3 Fiscal Rigidities, Public Debt, and Capital Flight
- Mario Bléjer, and Ke-young Chu
- Published Date:
- June 1989
Alain Ize and Guillermo Ortiz*
One of the salient features of the recent debt crisis in several Latin American countries has been the coexistence of inverse capital flows. In particular, while the proceeds of public external borrowing were flowing in, private capital was flowing out, as domestic investors made massive switches from domestic financial assets into foreign assets.1 Since domestic public debt was generally quite substantial, a large proportion of these domestic assets were government obligations. Thus, while domestic creditors were reducing their exposure to public debt, foreign creditors were increasing theirs.
One explanation for this portfolio substitution is the asymmetrical information available to economic agents: domestic creditors predicted a crisis well before foreign bankers. Although this argument is probably not completely devoid of empirical relevance, it hinges on the existence of substantial long-run irrationality, as this phenomenon occurred over several years and on a scale that should have eventually attracted the attention of the international banking community and led it to revise its lending operations much earlier.
There exists, however, a fully rational way to justify these seemingly contradictory capital flows. It involves asymmetric risk, rather than asymmetric information. The debt crisis corresponded, in many cases, to a fiscal crisis in which governments were faced with the prospect of not being able to keep servicing their debts, domestic or foreign, as fiscal rigidities prevented a sufficiently rapid adjustment of the budget deficit, following, in particular, the occurrence of large external shocks and fast-rising external debts. In this situation, perceived risks of default on government obligations grew rapidly. However, while a declared default on foreign obligations is a major step which entails large potential costs to the borrowing country,2 it is much easier to default in all but name on domestic debt: all this requires is a discrete devaluation which, by raising the price level, erodes the real value of domestic debt. Faced with an asymmetry of exposure between domestic and foreign debt, domestic wealth holders are likely to be the first to pull the trigger on the debt crisis because they perceive themselves as “junior” creditors.3 Furthermore, if domestic assets can be taxed, private capital flight can be encouraged by public foreign borrowing, because the government may be perceived as counting on revenue from domestic asset taxation to service its higher foreign debt in the future. Paradoxically, a country committed to servicing its external obligations can thus be more prone to capital flight, as domestic creditors suspect that the government may be able to maintain external debt servicing only by taxing domestic assets.
The notion that investors shift away from domestic assets to avoid inflation taxes brought about by fiscal disequilibrium underlies the whole literature on speculative attacks.4 However, the origins and implications of the weak fiscal stance of the government have seldom been explored, since the analysis has been generally limited to the consideration of an “excessive” rate of credit creation, with money the only asset explicitly considered. From the existing literature it is particularly difficult to understand why governments do not implement timely corrective measures to prevent a balance of payments crisis. Nor, in spite of the arguments given above, is it clear why the public does not acquire domestic bonds, which could be as good an inflation hedge as foreign bonds and may be closer substitutes for domestic money. Ex ante, exchange risk is not a satisfactory explanation, since the interest premium on domestic bonds could fully adjust to discount expected movements in the exchange rate. Moreover, in some countries, domestic banks have been offering dollar-denominated deposits.
To justify capital flight and the preference for foreign over domestic instruments, it seems more appropriate, then, to generalize the risk factor associated with the overall financial solvency of the public sector to all domestic public debt—not only to money. The government’s weak fiscal stance, which may force it to impose an inflation tax, could also induce it to reduce domestic debt servicing on bonds.
If prices are not perfectly flexible, a country may also experience the exchange rate overshooting that is often the product of balance of payments crises, such as the one experienced by Mexico in 1982. With price inertia, domestic debt servicing cannot be instantaneously reduced through a devaluation-induced jump in the price level. It can, however, be reduced through a fall in the domestic real interest rate, which is possible, even with interest rate parity, if, following an initial depreciation, the real exchange rate gradually appreciates over time, reducing the return on foreign bonds in terms of domestic currency. An expectational equilibrium is thus generated, as the public’s fear of lower returns on domestic assets leads it to shift into foreign instruments, provoking an overshooting that enables the authorities to lower domestic interest rates without violating interest rate parity.
