Jeffrey FrankelHarvard Kennedy School & NBER
NBER Conference on Sovereign Debt & Financial Crises,Organized by Sebnem Kalemli-Ozcan, Carmen Reinhart & Ken RogoffOctober 18-19, 2013
“Large T”I learned more from reading this paper than
from most.
In Oscar Jorda’s phrase: “Economic history has a lot to offer: ‘rare events’.”
I like to say: “The true value of the black swan metaphor is that one can estimate tail risk events if the data set includes enough countries & enough years.”
But as someone said yesterday: the research may require many days of going through dusty archives.
Financial boom-bust cycle
Kaminsky & Vega-Garcia: “1st financial globalization” era , 1820-
1931. 5 cycles experienced by Latin America
I. 1820-25 lending boom (low U.K. interest rates after Napoleonic Wars).
Ends in 1825 when BoE raises discount rate in London Panic.Followed by defaults of 1826-28.
II. 1860s boom (esp. railroads)
Ends in 1873 with Vienna market crash. Followed by 1873-1877 defaults.
III. 1880s lending boom (esp. railroads).
Ends in 1890 with Baring Brothers crash. Followed by 1890-94 defaults.
IV. 1890s-1914 boom (electricity). Ends in 1914 with WWI. 1914-18 defaults.
V. 1920s boom.Ends in 1929 with FRB tightening & US Wall Street crash. 1931-35 defaults.
Mean frequency of wave: 26 years
Let’s match it up with the 2nd era of financial globalization,
1974-2013. 3 cycles:
I. 1974-1981: lending boom, “recycling petrodollars” thru Euromarkets. Ends in 1982 with Volcker tightening.Followed by International Debt Crisis & “Lost Decade” of 1982-1989.
II. 1990-97: Emerging Markets capital flow wave.Ends in 1997 with East Asia crisis.Followed by Russia, Brazil, Argentina, Turkey crises of 1997-2002.
III. 2003-2008: Capital flows to EU periphery, BRICs & other EMs.Ends in 2008 or 2013…?
Mean frequency of wave: 15 years. (7 fat years, crisis, 7 lean years.)
hKaminsky & Vega-Garcia:
“1st financial globalization” era ,
1820-1931
Let’s match it up with the 2nd financial
globalization era, 1974-2013
Distinction regarding types of default
Distinctions regarding “Push/pull” factors
Defaults after crises in the periphery.
19 examples, including:Chile, 1879, War of the PacificBrazil, 1898, coffee crisis(& Peru, 1876 after guano market collapse?)
Local factors leading to crises.
Examples:
Mexico, 1994, political violence.
Indonesia, 1997, succession doubts.
Vs., defaults following crises in the financial center (London, Vienna, NY), e.g.: 1825, 1873, 1890, 1931.
US 2008 financial crisis precipitated Iceland crisis of 2008, euro periphery crises of 2010-12,etc.
The role of global interest rates
Kaminsky & Vega-Garcia:
1st financial globalization era 1820-
1931
2nd financial globalization
era 1974-2013
Finding:“Most of the systemic sovereign crises occur in the midst of a sharp increase in real interest rates.” (p.27)
E.g.: BoE raised interest rates in 1825, 1873, 1890, and 1927-31.
Low US real interest rates in late 1970s, 1991-93, 2001-06,contributed to flows, e.g., Calvo, Leiderman, Reinhart.
Ended in Fed tightening of:1980-82, precipitating Intl.Debt
Crisis,1994, followed by Mexico peso
crisis,2013 taper talk => BRIC outflows
“Fragilities” or “shocks”?The authors say global interest rates
are indicators of “global fragilities”: “International liquidity as captured by international issuance
and real interest rates in the financial center.”
Similarly they say changes in export revenues & terms of trade are indicators of “country-specific fragilities.”
“adverse shocks to the permanent component of output” -- Aguiar & Gopinath (2006).
The empirical focus on all these indicators is fine. But classifying them as fragility or vulnerability is a wrong turn from the beginning. These are shocks.
