It’s easy to assume that major oil-producing countries are rich enough to repay their publicly held debt. But what if having more oil actually increased their likelihood of default in the long run? St. Louis Fed economist Paulina Restrepo-Echavarria goes into detail about her research on oil-producing countries in the developing world and sovereign debt. She finds that having more oil doesn’t necessarily mean a country won’t default.
This 12-minute podcast was released May 4, 2018.
Kristie Engemann: Welcome to the Timely Topics series from the St. Louis Fed. I’m Kristie Engemann, your host for this podcast. With me is Paulina Restrepo-Echavarria, an economist in the St. Louis Fed’s Research division. Today we’ll be talking about her research on oil-producing countries in the developing world, specifically on the likelihood of their defaulting on their public debt, which is also known as sovereign debt. Thank you for joining us today, Paulina.
Paulina Restrepo-Echavarria: Thank you very much for having me.
Kristie Engemann: Could you first tell us what interests you in this topic?
Paulina Restrepo-Echavarria: So I come from Latin America, so I’m naturally interested in the economic conditions of developing countries. And something that differentiates developing countries from developed countries is that these countries are usually more prone to default than developed countries. At the same time, it is also the case that developing countries are more natural-resource intensive. They have more commodities and, specifically, they have larger amounts of oil. And nobody before has actually looked from an academic point of view at the relationship between sovereign default and oil, and how does having oil affect your ability to repay your debts or to default on them.
Kristie Engemann: And why might our listeners be interested in this topic?
Paulina Restrepo-Echavarria: So I think that in general, people are interested in why countries default. And if you think about it from the U.S. perspective, given that the U.S. is usually a lender to these countries, people might be interested to know whether we are getting paid back what was lent to these countries or not. At the same time, people care about oil, and they care about oil because oil, and specifically the price of oil, affects gas prices and so on. So they care about this in their daily lives. But they haven’t probably thought about the connection between the two things. About the price of oil and sovereign default.
Kristie Engemann: In your research, you’ve studied oil-producing countries that have defaulted on their public debt. Could you talk a little bit about what you’ve learned?
Paulina Restrepo-Echavarria: So the first thing is that people think that these countries don’t hold debt, but they do. And people think that because they’re very rich, even though they hold debt, they always have an ability to repay, so they will always repay their debt. But we see that this is not the case. We see that there are countries that actually hold large amounts of external public debts and they actually default on them, and they’re very big oil producers. So this is something that catches people’s attention.
Kristie Engemann: And could you give some examples of these oil-producing countries that have defaulted and maybe a few that haven’t defaulted?
Paulina Restrepo-Echavarria: So among developing countries, we looked at the top 35 net oil exporters from 1979 to 2010. And all but eight of them have defaulted on their debt during that period. So some examples are Argentina, Sudan, Iran, Iraq, Russia, Mexico, Egypt. And over that 30-year period that we look at, the amount of time in default that they’ve spent ranges between two years and 25 years. And actually, when we look at how many default episodes they have gone through, we see that it oscillates between one and three episodes in those 30 years, which is kind of considerable. And in terms of those that have not defaulted, there’s Saudi Arabia, the Arab Emirates, Kazakhstan and Oman.
Kristie Engemann: You mentioned that sometimes they hold large amounts of public debt. How much do these countries typically have?
Paulina Restrepo-Echavarria: So they usually have an average of 40 percent of GDP. If we look at the one that has the least amount, it would be the Emirates with 7 percent of GDP. And Sudan has the largest amount with 160 percent of GDP.
Kristie Engemann: In this line of research that you’re focusing on today, what was the main question that you were trying to address?
Paulina Restrepo-Echavarria: So basically, how does having oil affect the country’s ability to repay its public debt, and how does sovereign risk or the interest rate that these countries face increases or decreases when they’re larger producers of oil. We also want to see how sovereign risk is affected by how much oil they have underground, because there’s a difference between the effect that the amount of oil that you can extract has versus the amount of oil that you have underground has.
Kristie Engemann: And what did you find is the effect of having oil on sovereign risk?
Paulina Restrepo-Echavarria: So the most interesting thing is that it can have two different effects—one in the short run and another one in the long run. So in the short run we see that countries that have oil have a higher ability to repay. So, basically, if you can extract more oil from the ground, then you can sell that in international markets and that will help you repay your debt.
However, in the long run, we see that the effect is the opposite. Because the fact that you have more oil underground makes you feel more comfortable about going into autarky, into financial autarky. And what does that mean? Going into financial autarky means that you are excluded from international financial markets. You cannot borrow and lend in them. So, basically, your consumption—your domestic consumption—depends only on your domestic income. But given that you have oil underground, then you know that you can just extract this oil and sell it in international markets and that will allow you to maintain your levels of consumption or to smooth out consumption over time.
So the bottom line is in the long run, if you have a larger stock of reserves, then this increases the value of autarky or what we as economists call this will trigger a limited commitment mechanism and this will increase the probability of default for these countries.
Kristie Engemann: Were those results surprising to you at all?
