to default or not? the crisis outcomes of sovereign defaults and imf austerity programs

Motivation Motivation Data and methods Results Robustness tests Conclusions

To default or not? The crisis outcomes of

sovereign defaults and IMF austerity

programs

Tuomas MalinenUniversity of Helsinki

Olli RopponenVATT Institute for Economic Research

Open Seminar, Eesti Pank, February 13 2017


IMF has pursued policies that in many cases not onlyfailed to promote the stated objectives of enhancinggrowth and stability, but were probablycounterproductive.

-Joseph Stiglitz 2003

Indeed the efforts needed to avoid a default - whichwould be a catastrophe for Greece - are theresponsibility of all political forces.

-Comissioner Olli Rehn, 16th of June 2011


This study

• Aims to shed some light on the question: is it beneficialfor a country to default or enter into IMF program whenfacing an economic crisis?

• We estimate the outcomes of these actions on the growthof real GDP per capita of crisis countries after they havebeen implemented relative to other comparable countries.

• We find that developing countries should in general avoiddefaults and that IMF programs provide the most lenientcrisis outcome.


Defaults

• Sovereign defaults free government resources, which canbe used on health care, education and for growthenhancing policies (e.g. public investments)

• But, after a default, country is likely to remain outsideinternational capital markets for an extended period oftime.

• This leaves the government with two options to cover itsfinances:

• it either has to ’live by its means’, that is, cutexpenditures so that they can be covered withdiminished revenues, or

• resort to monetization of budget deficits through centralbanks.


IMF programs

• IMF programs provide emergency funding, technical andfinancial assistance and enforce unpopular but oftennecessary economic reforms during crises.

• IMF offers four types of assistance programs for sovereignnations:

• Stand-By Arrangements (since 1952)• Extended Fund Facilities (since 1974)• Structural Adjustment Facilities (since 1986)• Enhanced Structural Facilities / The Poverty Reduction

and Growth Facilities (since 1988)

• SBA’s are the most lenient of the arrangements, but allarrangements involve some form of conditionality.


Conditionalities of IMF programs

• Even the earliest IMF programs imposed conditions ongovernment behavior. Conditions demanded removal ofsubsidies and price controls from state economicenterprises (Krueger 2003).

• Almost always there were also an agreement of ceiling onfiscal deficit and domestic redit.

• Other conditions included the rescheduling of private andpublic debt, and the change or removal of the nominalexchange rate regime

• The exact nature of conditions of IMF programs havechanged (and continue to change), but some form ofausterity has always been (and continue to be) a part ofthem


Data

• We concentrate on three types of crises: finance, currencyand inflation.

• We use data on 45 countries for a period of 60 years(1951-2010)

• Data are obtained from the IMF Staff Reports andSurveys, Penn World Tables, the World Bank, and fromdatasets of Bordo and Schwartz (2000), Ilzetzki et al.(2010), Przewoski et al. (2000) and Reinhart and Rogoff(2011).

• In total we have 857 year-country crisis observations.


Descriptives

Table: Descriptive statistics for countries in crisis, N=857

Categorical (dummy) variables YES NO

Crises:Banking crisis 299 558Currency crisis 540 317Inflation crisis 534 323Under at least 1 crisis 857 0

IMF program and sovereign defautsUnder IMF program 404 453Foreign default 274 583Domestic default 66 791


Regressions

• Our baseline growth model is given by

growthcy =kUB

∑k=kLB

γk ∗DOMdefkcy +kUB

∑k=kLB

δk ∗ FORdefkcy +

+kUB

∑k=kLB

ηk ∗ IMFkcy + αc + βy + δxcy + εcy .

where growthcy is the change in the logarithmic real GDP percapita of crisis country c in year y , −2 ≤ k ≤ 5, and xcy are thecontrol variables: growth of real gross capital formation, growth ofreal gross government consumption and change in trade openness.

• The DID-estimations are performed by OLS-regressions, where theoutcome variable is regressed on control variables (xcy), the year(βy ) and country (αc) dummies as well as on the dummies for anaction(s) taken k years ago (DOMdefkcy , FORdefkcy , IMFkcy ).


The counterfactual

• Identification: The counterfactual growth evolution ofcrisis country c in year y that has taken an action kperiods ago follows that of those countries that have nottaken a given action between −2 ≤ k ≤ 5 years ago, andwho are also under at least one crisis.

• That is, the counterfactual also includes observations of acountry in crisis that has not taken a given action -2 to 5years ago, but may have done so earlier (or later).

• For example, Finland is in the counterfactual crisiscountry group in 1991-94 and in the IMF program crisiscountry group in year 1967 (-2 to 5 years).