“Fragility” should refer to indicators such as Debt/Export ratio, which the authors use in their “Insolvency index.”
The case of commodity exporters A high dependence on commodity exports in GDP might
be an indicator of vulnerability. If so, that could be one explanation for the Natural
Resource Curse.E.g., Manzano & Rigobon (2008) argue that the negative
effect of resource dependence on growth rates (NRC) observed during 1970-1990 was mediated through international debt,
which was incurred when commodity prices were high.
But a fall in the global price of the export commodity is an adverse shock. It can precipitate a debt crisis,especially if the country is vulnerable in various ways.The price fall is not an “indicator of fragility.”
“Fragilities” and “shocks”
“What Triggers a Default” (section IV.2) is a better label.
But it should be the interaction of vulnerability & shocks.
Vulnerability could also include, in addition to debt/exports, such indicators from the 1994-2013 crisis literature as:
Foreign exchange reserves Real exchange rate Domestic credit growth Short-term debt Currency mismatch…
Explaining delays in debt renegotiations
Sections IV.3.1. -V.3.2 “examine whether the decision to renegotiate the debt is delayed until [there is a sufficient increase in] the probabilities that growth resumes and the debt/export ratio stabilizes” (p.30-31).
If the debt/export path looks unsustainable then they don’t renegotiate the debt? That struck me as sounding backwards.
Is the idea that the debtor has to grow its way out
before restructuring?
What does debt/export sustainability determine?
Maybe the authors mean that only if the write-down is big enough to bring debt back to a stable path will the two sides agree on restructuring plan; until they can agree on that, they are just in a
state of default/suspended debt service/negotiation.
Finding: zero probability of stabilizing debt/export path implies biggest haircuts (p.33) . That makes sense. But ≠ implying longest delays in coming to agreement.
What does debt/export sustainability determine? continued
The debt/export sustainability calculations should be a determinant of the beginning of the default period, not just the end.
Indeed: “at the time of the default, most countries cannot stabilize the debt/export ratio according to our metric.” (p.32)
Abrupt improvements suggest partialhaircuts before end of “default period,”not slowly growing out of debt trouble.
Consider two other theories of default period length, both of which should sound familiar.
(1) So long as a country is still running a primary deficit, it can’t solve its problems by telling its creditors to get lost; it still has to borrow to finance the deficit.
As soon as it is able to eliminate the primary deficit (e.g., it has taken Greece 4 years to close its primary budget deficit), it is in a stronger bargaining position:
If creditors won’t agree to a write-down, the country can unilaterally default and save itself the interest payments.
So then a write-down is agreed.
Other theories of default period length
(2) So long as a write-down would wipe out the creditor bank’s capital, it cannot afford to admit that the loans are not worth their full face value.
The creditor banks may be the ones who need time to “grow their way out” of the debt,
rather than the debtors, who may be incapable of growing their way out of it
(if they are like Latin America in 1982-89 or Greece in 2010-2013)
It is why the Brady Plan was not adopted before 1989;
only then had the banks’ balance sheets become strong enough that they could afford to write downthe debts without jeopardizing their own solvency.
The literature on duration of default spells
I am probably not sufficiently familiar with it.
Can it be true that the literature looks exclusively at the debtors’ side & not at the creditors’ balance sheet?
Why not look at debt (or write-down amount) as a percentage of UK or US bank assets, rather than just the country’s ability to pay (exports)?
Default, delay, write-down“Naturally, all the renegotiation of sovereign contracts
will collapse in the midst of a liquidity crunch.” (p.34). Why is this natural? I’d say because creditors can’t afford
to admit formally that the loans are no longer worth full value,as came up in Cristina Arellano, et al, session yesterday.
This explains not only the duration, but also the chronic pattern of official over-optimism in growth forecasts that are made after defaults (Latin America, 1982-89; euro periphery, 2010-12).
In any case, it seems to me that you can’t model the effects of such variables as Debt/X, growth, etc. on duration without simultaneously modeling their effects on (i) the default itself (ii) the magnitude of the write-down when it comes.
