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San JoseSan JoseFebruary 9, 2007February 9, 2007
Eduardo BorenszteinEduardo Borensztein
San JoseSan JoseFebruary 9, 2007February 9, 2007
Eduardo BorenszteinEduardo Borensztein
2
Why Now?Why Now?(when we have no crises)(when we have no crises)
• Precisely. Crises can be prevented (at least some)
• Favorable Markets. Possibility of improving debt management (local currency, new instruments)
• Role of the IFIs is being reconsidered. New ideas to make global finance safer
3
OutlineOutline
•Stylized Facts• International Borrowing•Domestic Borrowing•Towards Safer Debt
4
OutlineOutline
• Stylized FactsStylized Facts• International BorrowingInternational Borrowing• Domestic BorrowingDomestic Borrowing• Towards Safer DebtTowards Safer Debt
5
Public debt is not going Public debt is not going away…away…
Public Debt in Latin America and the Caribbean
0
20
40
60
80
100
120
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 20050
10
20
30
40
50
60
70
80Weighted average (right axis)
Average (left axis)
Median (right axis)
Weighted average excluding Argentina (right axis)
Source: Authors' calculations based on Cowan et al. (2006).Note: Countries included: Argentina, Bahamas, Barbados, Belize, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Guyana, Haiti, Honduras, Jamaica, Mexico, Nicaragua, Panama, Paraguay, Peru, Trinidad and Tobago, Uruguay, and Venezuela.
6
..and domestic debt is ..and domestic debt is increasingincreasing
Composition of Public Debt in Emerging Latin American Countries
0
10
20
30
40
50
60
70
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Domestic debtExternal due to private creditorsExternal due to official creditors
Source : Authors' calculations based on Cowan et al. (2006).Note : Countries included: Argentina, Brazil, Chile, Colombia, Ecuador, El Salvador, Mexico, Panama, Peru, Uruguay, and Venezuela.
7
Domestic Debt is also Domestic Debt is also growing in the smaller growing in the smaller
marketsmarkets
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Domestic
External due to Private Creditors
External due to Official Creditors
Countries Included: Barbados, Belize, Bolivia, Costa Rica, Guatemala, Honduras, Jamaica, Nicaragua, Paraguay.
8
Official borrowing Official borrowing remains important…remains important…
Composition of Public External Debt in Latin American and Caribbean Countries
with Limited Market Access
0
10
20
30
40
50
60
70
80
90
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Bank loans
Bonded debt
Other external
Bilateral
Multilaterals
IMF
Source : Authors' calculations based on Cowan et al. (2006).Note : Countries included: Belize, Bolivia, Costa Rica, Guatemala, Guyana, Honduras, Jamaica, Nicaragua, and Paraguay.
9
LAC debt levels are not LAC debt levels are not very high…very high…
Public Debt around the World (weighted averages)
0 10 20 30 40 50 60 70 80 90
EAP
ECA
LAC
SSA
IND
MNA
SAS
2001–2005
1996–2000
1991–1995
Source: Authors' calculations based on Jaimovich and Panizza (2006).
10
……but debt structure but debt structure matters more than debt matters more than debt
levellevel Public Debt and Sovereign Rating (1995–2005)
Italy
Jamaica
Japan
Israel
Belgium
Ghana
Jordan
Saudi Arabia
Pakistan
Egypt
MongoliaSenegal
Morocco
Grenada
Argentina
Barbados
Bolivia
Panama
Indonesia
Bulgaria
Portugal
Cyprus
Hungary
Sweden
Philippines
Papua New Guinea
Austria
Tunisia
Malta
Denmark
Ecuador
India
Benin
CanadaFinland
Qatar
Netherlands
SpainFrance
Uruguay
Russian Federation
Venezuela
United Kingdom
PeruCroatia
Brazil
Poland
South Africa
Ireland
Malaysia
Trinidad and Tobago
United States
Iceland
Belize
Turkey
Costa Rica
Ukraine
El SalvadorColombia
Bahamas
New Zealand
Paraguay
Germany
Slovak RepublicMexico
Switzerland
Lithuania
Bahrain
Slovenia
Norway
OmanChinaThailand
Kazakhstan
Guatemala
KoreaCzech RepublicChile
Australia
Latvia
Botswana
Estonia
Luxembourg
0 10 20 30 40 50 60 70 80 90 100 110
Public debt (percentage of GDP)
Sta
ndar
d &
Poo
r's s
over
eign
rat
ing
AAA
B
BB?
