Portfolio Balance Lecture 24 assumption: exchange risk is the only important risk. Lecture 25 assumption: default risk is important. API-120 - Prof.J.Frankel

Recap of L24 Questions Key parameters Home bias in portfolio holdings How can we allow for effects of risk? Currency risk. Country risk. How can we allow for effects of debt even if it is not monetized? Effects of budget deficits & current account deficits. Key parameters Risk-aversion, ρ Variance of returns, V Covariances among returns, Cov. Home bias in portfolio holdings API-120 - Prof.J.Frankel

Evidence of home bias in US holdings Equity shares are from 1997 comprehensive survey of US residents’ holdings of foreign securities. Bias column ≡ 1 minus (foreign equity share / world market share). If US investors held foreign securities in proportions equal to those in the world equity market benchmark, bias would = 0. From: G.Baekert & R.Hodrick, Intl. Fin.Management, 2004, Table 14.16, Panel A Source: Based on Table 1, in Ahearne, Griever & Warnock (2002). Country Share in U.S. Bias Equity Portfolio US 89.90 UK 1.82 0.79 Japan 1.14 0.88 France 0.71 0.75 Canada 0.59 0.75 Germany 0.54 0.85 Italy 0.35 0.76 Netherlands 0.89 0.55 Switzerland 0.52 0.79 Sweden 0.32 0.72 Country Share in U.S. Bias Equity Portfolio Spain 0.21 0.83 Australia 0.26 0.79 Hong Kong 0.23 0.87 Mexico 0.29 0.56 Brazil 0.26 0.76 India 0.05 0.91 China 0.02 0.98 Taiwan 0.04 0.97 Russia 0.07 0.87 South Africa 0.08 0.92

International diversification has risen Proportion of foreign bonds + equities in total equity + bond portfolios of residents in the reported countries. From a 2002 UBS Asset Management study. Source: Baekert & Hodrick, op.cit., Table 14.16, Panel B 1991 2000 US 4% 11% Japan 12% 27% The Netherlands 12% 62% UK 23% 26% Switzerland 11% 21% Australia 14% 19% Sweden 4% 25%

Home bias in equity holdings Home bias in equity holdings. Most equities are held by domestic residents.

Home bias in equity holdings has slowly declined

Lecture 25: Country Risk One lesson of portfolio diversification theory: A country borrowing too much drives up the expected rate of return it must pay. The supply of funds is not infinitely elastic. -- especially for developing countries. The portfolio-balance model can be very general (menu of assets). In Lecture 24, we considered a special case relevant especially to rich-country bonds: exchange risk is the only risk. Some modifications are appropriate for developing country debt. API-120 - Prof.J.Frankel

API-120 - Prof.J.Frankel

EM sovereign spreads Spreads rose again in Sept. 2008 ↑ , Bpblogspot.com Spreads rose again in Sept. 2008 ↑ , esp. on $-denominated debt & in E.Europe. ↑ Spreads shot up in 1990s crises, and fell to low levels in next decade.↓ WesternAsset.com World Bank API-120 - Prof.J.Frankel

Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011 What determines spreads? EMBI is correlated with risk perceptions risk off “risk on” Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011 API-120 - Prof.J.Frankel

The portfolio balance model can be applied to country risk Demand for assets issued by various countries f: x i, t = Ai + [ρV]i -1 Et (r ft+1 – r dt+1) ; Now the expected return Et (r ft+1) subtracts from i ft the probability of default times loss in event of default. Similarly, the variances & covariances factor in risks of loss through default. When perceptions of risk are high, sovereign spreads must be high for investors to absorb given supplies of debt. API-120 - Prof.J.Frankel

In developing countries: The view from the South In developing countries: Domestic country is usually assumed a debtor, not a creditor. It must pay a premium as compensation for default risk. Debt to foreigners was usually $-denominated (before 2000). Then, expected return = observed spread between interest rate on the country’s loans or bonds & risk-free $ rate, minus expected loss through default -- instead of rp . Denominator for Debt : More relevant than world wealth is the country’s GDP or X. Why? Earnings determine ability to repay. Supply-of-lending-curve slopes up: when debt is large investors fear default & build a country risk premium into i. API-120 - Prof.J.Frankel

