VIETNAM - NETHERLANDS PROGRAMME FOR M. IN DEVELOPMENT ECONOMICS EARLY WARNING SYSTEM FOR SOVEREIGN DEBT CRISIS IN DEVELOPING COUNTRIES FOR PERIOD 1981-2010 Supervisor: Prof. Nguyen TrongHoai Student: Vu ThiLan Phuong Class: MDE 20 Ho Chi Minh City, October 2016 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ABSTRACT This study constructed an Early warning system to explain and predict sovereign debt crisis in 31 developing countries whose data is available through the period 1981-2010 at one year precedence by employing three-stage strategy with multinomial logit regression. While three-stage strategy allowed selecting the best predictors among wide range of explanatory variables, multinomial logit regression solved “post-crisis” bias and thus, improved prediction quality.
The main findings are: (i) Solvency, measured by Public debt over GDP ratio, is positively correlated with sovereign debt crisis; (ii) Liquidity measures are highly associated with sovereign debt crisis. When short-term debt to total external debt ratio grows up or reserves to total external debt ratio decrease, the likelihood of both entering into debt crisis and remaining in debt crisis rises; (iii) The macroeconomic fundamentals significantly affect sovereign debt crisis: while GDP per capita growth rate is negatively associated with both entering into and remaining in crisis , inflation only affect positively post-crisis period; (iv) The international liquidity, represented by the three-month the U. Treasury bill rate, is highly associated with the first year of crisis and the following years of crisis rather than the initial year of crisis and (v) both external trade link and political institution measurements do not impact on sovereign debt crisis. As a result, the study specified a multinomial logit Early warning model predicting sovereign debt crisis at one year precedence with six determinants namely Public debt over GDP ratio, Short-term debt to total external debt ratio, Reserves to total external debt ratio, GDP per capita growth rate, Inflation rate and Three-month the U.
Treasury bill rate. In addition, several policy implications are recommended for the countries to avert sovereign debt crisis. LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ACKNOWLEDGEMENT First and foremost, I would like to take this opportunity to express my sincere gratitude to Prof. Nguyen Trong Hoai, my supervisor, for his strong support and useful advice from the very first days of my research work.
He was patient and sympathetic towards my delay. His inspiration as well as prompt and intellectual guidance has encouraged me to finish the thesis. Finally, I would like to express my deepest grateful to my family, my colleagues and my friends for their continuous encouragement and support during the time I were busy with the study. Thanks to their understanding and help, my thesis was finally completed.
LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com TABLE OF CONTENTS CHAPTER I: INTRODUCTION. 2 CHAPTER II: LITERATURE REVIEW .1 SOVEREIGN DEBT CRISIS AND EARLY WARNING SYSTEM .1 Sovereign debt crisis .2 Early warning system (EWS) .2 THEORETICAL LITERATURE ON DEBT DEFAULT.1 Model of debt overhang .2 Model of debt repudiation .3 EMPIRICAL LITERATURE ON SOVEREIGN DEBT CRISIS .1 Sovereign debt crisis and liquidity measures .2 Sovereign debt crisis and solvency measures .3 Sovereign debt crisis and macroeconomics fundamentals .4 Sovereign debt crisis and external trade link .5 Sovereign debt crisis and political institutions .6 Sovereign debt crisis and global liquidity .16 CHAPTER III: RESEARCH METHODOLOGY .2 VARIABLES AND MEASUREMENTS .1 Sovereign debt crisis .3 Analytical framework for the study .27 CHAPTER IV: RESEARCH RESULTS.30 LUAN VAN CHAT LUONG download : add luanvanchat@agmail. REGRESSION RESULTS FOR EWS .2 Backward stepwise regression .3 Multinomial logit regression and final specification .4 FURTHER RESEARCH RECOMMENDATION. 54 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com LIST OF ABBREVIATIONS CPIA Country Policy and Institutional Assessment EWS Early Warning System FDI Foreign Direct Investment GDP Gross Domestic Product IMF International Monetary Fund M2 Broad Money Supply NEER Nominal effective exchange rate REER Real effective exchange rate U.
United States WB World Bank WDI World Bank Development Indicators WEO World Economic Outlook Database WGI Worldwide Governance Indicators LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com LIST OF TABLES Table 3.1: Regime definition in Multinomial logit model.2: Countries and sovereign debt crisis episodes during 1980-2010 .1: Summary on crisis occurrence during 1981-2010.2: Average of explanatory variables .3: 17 Variables passing first step .4: Eight variables passing second step .5: Correlation matrix of benchmark model .6: Multinomial logit regression result .7: Relative risk ratio of benchmark model .8: Average marginal effect of explanatory variables .39 Table A1: Summary statistics of 27 explanatory variables .54 Table A2: Binominal logit variable-by-variable regression result .55 Table A3: Backward Stepwise regression result .56 Table A4: Benchmark model regression result – Full sample .57 Table A5: Benchmark model regression result – Restricted sample .58 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com CHAPTER I: INTRODUCTION 1.1 RESEARCH STATEMENT The world has witnessed a numerous debt crises arising in recent years, for instance the 1997-1998 crisis in Asia region, the outright default of Argentina in 2001, the external crisis of Honduras prolongs from 1981 to 2010, and more recently, the crisis Eurozone such as Greece, Spain, Ireland and Portugal since the year of 2009. The crises had disruptive influence on the performance of the in-trouble countries and even, the regional or global economy. The frequent occurrence of debt crises and crisis’s serious consequences challenges the governments, especially developing countries where appear to be much more vulnerable compared to advanced economies. It, in turn, has stimulated a controversy among various researchers on identification of leading indicators of debt crises, Kaminsky and Reinhart (1999), Manasse et al (2003) and Kraay and Nehru (2006) for example.
