Three Essays on the Evolution of Government Domestic Debt in the Emerging Market Countries Open Access
Debt crises that have shaken Latin America, Asia and Russia have brought increasing attention to the structure of sovereign debt in the emerging market countries. As shown by the recent debt crises in Mexico, Asia, and Russia, the structure of domestically issued debt has important implications for the probability and severity of debt crises. Thus a comprehensive approach is needed for studying debt issues - one that would take account of the size and structure of government debt in terms of place of issuance, maturity, currency of denomination and indexation and the interest rate structure. Lack of data on the structure of domestically issued debt made such comprehensive analysis difficult. This study tries to fill the gap in the existing literature in a series of three essays: (1) impact of macroeconomic, political, and institutional factors on the structure of government debt in EM countries, (2) pro-cyclical fiscal policy and dollarization of domestic sovereign debt, and (3) factors affecting the yields on government domestic bonds in Mexico: a cointegration analysis. The first essay uses the newly released Jeanne-Guscina EM Government Debt Database 2006 and empirically explores the role of macroeconomic, political, and institutional factors in determining the structure of government debt. Results show that an unstable macroeconomic environment, poor quality institutions, and uncertain political climate hinder the development of the domestic debt market. Moreover, such instability shifts the debt structure away from long-term local currency fixed rate debt towards short-term debt or towards debt indexed to foreign currency, short-term interest rates or inflation. Recent years have seen a movement towards safer debt structures which can be explained by successful macroeconomic stabilization policies and lessons learned from the past debt crises. The second essay focuses on the currency composition of domestic sovereign debt, i.e., debt issued in national jurisdictions. The empirical analysis is anchored in a stylized general equilibrium model developed by Guscina, Ilyina and Kamil in IMF 2009 mimeo (hence referred to as GIK), in which the dollarization of sovereign debt arises as a result of the optimal portfolio choices by risk-averse investors and sovereign debt manager, who takes the fiscal policy as given. The model prediction - that a country where exchange rate is counter-cyclical and fiscal policy is pro-cyclical would have, on average, a more dollarized domestic sovereign debt - is validated by the empirical evidence. This finding has several implications for the current discussion on the benefits of developing bond markets, especially in terms of reducing exposure to foreign exchange rate risk.The third essay explores the relationship between the interest rates on government debt, macroeconomic fundamentals, and the level of risk inherent in the structure of domestic debt (in terms of its maturity, currency of denomination, and indexation). An emerging market government's inability to borrow at long tenors in local currency has been referred to in the literature as "domestic original sin". This chapter constructs an index of risk inherent in the structure of Mexico's government debt and conducts a cointegration analysis between the yields on government bonds, macroeconomic fundamentals, and a measure of "domestic original sin". Mexico makes for an interesting case study due to the fact that Tesobono crisis was partly caused by accumulation of short-term foreign currency denominated debt. The spike in yields on government bonds that the crisis produced makes for an interesting modeling exercise. I find that the yields on government securities are shaped not only by macroeconomic fundamentals, but also by investor's perception of risk inherent in the debt structure.
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