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IPE > Sovereign Debt Crisis > Flashcards

Sovereign Debt Crisis Flashcards

1
Q

Types of deficits

A
  • Current account deficit
  • Budget deficit
  • Savings deficit
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2
Q

What is interest rate?

A

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

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3
Q

What is economic growth?

A

Percentage change in value of goods and services produced within period

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4
Q

Two reasons to borrow

A

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)

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5
Q

What does it mean that debt is intertemporal?

A

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

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6
Q

What are debt-for-nature swaps?

A

Creditors forgive part of debt, in exchange government expands conservation

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7
Q

What are blue and green bonds?

A

Governments borrow and use funds for climate mitigation and environmental investments

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8
Q

Political benefits of debt

A
  • 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
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9
Q

The problems with sovereign debt

A
  • Government is exposed to high risks
  • High debt may cause inflation, or make it hard to lower inflation
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10
Q

What is debt service capacity?

A

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?

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11
Q

Russian debt 2022 example

A
  • US sanctions froze Russian assets
  • Creditors demanded to be paid in dollars, not rubles
  • Russia ran out of dollars, defaulted in April
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12
Q

Fallacy of believing public debt = private debt

A

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?

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13
Q

Capital flow cycle

A
  • 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)
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14
Q

How does a debt crisis happen?

A
  • 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
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15
Q

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

A

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

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16
Q

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

A
  • Repay debt
  • Default
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17
Q

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

A

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

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18
Q

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

A

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

19
Q

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

A

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

20
Q

Ongoing debate about the effects of austerity

A
  • 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
21
Q

Default (debt crisis on horizon solutions)

A

Government misses a payment by one or more of its creditors

22
Q

Consequences of default (debt crisis on horizon solutions)

A

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

23
Q

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

A

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)

24
Q

What is a war of attrition?

A

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

25
Q

War of attrition example, US debt ceiling negotiations

A
  • 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
26
Q

What is a key predictor of unsustainable sovereign debt?

A

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

27
Q

Common pool budgeting problem

A

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

28
Q

3 missions of the IMF

A

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

29
Q

IMF as International Lender of Last Resort (ILLR)

A

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

30
Q

The IMF problem, moral hazard

A

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

31
Q

IMF backlash, sovereignty (external, Western intervention)

A
  • 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?
32
Q

IMF backlash, strong, fiscally conservative conditions

A
  • 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”
33
Q

IMF backlash, creditor bias

A
  • Conditions often help creditors regain investments: IMF helps coordinate creditors, may give them more power
34
Q

Why do governments still borrow from the IMF?

A

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”

35
Q

Demand for capital, Latin American debt crisis causes

A
  • 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
36
Q

Supply of capital, Latin American debt crisis causes

A
  • 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
37
Q

Shocks, Latin American debt crisis causes

A
  • 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
38
Q

Resolution of LA debt crisis

A

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

39
Q

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

A
  • 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)
40
Q

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

A
  • 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
41
Q

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

A
  • 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
42
Q

Who did the outcome of the LA debt crisis favor?

A

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

43
Q

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

A
  • 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

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