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Assessing the Appropriate Size of Relief inSovereign Debt Restructuring
The New School for Social Research, Department of Economics
Martin Guzman (Columbia-UBA-CIGI) Domenico Lombardi (CIGI)
April 18, 2017
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Motivation
What’s the “appropriate” size of relief in a sovereign debtrestructuring process?
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Related literature
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Related literature
Principles for sovereign debt restructuring (Guzman-Stiglitz 2015,
2016)
Must ensure proper functioning of sovereign lending markets
Ex-ante efficiency
Ex-post efficiency
The restructuring must restore the conditions for pursuing thesovereign’s development goals
The ultimate goal of a sovereign restructuring is therestoration of debt sustainability
But what does it mean?
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Related literature
Edwards (2015): Inter-country comparison of market haircuts
180 restructuring episodes with private creditors from 1970 to2010 (data from Cruces-Trebesch 2013)
Actual haircuts vs. Predicted haircuts
If actual haircut >> (<<) predicted haircut =⇒ too much(too little) haircut
But the approach is flawed
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Related literature
The majority of the restructurings in the sample were noteffective for achieving the necessary relief
Haircut is not a measure of debt relief but a proxy of investorlosses
Ht = 1− PV new bond(rt+ε)
PV old bond(rt+ε)
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
The “too little” syndrome
t 3 4 5 6 7
Frequency 0.497 0.525 0.553 0.575 0.6
Frequency: denotes fraction of restructuring with privatecreditors (bondholders and bank loans) followed by anotherrestructuring or default with the same group within t years
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Relation to other literature
Empirical literature on fiscal sustainability (Bohn 1995, 2005, 2008,
Mendoza-Ostry 2008)
Commitment issues and strategic defaults (D’Erasmo-Mendoza
2013, 2014; D’Erasmo et al. 2015; Eaton-Gersovitz 1981; Aguiar-Gopinath
2006)
Excusable defaults (Grossman-Van Huyck 1988; Levy Yeyati-Panizza 2007;
Collard et al. 2015)
Strategic default is a matter of will. Excusable default is amatter of means
Effects of debt relief on economic performance (Reinhart-Trebesch
2016; LDA for West Germany)
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
The concept of debt sustainability
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
The concept of debt sustainability
Consistency issues (Guzman-Heymann 2015)
Any borrowing can be considered ‘sustainable’ if thelending-borrower transaction is consistent, in the sense thatthe borrowing cost reflect the actual probability of default
When market participants refer to sustainability, theyintuitively refer to the risk of a country falling into a situationof debt distress (IMF 2013)
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
The concept of debt sustainability
A general definition: public debt is economically sustainablewhen its repayment does not rely on a sequence of unboundedfuture borrowings
Caveat 1: Economic sustainability is a necessary but notsufficient condition for principles-based sustainability
Caveat 2: the analyst cannot know with certainty what will bethe evolution of the state variables that determine the debtrepayment capacity
Therefore, any statement on debt sustainability is by definitionprobabilistic
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Empirical approach for testing debt sustainabilityAd hoc sustainability
Notation:
st : fiscal surplus to GDP ratio
1 + r = 1+R1+γ
R: constant nominal interest rate
γ: constant growth rate of output
d∗t : outstanding debt payments in period t
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Empirical approach for testing debt sustainabilityAd hoc sustainability
(TC) holds iff (IBC) holds:
(IBC):
d∗t =∞∑j=0
(1 + r)−jEtst+j
(TC):limj→∞(1 + r)−jEtdt+j = 0
Definition 1
Fiscal policy satisfies ad hoc sustainability if (IBC) holds
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Empirical approach for testing debt sustainabilityModel-based sustainability
Bohn (1995, 2005, 2008)
Arrow-Debreu securities
=⇒ Lenders use the same pricing kernel ut+j
(IBC’):
d∗t (zt) =∞∑j=0
Et [ut+jst+j ]
(TC’):limj→∞Et [ut+jdt+j ] = 0
Definition 2
Fiscal policy satisfies model-based sustainability if (IBC’) holds
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Empirical approach for testing debt sustainabilityModel-based sustainability
=⇒(1 + r)−j = βjEt
uc(ct+j(zt+j))
uc(ct(zt))
(IBC’) can be rewritten as follows (Mendoza-Ostry 2008):
d∗t (zt) =∞∑j=0
{(1 + r)−jEtst+j + covt
[βj
uc(ct+j(zt+j))
uc(ct(zt)), st+j
]}Under complete markets, there cannot be excessive borrowing
The government trades insurance across possible states ofnature
Test: regress primary balance on outstanding debt → positive(significant) coefficient is sufficient condition for sustainability
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Empirical approach for testing debt sustainability
What the test informs: assuming the past is a representativeguide for the future, would fiscal policy be sustainable?
But the course of policies could be reversed
Our question: Is there any feasible course of policies consistentwith the satisfaction of the transversality condition (plus otherconditions) with high probability?
