Lecture 3: Country Risk The portfolio-balance model with default risk. When countries default. What determines sovereign spreads? Debt Sustainability Analysis (DSA). API-119 - Prof.J.Frankel

1. The portfolio balance model applied to country risk One lesson of portfolio diversification theory: A country that borrows 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 portfolio-balance model can be very general (menu of assets). In Lecture 2, we considered a special case relevant to rich-country bonds: currency risk is the only risk. Some modifications are appropriate for developing-country debt, starting with the risk of default. API-119 - Prof.J.Frankel

Demand for assets issued by various countries f: x i, t = Ai + [ρV]i -1 Et (r ft+1 – r dt+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. When perceptions of risk are high [ρV], interest rates must be high for investors to absorb given supplies of debt. “Risk off” in global financial markets. API-119 - Prof.J.Frankel

Developing countries: The view from the South Developing countries: are usually assumed to be debtors; must pay a premium as compensation for default risk. Debt to foreigners was usually $-denominated (before 2000). Then, expected return differential = observed spread between interest rate on the country’s loans or bonds & 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: when debt is large investors fear default & build a country risk premium into i. API-119 - Prof.J.Frankel

2. When countries default The international debt crisis Asia crisis Great Depression Latin American independence GFC Venezuela has defaulted 9 times since independence in 1821. Nigeria has defaulted 5 times since independence in 1960. Greece has been in default on its debt half the time since independence in 1829. Spain has defaulted the most: 6 times in the 18th century, and 7 in the 19th. Source: Reinhart and Rogoff, This Time is Different: Eight Centuries of Financial Folly, 2011, pp.86-100.

Why don’t debtor countries default more often, given absence of an international enforcement mechanism? They want to preserve their creditworthiness, to borrow again in the future. Kletzer & Wright (2000), Amador (2003), Aguiar & Gopinath (2006), Arellano (2008), Yue (2010). But: • Some find defaulters don’t seem to bear much of a penalty for long: Eichengreen (1987), Eichengreen & Portes (2000), Arellano (2009), Panizza, Sturzenegger & Zettelmeyer (2009). • It is not a sustainable repeated-game equilibrium: Bulow-Rogoff (1989). 2. Best answer (perhaps): 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 1986). Evidence: Rose (JDE 2005). 3. Cynical answer: Finance Ministers want to remain members in good standing of the international elite. API-119 - Prof.J.Frankel

Estimated from 67 restructurings, 1980-2009 New finding: For some years after a restructuring, the defaulter is excluded from access to international finance. Estimated from 67 restructurings, 1980-2009 Juan Cruces & Christoph Trebesch, 2013, “Sovereign Defaults: The Price of Haircuts,” AEJ: Macro, Fig.5, p. 111. especially the 1st 5 years API-119 - Prof.J.Frankel

3. What determines sovereign spreads? EMBI is correlated with risk perceptions risk off “risk on” Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011 API-119 - Prof.J.Frankel

For some years after a restructuring, the defaulter has to pay higher interest rates, especially if creditors had to take a big write-down (“haircut”). Estimated, 1993-2010 especially the 1st 5 years Cruces & Trebesch, 2013, “Sovereign Defaults: The Price of Haircuts,” Fig.3. API-119 - Prof.J.Frankel

Spreads charged by banks on emerging market loans are significantly: Eichengreen & Mody (2000): Spreads charged by banks on emerging market loans are significantly: higher 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 API-119 - Prof.J.Frankel

The spread may rise steeply when Debt/GDP is high. Stiglitz: it may even bend backwards, due to rising risk of default. Supply of funds from world investors i US ≡ Debt/GDP API-119 - Prof.J.Frankel

4. Debt dynamics: What determines if a country becomes “insolvent”? It depends not on the level of debt directly, but, rather, on whether the ratio b ≡ debt/GDP is on an unsustainable path. Definition of sustainability: a steady or falling debt/GDP ratio. API-119 - Prof.J.Frankel

