Foreign currency debt,financial crises and economic growth: A long-run view

Foreign currency debt is widely believed to increase risks of financial crisis, especially after being implicated as a cause of the East Asian crisis in the late 1990s. In this paper, we study the effects of foreign currency debt on currency and debt crises and its indirect effects on short-term growth and long-run output effects in both 1880–1913 and 1973–2003 for 45 countries. Greater ratios of foreign currency debt to total debt are associated with increased risks of currency and debt crises, although the strength of the association depends crucially on the size of a country's reserve base and its policy credibility. We found that financial crises, driven by exposure to foreign currency, resulted in significant permanent output losses. We estimate some implications of our findings for the risks posed by currently high levels of foreign currency liabilities in eastern Europe.     

Financial crises and political crises

The simultaneous determination of financial default and political crises is studied in an open economy model. Political crises accompany default in equilibrium because of an information transmission conflict between the government and the public. Multiple equilibria are possible: if foreign lenders are pessimistic about the country's stability, they demand a high interest on the debt, exacerbating distortions and possibly leading to political crisis; but if lenders are optimistic, the cost of the debt falls and political crises disappear. In such a case, international liquidity packages can select the best equilibrium and rule out political crises at negligible cost.     

The simple dynamics of a debt crisis

Optimal growth path of an ‘impatient’, neoclassical economy is studied, when creditors impose a credit ceiling to prevent debt repudiation. The ceiling becomes binding in finite time. When the credit-constrained regime begins, foreign capital inflows and domestic investment fall abruptly. Output per-capita, consumption, and real wages gradually decline, while the real interest rate rises. These results show that debt crises, in which high external debt is associated to low growth, can occur even in the absence of unanticipated shocks, policy mistakes, or ‘debt overhang’ effects. If distortionary policies cause ‘impatient’ behavior, the model is consistent with chronic capital flight in the debtor country. (JEL F34, F32)     

Capital structure and international debt shifting

This paper presents a model of a multinational firm's optimal debt policy that incorporates international taxation factors. The model yields the prediction that a multinational firm's indebtedness in a country depends on a weighted average of national tax rates and differences between national and foreign tax rates. These differences matter as multinationals have an incentive to shift debt to high-tax countries. The predictions of the model are tested using a novel firm-level dataset for European multinationals and their subsidiaries, combined with newly collected data on the international tax treatment of dividend and interest streams. Our empirical results show that a foreign subsidiary's capital structure reflects local corporate tax rates as well as tax rate differences vis-à-vis the parent firm and other foreign subsidiaries, although the overall economic effect of taxes on leverage appears to be small. Ignoring the international debt shifting arising from differences in national tax rates would understate the impact of national taxes on debt policies by about 25%.     

The cost of private debt over the credit cycle

We identify global and regional fluctuations in international private debt flows to emerging and developing countries using data on cross-border loans and international bond issuance over 1993–2009. We use micro-level data on syndicated cross-border loans and international bond placements to estimate the effects of individual borrower characteristics as well as macroeconomic conditions on the cost of foreign borrowing and test whether these effects differ across phases of the lending cycle. First, we find that borrower characteristics associated with lower loan spreads are not necessarily associated with lower bond spreads. Second, we find differential effects of borrower characteristics between cycle phases for loans and bonds separately. Third, we find strong reductions in the cost of debt finance during periods when international debt flows are more than one standard deviation above their mean, but not for expansionary periods, when the growth rate of debt flows is increasing. We also find that higher trade ratios in the borrower's home country raise loan spreads more in periods of high credit flows but have no effect on bond spreads. At the same time, borrowers residing in countries with high investment ratios pay lower spreads on bond issuance particularly during periods of high credit flows, but we find no similar effect for loan spreads. Inflation rates, real exchange rates and previous banking crises have small impacts on loan and bond spreads.     

Uncertainty and international debt maturity

This paper shows that high macroeconomic volatility, lax rule of law, and inefficient bureaucracy in foreign countries contributes to a tilt toward short-term maturity of international debt. The results are important as short-term debt has been linked to several financial crises in recent years. The paper explores factors that contribute to short-term lending. The results are obtained using data on international lending by three groups of U.S. banks: large, medium-sized, and small. The effect of uncertainty on debt maturity is particularly strong in emerging economies and for smaller banks.     

Granger-causality in peripheral EMU public debt markets: A dynamic approach

Our research aims to analyze the possible existence of Granger-causal relationships in the behavior of public debt issued by peripheral member countries of the European Economic and Monetary Union (EMU), with special emphasis on the recent episodes of crisis triggered in the eurozone sovereign debt markets since 2009. With this goal in mind, we make use of a database of daily frequency of yields on 10-year government bonds issued by five EMU countries (Greece, Ireland, Italy, Portugal and Spain), covering the entire history of the EMU from its inception on 1 January 1999 until 31 December 2010. In the first step, we explore the pair-wise Granger-causal relationship between yields, both for the whole sample and for changing subsamples of the data, in order to capture the possible time-varying causal relationship. This approach allows us to detect episodes of significant increase in Granger-causality between yields on bonds issued by different countries. In the second step, we study the determinants of these episodes, analyzing the role played by different factors, paying special attention to instruments that capture the total national debt (domestic and foreign) in each country.     