Preselection and expectations• We pool observations around years of action into three

periods: before, impact and after. We also measureoverall outcome consisting of growth performance duringimpact and after periods.

• It is possible that the time periods when countries defaultor enter into IMF programs have different characteristicsthan those periods when they do not.

• We analyzed four main selection criteria from theliterature: budget balance, public debt, foreign reservesand external debt.

• They did not differ statistically between actions orbetween those periods when crisis countries took anaction and when they did not.

• We thus consider the difference in trends before actions,if any, to result from expectations not from preselection.


Growth evolution of different actions in crisis

countries vs. the counterfactual

−2 −1 0 1 2 3 4 5

−10

−5

05

10

Years after joining the IMF program

Growth evolution after IMF

IMF programbegins

−2 −1 0 1 2 3 4 5

−10

−5

05

10

Years after foreign default

Growth evolution after foreign default

Foreign

default

−2 −1 0 1 2 3 4 5

−10

−5

05

10

Years after domestic default

Growth evolution after domestic default

Domesticdefault


The role of debt

• Although the level of sovereign or external debt does notseem to affect the selection process of countries todefault or enter into IMF programs, they are likely toinfluence the outcomes of actions.

• We analyze the role of sovereign and external debt usingthresholds of 150% of GDP (sovereign debt) and 60% ofGNI (external debt).


Growth evolution during an economic crisis in

countries with high levels of public debtDependent variable: growth of the real GDP per capita

IMF Foreign DomesticPublic debt < 150% of GDPBefore (2y) 1.056* -1.226 -0.090

(0.521) (0.635) (1.056)Overall 0.280 -0.372 -1.661*

(0.364) (0.376) (0.659)Impact (1y) 0.286 -1.695* 0.548

(0.645) (0.817) (1.227)After (5y) 0.307 -0.078 -2.240**

(0.390) (0.408) (0.708)

Interaction terms for public debt > 150% of GDPHigh debt ×before (2y) -6.061* -2.889 3.849

(2.466) (3.667) (3.485)High debt × overall 0.582 1.485 -2.178

(1.260) (1.273) (1.860)High debt × impact (1y) 3.295 2.476 -2.156

(2.516) (3.047) (4.646)High debt × after (5y) -0.478 1.472 -1.425

(1.331) (1.416) (1.965)countries 45years 1951-2010observations 857

* = p<.05, ** = p<.01, *** = p<.001.


Growth evolution during an economic crisis in

countries with high levels of external debtDependent variable: growth of the real GDP per capita

IMF Foreign DomesticExternal debt < 60% of GNIBefore (2y) 1.576* -1.366 -0.967

(0.737) (0.997) (1.315)Overall -0.136 -0.313 -0.339

(0.506) (0.575) (0.905)Impact (1y) -1.154 -0.094 0.308

(0.956) (1.303) (1.846)After (5y) 0.206 -0.379 -0.516

(0.558) (0.621) (0.991)

Interaction terms for external debt > 60% of GNIHigh debt × before (2y) -1.311 0.767 1.048

(1.127) (1.477) (2.149)High debt × overall 0.558 -0.317 -3.017*

(0.754) (0.810) (1.218)High debt × impact (1y) 1.752 -2.001 -1.282

(1.400) (1.852) (2.464)High debt × after (5y) 0.088 -0.008 -3.310*

(0.812) (0.892) (1.345)countries 45years 1951-2010observations 857

* = p<.05, ** = p<.01, *** = p<.001.


The role of external debt

• The result that external debt is more harmful in domesticdefault is likely to reflect the costs that it inflicts to theindebted domestic financial sector.

• Financial companies of a country often hold a fairly largeamount of domestic government bonds as collateral intheir balance sheets.

• When they also hold large amounts of external debt,haircuts to their collateral through cuts on the principaland/or interest payments of government bonds willcause insolvencies and force financial companies todefault on their external debt.

• This leads to diminution of credit in the economy and tobankruptcies in the private sector, which causes theGDP of a country to fall but with a lag.


Robustness checks

• Few issues can affect our main findings.

1. The role of the IMF changed rather drastically during thecurrency crises of Latin American countries in the 1980sand after the fall of the Soviet Bloc that started in 1989.

2. The level of economic development.3. Political crises.

• We re-estimated our model using data from 1990onwards. Results were qualitatively unchanged from thosepresented previously.


