OECD Conferenceon

“How to Reduce Debt Costsin Southern Africa?”

Johannesburg, March 25-26, 2004

Presentation by Vivek Arora (IMF)on “Sovereign Spreads in South Africa”

This paper should not be reported as representing the views of the IMF. The views expressed are those of the author and do not necessarily reflect the views of the IMF or IMF policy.

I Introduction

Two main questions:

1. Why do sovereign spreads matter?2. What determines sovereign spreads?

1. Role of spreads in a small open economy with relatively free capital flows:

• Key determinant of domestic interest rates (i = i* + E(e) + spread); Close correlation with interest rates in South Africa (Figure 1 of Ahmed (2004)).

• Indicator of external vulnerability.

0

4

8

12

16

20

1997 1999 2000 2001 2002 2003

Long-term Government Bond YieldsSovereign Spread

Figure 1: Long-term Government Bond Yields vs. Risk Premium(In percent)

Sources: South African Reserve Bank, Quarterly Bulletin

2. Literature:

Emerging market spreads are influenced by both global factors:

• risk appetite,

• industrial country interest rates,

• liberalization of investment rules;

and country-specific factors:

• public finances,

• international reserves and obligations,

• inflation expectations.

II What determines sovereign spreads in emerging markets?

Theory

Arbitrage condition: the risk-adjusted payoff on emerging market bonds and risk-free bonds must be equal:

(1+r) = p. (1+i) + (1-p).0, where (1-p) = risk of nonrepayment.

Spread, S, or emerging market rate minus risk-free rate is:

S = (1+r).(1-p)/p

The spread rises in response to higher risk from:(i) domestic factors (1-p); and (ii) global factors (r).

The literature focuses on:(i) identifying sources of (1-p) and r; and (ii) the relative importance of domestic and global risk.

Empirical evidence

Both domestic and global factors matter [Table 1, Arora and Cerisola (2001)].

Domestic factors: Net foreign assets; fiscal balance and government debt; foreign reserves; external debt and debt service.

Global factors: industrial-country interest rates; world market volatility.

Previous empirical literature was inconclusive partly because it focused on launch spreads and ignored market volatility.

A

Argentina Brazil Mexico Panama Colombia Poland Bulgaria Philippines Thailand KoreaPeriod 94:4-99:12 94:4-99:12 94:4-99:12 96:8-99:12 97:4-99:12 94:11-99:12 95:06-99:12 94:4-99:12 97:11-99:12 98:7-99:12

U.S. 10-year treasury yield 0.51 0.96 0.84 0.21 0.54 1.01 1.08 0.54 0.54 1.54(.000) (.000) (.000) (.208) (.000) (.000) (.000) (.000) (.002) (.000)

Net foreign assets -0.05 … … -0.09 -0.47 -0.32 0.00 … -0.01 -0.08(in percent of GDP) (.000) (.000) (.001) (.000) (.493) (.000) (.000)

Fiscal balance … -0.01 … -0.09 … … … … … …(in percent of GDP) (.395) (.000)

Gross reserves to imports … … -0.39 … … -2.25 … -3.71 … …(.708) (.050) (.002)

Debt-service ratio … … … … … … 0.02 0.01 0.11 …(.011) (0.117) (.036)

Central government debt 0.14 0.101 0.06 … 0.21 … … 0.08 … …(in percent of GDP) (.000) (.000) (.000) (.000) (.000)

Total external debt … … … 0.09 … … … … … …(in percent of GDP) (.000)

Dummy2 … … … … … … -0.53 … … …(.000)

Adjusted R -squared 0.53 0.33 0.24 0.60 0.76 0.50 0.57 0.29 0.77 0.75

Source: IMF staff estimates.Note: Probablility values, for the null hypothesis of a coefficient equal to zero, are reported in parentheses. Standard errors have beenadjusted following the Newey-West procedure.1 Refers to net debt.

From Arora and Cerisola (2001)Table 1. Determinants of Sovereign Bond Spreads for Selected Emerging Markets

III Sovereign spreads in South AfricaBased on Ahmed (2004)

DataSample: June 1997- September 2003 monthly data.

