1. The elusive quest for macro stability: the role of debt denomination Ricardo Hausmann Kennedy School of Government Harvard University March 10, 2002 Fortaleza, Brazil

2. Unrewarded good behavior Many things have been tried to achieve macro stability

3. Most governments have achieved… Inflation stabilization Trade liberalization Privatization Social security reform Improved regulation Efforts in institutional reform

4. External public debt ratios have declined sharply

5. …even faster as a share of exports

6. …based on a significant cut in fiscal deficits

7. 200 400 600 800 1000 1200 Jan-97 May-97 Sep-97 Jan-98 May-98 Sep-98 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 776 pb But market access remains a problem (LEI, Spread over US Treasuries) Pre-Asian Crisis Pre-Russian Crisis Pre-Argentine Crisis Current level

8. Why do good ratios not get good ratings?

9. Start with the popular ratio

10. Public debt/GDP Paraguay Guatemala Rep Dom Haití El Salvador Colombia Uruguay Costa Rica México T&T Venezuela Chile Argentina Perú Bolivia Belice Panamá Honduras Ecuador 020406080100120140 Debt to GDP ratios look modest

11. …consider the smaller tax base: the debt to tax ratio

12. …debt to tax ratios are comparable 0123456 BHS BLZ CHL COL MEX URY PRY TTO BRA OCDE ARG GTM LA VEN SLV JAM CRI ECU DOM PAN BOL SUR HND PER GUY NIC Public debt (as a share of tax revenues) Nota: NIC and GUY tienen valores de 26.0 y 12.6 respectivamente. Promedios regionales están ponderados por población.

13. …consider higher interest rates: the debt service to revenue ratio

14. Debt service to revenue is much higher

15. …but where would the higher interest rates come from? It must involve some risks

16. A model of fiscal risk Markets are concerned with the solvency of the government But there is uncertainty over future flows Reduced form: markets will set a limit to the share of interest payments in the budget –Just as mortgage banks do What is the likelihood that the country would hit this limit?

17. …a graphical representation Higher expected value Greater variance

18. The possibility of multipliers and multiple equilibria High risk causes high interest rates –Fat tails raise the interest rate High interest rates causes high risk –High interest rates increases the expected value of debt service Fiscal consolidation may be self-reinforcing –The examples of Italy and Spain BUT WHAT RISKS ARE WE TALKING ABOUT?

19. How about revenue volatility?

20. Revenue volatility is higher

21. A simulation

22. …and it could explain part of the problem Impact of 1 standard deviation shock to revenues on the the debt service to tax ratio ShockImpact OECD -5.0 0.3 LAC -8.0 1.7 Its part of the problem, but only a small part.

23. The original sin hypothesis Definition: you cannot borrow long term at fixed rates in your own currency. You are condemned to choose between short term debt in pesos, or long term debt in dollars. This makes debt service sensitive to the real exchange rate and the real interest rate

24. The impact of original sin Volatility of real interest rates Volatility of real exchange rates Volatility of revenue

25. Real exchange rates are volatile and pro-cyclical

26. …and real interest rates are on a class by themselves

27. They move together in the “wrong” direction

28. A simulation

29. Vive la petite difference

30. Conclusions Why do Latin American countries borrow in dollars? –Because it is safer than borrowing short-term in pesos. Not because of moral hazard. –Because they want to preserve the independence of their monetary policy

31. Conclusion Why do countries float the way they float? –Because they borrow the way they borrow –Since they borrow in dollars, the central bank prefers to stabilize the exchange rate and concentrate the volatility on the interest rate Why do countries borrow the way they borrow? –Because they float the way they float –You would borrow in whatever is more stable. If it is the exchange rate, then you want to borrow in dollars

32. 0 5 10 15 20 G3Other DevelopedEmergingOther DevelopingLA EmergingEast Asia 17.559 5.074 1.760 0.820 1.123 2.626 Relative Volatilities: Exchange Rate and Reserves std(dev)/std(res/m2) Countries with OS keep their volatility in the interest rate

33. Conclusion Why has good fiscal behavior remained largely unrewarded? Because debt structure (original sin) makes real exchange rates and real interest rates matter for debt service And these are very volatile and have the “wrong” cyclical properties, making debt service much riskier

34. Conclusions Why is Latin America trapped in a pro- cyclical fiscal response in bad times? Because in bad times they need to finance not just the decline in tax revenues but also the jump in debt service

35. Implications Reduction of the debt to GDP ratio may not be the most efficient way to achieve fiscal consolidation –We already tried that Working on debt denomination may be more effective –It would lower the “value at risk” –…which would lower the interest rate –…which would allow fiscal consolidation

36. Implications Governments should target a risk-weighted debt level –Risk weights should depend on the volatility and cyclicality of its determinants –In the previous examples, short term domestic currency debt should get the highest weight. Followed by foreign currency debt

37. Conclusions A risk-weighted debt target should create incentives for countries to optimize the trade-off between cheaper and safer debt –A deficit target favors cheap, risky debt Long-term fixed-rate domestic-currency debt is best but it is hard to develop –Bravo Mexico Inflation-indexed, long-term, fixed-rate domestic debt are second best and are easier to develop –Chile dixit

38. Conclusions International financial institutions are now part of the problem –They borrow and lend only in foreign currency They could be part of the solution –They need to help develop the international market for long-term fixed-rate bonds by issuing their own obligations and on-lend to borrowers