The spread may rise steeply when Debt/GDP is high. Stiglitz: it may even bend backwards, due to rising risk of default. Supply of funds from world investors ≡ Debt/GDP API-120 - Prof.J.Frankel

Spreads charged by banks on emerging market loans are significantly: Eichengreen & Mody (2000): Spreads charged by banks on emerging market loans are significantly: lower if the borrower generates more business for the bank, but higher if the country has: -- high total ratio of Debt/GDP, -- rescheduled in previous year -- high Debt Service / X, or -- unstable exports; and  reduced if it has: --  a good credit rating, -- high growth, or --  high reserves/short-term debt API-120 - Prof.J.Frankel

Estimated from 67 restructurings, 1980-2009 For some years after a restructuring, the defaulter may be excluded from access to international finance. Estimated from 67 restructurings, 1980-2009 Juan Cruces & Christoph Trebesch, 2013, “Sovereign Defaults: The Price of Haircuts,” AEJ: Macro, Fig.5, p. 111.

For some years after a restructuring, the defaulter has to be paid higher interest rates, especially if creditors had to take a big write-down (“haircut”). Estimated, 1993-2010 especially the 1st 5 years Cruces & Trebesch, 2013, “Sovereign Defaults: The Price of Haircuts,” Fig.3. API-120 - Prof.J.Frankel

Why don’t debtor countries default more often, given absence of an international enforcement mechanism? Common answer: They want to preserve their creditworthiness, to borrow again in the future. Kletzer & Wright (2000), Amador (2003), Aguiar & Gopinath (2006), Arellano (2008), Yue (2010). But: • “Defaulters don’t seem to bear much of a penalty for long”: Eichengreen (1987), Eichengreen & Portes (2000), Arellano (2009), Panizza, Sturzenegger & Zettelmeyer (2009). • “Not a sustainable repeated-game equilibrium”: Bulow-Rogoff (1989). 2. Cynical answer: Finance Ministers want to remain members in good standing of the international elite. 3. Best answer (perhaps): Defaulters may lose access to international banking system, including trade credit. Loss of credit disrupts production, even for export. Theory: Eaton & Gersovitz (RES 1981, EER 1986). Evidence: Rose (JDE 2005). API-120 - Prof.J.Frankel

Definition of sustainability: a steady or falling debt/GDP ratio Debt dynamics: Definition of sustainability: a steady or falling debt/GDP ratio 𝑏 ≡ 𝐷𝑒𝑏𝑡 𝑌 where Y ≡ nominal GDP. 𝑑𝑏 𝑑𝑡 = 𝑑 𝐷𝑒𝑏𝑡/𝑑𝑡 𝑌 − 𝐷𝑒𝑏𝑡 𝑌2 𝑑𝑌 𝑑𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑠𝑐𝑎𝑙 𝐷𝑒𝑓𝑖𝑐𝑖𝑡 𝑌 − 𝐷𝑒𝑏𝑡 𝑌 𝑑𝑌/𝑑𝑡 𝑌 = 𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝐷𝑒𝑓𝑖𝑐𝑖𝑡 + (𝑖 𝐷𝑒𝑏𝑡) 𝑌 −𝑏𝑛 where n  nominal growth rate. => 𝑑𝑏 𝑑𝑡 = 𝑑 + 𝑖 𝑏 − 𝑏𝑛 where d  Primary Deficit / Y . = 𝑑 + 𝑖 − 𝑛 𝑏. => Debt ratio explodes if d > 0 and i > n (or r > real growth rate). API-120 - Prof.J.Frankel 18

= d + (i - n) b. where n  nominal growth rate, and d  primary deficit / Y . Debt dynamics line shows the relationship between b and (i-n), for db/dt = 0. Even with a primary surplus (d<0), if i is high (relative to n), then b is on explosive path. db/dt=0 range of explosive debt range of declining Debt/GDP ratio b API-120 - Prof.J.Frankel 19