In this paper, we develop simple models to clarify these issues, using the recent experience of Mexico as an illustration. Section II relates the occurrence of speculative attacks to the solvency of the public sector in an economy with interest-bearing debt and perfect price flexibility but imperfect asset substitution. In a departure from the usual speculative-attacks literature, endogenous lending ceilings are derived which are fully consistent with the behavior of both domestic and foreign creditors. Section III explores exchange rate dynamics and overshooting phenomena in the opposite case of price inertia and perfect asset substitution. Section IV illustrates the results of the analysis using Mexico’s recent experience, and the final section offers concluding comments.
II. Public Debt and Capital Flight
Consider an economy in which prices are perfectly flexible and purchasing power parity (PPP) holds continuously, so that the real exchange rate equals one. The government finances its deficit through domestic and foreign debt. For greater simplicity, real domestic debt is taken as a single composite of money and bonds, bh, with an average real interest cost rh. Since bh is an aggregate and rh is the real average interest rate, rh can be negative, even when the real rate on the bond component is positive, if the inflation tax on money balances outweighs the real interest rate paid on bonds.5 With the domestic price index as a deflator, except for the real foreign debt, bw, and the real interest rate, rf, which are expressed in terms of foreign prices—the real budget restriction of the public sector can be written as
where dotted variables are time derivatives and g and t—real expenditures and taxes, respectively—are assumed to be fixed, reflecting fiscal weaknesses. Residents hold both domestic and foreign assets, but foreigners do not hold domestic assets. Consider the portfolio equilibrium condition
where bf represents privately held foreign bonds and σ the semi-elasticity of substitution between home and foreign assets. Define
Equation (4) may be rewritten as
As shown on the right-hand side of equation (5), the interest bill can be decomposed into two elements: rf(bw + bh) corresponds to the cost of servicing total public debt at the real world interest rate; the second term, -φ, can be positive or negative depending on portfolio composition. On the one hand, when bh > λbf, the government must pay a premium on domestic debt and φ is negative. On the other hand, when bh < λbf, φ is positive and the government can extract a “tax revenue” on domestic assets.
The φ contours shown in Figure 1 have the usual inflation tax shape. Tax revenue from private holdings of domestic debt first rise and then fall as the proportion of these holdings in total private wealth rises. Initially, φ(0, σ) = 0; φ then rises with bh, reaches a maximum when bh =
Figure 1.Asset Tax Revenue
The shape of the iso-interest contours, R(σ), can then be diagrammed as in Figure 2. For bh = 0, all contours corresponding to the same R intersect the vertical axis at the same point, independently of σ. For a given σ, the contours rise as bh becomes positive; reach a maximum where bh =
Figure 2.Iso-lnterest Contours
The government can intervene by borrowing abroad and reducing domestic debt. In Figure 2, this operation moves the economy leftward on a line with a slope of minus one. If assets are perfect substitutes, the total interest bill remains invariant, and the economy moves on the same R* contour. When σ is finite and assets are imperfect substitutes, a marginal intervention leaves the interest bill unchanged when bh >
Consider now the following experiment: Suppose that a permanent negative fiscal shock, ∆(t − g) < 0, hits the economy, while the budget is initially in equilibrium with ḃh = ḃw = 0. If assets are perfect substitutes, an immediate default will be unavoidable, since the total interest bill cannot be altered by intervention. A reduction of the domestic debt burden is more likely to occur than a default on foreign debt, because the former is much simpler to achieve. With perfect price flexibility, all it takes is a discrete devaluation, which, by instantaneously raising the domestic price level, reduces bh and moves the economy horizontally to the left in Figure 2, until an R* contour is reached that is low enough to close the fiscal gap.8
However, if assets are imperfect substitutes, the imposition of capital losses for domestic wealth owners can be avoided if a change in debt composition can, by itself, reduce R sufficiently. Suppose that the economy is initially on the R1(σ) contour at a point such as H in Figure 2, where
