5.2

Question 1

what is sovereign debt?

Answer 1

when expenditure exceeds income, difference is made up with borrowing

govt budget deficit -> public/national debt

citizens’ saving deficits -> private/personal debt

Question 2

which govs borrow?

Answer 2

everyone

top 20 debtors:

• many low income, emerging markets (Sudan, Venezuela, Argentina)
• also high income, market leaders (Japan, Singapore, US)
• Europe-heavy (Greece, Italy, France, Spain, Belgium)

Question 3

who lends to govs?

Answer 3

since 1970s: private foreign capital > foreign aid and FDI

• multilateral institutions (IMF, WB)
• bilateral governments (China, US, etc.)
• private market (= International Sovereign Bonds (ISB))

private market = “international Sovereign Bonds (ISB)”

• commercial banks issue loans (less popular since 1980s)
• asset managers (pension funds, other private investors) & citizens buy sovereign bonds (seen as save investments, e.g. US treasury)
• central banks (like ECB during covid)

Question 4

debt is unproblematic when:

Answer 4

interest rate (r): cost of borrowing: percentage of principal loan that is due per period

economic growth (g): percentage change in value of goods and services produced within period

debt “works” when r<g (interest rate-growth differential)

when interest rates increase or growth slows, debt becomes unsustainable

when eco growth is larger than the cost of borrowing

Question 5

why borrow?

Answer 5

1. investment in growth
2. consumption smoothing (to manage crises)
3. short-term boost in domestic economy

!debt is inter-temporal: future generation responsible for paying it back in taxes

investment in growth:

• especially in poor countries: low domestic savings -> low investment
• debt fills this savings gap
• “works” if truly spent on growth-enhancing projects (not consumption or “white elephants” (prestige projects that don’t actually produce growth)) = bc when you have to pay it back your econ is larger, can bear the cost of repayment

consumption smoothing (to manage crises)

• crisis (e.g. pandemic) with huge, sudden costs: borrow to smooth costs out over the future = also called TAX SMOOTHING
• (essentially Keynesian)
• one crisis this can help with: Climate crisis

short-term boost in domestic economy

• attractive to politicians: purchase goods to reward supporters, increase popularity by borrowing to fund war, use debt for a short-term eco stimulus before an election
• in the long-run: debt problematic if it doesn’t boost eco growth, short run helps win elections
• TIME-INCONSISTENCY PROBLEM for short-sighted elected officials

Question 6

debt and climate crisis

Answer 6

sovereign debt + climate change are both INTERTEMPORAL PROBLEMS: future generation faces the costs

• gov can borrow $$ to invest in climate change mitigation
• instead of experiencing environmental disaster, next gen will pay higher taxes (will probably be less costly than having to live through the crisis)

debt-for-nature swaps: creditors forgive part of debt in exchange govt expands conservation

blue and green bonds: govt borrow and use funds for climate mitigation and environmental investments

is this the answer to all our climate woes?

probs not: meaningful climate mitigation would likely need to come through grants, massive debt relief for low-income states, or massive low-cost lending

Question 7

sovereign borrowing is not the same as private borrowing!!!

Answer 7

public debt is not the same as private debt!!

gov can be in constant debt -> why can’t private firms/people

• gov lives forever (+ new govs often respect debt that previous governments had)
• CB can influence r to reduce debt service (e.g. Japan, US, UK)(when you borrow in your own currency, CB can lend trough sovereign bonds (with low interest rate) + can cause inflation by printing money)
• MULTIPLIER EFFECT: govt sending (&other fiscal policy) can influence g (lot of gov spending leads to economic growth)
• gov can force household to repay its debt (via the courts) -> who forces te govt to repay?

