About the blog
The BCC blog is a space of exchange among BCC stakeholders about topics of interest in the realm of central banking. It offers a space where latest trends can be discussed, practical experiences be shared, and a BCC community be developed.
The BCC programme, funded by SECO and implemented by The Graduate Institute, Geneva aims to support partner central banks in emerging countries in building the analytical and technical expertise to conduct effective monetary policy, promote stable and efficient financial sector, and be more operationally sustainable.
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Faiçal Belaid, PhD Economics
How bank lending boosts or impedes economic activity is a fundamental question in financial economic research, and has been assessed in many studies. In recent research, I focus on whether the link is different for young firms.
The key dimension through which the financial system impacts economic development is through the provision of external finance to new businesses or start-ups. Given start-ups’ role in enhancing employment growth, innovation, competition and exports, their financing has important implications for the economy. The two most common start-ups financing mechanisms are equity (internal finance) and bank debt. In underdeveloped financial systems with limited access to venture capital banks are the most important providers of external financing to start-ups. The use of debt by start-ups has significant implications for their profit performance, risk profile and the potential of the business expansion.
A situation where banks charge high interest rates for start-ups, reflecting a risk premium or rent-seeking if competition is limited can negatively affect their performance. Lending to start-ups can entail high lending costs (agency costs, monitoring costs and enforcement costs), leading banks to charge higher interest rates, thereby extracting a large share of start-ups’ rents. This impedes start-ups’ performance by squeezing down their profits and their market shares. Also, the higher cost of borrowing creates a financing barrier for start-ups. While the interest rate on loans is an input cost for all firms, we are interested in whether the impact of interest rates on profit is higher for start-ups than the one for existing firms.
I study the role of the Tunisian bank-centered financial system in financing firms at the time of creation. I find evidence that bank debt costs impede firms’ performance, and that this is more pronounced during the early stage of firms’ life cycle (the first five years of activities). Further, the impeding effect of bank debt on start-ups’ performance is relatively stronger for firms with low amount of collateral. My study finds that the weight of bank debt cost is more pronounced for new businesses than for existing firms which negatively impacts start-ups’ performance.
In countries where the financial system is bank-centered, banks can also take advantages of their monopolistic power and apply higher interest rates than what a competitive risk premium would warrant. This would impede firms’ development.
This study on the role of bank funding on new businesses development in an emerging economy complements the growing theoretical and empirical literature on firm’s capital structure. Policy makers should seek to develop alternative funding strategies for new businesses, such as venture capital. A state owned companies of venture capital could be one possible solution to promote this. Doing so will improve the sustainability of new firms and enhance jobs creation and economic growth.
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A tale of two shocks: financial stress and sovereign default risk during the Covid19 crisis - by Caterina Rho
Caterina Rho, Economist at the DG Financial Stability of Banco de México
The Covid19 pandemic is causing unprecedented stress on public finances. The virus is simultaneously hitting financial markets and the real economy, with potential disruptive effects on public finances in advanced (AEs) and especially emerging market economies (EMs). The health emergency called for sudden increases in fiscal spending, not only to assure adequate hospital care and protection to medical practitioners and coronavirus patients, but also to fund exceptional unemployment insurance programs and emergency support to the private sector, especially strategic firms and small and medium-sized enterprises. Higher public spending, combined with lower fiscal revenues as well as contracting GDP, is leading to increases in the government debt-to-GDP ratio, calling into question the sustainability of the current fiscal stance. At the same time, the increase in uncertainty due to the effects of the virus and the duration of the epidemics hit financial markets. This caused a drop in stock market prices and a sudden stop in capital flows to EMs, with negative effects on domestic currencies, inflation expectations and balance sheets.
The contemporaneous impact of the Covid19 outbreak on the real economy and financial markets is significantly increasing the risk of sovereign default in many EMs. Financial stress can amplify the impact of fiscal vulnerabilities and deteriorating economic fundamentals on the probability of sovereign default through a variety of channels. First, financial stress may weaken markets’ ability to finance sovereign liabilities to the extent that it impacts risk appetite and market liquidity. Second, financial stress can act as a wake-up call that induces complacent or inattentive investors to pay more attention to hitherto-ignored weak fundamentals. Third, financial stress can shed new information on a country’s contingent liabilities that might inflate future public debt. To the extent that the impact of public debt on sovereign risk is non-linear and increasing, information on future upsurges of public debt should have a bigger impact on sovereign risk, the higher the level of current debt.
