To default or not? The crisis outcomes of sovereign defaults and IMF austerity programs

Motivation Motivation Data and methods Results Robustness tests Conclusions
To default or not? The crisis outcomes of
sovereign defaults and IMF austerity
programs
Tuomas Malinen
University of Helsinki
Olli Ropponen
VATT Institute for Economic Research
Open Seminar, Eesti Pank, February 13 2017

IMF has pursued policies that in many cases not only
failed to promote the stated objectives of enhancing
growth and stability, but were probably
counterproductive.
-Joseph Stiglitz 2003
Indeed the eﬀorts needed to avoid a default - which
would be a catastrophe for Greece - are the
responsibility of all political forces.
-Comissioner Olli Rehn, 16th of June 2011

This study
• Aims to shed some light on the question: is it beneﬁcial
for a country to default or enter into IMF program when
facing an economic crisis?

This study
• Aims to shed some light on the question: is it beneﬁcial
for a country to default or enter into IMF program when
facing an economic crisis?
• We estimate the outcomes of these actions on the growth
of real GDP per capita of crisis countries after they have
been implemented relative to other comparable countries.
• We ﬁnd that developing countries should in general avoid
defaults and that IMF programs provide the most lenient
crisis outcome.

Defaults
• Sovereign defaults free government resources, which can
be used on health care, education and for growth
enhancing policies (e.g. public investments)
• But, after a default, country is likely to remain outside
international capital markets for an extended period of
time.
• This leaves the government with two options to cover its
ﬁnances:
• it either has to ’live by its means’, that is, cut
expenditures so that they can be covered with
diminished revenues, or
• resort to monetization of budget deﬁcits through central
banks.

IMF programs
• IMF programs provide emergency funding, technical and
ﬁnancial assistance and enforce unpopular but often
necessary economic reforms during crises.
• IMF oﬀers four types of assistance programs for sovereign
nations:
• Stand-By Arrangements (since 1952)
• Extended Fund Facilities (since 1974)
• Structural Adjustment Facilities (since 1986)
• Enhanced Structural Facilities / The Poverty Reduction
and Growth Facilities (since 1988)
• SBA’s are the most lenient of the arrangements, but all
arrangements involve some form of conditionality.

Conditionalities of IMF programs
• Even the earliest IMF programs imposed conditions on
government behavior. Conditions demanded removal of
subsidies and price controls from state economic
enterprises (Krueger 2003).
• Almost always there were also an agreement of ceiling on
ﬁscal deﬁcit and domestic redit.
• Other conditions included the rescheduling of private and
public debt, and the change or removal of the nominal
exchange rate regime
• The exact nature of conditions of IMF programs have
changed (and continue to change), but some form of
austerity has always been (and continue to be) a part of
them

Data
• We concentrate on three types of crises: finance, currency
and inflation.
• We use data on 45 countries for a period of 60 years
(1951-2010)
• Data are obtained from the IMF Staff Reports and
Surveys, Penn World Tables, the World Bank, and from
datasets of Bordo and Schwartz (2000), Ilzetzki et al.
(2010), Przewoski et al. (2000) and Reinhart and Rogoff
(2011).
• In total we have 857 year-country crisis observations.

Descriptives
Table: Descriptive statistics for countries in crisis, N=857
Categorical (dummy) variables YES NO
Crises:
Banking crisis 299 558
Currency crisis 540 317
Inﬂation crisis 534 323
Under at least 1 crisis 857 0
IMF program and sovereign defauts
Under IMF program 404 453
Foreign default 274 583
Domestic default 66 791

Regressions
• Our baseline growth model is given by
growthcy =
kUB
∑
k=kLB
γk ∗ DOMdefkcy +
kUB
∑
k=kLB
δk ∗ FORdefkcy +
+
kUB
∑
k=kLB
ηk ∗ IMFkcy + αc + βy + δxcy + cy .
where growthcy is the change in the logarithmic real GDP per
capita of crisis country c in year y, −2 ≤ k ≤ 5, and xcy are the
control variables: growth of real gross capital formation, growth of
real gross government consumption and change in trade openness.

