Default risk and the effective duration of bonds

Basis risk is the risk attributable to uncertain movements in the spread between yields associated with a particular financial instrument or class of instruments, and a reference interest rate over time. There are seven types of basis risk: Yields on 1) Long-term versus short-term financial instruments, 2) Domestic currency versus foreign currencies, 3) Liquid versus illiquid investments, 4) Bonds with higher or lower sensitivity to changes in interest rate volatility, 5) Taxable versus tax-free instruments, 6) Spot versus futures contracts and 7) Default-free versus non-default-free securities. Basis risk makes it difficult for the fixed-income portfolio manager to measure the portfolio's exposure to interest rate risk, heightens the anxiety of traders and arbitrageurs who are hedging their investments, and compounds the financial institution's problem of matching assets and liabilities. Much attention has been paid to the first type of basis risk. In recent years, attention has turned toward understanding the relation between credit risk and duration. The authors focus on that, emphasizing the importance of taking credit risk into account when computing measures of duration. The consensus of all work in this area is that credit risk shortens the effective duration of corporate bonds. The authors estimate how much durations shorten because of credit risk, basing their estimates on observable data and easily estimated bond pricing parameters.Banks&Banking Reform,Payment Systems&Infrastructure,International Terrorism&Counterterrorism,Economic Theory&Research,Insurance&Risk Mitigation,Environmental Economics&Policies,Strategic Debt Management,Economic Theory&Research,Banks&Banking Reform,Insurance&Risk Mitigation

Raising household energy prices in Poland : who gains? who loses?

The authors examine the welfare effects of increasing household energy prices in Poland. Their main finding is that the policy of subsidizing household energy prices, common in the transition economies of Eastern Europe and the former Soviet Union, is regressive. Such programs do help the poor by providing them with lower-cost energy, but they are more useful to the rich, who consume more energy. What is surprising is the extent to which Poland's nonpoor have benefited from lower energy prices. Non only do the wealthy consume more energy in absolute terms than the poor, but they also spend a larger portion of their income on energy. Their analysis allowed the authors to rule out the oft-used social welfare argument for delaying increases in household energy prices, but they do not try to recommend a dynamically efficient pricing path. The first-best response would be to raise energy prices while targeting cash relief to the poor through a social assistance program. This is far more efficient than the present go-slow price adjustment policies, which imply energy subsidies that provide across-the-board relief to all consumers. But if governments want to provide some relief for consumers to ease the adjustment, several options are available: in-kind transfers to the poor, vouchers, cash transfers, and lifeline pricing for a small block of electricity combined with significant price increases. Simulations show that if raising prices to efficient levels for all consumers is not now politically feasible, it may be socially better to use lifeline pricing and a large price increase rather than an overall (but smaller) price increase. Lifeline pricing for electricity in combination with an 80 percent price increase has better distributional effects than a 50 percent across-the-board price increase. Ideally, the public utility would be compensated from the budgtet for any reduced-price sales, rather than having to finance them through internal cross-subsidies. In-kind transfers to poor households are also effective in terms of efficiency, but may be harder to administer in some countries than lifeline pricing.Engineering,Environmental Economics&Policies,Economic Theory&Research,Markets and Market Access,Payment Systems&Infrastructure,Environmental Economics&Policies,Economic Theory&Research,Markets and Market Access,Access to Markets,Energy Demand