In a recent paper with Manrique Saenz (Rho and Saenz, 2020) I analyze how financial stress amplifies the negative effects of fragile macroeconomic fundamentals on the probability of sovereign default, a risk that may be underestimated in normal times. This is relevant in the context of the Covid19 crisis, where a contemporaneous negative shock increased both financial stress and the fragility of the real economy. We use a panel dataset of debt burden indicators, sovereign spreads and sovereign defaults that covers 113 Market Access countries, including AEs and EMs, over the period 1990-2014.
We consider two measures of sovereign risk: (i) the country’s 10-year sovereign bond spread with respect to the US-Treasury bond and (ii) the probability of sovereign default. The first measure has the advantage of capturing increases in vulnerabilities even when these are not big enough as to lead to sovereign default. We use an OLS model to estimate the impact of fiscal vulnerabilities on sovereign bond spreads in AEs and EMs and whether such impact is amplified during times of distress in financial markets. Our second measure of sovereign risk is estimated using a logit model based on a dummy for sovereign default episodes. This estimation applies only to EMs given the lack of sovereign default episodes among AEs.
Financial stress can originate from domestic or foreign causes, and we therefore, use two different indicators of private financial stress, a local one and a global one. The local stress indicator is the time series of systemic banking crises estimated by Laeven and Valencia (2018). We consider two alternative measures for the global indicator. The first is a dummy based on the growth rate of the broker-dealer leverage. The second is a dummy that signals excessive increases (higher than 2 standard deviations from the mean) in the VIX index.
We find that sovereign spreads increase with public debt, higher inflation and exchange rate overvaluation, but decrease with higher real GDP growth, GDP per capita, and global growth. We also find that at times of financial distress, the impact of public debt on sovereign spreads is significantly amplified. At times of local financial distress, the impact of other economic fundamentals on sovereign spreads is also amplified: GDP per capita and the level of international reserves (in percent of GDP) seem to matter significantly more for sovereign risk at times of local financial distress than during tranquil times.
Table 1: Average marginal effects of the macroeconomic indicators during tranquil and financial stress periods (Logit model, Emerging markets, 1990-2014)
Table 1 presents the average marginal effects of our set of macroeconomic indicators on the probability of sovereign default in EMs, computed with the logit model. Columns (1) to (3) consider financial stress driven by a local shock, while columns from (4) to (9) consider financial stress from a global financial shock. Public debt is found to impact the probability of default of EMs, and its impact is also amplified significantly during periods of global financial stress. International currency reserves are found to mitigate the probability of default, particularly during times of local financial stress. Finally, a drop in GDP growth rate during times of local or global financial stress is also worsening the sustainability of sovereign debt. We can interpret the Covid19 pandemic as an exogenous global shock that increases financial stress in EMs. Our empirical results justify the current concern for sovereign debt sustainability in those markets.
Laeven, Luc and Fabian Valencia (2018). “Systemic Banking Crises Revisited”. IMF Working Paper 18/206, September
Rho, Caterina and Manrique, Saenz, (2020). “Financial Stress and the Probability of Sovereign Default”, submitted.
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Exceptional measures for exceptional times - by Patrick Bolton, Lee Buchheit, Pierre-Olivier Gourinchas, Mitu Gulati, Chang-Tai Hsieh, Ugo Panizza, Beatrice Weder di Mauro
Patrick Bolton, Lee Buchheit, Pierre-Olivier Gourinchas, Mitu Gulati, Chang-Tai Hsieh, Ugo Panizza, Beatrice Weder di Mauro*
Terrible times ahead, especially in emerging and developing countries
These are not normal times, and what the world is experiencing is not a normal recession. The IMF predicts that only 9 countries out of 190 will have positive per capita GDP growth in 2020 (and none of them will record a growth rate above 2%). To put this in context, at the peak of the global financial crisis more than 75 countries registered positive GDP per capita growth.
A downturn of this magnitude can cause tremendous long-term damage, especially so in emerging and developing economies with high degree of informality and weaker social and economic safety nets.
While many advanced economies are able to finance massive fiscal stimulus packages with super low interest rates, emerging and developing countries are hit by a double whammy as the COVID-19 crisis has led to a sudden stop in capital flows. According to estimates by the Institute of International Finance, non-resident portfolio outflows from emerging market countries amounted to nearly $100 billion over a period of 45 days starting in late February 2020. For comparison, in the three months that followed the explosion of the Global Financial Crisis, outflows were less than $20 billion.
This situation has led more than 100 countries to seek IMF help. As explained in an April 30, 2020 Op Ed by the Ethiopian prime minister Abiy Ahmed, many countries are facing a dilemma: continue to service their external debts or redirect resources to save lives and livelihoods?
