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Does compliance matter? Assessing the relationship between sovereign risk and compliance with international monetary law

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Abstract

An important theory of international cooperation asserts that governments comply with international law because of the reputational costs incurred by reneging on public agreements. Countries that sign binding international agreements in the realm of monetary relations signal their commitment to an open economic system, which should reassure international market actors that the government is committed to sound economic policies. If the theory is correct, we should observe evidence that noncompliance is in fact costly. I test this argument by examining the effect of noncompliance with Article VIII of the IMF’s Articles of Agreement on sovereign risk ratings. The results show that noncompliance with the agreement mitigates any benefits that accrue to Article VIII signatories. The empirical evidence suggests that, in addition to improving economic and political conditions at home, governments in the developing world would improve their access to financial markets by signing and complying with international monetary agreements.

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Notes

  1. See Simmons and Hopkins (2005); von Stein (2005); Grieco et al. (2009).

  2. In addition to serving as the empirical fulcrum for the important debate on compliance between von Stein and Simmons and Hopkins, Article VIII is, as a central part of the IMF Treaty, the “first international accord in history to obligate signatories to particular standards of monetary conduct” (Simmons 2000b, 820). Countries that are signatories to Article VIII are required to maintain an open current account. Article VIII signatories are prohibited from placing restrictions on the availability of foreign exchange for goods, services, and “invisibles”—services such as legal and financial advisement, royalties, foreign remittances, etc. Sections 3 and 4 of Article VIII also proscribe states from engaging in, or permitting any of their fiscal agencies to engage in, any discriminatory currency arrangement or multiple currency practices. Although there was discussion within the IMF in the mid-1990s about adding a section to Article VIII requiring capital account convertibility, the requirement only extends to commercial credits granted by exporters or received by importers. See McKinnon (1979, 4–7).

  3. For example, Jensen (2003) and Sobel (1999).

  4. In the statistical analysis, use of Fund credits—a proxy for the Fund’s sanctioning power—is unrelated to the decision to comply.

  5. Italics added for emphasis.

  6. The argument dovetails with Tomz’s (2007) historical analysis of sovereign borrowing. Tomz provides evidence that enforcement through coercive measures (gunboat diplomacy and trade sanctions) cannot explain historical patterns of lending and repayment; rather, governments with good reputations were charged lower interest rates by private lenders, and, preferring to maintain their good reputations, tended to honor their debts in both favorable and adverse economic circumstances.

  7. See North and Weingast (1989). Büthe and Milner (2008) show that membership in GATT/WTO increases foreign direct investment in developing countries.

  8. Downs et al. (1996) suggest that the high rate of compliance identified by Chayes and Chayes (1993) and Mitchell (1994) is a consequence of selection effects.

  9. The literature in political science on the importance of audience costs is large. Some important works include: Fearon (1994); Gaubatz (1996); Lohmann (1997); Mansfield et al. (2002).

  10. See McKinnon (1979, 41) and Simmons (2000b, 820).

  11. I am only excluding wealthy, mature democracies in Western Europe, North America, Oceania, and Japan from the analysis. Since the early 1980s, the only significant incidences of an imposition of current account restrictions by Article VIII members in the OECD occurred in France during Mitterrand’s “U-Turn” in 1983 and in Greece in 1996–97. In addition, the focus of this article is on how compliance may or may not affect reputations, which influence access (and the terms of access) to foreign capital; OECD countries have essentially unlimited access to capital markets, so compliance with Article VIII theoretically should have little effect on the reputation of these countries. There is an additional empirical justification for limiting the sample: Blonigen and Wang (2004) present evidence suggesting that pooling of rich and poor countries is inappropriate in studies of FDI.

  12. Previous work has demonstrated a strong correlation between risk ratings and interest rate spreads (Feder and Ross 1982; Mosley 2006, 98). As an admittedly crude additional test, I used Ahlquist’s (2006) data on portfolio capital inflows as a proportion of GDP to produce a bivariate correlation with my measures of creditworthiness. Unsurprisingly, I found a strongly negative correlation between portfolio inflows/GDP and IIR (ρ = −0.31, p = 0.0000) and the annual size of capital inflows and Euromoney (ρ = −0.37, p = 0.0000).

