Risk, Uncertainty, and Autonomy: Financial Market Constraints in Developing Countries

1. Risk, Uncertainty, and Autonomy: Financial Market Constraints in Developing Countries Sarah Brooks & Layna Mosley Ohio 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

2. 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

3. 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)

4. 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

5. Risk and Uncertainty in International Bond Markets Sources of risk and uncertainty in sovereign debt markets: • Default risk • Ability to pay • Willingness to pay • Currency risk(including inflation) • Policy Stability (long-run value of asset)

6. 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)

7. 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

8. 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

9. Observable Implications • Bond markets should respond more negatively to Left candidates and new presidents than to those on the Right, all else being equal. • 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.

10. Empirical Analysis: Dependent Variable • Sovereign risk is captured through 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

11. Empirical Analysis: Independent Variables • Partisanship of Executive • Years in Office • Partisanship * Years in Office

12. 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

13. 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

17. 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

18. Case Study: Brazil 2002

19. Case Study: Brazil 2002 • Market response unlikely to be due solely to changes in fundamentals or risk aversion • Debt, although rising, was considered manageable (Martinez & Santiso 2003: 371) • Brazil spreads diverged from EMBI Global Composite Index • Composite reflects broader risk appetite for emerging market debt

20. Case Study: Brazil 2002

21. Case Study: Brazil 2002

22. Case Study: Brazil 2002

23. 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

24. 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

25. Case Study: Brazil 2002-2006

26. 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

27. Case Study: Brazil 2006

28. Case Study: Brazil 2006

29. 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.