Essays on Modelling the Sovereign Default Risk PDF Download

Author: Sébastien Villemot
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Languages : en
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Author: Sébastien Villemot
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Languages : en
Pages : 316

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This thesis contributes to the literature on sovereign debt and default risk, building on theoretical models of strategic default and on more recent developments of the quantitative sovereign debt literature. The first contribution is to suggest a solution to the "sovereign default puzzle:" most quantitative sovereign debt models predict a default at very low debt-to-GDP thresholds, in clear contradiction with what is observed in the data. Starting from the observation that countries generally do not want to default but are rather forced into it by the markets, I present a model which can replicate the key stylized facts regarding sovereign risk. As another contribution, I establish a typology of debt crises in three categories: those crises that are the consequence of exogenous shocks, those that are self-fulfilling prophecies, and those self-enforcing crises that are the consequence of a rational tendency to over-borrow when the risk of a negative shock is high. The estimated proportion of self-fulfilling and self-enforcing crises in the data is about 10% in each case. I also study how sovereign default can be understood in the context of small open economy real business cycle models. The conclusion is that these models oscillate between two polar cases: default is either inexistent or too frequent, depending on the chosen parameter values. These models are therefore not well suited for studying sovereign risk, and default needs to be fully endogeneized in order to get meaningful results. Finally, I make a methodological contribution by presenting a new computational method for solving endogenous default models. It is shown to dramatically improve the existing speed-accuracy frontier.

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Languages : en
Pages : 78

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This dissertation consists of three independent essays on sovereign default. In the first chapter, I develop a quantitative general equilibrium model of sovereign default to account for spillover of default risk across countries. When the collateral constraint for investors binds due to a decrease in the value of collateral, triggered by a high default risk for one country, credit constrained investors ask for liquidity premiums even to countries with normal fundamentals. This increase in the cost of borrowing increases incentives to default for the other countries with normal fundamentals, further constraining investors in obtaining credit through a decrease in the value of collateral. The quantitative results show that this model can generate spillover of default risk across countries. The essay in the second chapter introduces endogenous capital accumulation to a quantitative model of sovereign default based on Eaton and Gersovitz (1981). With a production technology in the model, output and interest rates are jointly determined by the interaction between a sovereign government who can optimally default and foreign creditors taking into account default risk. Adding investment enables the model to generate unique economic dynamics similar to those observed around emerging economies' default crises: (1) Emerging economies' debt crises display a boom-bust pattern. (2) A non-negligible fraction of sovereign defaults occur in good times. The essay in the third chapter explains why emerging economies borrow abroad in foreign currency. We present a two-period model in which foreign lenders offer a small open economy an optimal self-enforcing contract in which borrowing is denominated in borrowers' currency. Taking into account the government's incentive to inflate away the debt, the optimal lending contract provides consumption insurance for the economy in that the contract allows the economy for inflation in bad times but asks for deflation in good times. As the variance of income shocks for the economy increases, it gets more difficult for the contract to satisfy the incentive compatible constraints at the good income state. The numerical results are consistent with the fact that emerging economies with high income volatility suffer from "Original Sin".

Author: JungJae Park
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Languages : en
Pages : 0

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This dissertation consists of three independent essays on sovereign default. In the first chapter, I develop a quantitative general equilibrium model of sovereign default to account for spillover of default risk across countries. When the collateral constraint for investors binds due to a decrease in the value of collateral, triggered by a high default risk for one country, credit constrained investors ask for liquidity premiums even to countries with normal fundamentals. This increase in the cost of borrowing increases incentives to default for the other countries with normal fundamentals, further constraining investors in obtaining credit through a decrease in the value of collateral. The quantitative results show that this model can generate spillover of default risk across countries. The essay in the second chapter introduces endogenous capital accumulation to a quantitative model of sovereign default based on Eaton and Gersovitz (1981). With a production technology in the model, output and interest rates are jointly determined by the interaction between a sovereign government who can optimally default and foreign creditors taking into account default risk. Adding investment enables the model to generate unique economic dynamics similar to those observed around emerging economies' default crises: (1) Emerging economies' debt crises display a boom-bust pattern. (2) A non-negligible fraction of sovereign defaults occur in good times. The essay in the third chapter explains why emerging economies borrow abroad in foreign currency. We present a two-period model in which foreign lenders offer a small open economy an optimal self-enforcing contract in which borrowing is denominated in borrowers' currency. Taking into account the government's incentive to inflate away the debt, the optimal lending contract provides consumption insurance for the economy in that the contract allows the economy for inflation in bad times but asks for deflation in good times. As the variance of income shocks for the economy increases, it gets more difficult for the contract to satisfy the incentive compatible constraints at the good income state. The numerical results are consistent with the fact that emerging economies with high income volatility suffer from "Original Sin".