The cross-section of stock returns : evidence from emerging markets

Cross-sectional tests of asset returns have a long tradition in finance. The often-used capital asset pricing model (CAPM) and the arbitrage pricing theory both imply cross-sectional relationships between individual asset returns and other factors, and tests of those models have done much to increase understanding of how markets price risk. But much about the way assets are priced remains unclear. After much testing, numerous empirical anomalies about the CAPM cast doubt on the central hypothesis of that theory: that on a cross-sectional basis a positive relationship exists between asset returns and assets'relative riskiness as measured by their Bs (beta being the ratio of the covariance of an asset's return with the market return to the variance of the market return). As tenuous as the relationship between B and returns may be, other risk factors apparently influence U.S. equity market returns significantly: market capitalization (or size), earnings-price ratios, and book-to-market value of equity ratios. Once these factors are included as explanatory variables in the cross-sectional model, the relationship between B and returns disappears. Much"international"empirical work has focused on more developed markets, especially Japan and the United Kingdom, with some evidence from other European markets as well. The international evidence largerly confirms the hypothesis that other factors besides B are important in explaining asset returns. The authors expand the empirical evidence on the nature of asset returns by examining the cross-sectional pattern of returns in the emerging markets. Using data from the International Finance Corporation for 19 developing country markets, they examine the effect on asset returns of several risk factors in addition to B. They find that, in addition to B, two factors - size and trading volume - have significant explanatory power in a number of these markets. Dividend yield and earnings-price ratio are also important, but in slightly fewer markets. For several of the markets studied, the relationship between all four of these variables and returns is contrary to the relationship documented for U.S. and Japanese markets. In several countries, exchange-rate risk is a significant factor. With independent new empirical evidence introduced into the asset-pricing debate, future research must now cope with the idea that any theory hoping to explain asset pricing in all markets must explain how factors can be priced differently simply by crossing an international border. Is it market microstructure that causes these substantial differences? Or (perhaps more likely) do regulatory and tax regimes force investors to behave differently in various countries? As a final hypothesis, can any of these results be attributed to the segmentation or increasing integration of financial markets? The authors offer little evidence on these questions but hope their results will spur further work on the cross-sectional relationship of markets and of assets in testing asset pricing theories.Banks&Banking Reform,Payment Systems&Infrastructure,Economic Theory&Research,Markets and Market Access,International Terrorism&Counterterrorism,Economic Theory&Research,Access to Markets,Markets and Market Access,Banks&Banking Reform,Financial Intermediation

Trade Facilitation and Expanding the Benefits of Trade: Evidence from Firm Leval Data

Existing empirical studies on trade costs and trade facilitation largely focus on aggregate impacts of reform due to data availability. We take a step toward filling in this gap in literature. Using the World Bank Enterprises Surveys, the study extends the scope of empirical literature to firm dimension with a focus on SMEs.Trade Facilitation, Expanding the Benefits of Trade

Reviving project appraisal at the World Bank

The authors focus on two broad questions: 1) what is the proper role for project evaluation in today's world, where countries have reduced major economic distortions and are reconsidering the role of the state? and 2) besides project evaluation, how else can economic analysis ensure high-quality projects? The authors argue for a shift in the emphasis of project evaluation away from a concern with precise rate of return calculations to a broader examination of the rationale for public provision. In this context, three areas critical for proper project appraisal are the counterfactual private sector supply response, the fiscal impact, and the fungibility of lending. (1) Counterfactual private sector supply response. Any type of cost-benefit analysis - be it in the public or the private sector - requires the project evaluator to specify the counterfactual: what wouldthe world have looked like in the absence of the project? Since World Bank projects are public sector projects, the relevant counterfactual involves assessing what the private sector would have otherwise provided, and the relevant magnitude for evaluation purposes is the net contribution of the public project. Failure to consider explicitly the private sector counterfactual during evaluation biases the lending mix of the Bank away from projects with strong public good characteristics toward projects with private good characteristics. (2) Fiscal impact. Applying the private sector couterfactual would lead the Bank to undertake projects with a reasonable case for public intervention, such as basic infrastructure, primary education, and rural health. These projects typically share the characteristics that costs are borne by the public sector while benefits are enjoyed by the private sector. But in the absence of nondistortionary, lump sum taxes, there is likely to be a positive marginal cost of taxation and a premium on public income. Since the Bank has not used such a premium and treats public costs and private benefits equally, it has systematically overestimated the net benefits of these projects. (3) Fungibility of lending. Project-specific appraisal can at best assess only the rate of return and the acceptability of the project being appraised. This limitation is problematic because the project might have been undertaken even without Bank financing. If that is the case, the Bank is actually financing some other project - one not subject to appraisal by the Bank - that would not have been in the investment program without Bank financing. This problem arises because financial resources are fungible to some extent. One way to alleviate this concern is to conduct public expenditure reviews before embarking on the appraisal and financing of specific projects. Furthermore, financing a portion of the government's sectoral investment program may be more effective than project-specific lending.Decentralization,Health Economics&Finance,Public Health Promotion,Poverty Monitoring&Analysis,Environmental Economics&Policies,Health Economics&Finance,Environmental Economics&Policies,Poverty Monitoring&Analysis,Economic Theory&Research,Health Monitoring&Evaluation

