Graduate Institute of International and Development Studies International Economics Department Working Paper Series Working Paper No. HEIDWP09-2020 Local Currency Denominated Sovereign Loans A Portfolio Approach to Tackle Moral Hazard and Provide Insurance Ugo Panizza Graduate Institute, Geneva & CEPR Filippo Taddei SAIS - The Johns Hopkins University February 2020 Chemin Eug`ene-Rigot2 P.O. Box 136 CH - 1211 Geneva 21 Switzerland c The Authors. All rights reserved. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. No part of this paper may be reproduced without the permission of the authors. Local Currency Denominated Sovereign Loans A Portfolio Approach to Tackle Moral Hazard and Provide Insurance Ugo Panizza Filippo Taddei The Graduate Institute Geneva The Johns Hopkins University & CEPR SAIS February 2020* Abstract This paper studies how the currency composition of public debt affects debt sustainability in developing countries. We show empirically that the debt-to-GDP ratio tends to grow at a faster rate when countries with a high share of foreign currency debt face a currency depreciation. The paper also discusses the moral hazard problems associated with the presence of domestic currency debt and shows that, for the average country, there is no evidence of a positive correlation between local currency borrowing and inflation. However, moral hazard is a concern for countries with weak institutions where we find that a large share of domestic currency debt is associated with higher inflation. The paper also develops a stylized model that emphasizes the complementarities between foreign and local currency borrowing and highlights that they are complements rather than substitutes. The key intuition is that, while foreign currency debt reduces the incentives to debt monetization, local currency improves debt sustainability by providing a better hedge against external shocks. The paper concludes that the policy framework should consider encouraging a mix of foreign and domestic currency borrowing. This is likely to be particularly useful for low-income countries that are jointly characterized by weak institutions (hence, the importance of the commitment device associated with foreign currency debt) and large external shocks (hence, the importance of the insurance element associated with the presence of domestic debt). JEL codes: H63, F34, C82 Keywords: Sovereign debt, Currency mismatches, Fiscal sustainability, Developing Countries * We would like to thank Harald Hirschhofer for asking us to write this paper, Andrea Greppi for excellent research assistance, and Doerte Doemeland, Steen Byskov, Diego Rivetti, Sahar Ghoussoub, David Nagy, and Miguel Navarro-Martin for helpful comments. Research for this paper was funded by the Federal Ministry of Economic Cooperation and Development (Germany). The usual caveats apply. 1 Executive summary The COVID-19 crisis will have a massive effect on debt sustainability in developing countries. Higher healthcare costs, lower tax and export revenues and frozen debt markets will limit governments’ ability to cover existing expenditure and refinance their maturing debts. The large capital outflows, the currency depreciation, fall in commodity prices, and economic slump associated with the COVID- 19 crisis are likely to lead to a large number of debt crises. These problems are not due to policy failures in the developing world but to external factors including skyrocketing financing needs in advanced economies, elevated risk aversion among investors and a global economic slump. This paper studies how the currency composition of public debt affects debt sustainability in developing countries. It shows that the debt-to-GDP ratio tends to grow at a faster rate when countries with a high share of foreign currency debt face a currency depreciation. The study also highlights that the data are not consistent with the idea that, for countries with average policies and institutions, more local currency debt would lead to moral hazard problems. However, moral hazard is a concern for countries with weak institutions where a large share of domestic currency debt is associated with higher inflation. The paper also develops a simple and stylized model that emphasizes the complementarities between foreign and local currency borrowing. The key intuition is that, while foreign currency debt reduces the incentives to debt monetization, local currency debt improves debt sustainability in bad times by providing a better hedge against economic fluctuations. The paper concludes that a mix of foreign and domestic currency debt is likely to be particularly useful for low-income countries that are jointly characterized by weak institutions (hence, the importance of the commitment device associated with foreign currency debt) and large external shocks (hence, the importance of the insurance element associated with the presence of domestic debt). While an estimation of the optimal share of local currency debt for a sample of low-income countries goes well