No Slide Titlepubdocs.worldbank.org/en/678381478750940288/... · share of the world economy. 16...

Sovereign default

Kuala Lumpur 2016 -- Luis Servén

Kuala Lumpur 2016 -- Luis Servén2

Plan

1. Sovereign default in retrospect

2. Modeling sovereign default

3. Self-fulfilling debt crises

4. The maturity of sovereign borrowing

5. Sovereign theft

6. The timing of default

7. The cost of default

8. Financial repression


Gross public debt, percent of GDP

The tables have turned.


General government debt (% GDP)

Source: Trading Economics (http://www.tradingeconomics.com/euro-area/government-debt-to-gdp)

http://www.tradingeconomics.com/greece/government-debt-to-gdp


Sovereign credit events are often seen as a feature of

today’s emerging markets – but their frequency was

as high or higher in the past of today’s rich countries

(and perhaps their near future too!)

The biggest bunching of default episodes happened (i)

after the Napoleonic wars, and (ii) after World War II.

In the 19th century alone, Portugal, Germany and Austria

defaulted 5 times each.

Between 1550 and 1880 Spain defaulted 13 times.

In comparison, the emerging-market defaults of the

1980s and 1990s were sparser and affected a smaller

share of the world economy.


Sovereign default tends to happen more frequently in the

wake of capital flow booms


Defaults are more frequent at (or following) times of low

commodity prices


The run-up to default is characterized by rising debt


Incidence of default and debt levels: all countries


Incidence of default and debt levels: emerging markets


Public debt, banking crises and sovereign default

Multinomial logit regressions, panel data

Source: Reinhart and Rogoff 2011




Source: Reinhart and Rogoff 2011


Modeling sovereign default

Two theoretical views of sovereign default:

(1) Contingent debt: incentive-compatible contracts with state-

contingent payments. Incentives to default are greater in

good states, so default risk should be pro-cyclical.

Typically no defaults in equilibrium.

(2) Non-contingent debt (Eaton-Gersovitz 1981): default

offers a form of risk-sharing to the debtor in the absence of

state-contingent payments. Equilibrium default tends to

happen at times of economic adversity.


With non-contingent debt, when is sovereign default optimal?

Cost vs benefit calculation:

Benefit: keeping the resources (for consumption and/or

investment) rather than using them for debt service.

Cost: usually taken to be exclusion form financial markets

It may take other forms too (more on this later):

Seizure of assets abroad

Disruption of trade (including curoff of trade financing)

Secondary debt markets – absent discriminatory default

Debt holdings of domestic banks


Hence default is more likely to be the right choice if

-- debt service due is large (so large benefit)

-- the government is not in (much) need of new borrowing (so

small cost of losing access to markets)

e.g., a sovereign with a big debt stock but a small (or no)

deficit in the present and near future.


Basic framework to study sovereign default (Arellano

2008):

• benevolent government in small open economy trading bonds

with risk-neutral foreign creditors

• Asset incompleteness: it makes lenders willing to offer

defaultable debt contracts by charging a premium.

• Bond contracts reflect default probabilities endogenous to the

borrower’s incentives to default. Hence the equilibrium

borrowing rate is linked to default.

• Default is penalized with temporary exclusion from financial

markets.

This setup delivers counter-cyclical default risk – as

intuitively expected.


Model setup:

• One-period discount bond B (debt if B < 0).

• Uninsurable shocks to income y (Markov with

transition function f(y’, y))

• Risk neutral creditors: bond price incorporates default

probability. Price of B units of bond, given y, is q(B,y).

• Risk averse borrower: default provides a form of risk-

sharing, given that debt is non-contingent.

• Zero recovery: default is full, not partial.


Resource constraint under repayment:

c = y + B - q(B’ ,y)B’

(B are bonds carried over from last period)

When the government chooses to default, assume old debts

are erased, and a period of financial autarky follows. In

addition, there are direct output losses.

Resource constraint under default: c = ydef

Output loss: ydef = h(y) < y, where h’ > 0.

Foreign creditors can borrow (or lend) without limit at fixed

r. They have perfect information about y and f.


Risk-neutral lenders maximize expected profits choosing B’

and taking bond prices as given:

E profits = qB’ – (1- δ)B’/(1+r)

δ is the (endogenous!) probability of default. For positive

B’, δ = 0, so the equilibrium price q = 1/(1+r).

For negative B’ , default may occur, so the equilibrium price

must compensate for the possibility of default:

q = (1- δ)/(1+r)

Hence q lies in [0, 1/(1+r)].

The government starts with initial assets B, observes y, and

decides to repay or default. If it repays, it can choose B’

subject to the resource constraint, taking q(B’, y) as given.


The government’s value function reflects the option to

default:

If the government chooses to repay, the value conditional

on not defaulting is

Under default, income (= consumption) falls and there is

financial autarky that ends with probability θ:


In equilibrium, ( , ') reflects the government's default

probabilities (and is consistent with lenders' zero expected profits).

Define the 'stopping region' in which default is optimal, given :

q y B

B

( ) : ( , ) ( )c dD B y v B y v y

Some basic results:

• D(B) is larger the smaller B – i.e., default is more likely

with higher initial debt.

• For sufficiently low B (=sufficiently high debt), default

happens for any realization of y.

• For sufficiently high B, default does not happen for any y

(note that default can never be optimal for B>0)


• If output is iid, today’s realization of y gives no

information on tomorrow’s realization. Hence bond

prices depend only on debt: q(y, B’) = q(B’)

• Default incentives then are stronger the lower output: if

y2 is in the default set, and y1< y2, then y2 is too.