Consider then what happens when a negative fiscal shock hits the budget. If ∆(g − t) < (R1 − R4) the government remains fully solvent and rational creditors, whether domestic or external, should be fully willing to finance the emerging fiscal gap by acquiring new debt. The authorities could then, for example, increase foreign borrowing along a vertical trajectory, from H up to Q, the point from which the minimum iso-interest contour that can be reached is R2(σ), such that ∆(g − t) = R1 − R2. To the extent that the government would rather devalue than default on its foreign obligations, and since the R2 contour could no longer be reached beyond Q through intervention, foreign borrowing beyond Q would eventually require a discrete devaluation to maintain foreign debt servicing. To avoid a certain capital loss, domestic creditors should, at that point, shift from domestic into foreign assets, forcing the government to intervene. Capital flight, financed by a large burst of foreign borrowing, will occur as a result, moving the economy from Q to N.9
The new steady-state equilibrium is at N, and the fixed exchange rate rule should be abandoned at that point. To see this, let R3(σ) be the iso-interest contour whose tangent to the point of maximum domestic asset taxation, V in Figure 2, goes through N. Since R2 − R3 > 0, a margin is still available to service additional borrowing, and foreign lending can, in principle, continue. However, if the government is committed to honoring its foreign obligations, any further external borrowing will require a default on domestic obligations, since the total interest bill can no longer be reduced by reshuffling debt through intervention. Even if there is a one-to-one conversion of new foreign borrowing into capital flight, the total interest bill rises and a jump devaluation remains unavoidable. Thus, any additional external borrowing should give rise to a larger increase in the private demand for foreign assets, as domestic creditors try to protect themselves from a certain capital loss. Since no net additional financing can therefore be obtained,10 a rational government should, at that point, abandon the fixed exchange rate rule and finance the deficit by means of a higher tax on domestic assets, which would be made possible by the switch in private portfolio composition and the higher rate of depreciation, as documented in the usual speculative-attacks literature. Here, however, the timing of the attack is determined within the model, instead of by an exogenous stock of foreign reserves.
Point N will only be reached by a government that is willing to postpone an exchange rate adjustment, and to keep servicing its foreign debt, whatever the final cost of taxing its domestic obligations. The associated level of inflation or of financial repression can be so high, however, that it forces the government to abandon its exchange rate policy earlier, or to contemplate a partial default on its foreign obligations as a less costly way of closing its financing gap. If this is anticipated by investors, capital flight will occur earlier on the HQ segment, say at Q′, when all the desired portfolio substitution from domestic into foreign assets can be carried out before intervention ceases or foreign lending is cut off. The new endpoint on the R2 contour, M, is associated with a lower level of asset taxation. Depending, therefore, upon the perceived comparative willingness of the government to accept earlier exchange rate adjustment or higher eventual asset taxes, the economy may end up at any point of the KN segment. If the government’s intentions are not known, capital flight should gradually accelerate as foreign borrowing increases, since the rising level of asset taxation that will eventually be needed makes a collapse of a pegged exchange rate more and more likely over time, either because the government may stop intervening or because foreign creditors may decide on their own to stop lending.11 Furthermore, since, in the context of uncertainty, the collapse of the exchange rate regime cannot be perfectly anticipated, a jump devaluation will necessarily occur at the time of the collapse, as documented in the speculative-attacks literature.12
III. Price Inertia and Overshooting
In the previous model, an immediate adjustment in the debt-servicing burden following a devaluation could be obtained as a result of an instantaneous adjustment of the price level which reduced the real value of domestic debt. However, if prices are not perfectly flexible, adjustment can only be achieved by reducing the real interest rate. In this section, it will be shown that real interest rates can be substantially reduced even when a large share of domestic debt is composed of interest-bearing instruments that are close substitutes for foreign bonds, so that interest rate parity holds. Real interest rates will fall if a large overshooting of the real exchange rate is engineered when the nominal exchange rate collapses.