Regressions
• Our baseline growth model is given by
growthcy =
kUB
∑
k=kLB
γk ∗ DOMdefkcy +
kUB
∑
k=kLB
δk ∗ FORdefkcy +
+
kUB
∑
k=kLB
ηk ∗ IMFkcy + αc + βy + δxcy + cy .
where growthcy is the change in the logarithmic real GDP per
capita of crisis country c in year y, −2 ≤ k ≤ 5, and xcy are the
control variables: growth of real gross capital formation, growth of
real gross government consumption and change in trade openness.
• The DID-estimations are performed by OLS-regressions, where the
outcome variable is regressed on control variables (xcy), the year
(βy ) and country (αc) dummies as well as on the dummies for an
action(s) taken k years ago (DOMdefkcy , FORdefkcy , IMFkcy ).

The counterfactual
• Identiﬁcation: The counterfactual growth evolution of
crisis country c in year y that has taken an action k
periods ago follows that of those countries that have not
taken a given action between −2 ≤ k ≤ 5 years ago, and
who are also under at least one crisis.

The counterfactual
• Identiﬁcation: The counterfactual growth evolution of
crisis country c in year y that has taken an action k
periods ago follows that of those countries that have not
taken a given action between −2 ≤ k ≤ 5 years ago, and
who are also under at least one crisis.
• That is, the counterfactual also includes observations of a
country in crisis that has not taken a given action -2 to 5
years ago, but may have done so earlier (or later).
• For example, Finland is in the counterfactual crisis
country group in 1991-94 and in the IMF program crisis
country group in year 1967 (-2 to 5 years).

Preselection and expectations
• We pool observations around years of action into three
periods: before, impact and after. We also measure
overall outcome consisting of growth performance during
impact and after periods.

• It is possible that the time periods when countries default
or enter into IMF programs have diﬀerent characteristics
than those periods when they do not.
• We analyzed four main selection criteria from the
literature: budget balance, public debt, foreign reserves
and external debt.
• They did not diﬀer statistically between actions or
between those periods when crisis countries took an
action and when they did not.

• It is possible that the time periods when countries default
or enter into IMF programs have different characteristics
than those periods when they do not.
• We analyzed four main selection criteria from the
literature: budget balance, public debt, foreign reserves
and external debt.
• They did not differ statistically between actions or
between those periods when crisis countries took an
action and when they did not.
• We thus consider the difference in trends before actions,
if any, to result from expectations not from preselection.

Growth evolution of diﬀerent actions in crisis
countries vs. the counterfactual
−2 −1 0 1 2 3 4 5
−10−50510
Years after joining the IMF program
Growth evolution after IMF
IMF program
begins
−2 −1 0 1 2 3 4 5
−10−50510
Years after foreign default
Growth evolution after foreign default
Foreign
default
−2 −1 0 1 2 3 4 5
−10−50510
Years after domestic default
Growth evolution after domestic default
Domestic
default

The role of debt
• Although the level of sovereign or external debt does not
seem to aﬀect the selection process of countries to
default or enter into IMF programs, they are likely to
inﬂuence the outcomes of actions.

The role of debt
• Although the level of sovereign or external debt does not
seem to aﬀect the selection process of countries to
default or enter into IMF programs, they are likely to
inﬂuence the outcomes of actions.
• We analyze the role of sovereign and external debt using
thresholds of 150% of GDP (sovereign debt) and 60% of
GNI (external debt).