Question 8

risk of borrowing

Answer 8

• if debt servicing becomes too expensive, it can crowd out other spending (the more you spend on financing your debt, the less you can spend on infrastructure, education etc.)
  *WB: 3.3 billion people live in countries that spend more on interest payments than on either education or health
• high debt may cause inflation, or make it hard to lower inflation (high interest rates problematic if some of your debt is paid at those interest rates + tempting to print money to repay debt)

Question 9

debt service capacity

Answer 9

= ability of the government to make payments on interest and principal as required by loan terms

• function of foreign reserves: govt needs dollars (or euros or yuan) to repay debt
• creditors don’t accept local currency, want their own currency

(principle = actual amount of the loan, what the gov borrowed)

what happens when export collapses? -> not enough foreign reserves to repay

Russia 2022: US sanctions froze Russian assets, creditors demanded to be paid in dollars, not rubles -> Russian ran out of dollars, defaulted in April

Question 10

capital flow cycle

Answer 10

1. there is an excess of currency in the world seeking a home (supply of money is high)
   - banks don’t like to sit on money: want to invest rather than led it erode with inflation -> look for ways to spend it
2. foreign capital floods a country with a demand for capital (country starts taking debt)
3. stimulates economic boom: more borrowing -> more jobs and consumption + capital account surplus
4. encourages financial leveraging and risk taking: more money and fewer safe assets + investors have FOMO (-> more lending)
5. culminates in a crash as banks realize they’ve made too many bad bets and restrict credit to most borrowers (CREDIT CRUNCH)
   - countries start defaulting, lend more to finance debt but take on more debt as a result

e.g.

• 1980s L-A Debt crisis
• 1997 Asian Crisis
• Mexican 1994 crisis
• Russian, Brazilian, Turkish and Argentinian crises (late 90s)
• Germany 1930s
• Great recession of 2008/2009

Question 11

how does a debt crisis happen? illustration of a circle

Answer 11

1. gov borrowers (needs to pay interest and eventually principal)
2. debt starts to accumulate -> creditors start to worry if gov maybe won’t pay them back -> credit ratings go down and interest rate go up (bc higher risk)
3. credit crunch, borrowing gets more expensive (bc country considered less-credit worthy) -> gov may borrow even more to pay off some creditors in short-term
4. govt misses a payment: default -> panic: capital fight (portfolio investment leaves) -> domestic economic crisis
5. restructuring debt (often with help institution): debt relief, haircut (every creditor only gets a specific % back), more time to repay
6. punishment: creditors don’t trust gov + no access to private credit for a while
7. eventually markets will forgive you and the cycle can start again

!at any point the gov can intervene and stop this process

Question 12

what happens when there’s a debt crisis on the horizon?

Answer 12

Gunboat diplomacy = foreign policy goals achieved by threat of military force

• 1902: Germany, Britain & Italy imposed a naval blockade on Venezuela: pay us back or else

not really accepted/done/effective anymore -> less costly options:

-> gov repays debt (austerity or print money) or defaults

Question 13

horizon of crisis - solution 1a: print money

Answer 13

govt needs money to repay creditors, so it just prints more!

• Citizens hate it: inflation is painful, especially for poor
• Creditors hate it: their investment is worth less
• Not a popular strategy to cause inflation. However, this could be a side benefit of inflationary periods: debt is worth less

ORIGINAL SIN (Eichengreen, Panizza, & Hausmann): governments can’t borrow domestically or internationally in their own currency
- some gov is not trusted enough to borrow in their own currency -> can’t take on debt in own currency -> can’t repay by printing money
this is often the case

• Creditors worry govt might print more money to “inflate away” their debt, so they only lend in other “safe” currencies
• Govt needs access to dollars, euros, yuan to repay debt

Question 14

horizon of crisis - solution 1b: austerity to repay debt

Answer 14

Austerity: govt cuts spending and/or increases taxes to raise the money it needs to repay creditors

• Creditors love it. We’ll come back to this and the IMF
• Citizens…sometimes hate it (think Greece 2013 from last lecture). Sometimes they don’t mind, austerity can be popular (e.g. UK tories)

ongoing debate about the effects of austerity:

