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

2. 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 Prof.J.Frankel

3. 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 Prof.J.Frankel

4. 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 Prof.J.Frankel

5. 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

6. 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).
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 Prof.J.Frankel

7. 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,
Juan Cruces & Christoph Trebesch, 2013, “Sovereign Defaults: The Price of Haircuts,” AEJ: Macro,
Fig.5, p. 111.
especially the 1st 5 years
API Prof.J.Frankel

8. 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 Prof.J.Frankel

9. 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,
especially the 1st 5 years
Cruces & Trebesch, 2013, “Sovereign Defaults: The Price of Haircuts,” Fig.3.
API Prof.J.Frankel

10. 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 Prof.J.Frankel

11. 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 Prof.J.Frankel

12. 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 Prof.J.Frankel

13. 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 Prof.J.Frankel 13

14. = 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 Prof.J.Frankel 14

15. 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 Prof.J.Frankel 15

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

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

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

19. (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 Prof.J.Frankel

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

21. Sovereign spreads Spreads rose again in Sept. 2008 ↑ ,
Bpblogspot.com
Spreads rose again in Sept ↑ ,
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 Prof.J.Frankel

22. 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 Prof.J.Frankel

23. 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 Prof.J.Frankel