BBB
A?
AA?
Source : Jaimovich and Panizza (2006) and Standard & Poor's.
Investment grade line
11
Composition of Sovereign Debt, 2000-Composition of Sovereign Debt, 2000-0404
Domestic debt in local currency Domestic debt in foreign currency External debt
.
Costa Rica 1
0 10 20 30 40 50 60
2000 2001 2002 2003 2004
Dominican Republic 2
0 10 20 30 40 50 60
2000 2001 2002 2003 2004
Guatemala 4
0 5
10 15 20 25 30
2000 2001 2002 2003 2004 4 Central government.
El Salvador 3
0 10 20 30 40 50 60
2000 2001 2002 2003 2004 3 Nonfinancial public sector.
Panama 7
0 10 20 30 40 50 60 70 80
2000 2001 2002 2003 2004 7 General government.
Honduras 5
0 10 20 30 40 50 60 70 80
2000 2001 2002 2003 2004 5 Nonfinancial public sector.
Nicaragua 6
0 20 40 60 80
100 120 140 160 180 200
2000 2001 2002 2003 2004
1 Public sector. 2
Nonfinancial public sector and central bank.
6 Public sector and central bank.
(in percent of GDP)
Source: Faria and Tolosa, forthcoming IMF Occasional Paper
12
Structure of External DebtStructure of External Debt 2001–04 2001–04
,
GROUP ITotal PPG debt Total PPG debt Privately-held PPG debt
GROUP IITotal PPG debt Total PPG debt Privately-held PPG debt
Group I consists of Costa Rica, Dominican Republic, El Salvador, Guatemala, and Panama. Group II includes Honduras and Nicaragua.
Concessional
Private
Official Concessional
Nonconcessional
Private
OfficialNonconcessional
Bonds
OtherBank loans
Other
Bank loans
Source: Faria and Tolosa, forthcoming IMF Occasional Paper
13
Debt and DeficitsDebt and Deficits
• Discussions on how to control the growth public debt focus on the fiscal deficit
• This is not surprising as: DEBT GROWTH = DEFICIT + SF
• We expect SF (stock-flow reconciliation) to be a small adjustment
• But this is not the case
14
SF around the worldSF around the worldThe Stock- Flow Adjustment
(percentage of GDP)
0 1 2 3 4 5 6 7 8 9 10
Advanced economies
South Asia
East Asia and Pacific
Eastern Europe and Central Asia
All Countries
Middle East and North Africa
Latin America and the Caribbean
Sub-Saharan Africa
All observations
Excluding outliers
Source : Campos, Jaimovich, and Panizza (2006).
15
SF around the worldSF around the world
Decomposition of Debt Growth in Different Regions of the World
-15
0
15
IND SAS Caribbean EAP ECA MNA LA SSA
Per
cent
age
of G
DP Inflation
GDP growth
PrimarybalanceInterestexpenditureStock flowadjustment
Source: Campos, Jaimovich, and Panizza (2006).
16
OutlineOutline
• Facts Facts • International BorrowingInternational Borrowing• Domestic BorrowingDomestic Borrowing• Towards Safer DebtTowards Safer Debt
17
The emerging bond The emerging bond market todaymarket today
• Private international lending revived in the 1970s in the form of syndicated bank loans
• This new wave of sovereign lending ended with the debt crisis of the 1980s
• The Brady deals restarted the market for emerging market bonds and gave birth to a new asset class
18
The International The International Market: Large but Market: Large but
Volatile… Volatile…
• Capital flows to emerging markets tend to be volatile and procyclical
• External factors explain a large share of this volatility
• External debt is almost all in foreign currency
19
Mark Twain on procyclicality
A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain.
