International Debt and Financial Crises

The latest issue of the IMF’s World Economic Outlook has a chapter on global imbalances that discusses the evolution of net foreign assets (also known as the net international investment position) in debtor and creditor nations. The authors warn that increases in the foreign holdings of domestic liabilities can raise the probability of different types of financial crises, including banking, currency, sovereign debt and sudden stops. A closer inspection of the evidence that has been presented elsewhere suggests that it is foreign-held debt that poses a risk.

The role of international debt in increasing the risk of crises was pointed out by Rodrik and Velasco (working paper 1999), who showed that short-term bank debt contributed to the occurrence of capital flow crises in the period of 1988-98. More recently, Joyce (2011) (working paper here) looked at systemic bank crises in a sample of emerging markets, and found that an increase in foreign debt liabilities contributed to an increase in the incidence of these crises, while FDI and portfolio equity liabilities had the opposite effect. Ahrend and Goujard (2014)(working paper here) confirmed that increases in debt liabilities increase the occurrence of systemic banking crises. Catão and Milesi-Ferretti (2014) (working paper here) found that an increase in net foreign assets lowered the probability of external crises. Moreover, they also reported that this effect was due to net debt. FDI had the opposite effect, i.e., an increase in FDI liabilities lowered the risk of a crisis. Al-Saffar, Ridinger and Whitaker (2013) have looked at external balance sheet positions during the global financial crisis and reported that gross external debt contributed to declines in GDP.

There are also studies that compare the effect of equity and debt flowsLevchenko and Mauro (2007), for example, investigated the behavior of several types of flows, and found that FDI was stable during periods of “sudden stops,” while portfolio equity played a limited role in propagating the crisis. Portfolio debt, on the other hand, and bank flows were more likely to be reversed. Similarly, Furceri, Guichard and Rusticelli (2012) (working paper here) found that large capital inflows driven by debt increase the probability of banking, currency and balance-of-payment crises, while inflows that are driven by FDI or portfolio equity have a negligible effect.

Why are debt liabilities more risky for countries than equity? Debt is contractual: the holder of the debt expects to be paid regardless of economic conditions. Equity holders, on the other hand, know that their payout is tied to the profitability of the firm that issues the debt. Moreover, during a crisis there are valuation effects on external balance sheets. The value of equity falls, which raises the net foreign asset position of those countries that are net issuers of equity, while lowering it for those that hold equity. In addition, debt may be denominated in a foreign currency to attract foreign investors worried about depreciation. A currency depreciation during a crisis raises the value of the debt on the balance sheet of the issuing country.

These results have consequences for the use of capital controls and the sequence of decontrol. Emerging markets should be careful when issuing debt. However, the evidence to date of trends in the international capital markets shows a rise in the use of debt by these countries.Emerging market governments, for example, issued $69 billion in bonds in the first quarter. In addition, the BIS has drawn attention to the issuance of debt securities by corporations in emerging markets.

The IMF has warned of a slowdown in the emerging market countries, with the Fund’s economists forecasting GDP growth rates below the pre-crisis rates.  Speculation about the impact of changes in the Federal Reserve’s quantitative easing policies has contributed to concerns about these countries. If a slowdown does materialize, the debt that was issued by these countries may become a burden that requires outside intervention.