Leaders may bepunished at the next election, or maybe
voters don’treallycare*Sometimes helps economic growth by reducing wasteful spending, sometimes harms growth by cutting investment21

Question 15

horizon of crisis - solution 2: default

Answer 15

gov misses a payment to one or more of its creditors

consequences:

• eco crisis: capital flight, unemployment, recession
• damage supporters: right-wing voters may be both investors and citizens
• reputation: credit rating drops, more expensive to borrow in future
• institutions: some countries have rules/norms that punish a leader for fault

country that defaulted the most in history = Argentina

Question 16

horizon of crisis - solution 3: get creative

Answer 16

e.g. debt-land swaps

• Sri Lanka sold land to China: urgently needed USD bc of massive debt -> China bought 99y lease to Hambantota Port -> Sri Lanka used dollars from sale to repay bondholders

debt-trap diplomacy?

• China is Sri-Lanka’s largest single creditor
• media and political concern that China has strategic influence over its debtors (polsci is less concerned: haven’t abused this power very much (yet))
• port was leased, not technically sold, but could Sri Lanka change the terms of the lease agreement if it wanted to (probs not)

Question 17

the firefighters: IMF and WB

Answer 17

Bretton Woods organizations

taken together these are members of the World Bank Group

• IMF = loans to prevent/resolve eco crisis = in troublesome time
• WB = loans to fund development projects
  in crisis creditor that helps negotiate + provides additional funding together with IMF

!head of the World Bank Group is always a US citizen + US based)

organizations funded by contributions from member states (quotas)

• if your quota is higher = you get more votes in decision-making
• with 15% you can veto decisions, EU, US ? each have veto, developing countries have veto when acting together

global financial safety net = when gov runs out of funds or can’t get loans from other creditors, turn to the IMF/WB

Question 18

IMF

Answer 18

3 missions: monitor, assist, develop

• Monitor = track state of the economy during annual Article IV visits
• Assist = provide financial assistance to govts in crisis (loans)
• Develop = technical assistance & train so govt can monitor itself, implement “sound” policies

International Lender of Last Resort (ILLR): IMF as “bailout” system to rescue governments in a balance-of-payments crisis & help them repay their debts
- when you can’t borrow from anyone else, usually when severe BoP deficit

two types of debts the IMF responds to

• liquidity crisis: gov (temporarily) ran out of cash bc of shock to the system = short term, can be solved relatively quickly, not structural (South Korea, 1998)
• structural crisis: structure of economy causes/intensifies crisis (Argentina 1983) = need to reorganize the econ to dig yourself out

IMF lends to gov that have run out of cash and credit -> gov’s creditors get repaid, avoid default + gov has to implement policy conditions to prevent future crises and make sure IMF gets repaid

Question 19

the IMF problem: moral hazard

Answer 19

by having IMF in systmem, you’re guaranteed to be bailed out -> incentivizes risky behavior

MF as ILLR provides an implicit bailout guarantee for countries that have high debt burdens and balance of payment problems.

A prospective bailout incentivizes irresponsible behavior (on both sides)

• Borrowers: “Why change policies if the IMF will just keep bailing me out?” -. Remember, our survival-motivated politician: extra incentive to borrow a lot right before an election, if they know they can rely on the IMF to deal with the debt later
• Creditors: “Why not lend to very risky governments if an IMF bailout will make sure I get repaid?”

How can the IMF prevent this behavior and make sure problems that lead to unsustainability do not continue?

• POLICY CONDITIONS on loans help borrower moral hazard: these act like collateral
• Selective lending helps creditor moral hazard: IMF doesn’t bail every govt out!