Spread: on 20-year U.S.$500 million government bond issued in 1997 over comparable U.S. Treasury security. [Also: EMBISA, for comparison.]

Global factors: proxied by EMBI spread for emerging markets, and its volatility.

Domestic factors: Domestic and foreign debt levels and maturities; forward book and NOFP; inflation; exchange rate volatility; GDP growth.

ResultsBoth global and domestic factors matter. The forward book was a

significant contributor to sovereign spreads.

Source: Ahmed 2004Determinants of Spread (Specification 1)

Independent VariablesIndependent Variables Dependent Variable: Dependent Variable: SPREADSPREAD

EMBISPEMBISP 0.41 0.41 (6.47)(6.47)

0.420.42(6.99)(6.99)

0.430.43(7.84)(7.84)

DEBT_FDEBT_F 9.27 9.27 (0.57)(0.57)

16.5016.50(0.92)(0.92)

22.4522.45(1.34)(1.34)

MATURITY_FMATURITY_F 2.97 2.97 (2.03)(2.03)

3.193.19(2.17)(2.17)

2.982.98(2.29)(2.29)

DEBT_DDEBT_D -2.10 -2.10 (-0.77)(-0.77)

-2.38-2.38(-0.83)(-0.83)

-3.52-3.52(-1.26)(-1.26)

MATURITY_DMATURITY_D 5.44 5.44 (1.27)(1.27)

4.454.45(1.01)(1.01)

2.832.83(0.74)(0.74)

FORWBFORWB 7.43 7.43 (1.77)(1.77)

36.9436.94(2.97)(2.97)

NOFPNOFP -21.88-21.88(-1.87)(-1.87)

INFLINFL 2.67 2.67 (0.72)(0.72)

2.602.60(0.71)(0.71)

1.221.22(0.34)(0.34)

EXCHDEPREXCHDEPR -0.12 -0.12 (-0.10)(-0.10)

0.160.16(0.14)(0.14)

0.580.58(0.46)(0.46)

RGDPGROWTHRGDPGROWTH -17.70-17.70(-2.04)(-2.04)

-21.48-21.48(-2.35)(-2.35)

-26.40-26.40(-3.07)(-3.07)

FORWBSQRFORWBSQR -0.77-0.77(-2.42)(-2.42)

NOFPSQRNOFPSQR -0.49-0.49(-1.57)(-1.57)

R-squaredR-squared 0.930.93 .93.93 .94.94

Specification 1:

Significant variables:

• EMBI spread

• Maturity of foreign debt

• NOFP, consistent with previous analysis by Jonsson (2001)

• Forward book, non-linear impact

• GDP growth

Not significant: levels of debt; inflation; exchange rate volatility.

Source: Ahmed 2004Determinants of Spread (Specification 2)

Sample: 1997:06-2003:09

Independent VariablesSPREAD (-1) 0.37 0.39 0.38

(3.03) (3.15) (3.40)EMBISP 0.26 0.27 0.27

(2.62) (2.77) (3.10)DEBT_F 13.31 23.72 27.02

(0.91) (1.73) (2.20)MATURITY_F 1.94 2.21 1.87

(1.03) (1.15) (1.08)DEBT_D -2.66 -3.17 -4.31

(-0.98) (-1.21) (-1.81)MATURITY_D 2.75 0.53 -0.26

(0.88) (0.16) (-0.09)FORWB 5.84 36.99

(2.28) (4.09)NOFP -26.86

(-3.26)INFL 1.17 0.49 -0.39

(0.39) (0.16) (-0.13)EXCHVOL -1.44 2.73 1.68

(-0.15) (0.29) (0.20)RGDPGROWTH -18.40 -27.11 -29.99

(-2.36) (-3.39) (-4.08)FORWBSQR -0.83

(-3.44)NOFPSQR -0.69

(-3.01)Adj R-squared 0.94 0.95 0.95

Dependent Variable: SPREAD (Dynamic Specification)

Specification 2 (with lagged dependent variable):

Significant variables:

• EMBI spread

• Persistence, measured by previous month’s spread

• Level of foreign debt

• NOFP

• Forward book, again a non-linear impact

• NIR

• GDP growth

Not significant: debt maturity; inflation; exchange rate volatility.

