1. Portfolio Balance
Lecture 23 assumption: exchange risk is the only important risk.
Lecture 24 assumption: default risk is important.

2. Recap of L23 Questions Key parameters
How can we allow for effects of risk?
Currency risk.
Country risk.
How can we allow for effects of debt even if it is not monetized?
Effects of budget deficits &
current account deficits
Key parameters
Risk-aversion, ρ
Variance of returns, V
Covariances among returns, Cov.

3. Professor Jeffrey Frankel, Harvard University
Lecture 24: Country Risk
One lesson of portfolio diversification theory: A country borrowing 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 23, we considered a special case relevant especially to rich-country bonds: exchange risk is the only risk.
What modifications are appropriate for developing country debt?
The view from the South:
Professor Jeffrey Frankel, Harvard University

4. Debt crowds out investment
Most low-income countries have to run primary surpluses (to service past debt).
International Monetary Fund, 2014

6. Professor Jeffrey Frankel, Kennedy School, Harvard University
EM sovereign spreads
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
Professor Jeffrey Frankel, Kennedy School, Harvard University

7. What determines spreads?
EMBI is correlated with risk perceptions
risk off
“risk on”
Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, March 2011

8. The portfolio balance model can be applied to country risk
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, sovereign spreads must be high for investors to absorb given supplies of debt, and vice versa.

9. In developing countries:
Domestic country is usually assumed to be a debtor, not a creditor.
It must pay a premium as compensation for default risk.
Debt to foreigners was usually $-denominated => no exchange risk .
Then, expected return = observed “spread” between interest rate on the country’s loans or bonds and 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 Macroeconomic Policy Analysis I , Professor Jeffrey Frankel,, Harvard University

10. 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
≡ Debt/GDP
Professor Jeffrey Frankel, Kennedy School, Harvard University

11. Spreads charged by banks on emerging market loans are significantly:
Eichengreen & Mody (2000):
Spreads charged by banks on emerging market loans are significantly:
reduced if the borrower generates more business for the bank, but
increased 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

12. API-120 - Professor Jeffrey Frankel, Harvard Kennedy School
Why don’t debtor countries default more often, given absence of an international enforcement mechanism?
1. Common answer: They want to preserve their creditworthiness, to borrow again in the future.
Not a sustainable repeated-game equilibrium: Bulow-Rogoff (AER, 1989).
Defaulters seem to return to the market before long: Eichengreen (1987), Arellano (2009).
2. Cynical answer: Finance Ministers want to remain members in good standing of the international elite.
3. Best answer (probably): 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 86). Evidence: Rose (JDE, 2005).
API Professor Jeffrey Frankel, Harvard Kennedy School

13. Definition of sustainability: a steady or falling debt/GDP ratio
Debt dynamics:
Definition of sustainability: a steady or falling debt/GDP ratio
where Y ≡ nominal GDP
where n  nominal economic growth rate and d  primary deficit / Y .
= d + i b - bn = d (i - n) b.
=> Debt ratio explodes if d > 0 and i > n (or r > real growth rate). 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
Copyright Jeffrey Frankel 14

15. Debt dynamics, continued
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, 2014?), or
an increase in risk concerns (e.g., 2008);
or n exogenously slows down.
Now add the upward-sloping supply of funds curve.
i includes a default premium, which probably depends in turn on db/dt.
=> 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. 15

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

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

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

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….

20. Appendix 2: The blurring of lines between debt of advanced countries and developing countries
1) Since the crisis of the euro periphery began in Greece in 2010, we have become aware that “advanced” countries also have sovereign default risk.
2) Since 2000, Emerging Market Countries have increasingly been able to borrow in their own currencies, so their debt carries currency risk (not just default risk).

21. 1) Country creditworthiness is now inter-shuffled
“Advanced” countries (Formerly) “Developing” countries AAA Germany, UK Singapore, Hong Kong AA+ US, France AA Belgium Chile AA- Japan China A+ Korea A Malaysia, South Africa A- Brazil, Thailand, Botswana BBB+ Ireland, Italy, Spain BBB- Iceland Colombia, India BB+ Indonesia, Philippines BB Portugal Costa Rica, Jordan B Burkina Faso SD Greece
S&P ratings, Feb.2012 updated 8/2012 21

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

23. 2) The end of Original Sin: After 2000, Emerging Markets successfully issued more debt in their own local currencies (LC), instead of $-denominated (FC).
Fig. 2 from Jesse Schreger & Wenxin Du
“Local Currency Sovereign Risk,” HU, March 2013

24. 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 {
Fig. 5 from Schreger & Du, “Local Currency Sovereign Risk,” HU, March 2013