Definition Sustainability Analysis: Is 𝑑𝑏 𝑑𝑡 > 0 or < 0? 𝑏 ≡ 𝐷𝑒𝑏𝑡 𝑌 where Y ≡ nominal GDP. 𝑑𝑏 𝑑𝑡 = 𝑑 𝐷𝑒𝑏𝑡/𝑑𝑡 𝑌 − 𝐷𝑒𝑏𝑡 𝑌2 𝑑𝑌 𝑑𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑠𝑐𝑎𝑙 𝐷𝑒𝑓𝑖𝑐𝑖𝑡 𝑌 − 𝐷𝑒𝑏𝑡 𝑌 𝑑𝑌/𝑑𝑡 𝑌 = 𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝐷𝑒𝑓𝑖𝑐𝑖𝑡 + (𝑖 𝐷𝑒𝑏𝑡) 𝑌 −𝑏𝑛 where n  nominal growth rate. => 𝑑𝑏 𝑑𝑡 = 𝑑 + 𝑖 𝑏 − 𝑏𝑛 where d  Primary Deficit / Y . = 𝑑 + 𝑖 − 𝑛 𝑏. => Debt ratio explodes if d > 0 and i > n (or r > real growth rate). API-119 - Prof.J.Frankel 13

= d + (i - n) b. where n  nominal growth rate, and d  primary deficit / Y . Debt dynamics line shows the relationship between b and (i-n), for db/dt = 0. Even with a primary surplus (d<0), if i is high (relative to n), then b is on explosive path. db/dt=0 range of explosive debt range of declining Debt/GDP ratio b API-119 - Prof.J.Frankel 14

Debt dynamics, continued Conclusion: It is best to keep b low to begin with, especially for “debt-intolerant countries.” Otherwise, it may be hard to stay on the stable path if i rises suddenly, due to either a rise in world i* (e.g., 1982, 2016), or an increase in risk concerns (e.g., 2008); Or if n slows down exogenously. Now add the upward-sloping supply of funds curve. i includes a default premium, which probably depends in turn on debt sustainability. => It may be difficult or impossible to escape the unstable path without default, write-down, or restructuring of the debt, or else inflating it away, if you are lucky enough to have borrowed in your own currency. API-119 - Prof.J.Frankel 15

Debt dynamics, with inelastic supply of funds Greece 2012 range of explosive debt range of declining Debt/GDP Ireland 2012 b API-119 - Prof.J.Frankel

Professor Jeffrey Frankel, Kennedy School, Harvard University explosive debt path Professor Jeffrey Frankel, Kennedy School, Harvard University API-119 - Prof.J.Frankel 17

Appendix 1: Debt dynamics graph, with possible unstable equilibrium Supply of funds line i Initial debt dynamics line { sovereign spread iUS API-119 - Prof.J.Frankel

(1) Good times. Growth is strong. db/dt = 0, or if > 0 nobody minds (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…. API-119 - Prof.J.Frankel

Appendix 2: Recent history of sovereign spreads EM sovereign spreads, 1994-2008 The blurring of lines between debt of advanced countries and developing countries, 2009-. Since the crisis of the euro periphery began in Greece, we have become aware that “advanced” countries also have sovereign default risk. API-119 - Prof.J.Frankel

Sovereign spreads Spreads rose again in Sept. 2008 ↑ , Bpblogspot.com Spreads rose again in Sept. 2008 ↑ , esp. on $-denominated debt & in E.Europe. ↓ ↑ Spreads shot up in 1990s crises, and fell to low levels in next decade.↓ WesternAsset.com World Bank API-119 - Prof.J.Frankel

Spreads for Italy, Greece, & other Mediterranean members of € were near zero, from 2001 until 2008 and then shot up in 2010 Market Nighshift Nov. 16, 2011 API-119 - Prof.J.Frankel

Turkey is able to borrow in local currency (lira), but has to pay a high currency premium to do so. { Total premium on Turkey’s lira debt over US treasuries Pure default risk premium on lira debt { Schreger & Du, “Local Currency Sovereign Risk,” HU, 2013, Fig. 5 API-119 - Prof.J.Frankel