre-Argentine Crisis
Current level
Albania
Algeria
Angola
Azerbaijan
BangladeshBolivia
Bosnia and HercegovinaBrazil
BulgariaCameroon
Chile
China
ColombiaCosta Rica
Cote d'Ivoire
Croatia
CubaDominican Republic
Ecuador
Egypt
El Salvador
Ethiopia
Gabon
Ghana
Guatemala
Honduras
IndiaIndonesia
Iran
Jamaica
Jordan
Kazakhstan
Kenya
Latvia
Lebanon
Libya
Macedonia
MalawiMalaysia
Mauritius
Mexico
Moldova
Morocco
MozambiqueNamibia
Nicaragua
Nigeria
PakistanPanama
Papua New Guinea
Paraguay Peru
Philippines
Poland
RomaniaRussia
Saudi Arabia
Senegal
South Africa
Sri Lanka
Sudan
Syria
Tanzania
Thailand
TunisiaTurkey
UgandaUkraine
Uruguay
Uzbekistan Venezuela
Vietnam
Yemen
Zambia
Zimbabwe
050
100
150
200
Pub
lic d
ebt (
% o
f GD
P)_
__E
IU
5 6 7 8 9 10LGDPPC
MaastrichtCriterion
12
24 24
8
32
1 1
05
1015
2025
Fre
que
ncy
0 50 100 150 200Public debt (% of GDP)___EIU
Public debt/GDP
ParaguayGuatemala
Rep DomHaitíEl Salvador
ColombiaUruguayCosta RicaMéxicoT&T
VenezuelaChile
ArgentinaPerúBolivia
BelicePanamá
HondurasEcuador
0 20 40 60 80 100 120 140
Debt to GDP ratios look modest
Y
Dx 1
rati
ng
fo
reig
n c
urr
ency
net_debt/gdp-.291965 1.13803
5
19
ARG
AUS
AUT
BEL
BRA
CAN
CHN
CRI
CYP
CZE
DNK
DOM
EST
FIN
DEU
GRC
HUN
ISL
IND
ISR
ITA
JPN
JOR
LVA
MEXMAR
NOR
PAK
PAN
PRY
POL
PRT
SVN
ESPSWE
TTO
TUN
TUR
GBR USA
tY
Dx 2
cred
it ra
ting
1992
-99
aver
age
DE_RE2-.579362 4.13906
5
19
ARG
AUS
AUT
BEL
BOLBRA
CAN
CHL
CHN
COL
CRI
CYP
CZE
DNK
DOM
SLV
EST
FIN
DEU
GRCHUN
ISL
INDIDN
ISR
ITA
JORKAZ
KOR
LVA
LUX
MLT
MEX
MNG
MAR
NOR
PAN
PRY
PER
POL
SGP
SVK
SVN
ZAF
ESPSWE
CHE
THA
TUN
TUR
GBR USA
tY
iDx 3
Interest payments as a share of total government expenditures 1990-94
0
5
10
15
20
25
30
OECD LAC
Argentina
Austria
Belgium
BotswanaCanada
Cyprus
Czech RepublicDenmark
Estonia
FinlandFranceGermany
GreeceHungary
Ireland
Israel
Italy
JapanNetherlandsNew Zealand
Portugal
QatarSlovakiaSloveniaSpain
Sweden
Trinidad & TobagoUnited KingdomUnited States
AlgeriaAzerbaijan
Bolivia
Brazil
Bulgaria
Chile
ColombiaCosta Rica
Croatia
Dominican Republic
Ecuador
Egypt
El Salvador
Ethiopia
India
Indonesia
Jamaica
Kazakhstan
MalaysiaMexico
Pakistan
Papua New GuineaPeru
Philippines
Poland
Romania
Russia
South Africa
Thailand
Tunisia
Turkey
Uruguay
Venezuela
Yemen
0.0
5.1
.15
PU
B_
DE
BT
_SE
RV
_G
DP
0 50 100 150 200Public debt (% of GDP)___EIU
PUB_DEBT_SERV_GDP PUB_DEBT_SERV_GDP
It must involve some risks
Markets are concerned with the solvency of the government. There is a maximum level of debt service that the government can absorb
But there is uncertainty over future flows
)Pr(_
xxi
i
tY
Dx
Figure 1
X~
Prob.
X OECD
X LA X
Same expected value
Greater variance
i
x
_x
i*
itY
Dx
)Pr(_
xxi
Sound
Fragile
Bankrupt
i
x
_x
i*
High variance
Less variance
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 BUT WHAT RISKS ARE WE TALKING ABOUT?
tY
iDx 3
Table 1: Volatility of GDP Growth (1980-1999)
All Countries
Industrial Countries
Developing countries
Real GDP Growth 5.0% 2.7% 5.8%
N. Countries 43 11 32
Fiscal revenue and GDP volatility(stdev of real rates of growth)
Revenue GDP
OECD (1970-1994) 5.2 2.2
LAC (1970-1994) 15.2 4.7
LAC (1994-2000) 7.9 3.4
Venezuela 21.9 4.8Ecuador 17.5 3.5Mexico 9.9 3.7Peru 6.6 4.3Uruguay 6.4 3.9Chile 6.4 3.7Colombia 5.0 2.9Argentina 4.0 5.0Costa Rica 3.0 3.0Panama 3.0 2.5Bolivia 3.0 1.4
Volatiliy
Stress test on the debt service capacity: an illustration.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%
Real Interest rate (local)Fiscal revenue to GDPDebt to GDPDebt to revenue Debt service to GDPDebt service to revenue
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 part.