Source: Ahmed (2004)

Regression with significant variables

Independent Independent VariablesVariables Dependent Variable: SPREADDependent Variable: SPREAD Dependent Variable: Dependent Variable:

EMBISAEMBISA

EMBISPEMBISP 0.420.42(9.10)(9.10)

0.450.45(9.11)(9.11)

0.410.41(7.41)(7.41)

0.320.32(8.03)(8.03)

0.320.32(6.29)(6.29)

0.300.30(6.64)(6.64)

MATURITY_FMATURITY_F 3.173.17(1.88)(1.88)

3.083.08(1.79)(1.79)

3.163.16(1.89)(1.89)

3.213.21(1.69)(1.69)

3.203.20(1.67)(1.67)

3.233.23(1.74)(1.74)

FORWBFORWB 9.599.59(3.18)(3.18)

9.989.98(4.67)(4.67)

14.7414.74(4.66)(4.66)

14.7714.77(5.09)(5.09)

NOFPNOFP -8.13-8.13(-2.41)(-2.41)

-13.58-13.58(-3.37)(-3.37)

RGDPGROWTHRGDPGROWTH -17.61-17.61(-2.16)(-2.16)

-24.04-24.04(-2.89)(-2.89)

-15.22-15.22(-1.78)(-1.78)

-18.46-18.46(-1.61)(-1.61)

-18.90-18.90(-1.42)(-1.42)

-14.93-14.93(-1.21)(-1.21)

R-squaredR-squared .93.93 .93.93 .92.92 .89.89 .89.89 .88.88

B

Regressions with significant variables(Dynamic Specification)

Independent Variables Dependent Variable: SPREAD

SPREAD(-1) 0.36(3.76)

0.35(3.67)

0.38(3.88)

EMBISP 0.29(4.69)

0.32(4.62)

0.28(4.31)

MATURITY_F 2.36(1.68)

2.33(1.68)

2.31(1.64)

FORWB 5.70(3.46)

6.12(3.73)

NOFP -4.64(-3.13)

RGDPGROWTH -16.61(-2.45)

-20.59(-2.76)

-15.48(-2.27)

R-squared 0.95 0.95 0.94

Parsimonious specification:

• NOFP (8bp)

• Forward book(10bp)

• GDP growth (15-24 bp)

• EMBI spread (0.4bp)

•Debt Maturity (3bp)

Main message: Eliminating first the NOFP and then the forward book contributed

significantly to lower spreads. Building up reserves should help further reduce

spreads. Also, reduce currency volatility

IV Impact on domestic interest rates

How do spreads matter for the economy? Impact on domestic interest rates.

•Channels:Repo rate (through inflation expectations); Longer-term rates through shift in the term structure and (for nongovernment debt) through change in credit risk.•In South Africa, Ahmed: 100bp increase in spreads 40-65 bp increase

in long-term domestic government interest rates.•Inflation is significant in determining domestic interest rates, as expected

through the interest parity condition:

Vocke (2003): a 1 percentage point inflation gap (deviation of inflation from target) adds 13–15 basis points to spreads of domestic-currency interest rates to U.S. rates.

Ahmed (2003): 100 bp increase in SA-US expected inflation differential 80 bp increase in domestic interest rates.

Exchange rate volatility is reduced through higher reserves: Hviding et al. (2004).

Gross foreign exchange reserves and the ratio of gross reserves to short- term debt plus the forward book were both significant, with negative sign.