  13. As discussed in Dreher and Voigt (2008, 25), the construction of the Euromoney rating might pose an endogeneity problem for some of the covariates described in the next section, because factors such as debt level and composition and economic performance are built into the indicator (and thus almost by definition correlated with the country ratings). For this reason, Dreher and Voigt use a modified version of the Euromoney score that extracts three components which are clearly parts rather than determinants of creditworthiness (it is worth noting that Dreher and Voigt report a very high correlation (0.97) between the original and modified ratings). Unfortunately, detailed data that enable the authors to construct a modified rating are only available after 1992; since, following Simmons (2000a, b) and Grieco et al. (2009), my dataset ends in 1997 (and an important robustness check, described below, limits the sample to country-year observations prior to 1992), the Dreher and Voigt solution is too costly for me. However, it is important to note that the explanatory variables I am most interested in—those related to compliance with Article VIII—are not components of either of the two measures of perceptions of credit risk employed in this article.

  14. Reliable data on bond spreads are available for only eight emerging markets from 1994 to the present, and sovereign bond ratings by credit rating agencies are available for a smaller number of countries than either IIR or Euromoney scores (see Mauro et al. 2006, 100). Interest rate differentials are another alternative market-based measure of risk, but this indicator has drawbacks: the availability of data on national interest rates is spotty at best, and until the 1990s, own interest rates in most developing countries were not market-determined (Aizenman and Marion 2004, 575). Nonetheless, I used a simple t-test, relying on Aizenman and Marion’s (2004) construction of the interest rate differential (ln[(1 + i)/(1 + i US)], where i US is the US T-bill rate and i is the national deposit rate), to see whether countries that fail to comply with Article VIII pay higher relative interest rates. On average, the logged interest rate differential is almost twice as large for countries that are noncompliant with Article VIII (0.41) than it is for countries in which the noncompliance variable equals zero (0.22). The large t-statistic (6.07) indicates that the difference of means between the two groups (compliant and non-compliant) is highly significant (p = 0.0000).

  15. Quinn (1997, 531). See footnote 2 for a description of the actions prohibited by Article VIII.

  16. All member countries of the IMF are, in principle, committed to removing restrictions on the current account. However, upon joining the IMF countries are allowed to retain existing restrictions under Article XIV, which sanctions “transitional” arrangements for countries that are not prepared (or are unwilling) to accept sections 2, 3, and 4 of Article VIII. The IMF attempts to persuade transitional countries to join Article VIII, but some members remained under Article XIV for decades—the Philippines, for example, remained under Article XIV for 50 years (IMF 2006). The Executive Board of the Fund agreed in 1992 that the transitional arrangements had been abused and officials became more forceful in encouraging adoption of Article VIII. It is important to note that once a country notifies the Fund of its acceptance of Article VIII obligations it gives up the right—in perpetuity—to retain existing or impose new current account restrictions. The Fund’s Executive Board has the ability, however, to approve short-term restrictions by Article VIII. The decisions by the Executive Board to approve temporary restrictions are confidential. However, as I discuss in detail below, I take steps to attempt to strip out possible “sanctioned renegers” from the analysis.

  17. 16 percent of all country-year observations in the sample are coded as noncompliant.

  18. For example, if a country was in default in each year from 1960 to 1980, Percent Default would take a value of 100 in 1980; if the country began to service its external debt in 1981, the value would decline to 95.2, and if it stayed current on its payments in the next year, the value would decline to 90.9 (since the country was in default for 20 of 22 years in the observation window), and so on.

  19. Biglaiser and DeRouen’s analysis of sovereign bond ratings in Latin America tests the effects of indexes of trade and capital market liberalization, financial liberalization, tax reform, and privatization. The results show that trade reform is the only variable that has a strong (positive) effect on perceptions of creditworthiness (Biglaiser and DeRouen 2007).

  20. The debate on the “catalytic” effect of IMF loans is extensive; see, for example, Bordo et al. (2004); Jensen (2004).

  21. Laevan and Valencia (2008) update the measure of currency crisis originally developed by Frankel and Rose (1996).

  22. The Wooldridge test for autocorrelation is implemented in Stata 11.0 through the xtserial command (Drukker 2003; Wooldridge 2002).

  23. My interest in explaining differences between countries, the relative invariance of the key explanatory variables, and the fact that my data includes many more units (95 countries at most) than observations per unit (18 for panels without missing data on covariates) imply that the fixed effects estimator is inappropriate (Abrevaya 1997). Plümper and Troeger (2007) propose a solution (the fixed effects vector decomposition estimator) that “allows estimating time-invariant variables and that is more efficient than the FE model in estimating variables that have very little longitudinal variance” (2007, 125). When I re-estimated the models in Table 5 with Plümper and Troeger’s xtfevd routine in Stata 11, I obtained very similar findings; in fact, the coefficient on the noncompliance variable is slightly larger in both the fixed effects vector decomposition regressions and OLS regressions with standard errors that assume clustering by country (due to space considerations, the additional results are not reported here, but are available in the online Appendix that supplements the electronic version of this article).