Definition: You cannot borrow abroad in your own currency
…if in addition you do not have long-term fixed-debt markets in local 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
t
ttlt
lt
st
st
tY
eDiDiDix
*1
*1111
4
Volatility of real interest rates Volatility of real exchange rates
Volatility of revenue
Table 1: Volatility of GDP Growth (1980-1999)
All Countries
Industrial Countries
Developing countries
Real GDP Growth 5.0% 2.7% 5.8%
Real Dollar GDP Growth
12.3% 10.3% 13.0%
N. Countries 43 11 32
Country YearChange in Dollar
GDPChange in Real
GDP
Nigeria 1999 -74% -2%
Uruguay 1984 -67% -8%
Egypt, Arab Rep. 1991 -63% 4%
Indonesia 1998 -60% 7%
Sierra Leone 1986 -57% -10%
Mexico 1983 -56% -9%
Uruguay 1983 -55% -17%
Costa Rica 1982 -54% -10%
Nigeria 1986 -52% 1%
Syrian Arab Republic 1989 -48% 9%
Jamaica 1985 -46% 4%
Honduras 1991 -46% -4%
Country YearChange in Dollar
GDPChange in Real
GDP
Jordan 1990 -40% -19%
Guatemala 1987 -40% 3%
Syrian Arab Republic 1988 -40% -13%
Trinidad and Tobago 1987 -38% -20%
Togo 1982 -38% -15%
Mexico 1982 -38% 8%
South Africa 1985 -38% 4%
Ecuador 1987 -38% 1%
Egypt, Arab Rep. 1992 -37% 6%
Indonesia 1999 -37% -7%
Egypt, Arab Rep. 1990 -36% 10%
Trinidad and Tobago 1986 -36% -13%
Swaziland 1985 -36% 2%
Namibia 1985 -35% 15%
Country YearChange in
Dollar GDPChange in Real
GDP
Paraguay 1985 -35% 13%
Ecuador 1999 -33% -2%
Jamaica 1984 -33% 12%
Papua New Guinea 1999 -33% -5%
Mexico 1995 -33% 1%
Sierra Leone 1998 -31% -22%
Sweden 1982 -31% -1%
Papua New Guinea 1998 -31% -4%
Madagascar 1988 -31% 7%
Jamaica 1992 -30% -10%
Morocco 1982 -30% 1%
Venezuela 1984 -30% 4%
AVERAGE -46% -2%
Industrialized countries Developing countries
Volatility of Real Exchange rate over 5-year periods(Cross-Country Average Normalized to 1)
Norw
ay
Neth
erl
ands
Irela
nd
Denm
ark
Aust
ria
Baham
as,
The
Fra
nce
Isra
el
Canada
Sw
itze
rland
Germ
any
Taiw
an
Cypru
sG
reece
Papua N
ew
Guin
ea
Sw
eden
St.
Vin
c&G
renadin
es
Malt
aIc
ela
nd
St.
Luci
aG
am
bia
, The
Belg
ium
Leso
tho
Kore
a,
Rep.
Hong K
ong,
Chin
aSpain
Fin
land
Unit
ed K
ingdom
Italy
Moro
cco
Aust
ralia
Phili
ppin
es
Thaila
nd
Cost
a R
ica
Beliz
eJa
pan
New
Zeala
nd
Togo
Tunis
iaH
ungary
Unit
ed S
tate
sSin
gapore
Fiji
Turk
ey
India
Mala
ysi
aPort
ugal
Pakis
tan
South
Afr
ica
Bahra
inPeru
Mexic
oB
razi
lSaudi A
rabia
Tri
nid
ad a
nd T
obago
Chile
Kuw
ait
Para
guay
Cote
d'Iv
oir
eD
om
inic
an R
epublic
Cam
ero
on
Colo
mbia
Arg
enti
na
Indonesi
aB
uru
ndi
Uru
guay
Chin
aV
enezu
ela
Ecu
ador
Zam
bia
Rom
ania
Boliv
iaN
igeri
a
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
1YR
Vol.
5YR
Vol.
