III. Sound Fundamentals and Liability Structures
- Paolo Mauro, Torbjorn Becker, Jonathan Ostry, Romain Ranciere, and Olivier Jeanne
- Published Date:
- April 2007
It is generally recognized that countries can self-insure significantly against shocks through their own policies and institutions. Beyond prudent macroeconomic policies, resilience to shocks can be fostered through measures and reforms aimed at increasing flexibility in the exchange rate regime (Mussa and others, 2000; Rogoff and others, 2004), openness in the financial account (which may help cushion consumption and investment from the impact of output shocks, though it may also bring volatilities of its own, at least in the short run—see Prasad and others, 2003), and goods and labor market flexibility. Reducing constraints on the ability of entrepreneurs to shift resources across sectors might also foster resilience by enhancing sectoral diversification, though there are, of course, trade-offs between the gains from specialization and the benefits from greater output stability.12 This section, however, will focus on a specific aspect of sound fundamentals, namely the role of countries’ external liability structures in fostering international risk sharing of the costs of adverse shocks, and the role of sound policies and institutions in promoting structures that can better meet countries’ insurance needs.
External Capital Structure of Countries
The composition of a country’s external liabilities (that is, the shares of foreign direct investment, portfolio equity, and external debt in its external finance) is often held to be an important determinant of the risk of crisis and the economic costs countries incur when they experience a crisis. Two types of argument are put forward to support this view.
First, the payments associated with some types of external liabilities have desirable cyclical properties. For example, with equity-like forms of finance such as portfolio equity or FDI, payments are lower when economic performance is worse. Equity finance thus makes it possible for domestic producers to share risk with foreign investors, which helps to stabilize domestic consumption and improves domestic producers’ ability to undertake projects with higher risk and expected return. Indeed, it has been argued that emerging market countries should adopt a less debt-intensive structure of external finance (Rogoff, 1999).
Second, some forms of flows behave in a more desirable manner during a crisis than others. For example, liquidity crises have often been triggered by sudden stops in debt flows, rather than flows of equity-like forms of finance. More generally, foreign direct investment has traditionally been viewed as more stable than portfolio financial flows.
The analysis in this paper offers broad support for the conventional wisdom about the external capital structures of countries during sudden stops:
An analysis of 33 sudden stop episodes using annual data over the period since 1980 suggests that FDI has played essentially no role in financial flow reversals (Figure 3.1). This result is robust to alternative thresholds for defining sudden stops and also holds using quarterly data for all emerging market countries in a specific analysis of reversals during the Russia/Long Term Capital Management (LTCM) crisis.
Portfolio equity also seems to play a limited role in sudden stops. Portfolio debt plays a more prominent role, though it recovers relatively quickly.
Bank lending flows and official flows experience severe drops and remain depressed for several years after sudden stops.
Figure 3.1.Composition of Financial Flows Around All Sudden Stops, 1980–2004
Source: IMF, Balance of Payments Statistics database.
Notes: The behavior of different types of flows is illustrated in sudden-stop time, with t=1 being the year the sudden stop occurred. The solid line represents the average across episodes for each type of financial flow. The dotted lines are one-standard-error bands. Sudden stops are reversals in the financial account by more than 5 percentage points of GDP. The sample is restricted to instances in which all six subcomponents of the financial account are available for at least a five-year period around the sudden-stop year. The sample consists of 33 episodes: Argentina (2001); Barbados (1992, 2002); Brazil (1983); Chile (1991); Côte d’Ivoire (1983, 1996), Croatia (1998); the Czech Republic (1996); Estonia (1998); the Republic of Korea (1997); Latvia (2000); Lithuania (1999); Mauritius (2001); Mexico (1995); Namibia (1991, 1999); Panama (2000); Peru (1998); the Philippines (1997); the Russian Federation (1998); Senegal (1982); Slovenia (1998); Swaziland (1993); Thailand (1982, 1997); Togo (1992); Turkey (1994, 2001); Ukraine (1998); and República Bolivariana de Venezuela (1980, 1989, 2002). For each type of financial flow, the entire available sample of countries and years is first regressed on a full set of country and year fixed effects to remove country-specific means and global trends from the data.