beyond the objectives of this paper, conversations with a number of practitioners and policymakers suggest that the share of domestic debt in many low-income countries is lower than what prescribed by their own medium-term debt strategies. It is also worth noting that all (or almost all) official lending from the World Bank, IDA, and other multilateral development banks is denominated in foreign currencies. There are two possible reactions to this situation. The first is that what we observe is a market outcome and that the status quo is just a reflection of deeper problems driven by institutional failures. The second reaction is that the current situation is partly driven by historical accidents and that the status quo persists because of inertia and of a series of market and political failures. According to this view, good policies and institutions are a necessary but not sufficient condition for increasing access to local currency debt at reasonable interest rates: policy action to develop a market is needed. The paper concludes with a discussion of the market, policy, and political distortions that may prevent low-income countries from increasing their share of local currency debt. Policy failures relate to the limited debt management capacity of many low-income countries and political failures related to the limited incentives of myopic and self-interested politicians to pay an “insurance’ premium for a safer debt structure that may end up benefitting their successors. 2 1 Introduction The COVID-19 crisis will have a massive effect on debt sustainability in developing countries. Higher healthcare costs, lower tax and export revenues and frozen debt markets will limit governments’ ability to cover existing expenditure and refinance their maturing debts. The large capital outflows, the currency depreciation, fall in commodity prices, and economic slump associated with the COVID-19 crisis are likely to lead to a large number of debt crises. These problems are not due to policy failures in the developing world but to external factors including skyrocketing financing needs in advanced economies, elevated risk aversion among investors and a global economic slump. This paper studies how the currency composition of public debt affects debt sustainability in developing countries. In other words, we ask if Dalio (2018, p.12) is right in claiming that: “when debts are denominated in foreign currencies rather than one’s own currency, it is much harder for a country’s policy makers to do the sorts of things that spread out the debt problems.” There is a long literature on the problems associated with balance sheet effects related to the presence of currency mismatches and on how the multilateral financial institutions could alter the structure of their balance sheets to mitigate the “original sin” problem (Eichengreen et al. 2005, Eichengreen and Hausmann, 2005). However, not much has been done so far, especially in the case of low-income countries. More than 15 years ago, Hausmann and Rigobon (2003) put forward a proposal aimed at dedollarizing lending by the International Development Association (IDA), and yet a recent IDA report on “Addressing Debt Vulnerabilities in IDA Countries,” only includes a short paragraph on the desirability of local currency lending and it does not include a detailed analysis of the costs associated with foreign currency debt. 3 Anecdotal evidence on the dramatic effects of debt composition on debt sustainability is plentiful. For instance, focusing on the crises that hit Latin America at the turn of the century, Borensztein et al. (2006, p. 42) give the following examples: In December 1998, Brazil’s net public debt stood at approximately 42% of GDP, but by January 1999 Brazil’s public debt surpassed 51% of GDP. Could the Brazilian government have run a fiscal deficit of almost 10% of GDP in just one month? Uruguay presents another interesting case. In March 2002, Uruguay’s debt was 55% of GDP, yet by the end of 2003 debt had soared to 110% of GDP. Could the Uruguayan authorities have run a deficit of 55% of GDP in less than two years? Finally, let's look at Argentina. In 2001 Argentina’s debt was just above 50% of GDP. By 2002 Argentina's debt was well above 130% of GDP. Did Argentina really run a deficit of 80% of GDP in just one year? Campos et al. (2006) move beyond anecdotal evidence and use data from 117 countries over a period of 30 years (1972–2003) to show how, among other things, debt composition influences debt explosions. The objective of this paper, which builds on Campos et al.’s (2006) work and expands and refines several of their exercises, is to reignite the debate by analyzing how the interaction between the presence of foreign currency debt and currency depreciations affects debt sustainability. The paper also discusses whether a mix of foreign and local currency debt can strengthen the borrowing position of a sovereign. We start by describing our data and, en passant, making the case for greater data transparency (Section 2).