Risk, Uncertainty, and Autonomy: Financial Market

Constraints in Developing Countries

Sarah Brooks & Layna MosleyOhio State University & University of North Carolina, Chapel

Hill

Prepared for the 1st meeting of the International Political Economy Society, Princeton University, Nov. 17-18, 2006

Political Risk

Exposure to the possibility that political events will adversely affect the profitability of an investment (Bailey & Chang 1995: 542)

Especially problematic for developing countries

Less transparent to foreign investors

Uncertainty / incomplete information are central to the problem of political risk

Previous Research Elections are a key source of political risk:

Uncertain outcomes Incentives for opportunistic behavior, policy

change Associated with turbulence in currency, bond

markets (Martinez & Santiso 2003; Reinhart 2002)

Both the outcome of the election and the possibility of policy discontinuity are considered sources of uncertainty (Jensen & Schmith 2005)

Uncertainty is said to be largely resolved following the election (Bernhard & Leblang 2002)

Political Risk v. Political Uncertainty Difference between risk and

uncertainty largely elided Knight (1957):

Risk can be quantified, measured Uncertainty is unmeasurable

Difference between risk and uncertainty has to do with the degree of knowledge about a situation Important implications for market

behavior, government autonomy

Risk and Uncertainty in International Bond MarketsSources of risk and uncertainty in

sovereign debt markets:1. Default risk

Ability to pay Willingness to pay

2. Currency risk (including inflation)

3. Policy Stability (long-run value of asset)

Risk and Uncertainty in International Bond Markets Information derived from institutional,

ideological factors, and past policy behavior Challengers to the incumbent often lack a

past policy record Elections thus increase uncertainty, even if

outcome is predictable Information frictions: little incentive to

become fully informed (Calvo & Mendoza 2000)

Risk and Uncertainty in International Bond Markets Investors can and do acquire information to

reduce uncertainty about candidates, new incumbents

Partisan cues

Assimilate candidates into a group of similar situations for which probability of default can be calculated

Left/Right partisan archetypes Right more committed to fiscal probity, willing to

honor debt commitments Left more likely to inflate economy, default

Risk and Uncertainty in International Bond Markets Since 1990s, these archetypes have been

less valid Left governments adopting orthodox liberal

policies “Nixon in China”: e.g., Menem, Fujimori

Not universal: e.g., Kirschner, Morales, Chávez

Partisan cues – for the Left – thus are ambiguous

Elections do not fully resolve uncertainty about Left candidates’ willingness to honor sovereign debt commitments

Observable Implications

1. Bond markets should respond more negatively to Left candidates and new presidents than to those on the Right, all else being equal.

2. Time in office (opportunity to gain information about type) should reduce market premium for Left governments, but should not change assessments for the Right, all else being equal.

Empirical Analysis: Dependent Variable Sovereign risk is captured through

spreads:spreads:

Difference between yield on government bond and benchmark ‘risk-free’ U.S. Treasury bond Higher spreads indicate negative market sentiment

about a country’s economic and political risk (Eichengreen & Mody 1998)

J.P. Morgan’s EMBI Global Index Foreign currency denominated debt instruments:

isolates default risk; no currency risk 33 ‘emerging market’ countries 1993-2004

Empirical Analysis: Independent Variables Partisanship of Executive Years in Office Partisanship * Years in Office

Empirical Analysis: Controls Political Controls

Divided Government Democracy Presidential Election Year

Creditworthiness Indicators Inflation (ln) External balance Debt/GDP Ratio Debt Service/Export Ratio

Macroeconomic Controls GDP (ln) Growth (% per capita) Trade exposure

Empirical Model

ΔS = β0St-1 + β1Partisanship + β2YrsOffice + β3Partisan* YrsOffice + β4 Divided Govt + β5Democracy + β6Election Year + β[Creditworthiness] + β[Macroeconomy] + β7Time

Random effects cross-sectional, time-series estimation

Temporal dependence: AR-1 Cross-sectional correlation: PCSE

Political Variables      

Left Executive 142.372** 205.658** 218.025***

(66.655) (84.432) (87.070)

Years in Office -4.935 -3.354 -4.430

(3.811) (3.764) (3.484)

Left Executive * Years Office - -13.630* -15.705*

(7.955) (8.766)

Majority -130.655* -134.859* -133.283*

(72.792) (71.981) (72.852)

Presidential Election Year - - 97.428

(90.374)

Democracy -8.006* -8.827* -10.610***

(4.698) (4.621) (4.128)

Creditworthiness      

External Balance 4.825 4.659 5.249

(5.677) (5.688) (5.889)

Inflation (Ln) -11.847 -15.003 -17.801

(19.354) (19.469) (18.991)

Debt: GDP 919.580*** 970.53*** 971.356***

(272.468) (280.069) (279.721)

GDP Growth -6.437*** -6.321*** -6.505***

(1.974) (1.994) (1.871)

