Government debt: The economic consequences of natural disasters and pension funds' herding

Abstract

This dissertation investigates the average and median impact of large natural disasters on government debt. It includes 163 countries for the period 1971 to 2014. We apply a panel synthetic control method which constructs a counterfactual for the disaster country. This synthetic control group consists of nondisaster countries that closely resemble the macroeconomic, institutional, geographical and other characteristics of disaster country in the predisaster period. We investigate the difference in government debt between the disaster countries and their respective synthetic control groups. Our findings reveal a considerable increase in government debt for most damaging and deadliest disasters. Government debt, on average, increases by 11.3% of GDP compared to the synthetic control group. The median effect on government debt is 6.8% of GDP. Some natural disasters result in a debt increase over 20% of GDP. When we investigate only the 0.5% largest natural disasters, this study finds even larger effects on government debt. We also investigate the different impacts of different types of disasters. Earthquakes, on average, lead to an increase in government debt of 30.2% of GDP. Floods increase government debt by 7.7% of GDP, while storms increase the level of government debt by 9.5% of GDP compared to the synthetic control group. The effect of natural disasters is even larger than the fiscal costs of financial sector bailouts during the financial crisis. This dissertation also investigates herding behavior exhibited by Dutch pension funds in the sovereign bond market. It uses a unique dataset on sovereign bond holdings of 67 large Dutch pension funds, mutations, and transactions in 109 countries between December 2008 and December 2014. We find evidence of intensive herding behavior of Dutch pension funds in sovereign bonds. Our findings also show that institutional factors, the macroeconomic environment, and the financial market environment are among the determinants of herding behavior in sovereign bonds. Our results also indicate that high diversification is not without costs as it intensifies herding behavior. The destabilizing effect of herding is most pronounced on the sell side, while stabilization is most prominent under more extreme price shocks. Thus, pension funds act as stabilizers, when it is most needed, during a crisis. We also investigate asset class herd behavior for Dutch pension funds from 1999 to 2014 using quarterly data. We find considerable asset class herd behavior, which is more intensive for the more ‘exotic’ sub-asset classes, such as private equity and emerging market shares. We find destabilizing effects of herd behavior for shares and private equity on the sell side, for fixed-interest investments on the buy side and for real estate on both the buy and sell side. We find stabilizing effects of herd behavior for shares and private equity on the buy side, for fixed interest investments on the sell side and for other investments on both the buy and the sell side. For crises, we find evidence that destabilizing behavior is concentrated on the buy side, whereas sell herd behavior mostly has a stabilizing effect.