Political instability and the Peso problem

In Latin American countries, political instability is not uncommon: in particular, the transfer of power is not always subject to normal terms of election. In these circumstances, market expectations must not only take into account the commitment of the present government, but also incorporate future decisions of its potential successor. This could increase country risk even when the incumbent government is fully committed to a pegged exchange rate, particularly if the successor government is known to be considering devaluation and strategic default. We develop a model suitable for situations of political instability and substantial dollarisation --- both pervasive factors in emerging markets. The former has been studied by Alesina et al. (1996), who defines political instability as the tendency of a government to collapse (Using a sample of 113 countries for the period 1950 through 1982 they find that in periods of such instability growth is significantly lower than otherwise.); and Annett (2001) has shown how political instability in emerging markets is linked to racial and religion divisions. "Dollarization, defined as the holding by residents of foreign currency and foreign currency-denominated deposits at domestic banks'' has been at the centre of the debate on "original sin'' (Eichengreen & Hausmann 1999). Dollarisation may appear an attractive monetary regime for checking inflation, but if a country has an exchange rate misalignment, the possibility of a financial crisis becomes an issue (Calvo, 2002). In the present model it is assumed that the country under analysis has two possible governments with different ideologies and policy preferences: the existing government, who is fully committed to maintaining the peg, and the successor government which has a low cost of switching to float. Market expectations of a change of government can undermine the effectiveness of the most committed policy-maker: and sovereign spreads can rise even when a currency board is fully supported by the current administration. This paper provides an explicit pricing of such risk when political instability is given exogenously. The Argentinean crisis is used to illustrate the argument. Argentina had a fixed exchange regime and the contractual structure was very much dollarised (Galiani, Heymann & Tommasi 2002), with 2/3 of commercial debt in dollars (IADB, 2004) (Calvo, Izquierdo & Talvi 2003). This left Argentina very vulnerable to a sudden stop. Argentina in 2001 was in a fixed exchange rate regime with a completely committed and fully credible policy-maker to maintain it: Mr Cavallo. Nevertheless, during 2001 the country suffered high country risk and a deep financial crisis, see Figure 1. Hence the issue: why high country risk, even if the current government was fully committed to maintain the peg? The confused nature of the transfer of power in the Argentine case is underlined by the fact that there were 5 presidents in 10 days: and that President Duhalde was only regarded as a care-taker, precluded from running for office when the next round of elections were held in 2003 (Bruno, 2004). Lack of political legitimacy, coming after capital flight had stripped off the central bank of its dollar reserves, could help to explain the chaotic end to convertibility. These could prove interesting extensions to the political economy approach adopted here

Good faith in soverign debt restructuring: the evolution of an open norm in 'localised' contexts?

Since the Argentine debt crisis in 2001 (and the settlement of 2005) the influence and credibility of the official sector especially the IMF is at a historical low. It is in this context that changes in sovereign bond contracts, for instance, the widespread adoption of collective action clauses raise questions about future debt restructurings. Market participants, especially creditors overwhelmingly believe that contract modification is important but only ‘at the margins’. If contractual change is marginal, what then are the mechanisms that will ensure fair and orderly debt workouts? In the absence of a global, multilateral, regulatory framework for sovereign debt restructuring, our examination of changes in the period leading up to the Argentine settlement and after, reveals that market participants may instead be relying on good faith to do the job with the court recognising similar expectations. Good faith, though entrenched as a legal norm in several domestic jurisdictions, such as Germany and the U.S., is a relative newcomer to sovereign debt workouts. This evolving norm is not institutionally embedded and unlike the domestically entrenched version, is not a legal rule with specific requirements that needs to be fulfilled. We conclude by showing that good faith is an open norm ‘localised’ inter alia in formal and informal contexts in which market participants interact with each other and therefore conceptually similar to Treu und Glauben as recognised in section 242 BGB

