Sovereign Debt Crisis

Question 1

Types of deficits

Answer 1

• Current account deficit
• Budget deficit
• Savings deficit

Question 2

What is interest rate?

Answer 2

Cost of borrowing: percentage of principal loan that is due per period

Question 3

What is economic growth?

Answer 3

Percentage change in value of goods and services produced within period

Question 4

Two reasons to borrow

Answer 4

Invest in growth
- Especially in poor countries
– Low domestic savings = low investments, debt fills this gap
Consumption smoothing
- Crisis (eg. pandemic) with huge, sudden costs
– Borrow to smooth costs out over the future (tax smoothing)

Question 5

What does it mean that debt is intertemporal?

Answer 5

A bet on future generation, as they’re responsible for paying back the debt with their taxes

Question 6

What are debt-for-nature swaps?

Answer 6

Creditors forgive part of debt, in exchange government expands conservation

Question 7

What are blue and green bonds?

Answer 7

Governments borrow and use funds for climate mitigation and environmental investments

Question 8

Political benefits of debt

Answer 8

• The benefits of tax smoothing assumes governments care about the long term health of the economy
• Immediate benefits of debt to politicians:
  – Purchase public and private goods to reward your supporters
  – Increase popularity by borrowing to fund a war
  – Use debt for a short term economic stimulus (right before an election)
  —> The political business cycle
• If politicians are short-sighted and care about elections, then debt can help them stay in power

Question 9

The problems with sovereign debt

Answer 9

• Government is exposed to high risks
• High debt may cause inflation, or make it hard to lower inflation

Question 10

What is debt service capacity?

Answer 10

The ability of the government to make payments on interest and principal as required by loan terms
- Functions of foreign reserves
– Government needs dollars (or euros, or yuan) to repay debt
- What happens if exports collapse?

Question 11

Russian debt 2022 example

Answer 11

• US sanctions froze Russian assets
• Creditors demanded to be paid in dollars, not rubles
• Russia ran out of dollars, defaulted in April

Question 12

Fallacy of believing public debt = private debt

Answer 12

Why can the government be in constant debt, when this would be a disaster for a household?
- The government lives forever
- Central Bank can influence interest rate to reduce debt service
- The multiplier effect
– Government spending (and other fiscal policy) can influence economic growth
- The government can force a household to repay its debt (via the courts) however who forces governments?

Question 13

Capital flow cycle

Answer 13

• There is an excess of currency in the world seeking a home (supply)
  – Banks don’t like to sit on capital they want to invest to make money
• Foreign capital floods a country with a demand for capital
• Stimulates economic boom
  – More borrowing -> More jobs and more consumption
  – Capital account surplus
• Encourages financial leveraging and risk taking
  – More money and fewer safe assets
  – Investors have FOMO, even more lending
• Culminates in a crash as banks realize they’ve made too many bad bets and restrict credit to most borrowers (credit crunch)

Question 14

How does a debt crisis happen?

Answer 14

• Government borrows
  – Needs to pay interest, principal
• Creditors worry, what if government doesn’t pay us back?
  – Maybe government borrowed too much, external shocks, etc.
  – When creditors worry, credit ratings go down and interest rates go up
• Credit crunch, borrowing gets more expensive
  – Government may borrow even more to pay off some creditors in short-term
• Government misses a payment, default
  – Capital flight, domestic economic crisis
• Restructure debt
  – Negotiation between government and creditors for debt relief, “haircut”, more time to repay
• Punishment
  – Creditors don’t trust government
  – No access to credit for a while, or only very expensive credit

Question 15

What did countries used to do when a debt crisis was on the horizon?

Answer 15

Gunboat diplomacy, foreign policy goals achieved by the threat of military force
- 1902: Germany, Britain, and Italy imposed a naval blockade on Venezuela “pay us back or else”
– Not much militarized debt collections since the 19th century

Question 16

What do we see from states nowadays when there’s a debt crisis on the horizon?

