...We introduce the concept of "debt intolerance" (drawing an analogy to, for example, "lactose intolerance"), which manifests itself in the extreme duress many emerging market economies experience at overall debt levels that would seem quite manageable by the standards of the advanced industrial economies. For external debt, "safe" thresholds for highly debt-intolerant emerging markets appear to be surprisingly low, perhaps as low as 15 to 20 percent of GNP in many cases, and these thresholds depend heavily on the country's record of default and inflation. Debt intolerance is indeed intimately linked to the pervasive phenomenon of serial default that has plagued so many countries over the past two centuries. Debt-intolerant countries tend to have weak fiscal structures and weak financial systems. Default often exacerbates these problems, making these same countries more prone to future default. Understanding and measuring debt intolerance is fundamental to assessing the problems of debt sustainability, debt restructuring, and capital market integration, and to assessing the scope for international lending to ameliorate crises.

Certainly, the idea that factors such as sound institutions and a history of good economic management affect the interest rate at which a country can borrow is well developed in the theoretical literature. Also well established is the notion that, as its external debt rises, a country becomes more vulnerable to being suddenly shut out of international capital markets, that is, to suffer a debt crisis. (1) However, there has to date been no attempt to make these abstract theories operational by identifying the factors (in particular, a history of serial default or restructuring) that govern how quickly a country becomes vulnerable to a debt crisis as its external obligations accumulate. One goal of this paper is to quantify this debt intolerance, drawing on a history of adverse credit events going back to the 1820s. We argue that a country's current level of debt intolerance can be approximated empirically as the ratio of the long-term average of its external debt (scaled by GNP or exports) to an index of default risk. We recognize that other factors, such as the degree of dollarization, indexation to inflation or short-term interest rates, and the maturity structure of a country's debt, are also relevant to assessing a country's vulnerability to symptoms of debt intolerance. (2) We argue, however, that in general these factors are different manifestations of the same underlying institutional weaknesses. Indeed, unless these weaknesses are addressed, the notion that the "original sin" of serial defaulters can be extinguished through some stroke of financial engineering, allowing these countries to borrow in the same amounts, relative to GNP, as more advanced economies, much less at the same interest rates, is sheer folly. (3)

The first section of the paper gives a brief overview of the history of serial default on external debt, showing that it is a remarkably pervasive and enduring phenomenon: the European countries set benchmarks, centuries ago, that today's emerging markets have yet to surpass. For example, Spain defaulted on its external debt thirteen times between 1500 and 1900, whereas Venezuela, the recordholder in our sample for the period since 1824, has defaulted "only" nine times. We go on to show how countries can be divided into debtors' "clubs" and, within those clubs, more or less debt-intolerant "regions," depending on their credit and inflation history. We also develop first broad-brush measures of safe debt thresholds. The data overwhelmingly suggest that the thresholds for emerging market economies with high debt intolerance are much lower than those for advanced industrial economies or for those emerging market economies that have never defaulted on their external debt. Indeed, fully half of all defaults or restructurings since 1970 took place in countries with ratios of external debt to GNP below 60 percent. (4)

Our key finding, presented in the second section of the paper, is that a country's external debt intolerance can be explained by a very small number of variables related to its repayment history, indebtedness level, and history of macroeconomic stability. Markets view highly debt-intolerant countries as having an elevated risk of default, even at relatively low ratios of debt to output or exports. Whether markets adequately price this risk is an open question, but it is certainly a risk that the citizens of debt-intolerant countries should be aware of when their leaders engage in heavy borrowing.

The third section turns to the question of how debt intolerance affects conventional calculations of debt sustainability, which typically assume continual market access. For debt-intolerant countries, sustaining access to capital markets can be problematic unless debt ratios are quickly brought down to safer levels. To assess how such "deleveraging" might be accomplished, we examine how, historically, emerging market economies with substantial external debts have managed to work them down. To our knowledge, this is a phenomenon that has previously received very little, if any, attention. We analyze episodes of large debt reversals, where countries' external debt fell by more than 25 percentage points of GNP over a three-year period. Of the twenty-two such reversals that we identify for a broad group of middle-income countries since 1970, two-thirds involved some form of default or restructuring. (Throughout the paper "restructuring" denotes a recontracting of debt service payments at terms that are tantamount to a partial default.) Only in one case-Swaziland in 1985--was a country able to bring down a high ratio of external debt to GNP solely as a result of rapid output growth.

