Sovereign debt and sovereign default: Theory and Reality

1. Sovereign debt and sovereign default:Theory and Reality Ugo Panizza These are my own views

2. Bertrand Russell • If a man is offered a fact which goes against his instincts, he will scrutinize it closely, and unless the evidence is overwhelming, he will refuse to believe it. If, on the other hand, he is offered something which affords a reason for acting in accordance to his instincts, he will accept it even on the slightest evidence. The origin of myths is explained in this way. • In all affairs it's a healthy thing now and then to hang a question mark on the things you have long taken for granted • The most savage controversies are those about matters as to which there is no good evidence either way • I would never die for my beliefs because I might be wrong

3. The standard view • Facts • Countries get into debt problems because of lax fiscal policies • Countries have an incentive to default on their external debt obligations • Policies • Debt crises should always be followed by a fiscal retrenchment • We need to implement policies that reduce a country's incentive to default

4. Background • U. Panizza, F. Sturzenegger, and J. Zettelmeyer (2009) "The Economics and Law of Sovereign Debt and Sovereign Default" Journal of Economic Literature • B. Eichengreen, R. Hausmann, and U. Panizza (2003) “The Pain of Original Sin” University of Chicago Press • E. Borensztein, and U. Panizza (2009)"The Costs of Sovereign Default" IMF Staff Papers • E. Levy Yeyati and U. Panizza (2010) "The Elusive Cost of Sovereign Default," Journal of Development Economics • E. Borensztein, E. Levy Yeyati, and U. Panizza (2006) Living with Debt, Harvard University Press and IDB • C. Campos, D. Jaimovich, and U. Panizza (2006) “The Unexplained Part of Public Debt,” Emerging Markets Review • U. Panizza and A. Presbitero (2012) "Public Debt and Economic Growth: Is There a Causal Effect?," Mo.Fi.R. Working Papers 65.

5. Outline • Facts • How debt grows • When do countries borrow and default • Policies • What to do during debt crises • How to deal with defaults

6. Debt and Politics in Tranquil Times • Politics and deficit (debt) bias • Because of excessive optimism • Not enough savings in good times • Remember the official reason for Greenspan’s support of tax cuts during the Bush administration • Because issuing debt allows to postpone difficult decisions • Because of strategic considerations • Why would Ronald Reagan run a large budget deficit?

7. Solutions • Budgetary institutions • Smart budgetary rules • Transparency rules • Hierarchical rules • Like motherhood and apple pie, these are great things…

8. …but they may not be enough • The relationship between deficit and debt is not as tight as you may think • Low debt is not enough

9. How Debt Grows? • The economics 101 debt accumulation equation states that: • CHANGE IN DEBT = DEFICIT • Practitioners use: • CHANGE IN DEBT = DEFICIT+SF • SF=Stock-flow reconciliation, or the unexplained part of public debt • The stock-flow reconciliation is often considered a residual entity of small importance • Is it?

10. If we estimate: We expect: band R2 to be close to 1 and a = 0 R-Squared Source: Campos, Jaimovich and Panizza (2006)

11. The Unexplained Part of Public Debt Source: Campos, Jaimovich and Panizza (2006)

12. The Unexplained Part of Public Debt • The growth rate of the debt-to-GDP ratio is equal to: • Primary deficit/GDP + interest payments/GDP+ – GDP growth – inflation • The last two variables are multiplied by the debt-to-GDP ratio • If you like math:

13. The Unexplained Part of Public Debt 15 10 5 INFLATION GDP GROWTH 0 UNEXPLAINED PART INTEREST EXPENDITURE PRIMARY DEFICIT -5 -10 -15 IND SAS CAR EAP ECA MNA LAC SSA Source: Campos, Jaimovich and Panizza (2006)

14. The Unexplained Part of Public Debt • What explains the “Unexplained” part of debt • Skeletons • Fiscal policy matters! • Transparent fiscal accounts are important • Banking Crises • Balance Sheet Effects due to debt composition Much more about this in a while

15. The Unexplained Part of Public Debt • There are also things that we can explain but may not have anything to do with fiscal policy • Output collapses • Sudden jumps in borrowing costs • Natural disasters

16. Example: Argentina

17. Source: JP Morgan (post 1998) and CLYPS

18. Incidentally

19. Budget Balance as % of GDP(average 2000-2007) Source: Eurostat

20. Primary Budget Balance as % of GDP(average 2000-2007) Source: Eurostat

21. What really went wrong in Europe Inflation Divergence in EMU Southern Europe ECB‘s Inflation Target France EMU Germany Inflation=GDP deflator 1999 = 100; SE=Greece, Italy, Portugal, and Spain; ECB IT= 2%; EMU=EMU12 average Source: Heiner Flassbeck

22. So, how debt grows? • IMF? • Its Mostly Fiscal • or • INAF • It’s Not Always Fiscal

23. … but they may not be enough • The relationship between deficit and debt is not as tight as you may think • Low debt is not enough • Example: UK versus Spain • (with thanks to Paul De Grauwe)

24. Low debt can’t buy you love

25. Debt …

26. …and yields

27. The importance of debt structure • Debt denominated in foreign currency or short-maturity debt is associated with: • Lower Credit Ratings • Sudden Stops • Higher volatility • Limited ability of conducting monetary policy • Contractionary devaluations • An appropriate debt structure can reduce risk

28. How to make debt safer • New and safer instruments • Local currency • Contingent debt instruments • GDP index bonds • Commodity linked bonds • Catastrophe bonds • Dedollarize official lending

29. Why do we need official intervention? • Market failures • Critical mass • Standards • Instruments cannot be patented • Political economy • Shortsighted politicians may underinsure

30. Outline • Facts • How debt grows • When do countries borrow and default • Policies • What to do during debt crises • How to deal with defaults

31. Why is sovereign debt special? • Creditor rights are not as well defined for sovereign debt as is the case for private debts. • If a private firm becomes insolvent, creditors have a claim on the company’s assets. • In the case of a sovereign debt, in contrast, the legal recourse available to creditors has limited applicability and uncertain effectiveness. • Sovereign immunity • Little to attach • So, why do countries repay and why do lenders lend?

