Debt and Debt Crises

Ugo Panizza
UNCTAD

There are my own views

 The standard view
• Facts
– Countries get into debt problems because of
lax fiscal policies
– Countries have an incentive to default on their
external debt obligations
• Policies
– Debt crises should always be followed by a
fiscal retrenchment
– We need to implement policies that reduce a
country's incentive to default
 Background
• U. Panizza, F. Sturzenegger, and J. Zettelmeyer (2009)
"The Economics and Law of Sovereign Debt and
Sovereign Default" Journal of Economic Literature
• B. Eichengreen, R. Hausmann, and U. Panizza (2003)
“The Pain of Original Sin” University of Chicago Press
• E. Borensztein, and U. Panizza (2009)"The Costs of
Sovereign Default" IMF Staff Papers
• E. Levy Yeyati and U. Panizza (2010) "The Elusive Cost
of Sovereign Default," Journal of Development
Economics
• E. Borensztein, E. Levy Yeyati, and U. Panizza (2006)
Living with Debt, Harvard University Press and IDB
• C. Campos, D. Jaimovich, and U. Panizza (2006) “The
Unexplained Part of Public Debt,” Emerging Markets
Review
 Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
 How Debt Grows?
• The economics 101 debt accumulation equation
states that:
– CHANGE IN DEBT = DEFICIT
• Practitioners use:
– CHANGE IN DEBT = DEFICIT+SF
– SF=Stock-flow reconciliation, or the unexplained part
of public debt
• The stock-flow reconciliation is often considered
a residual entity of small importance
• Is it?
If we estimate: Di ,t   i  d i ,t   i ,t
We expect: and R2 to be close to 1 and = 0
R-Squared
0.55
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
All SSA LAC SAS EAP MNA ECA IND
Countries
Source: Campos, Jaimovich and Panizza (2006)
 The Unexplained Part of Public
Debt

6
Stock-flow reconciliation

5
% of GDP

0
IND MNA EAP ECA LAC SSA

Source: Campos, Jaimovich and Panizza (2006)

 The Unexplained Part of Public
Debt
• The growth rate of the debt-to-GDP ratio is
equal to:
– Primary deficit/GDP + interest payments/GDP+
– GDP growth – inflation
• The last two variables are multiplied by the debt-to-
GDP ratio
• If you like math:
 D  Dt Dt 1 PDt Dt 1 Dt 1 SFt
     i  (g   ) 
 Y  Yt Yt 1 Yt Yt Yt Yt
 The Unexplained Part of Public
Debt
15

10

5
INFLATION
GDP GROWTH
0 UNEXPLAINED PART
INTEREST EXPENDITURE
PRIMARY DEFICIT
-5

-10

-15
IND SAS CAR EAP ECA MNA LAC SSA

Source: Campos, Jaimovich and Panizza (2006)

 The Unexplained Part of Public
Debt

• What explains the “Unexplained” part of

debt
– Skeletons
• Fiscal policy matters!
• Transparent fiscal accounts are important
– Banking Crises
– Balance Sheet Effects due to debt
composition
Much more about this in a while
 The Unexplained Part of Public
Debt

• There are also things that we can explain

but may not have anything to do with fiscal
policy
– Output collapses
– Sudden jumps in borrowing costs
– Natural disasters
 Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
 Why is sovereign debt special?
• Creditor rights are not as well defined for
sovereign debt as is the case for private debts.
• If a private firm becomes insolvent, creditors
have a claim on the company’s assets.
• In the case of a sovereign debt, in contrast, the
legal recourse available to creditors has limited
applicability and uncertain effectiveness.
– Sovereign immunity
– Little to attach
• So, why do countries repay and why do lenders
lend?
Theory
The Economic Theory of Sovereign
Debt
• The literature started with (and it's still tied to) an
influential theoretical paper by Eaton and Gersovitz
(Review of Economic Studies, 1981)
• The story of the paper was:
– Countries borrow in bad times (low economic growth) and repay
in good times (high economic growth)
– Since there are no repayments in bad times, there cannot be
defaults either
– As a consequence, defaults can only happen in good times
– Defaults are thus strategic (countries can pay but they decide
not to pay)
– The only reason that prevents countries from defaulting is that
defaults are costly
The Economic Theory of Sovereign
Debt
• So, what are the costs of default?
– The traditional economic literature has
emphasized
– Reputational costs
• Countries that default will no longer be able to
access the international capital market
– Trade costs
• Default will lead to sanctions which, in turn, will
have a negative effect on trade
From the theory to the
data
Do countries borrow in bad
times?
 What do the data say?
4.5
4.0
Net private transfer to the
sovereing as a % of GDP 3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5 Good times
-1.0
-1.5 Bad times
-2.0
-2.5
-3.0
-3.5
-4.0
-4.5
Private Official Total
Flows Flows Flows
• Government external borrowing is procyclical and not countercyclical
(probably because countries borrow when they can)

