Seminar Paper, 2006
28 Pages, Grade: 2.0
i. List of Abbreviations
ii. List of Symbols
2. Structure of Debt
2.1 Foreign Currency and Debt
2.3 Maturity Composition of Sovereign Debt
3. Jeanne’s Model
3.2 Debt Maturity
3.4 Renegotiation-friendly Clauses
4. International Financial Architecture
4.1 Famous Recent Crises
4.1.1 The Tequila Crisis
4.1.2 The Asian Crisis
4.1.3 What Happened Then
4.2 Reforming the IFA
4.2.1 Crisis Prevention
4.2.2 Crisis Treatment
188.8.131.52 International Lender of Last Resort
184.108.40.206 Crisis Insurance Fund
4.3 IMF & IFA
Appendix A: Functions
Appendix B: Figures
Appendix C: Tables
References – Online
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The initial paper for this work had the title “Sovereign Debt Crisis and the International Financial Architecture” by Olivier Jeanne. That paper analyzes why sovereign debt of emerging countries during debt crisis mainly consists of short-term debt borrowed in foreign currency. Before I get back to the content of that paper I first want to describe the situation during the last years concerning public debt structure in different countries and how they differ from each other with special aim on a comparison between emerging market countries and advanced market countries.
If we have a look at the composition of total debt of different countries it is easy to see (Figure 1.2) that from 1992 to 2002 the advanced countries’ total debts mainly consisted of domestic currency, whereas those of emerging market countries where mainly borrowed in foreign currency. If we focus our view on sovereign debt only, this difference vanishes. From 1980 to 2003 about 99.7 percent (Table 1) of sovereign debt in emerging market countries was borrowed in foreign currency. In advanced economies it was slightly less (92.5%). Nevertheless, in both cases the U.S. dollar was the dominating foreign currency. A reason for this might be that this currency is considered as very important in international trade.
A comparison between these facts leads me to the conclusion that private persons in advanced countries trust their own currency, whereas private persons in emerging market economies seem to trust foreign currencies. Otherwise the currency composition between total debt and sovereign debt would not differ so much from each other. Another interesting fact concerns which other currencies states prefer to borrow in. They like advanced economies’ currencies instead those of emerging market countries.
Another important point concerning public debt structure is their composition structure concerning maturity. It can be seen (Figure 4.2) that during 1988 the average maturity of sovereign debt issued in both kinds of countries was little below 8 years. But during the following 14 years the average maturity rate in emerging market countries decreased to about 5 years while the maturity rate of advanced countries sovereign debt increased to almost 10 years. This tendency towards short-term debt can also be seen on Figure 4.1. It is interesting to note the fall in 1999 in both markets (Figure 4.2) which was nevertheless stronger in emerging countries. Later I will show that there is a connection between the Asian crisis and this development.
One last important difference between developed and emerging market countries concerning structure of sovereign debt is indexation. A debt can either be nominal or indexed to certain variables like the GDP or commodity prices. Until 1997 U.S. debt consisted only of nominal debt, whereas in 2004 the debt of Brazil was to 90 percent indexed debt (Alfaro 2006a, 1). But in general, governments normally seem to avoid indexation (Alfaro 2006b, 8).
After these historical details about debt structures in different countries I want to give a short outline of what will follow. I mentioned that the initial point for my paper was a paper written by Olivier Jeanne. But before I will get to that paper and the model Jeanne developed, I first want to present incentives for different debt structure concerning currency composition, indexation and debt maturity. After that I will give a short summary of Jeanne’s paper including a presentation of his model, equilibrium and renegotiation-friendly clauses in debt contracts. The next part concerns another important part of his paper, namely “International Financial Architecture”. In this part I will describe what happened during the Tequila Crisis and the Asian Crisis and which measures had been taken to treat them and how they influenced the IFA. After that I will state theoretical thoughts on how sovereign debt crises could be prevented and how they should be treated if they occur. In his paper Jeanne (2001, 15 et seq.) presents some suggestions for treatment which I will restate. This is followed by analyzing the question which role the IMF plays concerning IFA. As it can be seen from several debt crises in the past, the IMF took a leading role in supplying help for those countries affected by crises. So the question to ask is whether this help was any good or not. In chapter five I will conclude.
