Model Of Sovereign Debt Research Articles

Duration of sovereign debt renegotiation

In the period since 1990, sovereign debt renegotiations take an average of five years for bank loans but only one year for bonds. We provide an explanation for this finding by highlighting one key difference between bank loans and bonds: bank loans are rarely traded, while bonds are heavily traded on the secondary market. In our theory, the secondary market plays a crucial information revelation role in shortening renegotiations. Consider a dynamic bargaining game with incomplete information between a government and creditors. The creditors' reservation value is private information, and the government knows only its distribution. Delays in reaching agreements arise in equilibrium because the government uses costly delays to screen the creditors' reservation value. When the creditors trade on the secondary market, the market price conveys information about their reservation value, which lessens the information friction and reduces the renegotiation duration. We find that the secondary market tends to increase the renegotiation payoff of the government but decrease that of the creditors while increasing the total payoff. We then embed these renegotiation outcomes in a simple sovereign debt model to analyze the ex ante welfare implications. The secondary market has the potential to increase the government ex ante welfare when the information friction is severe.

Maturity, Indebtedness, and Default Risk

We advance quantitative-theoretic models of sovereign debt by proving the existence of a downward sloping equilibrium price function for long-term debt and implementing a novel method to accurately compute it. We show that incorporating long-term debt allows the model to match Argentina's average external debt-to-output ratio, average spread on external debt, the standard deviation of spreads, and simultaneously improve upon the model's ability to account for Argentina's other cyclical facts. We also investigated the welfare properties of maturity length and showed that if the possibility of self-fulfilling rollover crises is taken into account, long-term debt is superior to short-term debt. (JEL E23, E32, F34, O11, O19)

Optimal Sovereign Debt: An Analytical Approach

This paper develops a model of sovereign debt where governments are myopic. Instead of focusing on the incentives to repay, as in most of the theoretical literature on the topic (which assumes implicitly that governments have long-term objectives), I therefore consider that governments always repay when they can, but also borrow as much as possible. without paying attention to the burden of future repayments. The pattern of debt is then only determined by the willingness of international investors to lend to the country. I characterize the Rational Expectations Equilibria of the credit market. These equilibria behave like rational bubbles: international investors lend a lot because they anticipate that other investors will lend again in the future. Capital flows are procyclical: the government borrows a fixed proportion of its income until a sudden stop occurs, generating default and an economic crisis. I suggest possible remedies to the high volatility of public expenditures that is generated by such borrowing patterns.

External Sovereign Debt in a Monetary Union: Bailouts and the Role of Corruption

We build a tractable stylized model of external sovereign debt and endogenous international interest rates. In corrupt economies with rent-seeking groups stealing public resources, a politico-economic equilibrium is characterized by permanent fiscal impatience which leads to excessive issuing of sovereign bonds. External creditors envision the corrupt economy’s fiscal impatience and buy its bonds at higher interest rates. In turn, this interest-rate increase exacerbates the problem of oversupplying debt, leading the economy to a perfect-foresight trap. In incorrupt countries which have entered a high-interest-rate/high debt-GDP-ratio trap because an immediately recent disaster has caused a sudden jump to a high outstanding debt-GDP ratio, we show that bailout plans with controlled interest rates can help in reducing debt-GDP ratios after some time. On the contrary, under corruption, we show that bailouts are ineffective unless rent-seeking groups are eradicated.

Sovereign Default, Domestic Banks, and Financial Institutions

We present a model of sovereign debt in which, contrary to conventional wisdom, government defaults are costly because they destroy the balance sheets of domestic banks. In our model, better financial institutions allow banks to be more leveraged, thereby making them more vulnerable to sovereign defaults. Our predictions: government defaults should lead to declines in private credit, and these declines should be larger in countries where financial institutions are more developed and banks hold more government bonds. In these same countries, government defaults should be less likely. Using a large panel of countries, we find evidence consistent with these predictions.

News and Sovereign Default Risk in Small Open Economies

This paper builds a model of sovereign debt in which default risk, interest rates, and debt depend not only on current fundamentals but also on news about future fundamentals. News shocks affect equilibrium outcomes because they contain information about the future ability of the government to repay its debt. First, in the model with news shocks not all defaults occur in bad times, bringing the model closer to the data. Second, the news shocks help account for key differences between emerging markets and developed economies: as the precision of the news improves the model predicts lower variability of consumption, less countercyclical trade balance and interest rate spreads, as well as a higher level of debt more in line with the characteristics of developed economies. Finally, the model also captures the hump-shaped relationship between default rates and the precision of news obtained from the data.