Unemployment and debt dynamics in a highly indebted small open economy

The paper analyzes the dynamic effects of a total factor productivity shock and an interest rate risk premium shock in a highly indebted open economy. In contrast to the standard open economy framework, search unemployment and wage bargaining are introduced. We find that a negative total factor productivity shock primarily has effects on the economy's production side and on welfare, but not on its stock of foreign debt and the country specific risk premium, and large part of the adjustment happens in the short-run. In contrast, a pure increase in the country specific risk premium causes substantial dynamics and a considerable reduction in foreign debt, allowing higher consumption in the long run and creating an intertemporal welfare gain, even though unemployment increases strongly in the short-run. A 50% haircut of foreign debt significantly reduces the initial response of the unemployment rate. In case of a temporary productivity shock, sticky wages imply smaller employment, but generate higher welfare than flexible wages.     

Risky public domestic debt composition in emerging economies

This paper explains why public domestic debt composition in emerging economies can be risky, namely in foreign currency, with a short maturity or indexed. It analyses empirically the determinants of these risk sources separately, developing a new large dataset compiled from national sources for 33 emerging economies over 1994–2006. The paper finds that economic size, the breadth of the domestic investor base, inflation and fiscal soundness are all associated with risky public domestic debt compositions, yet to an extent that varies considerably in terms of magnitude and significance across sources of risk. Only inflation impacts all types of risky debt, underscoring the overarching importance of monetary credibility to make domestic debt compositions in emerging economies safer. Given local bond markets' rapid development, monitoring risky public domestic debt compositions in emerging economies becomes increasingly relevant to global financial stability.     

Are twin currency and debt crises special?

In the literature on currency and banking crises it has become the standard procedure to distinguish pure currency crises, pure banking crises and combined (“twin”) currency and banking crises. We show theoretically and empirically that a similar differentiation should be chosen with regard to currency and debt crises. Twin currency and debt crises differ from both pure currency and pure debt crises in their determinants, course of events, and economic consequences. We find that each type of crises has a unique set of macroeconomic causes. We also identify internal contagion and selection bias effects, which may lead to biased empirical estimates if twin crises are not treated as a specific type of crises. Such a separation allows in significantly improving the efficiency of early warning systems especially for debt and twin crises.     

Foreign debt supply in an imperfect international capital market: Theory and evidence

We investigate the determinants of foreign borrowing costs in a stochastically growing economy. We find that these increase with the debt-wealth ratio, depending also upon the volatilities of domestic and foreign origin, and the length of debt contract. In addition, the sensitivity of the short-term debt supply to the debt-wealth ratio exceeds that of long-term debt, and the effects of volatility on the borrowing premium, growth of wealth, and its volatility, depend on the relative size of a direct effect and a secondary portfolio-adjustment effect of the initial shock, as well as the length of the debt contract. Panel regressions suggest that the empirical evidence generally support the theoretical predictions.     

Some macroeconomic effects of nationalizing private sector foreign debt

In the recent debt crisis years, many governments have adopted foreign debts of their domestic private sectors. This paper uses a simple small open economy version of Blanchard's (1985) overlapping generations model to demonstrate that such a policy encourages the accumulation of national foreign debt and can contribute to higher inflation. Because individuals have finite lives they fail to fully internalize the government's intertemporal budget constraint. Current generations therefore regard the debt relief as an increase in wealth. They raise consumption which causes current account deficits. Future generations have to lower consumption to service the additional debt. The debt service takes the form of a higher inflation tax. If the government tries to stabilize exchange rates while nationalizing debt, both the debt and inflation problems are exacerbated.     

Twin deficits and the sustainability of public debt and exchange rate policies in Lebanon

This paper examines empirically using time series econometric models the sustainability of public debt and exchange rate policies, as well as, the relationship between current account and budget deficits in the emerging small open economy of Lebanon. The empirical results point to unsustainable debt and exchange rate policies. Other empirical results support the existence of a uni-directional causal relationship, in the short run, between the budget and current account deficits, indicating that rising fiscal deficits have started to put even more strain on the current account deficits and on the national public debt. To avoid a future depreciation of the exchange rate and perhaps a fiscal and currency crises, the government will have to timely introduce austerity measures to curb the negative implications of its rising budget and current account deficits and debt on Lebanon's economy.     

