Wednesday, 23 January 2013

Graph of the week: sovereign debt distribution

From the IMF comes a text on what demand for government debt can tell us about future risks of an economy. This basically means that the risk of potential default depends very much on who's holding the government debt, foreigners or domestic investors. Here is the paper, and this is their most interesting finding: 

Source: Arslanalp, Tsuda (2012): "Tracking Global Demand for Advanced
Economy Government Debt"
, IMF working paper
HT: The Economist 

In Quadrant I we have countries with high debt but resilient to a run. In the second quadrant, we have countries with high debt and a high risk of a run (the worse combination). The third quadrant features countries with low debt and resilience to a run (the best combination), while in the fourth are countries with low debt, but prone to a run. The two measures used in designing the investor base index are the demand-side risk indicator (on the horizontal axis), and the supply-side risk indicator (on the vertical axis). And while the supply side indicator is simply a measure of debt-to-GDP, the demand-side indicator looks at ownership of debt (the investor base): 
"By this metric, countries with a high share of domestic investors, such as domestic banks and central banks, as well as foreign central banks in their investor base receive lower scores. In contrast, we assign high scores to countries whose investor base has a high share of foreign private investors as we find they are the most skittish in times of trouble."
The findings are particularly interesting when observing them on a country by country basis, as is done in the graph. It tells us of the high riskiness of peripheral eurozone economies (rightfully including Belgium, but also France and Austria), and a worrying situation in the world's biggest economies of Japan, Germany, US and UK. Even though the later countries don't suffer directly from the risk of default, their high debt-to-GDP ratio makes them potentially risky, at least from the supply perspective. However, have in mind that the methodology of acquiring this data was to give low scores to countries whose debt is own mostly by domestic investors (as is the case with Japan, UK and USA). What this essentially implies is that all countries left of the vertical axis shouldn't worry about the sustainability of their debt since they have a lower risk exposure then their counterparts on the right of the axis. This is a dubious conclusion, as it would imply (from a game theoretical and political economy perspective) that all countries in the third quadrant should converge towards higher debt-to-GDP levels, which are apparently sustainable no matter how high they get, as the majority of debt owners are domestic households or investors. Why did I say political economy perspective? Because the governing politicians will find it more rewarding to run higher public debts to finance their concessions to various supporting interest groups. As long as the domestic entities are the ones barring the burden, there would be no reason for the government to stop this any time soon. Isn't this exactly the case of Japan?

On the other hand, any small open economy (which is basically every economy on the right side of the vertical axis except France) with greater exposure to foreign investments will never be able to run too high debt-to-GDP as their biggest constraint will be foreign ownership of government debt, and hence a higher risk of default. These countries will be (should be) converging towards the fourth quadrant. As a result we should end up with two types of countries; (1) those with high debt-to-GDP but with greater domestic ownership, thus making them less riskier (all the countries on the left do actually have lower bond yields than the countries on the right) and (2) those with low debt-to-GDP, where a constraint to higher debt levels will mainly be foreign ownership of debt. 

I don't buy it. Even though their graph very precisely depicts the actual ratings on the sovereign debt market (except for France and Austria), the source of investment is not good enough of a category to differ between high and low risk countries. There is a multitude of other factors at work here. The Economist has a good explanation:
"There is no reason to think that domestic savers in the currency area are inherently less flighty than foreign ones. In previous currency crises, such as in Southeast Asia in 1997 and Argentina in the early 2000s, the first people to pull their money out were well-connected insiders rather than skittish foreigners. Something similar may have occurred in the euro zone. A Spaniard has very little reason to own Spanish government bonds rather than Dutch government bonds since both instruments are denominated in euros and both are ostensibly free of risk. However, if the Spaniard starts to think that a Spanish bond could be redenominated into pesetas, or could be written down as part of a “voluntary” “private sector initiative,” he has every reason in the world to swap his Spanish bonds for German or Dutch bonds—even if the risk seems vanishingly small. (In contrast, savers in countries with their own currency have to buy locally-denominated debt if they want to hedge long-duration fixed-income liabilities.)"

7 comments:

  1. I really like how you noticed that certain countries will be prone to converging to one group and others to a second one. There are really multiple factors that can influence the outcomes.

    I dont have time to read IMF paper right now, but I like the fact that "The Economist" mentioned expectations. I think expectations of market participants show how credible are the policy makers, and that is basically also one factor that isnt part of the IRI. It is not only question of present policies, but future as well.

    Another thing regarding the use of Debt/GDP ratio in the analysis is the fact that not all levels of the indicator equal same rating grade (and this has also a lot to do with what I mentioned above, even in the world where rating agencies are perfect and work under correct market incentives). So, when a changes in rating of the sovereign occur, debt holders need to change their asset portfolio, not only because they have certain expectations regarding the performance of the bonds - but because regulations require them to do it. In that sense, even if spanish banks/public(through pension or other funds) really want to hold their governments debt, sometimes regulators wont "allow" them to.