32. Theory

33. The Economic Theory of Sovereign Debt • The literature started with (and it's still tied to) an influential theoretical paper by Eaton and Gersovitz (Review of Economic Studies, 1981) • The story of the paper was: • Countries borrow in bad times (low economic growth) and repay in good times (high economic growth) • Since there are no repayments in bad times, there cannot be defaults either • As a consequence, defaults can only happen in good times • Defaults are thus strategic (countries can pay but they decide not to pay) • The only reason that prevents countries from defaulting is that defaults are costly

34. The Economic Theory of Sovereign Debt • So, what are the costs of default? • The traditional economic literature has emphasized • Reputational costs • Countries that default will no longer be able to access the international capital market • Trade costs • Default will lead to sanctions which, in turn, will have a negative effect on trade

35. From the theory to the data In theory, there is no difference between theory and practice. In practice, there is

36. Do countries borrow in bad times?

37. What he really said: • "Why did I rob banks? Because I enjoyed it. I loved it. I was more alive when I was inside a bank, robbing it, than at any other time in my life. I enjoyed everything about it so much that one or two weeks later I'd be out looking for the next job. But to me the money was the chips, that's all." What do the data say? • Government external borrowing is procyclical and not countercyclical (probably because countries borrow when they can) • This confirms the idea that the seeds of debt crises are planted during good times

38. Do countries default in good times?

39. What do the data say? Default Happen in Waves…. • 1824-1840. 19 events (14 in Latin America: recent independence, civil wars). Long restructuring periods • 1840-1860. 6 events. Credit boom • 1861-1920. 58 events. Much faster restructuring • 1921-1940. 39 events. Great Depression and WWII. • 1941-1970. 6 events (but little lending) • 1971-1981. 15 events. Boom in syndicated bank loans • 1982-1990. 70 events. The “Debt Crisis” • 1991-2004. 40 events. Lending booms and Sudden Stops

40. Do defaulter pay a high cost?

41. What do the data say? • 3 years after the resolution of a default episode, there is no statistically significant difference between the spreads paid by defaulters and non defaulters • We find similar results if we look at access • Global factors (risk aversion and US interest rate) appear to be more important than default history

42. What do the data say? • There is some evidence that defaults have a negative effect on trade • But this is still controversial and the channel is not clear • No evidence that defaults have a direct impact on trade credit • No evidence (at least in recent years) of explicit sanctions

43. What do the data say? • Anyway, who cares? • We do know that defaults are bad because they lead to deep recessions • Econometric estimates found that, on average, default episodes are associated with a 2 percentage points drop in GDP growth • But do we really know what we think we know? • Are default episodes bad for growth or is it low growth that causes default? • That is, do defaults happen in bad times?

44. What do the data say? • Causality is always very hard to assess • But, if we look at high frequency data, we find that: • Growth collapses anticipate defaults • Default episodes are often followed by a rapid rebound of the economy

45. What do the data say?

46. Do countries default too early or too late? • Hell, the last thing I should be doing is tell a country we should give up our claims. But there comes a time when you have to face reality. • Unnamed financial industry official. Both are taken (Source: Bluestein, 2005, p 163) • The problem historically has not been that countries have been too eager to renege on their financial obligations, but often too reluctant. • Memo prepared by the Central Banks of England and Canada (Source: Bluestein, 2005, p 102)

47. Political costs of default • There is a (small) literature of political costs of currency devaluations (Cooper 1971). • Frankel (2005) finds that a devaluation increases turnover of finance ministers from 36 to 58 percent. • Applying Frankel’s approach, bond defaults increase minister turnover from 19 to 40 percent. But bank defaults increase it only to 24 percent. • Governments lose votes after defaults • The high political cost of default may affect the timing of the decision by the government. It could cause “gambles for redemption” • Mickey Mouse model (Borensztein and Panizza, 2009)

48. The politics of sovereign default • Policymakers (domestic and international) have strong incentives to gamble for redemption and delay the moment of reckoning • Borensztein and Panizza (2009), Levy Yeyati and Panizza (2010) • The problem historically has not been that countries have been too eager to renege on their financial obligations, but often too reluctant. • Memo prepared by the Central Banks of England and Canada (Source: Bluestein, 2005, p 102) • And this is bad because it prolongs the economic crisis and reduces recovery value • For both economic and political reasons • Everybody is worse off

49. Summing up: Theory versus Reality • Theory • Countries get into trouble because of lax fiscal policy • Countries borrow in bad times • If ever, countries default in good times (strategic defaults) • So, if anything, they default too much • Defaults are very bad for the economy, with long lasting negative consequences • Reality • Many debt explosions have nothing to do with fiscal policy • Countries borrow in good times • Countries default in bad times (justified defaults) • And sometimes too late • Defaults do not seem to have long lasting negative consequences

50. Outline • Facts • How debt grows • When do countries borrow and default • Policies • What to do during debt crises • How to deal with defaults