• This confirms the idea that the seeds of debt crises are
planted during good times
Do countries default in good
times?
 What do the data say?
Default Happen in Waves….
• 1824-1840. 19 events (14 in Latin America: recent
independence, civil wars). Long restructuring periods
• 1840-1860. 6 events. Credit boom
• 1861-1920. 58 events. Much faster restructuring
• 1921-1940. 39 events. Great Depression and WWII.
• 1941-1970. 6 events (but little lending)
• 1971-1981. 15 events. Boom in syndicated bank loans
• 1982-1990. 70 events. The “Debt Crisis”
• 1991-2004. 40 events. Lending booms and Sudden Stops
…and they are often linked to bad external financial
conditions
Do defaulter pay a high cost?
 What do the data say?
700

600
Sovereing Spread
(basis points)
500

400

300

200

100

-100

1 2 3 4
Years after the default episode

• 3 years after the resolution of a default episode, there is no statistically

significant difference between the spreads paid by defaulters and non defaulters
• We find similar results if we look at access
• Global factors (risk aversion and US interest rate) appear to be more
important than default history
 What do the data say?
• There is some evidence that defaults have
a negative effect on trade
• But this is still controversial and the
channel is not clear
– No evidence that defaults have a direct
impact on trade credit
– No evidence (at least in recent years) of
explicit sanctions
 What do the data say?
• Anyway, who cares?
– We do know that defaults are bad because they lead
to deep recessions
• Econometric estimates found that, on average, default
episodes are associated with a 2 percentage points drop in
GDP growth
• But do we really know what we think we know?
– Are default episodes bad for growth or is it low growth
that causes default?
– That is, do defaults happen in bad times?
 What do the data say?
• Causality is always very hard to assess
• But, if we look at high frequency data, we
find that:
– Growth collapses anticipate defaults
– Default episodes are often followed by a rapid
rebound of the economy
 What do the data say?
115

110

105

100

95

90

85
-12 -8 -4 0 4 8 12
Event time
Do countries default too early or too
late?
• Hell, the last thing I should be doing is tell a
country we should give up our claims. But there
comes a time when you have to face reality.
– Unnamed financial industry official. Both are taken
(Source: Bluestein, 2005, p 163)
• The problem historically has not been that
countries have been too eager to renege on their
financial obligations, but often too reluctant.
– Memo prepared by the Central Banks of England and
Canada (Source: Bluestein, 2005, p 102)
 Political costs of default
• There is a (small) literature of political costs of currency
devaluations (Cooper 1971).
• Frankel (2005) finds that a devaluation increases turnover of
finance ministers from 36 to 58 percent.
– Applying Frankel’s approach, bond defaults increase minister turnover
from 19 to 40 percent. But bank defaults increase it only to 24 percent.
– Governments lose votes after defaults
• The high political cost of default may affect the timing of the
decision by the government. It could cause “gambles for
redemption”
– Mickey Mouse model (Borensztein and Panizza, 2009)
Summing up: Theory versus Reality
• Theory
– Countries get into trouble because of lax fiscal policy
– Countries borrow in bad times
– If ever, countries default in good times (strategic defaults)
• So, if anything, they default too much
– Defaults are very bad for the economy, with long lasting negative
consequences
• Reality
– Many debt explosions have nothing to do with fiscal policy
– Countries borrow in good times
– Countries default in bad times (justified defaults)
• And sometimes too late
– Defaults do not seem to have long lasting negative
consequences
 Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
 Prudent Fiscal Policy
• Control the flow of debt
– Only borrow when the social return is higher than
the opportunity cost of funds
– This requires strengthening fiscal policies and
institutions
• Fiscal rules
• Budget institutions
– Hierarchical rules
– Transparency Rules
– Like motherhood and apple pie, this is always
good, but it may not be enough
 Avoid disasters in the banking
sector
• It is mostly about preventing lending
booms (Borio, Reinhart, Rogoff)
But low debt can’t buy
you love
 Low debt is not enough
Public Debt and Sovereign Rating (1995-2005)