Debt dynamics, continued It is best to keep b low to begin with, especially for “debt-intolerant countries.” Otherwise, it may be hard to stay on the stable path if i rises suddenly, due to either a rise in world i* (e.g., 1982, 2015?), or an increase in risk concerns (e.g., 2008); or n exogenously slows down. Now add the upward-sloping supply of funds curve. i includes a default premium, which probably depends in turn on db/dt. => It may be difficult or impossible to escape the unstable path without default, write-down, or restructuring of the debt, or else inflating it away, if you are lucky enough to have borrowed in your own currency. API-120 - Prof.J.Frankel 20

Debt dynamics, with inelastic supply of funds Greece 2012 range of explosive debt range of declining Debt/GDP Ireland 2012 b API-120 - Prof.J.Frankel

Professor Jeffrey Frankel, Kennedy School, Harvard University explosive debt path Professor Jeffrey Frankel, Kennedy School, Harvard University API-120 - Prof.J.Frankel 22

Appendix 1: Debt dynamics graph, with possible unstable equilibrium Supply of funds line i Initial debt dynamics line { sovereign spread iUS API-120 - Prof.J.Frankel

(1) Good times. Growth is strong. db/dt = 0, or if > 0 nobody minds (1) Good times. Growth is strong. db/dt = 0, or if > 0 nobody minds. Default premium is small. (2) Adverse shift. Say growth n slows down. Debt dynamics line shifts down, so the country suddenly falls in the range db/dt>0. => gradually moving rightward along the supply-of-lending curve. (3) Adjustment. The government responds by a fiscal contraction, turning budget into a surplus (d<0). This shifts the debt dynamics line back up. If the shift is big enough, then once again db/dt=0. (4) Repeat. What if there is a further adverse shift? E.g., a further growth slowdown (n↓) in response to the higher i & budget surplus. => b starts to climb again. But by now we are into steep part of the supply-of-lending curve. There is now substantial fear of default => i rises sharply. The system could be unstable…. API-120 - Prof.J.Frankel

Appendix 2: The blurring of lines between debt of advanced countries and developing countries 1) Since the crisis of the euro periphery began in Greece in 2010, we have become aware that “advanced” countries also have sovereign default risk. 2) Since 2000, Emerging Market Countries have increasingly been able to borrow in their own currencies, so their debt carries currency risk (not just default risk). API-120 - Prof.J.Frankel

1) Country creditworthiness is now inter-shuffled “Advanced” countries (Formerly) “Developing” countries AAA Germany, UK Singapore, Hong Kong AA+ US, France AA Belgium Chile AA- Japan China A+ Korea A Malaysia, South Africa A- Brazil, Thailand, Botswana BBB+ Ireland, Italy, Spain BBB- Iceland Colombia, India BB+ Indonesia, Philippines BB Portugal Costa Rica, Jordan B Burkina Faso SD Greece S&P ratings, Feb.2012 updated 8/ 2012 API-120 - Prof.J.Frankel 26

Spreads for Italy, Greece, & other Mediterranean members of € were near zero, from 2001 until 2008 and then shot up in 2010 Market Nighshift Nov. 16, 2011 API-120 - Prof.J.Frankel

2) The end of Original Sin: After 2000, Emerging Markets successfully issued more debt in their own local currencies (LC), instead of $-denominated (FC). Fig. 2 from Jesse Schreger & Wenxin Du “Local Currency Sovereign Risk,” HU, March 2013 API-120 - Prof.J.Frankel

Many developing country governments increasingly borrow in terms of local currency rather than foreign. International Monetary Fund, 2014 API-120 - Prof.J.Frankel

Turkey is able to borrow in local currency (lira), but has to pay a high currency premium to do so. { Total premium on Turkey’s lira debt over US treasuries Pure default risk premium on lira debt { Schreger & Du, 2013, “Local Currency Sovereign Risk,” HU, 2013, Fig. 5 API-120 - Prof.J.Frankel