Maturity, Indebtedness, and Default Risk

We present a novel and tractable model of long-term sovereign debt. We make two sets of contributions. First, on the substantive side, using Argentina as a test case we show that unlike one-period debt models, our model of long-term sovereign debt is capable of accounting for the average spread, the average default frequency, and the average debt-to-output ratio of Argentina over the 1991-2001 period without any deterioration in the model's ability to account for Argentina's cyclical facts. Using our calibrated model we determine what Argentina's debt, default frequency and welfare would have been if Argentina had issued only short-term debt. Second, on the methodological side, we advance the theory of sovereign debt begun in Eaton and Gersovitz (1981) by establishing the existence of an equilibrium pricing function for long-term sovereign debt and by providing a fairly complete set of characterization results regarding equilibrium default and borrowing behavior. In addition, we identify and solve a computational problem associated with pricing long-term unsecured debt that stems from nonconvexities introduced by the possibility of default.

News and Sovereign Default Risk in Small Open Economies

This paper builds a model of sovereign debt in which default risk, interest rates, and debt depend not only on current fundamentals but also on news about future fundamentals. News shocks affect equilibrium outcomes because they contain information about the future ability of the government to repay its debt. First, in the model with news shocks not all defaults occur in bad times, bringing the model closer to the data. Second, the news shocks help account for key differences between emerging markets and developed economies: as the precision of the news improves the model predicts lower variability of consumption, less countercyclical trade balance and interest rate spreads, as well as a higher level of debt more in line with the characteristics of developed economies. Finally, the model also captures the hump-shaped relationship between default rates and the precision of news obtained from the data.

Default, Settlement, and Repayment History: A Unified Model of Sovereign Debt

This paper proposes a dynamic model of sovereign debt that combines default, settlement, and repayment history. The model addresses two questions: 1) how level of debt and income proflle afiect the length of time a country in default is excluded from the international credit market, and 2) how repayment history afiects the credit limit and interest rate lenders ofier, and the borrower’s incentive to default. In the model, borrowers weigh the beneflts from defaulting against the penalties associated with it, namely a lengthy exclusion from the market and a potential deterioration in the credit terms. The paper models the settlement as a random process to re∞ect ine‐ciencies that arise due to the existence of private information, but conditions the probability of a settlement on the portion of the defaulted debt borrowers agree to repay. The model incorporates repayment history (i.e., the number of years a country has been active in the international credit market) into the information set used by lenders. Quantitative analysis shows that the model can replicate some key stylized facts of sovereign debt: 1) settlement ofiers depend positively on a debtor’s current income level and negatively on its level of debt; 2) the debt-to-GDP ratio that new borrowers or serial defaulters can support is well below the ratio that proven debtors can safely manage; 3) the probability of default is larger for debtors with recent payment di‐culties; 4) once a country defaults, it takes many years of perfect repayment and low levels of debt for that country to gain continuous access to international credit markets at low cost; this process is slow and backsliding into default is di‐cult to avoid.

Sovereign default, interest rates and political uncertainty in emerging markets

A large body of the empirical literature shows that high turnover rates/length of tenure of policymakers and the degree of conflict within a country affects sovereign spreads, debt and default rates. We help to rationalize such claims by including these political features in a dynamic stochastic small open economy model of sovereign debt and default. In this way we offer a complementary approach to the econometric analyses in the literature. Consistent with the data, the quantitative analysis shows that politically unstable and more polarized economies experience higher default rates and larger level and volatility of sovereign interest rate spreads.

Optimal Debt? On the Insurance Value of International Debt Flows to Developing Countries

According to reputation models of sovereign debt, the incentives to repay are proportional to the income insurance benefits provided by the access to international markets. This paper, however, documents that private net lending to developing countries exhibits a procyclical or acyclical pattern, contradicting this premise. By contrast, official debt net flows exhibit a countercyclical patter. In addition, the paper shows that (both current and past) defaults are associated with lower net debt flows. The findings suggest that, while reputation models may explain the preferred creditor status enjoyed by official lenders, they cannot account for the presence of sovereign debt markets in developing countries.

A Model of Sovereign Debt in Democracies

This paper develops and empirically tests a political economy model of sovereign debt. The main incentive for repaying sovereign debt is to maintain access to international capital markets. However, in a democracy, one generation may choose default regardless of its consequences for future generations. An old generation with little concern for its country's access to capital markets can force a default on debt if it has the majority of voters. On the other hand, if the younger generation is more numerous, it can force repayment of previously defaulted debt. Other voter heterogeneities, such as in income, can generate similar results.

A Model of Sovereign Debt in Democracies

This paper develops and empirically tests a political economy model of sovereign debt. The main incentive for repaying sovereign debt is to maintain access to international capital markets. However, in a democracy, one generation may choose default regardless of its consequences for future generations. An old generation with little concern for its country's access to capital markets can force a default on debt if it has the majority of voters. On the other hand, if the younger generation is more numerous, it can force repayment of previously defaulted debt. Other voter heterogeneities, such as in income, can generate similar results.

Original Sin and Procylical Fiscal Policy: Two Sides of the Same Coin?