Although the results mentioned previously underscore a protective role of FDI and equity flows during sudden stops, the relative stability of FDI also appears to hold more generally over the entire sample (including during noncrisis times). For emerging and developing countries, Table A2.2 (in Appendix II) suggests a clear ranking in volatility measures (taking into account the size of flows) from FDI and portfolio equity flows (low), to portfolio debt and official flows (medium), to bank flows (high). Moving beyond volatility measures, and perhaps in contrast with conventional wisdom, comovement across countries does not seem to be more pronounced for portfolio flows or bank flows (often viewed as a channel of contagion) than for FDI. Differences across financial flows with respect to other features—such as persistence, procyclicality, or responsiveness to Group of Seven (G-7) growth or U.S. interest rates—are also not particularly striking. Against this background, a key issue is what factors help to explain the external liability structures observed in particular countries. Although the empirical evidence is not extensive, results based on a cross section of emerging market and developing countries suggest that equity-like liabilities (foreign direct investment and, especially, portfolio equity) as a share of total external liabilities (or GDP) are positively and significantly associated with indicators of educational attainment and, especially, institutional quality (Faria and Mauro, 2004).13 Thus, by improving institutional quality, countries may be able to secure a beneficial impact on their national external liability structures, though the effect is likely to be gradual owing to the persistence of institutional quality through time (IMF, 2005b; and Johnson, Ostry, and Subramanian, 2006).
Box 3.1.Asian Bond Funds1
A number of bond funds have been recently set up by the Executives’ Meeting of East Asia and Pacific Central Banks (EMEAP) group of 11 central banks (Australia, China, Hong Kong SAR, Indonesia, Japan, the Republic of Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand). The main objectives are to invest Asian reserves in Asian bonds, rather than European or U.S. bonds; to provide a new regional channel of financial intermediation at lower costs than intermediation through nonregional banks; and to provide a catalyst for private investors—notably institutional investors from the region—to consider investment in Asian securities.
Ultimately, the Asian Bond Funds (ABFs) are intended to promote the development of regional bond markets and facilitate issuance of domestic currency bonds by the countries involved. The role of the ABFs is to create a demand for local instruments and—in the process of setting up ABFs—to identify and remove market impediments including capital controls and other legal constraints, withholding taxes, and deficient clearing and settlement infrastructures. Initiatives by other regional bodies, such as the Association of Southeast Asian Nations (ASEAN) and Asia-Pacific Economic Cooperation (APEC), are also aimed at removing regulatory and infrastructure obstacles and increasing the supply of local instruments through such measures as allowing multinationals to issue domestic currency bonds in local markets.
Thus far, two sets of bond funds have been launched under the ABF initiative. Their mandate is to invest in bonds issued by sovereigns and quasi-sovereigns from eight EMEAP countries (excluding Australia, New Zealand, and Japan). The ABF1 was set up in 2003, with US$1 billion supplied by the EMEAP central banks to be invested in U.S. dollar-denominated bonds; the ABF1 is managed by the Bank for International Settlements (BIS). The ABF2, launched in 2005, consists of nine separate funds (one pan-Asian fund, the Pan-Asia Bond Index Fund (PAIF), and eight local market funds) for a total of US$2 billion to be invested in local currency–denominated debt. These open-ended, exchange-traded funds are managed by private sector institutions and will gradually be opened up to institutional and retail investors.1 For further information on the Asian Bond Funds, see International Monetary Fund, 2005, Regional Outlook: Asia and Pacific, March 2005 (unpublished; Washington); IMF (2005c); and Ma and Remolona (2005).
