Risk, Uncertainty, and Autonomy: Financial Market Constraints in Developing Countries
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Transcript of Risk, Uncertainty, and Autonomy: Financial Market Constraints in Developing Countries
Risk, Uncertainty, and Autonomy: Financial Market
Constraints in Developing Countries
Sarah Brooks & Layna MosleyOhio State University & University of North Carolina, Chapel
Hill
Prepared for the 1st meeting of the International Political Economy Society, Princeton University, Nov. 17-18, 2006
Political Risk
Exposure to the possibility that political events will adversely affect the profitability of an investment (Bailey & Chang 1995: 542)
Especially problematic for developing countries
Less transparent to foreign investors
Uncertainty / incomplete information are central to the problem of political risk
Previous Research Elections are a key source of political risk:
Uncertain outcomes Incentives for opportunistic behavior, policy
change Associated with turbulence in currency, bond
markets (Martinez & Santiso 2003; Reinhart 2002)
Both the outcome of the election and the possibility of policy discontinuity are considered sources of uncertainty (Jensen & Schmith 2005)
Uncertainty is said to be largely resolved following the election (Bernhard & Leblang 2002)
Political Risk v. Political Uncertainty Difference between risk and
uncertainty largely elided Knight (1957):
Risk can be quantified, measured Uncertainty is unmeasurable
Difference between risk and uncertainty has to do with the degree of knowledge about a situation Important implications for market
behavior, government autonomy
Risk and Uncertainty in International Bond MarketsSources of risk and uncertainty in
sovereign debt markets:1. Default risk
Ability to pay Willingness to pay
2. Currency risk (including inflation)
3. Policy Stability (long-run value of asset)
Risk and Uncertainty in International Bond Markets Information derived from institutional,
ideological factors, and past policy behavior Challengers to the incumbent often lack a
past policy record Elections thus increase uncertainty, even if
outcome is predictable Information frictions: little incentive to
become fully informed (Calvo & Mendoza 2000)
Risk and Uncertainty in International Bond Markets Investors can and do acquire information to
reduce uncertainty about candidates, new incumbents
Partisan cues
Assimilate candidates into a group of similar situations for which probability of default can be calculated
Left/Right partisan archetypes Right more committed to fiscal probity, willing to
honor debt commitments Left more likely to inflate economy, default
Risk and Uncertainty in International Bond Markets Since 1990s, these archetypes have been
less valid Left governments adopting orthodox liberal
policies “Nixon in China”: e.g., Menem, Fujimori
Not universal: e.g., Kirschner, Morales, Chávez
Partisan cues – for the Left – thus are ambiguous
Elections do not fully resolve uncertainty about Left candidates’ willingness to honor sovereign debt commitments
Observable Implications
1. Bond markets should respond more negatively to Left candidates and new presidents than to those on the Right, all else being equal.
2. Time in office (opportunity to gain information about type) should reduce market premium for Left governments, but should not change assessments for the Right, all else being equal.
Empirical Analysis: Dependent Variable Sovereign risk is captured through
spreads:spreads:
Difference between yield on government bond and benchmark ‘risk-free’ U.S. Treasury bond Higher spreads indicate negative market sentiment
about a country’s economic and political risk (Eichengreen & Mody 1998)
J.P. Morgan’s EMBI Global Index Foreign currency denominated debt instruments:
isolates default risk; no currency risk 33 ‘emerging market’ countries 1993-2004
Empirical Analysis: Independent Variables Partisanship of Executive Years in Office Partisanship * Years in Office
Empirical Analysis: Controls Political Controls
Divided Government Democracy Presidential Election Year
Creditworthiness Indicators Inflation (ln) External balance Debt/GDP Ratio Debt Service/Export Ratio
Macroeconomic Controls GDP (ln) Growth (% per capita) Trade exposure
Empirical Model
ΔS = β0St-1 + β1Partisanship + β2YrsOffice + β3Partisan* YrsOffice + β4 Divided Govt + β5Democracy + β6Election Year + β[Creditworthiness] + β[Macroeconomy] + β7Time
Random effects cross-sectional, time-series estimation
Temporal dependence: AR-1 Cross-sectional correlation: PCSE
Political Variables
Left Executive 142.372** 205.658** 218.025***
(66.655) (84.432) (87.070)
Years in Office -4.935 -3.354 -4.430
(3.811) (3.764) (3.484)
Left Executive * Years Office - -13.630* -15.705*
(7.955) (8.766)
Majority -130.655* -134.859* -133.283*
(72.792) (71.981) (72.852)
Presidential Election Year - - 97.428
(90.374)
Democracy -8.006* -8.827* -10.610***
(4.698) (4.621) (4.128)
Creditworthiness
External Balance 4.825 4.659 5.249
(5.677) (5.688) (5.889)
Inflation (Ln) -11.847 -15.003 -17.801
(19.354) (19.469) (18.991)