Question 20

policy conditi: structural adjustment

Answer 20

Washington consensus??? (mentioned, not in slide)

govs need to take smaller role in policy areas where markets work reasonably well (neoliberal, pro-market idea)

stabilize macroeconomic environment, often includes:

• fiscal discipline: more taxes, less spending
• competitive exchange rate (often means devaluation or floating it)
• secure property rights and deregulate to make the market function better
• fight inflation with high domestic inflation rates

= short-run expensive for population

also: IMF will ask gov to:

• liberalize trade and FDI
• private state-owned enterprise

neocolonialism? some argue that this was a way for the West to impose policies that favored its industries over the development of the country

Question 21

IMF backlash - sources of criticism

Answer 21

sovereignty: external, Western intervention

• Kenya 2023: public protests against IMF loans as ‘undemocratic’
• which gov gets the best deals with the IMF (fewer/easier conditions) = often US allies
• can help keep incumbent gov in power
  should the IMF lend to dictators?

strong, fiscally conservative conditions:

• accusation of imposing the same conditions no matter the specific context/situation
• Pakistan 2022: devastating floods triggered eco crisis, IMF refused to lend unless fuel subsidies were cut and taxes increased (criticized bc crisis had nothing to do with eco mismanagement of the gov)
• limit social spending, dev. of welfare state in Global South, death by a “thousand cuts” (accusations they are inhumane)

creditor bias: conditions tend to help creditors regain investments, IMF helps coordinate creditors, may give them more power

• does not help debtors coordinate

Question 22

why do govs stil borrow from the IMF (despite criticsms)?

Answer 22

1. no/little choice: IMF is lender of LAST resort: can’t get funds from other creditors
2. shift in IMF policy: less stringent structural adjustment + more flexible in assesing what caused the crisis: e.g. more attention to climate investment + e.g. during Covid pushed for stimulus rather than austerity + e.g. incorporate social conditions (expansion of health and educain spending in Pakistan)
3. scapegoat hypothesis: leader wants to consolidate debt, raise taxes, cut spending, etc., but citizens are opposed -> bring in IMF to shift the blame

Question 23

the Latin American Debt Crisis
- Stage 1: Mounting Debt

Answer 23

Before the 1970s most developing countries couldn’t attract private capital flows. They depended on the World Bank and Foreign Aid for capital

1973 Oil Shock increases the “pool of money” in commercial banks

• Oil Producers made lots of $$$ and put their money in Western banks
• Oil Producers had large current account surpluses
• supply of petro dollars looking for somewhere to invest it

Seeking to make a return, banks were now willing to lend to “risky” countries by lending them “petrodollars”

LA govts were engaged in Import Substitution Industrialization (ISI) strategy: Remember, this requireda lot of cash!
- Exacerbated by high oil prices –> larger current account deficits –> more need for debt-finance

Supply of Petrodollars meets demand for funds in Latin America –> Latin American countries became world’s largest borrowers by early 1980s

Question 24

the Latin American Debt Crisis
- Stage 2: debt crisis

Answer 24

long-term structural cause = consistent debt-financed gov deficits to fund ISI

shocks:

• rising US interest rates (bf they were fighting inflation): most debt was borrowed in dollars + debt interest rates pegged to US rates -> interest rates rise for LA debt + as US interest rates rise, capital flowed out to the safer asset (US treasury bonds) + value of debts also grew as USD appreciated
• recession in developed world: reduced appetite for LA exports, less money coming in to pay debts
• oil prices rose again in 1979

= less money coming in and higher bills to pay -> incentive to borrow even more

eventually banks stop lending: first to Mexico (August 1982 bc it defaulted), then others

Question 25

LA debt crisis resolution

Answer 25

without foreign $$, buget deficits couldn't be sustained -> negative eco growth LA states turned to Lender of Last Resort: IMF and WB = offer some loans, implement policy conditions - first: creditors try macroeconomic stabilization (though this would be a quick fix, didn't work bc it wasn't a liquidity crisis -> govs still unable to ise neough money to repay debts) - second: creditors band together and push for deeper structural adjustement, reduce govt rle in econ = ISI ended *other countries started to recover from oil crisis, LA didn't -> realised it wasn't liquidity, it was structural result = creditors got most of their money back, LA countries faced significant eco losses - public opposed structural adjustment, domestic war of attriton on who needs to bear the costs - wasn't until late 1980s that govs succeeded in cutting expenditure and reducing public debt - inflation stayed high for a decade, higher unemployment, lower wages (partialy bc govs didn't want to cut spending at first)

Question 26

LA debt crisis = why weren't creditors punished for their "risky loans" why did LA govs pay the cost of the crisis?