Rising Trade Costs? Agglomeration and Trade with Endogenous Transaction Costs

While transport costs have fallen, the empirical evidence also points at rising total trade costs. In a model of industry location with endogenous transaction costs, we show how and under which conditions a decline in transport costs can lead to an increase in the total cost of trade.Transaction costs, trade costs, transport costs, agglomeration, vertically linkedindustries

Savings and education: a life-cycle model applied to a panel of 74 countries

The authors analyze how education contributes to savings. There are many reasons to believe that education and savings may be linked, either positively or negatively. It is generally expected that people with higher education will earn greater income, thereby leading to higher savings, even if the positive relationships between education and income andbetween income and savings take time to be completely realized. The relationship between education and income can be negative at first because education expenses initially increase consumption and reduce current disposable income. Another argument for a negative link concerns precautionary savings. If there is a precautionary motive for savings, education should reduce income volatility because educated people are less likely to be unemployed, or, if unemployed, they are covered by unemployment insurance. With less need for precautionay savings among the more educated, education and savings would be negatively correlated. The author's major findings for a panel of 74 countries over the period 1960-90 include the following views. Education positively influences savings in the long run. For each percentage point increase in education stock, the savings rate increases 0.37 percent. But it takes more than five years for the positive effect, through income, to compensate for the initial negative impact on savings. The lagged effect (five years) of a change in the stock of education appears positive in all regions except Latin America. The negative correlation in this region can be explained by the worsening quality of education, which reduces the ability to implement new technologies, and by the traditional focus on university education instead of primary and secondary education. Moreover, well-educated people in Latin America seem to have a lower precautionary motive for saving than in other regions. People are more productive, invest more, or are a better complement to physical capital in an environment where many people are well-educated. Accordingly, the positive effect of education on savings appears higher in industrial countries, given their higher initial stock of human capital, than in developing countries. The effects of primary and secondary education on savings are positive and significant in all regions, while the effects of university education is positive only in industrial countries. One explanation might be that industrial countries tend to invest in new projects rather than to adopt existing technology. The authors derive several policy recommendations from their conclusions. First, the positive effect of education on savings is enhanced by a reduction in the cost of education which automatically increases disposable income. In many countries, the unit cost of education may be reduced by exploiting economies of scale and by developing incentives for greater cost-consciousness among consumers and providers. Many education systems may need to upgrade their internal efficiency. Second, a focus on primary education should be encouraged, specifically in developing countries. The empirical results indicate that the positive long-run effect associated with primary education is twice as large as that for secondary and tertiary eduation. Latin America's traditional neglect of primary education contrasts sharply with the policy of Asian countries. Finally, it is important to increase the coverage of education, not only for equity but also for efficiency reasons. Indeed, how much a child learns is influenced by the nature of the learning environment, as supported by the role played by externalities and the intial level of education in the realtionship between eduation and savings.Curriculum&Instruction,Decentralization,Economic Theory&Research,Public Health Promotion,Health Monitoring&Evaluation,Gender and Education,Teaching and Learning,Economic Theory&Research,Curriculum&Instruction,Health Monitoring&Evaluation

Hungary's bankruptcy experience, 1992-93

Hungary adopted a tough new bankruptcy law in late 1991 that took effect on January 1, 1992. It required managers of firms with arrears over 90 days to any creditor to file for either reorganization or liquidation within eight days (the so-called"automatic trigger") and provided a rather sympathetic framework in which to do so. The result: since January 1992, more than 25,000 cases have been filed - far beyond lawmakers'expectations. Both positive and negative views about the law have been expressed, but details about how the process has actually worked have been scarce. The authors help fill this information gap by providing detailed data on a randomly selected stratified sample of actual cases filed in 1992-93, supplemented by information gained through interviews with judges, liquidations, and firms involved in bankruptcy. Their conclusions are as follows. First, the bankruptcy process appears to have had some degree of economic logic in 1992 and 1993. Better firms were more likely to enter and emerge"successfully"from reorganization, while worse firms were more likely either to fail in reorganization or to file directly for liquidation. Second, judicial reorganization need not be slow and costly. The first wave of reorganizations was handled surprisingly quickly, especially considering the sheer number of cases, the novelty of the process, and the shortage of trained judges. This quickness was possible largely because of the decentralized design of the process. Once the court approved a case, the court had little role. (Amendments added in 1993 may have made the process more bureaucratic and expensive). Third, in this sample, major delays occurred not in reorganization but in liquidation. Creditors will do almost anything to avoid filing for liquidation, and once firms enter liquidation they are still likely to be kept alive indefinitely. In the end, this lack of a viable creditor-led"exit"and debt collection mechanism harms firms by increasing the cost and reducing the flow of credit. Fourth, although the bankruptcy process displays some degree of economic logic, one should not assume that it operates as a similar law would in a market economy. In particular, a likely source of private gain in Hungary appears to be asset or other value diversion (or"value-stripping) before bankruptcy. Fifth, the main need is to strengthen the incentives of creditors to monitor the process closely and to improve their ability to do so.Banks&Banking Reform,International Terrorism&Counterterrorism,Strategic Debt Management,Small Scale Enterprise,Small and Medium Size Enterprises,Banks&Banking Reform,Strategic Debt Management,Legal Products,International Terrorism&Counterterrorism,Economic Theory&Research

