What are the main variables that influence the dynamics of Ecuador’s sovereign risk?
What are the main variables that influence the dynamics of Ecuador’s sovereign risk?
Carrillo-Maldonado, Paul; Díaz-Cassou, Javier; Flores, Miguel
JOURNAL OF APPLIED ECONOMICS 2023, VOL. 26, NO. 1, 2158009 https://doi.org/10.1080/15140326.2022.2158009 RESEARCH ARTICLE What are the main variables that influence the dynamics of Ecuador’s sovereign risk? a b c Paul Carrillo-Maldonado , Javier Díaz-Cassou and Miguel Flores Facultad de Ciencias Económicas y Administrativas, Universidad de Las Américas and Ecuadorian Political b c Economy Lab, Quito, Ecuador; World Bank, Rabat, Morocco; Departamento de Matemáticas, Escuela Politécnica Nacional, Quito, Ecuador ABSTRACT ARTICLE HISTORY Received 21 April 2022 This paper analyzes the determinants of Ecuador’s sovereign Accepted 03 November 2022 spreads as measured by the EMBI index. We use Bayesian algo- rithms to estimate a structural vector autoregressive model with KEYWORDS three blocks (international, regional, and domestic). Global vari- EMBI; Blocked SVAR; ables drive most of the dynamics of the Ecuadorian EMBI, also International market; influenced by the evolution of sovereign risks in other Latin Spillover effect American countries like Chile and Peru. We likewise show that the increase in public debt is the primary domestic variable affecting the Ecuadorian EMBI. 1. Introduction This study aims to identify the main variables that determine the dynamics of the interest rate spread of international bonds issued by the Ecuadorian sovereign. It uses the Emerging Markets Bonds Index (EMBI) or country risk to understand the determinants of the cost of Ecuador’s public debt. In principle, the EMBI is the interest rate premium over U.S. bonds that investors will demand to invest in Ecuador’s sovereign bonds. Therefore, it is usually interpreted as a measure of the country’s level of sovereign risk (Longstaff et al., 2011). Upon adopting the U.S. dollar as Ecuador’s legal tender in the year 2000, the authorities gave up the use of monetary and exchange rate policies as instruments for macroeconomic stabilization. At this point, fiscal policy became the main macroeco- nomic policy over which the government maintained some level of discretion; partially constrained by a succession of fiscal rules adopted over the past two decades (see Camino-Mogro & Brito-Gaona, 2021; Cueva et al., 2018; SRI, 2012). Ecuador’s level of fiscal spending has been primarily constrained by the government’s capacity to raise revenues. In this context, over the past decades, the government has attempted to increase tax collection through various fiscal reforms and institutional revenues (Carrillo-Maldonado, 2017). However, authors such as Cueva et al. (2018) or de la Cruz et al. (2020) indicate that the level of taxes collected in Ecuador has persistently remained below the Latin America average. This suggests a more ambitious domestic CONTACT Paul Carrillo-Maldonado firstname.lastname@example.org Facultad de Ciencias Económicas y Administrativas, Universidad de Las Américas and Ecuadorian Political Economy Lab, Quito, Ecuador © 2023 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group. This is an Open Access article distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/ licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. 2 P. CARRILLO-MALDONADO ET AL. revenue mobilization strategy may be needed going forward. Oil revenues have amounted to close to 27 percent of total public spending between 2000 and 2019, determined by relatively stable production and highly volatile prices. The oscillations of international oil prices are crucial to understanding the Ecuadorian business cycle and recent episodes of macroeconomic instability (see Carrillo-Maldonado & Díaz-Cassou, 2019; Cueva & Diaz, 2018; Díaz-Cassou & Ruiz-Arranz, 2018). The other source of resources to sustain public spending has been public debt obtained from multilateral and bilateral sources, banks, and institutional investors. Illustrating the growing relevance of this last source of financing, between 2014 and 2019, Ecuador’s stock of international bonds has increased from 13% to 38% of the total debt (Ministerio de Economía y Finanzas, 2020a). The main advantages of sovereign bond issues vis-a-vis the other source of finance are the depth of global financial markets and that these resources are not directly linked to specific investment projects or the implementation of a given reform. This has allowed greater flexibility in the execution of the budget. The growing relevance of bonded debt justifies analyzing the determinants of Ecuador’s sovereign spreads conducted in this paper. We build on other early contribu- tions, such as Hilscher and Nosbusch (2010) or Comelli (2012). These contributions have already tried to identify the determinants (or fundamental variables) that explain the dynamics of the EMBI in emerging and developing countries. This paper is related to Del Cristo and Gómez-Puig (2017). They indicate that the country’s risk of having a dollarized economy (Panama and Ecuador) shows a more stable dynamic than other Latin American economies such as Argentina or Brazil. Moreover, their results suggest that international factors are more important than national variables when explaining the variation of sovereign spreads. To the best of our knowledge, no empirical contributions have yet tried to identify “al” domestic and international variables that determine the dynamics of the Ecuadorian EMBI. Díaz-Cassou and Ruiz-Arranz (2018) show qualitatively that the global oil price (West Texas Intermediate, WTI) is the main variable explaining Ecuador’s country risk evolution. Del Cristo and Gómez-Puig (2017) use a vector autoregressive model with a correction equation, concluding that public debt is the most important domestic determinant of sovereign spreads in Ecuador. However, they only include four domestic variables in their specification. Our paper contributes to the literature by expanding to 21 the set of variables included in the analysis, including most of the factors identified in other contributions on the determinants of country risk. Another contribution of this paper is our empirical strategy. Given that Ecuador is a small open economy, we build structural autoregressive vectors (SVAR) with blocks of variables. International and domestic variables are included in the SVAR model, follow- ing the literature mentioned above. The national variables do not affect the global factors (neither the contemporary nor lagged ones). The EMBI of other Latin American coun- tries is also added to assess the relevance of contagion or spillover effects in Ecuadorian economy. By contrast, global VAR (GVAR) models, such as Favero (2013) or Temizsoy and Montes-Rojas (2019), allow for the interdependence of all variables among the countries included in the analysis. We use Bayesian econometrics to estimate this medium SVAR (21 variables), which allows us to obtain better estimates than the frequentist approach (see Chan, 2020; Karlsson, 2013; Koop & Korobilis, 2010). JOURNAL OF APPLIED ECONOMICS 3 The rest of the paper is structured as follows. Section 2 sketches a short history of the Ecuadorian public debt and the relationship between interest rate and the EMBI. Section 3 presents our methodology. Section 4 shows the main results of our estimations. Finally, section 5 concludes with the main takeaways of our analysis on the dynamics of the Ecuadorian EMBI. 2. Ecuadorian public debt and the EMBI Ecuador’s first sovereign bond issuance dates back from 1889, and was aimed at raising resources for the construction of the railroad (Acosta, 2006) . Throughout its history, the Republic of Ecuador has defaulted or restructured its bonded debt on various occasions. For instance, in 1999, Ecuador became the first country ever to default on Brady bonds, themselves the product of another debt restructuring (Díaz-Cassou et al., 2008). Another notorious debt event was that of 2008 when the government announced that it would suspend the servicing of two global bonds because these obligations were “odious, illegitimate and illegal”. This announcement led to a sharp reduction in the value of these two bonds in secondary markets and the EMBI exploded to a value of over 4000 points (see Figure 1); enabling the government to repurchase them at a steep discount (the equivalent of a 30 percent cut in face value terms). However, the 2008 debt event expelled Ecuador from international financial markets. It was not until 2014 that a new sovereign issuance could be placed. Since then, the participation of sovereign bonds issued internationally over total debt gradually increased, reaching a peak of 38 percent in 2019. The last reprofiling took place in 2020. It aimed to restore the sustainability of Ecuadorian public debt after the prolonged financial crisis that began with the end of the commodity super-cycle. However, it was aggravated by the COVID- 19 pandemic (Ministerio de Economía y Finanzas, 2020b). These events have caused the Ecuadorian EMBI to be one of the highest and one of the most volatile in Latin America (see Figure 1). Figure 1. Evolution of Ecuadorian EMBI and comparison with other Latin American countries. However, upon the foundation of the Republic, Ecuador “inherited” bonded debt from the Gran Colombia, which was issued to repay Great Britain for its support during the independence war. For more details about this concept, see Sack (1927) and the different cases on the website https://www.cadtm.org/. 