1. The Sovereign CCA Model, Financial Crises, and Venezuela Dr. Samuel Malone Profesor Invitado IESA Dr. Samuel Malone Profesor Invitado IESA

2. 2 CCA for Sovereigns vis-à-vis CCA for Firms Firms and BanksSovereigns Market Cap Number of shares*price =Market Cap Base Money plus Govt local-currency debt * exchange rate Distress BarrierSenior Debt Foreign Currency Debt CDS Spread Drivers Leverage, asset volatility, and market price of risk (correlation and Sharpe Ratio) Sovereign leverage, asset volatility, global sovereign market price of risk (correlation and “global Sharpe Ratio”?) (A proxy for the “global market Sharpe Ratio” is the excess return on global stock and bond markets per unit of volatility. This is the subject of ongoing research.)

3. 3 Sovereign CCA – Balance Sheets of Central Bank and Government Consolidated into Sovereign Balance Sheet Reserves Credit to Government Other PV Primary Surplus - Cont. Liab. Other Base Money Foreign Def-free Debt FX Credit from CB Local Currency Debt LC Government BS Central Bank BS Foreign Debt Value FX Base Money* local-currency debt* LC Reserves PV Primary Surplus - Cont. Liab. Other Sovereign (Consolidated) BS *Local Currency Liabilities are base money plus local currency debt

4. 4 Sovereign CCA - Calibrate (Unobservable) Sovereign Asset and Implied Asset Volatility INPUTS Value and Volatility of Local Currency Liabilities* Foreign Currency Debt Distress Barrier B f (from Book Value) Time Horizon *The value and volatility of local currency debt and part of base money, measured in foreign currency terms. See Annex 2 for details USING TWO EQUATIONS WITH TWO UNKNOWNS Gives: Implied Sovereign Asset Value and Asset Volatility Default Probabilities Spreads, Risk Indicators

5. 5 Robustness of Sovereign Risk Indicators: There are very high correlations the CCA Risk Indicators and Credit Default Swap Spreads (CDS) & EMBI bond spreads on foreign currency debt. Highly statistically significant Note that the Risk Indicators did not use sovereign bond or CDS spreads as an input! (See IMF Staff Paper 2008 and IMF Working Paper 05/155 for results and robustness tests)

6. 6 Examples: Risk Indicator vs. Credit Default Swap Spread Correlations are ~ 90 % for 12 countries Results from MfRisk model, Sovereign CCA models built for over 20 countries

7. 7 Example of BRAZIL- Implied Sovereign Asset Value vs Foreign Currency Debt Distress Barrier Sovereign Leverage Ratio was 0.8 in 2002 and 0.18 in 2006

8. 8 Rough Estimates of Drivers of Emerging Market (EM) Sovereigns and (EM) Corporate Credit Spreads EM Sovereigns Credit Spreads January 2007 100 -190 Increased Market Leverage +10-20 Change in Volatility+10-20 Mkt Price of Risk Increase +50-60? Credit Spreads January 2008 190 to 290 bps

9. 9 Sovereign, Bank, and Corporate Economy- wide CCA Sector Interlinked Balance Sheets Corporate Sector Assets Sovereign Assets Equity Default-free Debt Value – Put Option Money & Local Currency Debt Foreign Def-free Debt Value – Put Option Banking/ Financial Sector Assets Deposits and Debt Value – Put Option Equity Contingent Liab Risky Debt = Default-free Value of Debt minus Expected Losses Expected losses in risky debt are implicit put options, contingent liabilities are implicit put options, equity and junior claims are implicit call options See Annex Implicit Put Option

10. 10 Economy-wide CCA Balance Sheet Models Capture Non-linear Risk Transmission Note that if asset volatility in CCA sector balance sheets is set to zero: –Implicit put options go to zero, –Macroeconomic accounting balance sheets and traditional flow-of-funds are the result –Measurement of (non-linear) risk transmission is not possible using macroeconomic flow or accounting frameworks Interlinked implicit options result in compound options that exhibit highly non- linear risk transmission, as seen a variety of financial crises

11. 11 Now let’s relate these concepts to… Petrodollars, Inflation, and Country Risk in Venezuela

12. 12 The Price of Oil During the Past Decade

13. 13 The Bull Market for Commodities Over the Past 2.5 Years Source: see IMF GFSR 2008

14. 14 External Environment: Increase in Volatility and Risk Aversion in International Markets Source: see IMF GFSR 2008

15. 15 External Environment: A Rise in EMBI Spreads across Geographical Areas Source: see IMF GFSR 2008

16. 16 The Venezuelan Environment: A Volatile Fiscal Surplus/Deficit Source: Banco Central de Venezuela

17. 17 A High Rate of Money Growth From January 2003 Onward Source: Banco Central de Venezuela

18. 18 Consequences of Monetary Expansion and Fiscal Volatility

19. 19 High Rates of Consumer Price Inflation Source: Banco Central de Venezuela

20. 20 Source: Banco Central de Venezuela and author’s calculations

21. 21 Source: Banco Central de Venezuela and author’s calculations

22. 22 Negative Real Interest Rates Source: Banco Central de Venezuela and author’s calculations

23. 23 Depreciation of the Parallel Exchange Rate

24. 24 Spending of Petrodollars Causes Expansion of Real Output… Source: Banco Central de Venezuela

25. 25 …While Monetary Expansion Coupled with an Overvalued Exchange Rate Causes Import Boom (source: Malone and Puente, forthcoming) (source: Malone and Puente, forthcoming)

26. 26 Domestic Debt has Increased in Absolute Terms… But has not grown dramatically as a % of nominal GDP

27. 27 External Public Debt (including PDVSA) Increased Substantially in the Past Year Higher leverage contributes to higher spreads. Source: Banco Central de Venezuela and author’s calculations

28. 28 After Falling Sharply in mid-2007, International Reserves Have Recovered Recently Due to the Recent Spike in Oil Prices But high reserve volatility contributes to a high sovereign asset volatility…and that also contributes to higher spreads.

