Sovereign Debtors in DistressSovereign Debtors in Distress-- Who is Vulnerable?-- Who is Vulnerable?

Jeffrey FrankelJeffrey Frankel

Waterloo, Ontario, Canada, Feb. 24-26, Waterloo, Ontario, Canada, Feb. 24-26, 20122012

(1) Vulnerability to Sovereign Debt Crises(1) Vulnerability to Sovereign Debt Crises

Vulnerability is high now.Vulnerability is high now. My guess: Greece will make it past March 20,My guess: Greece will make it past March 20,

with usual 3-part formula of bail-out + conditionality + PSIwith usual 3-part formula of bail-out + conditionality + PSI ;; but then will default within a year.but then will default within a year.

Greece cannot get back to a sustainable debt path Greece cannot get back to a sustainable debt path by austerity, as has been clear for awhile.by austerity, as has been clear for awhile.

When it succeeds in eliminating its primary budget deficit, When it succeeds in eliminating its primary budget deficit, it will have no more incentive to keep servicing debt.it will have no more incentive to keep servicing debt.

Risk of contagion is highRisk of contagion is high not just to rest of periphery, but rest of euro;not just to rest of periphery, but rest of euro; and rest of world.and rest of world.

Country creditworthiness is now inter-shuffledCountry creditworthiness is now inter-shuffled““Advanced” countries Advanced” countries (Formerly) “Developing” countries(Formerly) “Developing” countries

AAA Germany, UKAAA Germany, UK SingaporeSingapore

AA+ AA+ US, FranceUS, France

AA AA BelgiumBelgium ChileChile

AA-AA- JapanJapan ChinaChina

A+A+ KoreaKorea

AA SpainSpain Malaysia, South AfricaMalaysia, South Africa

A-A- Brazil, Thailand, BotswanaBrazil, Thailand, Botswana

BBB+BBB+ ItalyItaly ColombiaColombia

BBB-BBB- Iceland, IrelandIceland, Ireland IndiaIndia

BB+BB+ Indonesia, PhilippinesIndonesia, Philippines

BBBB PortugalPortugal Costa Rica, JordanCosta Rica, Jordan

BB Burkina FasoBurkina Faso

CCCC GreeceGreece

S&P ratings, Feb.2012 domestic currency

(2) What(2) What Determines CountryDetermines Country Vulnerability?Vulnerability?

Fundamentally: Quality of institutions.Fundamentally: Quality of institutions. This does not mean “tough” rules – This does not mean “tough” rules –

like SGP, debt ceiling or BBA – which lack enforceability.like SGP, debt ceiling or BBA – which lack enforceability.

Better would be structural budget targets (Swiss) Better would be structural budget targets (Swiss) with forecasts from independent experts (Chile).with forecasts from independent experts (Chile).

One third of developing countries since 2000 have One third of developing countries since 2000 have graduated from pro-cyclical spending to countercyclical,graduated from pro-cyclical spending to countercyclical,

even while US, UK & euro countries have forgotten even while US, UK & euro countries have forgotten how to run countercyclical fiscal policy,how to run countercyclical fiscal policy,

and instead enact fiscal expansion in booms and instead enact fiscal expansion in booms & contraction after recessions.& contraction after recessions.

Correlations between Govt. Spending & GDP1960-1999

pro

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G always used to be pro-cyclical for most developing countries.

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Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”

Pro-cyclical spending

Counter-cyclical spending

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In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (2011)

pro

cyc

lica

lcou

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Correlations between Govt. Spending & GDP2000-2009

(3) It’s not so much the (3) It’s not so much the levellevel of debt/GDP that mattersof debt/GDP that matters

as the risk of getting stuck on an explosive as the risk of getting stuck on an explosive path, path, with ever-rising debt/GDPwith ever-rising debt/GDP because of high primary deficit or interest rates because of high primary deficit or interest rates

(or low growth), or risk of a sudden deterioration.(or low growth), or risk of a sudden deterioration.

Early Warning indicators:Early Warning indicators: compositioncomposition of capital inflows of capital inflows

Fx-denominated, ST, bank loans vs. Fx-denominated, ST, bank loans vs. FDI, equity & contracts with automatic adjustment FDI, equity & contracts with automatic adjustment provisions.provisions.

Plus real currency overvaluation, fx reserves Plus real currency overvaluation, fx reserves (for (for peggers)…peggers)…

Fiscal capacity.Fiscal capacity.