Model Of Sovereign Default Research Articles

Sovereign risk and intangible investment

This paper measures the output and TFP losses from sovereign risk, considering firm-level intangible investment. Using Italian firm-level data, we show that firms reallocated from intangible assets to tangible assets during the 2011–2012 Italian sovereign debt crisis. This asset reallocation is more pronounced among small firms and high-leverage firms. This reallocation affects aggregate output and TFP. To explain the reallocation pattern and quantify the output and TFP losses, we build a sovereign default model incorporating firm intangible investment. In our model, sovereign risk deteriorates bank balance sheets, disrupting banks’ ability to finance firms. Firms with greater external financing needs are more exposed to sovereign risk. Facing tightening financial constraints, firms shift their resources towards tangibles because they can be used as collateral. We find that elevated sovereign risk explains 45% of the observed output losses and 31% of the TFP losses in Italy from 2011 to 2016.

Sovereign risk and Dutch disease

I study how, in the presence of default risk, the Dutch disease amplifies an inefficiency in the sectoral allocation of capital. In a sovereign default model with commodities and production of traded and non-traded goods, default incentives increase when more capital is allocated to non-traded production. Households do not internalize this, giving rise to an inefficiently large non-traded sector. Commodity windfalls amplify this inefficiency through the classic Dutch disease mechanism. I characterize state-contingent subsidies that implement the efficient allocation and compare them to a simpler subsidy rule that ameliorates the externality. Evidence from spreads, natural-resource rents, and sectoral investment data support the main findings of the model.

Inequality, Taxation, and Sovereign Default Risk

Income inequality and worker migration significantly affect sovereign default risk. Governments often impose progressive taxes to reduce inequality, which redistribute income but discourage labor supply and induce emigration. Reduced labor supply and a smaller high-income workforce erode the current and future tax base, reducing government’s ability to repay debt. I develop a sovereign default model with endogenous nonlinear taxation and heterogeneous labor to quantify this effect. In the model, the government chooses the optimal combination of taxation and debt, considering its impact on workers’ labor and migration decisions. Income inequality accounts for one-fifth of the average US state government spread. (JEL D31, F34, H21, H23, H74, J61, R23)

Welfare gains from market insurance: The case of Mexican oil price risk

Mexico has a long-standing practice of hedging oil price risk through the purchase of put options. We examine the resulting welfare gains using a standard sovereign default model calibrated to Mexican data. We show that hedging increases welfare by reducing income volatility and reducing risk spreads on sovereign debt. We find welfare gains equivalent to a permanent increase in consumption of 0.44 percent with 90 percent of these gains stemming from lower risk spreads.

COSTLY INFORMATION AND SOVEREIGN RISK

AbstractThe consequences of costly information acquisition for sovereign risk are explored in a quantitative sovereign default model. We identify information costs empirically using Bloomberg news‐heat data. The calibrated model microfounds heteroskedasticity in the country risk spread as measured by a novel metric we call the Crisis Volatility Ratio (CVR). Crises are endogenously more volatile because more information is acquired and priced. Recalibrated extant models do not generate CVRs in the empirical range, but ours does. Because effective risk tolerance depends on the information set, the model also suggests that risk premia fall with information costs.

Reserve Accumulation, Macroeconomic Stabilization, and Sovereign Risk

Abstract In the past three decades, governments in emerging markets have accumulated large amounts of international reserves, especially those with fixed exchange rates. This article proposes a theory of reserve accumulation that can account for these facts. Using a model of endogenous sovereign default with nominal rigidities, we argue that the interaction between sovereign risk and aggregate demand amplification generates a macroeconomic-stabilization hedging role for international reserves. We show that issuing debt to purchase reserves during good times allows the government to stabilize aggregate demand when sovereign spreads rise and rolling over the debt becomes more expensive. We provide empirical evidence consistent with the model’s predictions.

Deadly Debt Crises: COVID-19 in Emerging Markets

Abstract Emerging markets have experienced large human and economic costs from coronavirus disease 2019, and their tight fiscal space has limited the support extended to their citizens. We study the impact of an epidemic on economic and health outcomes by integrating epidemiological dynamics into a sovereign default model. The sovereign’s option to default tightens fiscal space and results in an epidemic with limited mitigation and depressed consumption. A quantitative analysis of our model accounts well for the dynamics of fatalities, social distancing, consumption, sovereign debt, and spreads in Latin America. We find that because of default risk, the welfare cost of the pandemic is about a third higher than it is in a version of the model with perfect financial markets. We study debt relief programs and find a compelling case for their implementation. These programs deliver large social gains, improving health and economic outcomes for the country at no cost to international lenders or financial institutions.