Germany United Kingdom

Standard & Poor's Sovereign Rating

Switzerland France Austria

AAA Norway
Australia United States Spain Finland
CanadaDenmark
Luxembourg New Zealand Ireland Belgium
Portugal Italy Japan
Netherlands Sweden
AA- Iceland Cyprus

Malta Saudi Arabia

Botswana
Chile
Czech Republic Slovenia Israel
Korea, Rep.
A- Qatar
Estonia
Latvia BahrainBahamas Malaysia Barbados Investment grade
Thailand
China Poland Hungary
Oman Tunisia
Slovak Republic TrinidadSouth
and Tobago
Africa Egypt, Arab Rep.
BBB- Lithuania
Mexico El Salvador Croatia Panama
Colombia
Kazakhstan PeruUruguay India Morocco
Costa Rica
Guatemala Philippines
BB- Bulgaria
Brazil Senegal Jordan
Russian Federation Bolivia Mongolia
Ukraine Belize
Paraguay Benin Papua New Guinea
Grenada Ghana Jamaica
Turkey Venezuela, RB Indonesia Argentina Pakistan
B-

Ecuador

0 10 20 30 40 50 60 70 80 90 100 110

Public Debt as Percent of GDP

Source : Jaimovich and Panizza (2006) and Standard and Poor's
 Low debt is not enough

Source: De Grauwe (2011)

 Low debt is not enough

Source: De Grauwe (2011)

A tale of two countries
 The importance of debt structure
• Debt denominated in foreign currency or
short-maturity debt is associated with:
– Lower Credit Ratings
– Sudden Stops
– Higher volatility
– Limited ability of conducting monetary policy
– Contractionary devaluations
• An appropriate debt structure can reduce
risk
 How to make debt safer
• New and safer instruments
– Local currency
– Contingent debt instruments
• GDP index bonds
• Commodity linked bonds
• Catastrophe bonds
• Dedollarize official lending
 Why do we need official
intervention?
• Market failures
– Critical mass
– Standards
– Instruments cannot be patented
• Political economy
– Shortsighted politicians may underinsure
 Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
 Fiscal consolidation?
• The instinctive response to a debt crisis is
(almost) always: we need a fiscal adjustment
• This does not make much sense if the debt crisis
is not rooted in fiscal problems
• In fact, it may hurt.
• Not only in the short-run, but also in the long-
run:
– Recessions lead to a permanent output loss (Cerra
and Saxena, 2008)
– The adjustment variable is public investment
(Easterly, Irwin, Serven, 2008; Martner and Tromben,
2005)
 The adjustment variable is
public investment

Source: Martner and Tromben (2005)