Let Ph* be the equilibrium domestic price level obtained when PPP holds. Setting the foreign price equal to one, Ph* = E, where E is the nominal exchange rate. Suppose that Ph adjusts, with some inertia, toward its PPP equilibrium level13
With Ph as a deflator, equation (7) may be expressed in real terms as
where e is the real exchange rate. Since e can differ from 1, the budget restriction needs to be rewritten as
Suppose, finally, that interest rate parity is verified, so that
Assume that price adjustment is fast enough so that the impact of additional external borrowing on the stock of foreign debt can be ignored. On the one hand, in the phase diagram of Figure 3, equation (8) is simply an inertial adjustment that gives rise to a horizontal equilibrium schedule, ee. On the other hand, the bond equilibrium schedule corresponding to equation (11), bb, is positively sloped around the equilibrium exchange rate if the following condition is satisfied:
Figure 3.Dynamics of Adjustment in the Price-Inertia Case
In this case, a higher bh requires a compensating increase in e to maintain the budget in equilibrium. This is because a higher bh implies greater domestic debt servicing, which can be neutralized in one of two ways: by increasing the value of net public capital inflows caused by a devaluation when ḃw - rfbw is positive; or, by reducing rh which is only possible, with interest rate parity, if the exchange rate gradually appreciates after an initial devaluation. The latter effect is validated through price adjustment and applies to the value of domestic debt; this accounts for the first term appearing in condition (12). Suppose then that condition (12) is verified, in particular because price inertia is not too strong, so that the first term in condition (12) outweighs the second when there are net public capital outflows. It can be seen from Figure 3 that the dynamics of adjustment have the saddle-path property.
Suppose now that an unanticipated negative public finance shock—for example, a reduction in the flow of external lending—hits the budget. The bb schedule shifts leftward (Figure 4) and the real exchange rate overshoots before returning slowly to equilibrium. The interpretation is straightforward: The shock reduces the ability of the government to service its domestic debt. The public then shifts toward foreign bonds and the nominal exchange rate depreciates, in turn inducing a depreciation of the real exchange rate, since the price level does not jump owing to inertia. The ensuing gradual appreciation of the exchange rate toward equilibrium reduces the return of foreign bonds in domestic-currency terms and—through interest rate parity—the interest rate on domestic bonds, thus allowing for the collection of an interest tax and the adjustment of public finances. As the price level starts rising, real domestic bond balances fall and the domestic interest rate recovers gradually, until bond balances have been reduced to a level that can be serviced at the world interest rate.
Figure 4.Dynamics of Overshooting
Several remarks can be made. First, the overshooting mechanism depicted in Figure 4 is the same as the one in Dornbusch’s well-known 1976 paper. However, while in Dornbusch’s model interest rate movements are essentially monetary phenomena arising from the monetary equilibrium condition, in our model they are purely fiscal manifestations produced by the need to equilibrate the budget restriction of the government. Second, there is a direct relationship between the magnitude of the overshooting and the amount of foreign public debt. As the burden of foreign debt servicing net of new foreign loans increases, the bb schedule becomes steeper and the size of the real exchange rate jump needed to accommodate a fiscal shock increases. When foreign debt is large enough to reverse the sign of condition (12), adjustment through overshooting is no longer feasible with a single exchange rate regime.14 Third, the adjustment of domestic bond balances to the level that can be serviced by the government at the world interest rate provides a simple theory of private bond portfolio composition if it is extended to a longer-term horizon that includes current account adjustments. In particular, if a certain level of real financial wealth is desired, the public will have to acquire abroad those bonds that cannot be serviced internally. Fiscally weaker countries can thus be expected to have higher shares of foreign bonds in private portfolios. Finally, given that short-term fiscal adjustment requires real exchange rate overshooting if prices are not fully flexible, and given that the more “dollarized” an economy, the smaller will be its taxable base, it is clear that the existence of dollar-denominated domestic bonds tends to be destabilizing because it increases the size of the overshooting. Since the government may elect to default on its domestic dollar debt in order to avoid an excessive jump in the real exchange rate, investors may eventually lose confidence in this type of bond if its share in total domestic debt becomes substantial. This can explain why foreign dollar bonds may be preferred to their domestic counterparts.
IV. The Mexican Experience
In order to illustrate the correspondence between the recent Mexican experience and the models outlined above, Table 115 gives data on the real public sector deficit for 1978-84 and on the corresponding sources of funds.
|Use of funds|
|Domestic debt interest||2||−2||14||23||37||30||22|
|Foreign debt interest||−16||56||61||70||158||143||141|
|Source of funds|
|Changes in real money|
|Changes in real peso|
|Changes in real dollar|
|Real exchange rate||22.8||19.3||15.4||12.8||24.0||24.4||18.5|
|Nominal exchange rate||22.8||22.8||23.2||26.2||148.5||161.3||190.0|
Mexdollar balances. For an explanation of how the Mexdollar system worked, see Ortiz (1983).