29. 29 Country Risk (EMBI+) Venezuelan spreads have risen much more dramatically during the past 15 months than EMBI+ spreads as a whole.

30. 30 An apparent paradox: rising oil prices and rising external spreads for VZ Because of the increase in the oil price during the past year, we should expect the EMBI spread for VZ to decrease…yet we observe precisely the opposite trend: rising oil prices coupled with a rising EMBI spread. This effect cannot be explained solely by recent turmoil in the international markets, because the VZ spread has increased much more than the Latam or EM spread averages. Higher leverage, in the form of higher debt burdens, has a positive effect on country risk. So does higher sovereign asset volatility. The markedly increased borrowing needs of PDVSA during the past year have contributed to the level of foreign indebtedness and this appears to have played a role in increasing the cost of borrowing for VZ in international markets.

31. 31 FDI: Negative and Trending Downward Source: Banco Central de Venezuela and author’s calculations

32. 32 Recent Policy Dilemmas Money creation causes inflation. However, the government has committed to a wide variety of transfer programs and spending initiatives that keep the rent income flowing into the economy. The increase in the money supply, coupled with a fixed exchange rate, creates a high level of demand for imports of traded goods and services. This high import demand creates a drain on the government’s international reserves, especially as seen during 2007. The government has used a series of debt issues to drain liquidity from the domestic market. This has worked to lower the parallel market rate and, if the situation persists, should effectively lower the drain on foreign reserves.

33. 33 Recent Policy Dilemmas Nonetheless: the increased rate of debt issuance raises the degree of leverage of the government. This will translate into higher spreads on both domestic and foreign debt. These higher borrowing costs will be passed on the domestic firms and individuals, and will act as a disincentive for undertaking much needed investment. As we learn from the sovereign CCA model: the volatility of sovereign assets has a major effect on spreads as well. Thus volatile reserves and exchange rates (including the parallel market rate) contribute to high spreads. Also, volatile oil prices contribute to volatile base money, which implies a volatile sovereign asset.

34. 34 Conclusion The government’s desire to maintain a fixed exchange rate and capital controls is unsustainable in the medium term. We learned all of this years ago from e.g. Krugman, but the situation in Venezuela has the added interest of being a Dutch Disease economy combined with an unsustainable exchange rate regime. In addition to the above, the element of indebtedness and sovereign risk creates the possibility for Venezuela’s “slow motion” crisis of high inflation, low investment, and falling productive capacity in the non-oil traded sector to become a “fast motion” crisis of increasing probabilities of default. There is still room left to correct these imbalances…but the room to maneuver will decrease dramatically if there is a sustained fall in the oil price.

35. 35 Linking the economy-wide CCA models to macroeconomic models Ideally, we would like to link the sector CCA models to macro models in order to form an integrated model for the economy. Leonardo will discuss this in detail for Chile. I will just highlight the issue in two slides.

36. 36 Linking CCA Balance Sheets and Risk Indicators to Simple Macro Monetary Policy Models Monetary Policy Model (GDP gap, inflation, exchange rate, policy rate set by Taylor Rule) Include aggregate credit risk indicator (CRI) in GDP gap equation Include capital adequacy “Taylor-type rule” for the banking sector using CCA with macro variables Incorporates feedback between interest rates and financial system credit risk See (i) Macrofinancial Risk Analysis by Gray, Malone (2008) and (ii) Framework for Integrating Macroeconomics and Financial Sector Analysis by Gray, Karam, Malone, N’Diaye (forthcoming)

37. 37 Unified Macrofinance Framework (Targets: GDP, Inflation, Financial System Credit Risk, Sovereign Credit Risk) Sovereign CCA Model Monetary Policy Model Economic Capital Adequacy Interest Rate Term Structure Model CRIFinancial CCA (Merton-STV) Model (s) Fiscal Policy Debt Management Reserves / SWF Policy Rate Economic Capital Adequacy Bank and Financial Sector Regulations Domestic and International Factors Policies:

38. 38 Thank you, for more information see: Papers by D. Gray, Robert C. Merton, Zvi Bodie: NBER 12637 (2006) NBER 13607 (2007) Sovereign Credit Risk, JOIM v. 5, no. 4, Dec 2007 IMF Global Financial Stability Report (GFSR) IMF Working Papers: WP 05/155, 04/121, 07/233, Indonesia SIP (2006), Gray and Walsh (WP 08/89), Gray, Lim, Loukoianova, Malone (WP/08), IMF Staff Papers Gapen et. al v 55 #1 2008; Framework for Integrating Macroeconomics and Financial Sector Analysis by Gray, Karam, Malone, N’Diaye (forthcoming) Macrofinancial Risk Analysis, Gray and Malone (Wiley Finance book Foreword by Robert Merton) samuel.malone@gmail.com@