Growth evolution during an economic crisis in
countries with high levels of public debt
Dependent variable: growth of the real GDP per capita
IMF Foreign Domestic
Public debt < 150% of GDP
Before (2y) 1.056* -1.226 -0.090
(0.521) (0.635) (1.056)
Overall 0.280 -0.372 -1.661*
(0.364) (0.376) (0.659)
Impact (1y) 0.286 -1.695* 0.548
(0.645) (0.817) (1.227)
After (5y) 0.307 -0.078 -2.240**
(0.390) (0.408) (0.708)
Interaction terms for public debt > 150% of GDP
High debt ×before (2y) -6.061* -2.889 3.849
(2.466) (3.667) (3.485)
High debt × overall 0.582 1.485 -2.178
(1.260) (1.273) (1.860)
High debt × impact (1y) 3.295 2.476 -2.156
(2.516) (3.047) (4.646)
High debt × after (5y) -0.478 1.472 -1.425
(1.331) (1.416) (1.965)
countries 45
years 1951-2010
observations 857
* = p<.05, ** = p<.01, *** = p<.001.

Growth evolution during an economic crisis in
countries with high levels of external debt
External debt < 60% of GNI
Before (2y) 1.576* -1.366 -0.967
(0.737) (0.997) (1.315)
Overall -0.136 -0.313 -0.339
(0.506) (0.575) (0.905)
Impact (1y) -1.154 -0.094 0.308
(0.956) (1.303) (1.846)
After (5y) 0.206 -0.379 -0.516
(0.558) (0.621) (0.991)
Interaction terms for external debt > 60% of GNI
High debt × before (2y) -1.311 0.767 1.048
(1.127) (1.477) (2.149)
High debt × overall 0.558 -0.317 -3.017*
(0.754) (0.810) (1.218)
High debt × impact (1y) 1.752 -2.001 -1.282
(1.400) (1.852) (2.464)
High debt × after (5y) 0.088 -0.008 -3.310*
(0.812) (0.892) (1.345)
countries 45
years 1951-2010
observations 857
* = p<.05, ** = p<.01, *** = p<.001.

The role of external debt
• The result that external debt is more harmful in domestic
default is likely to reflect the costs that it inflicts to the
indebted domestic financial sector.
• Financial companies of a country often hold a fairly large
amount of domestic government bonds as collateral in
their balance sheets.
• When they also hold large amounts of external debt,
haircuts to their collateral through cuts on the principal
and/or interest payments of government bonds will
cause insolvencies and force financial companies to
default on their external debt.
• This leads to diminution of credit in the economy and to
bankruptcies in the private sector, which causes the
GDP of a country to fall but with a lag.

Robustness checks
• Few issues can aﬀect our main ﬁndings.
1. The role of the IMF changed rather drastically during the
currency crises of Latin American countries in the 1980s
and after the fall of the Soviet Bloc that started in 1989.
2. The level of economic development.
3. Political crises.

Robustness checks
• Few issues can aﬀect our main ﬁndings.
1. The role of the IMF changed rather drastically during the
currency crises of Latin American countries in the 1980s
and after the fall of the Soviet Bloc that started in 1989.
2. The level of economic development.
3. Political crises.
• We re-estimated our model using data from 1990
onwards. Results were qualitatively unchanged from those
presented previously.

Growth evolution during an economic crisis in low-
and high-income countries
IMF Foreign Domestic countries obs.
Developing countries
Before (2y) 0.666 1.134 0.061 20 355
(0.915) (1.263) (2.183)
Overall 0.262 -0.859 -3.198*
(0.648) (0.802) (1.270)
Impact (1y) -0.045 -3.871* -0.512
(1.195) (1.921) (2.546)
After (5y) 0.328 -0.492 -3.746**
(0.684) (0.827) (1.347)
Developed countries
Before (2y) 0.813 -0.238 -0.243 25 499
(0.454) (0.526) (0.860)
Overall -0.127 -0.400 -0.731
(0.318) (0.304) (0.546)
Impact (1y) -0.459 0.299 0.410
(0.558) (0.658) (1.055)
After (5y) -0.033 -0.563 -1.027
(0.344) (0.333) (0.594)
* = p<.05, ** = p<.01, *** = p<.001. The developing country group includes the poor and lower middle-income
countries and the developed countries group includes the higher middle-income and rich countries based on the
2010 World Bank classiﬁcation of countries.

