Fiscal policy bond prices credit ratings and original sin
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Fiscal Policy, Bond Prices, Credit Ratings and Original Sin. Problems with fiscal policy. Precarious creditworthiness Pro-cyclical outcomes Electoral budget cycles Today, the first two. Market access is a problem for most EMs (LEI, Spread over US Treasuries). 1200. Current level. 1000.

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Fiscal Policy, Bond Prices, Credit Ratings and Original Sin

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Fiscal policy bond prices credit ratings and original sin

Fiscal Policy, Bond Prices, Credit Ratings and Original Sin


Problems with fiscal policy

Problems with fiscal policy

  • Precarious creditworthiness

  • Pro-cyclical outcomes

  • Electoral budget cycles

  • Today, the first two


Fiscal policy bond prices credit ratings and original sin

Market access is a problem for most EMs

(LEI, Spread over US Treasuries)

1200

Current level

1000

Pre-Argentine Crisis

800

Pre-Russian Crisis

600

Pre-Asian Crisis

400

776 pb

200

May-97

May-98

May-99

May-00

May-01

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Sep-97

Sep-98

Sep-99

Sep-00

Sep-01


In many countries public debt to gdp ratios look modest 2006

In many countries public debt to GDP ratios look modest (2006)

Maastricht

Criterion


60 out of 75 developing countries had public debts below the maastricht criteria in 2006

60 out of 75 developing countries had public debts below the Maastricht criteria in 2006


Fiscal policy bond prices credit ratings and original sin

Debt to GDP ratios look modest

Public debt/GDP

Ecuador

Honduras

Panamá

Belice

Bolivia

Perú

Argentina

Chile

Venezuela

T&T

México

Costa Rica

Uruguay

Colombia

El Salvador

Haití

Rep Dom

Guatemala

Paraguay

0

20

40

60

80

100

120

140


Why do good ratios not get good ratings

Why do good ratios not get good ratings?


Start with the popular ratio

Start with the popular ratio


The weak relationship between debt gdp and credit ratings

The Weak Relationship Between Debt/GDP and Credit Ratings

NOR

JPN

GBR

AUT

DEU

USA

19

SWE

DNK

CAN

BEL

AUS

ESP

FIN

ITA

PRT

CYP

ISL

SVN

rating foreign currency

CZE

ISR

EST

CHN

GRC

LVA

HUN

TUN

POL

TTO

PAN

IND

MEX

CRI

ARG

MAR

DOM

BRA

JOR

PRY

TUR

PAK

5

-.291965

1.13803

net_debt/gdp


Consider the smaller tax base the debt to tax ratio

…consider the smaller tax base:the debt to tax ratio


Debt to tax ratios do remarkably poorly as predictors of ratings

Debt to tax ratios do remarkably poorly as predictors of ratings

NOR

LUX

CHE

AUT

GBR

DEU

USA

19

SGP

SWE

DNK

CAN

BEL

AUS

ESP

ITA

FIN

CYP

ISL

MLT

SVN

CZE

KOR

CHL

ISR

THA

credit rating 1992-99 average

EST

CHN

LVA

GRC

TUN

POL

HUN

COL

SVK

PAN

ZAF

IND

MEX

SLV

IDN

CRI

ARG

PER

MAR

TUR

KAZ

DOM

BOL

JOR

BRA

PRY

MNG

5

-.579362

4.13906

DE_RE2


Consider higher interest rates the debt service to revenue ratio

…consider higher interest rates:the debt service to revenue ratio


Debt service to revenue is much higher

Debt service to revenue is much higher


Poor countries seem to pay higher interest rates for their public debt

Poor countries seem to pay higher interest rates for their public debt


But where would the higher interest rates come from

…but where would the higher interest rates come from?

It must involve some risks


A model of fiscal risk

A model of fiscal risk

  • Markets are concerned with the solvency of the government. There is a maximum level of debt service that the government can absorb

  • But there is uncertainty over future flows


A graphical representation

…a graphical representation

Same expected value

Greater variance


A graphical representation1

A graphical representation

Bankrupt

_

x

Fragile

x

Sound

i

i*


The role of volatility

The role of volatility

_

x

Less variance

x

High variance

i

i*


The possibility of multipliers

The possibility of multipliers

  • High risk causes high interest rates

    • Fat tails raise the interest rate

  • High interest rates causes high risk

    • High interest rates increases the expected value of debt service

      BUT WHAT RISKS ARE WE TALKING ABOUT?


How about revenue volatility

How about revenue volatility?


Developing countries have more volatile gdps

Developing countries have more volatile GDPs

Table 1: Volatility of GDP Growth

(1980-1999)


Revenue volatility is higher

Revenue volatility is higher


A simulation

A simulation


And it could explain part of the problem

…and it could explain part of the problem

  • Impact of 1 standard deviation shock to revenues on the the debt service to tax ratio

    ShockImpact

  • OECD -5.0 0.3

  • LAC -8.0 1.7

    Its part of the problem, but only part.


The original sin hypothesis

The original sin hypothesis

  • Definition: You cannot borrow abroad in your own currency

  • …if in addition you do not have long-term fixed-debt markets in local currency

  • …you are condemned to choose between short term debt in pesos, or long term debt in dollars.

  • This makes debt service sensitive to the real exchange rate and the real interest rate


The impact of original sin

The impact of original sin

Volatility of real exchange rates

Volatility of real interest rates

Volatility of revenue


The risk in foreign currency debt

The risk in foreign currency debt

Table 1: Volatility of GDP Growth

(1980-1999)


What drives collapses in gdp

What drives collapses in $GDP?