Because history plays such a large role in our analysis, we focus primarily on understanding emerging market economies' access to external capital markets. For most emerging markets, external borrowing has been the only financial game in town for much of the past two centuries, and our debt thresholds are calculated accordingly. Over the past decade or so, however, a number of emerging market economies have, for the first time, seen a rapid expansion in domestic, market-based debt, as we document using an extensive new data set, which we present in the paper's fourth section. The calculus of domestic default obviously differs from that of default on external debt, and we lack sufficient historical data to investigate the question fully. However, we argue that a record of external debt intolerance is likely to be a good predictor of future domestic debt intolerance. It is certainly the case that many of the major debt crises of the past ten years have involved domestic debt, and that the countries that seem to be experiencing domestic debt intolerance rank high on our debt intolerance measures. (5)

Finally, if serial default is such a pervasive phenomenon, why do markets repeatedly lend to debt-intolerant countries to the point where the risk of a credit event--a default or a restructuring--becomes significant? Part of the reason may have to do with the procyclical nature of capital markets, which have repeatedly lent vast sums to emerging market economies in boom periods (which are often associated with low returns in the industrial countries) only to retrench when adverse shocks occur, producing painful "sudden stops." (6) As for the extent to which borrowing countries themselves are complicit in the problem, one can only conclude that, throughout history, governments have often been too short-sighted (or too corrupt) to internalize the significant risks that overborrowing produces over the longer term. Moreover, in the modern era, multilateral institutions have been too complacent (or have had too little leverage) when loans were pouring in. Thus a central conclusion of this paper is that, for debt-intolerant countries, mechanisms to limit borrowing, either through institutional change on the debtor side, or--in the case of external borrowing--through changes in the legal or regulatory systems of creditor countries, are probably desirable. (7)

Debt Intolerance: Origins and Implications for Borrowing

We begin by sketching the history of debt intolerance and serial default, to show how this history importantly influences what "debtors' club" a country belongs to.

Debt Intolerance and Serial Default in Historical Perspective

A bit of historical context will help to explain our approach, which draws on a country's long-term debt history. The basic point is that many countries that have defaulted on their external debts have done so repeatedly, with remarkable similarities across the cycles. For example, many of the Latin American countries that are experiencing severe debt problems today also experienced debt problems in the 1980s--and in the 1930s, and in the 1870s, and in the 1820s, and generally at other times as well. Brazil, whose debt problems have attracted much attention lately, has defaulted seven times on its external debt over the past 175 years. During that same period, Venezuela has defaulted nine times, as already noted, and Argentina four times, not counting its most recent episode. But the problem is by no means limited to Latin America. For example, Turkey, which has been a center of attention of late, has defaulted six times over the past 175 years. These same countries have at times also defaulted, de facto, on their internal obligations, including through high inflation or hyperinflation. On the other side of the ledger, a number of countries have strikingly averted outright default, or restructuring that reduced the present value of their debt, over the decades and centuries. India, Korea, Malaysia, Singapore, and Thailand are members of this honor roll.

The contrast between the histories of the nondefaulters and those of the serial defaulters, summarized in table 1, is stunning. Default can become a way of life. Over the period from 1824 to 1999, the debts of Brazil and Argentina were either in default or undergoing restructuring a quarter of the time, those of Venezuela and Colombia almost 40 percent of the time, and that of Mexico for almost half of all the years since its independence. On average, the serial defaulters have had annual inflation exceeding 40 percent roughly a quarter of the time as well. (8) By contrast, the emerging market economies in the table that have no external default history do not count a single twelve-month period with inflation over 40 percent among them. For future reference, the table also includes a sampling of advanced economies with no modern history of external default.

Today's emerging markets did not invent serial default. It has been practiced in Europe since at least the sixteenth century, as table 2 illustrates. As already noted, Spain defaulted on its debt thirteen times from the sixteenth through the nineteenth centuries, with the first recorded default in 1557 and the last in 1882. In the nineteenth century alone, Portugal, Germany, and Austria defaulted on their external debts five times, and Greece, with four defaults during that period, was not far behind. France defaulted on its debt eight times between 1550 and 1800. (Admittedly, the French governments' debts were mainly held internally before 1700, and "restructuring" was often accomplished simply by beheading the creditors--giving new meaning to the term "capital punishment." (9)

This central fact--that some countries seem to default periodically, and others never--both compels us to write on this topic and organizes our thinking. True, as we will later illustrate, history is not everything. Countries can eventually outgrow debt intolerance, but the process tends to be exceedingly slow, and backsliding is extremely difficult to avoid.

