The elusive quest for macro stability:

the role of debt denominationRicardo Hausmann

Kennedy School of Government

Harvard University

March 10, 2002

Fortaleza, Brazil

Unrewarded good behavior

Many things have been tried to achieve macro stability

Most governments have achieved…

• Inflation stabilization

• Trade liberalization

• Privatization

• Social security reform

• Improved regulation

• Efforts in institutional reform

External public debt ratios have declined sharply

Evolution of external public debt (%GDP)

Panama 100.10% 60.20% -39.90%Peru 80.50% 43.30% -37.20%Costa Rica 56.50% 19.80% -36.60%Bolivia 89.90% 54.20% -35.70%Chile 42.70% 7.90% -34.80%Venezuela 46.40% 18.10% -28.30%Mexico 32.00% 14.70% -17.30%Uruguay 44.50% 28.00% -16.50%Ecuador 94.80% 80.70% -14.10%Colombia 33.00% 24.90% -8.10%Brazil 22.90% 15.50% -7.40%Average 58.50% 33.10% -25.10%

Source: Institute for International Finance

1990 2000

…even faster as a share of exports

External Public debt (%XGS)1990 20002000-1990

Peru 5.41 2.48 -293.0%Ecuador 3.09 1.83 -127.0%Brazil 2.61 1.36 -125.0%Costa Rica 1.56 0.4 -116.0%Mexico 1.61 0.45 -116.0%Bolivia 4.32 3.31 -101.0%Chile 1.21 0.23 -98.0%Panama 2.12 1.43 -69.0%Colombia 1.71 1.23 -48.0%Venezuela 1.8 1.39 -40.0%Uruguay 1.71 1.39 -32.0%

Average 2.47 1.48 -99.0%

Source: Institute for International Finance

…based on a significant cut in fiscal deficits

Public Sector Borrowing Requirements(5 year averages)

86-90 96-00 (4)-(2)

Brazil 42.6 6.6 -36.0Mexico 10.4 0.8 -9.5Peru 8.0 1.6 -6.4Venezuela 4.0 -1.6 -5.6Panama 4.9 1.0 -3.9Bolivia 5.3 3.3 -2.0Ecuador 4.6 3.4 -1.2Costa Rica 1.6 1.6 0.0Chile -0.9 -0.7 0.2Argentina 1.5 1.9 0.4Uruguay 1.4 2.5 1.0Colombia 1.2 3.8 2.5Average 7.1 2.0 -5.0

Source: Institute for International Finance

200

400

600

800

1000

1200

Jan

-97

May

-97

Se

p-9

7

Jan

-98

May

-98

Se

p-9

8

Jan

-99

May

-99

Se

p-9

9

Jan

-00

May

-00

Se

p-0

0

Jan

-01

May

-01

Se

p-0

1

776 pb

But market access remains a problem(LEI, Spread over US Treasuries)

Pre-Asian Crisis

Pre-Russian Crisis

Pre-Argentine Crisis

Current level

Why do good ratios not get good ratings?

Start with the popular ratio

Y

Dx 1

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

…consider the smaller tax base:the debt to tax ratio

tY

Dx 2

…debt to tax ratios are comparable

0 1 2 3 4 5 6

BHSBLZCHLCOLMEXURYPRYTTOBRA

OCDEARGGTM

LAVENSLVJAMCRI

ECUDOMPANBOLSURHNDPERGUYNIC

Public debt(as a share of tax revenues)

Nota: NIC and GUYtienen valores de 26.0 y12.6 respectivamente.

Promedios regionalesestán ponderados porpoblación.

…consider higher interest rates:the debt service to revenue ratio

tY

iDx 3

Debt service to revenue is much higher

Interest payments as a share of total government expenditures 1990-94

0

5

10

15

20

25

30

OECD LAC

…but where would the higher interest rates come from?

It must involve some risks

A model of fiscal risk

• Markets are concerned with the solvency of the government

• But there is uncertainty over future flows• Reduced form: markets will set a limit to

the share of interest payments in the budget– Just as mortgage banks do

• What is the likelihood that the country would hit this limit?

…a graphical representation

Figure 1

X~

Prob.

XOECD

XLA X

Higher expected value

Greater variance

The possibility of multipliers and multiple equilibria

• 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

• Fiscal consolidation may be self-reinforcing– The examples of Italy and Spain

BUT WHAT RISKS ARE WE TALKING ABOUT?

How about revenue volatility?

tY

iDx 3

Revenue volatility is higherFiscal 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

A simulation

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

…and it could explain part of the problem

• 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 a small part.

The original sin hypothesis

• Definition: you cannot borrow long term at fixed rates in your own 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

The impact of original sin

t

ttlt

lt

st

st

tY

eDiDiDix

*1

*1111

4

Volatility of real interest rates Volatility of real exchange rates

Volatility of revenue

Real exchange rates are volatile and pro-cyclical

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

…and real interest rates are on a class by themselves

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)

They move together in the “wrong” direction

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

A simulation

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

Vive la petite difference

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%

Conclusions

• Why do Latin American countries borrow in dollars?– Because it is safer than borrowing short-term in

pesos. Not because of moral hazard.– Because they want to preserve the

independence of their monetary policy

Conclusion

• Why do countries float the way they float?– Because they borrow the way they borrow

– Since they borrow in dollars, the central bank prefers to stabilize the exchange rate and concentrate the volatility on the interest rate

• Why do countries borrow the way they borrow?– Because they float the way they float

– You would borrow in whatever is more stable. If it is the exchange rate, then you want to borrow in dollars

0

5

10

15

20

G3 Other Developed Emerging Other Developing LA Emerging East Asia

17.559

5.074

1.7600.820 1.123

2.626

Relative Volatilities: Exchange Rate and Reservesstd(dev)/std(res/m2)

Countries with OS keep their volatility in the interest rate

Conclusion

• Why has good fiscal behavior remained largely unrewarded?

• 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

Conclusions

• Why is Latin America 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

Implications

• Reduction of the debt to GDP ratio may not be the most efficient way to achieve fiscal consolidation – We already tried that

• Working on debt denomination may be more effective– It would lower the “value at risk”

– …which would lower the interest rate

– …which would allow fiscal consolidation

Implications

• 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

Conclusions

• 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

Conclusions

• International financial institutions are now part of the problem– They borrow and lend only in foreign currency

• They could be part of the solution– They need to help develop the international

market for long-term fixed-rate bonds by issuing their own obligations and on-lend to borrowers