As stated above, empirical research shows that emerging market economies like to issue their debt in foreign currency, especially when they suffer from sovereign debt crisis. The main questions therefore are what the incentives to borrow in foreign currency are and why these incentives are higher in emerging market countries than in advanced market countries.
One of the main arguments for this behavior is that “foreign currency debt results from a lack of monetary credibility” (Alfaro 2006a, 2). This means people and government don’t trust that their own currency will not devaluate. So a foreign currency such as the U.S. dollar gives them certain stability. Further more: Imagine a country having a lot of sovereign debt abroad. It would be quite irrational for such a country to devaluate because then its abroad debt would grow converted to domestic currency. So having foreign debt is an incentive to stabilize the own currency. Apart from that some people might use foreign currencies because they assume that the relevant currency will depreciate so that they will benefit from exchange rate fluctuations. Another argument worked out by Jeanne (2003, 2) is that borrowing in foreign currency gives certain protection from defaulting. In emerging market countries the government as well as private borrowers use foreign currency as part of a hedging strategy. Especially in countries which have a fixed peg to a foreign currency, borrowing domestic is dangerous.
This leads us to the difference between emerging market economies and advanced countries. If we look for example at those countries which were involved in the Asian crises we see that all of these countries had a peg to the U.S. dollar. So the question to ask is why they have such a peg.
Apart from that there are a lot of other risks when borrowing in foreign currency. In fact during time of crises foreign currency debts aggravate the situation and make it more difficult for the government to solve the problems.
Since indexation is not the gist of this paper I will only give a short overview. The difference between nominal and indexed debt concerning the behavior of governments lies in the incentive to default. If they have nominal debt, it is quite probable that the government will try to default through inflation, whereas indexation reduces this probability (Alfaro 2006a, 1). Apart from that, Alfaro (Alfaro 2006b, 9) mentions that indexed bonds are much easier to be turned into physical capital than other government liabilities. Moreover nominal debt allows the borrower of “hedging against unexpected shock that affect the fiscal budget and hence reduce tax distortions” (Alfaro 2006a, 1). Nevertheless rough changes of the indexes due to external shocks can lead to debt crises because of their inflexibility.
But according to Borenzstein (2004, 29) there is another advantage of indexed debt. Governments with such a debt are not so much under pressure to engage in procyclical fiscal policy.
After discussing the pros and cons it is also important to mention that indexed debt is not just indexed debt. Concerning indexation to real variables we can distinguish between variables which are out of a governments’ control from those who can be partially controlled by a government. Examples for the first group are commodity prices or imports. Examples for variables which can be influenced by the government could be GDP or GNP (cp. Borenzstein et al. 2004, 29).
Maturity in our case is understood as related to the date at which a debt becomes due for payment. As stated above sovereign debt can be divided into two groups, namely short-term debt and long-term debt. The risk that comes along with the first one is that it exposes the borrower to a rollover risk, which on the other hand has its advantages: Having this risk in mind the borrower has high incentives to pay his debt. This in turn generally leads to lower interest rates compared to long-term debt. Another reason why emerging market countries prefer to borrow short-term debt is pointed out by Borenzstein et al. (2004, 9). He says that a lack of monetary and fiscal credibility prevents emerging market economies from issuing long-term domestic debt in local currency. But according to Bleaney lack of credibility is not the only reason, because of “real exchange rate risk, loans denominated in the borrower’s currency are more state-contingent than loans denominated in the lender’s currency” (Bleaney 2006, 11). Moreover Knight (2004, 131) argues that in emerging market countries capital markets are normally thin and illiquid, especially at longer maturities.
In the following chapter I will give a summary of the model presented in the initial paper and show in detail the specialty concerning incentives to borrow short-term debt.