Debt Service: Exports -2.894 -3.086 -3.072

(1.946) (2.064) (2.002)

Macroeconomy      

GDP (ln) 15.482 21.305 23.124

(33.243) (33.450) (33.248)

Trade -2.177** -2.312** -2.275**

(1.1133) (1.130) (1.097)

Year -7.740 -6.680 -5.915

(16.178) (16.241) (16.071)

Constant -85.046 -239.949 -288.483

  (855.098) (862.632) (857.938)

rho 0.02 0.029 0.041

Observations (N) 193 193 193

R-squared 0.316 0.32 0.328

Case Study: Brazil

2002 Presidential election Front-runner: Luiz Inácio Lula da Silva

(“Lula”) Left-wing Worker’s Party Earlier rhetoric of debt restructuring Recent Argentine default Risk of policy discontinuity Previous elections followed by costly devaluation

Market response: Wall Street firms paid close attention to

domestic polls Spreads jumped sharply

Case Study: Brazil 2002Brazil and Emerging Market Indices, 2001-2003

0

500

1000

1500

2000

2500

Brazil Composite

Case Study: Brazil 2002

Market response unlikely to be due solely to changes in fundamentals or risk aversion

1. Debt, although rising, was considered manageable (Martinez & Santiso 2003: 371)

2. Brazil spreads diverged from EMBI Global Composite Index

Composite reflects broader risk appetite for emerging market debt

Case Study: Brazil 2002

Index Differentials and Inflation

-2000

200400600800

100012001400

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

EM

BI In

dex

02468101214161820

% a

nnua

l cha

nge

in C

PI

Brazil-Composite Inflation

Case Study: Brazil 2002

Brazil, 2002 Spreads

0

200

400

600

800

1000

1200

1400

4/15

/20

02

4/29

/20

02

5/13

/20

02

5/27

/20

02

6/10

/20

02

6/24

/20

02

7/8/

2002

7/22

/20

02

8/5/

2002

8/19

/20

02

9/2/

2002

9/16

/20

02

9/30

/20

02

10/14

/20

02

10/28

/20

02

0.75

0.8

0.85

0.9

0.95

1

1.05

Entropy Brazil minus Composite

Case Study: Brazil 2002

Brazil, 2002 Spreads

0

200

400

600

800

1000

1200

1400

4/15

/20

02

4/29

/20

02

5/13

/20

02

5/27

/20

02

6/10

/20

02

6/24

/20

02

7/8/

2002

7/22

/20

02

8/5/

2002

8/19

/20

02

9/2/

2002

9/16

/20

02

9/30

/20

02

10/14

/20

02

10/28

/20

02

0

5

10

15

20

25

30

35

Lula vs.Closest Rival Brazil minus Composite

Case Study: Brazil 2002

Efforts during the campaign to win confidence

All three candidates signed a Letter of Intent with IMF

Funds to be dispersed after the election

Lula’s “Letter to the Brazilian People”

Pledged to respect existing agreements with international institutions, companies

Laid out reform agenda

Case Study: Brazil Lula in office: Confidence-enhancing

measures Maintained, deepened policies of previous

government Wall Street executive Henrique Meireles named

President of the Central Bank Increased the autonomy of the Central Bank Reforms of social security, tax systems Primary surplus above IMF target

Market response: Sharp decline in spreads Currency and domestic stock market recovered

Case Study: Brazil 2002-2006

EMBI Indices, Blended Spreads, 2001-2006

-200

0

200

400

600

800

1000

1200

1400

1/1/

2001

5/1/

2001

9/1/

2001

1/1/

2002

5/1/

2002

9/1/

2002

1/1/

2003

5/1/

2003

9/1/

2003

1/1/

2004

5/1/

2004

9/1/

2004

1/1/

2005

5/1/

2005

9/1/

2005

1/1/

2006

5/1/

2006

9/1/

2006

Brazil minus Composite

Case Study: Brazil 2006 2006 Election Campaign

Lula once again front-runner Favorable global conditions Net government debt lower, dollar exposure

diminished Strong currency (appreciated 53% since Lula

took office) Low growth, string of high-profile scandals Scandals led to resignation of nearly all cabinet

ministers, top leaders of Lula’s Workers’ Party Market response was sanguine

Case Study: Brazil 2006Brazil and Emerging Market Indices, 2005-2006

0

50

100

150

200

250

300

350

400

450

500

Brazil Composite

Case Study: Brazil 2006Public Opinion Polls and Spreads,

2005-2006

0

20

40

60

80

100

120

-10

-5

0

5

10

15

20

25

30

35

Lula minus Closest Rival (Alckmin/ Serra) Brazil minus Composite

Conclusions Market learning extends beyond the

government formation period Especially for developing countries, left

governments. Partisanship matters

Left governments, all else equal, represent higher risk of default.

Left partisan signal is more ambiguous: thus Left governments also generate greater uncertainty.

Policy uncertainty, however, is resolved as Left executives govern, so that investment risk declines as time in office increases.