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Annex 1. Debt Intolerance as Consequence of Financial Frictions
Reinhart, Rogoff and Savastiano (2003) document that less developed countries encounter debt sustainability issues and face default at much lower levels of external debt. They link this “debt intolerance” to countries’ credit history (i.e., number of defaults). However, it can be traced directly to the net margin constraint underpinning the balance sheet effect.
In Townsend (1979), which underpins many models of contractionary currency crises, the sensitivity of the risk premium to the debt-to-net worth ratio depends positively on (i) the distribution of shocks, which gives rise to information asymmetry, and (ii) the verification (bankruptcy) costs the lender has to incur in case of default. Both factors vary across countries, with less developed economies suffering from both higher information asymmetries and higher verification costs. Higher “information asymmetry” can be driven by greater variance of shocks, and hence a larger share of ex-post outcomes falling below the bankruptcy threshold. Catão and Kapur (2004) model this and find empirical evidence for the link between GDP volatility experienced by EMs and spreads. “High verification costs” means that the creditor loses a larger share of the investment if the borrower goes bankrupt.
As shown in the figure below, the sample of analyzed large depreciations supports the link between severity of financial frictions and debt intolerance. Richer countries get into trouble at higher levels of external ST debt (left panel); i.e., debt intolerance is present in the data. Richer countries had lower growth variability pre-depreciation (middle panel), as well as more developed insolvency regimes, as documented by higher recovery rates for creditors.
The very terms emerging and developing markets suggest that financial markets are more prone to frictions and have less developed institutions for mitigating them (e.g., credit bureaus, bankruptcy courts and out-of-court debt restructuring mechanisms). Ultimately, for a certain reduction in net worth, interest rates increase more in less developed countries, making even moderate levels of debt potentially unsustainable. In short, “debt intolerance” can be (largely) attributed to cross-country variations in the severity of financial frictions.
Annex 2. Criteria for Inclusion of Large Depreciation Episodes30
Large depreciation episodes are identified on the log series of the end-of-period monthly bilateral exchange rate vis-à-vis the US dollar. Four criteria have to be met, with the first two conceptually identical to Frankel and Rose (1996) and Cavallo et al. (2005).
1. The depreciation must be large. Δeq,t, the three-month (quarterly) growth, must be above
2. The depreciation must accelerate relative to the previous period. Δeqq, the 3 month-on-3 month depreciation, must be above the 90th percentile, but not exceed the cutoff from the first criterion
3. The depreciation must accelerate relative to the average in the preceding year. Δeqy, the 3-month-on-preceding year’s average depreciation (expressed in terms of three month), must be above the 90th percentile, but not exceed
4. The depreciation must be significant on an annual basis. The year-on-year depreciation in at least one of the first six months into the episode must be above the 75th percentile. This excludes rebounds following short-lived appreciations.
Developing markets, as they are less exposed to private capital flows, which are an important ingredient of analyzed processes.
Nominal peak depreciation exceeding 1,000 percent within the 24 months from the onset of the episode. This eliminates cases with hyper- and very high inflation.
Episodes in transition economies between 1987 and 1996, as large depreciations at the time where driven by the pains of massive structural transformations.
Episodes with peak NEER depreciation under 10 percent. This eliminates cases where interlinked countries depreciated together vis-à-vis the dollar, but where dollar transactions and debt were limited (European countries during the 1992 ERM crisis).
GFC-era episodes where in the second year the currency is more appreciated to the dollar than pre-shock, as the GFC represented a brief but large appreciation episode of the US dollar, relative to which most floating currencies depreciated.