Debt Intolerance

Debt Intolerance Carmen M. Reinhart, Kenneth S. Rogoff, and Miguel A. Savastano In this paper we argue that history matters: that a country's record at meeting its debt obligations and managing its macroeconomy in the past is relevant to forecasting its ability to sustain moderate to high levels of indebtedness, both domestic and internal, for many years into the future. We introduce the concept of "debt intolerance" (drawing an analogy to, for example, "lactose intolerance"), which manifests itself in the extreme duress many emerging market economies experience at overall debt levels that would seem quite manageable by the standards of the advanced industrial economies. For external debt, "safe" thresholds for highly debt-intolerant emerging markets appear to be surprisingly low, perhaps as low as 15 to 20 percent of GNP in many cases, and these thresholds depend heavily on the country's record of default and inflation. Debt intolerance is indeed intimately linked to the pervasive phenomenon of serial default that has plagued so many countries over the past two centuries. Debt-intolerant countries tend to have weak fiscal structures and weak financial systems. Default often exacerbates these problems, making these same countries more prone to future default. Understanding and measuring debt intolerance is fundamental to assessing the problems of debt sustainability, debt restructuring, and capital market integration, and to assessing the scope for international lending to ameliorate crises. End Page 1 Certainly, the idea that factors such as sound institutions and a history of good economic management affect the interest rate at which a country can borrow is well developed in the theoretical literature. Also well established is the notion that, as its external debt rises, a country becomes more vulnerable to being suddenly shut out of international capital markets, that is, to suffer a debt crisis.1 However, there has to date been no attempt to make these abstract theories operational by identifying the factors (in particular, a history of serial default or restructuring) that govern how quickly a country becomes vulnerable to a debt crisis as its external obligations accumulate. One goal of this paper is to quantify this debt intolerance, drawing on a history of adverse credit events going back to the 1820s. We argue that a country's current level of debt intolerance can be approximated empirically as the ratio of the long-term average of its external debt (scaled by GNP or exports) to an index of default risk. We recognize that other factors, such as the degree of dollarization, indexation to inflation or short-term interest rates, and the maturity structure of a country's debt, are also relevant to assessing a country's vulnerability to symptoms of debt intolerance.2 We argue, however, that in general these factors are different manifestations of the same underlying institutional weaknesses. Indeed, unless these weaknesses are addressed, the notion that the "original sin" of serial defaulters can be extinguished through some stroke of financial engineering, allowing these countries to borrow in the same amounts, relative to GNP, as more advanced economies, much less at the same interest rates, is sheer folly.3 The first section of the paper gives a brief overview of the history of serial default on external debt, showing that it is a remarkably pervasive and enduring phenomenon: the European countries set benchmarks, centuries ago, that today's emerging markets have yet to surpass. For example, Spain defaulted on its external debt thirteen times between 1500 and 1900, whereas Venezuela, the recordholder in our sample for the period since 1824, has defaulted "only" nine times. We go on to show how countries End Page 2 can be divided into debtors' "clubs" and, within those clubs, more or less debt-intolerant "regions," depending on their credit and inflation history. We also develop first broad-brush measures of safe debt thresholds. The data overwhelmingly suggest that the thresholds for emerging market economies with high debt intolerance are much lower than those for advanced industrial economies or for those emerging market economies that have never defaulted on their external debt. Indeed, fully half of all defaults or restructurings since 1970 took place in countries with ratios of external debt to GNP below 60 percent.4...