Sovereign Debt Flashcards
What does it mean that the risk premium for investing in emerging market debt is above zero?
We would expect it to be 0 because investors in bonds/debts should be risk-neutral. But we see that the risk premium is actually 0.42 over the long term. This tells us either that:
- The performance of the market was better than investors anticipated.
- All investors were not risk-neutral.
What does it mean the spread variance is explained by a common component (underlying similarity) is 50% today but was 75% in the past?
It means that diversification benefits are lower today and that going overseas in the past had more benefit than today. The gain of international exposure is smaller today than it used to be.
What can the increased co-movement of crises be attributed to? (the fact that crises are more global today and was more country-specific in the past)
- Economic fundamentals
2. Changes in investor behaviour.
Why is the difference in mean spread between the emerging markets (EM) relative to the base country (US or UK) increasing from past to now?
Because something happens with the benchmarked currencies –> no gold standard anymore. So the common thing about EM countries is that they have different monetary regime than the base country.
Average correlation between countries in the sample almost doubles between past and now, what does this imply?
In the past - lot of extra return and diversification benefits of investing overseas - but today, these return or risk reduction benefits are much smaller.
Why do we see that the co-movement of stock return and market return is high but R^2 is really low in the past? And then this R^2 increases a lot until today?
Because back in the days we did not have that many professional investors as we have today, that trade overseas all the time. But today we have this and this create artificial contagion between countries that have no economic connection in reality but investors who stop investing in Thai when they get into trouble, also stop investing elsewhere because they need to reduce their risk. So, then a lot of countries move in the same direction just because investors behave like this.
What is the problem with the sample of countries in past vs now?
The problem is that the underlying assumption is that they are a proxy for all EM countries in each respective period. BUT there are many countries in the historical example that are very UNLIKE the modern sample (Queensland, Sweden etc). So it’s not surprising that we have less co-movement due to more heterogeneity. We don’t have that anymore. SO the authors argument about investor returns have changed is questionable.
How does debt change over time (the equation)?
change of debt = primary surplus(deficit) - ndfs (non-debt financing sources) + debt from last period * [(1+i)/(1+g)(1+pi)].
So How does interest, growth and inflation affect debt over time?
Interest rate push up the value of debt, whereas growth and inflation reduce the debt burden.
If we rewrite interest rate and inflation as real interest, how does the real interest-growth differential affect debt?
The larger differential, meaning that real interest is relatively large in comparison ot growth, the larger the debt will grow.
If we want a stable debt/GDP ratio –> what has to be true on the other side of the equation?
The other side of the equation must also equal =0, and therefore the primary deficit(surplus) must equal the change in debt (that is dependent on r and g). So, if the debt grows, there must be a primary surplus for the debt to be sustainable.
What is an important factor when looking at sustainability of debt, that is often missing?
The time-aspect!! Since the sustainability of debt is dependent on the interest rate and growth, and since these two factors vary over time, we must look at the time dimension. It is not a snapshot of the truth that we can just say “Yes this is a sustainable level”…
What do Bohn mean with the debt/GDP ratio should be stationary?
He means that if debt is growing, policy reaction should be such that the primary surplus increase, as corrective actions. If this holds, the debt/GDP ratio is stationary. In other words, this means that the time series has a constant variance over time and no trend.
What is the limitation of the Bohn approach of estimating the policy reaction function?
The limitation is that it does not say what the appropriate level of response is. The only thing they can state is that “yes, US correct increasing debt by raising the primary surplus”. But they don’t say if they do it big enough or what the right level of response is.
Apart from taking the time dimension into consideration when looking on how g and I affect debt, what more is important?
It is important to understand that those factors are also interrelated. Changing the interest, will affect growth and primary surplus, which in turn all affect the debt/GDP ratio. And changing the growth rate will also affect interest rates and so on. Interdependencies.
What is one of the first things you need to worry about when debt rise too high?
That mortgages will need to be re-financed, because typically they are contracted for only 3,5,10 years ahead, and now when you need to re-finance, the interest might be higher. Governments need to service this debt and often issue short-term debt (because cheaper) - this creates a roll over-risk. the bore debt you need to roll over, the more exposed you are to this risk - that the market conditions might be unfavourable at this future point in time.