Is Serial Default Really Such a Problem?

What does history tell us about the true costs of default? Might periodic default (or, equivalently, restructuring) simply be a mechanism for making debt more equity-like, that is, for effectively indexing a country's debt service to its output performance? After all, defaults typically occur during economic downturns. (10) Although there must be some truth to this argument, our reading of history is that the deadweight costs to defaulting on external debt can be significant, particularly for a country's trade, investment flows, and economic growth. In more advanced economies, external default can often cause lasting damage to a country's financial system, not least because of linkages between domestic and foreign financial markets. Indeed, although we do not investigate the issue here, we conjecture that one of the reasons why countries without a default history go to great lengths to avoid defaulting is precisely to protect their banking and financial systems. Conversely, weak financial intermediation in many serial defaulters lowers their penalty to default. The lower costs of financial disruption that these countries face may induce them to default at lower thresholds, further weakening their financial systems and perpetuating the cycle. One might make the same comment about tax systems, a point to which we will return at the end of the paper. Countries where capital flight and tax avoidance are high tend to have greater difficulty meeting debt payments, forcing governments to seek more revenue from relatively inelastic tax sources, in turn exacerbating flight and avoidance. Default amplifies and ingrains this cycle.

We certainly do not want to overstate the costs of default or restructuring, especially for serial defaulters. In fact, we will later show that debt-intolerant countries rarely choose to grow or pay their way out of heavy debt burdens without at least partial default. This revealed preference on the part of debt-intolerant countries surely tells us something. Indeed, many question whether, in the long run, the costs of allowing or precipitating a default exceed the costs of an international bailout, at least for some spectacular historical cases. But there is another side to the question of whether debt-intolerant countries really do borrow too much, and that has to do with the benefit side of the equation. Our reading of the evidence, at least from the 1980s and 1990s, is that external borrowing was often driven by shortsighted governments that were willing to take significant risks to raise consumption temporarily, rather than to foster high-return investment projects. The fact that the gains from borrowing come quickly, whereas the increased risk of default is borne only in the future, tilts shortsighted governments toward excessive debt. So, although the costs of default are indeed often overstated, the benefits to be reaped from external borrowing are often overstated even more, especially if one looks at the longer-term welfare of the citizens of debtor countries.

What does history tell us about the lenders? We do not need to tackle this question here. Each of the periodic debt cycles the world has witnessed has had its own unique character, either in the nature of the lender (for example, bondholders in the 1930s and 1990s versus banks in the 1970s and 1980s) or in the nature of the domestic borrower (for example, state-owned railroads in the 1870s versus core governments themselves in the 1980s). There are, however, clearly established cycles in lending to emerging markets, with money often pouring in when rates of return in industrial countries are low. Heavy borrowers are particularly vulnerable to "sudden stops" or reversals of capital flows, when returns in industrial countries once again pick up.

Debt Thresholds

Few macroeconomists would be surprised to learn that emerging market economies with ratios of external debt to GNP above 150 percent run a significant risk of default. After all, among advanced economies, Japan's current debt-to-GDP ratio, at 120 percent, is almost universally considered high. Yet default can and does occur at ratios of external debt to GNP that would not be considered excessive for the typical advanced economy: for example, Mexico's 1982 debt crisis occurred at a ratio of debt to GNP of 47 percent, and Argentina's 2001 crisis at a ratio slightly above 50 percent.

We begin our investigation of the debt thresholds of emerging market economies by chronicling all episodes of default or restructuring of external debt among middle-income economies during the period from 1970 to 2001. (11) Table 3 lists twenty-seven countries that suffered at least one default or restructuring during that period, the first year of each episode, and the country's ratios of external debt to GNP and to exports at the end of the year in which the episode occurred. (Many episodes lasted several years.) It is obvious from the table that Mexico's 1982 default and Argentina's 2001 default were not exceptions: many other countries also suffered adverse credit events at levels of debt below 50 percent of GNP. Table 4 shows further that external debt exceeded 100 percent of GNP in only 13 percent of these episodes, that more than half of these episodes occurred at ratios of debt to GNP below 60 percent, and that defaults occurred despite debt being less than 40 percent of GNP in 13 percent of episodes. (12) (Indeed, the external debt-to-GNP thresholds reported in table 3 are biased upward, because the debt-to-GNP ratios corresponding to the year of the credit event are driven up by the real depreciation that typically accompanies the event.)