20
Sudden Stops and Sudden Stops and ContagionContagion
• Episodes of “market closure” and jump in spreads that reverse within 2 years
• Spreads closely connected with global risk appetite
• Effects extend to countries with little economic link to the original event
• Uninformed investors may herd and/or chase an index
21
The international market The international market is large but volatileis large but volatile
Emerging Markets and Latin American Spreads
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
Ap
r-9
3
Fe
b-9
4
De
c-9
4
Oct
-95
Au
g-9
6
Jun
-97
Ap
r-9
8
Fe
b-9
9
De
c-9
9
Oct
-00
Au
g-0
1
Jun
-02
Ap
r-0
3
Fe
b-0
4
De
c-0
4
Oct
-05
Au
g-0
6
Ba
sis
po
ints
Composite Latin AmericaSource: Authors' calculations based on JPMorgan (2006) from Bloomberg (2006). Spreads are a combination of EMBI and EMBI plus indices. The Latin America index comprises the four largest debtors: Argentina, Brazil, Mexico, and Venezuela. Weights are adjusted to consider the structural break resulting from the Argentine default.
Tequilacrisis
Russian crisis
September11 attacks
Brazil elections and
22
Has volatility abated?Has volatility abated?
• Spreads are at record low levels; investors show appetite for local currency bonds
• Weak or no contagion from Brazil’s election anxiety and Argentina’s and Turkey’s crises
• Less cross correlation among EMBI assets
23
Has Contagion Has Contagion Disappeared?Disappeared?
Average Correlations among Sovereign Emerging Market Bonds and Industrial Sector Indices of US High Yield Bonds
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Jul-94 Oct-95 Jan-97 Apr-98 Jul-99 Oct-00 Jan-02 Apr-03 Jul-04 Oct-05
JP Morgan EMBI Plus Index Merrill Lynch U.S. High Yield Index
Note: Figure plots the average six-month correlation in 78 country pairs of the JPMorgan EMBI plus index and 465 sector pairs of the Merrill Lynch U.S. High Yield Index. Correlation coefficients are based on daily returns of indices.
Tequilacrisis Russian crisis
Source: Authors' calculations based on JPMorgan (2006) and Merril Lynch (2006) from Bloomberg (2006).
24
A new phase? A new phase?
• Policies are stronger: fiscal surpluses, reserve accumulation, current account surpluses
• Debt structure changing to local currency
• Investor base widening; EM assets more mainstream
• Or, in fact, are spreads too low?
25
Will the good times last?Will the good times last?
0
200
400
600
800
1000
1200
1400
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Predicted Spreads Actual Spreads
Spreads are lower than predicted
26
0
200
400
600
800
1000
1200
1400
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Spread for average External Conditions Actual Spreads
Predicted Spreads would be Predicted Spreads would be lower with average external lower with average external conditionsconditions
27
Possibly important Possibly important changes in global changes in global
marketsmarkets
• Impact of the growth of hedge funds
• Impact of the growth of credit derivatives
• Is the appetite for local currency instruments permanent?
28
OutlineOutline
• Facts Facts • International BorrowingInternational Borrowing• Domestic BorrowingDomestic Borrowing• Towards Safer DebtTowards Safer Debt
29
The Domestic Markets: The Domestic Markets: More Stable but Still More Stable but Still
SmallSmall
• Natural habitat of local currency instruments
• “Spare tire” for the banking system• High volatility in LA makes bank finance
a very short-run proposition• “Captive audience” of domestic
institutional investors (pension funds, banks)
30
Domestic bond markets in Domestic bond markets in LAC are growing but are LAC are growing but are
still smallstill small
0
20
40
60
80
100
120
140
Latin America 1994 Latin America 2004 East Asia 1994
East Asia 2004
Advanced 1994
Advanced 2004
Corporate issuers
Financial institutions
Governments
Percentage of GDP, simple average
31
But in fact it is the whole But in fact it is the whole financial sector that is financial sector that is
smallsmall
0
10
20
30
40
50
60
70
80
Latin America 1994 Latin America 2004 East Asia 1994 East Asia 2004 Advanced 1994 Advanced 2004
Corporate issuers
Financial institutions
Governments
Bond Markets relative to Domestic Bank Credit
32
Plausible Determinants of Plausible Determinants of Bond Market DevelopmentBond Market Development
• Scale of the market, in turn related to size of the economy and saving rates
• Scale of firms that are potential issuers
• Market liquidity• Institutional strength: creditor rights,
transparency, etc.• Market microstructure
33
Other Important Factors with Other Important Factors with Less Definite EffectLess Definite Effect
• Large domestic government debt: market development or crowding out?