Growth evolution during an economic crisis in low-

and high-income countries

Dependent variable: growth of the real GDP per capita

IMF Foreign Domestic countries obs.Developing countriesBefore (2y) 0.666 1.134 0.061 20 355

(0.915) (1.263) (2.183)Overall 0.262 -0.859 -3.198*

(0.648) (0.802) (1.270)Impact (1y) -0.045 -3.871* -0.512

(1.195) (1.921) (2.546)After (5y) 0.328 -0.492 -3.746**

(0.684) (0.827) (1.347)

Developed countriesBefore (2y) 0.813 -0.238 -0.243 25 499

(0.454) (0.526) (0.860)Overall -0.127 -0.400 -0.731

(0.318) (0.304) (0.546)Impact (1y) -0.459 0.299 0.410

(0.558) (0.658) (1.055)After (5y) -0.033 -0.563 -1.027

(0.344) (0.333) (0.594)

* = p<.05, ** = p<.01, *** = p<.001. The developing country group includes the poor and lower middle-incomecountries and the developed countries group includes the higher middle-income and rich countries based on the2010 World Bank classification of countries.


Why developing economies seem to be more

vulnerable to defaults?

• In developing countries, the (few) large institutionalinvestors and banks tend to hold large amounts ofdomestic debt as collateral.

• Domestic default will affect negatively on their balancesheet, which is likely to be already under stress because ofthe crisis.

• This will lead to private sector defaults and bankruptcies,diminution of credit and a fall in the output, with a lag(as the credit squeeze starts to bite).


Political crises

Dependent variable: growth of the real GDP per capita

IMF Foreign DomesticGovernment not in crisisBefore (2y) 0.739 -0.941 -1.863

(0.551) (0.676) (1.177)Overall 0.441 -0.277 -1.791**

(0.382) (0.388) (0.685)Impact (1y) 0.097 -2.334** 0.175

(0.689) (0.893) (1.324)After (5y) 0.545 0.141 -2.326**

(0.414) (0.416) (0.746)

Interaction terms for government in a crisis

Gov. crises × before (2y) 0.283 0.234 2.505(1.127) (1.233) (1.905)

Gov. crises × overall -0.511 -0.678 -0.608(0.786) (0.762) (1.201)

Gov. crises × impact (1y) 0.888 3.838* -1.260(1.482) (1.589) (2.452)

Gov. crises × after (5y) -0.804 -1.850* -0.353(0.839) (0.860) (1.304)

countries 45years 1951-2010observations 857

* = p<.05, ** = p<.01, *** = p<.001.


Actions and outcomes in different crises

• Above we have analyzed the outcomes of IMF programsand sovereign defaults using a dataset that pools all thecrisis as one.

• However, outcomes of IMF programs and defaults maydiffer between crises.


Growth evolution of different actions during a

banking crisis

−2 −1 0 1 2 3 4 5

−10

−5

05

10


Growth evolution after IMF, Banking crisis

IMF programbegins

−2 −1 0 1 2 3 4 5

−10

−5

05

10


Growth evolution after foreign default, Banking crisis

Foreigndefault

−2 −1 0 1 2 3 4 5

−15

−10

−5

05

1015


Growth evolution after domestic default, Banking crisis

Domesticdefault


Growth evolution of different actions during a

currency crisis

−2 −1 0 1 2 3 4 5

−10

−5

05

10


Growth evolution after IMF, Currency crisis

IMF programbegins

−2 −1 0 1 2 3 4 5

−10

−5

05

10


Growth evolution after foreign default, Currency crisis

Foreigndefault

−2 −1 0 1 2 3 4 5

−10

−5

05

10


Growth evolution after domestic default, Currency crisis

Domesticdefault


Growth evolution of different actions during an

inflation crisis

−2 −1 0 1 2 3 4 5

−10

−5

05

10


Growth evolution after IMF, Inflation crisis

IMF programbegins

−2 −1 0 1 2 3 4 5

−10

−5

05

10


Growth evolution after foreign default, Inflation crisis

Foreigndefault

−2 −1 0 1 2 3 4 5

−10

−5

05

10


Growth evolution after domestic default, Inflation crisis

Domesticdefault


Conclusions

• Developing countries should avoid defaulting, especiallyon domestic liabilities, as they lead to large fall in the realGDP per capita compared to developing countries in crisisthat did not default.

• Domestic default led to drop of more than -3% in theper capita output of a developing country.

• In addition, the level of external debt seems to be thedividing factor between outcomes of defaults.

• Under high external debt, domestic default leads to dropof more than 3% in the per capita output, while therewas no negative outcome under low external debt.

• IMF programs provide the most lenient crisis outcome,but they do not yield any statistically measurableeconomic benefits.


THANK YOU!

to default or not? the crisis outcomes of sovereign defaults and imf austerity programs

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