  24. Recall that the dependent variables have been re-scaled so that positive coefficients indicate greater country risk.

  25. The finding is consistent with Reinhart et al.’s (2003) contention that defaults in the past make countries more likely to default on their foreign debts in the future, regardless of the level of indebtedness. This result is also consistent with Archer et al.’s (2007) finding that bond ratings are strongly negatively affected by a history of default.

  26. Non-random selection is at the core of the debate between Simmons and Hopkins (2005) and von Stein (2005). They are interested in the question of whether Article VIII has an independent effect on state behavior, which is a very different question from the one I ask here, and which makes selection processes a much more pressing concern in their debate.

  27. I only report the results from the selection models and additional robustness checks with one-year lags for the variables on the right hand side; full results for models including the three-year lags, as in Table 5, are available in the online Appendix to this article.

  28. Note that the Shift Left variable is omitted from the first stage because, by construction, it is related to Article VIII status: to capture shifts in government partisanship away from the constellation of interests that produced the decision to sign the agreement, it takes a value of 1 if a country has accepted Article VIII obligations and the ideological makeup of the government subsequently moves to the left.

  29. Regional definitions, following Simmons, come from the World Bank’s regional classifications. The level of regional noncompliance should be relatively uncorrelated with a country’s sovereign risk rating: it seems unlikely, for example, that market actors would incorporate information about Peru’s compliance in developing risk assessments for Argentina. Evidence from research on compliance with transparency rules provides support: Glennerster and Shin (2007) examine whether adoption of IMF-led transparency reforms lowers sovereign bond spreads and find that regional adoption of transparency reforms has no effect on borrowing costs.

  30. This is implemented in Stata 11 via the cdsimeq command. The method reports correct standard errors when, in a system of simultaneous equations, one endogenous variable is continuous and the other is dichotomous. See Keshk (2003) for details.

  31. Simmons (2000a, b).

  32. Simmons (2000a, b).

  33. World Bank, Global Development Finance CD-ROM (2003).

  34. World Bank, Global Development Finance CD-ROM (2003).

  35. World Bank, Global Development Finance CD-ROM (2003).

  36. World Bank, World Development Indicators CD-ROM (2004).

  37. World Bank, World Development Indicators CD-ROM (2004).

  38. World Bank, World Development Indicators CD-ROM (2004).

  39. Monty Marshall and Keith Jaggers, “Polity IV Project: Political Regime Characteristics and Regime Transitions, 1800–2002,” Center for International Development and Conflict Management (CIDCM), http://www.cidcm.umd.edu/inscr/polity.

  40. Fearon and Laitin (2003).

  41. Ahlquist (2006).

  42. Wacziarg and Welch (2003, 2008). Expansion and improvement of trade openness measure developed in Sachs and Warner (1995).

  43. Vreeland (2003).

  44. Beck et al. (2001).

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Authors and Affiliations

  1. Department of Political Science, Northwestern University, 240 Scott Hall, 601 University Place, Evanston, IL, 60208, USA

    Stephen C. Nelson

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  1. Stephen C. Nelson
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Correspondence to Stephen C. Nelson.

Additional information

I thank Asaf Zussman, the participants at the graduate student colloquium at Cornell University, the anonymous reviewers and the editor of this journal for very helpful comments. I thank Beth Simmons and Daniel Hopkins for kindly sharing their data on Article VIII compliance. Christopher Way deserves particular thanks for his advice at every stage in the project. Any errors or omissions remain my own.

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Appendices

Appendix A: Description of Variables and Data Sources

1.1 Dependent Variables

Institutional Investorrating: ratings reported by Institutional Investor, compiled once yearly (either September or October). Ratings are based on survey responses provided by economists and sovereign risk analysts at leading global banks and securities firms. Responses are compiled, averaged across countries, and weighted by the publication’s perception of the bank’s credit analysis sophistication and global prominence. Countries are scored on a scale from 0 (high risk)–100 (low risk), which is transformed in the article such that 0 (low risk) ➔ 100 (high risk) to ease the interpretation of the coefficients reported in the analysis.

