1. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Lecture 25: COUNTRY RISK The portfolio-balance model can be very general (menu of assets). In Lecture 24, 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? 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 view from the South:

2. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University WesternAsset.com Bpblogspot.com ↑ Spreads shot up in 1990s crises, and fell to low levels in next decade.↓ Spreads rose again in Sept.2008 ↑, esp. on $-denominated debt & in E.Europe. World Bank

3. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University What determines spreads? AmChamGuat EMBI is correlated with risk perceptions:

4. The portfolio balance model can be applied to country risk Demand for assets issued by various countries f: x i, t = A i + [ρV] i -1 E t (r f t+1 – r d t+1 ) ; Now the expected return E t (r f t+1 ) subtracts from i f t the probability of default times loss in event of default. Similarly, the variances & covariances factor in risks of loss through default.

5. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University In developing countries: Domestic country is usually assumed to be a debtor, not a creditor. Debt to foreigners is often $-denominated => no exchange risk. Then, e xpected 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 because when debt is large investors fear default & build a country risk premium into i. Default risk is a major part of the premium it must pay.

6. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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

7. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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

8. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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). 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).

9. Debt dynamics 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 (≡ r > real growth rate ). where Y ≡ nominal GDP

10. Copyright 2007 Jeffrey Frankel, unless otherwise noted Debt dynamics line shows the relationship between b and (i-n), for db/dt = 0. It slopes down. = d + (i - n) b. where, n  nominal growth rate, and d  primary deficit / Y. b range of explosive debt range of declining Debt / GDP ratio 0 Db/dt=0

11. Debt dynamics, with inelastic supply of funds b 0 Greece 2011 Ireland 2011 range of explosive debt range of declining Debt / GDP

12. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Debt dynamics, continued It is best to keep b low to begin with, especially for “debt-intolerant countries.” Otherwise, it may be hard to keep db/dt < 0, if –i rises some time, due to either a rise in world i*, or an increase in risk concerns; –or n exogenously slows down. Now add the upward-sloping supply of funds curve. i includes a default premium, which depends in turn on db/dt.

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

14. (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….

15. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University explosive debt path