Answer 26

IMF and WB helped negotiate on behalf of the creditors, not on behalf of the govts without the IMF, creditors faced a collective action problem - States needed new loans to restart growth and to payback old loans - Each creditor didn’t want to be the ones to make the loans alone, they relied on the IMF to provide loans with conditions - IMF got creditors on board by coordinating and making new loans conditional on new loans from creditors (& on adoption of new policies)

Question 27

why didn't LA states default or threaten default en masse?

Answer 27

Why didn’t LA states default or threaten default en masse? 1.Crisis reduced power of key interest groups that had supported ISI, they were no longer strong enough to oppose reforms 2.US government intervened with Brady Plan: forced creditors to negotiate + made structural adjustment more palatable (got reasonable return) 3.Realization that maybe East Asian model was better after all... The collective action problem again: Default was only optimal if debtors did so together - If they collectively defaulted they could’ve bankrupted many western banks & thus had leverage - Yet some could get a better deal if they defected unilaterally (more capital from IMF & Banks): hard to get collective action - Banks negotiated new loans and payment schedules independently - Creditors engaged in a divide & conquer strategy Outcome was to the advantage of creditors. They got most of their money back AND economic policies across LA changed to be a lot more creditor-friendly

Question 28

a new global debt crisis?

Answer 28

cheap credit flowing into developing world (AGAIN) - after great recession, extremely low interest rates in the west -> returns are low + borrowing cheap - money is cheap + returns are low -> financial seek higher returns from riskier investmentsin developing and emerging economies triple-crisis threatens debt 1. pandemic: high budget deficits to support econ and expand healthcare 2. War in Ukraine: contributed to inflation, espacially on core products (grain + energy) -> many poor countries subsidized food and oil imports -> now govs need to borrow more to pay for them (see Egypt) 3. US interest rates rise and dollar appreciates: more expensive to pay back existing debts not quite of the waters yet: USD continues to appreciate for states that can borrow this is easy, for states that can't it will make it more difficult to pay back existing debt - why invest in Ghana when the US Fed will give you 4.5%? - look out for Ghana, Egypt, Kenya, El Salvador, Pakistan there is a movement to offer debt relief to developing countries from official lenders to avoid a widespread crisis - IMF and WB are working to coordinate creditors, but little progress - private bondholders and china are reluctant to cooperate

Question 29

example: Sri Lanka

Answer 29

“We borrowed too much money at very high interest rates in dollar terms in short maturity and invested in non-revenue generating infrastructure projects.” Causes of the 2022 debt crisis? - years of “imprudent” fiscal policy and risky borrowing - global shocks (COVID-19, war in Ukraine, high interest rates, inflation etc) - changing supply of credit (China stopped most of its official external lending after 2019) Sri Lanka has been in IMF programmesince 2023 Come back in a few years for a full post-mortem: it’s hard to identify causes while you’re still in crisis!

Question 30

takeaways

Answer 30

- Capital Flow Cycle: Supply & Demand of capital is important - Foreign capital is essential to economic growth and management of crises: funds investment & smooths consumption in crises - Debt can help politicians stay in office–can lead to time inconsistency problems - Creditors and Borrowers have collective action problems in times of crisis - IMF is often the lender of last resort for governments in crisis - IMF structural adjustment helps push through reforms to resolve crises, but with growth/social/democratic costs