Default Risk Dangers: The Effect of Downgrades in Public Credit on the Economy

Declining trust in a government’s fiscal health and a negative economic outlook often go hand in hand. It is generally accepted that the effects of a declining economy, such as an eroding tax base and an increasing need for public services, can strain a government’s budget. A new study, however, shows that this relationship can also run the other way: a government’s fiscal health may impact the health of the economy.

For example, Chicago’s general obligation debt has had a “junk” rating for about three years. Despite this, the city’s relatively stable economic picture in those three years suggested that the lack of public credit had a negligible effect on the broader economy. In a recent working paper from the National Bureau of Economic Research, authors Anusha Chari, Ryan Leary and Toan Phan used debt-stricken Puerto Rico as a case study to argue that negative public credit events can lead to decreases in employment and investment, and an increase in borrowing costs for businesses.

The key to understanding how fear of government default can impact the economy is anticipation. Fearing default, agents in the economy will take actions to anticipate it, negatively impacting the economy. Chari et al. examined the effects of these anticipatory actions in the case of Puerto Rico.

First, the paper determined whether Puerto Rico’s economic indicators changed significantly after its 2012 credit downgrade to junk status in a before-and-after comparison of macroeconomic data from 2006 to 2015. To eliminate the possibility that changes in Puerto Rico’s economic indicators were attributable to broader movements in the U.S. economy, they tracked the relationship between the same economic indicators in Puerto Rico and the U.S. The authors found that the economies of the two countries began to diverge following the credit downgrade. Whereas U.S. indicators such as employment, economic activity and investment improved, those same indicators in Puerto Rico fell.

Following this initial analysis, the researchers tested hypotheses regarding two potential mechanisms through which a negative public credit rating could affect the economy: the credit channel and the austerity channel. The credit channel hypothesis states that lending institutions carrying government debt cut back on making loans as they anticipate default, harming industries that depend on external financing. Lending support to this, the authors’ results showed that average monthly employment growth in Puerto Rico for manufacturing industries with higher-than-median dependence on external financing was -0.42 percent, whereas it was -0.28 percent for industries with lower-than-median dependence. Contextual banking data also backs up the credit channel hypothesis, showing that commercial and industrial loans as a percentage of GNP fell by 35.9 percent between 2008 and 2015.

The austerity channel hypothesis, on the other hand, states that industries more dependent on government demand reduce jobs and projects in anticipation of austerity measures and lower government spending for their services. The authors’ results showed that average monthly employment growth for manufacturing industries above median dependence on government demand was -0.58 percent compared with -0.30 percent for those below the median.

Finally, the authors examined changes to Puerto Rican firms’ stock returns to assess whether negative credit events such as downgrades had any transmission effect, whereby the government’s increased borrowing costs are passed on to the private sector. The results showed that negative rating actions on Puerto Rico’s general obligation debt were associated with abnormal returns of -4.1 percent on Puerto Rican firm stocks.

These results suggest that as a result of Puerto Rico’s worsening credit, businesses overall saw higher costs of capital and businesses that were financially fragile or dependent saw higher-than-average job losses. In the context of a larger recession, this contributed to Puerto Rico’s economic decline.

A government’s bad credit might seem like a problem for tomorrow. But if Puerto Rico’s case is generalizable, then businesses elsewhere may downsize in anticipation of future losses. In Puerto Rico’s fragile economy, these effects were observable; it is possible they are also present, though obscured, in a more robust economy like Chicago’s.

Article source: Chari, Anusha, Ryan Leary and Toan Phan, “The Costs of (sub)Sovereign Default Risk: Evidence from Puerto Rico,” National Bureau of Economic Research, Working Paper No. 24108 (2017).

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