The bribe rate and long run differences in sovereign borrowing costs

Sovereign spreads and the level of bureaucratic diversion of government spending vary widely across emerging economies and are correlated with each other. We build a sovereign default model where the government is constrained to use corrupt bureaucrats to deliver public goods and services in order to explain these facts. The diversion policy parameters are estimated using data on public resources and monitoring efficiency and used to calibrate the model. We use data on the average gift needed to be given to win public contracts in a country as a measure of bureaucratic diversion because it allows us to quantify diversion of public resources whereas tax evasion is hard to measure. We tie down the efficiency level to the Rule of Law index. We show that economies with low monitoring efficiency display higher diversion levels and higher default risk (and spreads) than those with higher efficiency. These results emerge because defaults reduce diversion levels and this benefit from default is higher for low monitoring efficiency economies, which encourages default.

Sovereign Debt and Credit Default Swaps

How do credit default swaps (CDS) affect sovereign debt markets? The answer depends crucially on trading frictions, risk-sharing, arbitrage violations, and spillovers from secondary to primary markets. We propose a sovereign default model where investors trade bonds and CDS over the counter via directed search. CDS affect bond prices through several channels. First, CDS act as a synthetic bond. Second, CDS reduce bond-investing risks, allowing exposure to be unwound. Third, CDS availability increases trading profitability, which induces entry and reduces trading costs. Last, these direct effects feedback into default decisions. Our novel identification strategy exploits confidential microdata to quantify the extent of trading frictions and risk-sharing. The model generates realistic CDS-bond basis deviations, bid/ask spreads, and CDS volumes and positions. Our baseline specification predicts large effects of frictions generally but small spillovers from a naked CDS ban. These predictions hinge crucially on the identified parameters.

Borrowing into debt crises

Quantitative models of sovereign default predict that governments reduce borrowing during recessions to avoid debt crises. A prominent implication of this behavior is that the resulting interest rate spread volatility is counterfactually low. We propose that governments borrow into debt crises because of frictions in the adjustment of their expenditures. We develop a model of government good production, which uses public employment and intermediate consumption as inputs. The inputs have varying degrees of downward rigidity, which means that it is costly to reduce them. Facing an adverse income shock, the government borrows to smooth out the reduction in public employment, which results in increasing debt and higher spread. We quantify this rigidity using the OECD Government Accounts data and show that it explains about 70% of the missing bond spread volatility.

Learning about Debt Crises

The European debt crisis presents a challenge to our understanding of the relationship between government bond yields and economic fundamentals. I argue that information frictions are an important missing element and support that claim with evidence on the evolution of GDP forecast errors after 2008. I build a quantitative model of sovereign default where output features rare disasters and agents learn about their realizations. Debt crises coincide with economic depressions and develop gradually while markets update their expectations about future income. Calibrated to the Portuguese economy, the model replicates the comovement of bond spreads and output before and after 2008. (JEL E23, E27, E32, E43, F34, H63)

Fiscal Rules and the Sovereign Default Premium

We study fiscal rules using a sovereign default model. A debt-brake (spread-brake) rule imposes a ceiling on the fiscal deficit when the sovereign debt (spread) is above a threshold. For our benchmark calibration, similar gains can be achieved with the optimal debt or spread brake. However, for a “Union” of heterogeneous economies, a common spread brake generates larger gains than a common debt brake. Furthermore, gains from abandoning a common debt brake may be significant for economies that are unnecessarily constrained by the rule. In contrast, abandoning a common spread brake would generate losses for any economy in the Union. (JEL E62, F34, F41, H61, H63)

Interest rate uncertainty and sovereign default risk

Empirical studies suggest that fluctuations in the level and volatility of the world interest rate affect sovereign spreads in emerging economies. We incorporate an estimated time-varying process for the world interest rate (with both level and volatility shocks) into a model of sovereign default calibrated to a panel of emerging economies. Time variation in the world interest rate interacts with default incentives in the model and leads to state contingent effects similar to the empirical literature. On average, in response to a rise in the world interest rate the model delivers a 1.4 times increase in the spread. The volatility state has a major impact on this average – the increase in spreads is much larger in high volatility states. Moreover, we show that fluctuations in the world interest rate can generate considerable co-movement in sovereign yields across nations, as seen in the data.

International reserves and central bank independence

Motivated by a positive correlation between reserve accumulation and the widespread adoption of central bank independence legislation in Latin America, this paper develops a sovereign default model with an independent central bank that can accumulate a risk-free foreign asset. I show that if the central bank is more patient than the government and as patient as households are, in equilibrium, the government issues more debt than what is socially optimal, and the central bank accumulates reserves to undo government over-borrowing. A key insight is that the government can issue more debt for any level of reserves but chooses not to because doing so would increase spreads, making it more costly to borrow. Quantitatively, I find that the lack of perfect coordination between the central bank and the government can rationalize levels of reserves and debt close to the observed levels in emerging economies.