Those empirical studies attempt to construct an effective empirical model which helps to identify factors driving to debt servicing difficulties as well as predict the eve of debt crisis, the so- called Early warning systems. However, due to unavailability of data on sovereign debt, only little work on establishment of Early warning system for debt crisis has been done compared to a wide range of researches on currency crisis and banking crisis. In addition, in almost previous empirical studies on establishment of Early warning system for debt crisis, binomial probit/ logit regression is highly preferred for example Manasse et al (2003), Kraay and Nehru (2006) and Fuertes et al (2007). However, the result of binary logit/ probit regression result may be impacted by “post-crisis bias”.
This term, originally proposed by Bussiere and Fratzscher (2006), describes the bias caused by disregarding the difference in economics factors’ behaviors between “tranquil” state, the run-up to the crisis, and “recovery” state – the adjustment period after crisis. Thus, discovery of more effective method tackling this kind of bias is open for researchers. Taken together above concerns, this study is carried out to answer the question which factors accounting for debt crisis in developing countries by applying more effective method – multinomial logit model – compared to empirical studies. Specifically, this study constructs an Early Warning System for explaining sovereign debt crisis in 31 developing countries through the period 1981-2010.
The results of the study will make a valuable contribution to the empirical literature on debt crisis determination, especially for Page | 1 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com developing countries group. By using multinomial logistic model which was proposed by the work of Bussiere and Fratzscher (2006) on predicting the onset of currency crisis in 20 open emerging markets during 1993-2001, the issue of post-crisis bias has been resolve. As a result, the study could work better at determining predictors for sovereign debt crisis in the developing countries. More important, this study recommends several policies/ measures for the countries to prevent the occurrence/ prolongation of sovereign debt crisis based on the result analysis.2 RESEARCH OBJECTIVES Sovereign debt crises have severe impact on the economies’ performance at country level and even at regional and global level.
The crises in Asia in 1997-1998 and European since 2009 are typical examples. For that reason, identification of sovereign debt crisis and implementation measures to avert the undesirable crisis is important and necessary mission for developing countries’ governments. Based on the facts, this study is designed with two principal objectives. Firstly, to determine an early warning system explaining for sovereign debt crisis in 31 developing countries whose data is available during the period from 1981 to 2010 at one year precedence.
Secondly, to be made some recommendations for policy makers preventing the countries from debt service difficulties.3 RESEARCH QUESTIONS To reach the two targets mentioned above, there are two research questions needs answering. In the first place, what factors drive to occurrence/ existence of sovereign debt crisis in 31 developing countries during the period 1981-2010? Secondly, by which measures/ policies, the developing countries are able to obviate sovereign debt crisis? 1.4 RESEARCH STRUCTURE The thesis is structured with five major chapters as follows. Chapter I introduces the research statement, research objectives and research questions. Page | 2 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com Chapter II reviews theoretical literature and empirical literature about heterogeneity of sovereign debt crisis definitions among studies and the nexus between sovereign debt crisis and potential explanatory variables which is useful for design of early warning model in this study.
Chapter II provides the research methodology consist of model specification, response variables and explanatory variables and measurements together with research hypotheses, data sources and estimation method employed in the study. Chapter IV presents preliminary statistic of all variables and empirical regression results. The result discussion in line with research’s questions is also provided in this chapter. Finally, Chapter V summarizes the main findings of the study as well as policy implications.
Besides, this chapter presents major concerns on the research limitation and proposal for further research. Page | 3 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com CHAPTER II: LITERATURE REVIEW This chapter consists of your main sections. The first section provides various definition of sovereign debt crisis among previous empirical studies as well as introduces the Early warning system. The second part reviews theoretical literature on sovereign debt default while the third section review discusses empirical literature on sovereign debt crisis.
The last section presents the major approach of this study including sovereign debt crisis definition, early warning system method and the backbone of model explaining debt crisis which was learnt from the relevant literature.1 SOVEREIGN DEBT CRISIS AND EARLY WARNING SYSTEM 2.1 Sovereign debt crisis In general, sovereign debt crisis is term describing the event of debt servicing difficulties of a country. However, the very first notion is that there is no consensus on the exact definition of debt crisis. According to Sachs (1983), how the empirical studies define debt crisis depends on the specific research questions and also, the data availability. Many researches define debt crisis as sovereign defaults.
Rating agencies such as Moody’s, Standard & Poor’s and Fitch’s often focus on default events. For instance, Standard and Poor’s defines default as “the failure of an obligor to meet a principal or interest payment on the due date (or within the specified grace period) contained in the original terms of the debt issue” (Chambers and Alexeeva, (2003)) including (i)outright defaults on external and/or domestic debt – in other words, scheduled debt services payment is not effected – for instance Argentina (2001) and Ecuador (1999) and (ii) rescheduling loan with new terms are less favorable to the creditors than the original loan such as Ukraine (2000) and Uruguay (2003). Numerous empirical studies consider a country rated as “default” by those rating agencies is being in debt crisis status, Manasse et al (2003) and Sy et al (2004) for example. However, defining debt crisis as sovereign default solely is inadequate for the reason that sovereign default is not the only possible consequence of a serious debt servicing difficulties.
To illustrate, the crisis in Mexico in 1994-1995 was determined through a large scale financial aid package from IMF and turmoil of sovereign debt market instead of default Page | 4 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.