Computed as errors and omissions plus variation in short-term assets held abroad by residents.
Mexdollar balances. For an explanation of how the Mexdollar system worked, see Ortiz (1983).
Computed as errors and omissions plus variation in short-term assets held abroad by residents.
The first obvious observation is that public deficit grew steadily from 1978 to 1982, the combined result of runaway public spending and lagging non-oil revenues, with the latter mostly stemming from falling real prices of goods and services produced by state enterprises. Up to 1981, the deficit was financed by rapidly growing oil revenues derived from expanding exports and favorable world prices; by a steady increase in domestic credit, made possible by rapid economic growth; and by a significant tax on both money and bond balances, with the latter facilitated by negative or low foreign real interest rates and by the continuous real appreciation of the peso. From 1978 to 1980, foreign lending to the public sector was largely used to cover interest payments and did not, therefore, constitute a significant financing source.
In 1980, signs of a lack of confidence in the path followed by the Government began to appear. Devaluation expectations, induced by a rapidly appreciating exchange rate, led to a growing dollarization of the economy, as was reflected in the expansion of dollar-denominated domestic debt, which became the main source of domestic finance in 1981. Together with dollarization, capital flight accelerated sharply from 1980 on, reflecting growing doubts about the public sector’s ability to honor its domestic debt commitments, both in pesos and in dollars.
The year 1981 marked the turning point in the development of the crisis. The pre-oil primary budget deficit (primary deficit, net of petroleum revenue) continued to explode while oil revenues reached a plateau, mainly because of falling oil prices and the continued appreciation of the peso. Despite substantial growth in domestic credit in real terms, owing to the Mexdollar system, a huge financing gap had to be covered by foreign borrowing, which, in that single year, rose in dollar terms by as much as it had in the previous five years. Simultaneously, capital outflows, as measured by the sum of errors and omissions plus variations in short-term assets held abroad by residents,16 reached more than $10 billion, most of which occurred in the second half of 1981, when the lack of fiscal adjustment, in the face of adverse external shocks, became quite evident.17
In 1982, the peak of the crisis, the budget deficit grew even larger, providing another clear indication of fiscal rigidities.18 The other dominant events were, of course, the interruption of foreign borrowing following a last burst of intense borrowing undertaken to sustain the peso in the face of the large capital outflows observed from March to August; and the final collapse of the Mexdollar system, after a massive loss of investor confidence in Mexdollar bonds. In August, Mexdollars were converted by the Government into pesos at 70 pesos per dollar, while the free exchange rate shot up to 130 pesos at the end of the month. This clearly amounted to a partial default by the state on its domestic dollar obligations.
The ongoing fiscal deficit and the foreign debt crisis created an enormous financial gap, which could not be financed by an increase in real domestic credit, given the exhaustion of the Mexdollar system and the massive capital outflows.19 A portion of the deficit was financed by higher oil revenues associated with the depreciation of the peso. But even after accounting for oil income, there was still a shortfall of 317 billion pesos in 1982 which had to come, in effect, from taxes on domestic assets. As seen in Table 1, 30 percent of this shortfall was covered by an inflation tax, the rest by a huge interest tax.
The years 1983 and 1984 marked the aftermath of the crisis. The Government finally reduced its pre-oil primary deficit from its peak of 429 billion pesos in 1982 to around 80 billion pesos—quite an impressive achievement. But despite the higher oil revenues associated with devaluation, this deficit reduction failed to compensate for the continued deterioration of net foreign capital inflows20 (-60 billion pesos in 1983 and -97 billion pesos in 1984, down from -26 billion pesos in 1982 and 159 billion pesos in 1981) and for the fall in real domestic credit associated with higher inflation, negative or low growth, and the portfolio reallocation resulting from the public’s preference for foreign bonds. Thus, high inflation and interest taxes were still needed; 106 billion pesos were obtained from money, and 117 billion pesos from bonds, during 1983-84.