4 P. CARRILLO-MALDONADO ET AL. The EMBI index tracks the performance of emerging markets sovereign debt instru- ments in secondary markets. It is calculated as a spread over comparable (and presum- ably risk-free) U.S. government debt securities. Therefore, the EMBI is commonly used as a proxy for the level of sovereign risk perceived by international investors in a particular country (or emerging market debt as an asset class). As such, at each specific point in time, the level of the EMBI index is expected to be correlated with the interest rate at which a country could issue new securities. Figure 2 shows a positive relationship between the cost of new bond issuances and Ecuador’s EMBI. This relationship is observed with the average country risk both one week and one month before the new allocation. This implies that gaining a better understanding of the determinant of its EMBI will help us shed some light on the drivers of the cost of finance for the Ecuadorian sovereign. Note: The graph shows the nominal bond interest rate since 2014, and the daily average of the EMBI in a week and a month before the bond issue (excluding Saturday and Sunday). The labels present the contract year and maturity of the bond. Also, bonds issued by oil companies are not considered. The literature has distinguished between “push” and “pull” determinants of the financial cost of sovereign bonds. The first set of variables is associated with external conditions. For instance, Del Cristo and Gómez-Puig (2017), Longstaff et al. (2011), Ordoñez-Callamand et al. (2017), and Presbitero et al. (2016) use variables to capture the performance international financial and commodity markets. Meanwhile, other studies such as Hilscher and Nosbusch (2010), Longstaff et al. (2011), and Uribe and Yue (2006) use other variables to capture U.S. Federal Reserve monetary policy stance. Finally, Comelli (2012),and Hilscher and Nosbusch (2010) use variables that capture financial markets’ volatility. These variables also are most important to explain the business cycles of developing countries (see Carrillo-Maldonado & Díaz-Cassou, 2019; Fernández et al., 2017). In addition, these external factors are associated with the global financial cycle, which denotes fluctuations in financial activities such as the prices of risky assets, the increase in credit levels, gross capital flows, and the leverage of financial intermediaries worldwide. This financial cycle could also be affected in a certain way by the US monetary policy since a monetary contraction in this country leads to a considerable reduction in the leverage of global financial intermediaries, as well as an increase in aggregate risk aversion (see S. Miranda-Agrippino & H. Rey, 2020b). In turn, pull determinants are country-specific characteristics, such as economic activity, or fiscal variables such as expenditure or levels of public debt (Comelli, 2012; Figure 2. Relationship between interest rate and EMBI of Ecuador. Source: Bloomberg. JOURNAL OF APPLIED ECONOMICS 5 Fracasso, 2006; Hilscher & Nosbusch, 2010; Presbitero et al., 2016). In addition, a number of studies use variables to capture the external position, as the current account balance, the terms of trade, or the level of international reserves, which are particularly relevant for developing and emerging economies (Hilscher & Nosbusch, 2010; Presbitero et al., 2016). Meanwhile, Gómez-Puig et al. (2014) also uses private banks’ leverage. Some researchers explain that these variables capture the dynamic of the country risk, however the historical defaults of (external) sovereign debt and (long-run) macroeconomic volatility explain the level of the EMBI (see Reinhart et al., 2003; C. M. Reinhart & K. S. Rogoff, 2004, 2009). Various studies, such as Presbitero et al. (2016), and Comelli (2012), find that institutional and political variables can also influence developing countries’ EMBI. Among the institutional variables that could be used, the authors see government effectiveness, institutional stability, the quality of the bureaucracy, or various socio- economic conditions. On the political front, the find democratic accountability, internal and external conflicts, the level of corruption, or religious tensions. 3. Methodology We implement a structural vector autoregressive model (SVAR) to identify the main determinants of the Ecuadorian EMBI, following Karlsson (2013) and Koop and Korobilis (2010). In addition, we include a block exogeneity model to distinguish between the effects of pull and push variables, with an Independent Normal-Inverse Wishart distribution (INIW). 3.1. Structural vector autoregressive model Following Rubio-Ramírez et al. (2010), consider the SVAR model as: A Y ¼ A X þ ε ; 2 ,Nð0; I Þ (1) 0 t þ t t t n � � where Y is a vector of n endogenous variables, X ¼ Y ; Y ; . . . ; Y ; C is the t t t 1 t 2 t p vector of retards (lags) of endogenous (Y ; j ¼ 1; . . . ; p) and deterministic variables (C, t j constant). A is an n� k matrix of structural parameters of X , ε is a vector of structural þ t t shocks, p is the number of lags, k ¼ npþ 1 is the number of right-hand side variables (RHS), and T is the sample size. The n� n matrix A contains the contemporaneous relationships with a recursive identification, like lower triangular matrix as: 2 3 a 0 . . . 0 1;1 6 7 a a . . . 0 2;1 2;2 6 7 6 7 . . . . . . . . A ¼ 6 7 . . . . 6 7 4 5 a a . . . a n;1 n;2 n;n Conditional on past information and initial conditions, the structural shocks follow a (Gaussian) Normal distribution with mean zero and an n� n identity matrix (I ) as covariance matrix. If A is invertible, the reduced form of the SVAR can be defined as: 0 6 P. CARRILLO-MALDONADO ET AL. Y ¼ BX þ μ (2) t t �