In this part I am getting to the initial point of this paper. First I want to describe a model developed by Olivier Jeanne which analyses the fact that emerging country economies tend to prefer short-term debt instead of long-term debt, especially during time of sovereign debt crisis. A great disadvantage of such debt in time of crises is that if they cannot be repaid they have to roll over the debt resulting in high renegotiating cost, loss of reputation etc.
His model consists of two players, scilicet the government and foreign investors. There are three periods. At the beginning the government can invest in a welfare- enhancing project. Because money is lacking it has to borrow from the foreign investors. It either can work hard on this project or not. The government’s efforts become visible in the next period. The investors can either lend money to the government or they can invest their money at an interest rate of zero. In the second period the investors receive some news about the governments’ project. This news can either be good or bad. Based on this news and the henceforth visible effort, the investors calculate a probability of a good fiscal outcome. The higher the efforts and the better the news are the higher is the probability for a good outcome. In the last period the government will use uncommitted fiscal resources to repay their debt which depends on the just stated probability. The next step Jeanne takes is differentiating between short-term debt and long-term debt, further he excludes mixing of these different types of debt. Long-term debt in his model is characterized by repayment in the last period, whereas short-term debt has to be repaid in the second period. Apart from the amount borrowed, there is an interest rate which the government has to pay. Nevertheless the government can try to renegotiate the short- term debt, so it will roll over to the last period. This process is modeled like this: Those investors who do not want to extend the debt are repaid by the government drawing on a special reserve. But in order to simplify, the amount of this reserve is infinitesimal small. If the government can successfully reschedule the debt it has to pay an additional interest rate for the added period. This interest rate depends on a certain variable which, according to Jeanne, can be seen as the bargaining power of the investors. With this modeling given the government will try to maximize its utility function (5).
As it can be seen very easily, the higher the value of the project is, the more utility will the government get. For the costs it is the other way round.
At the end of the description, Jeanne makes two assumptions which allow him to focus on the part of maturity composition. One is that the government is only solvent when it makes the fiscal adjustment and the other is: it is insolvent if the news in the second period is bad. With this modeling given let us now turn to how debt maturity is modeled.
In order to model the debt maturity, Jeanne starts with long-term debt. The crucial point is that the investors will only lend the money if they expect the government to work hard. So the question to ask is whether working hard increases the governments utility or not. In the paper it is shown that there is a threshold (3) which the cost for the fiscal adjustment must not exceed, otherwise the adjustment will not be done because it is not possible to borrow long-term debt. It can be calculated by equating the expected welfare function under high effort (1) with the expected welfare function under low effort (2). This constraint is necessary and sufficient for the modeling of long-term debt. From this constraint it can be seen that the welfare-enhancement resulting from the adjustment must be grater than its costs. If the cost is too high the investors won’t lend any money to the government on long-term basis, so short-term debt must be considered.
The difference between these kinds of debt is that short-term has to be repaid in the second period. And the investors’ decision either to roll-over debt or to get it back by all means is based on their observation done in the second period. This observation concerns the effort of the government and the value of the news. Moreover it is possible that the investors want the debt to be repaid because of self-fulfilling reasons. These self-fulfilling runs depend on the relation between the repayment in the second period and the expected repayment in the last period. If the expected payment is lower than the payment of period two, the investors will try to get their money. Since the model has multiple equilibriums the problem of selection of equilibrium is solved by m, which describes the probability of a self-fulfilling run. So the difference between the situation under long-term debt and the situation under short-debt is that now the parties may face the cost to reschedule. This leads to a different threshold for the government to act. Apart from that the government reschedules not if the investors don’t go for a self-fulfilling run and the government has to repay in the last period conditional on high fiscal returns. So as for long-term debt, there is also a threshold for short-term debt (4) which the cost for the fiscal adjustment must not exceed, otherwise it is not possible to borrow short-term debt.
 Of course there is still the reason that on short-term the lender gets his money back earlier. By this he can invest it somewhere else, so the interest rate is lower.
 This chapter is a short summary of the model presented in Jeanne (2001, 5 – 14). For a detailed (more mathematical) description of the model see chapter 2 of that paper
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