    There is a nice paper by R.Caballero , think its called "asset shortages" that shows the importance of safe assets which play almost a role of money in the global finanical system. And this is nothing new, even Hayek was mentioning this when criticizing conventional monetary aggregates. When we end in this kind of a slump as we saw in 2008 with a massive risk repricing, it is natural to observe global demand for safe assets and the shift it causes. Then it is hard to look at the domestic demand for certain assets(government bonds) and pronounce it as a indicator for low risk of abrupt capital outflow, since, there are a lot of other factors at play, as you concluded.

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    1. Good point on the portfolio holdings on debt. This is yet another factor that will bias their estimates on sovereign debt riskiness.

      Also, thanks for the hint on Caballero's paper, I'll look into it. As for the global demand for safe assets, I've been reading about another change in this trend, where investors are switching to buying junk bonds (in January this reached a new high - see the story on Bloomberg)

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    2. It is interesting - low interest rate policy is "blamed" for the facts that investors are seeking higher yielding assets, which is really plausible. While I do agree there is some arbitrage going on, I believe, it is not ZIRP but Feds bad managing of expectations what may be driving the whole thing. QEs are not meant to lower the rates (what everyone is implying). QEs should put money into the system creating inflation expectations and thereby causing a rise in longer term interest rates. If you take a look at Fed's own data on inflation expectations, you will see the curve tanking each year - so they havent done a good job. Fed has constantly been committed to keeping rates low as long as "something doesnt move" which in a way signals a long period of low interest rates (Japan style maybe :D) which induces investors to invest in riskier assets, but not to create safer assets. Some of that hole was filled by government safe assets, and there is an interest debate going on right now between David Beckworth (who also briefly addressed the junk bond issue on this post -http://macromarketmusings.blogspot.com/2013/01/why-we-need-more-private-safe-assets.html) and "The Economist's" Klein of Free Exchange who believes government can fill the gap with its own safe assets - http://www.economist.com/blogs/freeexchange/2013/01/safe-asset-shortage). Dont know how interested are you into monetary policy issues, but since we are throwing papers around, take a look at Whites paper http://dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf where he lists all sorts of possible problems with ultra easy monetary policy. (I dont necessarily agree that we had "ultra easy" monetary policy these last few years, though).

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    3. Exactly, I agree, the Fed is making a mistake and is invertedly causing rates to remain low, which is sending misguided signals to investors. I wasn't aware of the debate, but rest assure I'll look into it.

      I can see you are a market monetarist by vocation :) (and a libertarian by your very interesting blog) Don’t worry, I too am a libertarian, however, I have a few issues with market monetarism (at least as described by Scott Sumner) which I have summarized here – I encourage you to read it so that we may continue the discussion on monetary policy there, if you'd like..

      I don’t oppose it entirely, I just have a few issues with monetary stimuli, as I see it similar to a fiscal stimuli in terms of kick-starting a recovery. Noah Smith had a great comment on this once before.

      As a political economist, and an institutionalist, I believe rules rather than discretion are needed to combat recessions. In that perspective I am in favour of a complete institutional and constitutional reform, rather than short-term political concessions, exactly as the recently late prof. Buchanan has taught us. And as Acemoglu and Robinson have been proposing for some time. I've written about this on numerous occasions.

      I know that Sumner for one has agreed that to combat this recession we need to decide whether or not it was an aggregate demand shock or a structural shock. I think it was a structural shock, which is why I favour a different approach.. I could be wrong, but I find the systemic instabilities of certain nations too big to persist under short-run remedies.

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    4. Thnx for your comments on my blog, I'm writing it to settle my thoughts (i suspect I have maybe a small attention problem) rather than to "entertain/educate the public" :D. Anyways, I will take a look at your other writing when I get some time, but I do want to say now that market monetarists feel the same way about rules than you do, Lars Christensen wrote a post about a need for a monetary constitution : "The problem is that most observers and participants in the monetary policy debate continue to think about monetary policy in a highly discretionary way rather think about monetary policy in terms of rules." And he also mentioned Buchanan in that sense "The problem with today’s monetary policy debate is that it is not a Buchanan inspired debate, but a debate about easier or tighter monetary policy. The debate should instead be about rules versus discretions and about what rules we should have." http://marketmonetarist.com/2013/01/12/forget-about-hawks-and-doves-what-we-need-is-a-monetary-constitution/ **But as you said, any further discussion we may have, we can do it on the related post.

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    5. That is a good proposition indeed. As I said, I don't necessarily disagree with market monetarists, particularly with their calls for rules over discretion, it's just that I don't see their target rule as the necessarily best response to kick-start aggregate demand.
      I'm looking forward to the further discussion on that post.

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  2. Oh! I found it right here. In truth enormous job with the content Graph of the week: sovereign debt distribution . I worship this technique to work on. I will converse with my dearest and nearest concerning the topic. Sure, I will linger for more posts like this. Thanks a lot……..

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