PDF Ebook Missing Link: Volatility and the Debt Intolerance Paradox
It is a well documented empirical regularity that developing countries typically face an upward sloping supply schedule for international debt, and may be altogether excluded from international capital markets during bad states of the world (Diaz-Alejandro, 1984; and Sachs, 1989; Eichengreen and Lindert, 1989). In a recent paper, Reinhart, Rogoff, and Savastano (2003) take this evidence one step further. Combining macroeconomic data for the post-1970 period with information about sovereigns’ credit histories since the early nineteenth century, they argue that an important subgroup of middle-income countries or “emerging markets” have been systematically afflicted by what they call “debt intolerance.” That is, even though their external debt-to-GDP ratios are moderate by international standards and substantially lower than those of several high-income countries, these economies are perceived as riskier and unable to tolerate as much debt. Simply put, their sovereign riskiness appears to be out of proportion to the size of the respective debt burdens.
To explain this phenomenon, Reinhart, Rogoff, and Savastano (2003) invoke history. Virtually all these countries have tarnished credit histories, with several of them having defaulted a few times on their public debts. To the extent that those that have defaulted once or more in the past are likely to do so again in the future, the market threshold of what can be considered “safe” borrowing levels for these countries tends to be lower.2 As a theoretical story, however, this argument raises some important questions. For one, it touches on the contentious issue of what lenders take into account when evaluating sovereign risk.3 Also, it neither explains what causes serial defaulters to default in the first place, nor how most of today’s advanced economies—which have also defaulted several times in their history—managed to graduate out of the debt intolerant “club.”
This paper advances a simple but arguably more fundamental explanation for the debt intolerance phenomenon. We contend that the high volatility of macroeconomic aggregates—in particular, of domestic output and external terms of trade—is a key factor in the sovereign risk of many developing countries. We argue that this greater volatility is associated with higher default probability, and, as a result, these countries hit borrowing constraints at lower levels of indebtedness. To the extent that such volatility stems from structural and hence slowly evolving factors, the phenomenon can be fairly persistent even if there is scope for these countries to gradually evolve of this state. In this sense, we view the debt intolerance phenomenon as another—and so far relatively neglected—manifestation of macroeconomic volatility on developing country welfare. The evidence provided in this paper thus bridges a gap between the literature on sovereign debt and that on the adverse effects of macroeconomic volatility on growth and welfare (e.g., Mendoza, 1995, 1997; Ramey and Ramey, 1995; Agénor and Aizenman, 1998; Caballero, 2000; and Acemoglu and others, 2003).
Contents
I. Introduction
II. The Model
- A. Domestic Output
B. The Debt Contract
C. Lenders’ Supply Schedule and Interest Rate Spreads
D. The Sovereign Borrower’s Optimal Choice of Debt
E. Volatility and Optimal Debt
III. Empirics
IV. Conclusions
Figures
1. The Return to Lenders
2. ( L R D As a Function of D )
Tables
1. Optimal Debt as a Funtion of Volatility and Associated Default Probabilities for ? =0.3, R=1.05 and 100 Y = , q=0.5
2. Selected Macroeconomic and Debt Statistics, 1970–2001
3. Logit Estimates of Default Probabilities with Output Gap Volatility
4. Logit Estimates of Default Probabilities with Alternative Volatility Measures
5. Determines of Sovereign Debt: Regime Switching Model Estimates
Appendix
References
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PDF Ebook Missing Link: Volatility and the Debt Intolerance Paradox
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