Serial Default and Capital Flows

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As long as the odds of default are as high as 65 percent for some low-income countries, credit risk seems like a far more convincing reason for the paucity of rich-to-poor capital flows.

For some years now economists have been puzzled by the question of why, given the potential mutual benefits, rich countries do not invest more capital in poor countries. A number of explanations have been offered for the phenomenon of limited capital flow from rich to poor nations. Among these are the sense that investment is naturally drawn to environments that are already capital rich. Alternatively, a nation's reputation and debt history, its inflation history, the character of its domestic institutions, or its legal entanglements may inhibit investment. All of these may be interpreted as variants of expropriation risk. And, to a greater or lesser degree, there is evidence to support all of these explanations. But in Serial Default and the "Paradox" of Rich to Poor Capital Flows (NBER Working Paper No. 10296), authors Carmen Reinhart and Kenneth Rogoff maintain that the most compelling evidence lies in the area of serial default.

History shows that among debtor countries, serial default on debts in fact is the rule rather than the exception. Sovereign defaults - the failure of an obligor to meet a principal or interest payment in a timely manner - are difficult both to explain and to predict. But the fact remains that sovereign default tends to recur like clockwork in some countries, but not in others. And, the key explanation for why so little capital flows to poor countries, according to Reinhart and Rogoff, is simply that countries with a history of defaulting on debts find it difficult to borrow anew. So many poor countries are in default on their debts; so few funds are channeled through equity; and overall private lending rises more than proportionately with wealth. Therefore, credit markets and political risk are important reasons why less capital flows to developing countries. If credit market imperfections abate over time because of better institutions, then human capital externalities or other "new growth" elements may play a larger role. But as long as the odds of default are as high as 65 percent for some low-income countries, credit risk seems like a far more convincing reason for the paucity of rich-to-poor capital flows, at least for plausible underlying rate of return differentials.

Reinhart and Rogoff find support for this view by charting data on debt default among numerous nations throughout the modern era. A nation's debt history - and especially its record of defaulting on debt- provides a good measure of a country's capacity to bear future debt. Countries with "bad credit history" indeed can graduate from being serial defaulters, the authors note. They point to Greece as a recent example, and suggest that Chile is evidently in the process of graduating, in no small part by steadily reducing its external debt from 134 percent of GNP in 1985 to about 30 percent in 1997. But Reinhart and Rogoff add that full graduation for serial-defaulter status usually takes many years. More significantly, defaults exacerbate weak political institutions, laying the basis for further defaults. Hence, it is little surprise that capital fails to pour into such countries.

Reinhart and Rogoff's data strongly suggest that emerging market countries may need to aim for far lower levels of external debt-to-GDP ratios than has traditionally been considered prudent. Indeed, prudent external debt thresholds may be closer to 15-20 percent, a level seen in several emerging non-defaulting countries, as opposed to the much higher levels one sees today in countries like Turkey and Brazil, which have a history of serial default.

As far as emerging markets are concerned, comparisons to the lofty debt ratios borne by some richer countries are irrelevant. Governments that disregard this difference in debt tolerance, the researchers hypothesize, are likely to perpetuate the serial default syndrome. If anything, net external debt thresholds may have to become more conservative to accommodate the sharp rise seen in many countries' domestic public debt. For instance, domestic government debt as a percent of GDP in India, Korea, and Thailand was in single digits in the early 1980s, but by the late 1990s had risen to 86, 63, and 76 percent respectively, making these countries' reserve accumulation more understandable.

There is also a case for having rich countries make it more difficult, not less, to enforce debt contracts in rich-country courts. Though this would almost certainly reduce debt flows to many countries in the short run, say Reinhart and Rogoff, it would strengthen the international financial system in the long run by reducing reliance on debt and by helping to support the evolution of greater flows in equity and in direct foreign investment.

In short, Reinhart and Rogoff propose that rather than pondering the small flow of capital from rich to poor countries, the more productive concern should be preventing too much capital from flowing to serial defaulters - and especially to their governments - before they have "graduated" out of that status.

-- Matt Nesvisky