Why developing economies seem to be more
vulnerable to defaults?
• In developing countries, the (few) large institutional
investors and banks tend to hold large amounts of
domestic debt as collateral.
• Domestic default will aﬀect negatively on their balance
sheet, which is likely to be already under stress because of
the crisis.
• This will lead to private sector defaults and bankruptcies,
diminution of credit and a fall in the output, with a lag
(as the credit squeeze starts to bite).

Political crises
Government not in crisis
Before (2y) 0.739 -0.941 -1.863
(0.551) (0.676) (1.177)
Overall 0.441 -0.277 -1.791**
(0.382) (0.388) (0.685)
Impact (1y) 0.097 -2.334** 0.175
(0.689) (0.893) (1.324)
After (5y) 0.545 0.141 -2.326**
(0.414) (0.416) (0.746)
Interaction terms for government in a crisis
Gov. crises × before (2y) 0.283 0.234 2.505
(1.127) (1.233) (1.905)
Gov. crises × overall -0.511 -0.678 -0.608
(0.786) (0.762) (1.201)
Gov. crises × impact (1y) 0.888 3.838* -1.260
(1.482) (1.589) (2.452)
Gov. crises × after (5y) -0.804 -1.850* -0.353
(0.839) (0.860) (1.304)
countries 45
years 1951-2010
observations 857
* = p<.05, ** = p<.01, *** = p<.001.

Actions and outcomes in diﬀerent crises
• Above we have analyzed the outcomes of IMF programs
and sovereign defaults using a dataset that pools all the
crisis as one.
• However, outcomes of IMF programs and defaults may
diﬀer between crises.

Growth evolution of diﬀerent actions during a
banking crisis
−2 −1 0 1 2 3 4 5
−10−50510
Growth evolution after IMF, Banking crisis
IMF program
begins
−2 −1 0 1 2 3 4 5
−10−50510
Growth evolution after foreign default, Banking crisis
Foreign
default
−2 −1 0 1 2 3 4 5
−15−10−5051015
Growth evolution after domestic default, Banking crisis
Domestic
default

Growth evolution of diﬀerent actions during a
currency crisis
−2 −1 0 1 2 3 4 5
−10−50510
Growth evolution after IMF, Currency crisis
IMF program
begins
−2 −1 0 1 2 3 4 5
−10−50510
Growth evolution after foreign default, Currency crisis
Foreign
default
−2 −1 0 1 2 3 4 5
−10−50510
Growth evolution after domestic default, Currency crisis
Domestic
default

Growth evolution of diﬀerent actions during an
inﬂation crisis
−2 −1 0 1 2 3 4 5
−10−50510
Growth evolution after IMF, Inflation crisis
IMF program
begins
−2 −1 0 1 2 3 4 5
−10−50510
Growth evolution after foreign default, Inflation crisis
Foreign
default
−2 −1 0 1 2 3 4 5
−10−50510
Growth evolution after domestic default, Inflation crisis
Domestic
default

Conclusions
• Developing countries should avoid defaulting, especially
on domestic liabilities, as they lead to large fall in the real
GDP per capita compared to developing countries in crisis
that did not default.
• Domestic default led to drop of more than -3% in the
per capita output of a developing country.

Conclusions
• In addition, the level of external debt seems to be the
dividing factor between outcomes of defaults.
• Under high external debt, domestic default leads to drop
of more than 3% in the per capita output, while there
was no negative outcome under low external debt.

Conclusions
• In addition, the level of external debt seems to be the
dividing factor between outcomes of defaults.
• Under high external debt, domestic default leads to drop
of more than 3% in the per capita output, while there
was no negative outcome under low external debt.
• IMF programs provide the most lenient crisis outcome,
but they do not yield any statistically measurable
economic beneﬁts.

THANK YOU!

To default or not? The crisis outcomes of sovereign defaults and IMF austerity programs

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