Author: Ming Qiu
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Category :
Languages : en
Pages : 0

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This thesis consists of three papers on sovereign debt and default. Chapter 1 studies public provision of liquidity in a model of public and private linkages that allows partial sovereign default. Entrepreneurs use their holdings of domestic bonds as liquidity stock to carry out investment and the bond default risk arises from the government's trade-off between private consumption and public expenditure. The model features a feedback loop between aggregate investment and debt sustainability. An adverse productivity shock reduces the government's tax base and hence its ability to repay. The initial decrease in bond price shrinks the economy's liquidity stock and leads to more projects being liquidated. Lower tax base, in turn, reduces bond price further. Chapter 2 analyses the impact of disaster risk on risk premium of debt issued by emerging economies. I distinguish between "natural" and "economic" disasters based on the output dynamics prior to disaster occurrence. My empirical estimation results show that a sample of thirteen emerging countries are subject to economic disasters and the probabilities of disaster occurrence in those economies are positively correlated with their interest spreads. This is consistent with the theoretical prediction of a model constructed to compare economies with natural and economic disaster risks. Chapter 3 relaxes an assumption made in previous works on optimal policy that the government has perfect knowledge of states in the economy and considers a model of optimal provision of liquidity when the government only has partial information. I present solutions to the full information and partial information cases.

Author: Jarrod E. Hunt
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Category : Economics
Languages : en
Pages :

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This dissertation is comprised of two essays focused on the central theme of sovereign default. In the first essay, I detail a method to improve forecasting models of sovereign default by evaluating the impact of a country's composition of debt. For my second essay, I assess the long-horizon impact of a sovereign default episode on a country's economic volatility. A country's external debt relative to gross domestic product is positively associated with the probability of being in default. Aggregate measures of external debt are commonly used for this type of risk analysis. However, based on the details of each loan, there are numerous subsets of external debt. Using a dataset of 32 developing countries from 1971-2010, I find that short-term debt, commercial bank loans, and concessional debt owed to other countries are the categories responsible for the positive relationship between the aggregate and the probability of being in default. In addition to isolating the categories driving the relationship between total external debt and sovereign default, I distinguish between the associated impact of each debt category on the probability of entering default and the probability of prolonging default. This is an important distinction as some subsets, such as bonds and multilateral concessional debt, are only related to the probability of entering default, while others, such as the use of IMF credit, are only significant when a country is already in default. Additionally, I find that short-term debt, commercial bank loans, and concessional bilateral debt positively affect both the probability of entering default as well as the probability of remaining in default. Focusing on the composition of external debt provides a more complete picture of the effect of debt on the probability of default, allowing for more precise forecasts of default probabilities. In my second chapter, I evaluate the impact of sovereign default on the volatility of gross domestic product, a relationship related to two strands of literature: one focused on the impact of sovereign default on output and another that evaluates the impact of economic volatility on growth in output. In addition to bridging the gap between the existing strands of literature, the dataset and techniques employed in this analysis offer advantages over those currently in use. First, the use of the Beveridge-Nelson decomposition addresses issues encountered by other, common trend-cycle decomposition methods. Second, this dataset, which spans 1870-2008, includes more sovereign default episodes per country, allowing for a richer region-specific evaluation. Using a dataset of 7 South American countries, I find that the volatility of output decreases following a sovereign default episode. Taking advantage of the considerable longitudinal dimension, I am also able to assess the impact of volatility on economic growth by looking at different sub-periods. I show evidence that from 1870-1959, economic volatility is positively related to growth while from 1960-2008, a commonly used time period in the literature, there is no effect. These findings suggest that volatility's influence on economic growth may change over time.

Author: Eugenia Andreasen
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Category : Debts, Public
Languages : en
Pages : 61

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This thesis studies the causes and consequences of sovereign defaults focusing on non traditional links between sovereign default and the domestic economy: the impact of sovereign defaults on the external financial conditions for the private sector; and the ex-ante implications of the redistributive effects of default and repayment on the political support that the government requires to implement either of these decisions. In the first chapter of my thesis I analyze the worsening of the external financial conditions for the private sector that follows sovereign defaults. To explore the issue I develop a signaling model in which sovereign defaults reveal negative information to foreign lenders regarding the institutional quality in the country. Foreign lenders care about institutional quality because it affects the expected repayment of loans. Therefore, if foreign lenders receive negative information on the institutional quality from the sovereign default they worsen the financial conditions they offer to local firms triggering a sharp reduction in credit and investment (updating effect). The model can rationalize the worsened financial conditions in international capital markets for the private sector observed after default episodes. In the second chapter, a joint work with Guido Sandleris and Alejandro Van der Ghote, we analyze how the presence of political constraints affects sovereign governmentsborrowing and default decisions. We do so in a standard DSGE model with endogenous default risk where we introduce two novel features: heterogeneous agents in the domestic private sector and a requirement that the government obtains some of their support to implement the fiscal program needed to repay the debt. In this framework, we demonstrate that sovereign default can also arise due to insufficient political support and we explore the implications of different income distribution, political systems and tax systems over the repayment decision.