We next compare the external indebtedness profiles of emerging market economies with and without a history of default. The top panel of figure 1 shows the frequency distribution of the external debt-to-GNP ratio, and the bottom panel the external debt-to-exports ratio, for two groups of countries over the period 1970 2000. The two distributions are very distinct and show that defaulters borrow more (even though their ratings tend to be worse at a given level of debt) than nondefaulters. The gap in external debt ratios between those emerging market economies with and those without a history of default widens further when the ratio of external debt to exports is considered. It appears that those countries that risk default the most when they borrow (that is, those with the greatest debt intolerance) also borrow the most--much as if a lactose-intolerant individual were addicted to milk. It should be no surprise, then, that so many capital flow cycles end in an ugly credit event.

[FIGURE 1 OMITTED]

Figure 2 presents a subset of the numbers that underpin figure 1, as well as the cumulative distribution of external debt-to-GNP ratios for defaulters and nondefaulters. Over half of the countries with sound credit histories have ratios of external debt to GNP below 35 percent (and 47 percent have ratios below 30 percent). By contrast, for those countries with a relatively tarnished credit history, a threshold external debt-to-GNP ratio above 40 percent is required to capture the majority of observations. We can see already from table 4 and figure 2, without taking into account any country-specific factors that might explain debt intolerance, that when external debt exceeds 30 to 35 percent of GNP in a debt-intolerant country, the risk of a credit event starts to increase significantly. (13) We will later derive country-specific bounds that are much stricter for debt-intolerant countries.

[FIGURE 2 OMITTED]

The Components of Debt Intolerance

To operationalize the measurement of debt intolerance, we focus on two indicators: the sovereign debt ratings reported by Institutional investor, and the external debt-to-GNP ratio (or, alternatively, the external debt-to-exports ratio). The Institutional Investor ratings (IIR), which are compiled twice a year, are based on information provided by economists and sovereign risk analysts at leading global banks and securities firms. The ratings grade each country on a scale from to 100, with a rating of 100 given to those countries perceived as having the lowest chance of defaulting on their government debt obligations. (14) Hence we take the transformed variable (100--IIR) as a proxy for default risk. Market-based measures of default risk are also available, but only for a much smaller group of countries and over a much shorter sample period. (15)

The second major component of our debt intolerance measure is total external debt, scaled either by GNP or by exports. We emphasize total (public and private) external debt because most government debt in emerging markets until the late 1980s was external, and because it often happens that external debt that was private before a crisis becomes public after the fact. (16) (As we later show, however, in future analyses it will be equally important to measure intolerance with reference to the growing stock of domestic public debt.)

Figure 3 plots against each other the major components of debt intolerance for each year in the period 1979-2000 for sixteen emerging market economies. As expected, our preferred risk measure (100--IIR) tends to rise with the stock of external debt, but the relationship may be nonlinear. In particular, when the risk measure is very high (concretely, when the IIR falls below 30), it matters little whether the external debt-to-GNP ratio is 80 percent or 160 percent, or whether the external debt-to-exports ratio is 300 percent or 700 percent. This nonlinearity simply reflects the fact that, below a certain threshold of the IIR, typically about 24, the country has usually lost all access to private capital markets. (17)

[FIGURE 3 OMITTED]

Table 5 shows the period averages of various measures of risk and external debt (the components of debt intolerance) for a representative sample of countries, which we will refer to as our core sample (see appendix B). Because some researchers have argued that the "right" benchmark for emerging market indebtedness is the level of public debt that advanced economies are able to sustain, (18) table 5 also includes this measure for a group of nondefaulting advanced economies. The table makes plain that, although the relationship between external debt and risk may be monotonic for emerging market economies, it is clearly not monotonic for the public debt of advanced economies; in those countries, relatively high levels of...

NOTE: All illustrations and photos have been removed from this article.




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