Public Debt Management and Debt Structure
In spite of the desirability of equity-like instruments, debt will undoubtedly remain an important component of the capital structures of emerging market countries. The insurance perspective suggests that—for a given cost of borrowing—debt managers should seek to induce as high a correlation as possible between debt-service costs and the borrower’s ability to repay. A previous study (Borensztein and others, 2004) suggested that this objective could be pursued by (i) developing domestic debt markets so as to allow borrowers to extend maturities and to issue debt denominated in domestic currencies; and (ii) denominating international debt in the domestic currency or indexing it to real variables, such as economic growth. More specifically,
Credibility of fiscal and monetary policies is a key prerequisite for investors’ willingness to hold long-term local currency bonds. Credibility, in turn, depends on both the quality of institutions and a reputation for sound policymaking. This is reflected in the differences in debt structures among emerging markets. For example, the share of foreign currency–denominated or indexed debt is far higher in Latin America than in Asia, and this may reflect, at least in part, the regions’ different inflation histories (Figure 3.2). Building credibility in this area can take years, but a combination of macroeconomic stabilization and institutional reforms has, in practice, helped to accelerate this process. Countries that curbed inflation and committed themselves to macroeconomic stability through reforms, such as the establishment of central bank independence or inflation-targeting regimes; adopted pension reforms that widened the domestic investor base; and used inflation-indexed bonds in the transition toward a lengthened maturity structure of the debt have seen a payoff in their debt structures.14
Debt instruments with equity-like features, which provide for lower payments in the event of adverse shocks and weak economic performance, could help sovereigns to improve debt sustainability and international risk sharing. In particular, growth-indexed bonds would likely provide substantial insurance benefits to a broad range of countries, though they present a number of implementation challenges (Borensztein and Mauro, 2004; and Borensztein and others, 2004).15
Figure 3.2.Emerging Market Economies: Central Government Domestic Debt Composition, 1980–2004
Source: Guscina and Jeanne (2006).
Notes: Short-term debt has a maturity of less than one year; medium-term debt has a maturity of between one and five years; and long-term debt has a maturity of more than five years. The data are simple averages across countries for 1980–2004. Asian economies include China, India, Indonesia, the Republic of Korea, Malaysia, the Philippines, and Thailand. Latin American economies include Argentina, Brazil, Chile, Colombia, Mexico, and República Bolivariana de Venezuela. Indexed debt involves indexation to consumer prices (or, rarely, commodity prices) and may apply to principal or coupon payments. Floating-interest-rate debt involves indexation to short-term or foreign interest rates.
Box 3.2.Argentina’s GDP-Linked Securities1
In Argentina’s recent global debt restructuring, GDP-linked securities were included in the package of new bonds issued to creditors participating in the exchange. The warrants were intended to add value to the exchange offer by providing creditors with the potential to benefit from Argentina’s future economic growth while ensuring that the additional payments could be met by available resources. In settling its exchange on June 10, 2005, Argentina issued 11 new bonds, each with a detachable GDP-linked security. For each US$1 of defaulted debt tendered and accepted in the exchange, creditors received new restructured bonds and one unit of a GDP-linked security.
This was the largest operation to date involving the issuance of financial instruments indexed to economic growth. Following the conclusion of the exchange, a forward market for trading GDP-linked securities in isolation emerged, with market participants placing a higher value on the securities, partly reflecting a more favorable forecast of medium-term growth. The forward market was thin, however. Market activity picked up considerably after the GDP-linked securities were detached and began trading independently on November 30, 2005. At that time, total market capitalization amounted to US$2.9 billion. Subsequent upward revisions to growth expectations have led prices approximately to double—to 9.3 cents per dollar of notional value in mid-April 2006—with total market capitalization reaching US$5.8 billion.
Payments on the GDP-linked securities are contingent on Argentina’s economic performance. The securities will pay holders only if both the level and growth of GDP exceed a specified threshold in the relevant reference year, beginning in 2005 and ending in 2034. In addition, the sum of payments that can be received during the life of the security cannot be higher than 48 percent of its notional value. Payments will be made on December 15 of each year following the relevant reference year. The first payment, of about 0.2 percent of GDP, is expected to be made on December 15, 2006.
