Fiscal Policy, Bond Prices, Credit Ratings and Original Sin

1. Fiscal Policy, Bond Prices, Credit Ratings and Original Sin

2. Problems with fiscal policy • Precarious creditworthiness • Pro-cyclical outcomes • Electoral budget cycles • Today, the first two

3. Market access is a problem for most EMs (LEI, Spread over US Treasuries) 1200 Current level 1000 Pre-Argentine Crisis 800 Pre-Russian Crisis 600 Pre-Asian Crisis 400 776 pb 200 May-97 May-98 May-99 May-00 May-01 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01

4. In many countries public debt to GDP ratios look modest (2006) Maastricht Criterion

5. 60 out of 75 developing countries had public debts below the Maastricht criteria in 2006

6. Debt to GDP ratios look modest Public debt/GDP Ecuador Honduras Panamá Belice Bolivia Perú Argentina Chile Venezuela T&T México Costa Rica Uruguay Colombia El Salvador Haití Rep Dom Guatemala Paraguay 0 20 40 60 80 100 120 140

7. Why do good ratios not get good ratings?

8. Start with the popular ratio

9. The Weak Relationship Between Debt/GDP and Credit Ratings NOR JPN GBR AUT DEU USA 19 SWE DNK CAN BEL AUS ESP FIN ITA PRT CYP ISL SVN rating foreign currency CZE ISR EST CHN GRC LVA HUN TUN POL TTO PAN IND MEX CRI ARG MAR DOM BRA JOR PRY TUR PAK 5 -.291965 1.13803 net_debt/gdp

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

11. Debt to tax ratios do remarkably poorly as predictors of ratings NOR LUX CHE AUT GBR DEU USA 19 SGP SWE DNK CAN BEL AUS ESP ITA FIN CYP ISL MLT SVN CZE KOR CHL ISR THA credit rating 1992-99 average EST CHN LVA GRC TUN POL HUN COL SVK PAN ZAF IND MEX SLV IDN CRI ARG PER MAR TUR KAZ DOM BOL JOR BRA PRY MNG 5 -.579362 4.13906 DE_RE2

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

13. Debt service to revenue is much higher

14. Poor countries seem to pay higher interest rates for their public debt

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. There is a maximum level of debt service that the government can absorb • But there is uncertainty over future flows

17. …a graphical representation Same expected value Greater variance

18. A graphical representation Bankrupt _ x Fragile x Sound i i*

19. The role of volatility _ x Less variance x High variance i i*

20. The possibility of multipliers • 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 BUT WHAT RISKS ARE WE TALKING ABOUT?

21. How about revenue volatility?

22. Developing countries have more volatile GDPs Table 1: Volatility of GDP Growth (1980-1999)

23. Revenue volatility is higher

24. A simulation

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

26. The original sin hypothesis • Definition: You cannot borrow abroad in your own currency • …if in addition you do not have long-term fixed-debt markets in local 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

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

28. The risk in foreign currency debt Table 1: Volatility of GDP Growth (1980-1999)

29. What drives collapses in $GDP?

30. What drives collapses in $GDP?

32. Volatility of Real Exchange rate over 5-year periods (Cross-Country Average Normalized to 1) 4.5 Industrialized countries Developing countries Nigeria 4 3.5 Bolivia 3 Romania 2.5 Zambia Venezuela Ecuador China Uruguay Dominican Republic 2 Trinidad and Tobago Burundi Cote d'Ivoire Indonesia Argentina Cameroon Colombia Saudi Arabia Paraguay Kuwait Mexico Chile South Africa Brazil 1.5 Bahrain Pakistan Peru Malaysia Portugal United States Singapore Turkey India Hungary New Zealand Hong Kong, China Fiji United Kingdom Tunisia St.Vinc&Grenadines Costa Rica Philippines Papua New Guinea Thailand 1 Australia Togo Morocco Gambia, The Belize Japan Korea, Rep. Finland Belgium Lesotho St. Lucia Spain Italy Iceland Switzerland Sweden Bahamas, The Germany Malta Cyprus Greece Taiwan Netherlands Canada Denmark France Austria Israel Ireland 0.5 Norway 0

33. The real exchange rate is also more volatile at 5-year horizons

34. Real exchange rates are volatile and pro-cyclical

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

36. They move together in the “wrong” direction

37. A simulation

38. Vive la petite difference

39. Conclusion • Why do countries get into trouble at levels of debt that are manageable for other countries? • 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

40. Table 8: Original sin and credit ratings (1) (2) (3) (4) RATING1 RATING1 RATING1 RATING1 DE_GDP2 - 1.553 - 1.815 (1.91)* (2.19)** DE_RE2 - 0.599 - 0.665 (1.40) (1.52) LGDP_PC 3.189 3.051 2.884 2.76 4 (8.54)*** (7.59)*** (6.47)*** (5.68)*** OSIN3 - 3.429 - 3.324 - 4.883 - 4.435 (3.85)*** (3.49)*** (3.49)*** (3.11)*** Constant - 12.369 - 11.059 - 8.751 - 7.889 (3.16)*** (2.60)** (1.89)* (1.57) Observations 56 49 51 44 R - squared 0.82 0.81 0.81 0.80

41. Original sin: world patterns

42. The global cross-border portfolio (0.9857) 1 Debt by 0.9 Currency (0.8859) 0.8 Debt by Country 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 United States EUROLAND Japan U . K Switzerland Canada Australia

43. Total Debt issued by residents (99-01) International Organizations (7%) Other Developed (8%) Developing (8%) Euroland (33%) Major Financial Centers (45 %) Total Debt issued in own currency (99-01) Other Developed (<2%) Major Financial Centers (61 %) Euroland (37%)

44. Graph1: Measures of original sin by country groupings 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 Financial Centers Euroland Other Developed Developing OSIN1 OSIN2 OSIN3

45. Original sin is highly persistent OSIN3 and Flandreau-Sussman classification circa 1850

46. Conclusions • Why are countries 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 • This makes it harder to maintain spending and access to lenders

47. Policy ideas • Targets on the overall deficit are not credible because governments cannot control debt service • Primary balances are more credible but may be less relevant • Reduction of the absolute level of debt or even the debt to GDP ratio may not be the most efficient way to achieve fiscal consolidation • Working on debt denomination may be more effective

48. 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

49. Implications • 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

50. Take-away • Working on debt structure may be a more efficient way of achieving fiscal consolidation • Virtuous circle • Inflation-indexed fixed-rate long-term domestic- currency debt may be a practical way to go • Target adjusted primary deficits • …and risk-weighted debt levels