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Debt intolerance is a term coined by Carmen Reinhart, Kenneth Rogoff and Miguel Savastano referring to the inability of emerging markets to manage levels of external debt that, under the same circumstances, would be manageable for advanced countries, making a direct analogy to lactose-intolerant individuals.

Debt intolerance hypothesis
The concept of debt intolerance alludes to the extreme duress many emerging market economies experience with respect to their debt levels, even if they are apparently controllable for advanced economies. In other words, sovereign riskiness appears to be out of proportion considering the size of the debt burdens faced by these countries. This leads to extreme circumstances that most of the times translate into very high volatility and difficulty to repay the debt commitments.

The safe threshold of external debt-to-GNP for debt intolerant countries is particularly low and depends essentially on the history of default and inflation. Under the debt intolerance hypothesis, other factors determining the safe threshold, such as the degree of dollarization, the extent of indexation to inflation, the level of short term interest rates or the maturity structure of the outstanding debt, are all part of institutional weaknesses that may be the consequence of a history of weak and unreliable policies. In contrast, the original sin hypothesis, despite analyzing the same phenomenon, defines the safe threshold as depending mostly on the structure of global portfolios and international financial markets as well as on the difficulty to denominate debt in terms of a currency more tractable to each country’s repayment capacity. Nevertheless, for Eichengreen, Hausmann and Panizza these two concepts are interrelated since the inability of a country to borrow from abroad on its own currency postulated by the original sin hypothesis, could be one explanation of why emerging countries may have troubles managing debt levels that would be otherwise manageable for advanced economies.

By analyzing the debt levels and the default decisions of middle income countries during the period 1970-2001, Reinhart, Rogoff and Savastano find a peculiarity that gives support to their hypothesis: debt crisis in emerging economies tend to occur at levels of debt which may not be excessive. They found that, at the time of default, only in 13 percent of the cases the debt-to-GNP ratio was higher than 100 percent, while more than 50 percent of defaults occurred at levels of debt below 60 percent and 13 percent at levels of debt below 40 percent of GNP.

Debt intolerance clubs
Two common measures of the degree of debt intolerance, based on the default risk and the external debt-to-GNP-ratio, can be constructed making use of the sovereign debt rating reported by the Institutional Investor (IIR). The IIR rating grades a country on a scale of 0 to 100, with 100 representing the lowest probability of default.

By using data spanning the period 1979-2002, countries can be classified into “clubs” by adding and subtracting one standard deviation to the mean of the IIR. In such a way, club A represents countries with a continuous access to capital characterized by levels of IIR above 67.7, making them the least debt intolerant. On the other extreme, club C is constituted by countries whose IIR coefficient is below 24.2, making them the most debt intolerant countries, which only have sporadic opportunities to borrow from abroad. Club B is formed by the remaining countries.

The thresholds for club B are very wide, making it an extremely heterogeneous club that has both countries close to move up to the selective club A and countries close to move down to club C. To narrow down the classification in club B and to pin down the specific level of debt intolerance, countries are also classified in terms of their debt-to-GNP ratio. Club B is decomposed in 4 regions: region I represents the least debt intolerant, characterized by an IIR above the mean (45.9) and a ratio of debt-to-GNP below 35 percent; region II is formed by countries with an IIR above the mean and a ratio of debt-to-GNP above 35 percent; region III is composed by counties with an IIR below the mean and external debt-to-GNP below 35 percent; and, finally, region IV represents the most debt intolerant countries with an average IIR below the mean and a debt-to-GNP ratio above 35 percent.

Characteristics
A debt intolerant country is mainly characterized by a history of serial defaults and high levels of inflation. Most of the times this is also accompanied by other institutional problems, such as weak fiscal structures and vulnerable financial systems. This phenomenon recreates a vicious circle where defaulter countries become more prone to future default episodes, with past events having a decisive relevance on current outcomes.

Serial default and over-borrowing
Many countries that have defaulted on their history have done so repeatedly with remarkable similarities and synchronization, coinciding in most of the cases with economic downturns. In general, debt intolerant countries do not achieve a substantial debt reduction through sustained growth or lower interest rates; they may require a major credit event, which could be either default or debt restructuring.

The number and spells of default episodes brings about an important issue in emerging markets of default becoming a “way of life”. Evidence of this issue relies on the fact that, in the period 1824-2001, countries such as Brazil and Argentina were either on default or debt restructuring 26 percent of the time, Venezuela and Colombia 40 percent of the time and Mexico 50 percent of the time.

Persistent episodes of default have important economic repercussions on trade, investment flows and growth, but they also generate institutional erosion, immersing the economy in two well-defined vicious circles. On one hand, it erodes the financial system through the linkages between domestic and foreign financial markets. A weak financial system lowers the penalty to default inducing countries to default at lower levels of debt. This, for instance, weakens even more the financial system, reducing further the penalty to default and generating new incentives to default. On the other hand, persistent episodes of default weaken the tax system by encouraging tax avoidance and capital flight, making it more difficult to meet debt obligations. This forces countries either to acquire additional debt if available or to move towards more inelastic tax sources, exacerbating tax avoidance and capital flights and thus falling in a feedback loop that makes it more and more difficult to the country to commit to repay its debt.

One feature of debt intolerant countries that are serial defaulters and that go through the process described previously is their tendency to over-borrow. Making an analogy with lactose intolerance, this would be equivalent to lactose intolerant individuals generating an addiction to milk. Over-borrowing behavior was an important feature of default episodes in the 1980s and 1990s, and was the result of shortsighted governments willing to take risks in order to raise consumption temporally rather than seeking long-run goals, pushing them to contract excessive debt.

High inflation exposure
Historically, countries have developed de facto default mechanisms through inflation or hyperinflation. Between 1824 and 2001, serial defaulters presented annual inflation levels exceeding 40 percent in 25 percent of the period, with countries like Brazil and Turkey reaching levels of 59 and 57.8 percent, respectively. In contrast, non-defaulter countries (such as India, Korea, Malaysia, Singapore, and Thailand) never experienced episodes of high inflation which is only comparable to industrial economies with no external default history.

Hypothesis drawbacks
The relevance of past events over current outcomes is privileged in the debt intolerance literature, but the mechanism through which past events influence current events generates some controversy. Eichengreen, Hausmann and Panizza argue that the link between past and current outcomes may be induced by variables omitted in the initial analysis; more specifically, they stress the role of original sin as the linkage measure. Luis Catao and Sandeep Kapur postulate the role of the high volatility in domestic output and terms of trade as the key devices determining the indebtedness capacity of emerging economies. More volatility would induce a higher default risk, restricting the borrowing capacity of countries even at low levels of indebtedness. This cast serious doubts of one of the most prominent characteristics of the debt intolerance hypothesis, which is the fact that debt intolerance can be explained by just a very small number of variables.