Answer 16

• Repay debt
• Default

Question 17

Repay debt, print money (debt crisis on horizon solutions)

Answer 17

Government needs money to repay creditors so it print more money
- Citizens hate it
– Inflation is painful, especially for the 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

Question 18

Repay debt, original sin (debt crisis on horizon solutions)

Answer 18

Governments can’t borrow domestically or internationally in their own currency
- Creditors worry government might print more money to “inflate away” their debt, so they only lend in other “safe” currencies
- Government needs access to dollars, euros, yuan to repay debt

Question 19

Repay debt, austerity measure (debt crisis on horizon solutions)

Answer 19

Government cuts spending and/or increases taxes to raise the money it needs to repay creditors
- Creditors love it
- Citizens sometimes hate it, sometimes they don’t mind, austerity can be popular

Question 20

Ongoing debate about the effects of austerity

Answer 20

• Leaders may be punished at the next election, or maybe voters don’t really care
• Sometimes helps economic growth by reducing wasteful spending, sometimes harms growth by cutting investment

Question 21

Default (debt crisis on horizon solutions)

Answer 21

Government misses a payment by one or more of its creditors

Question 22

Consequences of default (debt crisis on horizon solutions)

Answer 22

Economic 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 to punish a leader for default

Question 23

Get creative, “debt-trap diplomacy” (debt crisis on horizon solutions)

Answer 23

Sri Lanka sold land to China
- 2016: Sri Lanka had massive debts, needed dollars urgently to pay
- China stepped in, bought a 99-year lease to Hambantota Port
- Sri Lanka used dollars from sale to repay bondholders
“Debt-trap diplomacy”
- China holds over 50% of Sri Lanka’s external debt, largest single creditor
- Media and political concern that China has strategic influence over its debtors, political scientists are less concerned
- Port was leased, not technically sold, but, could Sri Lanka actually change the terms of the lease agreement if they wanted to? (probs not)

Question 24

What is a war of attrition?

Answer 24

Two players compete up to a deadline, both incur heavier costs the longer the game lasts, but both continue in the hope that their opponent will give up first
- Debt context: interest groups fight over who bears the costs of debt reduction, the longer the fight the bigger the debt burden gets

Question 25

War of attrition example, US debt ceiling negotiations

Answer 25

- On 5 June 2023, US government was due to hit the debt ceiling, needed congressional approval to borrow more and keep the government running - Republicans denied this, only after huge budget cuts, Republican and Democrats disagreed over which cuts to make (whos support base would pay) - NOT raising the ceiling would have been a disaster for everyone, waiting until deadline to make a deal was also bad, markets panicked - Republicans and Democrats made a deal on 3 June, US didn't default, Republicans got some small budget wins, but both parties were worse off

Question 26

What is a key predictor of unsustainable sovereign debt?

Answer 26

Government fractionalization and divided government - The degree by which power is shared among parties - Many parties in government = greater fractionalization

Question 27

Common pool budgeting problem

Answer 27

More parties at the table, the higher preference to spend - eg. when splitting the bill for dinner with others, how does this affect your order? You'll get the lobster and the €50 bottle of wine - Also more veto players, more chance of a war of attrition when its time to cut spending to repay debt

Question 28

3 missions of the IMF

Answer 28

Monitor - Track state of the economy during annual Article IV visits Assist - Provide financial assistance to governments in crisis (loans) Develop - Technical assistance and training so government can monitor itself, implement "sound" policies

Question 29

IMF as International Lender of Last Resort (ILLR)

Answer 29

The IMF as a "bailout" system to rescue governments in a BoP crisis and help them repay their debts - Liquidity crisis: Government ran out of cash - Structural crisis: Structure of economy causes/intensifies crisis

Question 30

The IMF problem, moral hazard

Answer 30

IMF as ILLR provides an implicit bailout guarantee for countries that have high debt burdens and BoP problems - A prospective bailout incentivizes irresponsible behavior -- Borrowers: why change policies if the IMF will just keep bailing me out? -- Creditors: why not lend to very risk governments if an IMF bailout will make sure it gets repaid? Can be prevented by: - Policy conditions on loans help borrower moral hazard: these act like collateral - Selective lending helps creditor moral hazard: IMF doesn't bail out every government

Question 31

IMF backlash, sovereignty (external, Western intervention)

Answer 31

- Kenya 2023: public protests against IMF loan as "undemocratic" - Which governments get the best deals with the IMF? often US allies - Keep incumbent governments in power (scapegoat hypothesis) Should the IMF lend to dictators?

