Sovereign Debtors in Distress -- Who is Vulnerable? Jeffrey Frankel Waterloo, Ontario, Canada, Feb. 24-26, 2012

(1) Vulnerability to Sovereign Debt Crises Vulnerability is high now. My guess: Greece will make it past March 20, with usual 3-part formula of bail-out + conditionality + PSI ; but then will default within a year. Greece cannot get back to a sustainable debt path by austerity, as has been clear for awhile. When it succeeds in eliminating its primary budget deficit, it will have no more incentive to keep servicing debt. Risk of contagion is high not just to rest of periphery, but rest of euro; and rest of world. 2

Country creditworthiness is now inter-shuffled “Advanced” countries (Formerly) “Developing” countries AAA Germany, UK Singapore AA+ US, France AA Belgium Chile AA- Japan China A+ Korea A Spain Malaysia, South Africa A- Brazil, Thailand, Botswana BBB+ Italy Colombia BBB- Iceland, Ireland India BB+ Indonesia, Philippines BB Portugal Costa Rica, Jordan B Burkina Faso CC Greece S&P ratings, Feb.2012 domestic currency 3

(2) What Determines Country Vulnerability? Fundamentally: Quality of institutions. This does not mean “tough” rules – like SGP, debt ceiling or BBA – which lack enforceability. Better would be structural budget targets (Swiss) with forecasts from independent experts (Chile). One third of developing countries since 2000 have graduated from pro-cyclical spending to countercyclical, even while US, UK & euro countries have forgotten how to run countercyclical fiscal policy, and instead enact fiscal expansion in booms & contraction after recessions. 4

Correlations between Govt. Spending & GDP 1960-1999 } Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours” procyclical Pro-cyclical spending countercyclical Counter- cyclical spending G always used to be pro-cyclical for most developing countries. 5

Correlations between Govt. Spending & GDP 2000-2009 procyclical Frankel, Vegh & Vuletin (2011) In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. countercyclical 6

(3) It’s not so much the level of debt/GDP that matters as the risk of getting stuck on an explosive path, with ever-rising debt/GDP because of high primary deficit or interest rates (or low growth), or risk of a sudden deterioration. Early Warning indicators: composition of capital inflows Fx-denominated, ST, bank loans vs. FDI, equity & contracts with automatic adjustment provisions. Plus real currency overvaluation, fx reserves (for peggers)… Fiscal capacity. 7