What drives collapses in gdp1

What drives collapses in $GDP?


Fiscal policy bond prices credit ratings and original sin

Volatility of Real Exchange rate over 5-year periods

(Cross-Country Average Normalized to 1)

4.5

Industrialized countries

Developing countries

Nigeria

4

3.5

Bolivia

3

Romania

2.5

Zambia

Venezuela

Ecuador

China

Uruguay

Dominican Republic

2

Trinidad and Tobago

Burundi

Cote d'Ivoire

Indonesia

Argentina

Cameroon

Colombia

Saudi Arabia

Paraguay

Kuwait

Mexico

Chile

South Africa

Brazil

1.5

Bahrain

Pakistan

Peru

Malaysia

Portugal

United States

Singapore

Turkey

India

Hungary

New Zealand

Hong Kong, China

Fiji

United Kingdom

Tunisia

St.Vinc&Grenadines

Costa Rica

Philippines

Papua New Guinea

Thailand

1

Australia

Togo

Morocco

Gambia, The

Belize

Japan

Korea, Rep.

Finland

Belgium

Lesotho

St. Lucia

Spain

Italy

Iceland

Switzerland

Sweden

Bahamas, The

Germany

Malta

Cyprus

Greece

Taiwan

Netherlands

Canada

Denmark

France

Austria

Israel

Ireland

0.5

Norway

0


The real exchange rate is also more volatile at 5 year horizons

The real exchange rate is also more volatile at 5-year horizons


Real exchange rates are volatile and pro cyclical

Real exchange rates are volatile and pro-cyclical


And real interest rates are on a class by themselves

…and real interest rates are on a class by themselves


They move together in the wrong direction

They move together in the “wrong” direction


A simulation1

A simulation


Vive la petite difference

Vive la petite difference


Conclusion

Conclusion

  • Why do countries get into trouble at levels of debt that are manageable for other countries?

  • Because debt structure (original sin) makes real exchange rates and real interest rates matter for debt service

  • And these are very volatile and have the “wrong” cyclical properties, making debt service much riskier


Table 8 original sin and credit ratings

Table 8: Original sin and credit ratings

(1)

(2)

(3)

(4)

RATING1

RATING1

RATING1

RATING1

DE_GDP2

-

1.553

-

1.815

(1.91)*

(2.19)**

DE_RE2

-

0.599

-

0.665

(1.40)

(1.52)

LGDP_PC

3.189

3.051

2.884

2.76

4

(8.54)***

(7.59)***

(6.47)***

(5.68)***

OSIN3

-

3.429

-

3.324

-

4.883

-

4.435

(3.85)***

(3.49)***

(3.49)***

(3.11)***

Constant

-

12.369

-

11.059

-

8.751

-

7.889

(3.16)***

(2.60)**

(1.89)*

(1.57)

Observations

56

49

51

44

R

-

squared

0.82

0.81

0.81

0.80


Original sin world patterns

Original sin: world patterns


The global cross border portfolio

The global cross-border portfolio

(0.9857)

1

Debt

by

0.9

Currency

(0.8859)

0.8

Debt

by Country

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

United States

EUROLAND

Japan

U

.

K

Switzerland

Canada

Australia


Fiscal policy bond prices credit ratings and original sin

Total Debt issued by residents (99-01)

International

Organizations (7%)

Other Developed

(8%)

Developing

(8%)

Euroland

(33%)

Major Financial

Centers (45 %)

Total Debt issued in own currency (99-01)

Other Developed

(<2%)

Major Financial

Centers (61 %)

Euroland

(37%)


Graph 1 measures of original sin by country groupings

Graph1: Measures of original sin by country groupings

1

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

Financial Centers

Euroland

Other Developed

Developing

OSIN1

OSIN2

OSIN3


Original sin is highly persistent

Original sin is highly persistent

OSIN3 and Flandreau-Sussman classification circa 1850


Conclusions

Conclusions

  • Why are countries trapped in a pro-cyclical fiscal response in bad times?

  • Because in bad times they need to finance not just the decline in tax revenues but also the jump in debt service

  • This makes it harder to maintain spending and access to lenders


Policy ideas

Policy ideas

  • Targets on the overall deficit are not credible because governments cannot control debt service

    • Primary balances are more credible but may be less relevant

  • Reduction of the absolute level of debt or even the debt to GDP ratio may not be the most efficient way to achieve fiscal consolidation

    • Working on debt denomination may be more effective


Implications

Implications

  • Governments should target a risk-weighted debt level

    • Risk weights should depend on the volatility and cyclicality of its determinants

    • In the previous examples, short term domestic currency debt should get the highest weight. Followed by foreign currency debt


Implications1

Implications

  • A risk-weighted debt target should create incentives for countries to optimize the trade-off between cheaper and safer debt

    • A deficit target favors cheap, risky debt

  • Long-term fixed-rate domestic-currency debt is best but it is hard to develop

    • Bravo Mexico

  • Inflation-indexed, long-term, fixed-rate domestic debt are second best and are easier to develop

    • Chile dixit


Take away

Take-away

  • Working on debt structure may be a more efficient way of achieving fiscal consolidation

    • Virtuous circle

  • Inflation-indexed fixed-rate long-term domestic- currency debt may be a practical way to go

  • Target adjusted primary deficits

  • …and risk-weighted debt levels


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