In order to provide readers with a better appreciation of how these tax revenues were collected, the dynamics of the free exchange rate are shown in Chart 1, which uses the monthly closing date of the peso spot price on the New York foreign exchange market. The chart shows that overshooting reached its peak in August 1982. The free exchange rate then appreciated fairly smoothly until the end of 1984.21 This gradual appreciation allowed domestic real interest rates to fall below the world rate, to significant negative levels (below minus 1 percent per month) in 1982 and early 1983 and 1984, as shown in Chart 2, which compares real bond returns in Mexico and in the United States during 1978-84. As can be seen in the chart, the foreign real return in dollars was much higher than its domestic peso counterpart in 1982, early 1983, and early 1984, while owing to the expected real appreciation of the peso, the foreign real return in pesos, computed on the basis of the forward exchange market, was broadly comparable to the domestic return.
Chart 1.Real Exchange Rates, 1982-84
Source: Banco de México, Indicadores Económicos. Real exchange rates were obtained by deflating nominal exchange rates with the ratio of Mexican to U.S. consumer price indices.
Chart 2.Real Domestic and Foreign Returns, 1978-84
This paper has analyzed the linkages between fiscal rigidities, public debt, and exchange market adjustments. It is based on the concept that asset demands shift between domestic and foreign bonds in response to changes in the perceived ability of the state to service its domestic debt. In this context, internal or external shocks with an adverse impact on public finance create fiscal gaps that have to be filled, in the absence of fiscal adjustment, by taxing domestic holders of public debt. Asset substitution is then likely to give rise to capital flight or to sharp exchange rate movements. It was demonstrated that with imperfect asset substitutability, capital flight could be financed by foreign borrowing. This was a rational outcome if foreign creditors expected the state to tax its domestic creditors in order to maintain foreign debt servicing. In turn, it was rational for domestic creditors to attack the local currency and massively convert their domestic assets into foreign bonds so as to avoid a devaluation-induced default on domestic assets. In contrast to methods used in the usual speculative-attacks literature, debt ceilings fully consistent with rational behavior on the part of both domestic and foreign creditors of the public sector were derived endogenously.
We also showed that exchange rate overshootings are likely to occur in response to unanticipated public finance shocks if prices are not fully flexible. Price inflexibility implies that the real value of domestic debt cannot fall instantaneously, so that domestic debt servicing must be reduced through a fall in domestic real interest rates. In turn, with interest rate parity, this reduction can only result from an expected real exchange rate appreciation following an initial discrete devaluation.
We recognize that claims of rational behavior based on underlying fundamentals clearly should not be pushed too far. Nonetheless, our models suggest ways of interpreting the recent Mexican experience that do not rely on sheer speculation and disequilibrium dynamics, and that seem to be reasonably well supported by available evidence from the recent Mexican crisis.
This approach can be extended in a number of directions. Among them, two lines of analysis in particular merit investigation: (1) the introduction of a fully stochastic framework, such as that recently used by Penati and Pennachi (1986) for the monetary model; and (2) the analysis of fiscal rigidities and asset substitution in a richer intertemporal framework, which could integrate issues of credibility and temporal inconsistencies.22
Notes on Table 1: Budget Restriction of the Mexican Public Sector
The data for Table 1 were obtained from various issues of the Bank of Mexico’s Indicadores Económicos. The public sector deficit figures correspond to the concept of “financial deficit,” less oil tax income and interest payments. Domestic public debt was obtained as the sum of total domestic credit given by the financial sector to the public sector, plus bonds sold directly to the public. Foreign credit was obtained from balance of payments data.23 Finally, the figure for domestic dollar credit was computed as the flow of dollar credit granted by the financial sector, less foreign credit obtained by development banks, since this portion is already accounted for as external credit. From the comparison of the nominal figures, a statistical-discrepancy term was obtained for each year. A further separation between money and bonds was obtained by dividing domestic peso credit from banks to the public sector into interest-bearing and non-interest-bearing assets, according to the proportion of M1 into peso liabilities of the financial system.
Figures were then deflated by the yearly average consumer price index. Real interest payments on domestic debt were computed by applying the U.S. real interest rate, obtained by deflating the treasury bill rate using the consumer price index, to the stock of domestic bonds. To permit greater clarity of interpretation, interest payments on foreign debt were kept in nominal terms and taken directly from the balance of payments. In the case of peso credit flows, real increases were obtained by deflating end-of-period nominal balances by the end-of-period price index. The inflation tax on money balances was computed to be consistent with this deflation procedure, and the peso bonds tax was obtained as a residual.
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