Author: Jinwook Nam
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Category : Debts, Public
Languages : en
Pages : 0

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The first chapter examines the cyclicality of debt in standard quantitative sovereign default model, the strategic default model. The standard strategic default model has been a canonical model to explain high consumption volatility in emerging markets with default risks, such as Argentina in 2001. These emerging markets with high default risks can be characterized by exhibiting procyclical debt behavior and high level of mean and volatility of interest rate spreads. However, the notion of only emerging markets default has changed, since the Southern European debt crisis starting in 2010. Greece defaulted and other countries such as Italy, Spain, Portugal, and Ireland had debt crisis. Unlike the emerging market economies, these countries exhibited countercyclical debt and consumption less volatile than income. Then, can a standard strategic default model explain the default in advanced economies? We choose Greece as a reference country and attempt to match the Greek data leading up to a debt crisis. We find that the standard strategic default model is not capable of generating a countercyclical debt, therefore, leading to consumption more volatile than income. The experiment results suggest that the only way to make debt countercyclical in the standard strategic model is to raise the magnitude of patience parameter. However, doing so leads to very little borrowing and close to no defaults generated by the model, which would not be an appropriate model for explaining default events. The second chapter studies the sovereign default risk with stochastic risk-free interest rate. The vast majority of sovereign default literature assumes a constant risk-free interest rate, an innocuous assumption given stable US t-bill yields or German Bund yields that are often used as a proxy for risk-free rate. However, with highly inflationary environment and contractionary monetary policy in the US and the EMU, these risk-free interest rates have recently been increasing. We incorporate stochastic risk-free interest rate with the excusable default model that is used to explain defaults in advanced economy. We examine the effect of interest rates fluctuating on accumulation of debt and possibility of default. We find that the sovereign accumulates less debt and relatively at slower rate, when risk-free interest rate is high, lowering the probability of default. However, given high level of debt, an increase in risk-free interest rate leads to an increase in probability of default, because of a fall in ability to pay. In general, the increase in volatility of risk-free interest rates increases the probability of default. This result alarms many countries with high level of debt, given the level of interest rates around the world has been rising. The third chapter examines the stabilization policy in two sovereign default models with downward sticky wages. During recession, aggregate demand falls, but the real wage does not fall enough due to downward sticky wage, especially in countries that adopt a fixed exchange rate or are in monetary union. With the absence of monetary policy, involuntary unemployment arises due to the sticky wage. The governments can stimulate the economy by borrowing and making transfers to households. However, rising debt level increases the probability of default. We find that the strategic default model with downward sticky wage does not stabilize the economy, due to the risk of default. In the strategic default model, declaring default entails costs arising from no commitment to repay. This behavior is consistent with the default case of emerging markets, Argentina in 2001 that exhibited procyclical government debt issuance prior to default. On the other hand, the excusable default model with downward sticky wage stabilizes the economy despite of default of risk. In recession, the sovereign increases borrowing to stimulate the economy, leading to lower the unemployment level. However, if recession continues, the increased borrowing leads to default, which is consistent with the default case in Greece.

Author: Tiago Gomes da Silva Tavares
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ISBN:
Category : Debts, External
Languages : en
Pages : 124