…and this is very bad for growth,
and for the fiscal adjustment
When growth-promoting spending is cut
so much that the present value of future
government revenues falls by more than
the immediate improvement in the cash
deficit, fiscal adjustment becomes like
walking up the down escalator.
(Easterly, Irwin, Serven, 2008)
 What can the international
community do?
• Don’t ask for fiscal contractions if fiscal
profligacy was not the problem
• If a fiscal contractions is needed, don’t frontload it
(Blanchard and Cottarelli, 2010)
• Think about fiscal targets that protect
investment (Blanchard and Giavazzi,
2004, Buiter, 198?)
• Also think about the quality of public investment
(Pritchett, 2000, Dabla-Norris et al., 2011,)
 When is a fiscal contraction
needed?
• Think hard about the math
d=-ps+(i-g)d
– Multiple equilibria (high i and low i)
– The international community can help
(especially when the global i is very low)
– Don’t lend at punitive interest rates
• Bagehot was right for banking crises, but he might
be wrong for sovereign debt crises
– Moral hazard is often overstated (Meltzer versus
Krugman)
 Outline
• Facts
– How debt grows
– When do countries borrow and default
• Policies
– Avoiding debt explosions
– What to do during debt crises
– How to deal with defaults
 From earlier this morning
• Theory
– Countries borrow in bad times
– If ever, countries default in good times (strategic
defaults)
• So, if anything, they default too much
– Defaults are very bad for the economy, with long
lasting negative consequences
• Reality
– Countries borrow in good times
– Countries default in bad times (justified defaults)
• And sometimes too late
– Defaults do not seem to have long lasting negative
consequences
 To default or not to default?
• Let me start by saying that I am not (I repeat
NOT) suggesting that countries should default
more often
• But I want to ask, why is there this disconnect
between theory and reality?
• The theory might be wrong
• Or, they may be a problem with the world
• My hunch is that this is due to a mix of political
failure and a lousy international financial
architecture
 Is the world wrong?
• In a well working system, countries should be
able to borrow when they need funds (i.e., in bad
times)
– But during bad times, the international capital markets
are not willing to provide credit at a reasonable
interest rate
– Therefore, countries borrow in good times because
this is when they have access to credit
• Same reason why Willie Sutton robbed banks
– Unfortunately, sometimes they borrow too much in
good times and this behavior sows the seeds of future
crises
• We need to fix the political economy of debt
– The real reason why Willie Sutton robbed banks
 Strategic or justified?
• Most of the defaults we observe are
justified (or unavoidable, at least ex-post)
episodes
• Strategic defaults are very very very rare
– So, we cannot use econometric methods to
assess the cost of these very rare events
– What we are actually assessing is the cost of
non-strategic defaults
• But why are they rare?
• Probably because they are costly
• But what is the cost?
 The current system is inefficient:
It brings some pain…
Length of Debt-Restructuring Delays

10

6
Years
4

0
Low income Low middle income Upper middle income
(n=26) (n=31) (n=31)
Source: Wright (2010)
 …but little gain
Change in Indebtedness to Private Creditors following Debt Restructuring

1.5
Ratio of
Debt/GNI 1
Post-Default to
Pre-Default
0.5

0
Low income Low middle income Upper middle
(n=20) (n=26) income (n=31)

Source: Wright (2010)

Is this inefficient system efficient?
• Some pain and no gain might be inefficient ex-
post, but could be efficient ex-ante
• High costs of defaults are necessary to create
willingness to pay, establish credibility, and
lower borrowing cost
– Dooley (2000), Shleifer (2003)
• This is why countries suboptimally delay default
• This is why some borrowing countries are
opposed to the creation of a mechanism that
may eliminate these inefficiencies
 From second best to first best
• This is clearly a second best solution
– Countries suffer
– They destroy value and decrease recovery
rates
 From second best to first best
• An alternative story
– The international community and financial markets
implicitly forgive countries that default out of necessity
but would impose a harsh punishment on countries
that default strategically (Grossman and van Huyk,
AER 1988)
– If this is the case, policymakers need to signal that the
default is indeed unavoidable and not strategic
– A way of doing this is to go through considerable pain
in order to delay the default as long as possible
• Also second best, but in this case there is a
solution
 From second best to first best
• Solution:
– The first best could be achieved with the
creation of a body with the ability to assess
whether a default was indeed unavoidable
• A bankruptcy court for sovereigns
• By increasing potential recovery rates, it could be
efficient both ex-ante and ex-post
• Everybody (lenders and borrowers) is better off
Debt and Debt Crises

Ugo Panizza
UNCTAD

There are my own views