Euromoneyrating: index of “country creditworthiness.” Ratings are based on analytical, credit, and market indicators. The ratings are based on polls of economists and political analysts supplemented by quantitative data such as debt ratios and access to capital markets. The overall country risk score derives from nine separate categories, each with an assigned weighting: (1) political risk (25% weighting)—the risk of non-payment or non-servicing of payment for goods or services, loans, trade-related finance and dividends, and the non-repatriation of capital; (2) economic performance (25% weighting)—based on GNP figures per capita and on results of Euromoney poll of economic projections; (3) debt indicators (10% weighting), including total debt stocks to GNP, debt service to exports, and current account balance to GNP; (4) debt in default or rescheduled (10% weighting)—scores are based on the ratio of rescheduled debt to debt stocks; (5) credit ratings (10% weighting)—nominal values are assigned to sovereign ratings from Moody’s, S&P and Fitch IBCA; (6) access to bank finance (5% weighting)—calculated from disbursements of private, long-term, unguaranteed loans as a percentage of GNP; (7) access to short-term finance (5% weighting); (8) access to capital markets (5% weighting)—heads of debt syndicate and loan syndications rate each country’s accessibility to international markets; (9) discount on forfeiting (5% weighting)—reflects the average maximum tenor for forfeiting and the average spread over riskless countries such as the US. The original ratings are transformed by (100—Euromoney rating) so that 0 (low risk) ➔ 100 (high risk).

1.2 Independent Variables

Article VIII Signatory: dummy variable denoting 1 where countries have accepted Article VIII of the IMF’s Articles of Agreement and 0 if the country is subject only to Article XIV transitional arrangements.Footnote 31

Restriction: dichotomous variable denoting whether a country has imposed restrictions on payments in current account. This measure is taken from the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (1967–1997).

Noncompliance with Article VIII: variable is an interaction term (current account restriction * Article VIII signatory), where 1 equals noncompliance and 0 denotes compliance.Footnote 32

Reserves/debt: Ratio of international reserves to total external debt.Footnote 33

BOP/GDP: Current account balance (the sum of the credits less the debits arising from international transactions in goods, services, income, and current transfers; represents the transactions that add to or subtract from an economy’s stock of foreign financial items), measured in terms of GDP.Footnote 34

Debt/GNI: Ratio of total external debt to gross national product.Footnote 35

GDP Per Capita: Gross domestic product per capita, in constant $US 1995 benchmark.Footnote 36

GDP Per Capita Growth: Annual growth rate of GDP per capita.Footnote 37

Inflation: consumer price index, annual percentage.Footnote 38

Trade openness: the sum of exports and imports, as percentage of GDP.

Regime type: Polity2 measure, taken from the Polity IV project. The Polity2 democracy score computed by subtracting a measure of autocracy, AUTOC, from a measure of democracy, DEMOC; the score ranges from −10 (least democratic) to +10 (most democratic). The AUTOC and DEMOC scores are indexes of scores on different institutional factors (such as the competitiveness and openness of executive recruitment, constraints on the executive recruitment, competitiveness of political participation, etc.).Footnote 39

Political Instability: indicator that is coded 1 if the Polity2 regime type measure changes (either increases or decreases) by at least three points during a three-year period.Footnote 40

Percent Years in Default: a cumulative indicator that records the percentage of years since 1960 that a country was in default.Footnote 41

Openness: an update of the Sachs and Warner openness indicator, the measure takes a value of 1 in periods of openness and 0 if the country is closed. A country is coded as closed if any of the following conditions hold: (1) the average unweighted tariff rate >40%; (2) the average core non-tariff barrier frequency on capital goods and intermediaries >40%; (3) the annual black market premium >20%; (4) the country has a functioning marketing board for a major export good; (5) a socialist economic system.Footnote 42

IMF: variable equals 1 if a country is under an IMF lending program (standby arrangement, extended fund facility, structural adjustment facility, or enhanced structural adjustment facility) and 0 otherwise.Footnote 43

Currency Crisis: variable takes the value of 1 in years in which a country experienced a currency crisis. Laeven and Valencia, building on Frankel and Rose’s (1996) earlier effort, define a currency crisis “as a nominal depreciation of the currency of at least 30% that is also at least a 10% increase in the rate of depreciation compared to the year before” (2008: 6).

Shift Left: dichotomous measure that equals 1 in all country years in which the government in power is to the left of the government that initially signed the Article VIII agreement. In Grieco et al. (2009) coding, positions of governments along the ideological spectrum are drawn from the World Bank’s Database of Political Institutions.Footnote 44 In the words of the authors that created the variable, Shift Left “represents the ideal test of whether shifts away from the configuration of national preferences that produced the original decision to sign Article VIII serve to condition the probability of compliance with the treaty” (Grieco et al. 2009: 346).