• Well established banking system: competitor or complement?
34
Scale of the MarketsScale of the Markets Corporate bond market as a function of country size
ARG
BRA
CHL
COLMEXPER
CHN
HKG
IDN
KOR
MYS
PHL
SGP
THA
TWN
0.1
.2.3
.4T
ota
l C
orp
. S
ec.
over
GD
P
2 4 6 8 10Ln GDP
35
Scale of the Markets Scale of the Markets Market capitalization as a function of saving rates
ARG
BRA
CHL
COL
MEX
PER
CHNHKG
KOR
MYS
PHL
SGP
THA
TWN
0.2
.4.6
.81
Tota
l D
om
. S
ec. ove
r G
DP
0 .2 .4 .6Domestic Savings over GDP
36
ARG
BRA
CHL
COL
MEXPER
CHN HKGIDN
KOR
PHL
SGP
THA
0.1
.2.3
.4T
ota
l C
orp
. S
ec. o
ver
M2
-.05 0 .05 .1Adjusted Firm Size
Scale of Firms Scale of Firms Corporate Bond Market as a Function of Firm
Size
37
0 1 2 3 4 5 6 7 8 9
Argentina
Colombia
LAC AV
Thailand
Mexico
Brazil
India
EM AV
Chile
ASIA AV
Korea
Malaysia
G3 AV
Source: IMF, Global Financial Stability Report (2005)
Investor ProtectionInvestor Protection
38
Effects of Large Effects of Large Government DebtGovernment Debt
• Government bonds provide a reference yield curve
• Larger markets are needed for an efficient microstructure
• Crowding out?
39
Interaction between Interaction between government and private government and private
bond marketbond marketDomestic Government Bonds and Corporate Bonds
-0.04
-0.03
-0.02
-0.01
0
0.01
0.02
0.03
0.04
-0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4
Share of domestic government bonds in total public debtSha
re o
f co
rpor
ate
bond
s in
tota
l dom
esti
c cr
edit
to p
riva
te s
ecto
r
Latin AmericaOther emerging marketsFitted values
40
Investor Surveys in Argentina, Investor Surveys in Argentina, Brazil and MexicoBrazil and Mexico
Do you agree or disagree with the following statements? (1 = strongly agree,…, 5 = strongly disagree)
0 1 2 3 4
Government and corporate bonds aresubstitutes in your portfolio
If the yield on government bonds w ere toincrease signif icantly and that of private bonds
remained constant I w ould sell private bonds
A large stock of public sector bonds isimportant for the development of the corporate
bond market
The yield curve provided by public bonds iscrucial for pricing corporate bonds
Argentina Brazil Mexico
\
41
Banks vs. BondsBanks vs. Bonds
• Conventional sequence: 1) Banks
2) Bond Markets3) Equity Markets
• But interest groups can affect this evolution, e.g. Banks can prevent markets from developing (Rajan-Zingales)
42
Banks and Bonds: Banks and Bonds: Substitutes or Substitutes or Complements?Complements?
• Banks contribute to market infrastructure: bridge finance, distribution channels, primary dealer network.
• Banks contribute to secondary-market liquidity • Banks often are major issuers of domestic bonds
and structured securities
• Rather than being a political force against markets, banks and bonds seem to be held back by the same reasons in Latin America
43
GGoing Forward: oing Forward: New Investors, New New Investors, New
InstrumentsInstruments
• New investors needed. Savings are low and markets are small
• Institutional investors, especially pension funds, are starting to provide volume (but not liquidity).