Debt: GDP 919.580*** 970.53*** 971.356***
(272.468) (280.069) (279.721)
GDP Growth -6.437*** -6.321*** -6.505***
(1.974) (1.994) (1.871)
Debt Service: Exports -2.894 -3.086 -3.072
(1.946) (2.064) (2.002)
Macroeconomy
GDP (ln) 15.482 21.305 23.124
(33.243) (33.450) (33.248)
Trade -2.177** -2.312** -2.275**
(1.1133) (1.130) (1.097)
Year -7.740 -6.680 -5.915
(16.178) (16.241) (16.071)
Constant -85.046 -239.949 -288.483
(855.098) (862.632) (857.938)
rho 0.02 0.029 0.041
Observations (N) 193 193 193
R-squared 0.316 0.32 0.328
Case Study: Brazil
2002 Presidential election Front-runner: Luiz Inácio Lula da Silva
(“Lula”) Left-wing Worker’s Party Earlier rhetoric of debt restructuring Recent Argentine default Risk of policy discontinuity Previous elections followed by costly devaluation
Market response: Wall Street firms paid close attention to
domestic polls Spreads jumped sharply
Case Study: Brazil 2002Brazil and Emerging Market Indices, 2001-2003
0
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1000
1500
2000
2500
Brazil Composite
Case Study: Brazil 2002
Market response unlikely to be due solely to changes in fundamentals or risk aversion
1. Debt, although rising, was considered manageable (Martinez & Santiso 2003: 371)
2. Brazil spreads diverged from EMBI Global Composite Index
Composite reflects broader risk appetite for emerging market debt
Case Study: Brazil 2002
Index Differentials and Inflation
-2000
200400600800
100012001400
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
EM
BI In
dex
02468101214161820
% a
nnua
l cha
nge
in C
PI
Brazil-Composite Inflation
Case Study: Brazil 2002
Brazil, 2002 Spreads
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4/15
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4/29
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/20
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02
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2002
9/16
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10/14
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02
10/28
/20
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0.75
0.8
0.85
0.9
0.95
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1.05
Entropy Brazil minus Composite
Case Study: Brazil 2002
Brazil, 2002 Spreads
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800
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1200
1400
4/15
/20
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4/29
/20
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5/13
/20
02
5/27
/20
02
6/10
/20
02
6/24
/20
02
7/8/
2002
7/22
/20
02
8/5/
2002
8/19
/20
02
9/2/
2002
9/16
/20
02
9/30
/20
02
10/14
/20
02
10/28
/20
02
0
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10
15
20
25
30
35
Lula vs.Closest Rival Brazil minus Composite
Case Study: Brazil 2002
Efforts during the campaign to win confidence
All three candidates signed a Letter of Intent with IMF
Funds to be dispersed after the election
Lula’s “Letter to the Brazilian People”
Pledged to respect existing agreements with international institutions, companies
Laid out reform agenda
Case Study: Brazil Lula in office: Confidence-enhancing
measures Maintained, deepened policies of previous
government Wall Street executive Henrique Meireles named
President of the Central Bank Increased the autonomy of the Central Bank Reforms of social security, tax systems Primary surplus above IMF target
Market response: Sharp decline in spreads Currency and domestic stock market recovered
Case Study: Brazil 2002-2006
EMBI Indices, Blended Spreads, 2001-2006
-200
0
200
400
600
800
1000
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1400
1/1/
2001
5/1/
2001
9/1/
2001
1/1/
2002
5/1/
2002
9/1/
2002
1/1/
2003
5/1/
2003
9/1/
2003
1/1/
2004
5/1/
2004
9/1/
2004
1/1/
2005
5/1/
2005
9/1/
2005
1/1/
2006
5/1/
2006
9/1/
2006
Brazil minus Composite
Case Study: Brazil 2006 2006 Election Campaign
Lula once again front-runner Favorable global conditions Net government debt lower, dollar exposure
diminished Strong currency (appreciated 53% since Lula
took office) Low growth, string of high-profile scandals Scandals led to resignation of nearly all cabinet
ministers, top leaders of Lula’s Workers’ Party Market response was sanguine
Case Study: Brazil 2006Brazil and Emerging Market Indices, 2005-2006
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400
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Brazil Composite
Case Study: Brazil 2006Public Opinion Polls and Spreads,
2005-2006
0
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40
60
80
100
120
-10
-5
0
5
10
15
20
25
30
35
Lula minus Closest Rival (Alckmin/ Serra) Brazil minus Composite
Conclusions Market learning extends beyond the
government formation period Especially for developing countries, left
governments. Partisanship matters
Left governments, all else equal, represent higher risk of default.
Left partisan signal is more ambiguous: thus Left governments also generate greater uncertainty.
Policy uncertainty, however, is resolved as Left executives govern, so that investment risk declines as time in office increases.