All Countries 0.089 0.083
Developing 0.112 0.103
Industrial 0.044 0.041
Difference 0.068 0.062
T-statistics 4.262 4.818
P(Dev>Ind) 1.000 1.000
Real exchange rates: volatility and cyclical properties
volatility elasticity t-stat
United States 9.10% -0.03 -0.9Latin America 21.40% 0.18 8.9Peru 28.40% 0.15 3.1Ecuador 25.70% 0.27 3.7Venezuela 23.60% -1.04 -7.7Argentina 21.10% 0.02 1.2Colombia 19.30% 0.26 6.2Brazil 18.80% 0.42 10.4Mexico 18.30% 0.61 10.7Chile 16.00% 0.32 4.5
Elasticity of real exchange rate to the import gap in the 1990s
Note: excludes periods in which inflation exceeded 40 percent
Volatility elasticity t-stat
United States 0.9 -3.3 -4.1Latin America 10.5 -126.3 -10.9
Mexico 23.0 -73.3 -13.2Venezuela 17.6 0.1 0.0Brazil 17.2 -451.6 -3.4Ecuador 12.2 -2.4 -0.5Uruguay 11.8 2.6 0.4Peru 11.2 -151.4 -1.7Colombia 7.8 -16.6 -2.3Chile 5.4 -8.8 -1.0Costa Rica 5.0 -19.7 -5.0Argentina 4.0 -221.9 -10.3Panama 0.6 -0.4 -0.6
Note: excludes periods in which inflation exceeded 40 percent
(monthly data, 1990-1999)
Real exchange rates and real interest rates
(monthly data, 1990-1999)
Country elasticity t-statUnited States (1990s) -4.5 -1.8Latin America -153.7 -6.2
Argentina -174.5 -0.9Brazil -1430.5 -7.2Chile -66.6 -7.4Colombia -4.7 -0.4Ecuador -26 -5.2Mexico -93.6 -16.2Peru -555.3 -3.4Venezuela -28.8 -4.3
exceeded 40 percent
Elasticity of real interest rates vs. RER
Note: excludes periods in which inflation
Stress test on the debt service capacity: an illustration.OECD LAC
4.0% 10.0%4.0% 10.0%
100.0% 100.0%30.0% 20.0%
GDP 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%
Real Interest rate ($)Real Interest rate (local)Real exchange rateFiscal revenue to GDP
Debt to GDP -foreign currency - domestic long term -domestic short termDebt to revenue Debt service to GDPDebt service to revenue
OECD LAC
SHOCK
Real Interest rate (local) 1.0% 10.0%Real exchange rate -9.0% -21.0%Fiscal revenue to GDP -5.0% -8.0%GDP -2.0% -4.0%
IMPACT
Debt to GDP 0.8% 6.0% -foreign currency 0.0% 5.2% - domestic long term 0.6% 0.0% -domestic short term 0.2% 0.8%Debt to revenue 9.9% 50.2%Debt service to GDP 0.1% 2.7%Debt service to revenue 0.7% 16.3%
Why do countries get into trouble at levels of debt that are manageable for other countries?
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
(1) (2) (3) (4) RATING1 RATING1 RATING1 RATING1 DE_GDP2 -1.553 -1.815 (1.91)* (2.19)** DE_RE2 -0.599 -0.665 (1.40) (1.52) LGDP_PC 3.189 3.051 2.884 2.764 (8.54)*** (7.59)*** (6.47)*** (5.68)*** OSIN3 -3.429 -3.324 -4.883 -4.435 (3.85)*** (3.49)*** (3.49)*** (3.11)***
Constant -12.369 -11.059 -8.751 -7.889 (3.16)*** (2.60)** (1.89)* (1.57)
Observations 56 49 51 44 R-squared 0.82 0.81 0.81 0.80
Total Debt Total Debt in Total Debt in Own Currency SIN1 SIN3Own Currency Issued by the Country
Financial Centers 5324 77.0% 6698 96.8% 3425 96.8% 0.357 -0.258
Other developed 627 9.1% 121 1.7% 58 1.6% 0.907 0.807
Developing 592 8.6% 97 1.4% 55 1.6% 0.907 0.835
International Org. 373 5.4% 0 0.0% 0 0.0% 1.000 1.000
TOTAL 6916 100.0% 6916 100.0% 3538 100.0% 0.488 0.000
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
United States EUROLAND Japan U.K Switzerland Canada Australia
Debt by Country
Debt byCurrency
(0.9857)
(0.8859)
Major FinancialCenters (61 %)
Major FinancialCenters (45 %)
Euroland(37%)
Euroland(33%)
Other Developed (<2%)
Other Developed (8%) Developing
(8%)
InternationalOrganizations (7%)
Total Debt issued in own currency (99-01)
Total Debt issued by residents (99-01)
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Financial Centers Euroland Other Developed Developing
OSIN1 OSIN2 OSIN3
00.10.20.30.40.50.60.70.80.9
GoldClauses
MixedClauses
DomesticCurrency
OSIN3 and Flandreau-Sussman classification circa 1850
Why are countries trapped in a pro-cyclical 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
This makes it harder to maintain spending and access to lenders
Targets on the overall deficit are not credible because governments cannot control debt service Primary balances are more credible but
may be less relevant Reduction of the absolute level of debt
or even the debt to GDP ratio may not be the most efficient way to achieve fiscal consolidation Working on debt denomination may be
more effective
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
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
Working on debt structure may be a more efficient way of achieving fiscal consolidation Virtuous circle
Inflation-indexed fixed-rate long-term domestic- currency debt may be a practical way to go
Target adjusted primary deficits …and risk-weighted debt levels