Lecture 23 assumption:exchange risk is the only important

risk.

Lecture 24 assumption: default risk is important.

Portfolio Balance

Recap of L23 • Questions

– How can we allow for effects of risk?• Currency risk.• Country risk.

– How can we allow for effects of debt even if it is not monetized?• Effects of budget deficits &• current account deficits

• Key parameters– Risk-aversion, ρ– Variance of returns, V– Covariances among returns, Cov.

Professor Jeffrey Frankel, Harvard University

Lecture 24: Country Risk

The portfolio-balance model can be very general (menu of assets).

• In Lecture 23, 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:

Professor Jeffrey Frankel, Kennedy School, 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

EM sovereign spreads

What determines spreads?

Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, March 2011

EMBI is correlated with risk perceptions

“risk on”

risk off

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.When perceptions of risk are high, sovereign spreads must be highfor investors to absorb given supplies of debt, and vice versa.

API-120 - Macroeconomic Policy Analysis I , Professor Jeffrey Frankel,, Harvard University

In developing countries:

• Domestic country is usually assumed to be a debtor, not a creditor.

• Debt to foreigners was usually $-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: when debt is large investors fear default & build a country risk premium into i.

• It must pay a premium as compensation for default risk.

Professor Jeffrey Frankel, Kennedy School, Harvard University

• The spread may rise steeply when Debt/GDP is high.

b

iSupply of funds from

world investors

≡ Debt/GDP

Stiglitz: it may even bend backwards, due to rising risk of default.

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

API-120 - Professor Jeffrey Frankel, Harvard Kennedy School

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).Defaulters seem to return to the market before long:

Eichengreen (1987), Arellano (2009).

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 (or r > real growth rate).

where Y ≡ nominal GDP

Definition of sustainability: a steady or falling debt/GDP ratio

Copyright Jeffrey Frankel

dt

dbY

Debtb = 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 line shows the relationship between b and (i-n), for db/dt = 0.

Even with a primary surplus (d<0), if i is high (relative to n), then b is on explosive path.

Debt dynamics, continued

• It is best to keep b low to begin with,especially for “debt-intolerant countries.”

• Otherwise, it may be hard to stay on the stable path • if

– i rises suddenly,• due to either a rise in world i* (e.g., 1982, 2014?), or• an increase in risk concerns (e.g., 2008);

– or n exogenously slows down.

• Now add the upward-sloping supply of funds curve.• i includes a default premium,

which probably depends in turn on db/dt.

• => It may be difficult or impossible to escape the unstable path– without default, write-down, or restructuring of the debt,– or else inflating it away,

• if you are lucky enough to have borrowed in your own currency.

Debt dynamics, with inelastic supply of funds

n1

ius

i

b0

Greece2012

Ireland2012

range of explosive debt

range of declining Debt/GDP

Professor Jeffrey Frankel, Kennedy School, Harvard University

explosive debt path

Appendix 1: 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….

• 1) Since the crisis of the euro periphery began in Greece in 2010, we have become aware that “advanced” countries also have sovereign default risk.

• 2) Since 2000, Emerging Market Countries have increasingly been able to borrow in their own currencies, so their debt carries currency risk (not just default risk).

Appendix 2: The blurring of lines between debt of advanced countries and developing countries

1) Country creditworthiness is now inter-shuffled

“Advanced” countries (Formerly) “Developing” countriesAAA Germany, UK Singapore, Hong KongAA+ US, FranceAA Belgium ChileAA- Japan ChinaA+ KoreaA Malaysia, South AfricaA- Brazil, Thailand, BotswanaBBB+ Ireland, Italy, Spain BBB- Iceland Colombia, IndiaBB+ Indonesia, PhilippinesBB Portugal Costa Rica, JordanB Burkina FasoSD Greece

S&P ratings, Feb.2012 updated 8/2012

21

Spreads for Italy, Greece, & other Mediterranean membersof € were near zero, from 2001 until 2008

and then shot up in 2010

Market Nighshift Nov. 16, 2011

2) The end of Original Sin:After 2000, Emerging Markets successfully issued more debt

in their own local currencies (LC), instead of $-denominated (FC).

Fig. 2 from Jesse Schreger & Wenxin Du“Local Currency Sovereign Risk,” HU, March 2013

Turkey is able to borrow in local currency (lira),but has to pay a high currency premium to do so.

{Pure default risk premium on lira debt {

Total premium on Turkey’s lira debt over US treasuries

Fig. 5 from Schreger & Du, “Local Currency Sovereign Risk,” HU, March 2013