Africa's growth tragedy : a retrospective, 1960-89

Africa's economic history since 1960 fits the classical definition of tragedy: potential unfulfilled with disastrous consequences. The authors use one mehthodology - cross-country regressions - to account for sub-Saharan Africa's growth performance over the past 30 years and to suggest policies to promote growth over the next 30 years. They statistically quantify the relationship between long-run growth and a wider array of factors than any previous study. They consider such standard variables as initial income to capture convergence effects, schooling, political stability and indicators of monetary, fiscal, trade, exchange rate, and financial sector policies. They also consider such new measures as infrastructure development, cultural diversity, and economic spillovers from neighbors'growth. Their analysis: 1) improves substantially on past attempts to account for the growth experience of sub-Saharan African countries; 2) shows that low school attainment, political instability, poorly developed financial systems, large black-market exchange-rate premia, large government deficits, and inadequate infrastructure are associated with slow growth; 3) finds that Africa's ethnic diversity tends to slow growth and reduce the likelihood of adopting good policies; 4) identifies spillovers of growth performance between neighboring countries. The spillover effects of growth have implications for policy strategy. Improving policies alone boosts growth substantially, but if neighboring countries act together, the effects on growth are much greater. Specifically, the results suggest that the effects of neighbor's adopting a policy change is 2.2 times greater than if a single country acted alone.Economic Conditions and Volatility,Public Health Promotion,Health Monitoring&Evaluation,Economic Theory&Research,Environmental Economics&Policies,Achieving Shared Growth,Governance Indicators,Economic Growth,Economic Conditions and Volatility,Inequality

The impact of minimum wages in Mexico and Colombia

There are diverging views about how minimum wages affect labor markets in developing countries. Advocates of minimum wages hold that they redistribute resources in a welfare-enhancing way, and can thus reduce poverty, improve productivity, and foster growth. Opponents, on the other hand, contend that minimum wage interventions result in a misallocation of labor and lead to depressed wages in the very sectors - the rural and informal urban sectors - where most of the poor are found, with the effect of wasting resources and reducing the growth rate. Data from Colombia and Mexico for the 1980s provide an opportunity to evaluate the impact of minimum wages. In Mexico in the 1980s, the minimum wage fell in real terms roughly 45 percent. By 1990, Mexico's minimum wage was about 13 percent of the average unskilled manufacturing wage. During the same period, the minimum wage in Colombia increased at nearly the same rate, reaching roughly 53 percent of the average unskilled wage. The author charts how the mandated minimum wage affected the demand for skilled and unskilled labor in both countries during that decade. Findings are as follows. In Mexico, minimum wages have had virtually no effect on wages or employment in the formal sector. The main reason: the minimum wage is not an effective wage for most firms or workers. In the informal sector, in turn, there is considerable noncompliance with the mandated minimum wage, especially among part-time and female workers. As a result, significant numbers of workers are paid at or below minimum wages. In Colombia, minimum wages have a much stronger impact on wages, judging from their proximity to the average wage and both cross-section and time series estimates. The estimates imply that the elasticity of low-paid unskilled employment with respect to minimum wages is in the range of 2 to 12 percent.Wages, Compensation&Benefits,Environmental Economics&Policies,Labor Policies,Banks&Banking Reform,Municipal Financial Management,Environmental Economics&Policies,Wages, Compensation&Benefits,Child Labor,Banks&Banking Reform,Municipal Financial Management