Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I...
-
date post
19-Dec-2015 -
Category
Documents
-
view
216 -
download
2
Transcript of Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I...
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Lecture 25: COUNTRY RISK
The portfolio-balance model can be very general (menu of assets).
• In Lecture 24, we considered a special case relevant especially to rich-country bonds: exchange risk is the only risk.
• What modifications are appropriate for developing country debt?
One lesson of portfolio diversification theory: A country borrowing too much drives up the expected rate of return it must pay. The supply of funds is not infinitely elastic.-- especially for developing countries.
The view from the South:
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
WesternAsset.com
Bpblogspot.com
↑ Spreads shot up in 1990s crises,• and fell to low levels in next decade.↓
Spreads rose again in Sept.2008 ↑ , • esp. on $-denominated debt • & in E.Europe.
World Bank
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
What determines spreads?
AmChamGuat
EMBI is correlated with risk perceptions:
The portfolio balance model can be applied to country risk
Demand for assets issued by various countries f:
x i, t = Ai + [ρV]i -1 Et (r ft+1 – r d
t+1) ;
Now the expected return Et (r ft+1) subtracts from i ft
the probability of default times loss in event of default.
Similarly, the variances & covariances factor in risks of loss through default.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
In developing countries:
• Domestic country is usually assumed to be a debtor, not a creditor.
• Debt to foreigners is often $-denominated => no exchange risk .
• Then, expected return = observed “spread” between
interest rate on the country’s loans or bonds and risk-free $ rate, minus expected loss through default -- instead of rp .
• Denominator for Debt : more relevant than world wealth is the country’s GDP or X . Why? Earnings determine ability to repay.
• Supply-of-lending-curve slopes up because when debt is large investors fear default & build a country risk premium into i.
• Default risk is a major part of the premium it must pay.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
• The spread may rise steeply when Debt/GDP is high.
Stiglitz: it may even bend backwards, due to rising risk of default.
b
iSupply of funds from
world investors
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Eichengreen & Mody (2000):
Spreads charged by banks on emerging market loans are significantly:
• reduced if the borrower generates more business for the bank, but
• increased if the country has:-- high total ratio of Debt/GDP,-- rescheduled in previous year-- high Debt Service / X, or
-- unstable exports; and
• reduced if it has: -- a good credit rating, -- high growth, or
-- high reserves/short-term debt
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Why don’t debtor countries default more often, given absence of an international enforcement mechanism?
1. Common answer: They want to preserve their creditworthiness, to borrow again in the future.Not a sustainable repeated-game equilibrium: Bulow-Rogoff (AER, 1989).
2. Cynical answer: Finance Ministers want to remain members in good standing of the international elite.
3. Best answer (probably): Defaulters may lose access to international banking system, including trade credit.Loss of credit disrupts production, even for export.
Theory: Eaton & Gersovitz (RES 1981, EER 86). Evidence: Rose (JDE, 2005).
Debt dynamics
Y
Debtb
dtdYY
Debt
Y
dtdDebt
dt
db/
/2
Y
dtdY
Y
Debt
Y
lDeficitTotalFisca /
bnY
iDebtitimaryDefic
Pr
where n nominal economic growth rate and d primary deficit / Y .
= d + i b - bn = d + (i - n) b. dt
db
=> Debt ratio explodes if d > 0 and i > n (≡ r > real growth rate) .
where Y ≡ nominal GDP
Copyright 2007 Jeffrey Frankel, unless otherwise noted
dt
db
Y
Debtb
Debt dynamics line shows the relationship between b and (i-n), for db/dt = 0. It slopes down.
= d + (i - n) b. where ,
n nominal growth rate, and d primary deficit / Y .
n1
ius
i
b
range of explosive debt
range of declining Debt/GDP ratio
0
Db/dt=0
Debt dynamics, with inelastic supply of funds
n1
ius
i
b0
Greece2011
Ireland2011
range of explosive debt
range of declining Debt/GDP
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Debt dynamics, continued
• It is best to keep b low to begin with,especially for “debt-intolerant countries.”
• Otherwise, it may be hard to keep db/dt < 0, if– i rises some time,
• due to either a rise in world i*, or• an increase in risk concerns;
– or n exogenously slows down.
• Now add the upward-sloping supply of funds curve.
• i includes a default premium, which depends in turn on db/dt.
Appendix: Debt dynamics graph, with possible unstable equilibrium
Y
Debtb
{
sovereignspread
Initial debt dynamics line
Supply of funds line
iUS
i
(1) Good times. Growth is strong. db/dt = 0, or if > 0 nobody minds. Default premium is small.
(2) Adverse shift. Say growth n slows down. Debt dynamics line shifts down, so the country suddenly falls in the range db/dt>0. => gradually moving rightward along the supply-of-lending curve.
(3) Adjustment. The government responds by a fiscal contraction, turning budget into a surplus (d<0). This shifts the debt dynamics line back up. If the shift is big enough, then once again db/dt=0.
(4) Repeat. What if there is a further adverse shift? E.g., a further growth slowdown (n↓) in response to the higher i & budget
surplus. => b starts to climb again. But by now we are into steep part of the supply-of-lending curve. There is now substantial fear of default => i rises sharply. The system could be unstable….
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
explosive debt path