As the GDP-linked securities were attached to their underlying bonds at the time of the debt exchange, it was difficult to separate the valuation of each item. The value of the restructuring offer was priced by market participants in the range of 34–35 cents per dollar of principal claims. Market analysts at that time estimated the theoretical value of the GDP-linked securities to be about 4 points (cents per dollar of notional value) but recommended adopting a conservative approach and valuing the GDP-linked securities at half the estimated theoretical value. The conservative approach reflected a host of factors that are hard to quantify, including the novelty of the instrument and other possible obstacles; these are analyzed in Borensztein and others (2004).1 This box was prepared by Marcos Chamon and Cheng-Hoon Lim.
These considerations may have underpinned a number of developments in emerging market country debt structures in recent years, including the following:
Greater reliance on long-term, domestic currency debt by a number of emerging market issuers. Domestic currency bonds have become more attractive for nonresidents, owing in part to the development of local emerging market indices (IMF, 2005c, Chapter 2). In addition, a number of emerging market sovereigns have issued domestic currency debt on international markets.16 And the share of long-term, domestic currency debt issued on domestic markets has recently increased somewhat, though with considerable variation across regions (Figure 3.3).
Asian Bond Market Initiative. The establishment of a set of Asian Bond Funds has sought to foster the development of government bond markets in the domestic currencies of a number of East Asian countries (Box 3.1). This is aimed in part at reducing countries’ exposures to maturity and exchange rate risks as well as sudden stops.
Use of GDP warrants in Argentine debt exchange of early 2005. This is by far the largest issue of growth-indexed instruments to date, for a total market capitalization estimated at US$5.8 billion in mid-April 2006 (Box 3.2).
Figure 3.3.Emerging Market Economies: Shares of Long-Term and Medium-Term Fixed-Rate Domestic Currency Debt, 1990–2003
Source: Guscina and Jeanne (2006).
Notes: The sample includes emerging economies in Latin America (Argentina, Brazil, Chile, Colombia, Mexico, and República Bolivariana de Venezuela), Asia (China, India, the Republic of Korea, Malaysia, the Philippines, and Thailand), and other regions (Israel and Turkey). The share of long-term and medium-term fixed-rate domestic currency debt is far higher in Asia (left-hand scale) than it is in Latin America (right-hand scale). LHS denotes left-hand scale, and RHS denotes right-hand scale.
On the whole, these developments may be viewed as representing a gradual move toward greater reliance on long-term domestic currency debt and greater use of innovative forms of financing, such as growth-indexed instruments. Although this is encouraging, countries’ liability structures are unlikely to have evolved sufficiently rapidly to obviate the need for other forms of self-insurance against sudden stops and other shocks.
Some benefits of real sector diversification might be achievable through the financial system—for example, by holding foreign equities or engaging in total return swaps between governments or private entities of countries with different production structures—a proposal associated with Nobel laureate Robert C. Merton.
The Institutional Quality Index used in the estimation is the simple average of the Kaufmann, Kraay, and Mastruzzi (2003) indicators of voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. The results are robust to variations in how the index is computed. A recent firm-level analysis of corporate balance sheets in a panel of countries has also found an important effect of institutional quality on domestic financial structures, including debt-equity ratios and the ratio of short-term debt in total debt (Fan, Titman, and Twite, 2003).
These results are corroborated in a new dataset on the structure of government debt in emerging market countries (Guscina and Jeanne, 2006).
Chamon and Mauro (2006) provide a simple framework to price growth-indexed bonds.
Examples include Uruguay in 2003 and 2004, Colombia in 2004, and Brazil in 2005. In addition, private entities have issued global bonds denominated in or indexed to the local currencies in Mexico and Brazil.