Paulina Restrepo-Echavarria: Yes. They were very surprising because up to now everyone thinks that it’s about the ability to repay. So it’s basically about the fact that if you have more oil that you can extract and sell, then you can repay your debt more easily. But the fact that you have a larger stock of oil underground in the long run actually affects you negatively. This was very surprising.
Kristie Engemann: And what about oil prices? How was sovereign risk affected by changes in oil prices?
Paulina Restrepo-Echavarria: So we don’t have anything empirical on this dimension. We have the results from our theoretical model. And in particular, we know that when oil prices are lower, a country’s incentive to extract oil and sell oil is lower, naturally. And this is going to reduce a country’s ability to repay its debt. And if its fiscal income depends on oil, then this is going to increase the probability of default. Conversely, when oil prices are high, a country’s ability to repay its debt is higher, and the probability of default is going to be lower.
Kristie Engemann: So let’s say that a country actually does default on its debt. What would actually happen? So what would be the consequences for lenders, for the citizens of the country and for that government?
Paulina Restrepo-Echavarria: So there are obvious consequences for the lenders, because they won’t be able to collect back what they lent to this country. But in the country in the short run, people may not see the consequences of the default because life just goes on as usual. The problem is in the medium and long run. If the government fiscal ability relies largely on oil and they cannot cover for that gap, then they would have to end up cutting investments or public expenditures that might end up affecting people directly. However, this might not necessarily be the case. If we’re talking about specifically economies like the ones we’re looking at, they can still sell their oil in international markets and maybe smooth out their consumption that way. So it might be that they don’t see any consequences.
Now, what is largely argued in the literature of sovereign default is that default has more consequences in terms of reputation. So the lack of reputation is going to be reflected in sovereign risk. So in other words, these countries are going to end up paying much higher interest rates for the debt that they acquire in the future. And this is going to be costly for citizens because this can affect their tax rates, so that’s a way that it can certainly affect them.
Kristie Engemann: In your study, did you look at the impact of the large decline in oil prices in recent years on these oil-producing countries? And has there been an increase in defaults?
Paulina Restrepo-Echavarria: So no, we haven’t looked at that. We’ve looked at this from a historical point of view, so we haven’t looked at recent episodes.
Kristie Engemann: People in the U.S. who drive, they may think that low oil prices are a great thing. So why might they care about how low oil prices affect other oil producers?
Paulina Restrepo-Echavarria: So in principle, there’s no direct effect on them. So if you think about it that way, they don’t have anything to worry about. Now, if you think that everyone should be altruistic and care about the well-being of other people, disregarding the country they’re in, then they should care about the fact that people in these other countries where deficits are highly reliant on oil are going to suffer and maybe there are going to be budget cuts.
Kristie Engemann: This particular line of research focuses on developing countries, so it doesn’t include the U.S. But have you had a chance to look at the impact of lower oil prices on the U.S. in any of your other work?
Paulina Restrepo-Echavarria: So we’ve looked at the effect of oil prices on oil production in the U.S. in particular. So basically, even though prices have been lower for a much longer period of time than expected, we have seen that production of oil or oil extraction has kept increasing over time. This is interesting because one would think that at these prices it’s not worth it to extract more oil. However, what we found is that the costs of extraction have drastically gone down because technology of extraction has increased drastically over the last ten to 15 years. So the U.S. is taking advantage basically of this lower cost of extraction in order to extract more oil, and so prices haven’t really had an effect on the amount of oil that is extracted in the U.S.
Kristie Engemann: And since we’re talking about oil production in the U.S., does the U.S. entering this industry in a major way with shale formations have an impact on traditional oil-producing regions?
Paulina Restrepo-Echavarria: I think that at least in the short to medium term it will not affect other countries. The U.S. just became a net oil exporter a couple of years ago.
Kristie Engemann: Besides looking at the impact of having oil on sovereign risk, are there other related research questions that you’re exploring right now?
Paulina Restrepo-Echavarria: So we’re very interested in the question about debt sustainability. And this has been of great concern to economists. So basically, how much debt can a country sustain? And there’s no definite answer to this question because it depends a lot on the economic stability of the country. So take for a moment the U.S. So the U.S. has a debt-to-GDP ratio of about 105 percent, which is extremely high. But people don’t go around the U.S. talking about the fact that the U.S. might default on its debt, and how high is this percentage, and how scary that could be because we don’t think that the U.S. is likely to default. However, if we were to think about a country like Argentina, let’s say, or Russia with a debt that is of 105 percent of GDP, that would actually be pretty concerning from an economic standpoint.
Kristie Engemann: And as we wrap up this podcast, could you give two or three takeaways that you would want our listeners to remember?
Paulina Restrepo-Echavarria: So I would like them to remember that countries that produce oil do hold debt. Their external public debt is relevant. And that they do default on it sometimes. So having oil does not guarantee that a country won’t default. And also that having oil not only increases the ability of a country to repay, but the reason why having oil does not guarantee that a country won’t default is because in the long run having oil triggers the opposite effect. It basically increases the likelihood of a country defaulting on their debt because they have enough oil underground to extract and sell in international markets. So they can substitute their financial assets, which are their debt, for this real asset that is oil to smooth out their consumption.
Kristie Engemann: All right. Well, thank you very much for talking with us today. We really appreciate your time.