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A methodology for assessing the appropriate size ofrelief in sovereign debt restructuring
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt reliefA preview of the methodology
1 Define “restructuring principles” and translate them intoeconomic terms
2 Describe the model that represents the economy underanalysis
3 For each possible economic scenario, find the trajectory offixed points {st}t that satisfies IBC
4 Classify each fixed point according to its economic and“political” feasibility
5 If there is a “sufficiently large” mass of feasible trajectories offixed points, then the state variable d∗t satisfies sustainabilitywith high probability
6 Otherwise, there is need for a debt write off large enough asto achieve a “sufficiently large” mass of trajectories of fixedpoints
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt relief
Suppose (IBC) is the appropriate IBC
Suppose:
st = s(γt ,Rt ,Xst , ε
st )
γt = γ(st ,Xγt , ε
γt )
Rt = R(st ,XRt , ε
Rt )
=⇒
st = s[γ(st ,X
γt , ε
γt ),R(st ,X
Rt , ε
Rt ),X s
t , εst
]= T (st) ≡ s∗t
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt relief
Definition 3
The set of economically feasible st is defined as
JE = {st : γ(st ,Xγt , ε
γt ) > −1 ∧ R(st ,X
Rt , ε
Rt ) ≥ 0
∧ R(st ,XRt , ε
Rt ) > γ(st ,X
γt , ε
γt )}
Definition 4
s∗t is an economically feasible fixed point if s∗t ∈ JE
Definition 5
s∗t is a politically feasible fixed point if s∗t ∈ JP
Definition 6
s∗t is a feasible fixed point if s∗t ∈ JF = JE ∩ JP
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt relief
Definition 7
dt−1,t is x-sustainable if given the probability distributions for εit(i = s, γ,R), there are {s∗t }t ∈ JF s.t. IBC holds with probabilitymass not smaller than x
Definition 8
Suppose IBC holds with probability x ′ < x for d∗t . Then, theappropriate level of debt relief, ∆, must satisfy ∆ = d∗t − d∗
′t ,
where d∗′
t is the maximum value of d that satisfies x-sustainability
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A methodology for assessing the appropriate size ofrelief in sovereign debt restructuring:
An illustration of its applicability
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt reliefAn illustration: The case of constant fiscal surplus to GDP ratio
Commonly invoked object in practical episodes ofrestructuring: the debt-stabilizing constant fiscal surplus toGDP ratio
Suppose (IBC) is the relevant IBC
Suppose γt = γ, Rt,t+1 = R, both r.v. ex-ante
Let γn and Rn be any possible realization of γ and R=⇒
sn = d∗t
(Rn − γn
1 + γn
)
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt reliefAn illustration: The case of constant fiscal surplus to GDP ratio
Suppose
γn = α0 − α1sn
Rn = β0 − β1sn
αi and βi have discrete uniform distributions:α0 ∼ unif (0.02, 0.07) with pmf = 1/6; α1 ∼ unif (0, 1) withpmf = 1/11; β0 ∼ unif (0.03, 0.07) with pmf = 0.2;β1 ∼ unif (0, 101) with pmf = 1/101
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt reliefAn illustration: The case of constant fiscal surplus to GDP ratio
Under our distributional assumptions, N = 33, 330combination of states
Compute sn for each n, for d∗t ∈ [0.01, 1.8]
Multiple fixed points
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt reliefAn illustration: The case of constant fiscal surplus to GDP ratio
1 Eliminate dynamically inefficient combinations
2 Count scenarios where there is at least one economicallyfeasible fixed point
3 Political feasibility: supposeJP = {st ∈ (−1, 1) : γ(st ,X
γt , ε
γt ) ≥ 0.01}
4 Count scenarios where there is at least one politically feasiblefixed point
5 Compute ratio of relevant scenarios with feasible fixed point
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt reliefAn illustration: The case of constant fiscal surplus to GDP ratio
x-sustainability:
0
0.2
0.4
0.6
0.8
1
1.2
0.01
0.05
0.09
0.13
0.17
0.21
0.25
0.29
0.33
0.37
0.41
0.45
0.49
0.53
0.57
0.61
0.65
0.69
0.73
0.77
0.81
0.85
0.89
0.93
0.97
1.01
1.05
1.09
1.13
1.17
1.21
1.25
1.29
1.33
1.37
1.41
1.45
1.49
1.53
1.57
1.61
1.65
1.69
1.73
1.77
Fractio
n of states with
feasible fixed
points
Initial debt to GDP ratio
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt reliefAn illustration: The case of constant fiscal surplus to GDP ratio
Appropriate relief, x = 0.95
0
0.2
0.4
0.6
0.8
1
1.2
1.4
0.01
0.05
0.09
0.13
0.17
0.21
0.25
0.29
0.33
0.37
0.41
0.45
0.49
0.53
0.57
0.61
0.65
0.69
0.73
0.77
0.81
0.85
0.89
0.93
0.97
1.01
1.05
1.09
1.13
1.17
1.21
1.25
1.29
1.33
1.37
1.41
1.45
1.49
1.53
1.57
1.61
1.65
1.69
1.73
1.77
Approp
riate deb
t relief for x=
0.95
Initial debt to GDP ratio
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
A criterion for assessing the appropriate size of debt reliefDiscussion
Framework can be used for identifying the “optimal” fiscalplan from the perspective of debt relief
Framework can be used for designing GDP linked exchangebonds
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR
Conclusions
Need for clarifying what’s a sensible framework for assessinghow appropriate is a debt discount
Evidence that suggests presence of too little syndrome insovereign debt restructuring
Broad definition of concept of sustainability
Possible guide for practitioners
Framework could be the basis to codify the UN sustainabilityprinciple
Martin Guzman (Columbia-UBA), Domenico Lombardi (CIGI) Assessing the Appropriate Size of Relief in SDR