Foreign currency-denominated borrowing in the absence of operating incentives

It is well known that corporations issue foreign currency-denominated debt to hedge foreign currency cash flows with offsetting interest payments. We test an alternative “opportunistic” motive for foreign currency-denominated borrowing. We do so by constructing a comprehensive sample of foreign currency-denominated bonds issued by sovereign government and agency issuers with no foreign currency cash flows or foreign operations. We find strong and consistent evidence that the borrowers in our sample consider cross-currency differences in covered and uncovered interest yields in choosing the currency in which to denominate their international debt. We estimate the average gains to opportunistic covered yield borrowing to be 4 to 18 basis points. Interestingly, we also find that the average bond offering in our sample precedes a large and beneficial depreciation of the issue currency over the course of the following year. These results support what has been a frequent conjecture in the foreign debt market.     

Analysis of the seeds of the debt crisis in Europe

This paper presents an analysis of the seeds of the recent debt crisis that occurred in the Eurozone area using a variant of Fleming and Stein [2004. “Stochastic Optimal Control, International Finance and Debt.” Journal of Banking and Finance, 28: 979–996] model. This model has two risk drivers arising from uncertainties in the return on capital and the effective rate of return on net foreign assets. Given the risk drivers, we model the net worth value process of an economy under a stochastic setting and show that opening to the rest of the world by pursuing the growth maximizing leverage strategy is better than remaining closed, as that strategy enhances the growth of the net worth process. Second, we provide an extra condition to show when the excessive leverage poses a threat to the sustainable growth of an economy. In this way, we improve the model introduced by Fleming and Stein as a signal of possible debt crises. Finally, we conduct an econometric analysis for the group of countries considered under this study, and show that there is a long-run relationship between the capital stock and the total external debt justifying the use of the structural model we employ.     

The role of foreign currency debt in financial crises: 1880–1913 versus 1972–1997

We show that exposure to foreign currency debt does not necessarily increase the risk of having a financial crisis. Some countries do not suffer from financial fragility despite original sin. Before 1913 British offshoots and Scandinavia afflicted with it avoided financial meltdowns. Today many advanced countries have original sin, but few have had crises. In both periods, aggregate balance sheet mismatches are associated with a greater likelihood of a crisis. The evidence suggests that foreign currency debt is dangerous when mis-managed. This is part of the difference between developed countries and emerging markets both of which borrow in foreign currency.     

Sustainability of macroeconomic policies in selected MENA countries: Post financial and debt crises

In the wake of the recent financial and debt crises, the conduct of macroeconomic policies in the emerging MENA economies has recently become critical in determining those countries future economic situation, due to the accumulation since the early 1990s of a sizable level of external debt, and the pursuit by some countries of a fixed exchange rate regime. Using time series econometric models, this study assesses the sustainability of macroeconomic policies in a selected sample of 4 MENA countries. The empirical results point to sustainable fiscal and exchange rate policies in Tunisia and Morocco, and unsustainable external debt and exchange rate policies in Egypt and Jordan. While Egypt has recently moved to a flexible exchange rate regime, if Jordan still opts for maintaining a fixed exchange rate arrangement, it will have to implement crisis-prevention measures, namely by exercising fiscal discipline, and managing properly its external debt and foreign reserves.     

Does foreign competition affect corporate debt maturity structure? Evidence from import penetration

This paper examines an unexplored issue of how a firm's competitive environment, proxied by import penetration, affects its debt maturity structure. We document a significant, positive relationship between foreign product competition and the proportion of short-term debt. Our results are robust to a series of sensitivity tests and endogeneity concerns. Utilising large, unexpected reductions in import tariffs as exogenous shocks to foreign competition, we validate the positive effect of import penetration on short-term debt. Our results hold more strongly for firms with high information asymmetry and weak external monitoring. These findings indicate that lenders offer short-term debt to prospective borrowers when they exhibit higher information asymmetry in response to increased foreign competition. Additional tests reveal that short-term debt in a firm's financial structure, contingent upon foreign competition, encourages managers to engage in tax avoidance as an alternative funding source. Our study provides novel evidence of the consequential impact of foreign product competition in debt contracting, giving us insights into its practical implications for corporate strategies and the ramifications of trade liberalisation for policymakers.     

Investor information and bank instability during the European debt crisis

Outside of financial crises, investors have little incentive to produce private information on banks’ short-term liabilities held as information-insensitive safe assets. The same does not hold during crises. We compare the information effects of different policy interventions. We measure information production using credit default swap spreads during the Global Financial Crisis and the European debt crisis. We study abnormal information production around major events and find that capital injections reduced abnormal information production while early European stress tests increased it. High levels of information production predict bank balance sheet contraction and higher government expenditures to support financial institutions.     

Supersanctions and sovereign debt repayment

What might happen if a third-party entity had the power to implement fiscal reforms and/or punish sovereign debt defaulters? In contrast to recent history, extreme sanctions such as gunboat diplomacy and “fiscal house arrest” were used to punish debt defaulters during the period 1870–1913. We find that, after a “supersanction” was imposed, a country improved its fiscal discipline. As a result, ex ante default probabilities on new issues fell dramatically and the country spent no additional time in default. Our results suggest some type of external fiscal or monetary control may be effective in imposing discipline on serial debt defaulters.