• Foreign investors provide more liquidity (but also volatility). Less averse to long-term nominal instruments (see Mexico, Brazil). Capital account restrictions must be removed.
44
Institutional InvestorsInstitutional Investors
• Institutional investors have been growing and they can play a key role in developing a stable demand for local currency bonds
• But they could become victim of their own success, especially at times of crisis
45
Institutional InvestorsInstitutional Investors
Assets of Mutual Funds and Pension Funds
(percentage of GDP)
0
5
10
15
20
25
30
35
40
45
50
1997 1998 1999 2000 2001 2002 20030
20
40
60
80
100
120
140Emerging markets (left axis)
Latin America (left axis)
Advanced economies (right axis)
46
Institutional InvestorsInstitutional Investors
Government Bonds as a Share of Pension Fund Assets
0 10 20 30 40 50 60 70 80 90 100
GermanyUnited States
United KingdomCanada
SpainNetherlands
ItalyAustria
Thailand Korea
EstoniaSlovenia
Czech RepublicBulgaria
PolandHungary
SingaporeBrazilChilePeru
ColombiaUruguay
ArgentinaMexico
IND
Oth
er E
ML
AC
47
Institutional InvestorsInstitutional Investors
Banks' Exposure to Public Sector, 2003–2005
(percentage of total domestic credit)
0 10 20 30 40 50 60
Chile
Uruguay
Peru
Colombia
Brazil
Mexico
Argentina
United States
Euro area
Lat
in A
mer
ican
cou
ntr
ies
Mat
ure
mar
ket
s
48
International InvestorsInternational Investors
• Saving is low in Latin America and this affects the size of bond markets
• Institutional investors like pension funds do not provide liquidity
• Foreign investors display less aversion to long-term local currency instruments. But less stability. Need to open capital accounts to some extent.
• In Mexico, foreign investors hold more than 50% of the ten-year bond and more than 80% of the 20-year bond.
49
0 5 10 15 20 25 30 35 40 45 50 55
Bulgaria
Korea
Indonesia
Peru
Thailand
Brazil
Japan
Malaysia
Argentina
Turkey
Mexico
Poland
Hungary
Uruguay
USA
Percent of Foreign Percent of Foreign Holdings of Domestic Holdings of Domestic
BondsBonds
Sources: FMI (GFSR, 2005) y Takeuchi (“Study of Impediments…” 2005, asianbondsonline.adb.org)
50
Going Forward: Going Forward: New Instruments New Instruments
• New Instruments: Asset Backed Securities (mortgages, receivables, consumer loans, commercial paper)
• Less complicated enforcement of creditor rights (by recourse to collateral)
• Can overcome firms’ small scale problem • Strong growth in Mexico, Brazil, Chile, Argentina,
but from a very small base• Successful securitizations for working capital to
SMEs Can structured instruments also help SMEs get long-term, investment finance?
51
OutlineOutline
• FactsFacts• International BorrowingInternational Borrowing• Domestic BorrowingDomestic Borrowing• Towards Safer DebtTowards Safer Debt
52
Debt sustainabilityDebt sustainability
Traditional approach: Debt to GDP ratio to stay constant
s = (r – g) d
The primary surplus must be enough to cover interest (adjusted by growth) on the Debt to GDP ratio
53
Actual and “Required” Actual and “Required” Primary SurplusesPrimary Surpluses
7
2004 Real interest rates
Belize
Brazil
Colombia
Costa RicaDominican RepublicEcuador
El SalvadorGuatemala
Jamaica
Mexico
Panama
ParaguayPeru Trinidad and Tobago
Uruguay
Venezuela
-2
-1
0
1
2
3
4
5
6
7
-2 -1 0 1 2 3 4 5 6
Actual primary surplus
R
equ
ired
pri
ma
ry s
urp
lus
1992-2004 Median real interest rates
Argentina Pre
Argentina Post
Belize
Brazil
Chile
Colombia
Costa RicaDominican Republic
EcuadorEl Salvador
Guatemala
Jamaica
MexicoPanama
Paraguay
Peru
Uruguay
Venezuela
Trinidad and Tobago
-2
0
2
4
6
8
10
12
-2 0 2 4 6 8 10 12
Actual primary surplus
R
equ
ired
pri
ma
ry s
urp
lus
54
Sustainability Analysis Sustainability Analysis under Uncertaintyunder Uncertainty
• Variables that enter debt projections have large variance: interest rate, exchange rate, growth, primary surplus.