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"This dissertation contributes to literature of International Economics and, in particular, of Sovereign Default with the study of three distinct issues. In the first chapter, I study the role of international reserves in sovereign debt restructuring episodes when fiscal adjustment is costly. This study departs from the observation that highly indebted developing economies commonly also hold large external reserves. This behavior seems puzzling given that governments in these countries borrow with an interest rate penalty to compensate lenders for default risk. Reducing debt to the same extent as reserves would maintain net liabilities constant while decreasing interest payments. However, holding reserves can have insurance benefits in a financial crisis. To rationalize the levels of international reserves and external debt observed in the data, a standard dynamic model of equilibrium default is extended to include distortionary taxation and debt restructuring. This chapter shows that fiscal adjustments induced by sovereign default can generate large demand for reserves if taxation is distortionary. At the same time, a non-negligible position in reserves modifies the debt restructuring negotiations upon default. A calibrated version of the model produces recovery rate schedules that are increasing with reserves, as seen in the data, being also able to replicate large positions of reserves and debt to GDP. Finally, I study how both mechanisms play a key quantitative role to generate such result, in fact, not including them, produces a counterfactual demand for reserves that is close to zero. In the second chapter, the relationship between labor market distortions and sovereign debt crises is explored. It is noted that risk of sovereign debt default has frequently affected both emerging market and developed economies. Such financial crises are often accompanied with severe declines of employment that are hard to justify using a standard dynamic stochastic model. In this chapter, I document that a labor wedge deteriorates substantially around swift reversals of current accounts or default episodes. I propose and evaluate two different explanations for these movements by linking the wedges to changes in labor taxes and in the cost of working capital. With these two features included, a dynamic model of equilibrium default is able to replicate the behavior of the labor wedge observed in the data around financial crisis. In the model, higher interest rates are propagated into larger costs of hiring labor through the presence of working capital. As an economy is hit with a stream of bad productivity shocks, the incentives to default become stronger, thus increasing the cost of debt. This reduces firm demand for labor and generates a labor wedge. A similar effect is obtained with a countercyclical tax rate policy. The model is used to shed light on the recent events of the Euro Area debt crisis and in particular of the Greek default event. Finally, in the third chapter, I develop a debt-to-output decomposition and document that a large fraction of the increase in the debt to output ratio during default is accounted by variations in the exchange rate. Also, using a large dataset on historical sovereign debt crises, it is shown in this chapter that devaluations of the exchange rate during periods of default are positively associated with international investor losses (haircuts) when debt is restructured. These results can be rationalized with the fact that large real devaluation decrease output when measured in foreign goods, thus reducing the availability of resources that can be used during negotiations. This implies that exchange rate fluctuations are an important source of risk in emerging economies affecting, among other things, debt dynamics and restructuring outcomes. As such, I conclude that most of the exchange rate neglect, typical in the sovereign default literature, should be seriously reconsidered"--Pages iii-v.

Author: Diego J. Perez
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Languages : en
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This dissertation contains three essays on Sovereign Debt and Monetary Economics. The first chapter, entitled 'Sovereign Debt, Domestic Banks and the Provision of Public Liquidity' studies the effect of a sovereign default in the domestic economy and its implications for the government's incentives to repay its debt. I explore two mechanisms through which a sovereign default can disrupt the domestic economy via its banking system. First, a sovereign default creates a negative balance-sheet effect on banks, which reduces their ability to raise funds and prevents the flow of resources to productive investments. Second, default undermines internal liquidity as banks replace government securities with less productive investments. I quantify the model using Argentinean data and find that these two mechanisms can generate a deep and persistent fall in output post-default, which accounts for the government's commitment necessary to explain observed levels of external public debt. The balance-sheet effect is more important because it generates a larger output cost of default and a stronger ex-ante commitment for the government. Post-default bailouts of the banking system, although desirable ex-post, are welfare reducing ex-ante since they weaken government's commitment. Imposing a minimum public debt requirement on banks is welfare improving as it enhances commitment by increasing the output cost of default. The second chapter, entitled 'Sovereign Debt Maturity Structure Under Asymmetric Information' studies the optimal choice of sovereign debt maturity when investors are unaware of the government's willingness to repay. Under a pooling equilibrium there is a wedge between the borrower's true default risk and the default risk priced in debt, and the size of this wedge differs with the maturity of debt. Long-term debt becomes less attractive for safe borrowers since it pools more default risk that is not inherent to them. In response, safe borrowers issue low levels of debt with a shorter maturity profile -relative to the optimal choice under perfect information- and risky borrowers mimic the behavior of safe borrowers to preclude the market from identifying their type. In times of financial distress, the default risk wedge of long-term debt relative to short-term debt increases which makes borrowers reduce the amount of debt issuance and shorten its maturity profile. I present empirical evidence on sovereign debt maturity choices and sovereign spreads for a panel of emerging economies that is consistent with the model's implications. The third chapter, entitled 'Price Setting Under Uncertainty About Inflation', is based on a working paper coauthored with Andres Drenik. This chapter provides an empirical assessment of the effects of the availability of public information about inflation on price setting. We exploit an event in which economic agents lost access to information about the inflation rate: starting in 2007 the Argentinean government began to misreport the national inflation rate. Our difference-in-difference analysis reveals that this policy led to an increase in the coefficient of variation of prices of 18% with respect to its mean. This effect is analyzed in the context of a general equilibrium model in which agents make use of publicly available information about the inflation rate to set prices. We quantify the model and use it to further explore the effects of higher uncertainty about inflation on the effectiveness of monetary policy and aggregate welfare. We find that monetary policy becomes more effective in a context of higher uncertainty about inflation and that not reporting accurate measures of the CPI entails significant welfare losses.