The paper develops a simple model of sovereign debt where default both through direct repudiation and through inflation are possible and give rise to (endogenous) constraints on the currency composition and the level of public debt. This set up allows to show that procyclicality of fiscal policy in EMEs can arise as a by-product of the original sin and both can be explained by the presence of weak monetary institutions which cannot commit to price stability. The paper suggests that, as monetary institutions in EMEs strengthen, the original sin would fade away and the cyclical properties of fiscal policy would improve.

Original Sin and Procylical Fiscal Policy: Two Sides of the Same Coin?

The paper develops a simple model of sovereign debt where default both through direct repudiation and through inflation are possible and give rise to (endogenous) constraints on the currency composition and the level of public debt. This set up allows to show that procyclicality of fiscal policy in EMEs can arise as a by-product of the original sin and both can be explained by the presence of weak monetary institutions which cannot commit to price stability. The paper suggests that, as monetary institutions in EMEs strengthen, the original sin would fade away and the cyclical properties of fiscal policy would improve.

A Sovereign Debt Model with Trade Credit and Reserves

This paper analyzes sovereign debt in an economy in which the availability of short-term trade credit reduces international trade transaction costs. The model highlights the distinction between gross and net international reserve positions. Borrowed reserves provide net wealth and liquidity services during a negotiation, as long as they are not fully attachable by creditors. Moreover, reserves strengthen the bargaining position of a country by shielding it from a cut-off from short-term trade credits thereby diminishing its degree of impatience to conclude a negotiation. We show that competitive banks do lend for the accumulation of borrowed reserves, which provide partial insurance.

Optimal Debt? On the Insurance Value of International Debt Flows to Developing Countries

According to reputation models of sovereign debt, the incentives to repay are proportional to the income insurance benefits provided by access to international markets. This paper, however, documents that private net lending to developing countries exhibits a procyclical or acyclical pattern, contradicting this premise. By contrast, official debt net flows exhibit a countercyclical patter. In addition, the paper shows that (both current and past) defaults are associated with lower net debt flows. The findings, which are robust to various additional controls, cast doubt on the reputation view of sovereign debt markets. At the same time, they suggest that reputation may account for the success of the (implicit) preferred creditor status enjoyed by multilateral lenders.

COLLATERAL CONSTRAINTS, DEBT MANAGEMENT AND INVESTMENT INCENTIVES WITH A LOW DEFAULT PROBABILITY

This paper analyzes the hedging decisions of an emerging economy which is exposed to market risks and whose debt contract is subject to collateral constraints. Within a sovereign debt model with default risk and endogenous collateral, the hedging policy is studied in a market where both futures and non-linear derivatives are available. In developing this model, the paper looks at the cost of sovereign default, financial constraints after default and hedging as an optimal debt managment tool. Finally, the paper presents a contract framework which provides a lower default probability.

Russia, Sovereign Default, Reputation and Access to Capital Markets

THE LACK OF INSTITUTIONAL METHODS for protecting lenders' rights in cases of sovereign default is widely discussed in the academic literature. As conventional wisdom (supported by countless economic models) dictates, in the absence of an authority capable of forcing a sovereign to honour its debt obligations, only fear of future punishment motivates countries to pay their creditors back. Such punishment, according to sovereign debt experts, can take the form either of sanctions against an unfaithful borrower or of cutting its ability to borrow more. Sanctions-based theories are less in favour nowadays. After all, '... the US Marines are no longer used for debt collection from foreign governments, as they sometimes were before the First World War'.1 Other customarily mentioned sanctions, such as trade or economic ones, are almost equally ineffective in encouraging debt repayment. Disruption of trade can be a serious punishment only to a 'small' trade partner, because a bigger one will retaliate. Seizure of external assets, even with the blessings of international arbitration, can be more problematic still. The ongoing saga of the firm Noga (discussed later) which has struggled for almost 10 years to enforce court decisions against the Russian government, illustrates that. The weakness of sanctioning theories leaves a prominent place in social science to reputation models of sovereign debt, which generally argue that bad credit records close a country's future access to capital markets, and that to retain this access sovereigns choose to maintain a good reputation for repayment. This sentiment seems to be to some extent shared by market participants, both creditors and debtors, and, as will be shown later, has on occasion directly influenced outcomes of rescheduling negotiations. However, the widespread belief that a sovereign debtor's good reputation is a prerequisite for future loans is quite surprising, given the empirical evidence. This article, based on a review of theoretical and empirical literature and a case study of Russia's relations with foreign creditors, argues that reputational theories of debt fail in explaining the complex motivations that govern cross-border sovereign lending and the government's treatment of external creditors. It attempts to

Fiscal Adjustment and Official Reserves in Sovereign Debt Negotiations

countries. This evidence cannot be explained by existing bargaining models of sovereign debt, because sovereign immunity shelters official reserves from creditors' seizure. In the model proposed here, to service foreign debt the government must raise revenue through distortionary taxation. Large reserves reduce the fiscal burden of debt service, weakening the bargaining position of the debtor, and resulting in larger transfers to foreign creditors. In these circumstances, the debtor country may be better off repurchasing debt on the secondary market rather than accumulating official reserves.