• The more volatile these variables are, the lower the Debt/GDP ratio that is sustainable “for sure” (95% statistical confidence, for example)
55
Required Primary Surpluses Required Primary Surpluses and Credit Ratingsand Credit Ratings
Venezuela
Uruguay
Trinidad and Tobago El Salvador
Peru
Paraguay
Panama
Mexico
Jamaica
Guatemala
Ecuador
Dominican Republic
Costa Rica
Colombia
Brazil
Belize
y = ?0.087x + 8.6707 (0.7689)
R2 = 0.0064
0
2
4
6
8
10
12
14
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4Required minus observed primary surplus (percentage points of GDP)
Cre
dit
rat
ing
56
Sustainability Analysis Sustainability Analysis under Uncertaintyunder Uncertainty
• Many sources of risk– GDP volatility– Terms of trade shocks– Natural disasters
• A better debt structure can reduce risks
57
Debt Management can Debt Management can reduce the risk of reduce the risk of sovereign financesovereign finance
Debt-to-GDP Ratio Distribution
0.2
0.3
0.4
0.5
0.6
0.7
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Deb
t-to
-GD
P r
atio
Foreign currency
Foreign currency–local currency
Foreign currency–local currency–linked to GDP
58
Lowering the risks of Lowering the risks of sovereign financesovereign finance
• Should countries avoid government debt altogether?
• Useful purposes: investment in infrastructure and human capital, coping with natural disasters, crises
• But there are political economy distortions and market failures
59
Lowering the risks of Lowering the risks of sovereign financesovereign finance
• Controlling the flow of debt
• Managing the inherited stock of debt
• Improving the international financial architecture
60
Controlling the flow of Controlling the flow of debtdebt
• Fiscal rules– Structural balance target– Debt/GDP target
• Budget institutions– Hierarchical rules – Transparency Rules
61
Managing the inherited Managing the inherited stock of debtstock of debt
• Self-insurance policies– Stabilization funds– International reserves
• Contingent contracts– Cat bonds, commodities, GDP-linked
• Develop the domestic bond market– More use of local currency debt
62
Debt and Debt and Monetary/Exchange Monetary/Exchange
Rate SystemsRate Systems
• Exchange Rate System => Debt Structure– Fixed rates may promote foreign currency debt– Higher inflation discourages long duration, local
currency instruments– There is no “local currency” instrument in dollarized
economies (except inflation-linked bonds)
• Debt Structure => Exchange Rate System– Harder to use exchange rate flexibility in partially
dollarized economies– Do inflation-linked bonds discourage inflation?
Debt Structure
63
Depreciation and Debt Depreciation and Debt SustainabilitySustainability
• Depreciations are important source of large unexpected increases in Debt/GDP ratios (SFs)
• But the effect of depreciation is not necessarily negative. It depends on:– Net effect of the exchange rate on taxes
and spending (including indirect effects)– Size of Debt/GDP ratio– Currency composition of Debt
64
Debt Management in Debt Management in (fully) Dollarized (fully) Dollarized
EconomiesEconomies
• Use contingencies! • Contingencies: natural disasters, oil
prices, economic growth, domestic inflation
• It can be achieved through derivatives or insurance policies (cat bonds) and use payoffs to service debt.
65
Improving the Improving the international financial international financial
architecturearchitecture
• Rollover risk. Create a “Country Insurance” facility. Support pooling of reserves
• Contagion risk. “Emerging Market Fund”
• Currency and real economy risks. Help develop local currency and contingent debt instruments. “De-dollarize” multilateral lending
66
……and much moreand much more
• Latin American sovereign debt in 1820-1913
• The political economy of public debt• Public debt and public investment in
human and physical capital• Debt relief, has it worked?• The cost of default