Natural disasters, climate change, and sovereign risk

I investigate how natural disasters can exacerbate fiscal vulnerabilities and trigger sovereign defaults. I extend a standard sovereign default model to include disaster risk and calibrate it to a sample of seven Caribbean countries that are frequently hit by hurricanes. I find that hurricane risk reduces governments’ ability to issue debt and depresses welfare. Climate change will further restrict governments’ access to financial markets and weigh on welfare. “Disaster clauses”, especially those allowing governments to write off debt, improve governments’ borrowing terms and mitigate the impact of climate change on governments’ access to financial markets and households’ welfare.

Improving sovereign debt restructurings

The wave of sovereign defaults in the early 1980s and the string of debt crises in subsequent decades have fostered proposals involving policy interventions in sovereign debt restructurings. The global financial crisis and the recent global pandemic have further reignited this discussion among academics and policymakers. A key question about these policy proposals for debt restructurings that has proved hard to handle is how they influence the behavior of creditors and debtors. We address this challenge by evaluating policy proposals in a quantitative sovereign default model that incorporates two essential features of debt: maturity choice and debt renegotiation in default. We find, first, that a rule that tilts the distribution of creditor losses during restructurings toward holders of long-maturity bonds reduces short-term yield spreads, lowering the probability of a sovereign default by 25 percent. Second, issuing GDP-indexed bonds exclusively during restructurings also reduces the probability of default, especially of defaults in the five years following a debt restructuring. The policies lead to welfare improvements and reductions in haircuts of similar magnitude when implemented separately. When jointly implemented, they reinforce each other’s welfare gains, suggesting good complementarity.

Hidden Debt

We study the role of transparency in debt and default dynamics in a quantitative sovereign default model augmented with asymmetric information. We assume that the sovereign debt portfolio is not transparent and part of the debt is not observable to lenders. The quantitative model is calibrated to the Bolivian economy and matches its long-term and business cycle properties. The quantitative results show that when the government moves to a transparent reporting regime, bond prices improve and the sovereign debt portfolio shifts toward noncontingent debt with an increase in overall debt level. However, higher debt increases default frequency and reduces welfare.

Fiscal Regimes and the Exchange Rate

In this paper, we argue that the effect of monetary and fiscal policies on the exchange rate depends on the fiscal regime. A contractionary monetary (expansionary fiscal) shock can lead to a depreciation, rather than an appreciation, of the domestic currency if debt is not backed by future fiscal surpluses. We look at daily movements of the Brazilian real around policy announcements and find strong support for the existence of two regimes with opposite signs. The unconventional response of the exchange rate occurs when fiscal fundamentals are deteriorating and markets' concern about debt sustainability is rising. To rationalize these findings, we propose a model of sovereign default in which foreign investors are subject to higher haircuts and fiscal policy shifts between Ricardian and non-Ricardian regimes. In the latter, sovereign default risk drives the currency risk premium and affects how the exchange rate reacts to policy shocks.

The Bribe Rate and Long Run Differences in Sovereign Borrowing Costs

The average cost of borrowing on international financial markets varies widely from nation to nation even after controlling for the varying levels of indebtedness of their governments. This suggests that markets assign country specific default risk assessments. In this paper we focus on one natural source of this difference – the quality of their institutions. We begin by showing that the average sovereign spread is positively related to the average percentage of a government contract that must be given as a “gift” in order to secure the contract. We then build a sovereign default model where the government is constrained to use corrupt bureaucrats to deliver public goods and services and manage its accounts. Using the gift data as a measure of the public resources diverted by bureaucrats, and the Rule of Law index as a measure of institutional quality, we estimate the diversion policy of bureaucrats and use it to calibrate our model to international data. We use the model to generate an artificial international data set where countries vary only in the institutional quality parameter. Running the same regressions on our artificial data, we find that average spreads are positively associated with the bribe (gift) rate and with average debt levels. The model implies that when revenue streams are low, a benefit of default is that public services net of bureaucratic diversion actually increase. Since the net gain in public services obtained by defaulting is decreasing in the level of institutional quality, international lenders assign lower default risk to those countries.

Sovereign risk matters: Endogenous default risk and the time-varying volatility of interest rate spreads

Emerging markets’ interest rate spreads display substantial time-varying volatility. We show that models with endogenous sovereign default risk à la Eaton and Gersovitz (1981) can account for such volatility, even in the absence of shocks to the second moments of the exogenous stochastic variables. In particular, these models feature a key non-linearity that allows them to replicate the stochastic volatility of interest rate spreads and its comovement with other important economic variables. Volatility correlates positively with the level of the spreads and the trade balance, negatively with output and consumption. Hence, sovereign default models endogenize the stochastic volatility of interest rates observed in emerging market economies.