How to make debt safer Ugo Panizza Debt and Finance Analysis Unit DGDS UNCTAD

How to make debt safer Keep debt low –International policies (debt relief) –Domestic policies Keep debt safer –International policies –Domestic policies

Outline Reducing debt Managing debt Domestic policies International policies Conclusions

A brief history of debt relief Negotiations in Paris with Argentina (1956) It started with UNCTAD (1967) –A series of UNCTAD meetings in led official (bilateral) creditors to write off $6 billion of debt to 45 countries Brady Plan (1989) –Private creditors HIPC (1996) Enhanced HIPC (1999) MDRI (2005) –Multilateral official creditors

Domestic Policies Control the flow of debt –Strengthen fiscal policies and institutions Fiscal rules Budget institutions –Hierarchical rules –Transparency Rules –But this is never enough

Outline Reducing debt Managing Debt Domestic policies International policies Conclusions

Domestic Policies Manage the inherited stock of debt –Improve debt structure (long-term, local currency and contingent instruments) –Self insurance (reserves, stabilization funds) –Develop local markets

In fact, several countries are Accumulating huge reserves –But self insurance is a very inefficient way to protect yourself Switching to the domestic market –Currency mismatches are less likely –Sudden Stops are less likely

Domestic debt is becoming more important Source: Panizza (2007)

Domestic debt is becoming more important Source: Panizza (2007) EAPECALACMNASASSSAAll Countries Share of Domestic Debt (weighted average)

Can the switch to domestic debt eliminate all vulnerabilities? To some extent, but… –Need to be careful not to trade a currency mismatch for a maturity mismatch

Can the switch to domestic debt eliminate all vulnerabilities? Index of domestic original sin Note : Original sin is measured as share of domesic debt which is short term, denominated in foreign currency, or indexed to prices or the interest rate. "Latin America" includes: Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela. "Asia" includes: China, India, Indonesia (from 1998), Korea, Malaysia, Philippines, and Thailand. "Other emerging markets" includes: Czech Republic, Israel, Hungary, Poland, Russia, and Turkey. Source : Authors' calculations based on Jeanne and Guscina (2006) data set. Domestic Original Sin in Latin America and Other Emerging Regions LAC Other EMs Asia

Can the switch to domestic debt eliminate all vulnerabilities? To some extent, but… –The cost of borrowing needs to be evaluated carefully What happens if the currency appreciates –Need to be careful not to "force" domestic institutional investors and banks to assume "too much" government debt Especially banks –Domestic debt may be more difficult to restructure –Externalities

Can the switch to domestic debt eliminate all vulnerabilities? While the recent switch to more domestic borrowing may have important positive implications for debt management, policymakers should not be too complacent. –"The history of crisis modelling in international macroeconomics reveals that each successive wave of crises exposes possibilities for crisis that were overlooked in earlier analysis." (Krugman, 2006) As vulnerabilities are often identified after a financial crisis starts to unravel, crisis prevention requires detailed and prompt information on debt structure Yet, most research and DSA focuses on external borrowing and prompt and detailed information on the level and composition of domestic public debt is often not available to policymakers and analysts

Outline Reducing debt Managing Debt Domestic policies International policies Conclusions

International Policies Contagion risk –“Emerging Market Fund” that support the asset class at time of crisis Help develop new instruments –Local currency –Contingent debt instruments GDP index bonds

Why doesn’t the market develop such financial innovations? Coordination problems and the need to ensure “critical mass” for new instruments. –The appeal of an innovation often depends on its simultaneous adoption by many contracting parties. –Individual borrowers considering whether to issue a new financial instrument will not take into account the benefits for other borrowers and investors that would result from establishing a new asset class.

Why doesn’t the market develop such financial innovations? The highly competitive structure of financial markets. –A private financial institution would have to incur costs to develop a new type of financial instrument but it may be unable to maintain a monopoly over the provision of this instrument for a long time –Patents are still rarely used for financial instruments, and imitation is relatively easy.

Why doesn’t the market develop such financial innovations? The need for standards. The creation of a liquid secondary market requires instruments with the same features for all countries or all firms issuing them. –For financial instruments where payments are due when certain conditions are met, it is crucial to have verifiable standards for whether those conditions are met. –For example, the market for credit default swaps remained small for years but took off as soon as the standards for a “credit event” were properly defined and became broadly accepted

Why doesn’t the market develop such financial innovations? Signaling. –Individual countries may be reluctant to issue new financial instruments or existing instruments with new contractual features if they fear that such innovations may be misperceived as signs of weakness or lack of commitment to good policies.

Why doesn’t the market develop such financial innovations? So far, we assumed that these instruments are just impossible or too costly to develop –… but, even if they are not too costly, myopic politicians may not have the right incentives

International Policies Dedollarize official lending –The proposal for redemption from original Sin by Eichengreen and Hausmann would reach two objectives Create a market Lend in local currency –This could also benefit low income countries if multilateral lenders were to dedollarize their concessional lending as suggested by Hausmann and Rigobon

Outline Reducing debt Managing Debt Domestic policies International policies Conclusions

Summing up Two views on how to reduce vulnerabilities –Abstinence Borrow less –Use “safer” debt Borrow in a smarter way

Borrow Less The status quo is an adaptation to deeper problems, such as lack of credibility, and weaknesses in domestic institutions. The outcome may well be inefficient, but it cannot be improved without addressing the underlying problems… …and its going to take years See “Debt Intolerance” (Reinhart, Rogoff, and Savastano)

Borrow in a smarter way Today’s array of instruments is inherited from historical accident and has persisted owing to inertia The existing structures can be changed, though not without substantial effort, through reforms involving coordination among market participants I tend to share this view

How to make debt safer Ugo Panizza Debt and Finance Analysis Unit DGDS UNCTAD