Table 3: Determinants of RESIDUALDependent Variable: Log of RESIDUAL

Sample size: 2000:03-2003:06

Independent Variables

LINFLDIFF_B 1.07(9.22)

1.06(8.73)

0.96(6.56)

0.97(8.78)

0.93(8.07)

0.84(5.75)

LREER 0.28(1.45)

0.44(2.16)

0.49(2.41)

-0.67(-2.00)

-0.76(-2.14)

-0.77(-2.32)

NETBRSA_GDP 0.05(0.95)

0.04(1.03)

0.04(0.74)

LDEBT_F 0.20(1.37)

0.03(0.37)

0.07(0.66)

LDEBT_D 0.64(2.63)

0.74(2.82)

0.78(2.94)

INDCOIN -0.01(-1.89)

-0.02(-1.45)

CAPUTIL -0.03(-0.91)

-0.01(-0.25)

GROWTH 0.03(0.97)

0.07(1.05)

EXCHCON0203 0.29(4.48)

0.21(4.29)

0.26(3.50)

0.22(3.35)

0.21(2.84)

0.24(3.15)

Adj. R-squared 0.79 0.77 0.77 0.81 0.80 0.81

Determinants of long-term interest rates

• Spread

• Expected inflation differential (S.A. – U.S.)

• Debt

• Exchange controls

Contribute to the currency premium

V Conclusion: main messages

Both domestic and global factors affect South Africa, but domestic factors matter more.

Eliminating first the NOFP and then the forward book contributed significantly to lower spreads. Building up reserves should help further reduce spreads.

Source: Ahmed (2004)Regressions with log specifications

Independent Independent VariablesVariables Dependent Variable: LSPREADDependent Variable: LSPREAD

LEMBISPLEMBISP 0.730.73(9.58)(9.58)

0.740.74(10.69)(10.69)

0.700.70(9.75)(9.75)

LDEBT_FLDEBT_F 0.220.22(1.27)(1.27)

0.150.15(0.91)(0.91)

0.260.26(1.49)(1.49)

MATURITY_FMATURITY_F 0.0090.009(2.40)(2.40)

0.0080.008(2.22)(2.22)

0.0080.008(2.48)(2.48)

LDEBT_DLDEBT_D -0.37-0.37(-1.74)(-1.74)

-0.27-0.27(-1.26)(-1.26)

-0.34-0.34(-1.72)(-1.72)

MATURITY_DMATURITY_D 0.020.02(1.61)(1.61)

0.020.02(1.55)(1.55)

0.010.01(1.09)(1.09)

LFORWBLFORWB 0.310.31(2.57)(2.57)

LNIRLNIR

LGFEXRSVLGFEXRSV -0.47-0.47(-2.43)(-2.43)

LRESSTDEBTFBLRESSTDEBTFB -0.29-0.29(-3.46)(-3.46)

INFLINFL 0.0080.008(0.90)(0.90)

0.010.01(1.71)(1.71)

0.0080.008(1.03)(1.03)

EXCHDEPREXCHDEPR 0.0030.003(0.82)(0.82)

0.0020.002(0.71)(0.71)

0.0030.003(0.86)(0.86)

RGDPGROWTHRGDPGROWTH -0.08-0.08(-3.03)(-3.03)

-0.06-0.06(-2.22)(-2.22)

-0.07-0.07(-2.86)(-2.86)

R-squaredR-squared 0.940.94 0.940.94 0.940.94

References

Ahmed, Faisal, 2004, “Determinants of Interest Rates in South Africa,” draft, IMF, March.

Arora, Vivek and Martin Cerisola, 2001, “How Does U.S. Monetary Policy Influence Sovereign Spreads in Emerging Markets?” IMF Staff Papers, Vol. 48, 3, pp. 474-98.

Giavazzi, Francesco, 2003, “Inflation Targeting and the Fiscal Policy Regime,” Bank of England Quarterly Bulletin, Autumn, pp. 334-342.

Jonsson, Gunnar, 2001, “The Risk Premium in South African Long-Term Interest Rates,” in South Africa—Recent Economic Developments (unpublished, IMF).

Vocke, Matthias, 2003, “Sovereign Risk Spreads Under Inflation Targeting,” in South Africa, Selected Issues: IMF Staff Country Report, January 2003.