The help so far – and its limits
On April 15, 2020, the G20 announced a debt service standstill on bilateral loans for a group of 76 low-income countries, but private creditors were not asked to participate in this standstill. The Institute of International Finance (an organization with a large membership of international banks and fund managers) had, on April 9, called for international coordination and broad creditor participation to support fair burden sharing in this standstill. However, by May 1, it had backtracked, stating that participation of private creditors in the initiative would be on a voluntary basis and based on an assessment of NPV neutrality made by individual private creditors.
The idea that participation is on a voluntary basis, with each private creditor conducting its own NPV calculations, making individualized excuses about fiduciary duties and contractual complexities is a recipe for free riding. And the more free riders there are, the greater the likelihood that even those who were inclined to participate in the first place will back out. After all, no fund manager wants to look stupid in front of her investors. End result: The official sector – i.e., taxpayers – are going to bear the brunt of the cost unless something is changed in the current plan.
To us, it seems pointless for the G20 to provide debt relief for developing countries if the freed resources are directly siphoned into the pockets of private creditors as opposed to going to fighting Covid-19. Nevertheless, an argument can be made that this is not an enormous problem for the countries targeted by the G20 action. In these countries nearly 90% of total long-term external debt is owed to official creditors (multilateral and bilateral).
Middle-income countries are different from low-income countries
By contrast, in upper middle-income countries more than 80% of total long-term external debt is with commercial creditors. Figure 1 compares the G20 action, which amounted to approximately $14 billion, with our estimates of the external long-term debt that needs to be serviced by lower and upper middle-income countries. Estimated debt service to private creditors for lower middle-income countries amounts to $48 billion and estimated debt service to private creditors for upper middle-income countries is close to $200 billion. This is where the real money is.
Figure 1: Debt rollover needs of lower middle-income countries, upper middle-income countries and the G20 action.
Some middle-income countries will face choices similar to that highlighted by the Ethiopian Prime Minister and a standstill for these countries would be useless if it does not include all private creditors. But how can this be done without destroying the international debt market. This is the question that we address in a new report published in the CEPR Policy Insight series (Bolton et al. 2020).
What do to?
We propose that the official sector could coordinate such a standstill and propose a mechanism that would guarantee that the debt relief associated with it would be used for emergency funding related to the global pandemic. A multilateral institution such as the World Bank or other regional development banks could create for each participating country a central credit facility (CCF) allowing a country requesting temporary relief to deposit stayed interest payments for use for emergency funding to fight the pandemic. It is common sense that principal amortizations occurring during the standstill period should also be deferred, so that all debt servicing would be postponed. The CCF would be monitored by the multilateral institution to ensure that the payments that otherwise would have gone to creditors are used for emergency funding related to the global pandemic. Our assumption is that all funding from this emergency facility and associated deferred principal payments would eventually be paid back to creditors since it would be recognized as having the type of preferred creditor status typically associated with lending by a multilateral such as the World Bank or the IMF.
Our proposal is rooted in the doctrine of “necessity” from international law, under which nations are allowed to temporarily defer obligations during times of extreme crisis where they need to give priority to the needs of their populace. Past economic crises, whether in the US or elsewhere, have sometimes led to political interventions to suspend debt payments or to make other modifications to the terms of debt contracts. Such interventions do not automatically undermine credit markets. In some instances, they have actually had the opposite effect, resurrecting debt markets following the intervention. The reason why debt markets recovered was that creditors had anticipated widespread default in the absence of any modification of the repayment terms, and were pleasantly surprised by the intervention that had the effect of reducing the risk of default.
For many reasons most debt contracts are highly incomplete and do not contain provisions prescribing how the parties will react to contingencies such as a global pandemic that would merit lowering debt obligations in this event. Ex post it is easier, of course, to identify the contingency. The political intervention in debt contracts in these events serves the role of completing incomplete debt contracts.
Not all interventions are beneficial in this way. It is important that they take place only in verifiably unusual and urgent circumstances that are outside the debtor’s control. Unusual circumstances are precisely the ones that are hard to describe and to include in a debt contract. By certifying that such an event has occurred and by acting accordingly, the G-20 would ensure that contract terms will be modified only when absolutely necessary and when the modifications are likely to support credit markets.
* The authors are at Columbia University and Imperial College (Bolton), University of Edinburgh (Buchheit), University of California Berkeley (Gourinchas), Duke University (Gulati), University of Chicago (Hsieh), and The Graduate Institute Geneva (Panizza and Weder di Mauro). Parts of this blog post draw from a VoxEU piece titled “Necessity is the mother of invention” https://voxeu.org/article/debt-standstill-covid-19-low-and-middle-income-countries
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Wage Growth and Inflation in Europe: A Puzzle? - by Raju Huidrom, Petia Topalova, and Richard Varghese,
Raju Huidrom, Petia Topalova, and Richard Varghese,