Bargaining and sustainability: the Argentine debt swap of 2005

When Argentine sovereign default in December 2001 led to a collapse of the peso, the burden of dollar debt became demonstrably unsustainable. But it was not clear what restructuring was feasible, nor when. Eventually, in 2005 after a delay of more than three years, a supermajority of creditors accepted a swap implying a recovery rate of around 37 cents in the dollar. In this paper a bargaining approach is used to explain both the settlement and the delay. We conclude that the agreed swap broadly corresponds to a bargaining outcome where the Argentine government had “first mover” advantage: and that substantial delay occurred as negotiators seeking a sustainable settlement waited for economic recovery. Factors not explicit in the formal framework are also considered -- heterogeneity of creditors, for example, and the role of third parties in promoting “good faith” bargaining

Supply shocks and currency crises: the policy dilemma reconsidered

The stylised facts of currency crises in emerging markets include output contraction coming hard on the heels of devaluation, with a prominent role for the adverse balance-sheet effects of liability dollarisation. In the light of the South East Asian experience, we propose an eclectic blend of the supply-side account of Aghion, Bacchetta and Banerjee (2000) with a demand recession triggered by balance sheet effects (Krugman, 1999). This sharpens the dilemma facing the monetary authorities - how to defend the currency without depressing the economy. But, with credible commitment or complementary policy actions, excessive output losses can, in principle, be avoided

Contractionary devaluation and credit crunch: analysing Argentina

Sharp economic contraction often follows currency devaluation in emerging markets - due mainly to liability dollarisation. Such adverse balance sheet effects play a key role in the well-known model of Aghio et al (2000), by reducing investment and future supply. We show how the prompt contraction of output can be accounted for by incorporating demand failure - due to a slow export response and a credit crunch. The resulting eclectic framework is used to study the collapse of the Argentine economy when Convertibility ended in 2002; and to see why efforts to imitate President Roosevelt by 'pesifying' the economy proved counter-productive

Sovereign debt default: the impact of creditor composition

The main motivation of this paper is to study the impact of the composition of creditors on the probability of default and the risk premium on sovereign bonds, when there is debtor moral hazard. In the absence of any legal enforcement, relational contracts work only when there are creditors who have a repeated relationship with the borrower. We show that ownership structures with a larger fraction of long term lenders are associated with a lower default probability and lower risk premia. Moreover, competitive markets structures lead to loss in efficiency as well when there is moral hazard, in contrast to the case with perfect enforceability and information

Credit crunch and Keynesian contraction: Argentina in crisis

The Argentine convertibility regime, where the peso was fixed at parity with the US dollar, ended with a ‘twin crisis’ – a tripling in the price of a dollar and a protracted closure of the entire banking system – accompanied by an economic contraction so severe that it is often referred to as ‘Nuestra gran depresión’. But the government's attempt to imitate President Roosevelt by pesifying dollar loan contracts (while simultaneously protecting dollar depositors) had the effect of destroying bank net worth in the absence of credible compensation. To analyse the macroeconomic effects of credit crunch and currency collapse (and of policies to mitigate them), we turn to a model of crisis, specifically that of Aghion, Bacchetta & Banerjee (2000). Our account, however, combines the supply contraction cause by balance sheet effect with a Keynesian demand contraction due to a domestic credit crunch, exacerbated by unsuccessful resolution of the banking crisis. The latter is analysed as a game of political economy played between government and banks about who pays for the banking crisis induced by default and asymmetric pesification

Sovereign default by Argentina: 'slow motion train crash' or self-fulfilling crisis?

To check hyperinflation, Argentina pegged the peso at one US dollar in 1991. This stopped inflation in its tracks: but, with the rise of the dollar against the Euro and the substantial devaluation of the Brazilian real, the peso became increasingly over-valued leading to a significant country-risk premium on Argentine dollar liabilities as devaluation with ‘pesification’ was anticipated. Here, we apply the Ozkan and Sutherland (1998) model of over-valuation and currency crisis to analyse three scenarios: (i) that Cavallo unnecessarily delayed devaluation, (ii) that the delay was reasonable, and (iii) Cavallo’s view, that the peg should have been preserved but was destroyed by self-fulfilling panic. In conclusion, we argue that, as the costs associated with devaluation and default are largely determined ex post, so the appropriate interpretation depends on how the crisis is handled