Appendix B: List of Countries and Years of Article VIII Noncompliance, 1979–97

Country

Year of Article VIII Accession

Year(s) of Noncompliance

ALBANIA

–

–

ALGERIA

1997

1997

ANGOLA

–

–

ARGENTINA

1968

1983–93

ARMENIA

1997

–

AZERBAIJAN

–

–

BAHRAIN

1974

–

BANGLADESH

1995

1996–97

BELARUS

–

–

BENIN

1996

1996–97

BOLIVIA

1967

1982–86; 1996–97

BOTSWANA

1995

1995–96

BRAZIL

–

–

BULGARIA

–

–

BURKINA FASO

1996

1996–97

BURUNDI

–

–

CAMEROON

1996

1996–97

CENTRAL AFRICAN REPUBLIC

1996

1996–97

CHAD

1996

1996–97

CHILE

1977

1983–97

CHINA

1996

1996–97

COLOMBIA

–

–

REPUBLIC OF CONGO

1996

1996–97

COSTA RICA

1965

1982–95

CROATIA

1995

1995

CZECH REPUBLIC

1994

1994

DEM. REP. OF CONGO

–

–

DOMINICAN REPUBLIC

1953

1979–97

ECUADOR

1970

1983–94

EGYPT

–

–

EL SALVADOR

1946

1979–93

ESTONIA

1994

–

ETHIOPIA

–

–

FIJI

1973

1989–92; 1996–97

GABON

1996

1996–97

GAMBIA

1993

–

GEORGIA

1997

1997

GHANA

1995

1997

GUATEMALA

1947

1981–89; 1995

GUINEA BISSAU

1997

1997

GUINEA

1996

1996–97

GUYANA

1967

1979–93

HAITI

1954

–

HONDURAS

1951

1982–93

HUNGARY

1996

–

INDIA

1995

1995–97

INDONESIA

1989

–

IRAN

–

–

ISRAEL

1994

1996–97

IVORY COAST

1996

1996–97

JAMAICA

1963

1979–95

JORDAN

1995

1995–96

KAZAKHSTAN

1996

1996–97

KENYA

1995

1995

KOREA, SOUTH

1989

1996–97

KUWAIT

1963

–

KYRGYZSTAN

1995

–

LATVIA

1995

–

LEBANON

1994

–

LESOTHO

–

–

MACEDONIA

–

–

MADAGASCAR

1996

1996

MALAWI

1996

1996–97

MALAYSIA

1969

–

MALI

1996

1996–97

MAURITANIA

–

–

MAURITIUS

1994

–

MEXICO

1947

1983–87

MOLDOVA

1995

1995–97

MOROCCO

1993

1993; 1996–97

MOZAMBIQUE

–

–

NAMIBIA

1996

1996–97

NEPAL

1995

1995–97

NICARAGUA

1965

1979–95

NIGER

1996

1996–97

NIGERIA

–

–

OMAN

1975

1996–97

PAKISTAN

1995

1995–97

PANAMA

1947

–

PAPUA NEW GUINEA

1975

1995–97

PARAGUAY

1995

1996–97

PERU

1961

1985–92; 1996

PHILIPPINES

1995

1995–97

POLAND

1995

1996–97

ROMANIA

–

–

RUSSIA

1996

–

RWANDA

–

–

SENEGAL

1996

1996–97

SIERRA LEONE

1996

1997

SINGAPORE

1969

1997

SLOVAKIA

1995

1995–97

SLOVENIA

1995

1995–96

SOUTH AFRICA

1974

1979–93; 1994–95

SRI LANKA

1994

1996–97

SWAZILAND

1990

1996–97

SYRIA

–

–

TAJIKISTAN

–

–

TANZANIA

1996

1996–97

THAILAND

1990

–

TOGO

1996

1996–97

TUNISIA

1993

1996–97

TURKEY

1990

1996–97

TURKMENISTAN

–

–

UGANDA

1994

1994

UKRAINE

1997

1997

URUGUAY

1981

–

UZBEKISTAN

–

–

VENEZUELA

1977

1984–88; 1994–95

VIETNAM

–

–

YEMEN

1996

–

ZAMBIA

–

–

ZIMBABWE

1995

1995–97

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Nelson, S.C. Does compliance matter? Assessing the relationship between sovereign risk and compliance with international monetary law. Rev Int Organ 5, 107–139 (2010). https://doi.org/10.1007/s11558-010-9080-7

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