Question 32

IMF backlash, strong, fiscally conservative conditions

Answer 32

- Pakistan 2022: devastating floods triggered economic crisis, IMF refused to lend unless fuel subsidies were cut and taxes increased - Limit social spending, development of welfare state in Global South, death by "a thousand cuts"

Question 33

IMF backlash, creditor bias

Answer 33

- Conditions often help creditors regain investments: IMF helps coordinate creditors, may give them more power

Question 34

Why do governments still borrow from the IMF?

Answer 34

No (or little) choice: IMF isn't called the international lender of last resort for nothing - Governments can't get funds anywhere else, all other creditors refuse to lend Shift in IMF policy: less stringent structural adjustments - Increased attention to climate investment - eg. during Covid, IMF advocated for stimulus - Incorporating social conditions, like expansion of health and education spending in pakistan The scapegoat hypothesis - Leaders want to consolidate debt, raise taxes, cut spending, etc. - But citizens are opposed, leaders are worried about getting kicked out of office - Solution: bring in the IMF "I have no choice but to raise taxes, the IMF is making me do it"

Question 35

Demand for capital, Latin American debt crisis causes

Answer 35

- The oil shock increased the price of imports for non-oil producing states (LA), increasing current account deficits -- Because of ISI strategy and subsidized industries, can't pass on the costs to their political base - Beyond oil, ISI was inefficient and unprofitable, government cash was the only thing keeping the lights on and workers paid - Government expenditure -> revenue = Budget deficit -> debt

Question 36

Supply of capital, Latin American debt crisis causes

Answer 36

- Banks happy to lend, found eager customers: LA governments, government businesses, banks - Initially led to substantial economic growth (an cash infusion would) - Eventually (early 1980s), Latin American countries became the largest borrowers - Countries eventually couldn't service their debt -- Payments on interest and principal -- Debts didn't lead to enough growth

Question 37

Shocks, Latin American debt crisis causes

Answer 37

- Rising US interest rates -- Most debt was borrowed in dollars (original sin) -- Debt rates pegged to US rates (variable) -- As US interest rates rose, capital flowed out to the safer asset (US treasury bonds) -- Value of debts grew as US currency 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 more - Eventually banks stop lending

Question 38

Resolution of LA debt crisis

Answer 38

LA states turned to the lenders of last resort: IMF and WB offer some loans, implement policy conditions - First: creditors try macroeconomic stabilization (they thought this would be a quick fix) -- Doesn't work, governments still can't raise enough money to repay debts - Second: creditors band together and push for deeper structural adjustment, reduce government role in economy Creditors got some of their money back, LA countries faced significant economic losses - Inflation stayed high for a decade, public opposed structural adjustment, wasn't until later 1980s that governments succeeded in reducing public debt

Question 39

Without the IMF creditors faced a collective action problem (LA debt crisis)

Answer 39

- 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 - Banks could also be free riders on IMF lending (creditor moral hazard) - But the IMF made new loans conditional on new loans from creditors (and on adoption of new policies)

Question 40

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

Answer 40

- Crisis reduced power of key interest groups, they were no longer strong enough to oppose reforms - Reforms made LA governments more "outward oriented", exports grew - US government intervened with Brady Plan: forced creditors to negotiate

Question 41

Why was default for LA states only optimal if debtors did so together?

Answer 41

- If they collectively defaulted they could've bankrupted many western banks and thus had leverage - Yet some could get a better deal if they defected unilaterally (more capital from IMF and Banks) - Banks negotiated new loans and payment schedules independently - Creditors engaged in a divide and conquer stratgey

Question 42

Who did the outcome of the LA debt crisis favor?

Answer 42

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 43

Triple-crisis threatens debt (are we in a new global debt crisis?)

Answer 43

- Pandemic -- High budget deficits to support economy and expand healthcare - War in Ukraine -- Contributed to inflation, especially grain -- Many poor countries heavily subsidized food and oil imports, and new governments need to borrow money to pay for them - US interest rates rise and dollar appreciates -- More expensive to pay back existing debts