• This implies the existence of an upper bound y*(B) such

that default happens for any y < y* (where y* depends

negatively on assets, or positively on debt). The

equilibrium price then depends just on the boundary and

the distribution of y:

1

( ') 1 ( *( '))1

q B F y Br


Can there be default in equilibrium?

What matters for borrowers is the extra resources for

consumption they get from borrowing today, q(B)B.

Depending on the form of F, this may generate a ‘Laffer

curve’: a B* such that q(B*)B* provides the maximum

volume of resources for consumption.

The borrower will never choose B’ < B* because s/he can

get the same resources incurring a lower liability (more on

this later).


Contracts in the ‘risky borrowing’ region carry a default

premium.

Contracts to the right (with higher B’) are default-free.

Contracts to the left will never be taken due to the Laffer

curve.

For the ‘risky borrowing’ region to exist, the bond price

function needs to decrease slowly, so that lower asset levels

yield increasing resources for consumption.


Model simulation:

equilibrium prices for a high and a low income shock

(+/- 5% from trend)


To what extent can this simple framework fit the data?

The standard test in this literature is to calibrate the model

to Argentina (or some other serial defaulter!) and see if it

fits the facts.

The main finding is that the model can match the volatility

of spreads, but underpredicts their average level. It does

predict a default at the end of 2001 (as actually happened).


• One limitation of the basic framework is the assumption

of zero recovery. In reality, default episodes involve

partial recovery – whose extent varies a lot.

• Adding endogenous recovery rates allows studying how

renegotiation interacts with the default decision (Yue

2010). It also makes the period of exclusion from

markets endogenous.

• When default occurs, the lenders negotiate with the

country over debt reduction in a Nash bargaining game.

• The main new prediction is that recovery rates decrease

with the volume of debt – as actually observed.


• In this extended framework, the correspondence between

default probabilities and spreads is not one-to-one because of

the endogenous recovery value.

• Still, model simulations (calibrated to Argentina) cannot match

the average level of spreads.


The model does predict the default of 2001.

49

Self-fulfilling debt crises

In the conventional view default is driven by (bad)

fundamentals. There is a unique equilibrium.

Then sudden shifts in risk premia, seemingly unrelated to

fundamentals (such as those seen in the Eurozone crisis in

2010-2012), are hard to explain.

“…we are in a situation now where you have large parts of the euro

area in what we call a ‘bad equilibrium’, namely an equilibrium

where you may have self-fulfilling expectations that feed upon

themselves and generate very adverse scenarios.”

ECB President Mario Draghi, September 6, 2012


Euro area sovereign spreads


Sovereign CDS spreads, basis points

Source: Bloomberg

0

200

400

600

800

1,000

1,200

1,400

1,600

0

200

400

600

800

1,000

1,200

1,400

1,600

Jan-0

8M

ar-0

8A

pr-

08

Jun-0

8Ju

l-08

Sep

-08

Nov-0

8D

ec-0

8

Feb

-09

Mar

-09

May

-09

Jun-0

9A

ug-0

9

Oct

-09

No

v-0

9Ja

n-1

0

Feb

-10

Apr-

10

May

-10

Jul-

10

Aug-1

0

Oct

-10

Dec

-10

Jan-1

1

Mar

-11

Apr-

11

Jun-1

1Ju

l-11

Sep

-11

Nov-1

1D

ec-1

1F

eb-1

2

Mar

-12

May

-12

Jun-1

2

Aug-1

2O

ct-1

2N

ov-1

2Ja

n-1

3F

eb-1

3

Ap

r-1

3M

ay-1

3

Greece Portugal Ireland Spain

52 Kuala Lumpur 2016 -- Luis Servén

Sovereign CDS spreads, basis points

Source: Bloomberg and World Bank

0

200

400

600

800

1,000

1,200

1,400

1,600

0

200

400

600

800

1,000

1,200

1,400

1,600

Jan-0

8M

ar-0

8A

pr-

08

Jun

-08

Jul-

08

Sep

-08

Nov-0

8D

ec-0

8

Feb

-09

Mar

-09

May

-09

Jun

-09

Aug-0

9

Oct

-09

No

v-0

9Ja

n-1

0

Feb

-10

Apr-

10

May

-10

Jul-

10

Aug-1

0

Oct

-10

Dec

-10

Jan-1

1

Mar

-11

Apr-

11

Jun

-11

Jul-

11

Sep

-11

Nov-1

1D

ec-1

1F

eb-1

2

Mar

-12

May

-12

Jun

-12

Aug-1

2O

ct-1

2N

ov-1

2Ja

n-1

3F

eb-1

3

Ap

r-13

May

-13

Average BRCTI (Brazil, Russia, China, Turkey, Indonesia)

Average EU-5 (Greece, Spain, Portugal, Italy, Ireland)


Self-fulfilling sovereign debt crises are analogous to

second-generation currency crises

Two kinds:

• Rollover crises: creditor runs on short-term debt – just

like bank runs.

Self-fulfilling liquidity crises (Cole and Kehoe 2000): lenders’

refuse to roll over the debt coming due because of fears of default.

This forces immediate default – even though it would not be

triggered if lenders held more optimistic expectations.


Rollover crises can arise when the stock of debt coming

due is sufficiently large and economic fundamentals are

sufficiently weak (e.g., Bocola and Dovis 2015).

Role for a LOLR (the IMF?) to step in and avoid the

liquidity crisis

Standard policy advice: avoid short-term borrowing and

bunching of maturities.


• Multiple equilibria through risk spreads

In standard models of sovereign debt, interest rates are high when

default probabilities are high.

But there may be conditions under which the reverse is also true:

default probabilities are high because interest rates are high.

If creditors believe the borrower is likely to default, they may

demand a large risk premium for their loans, eventually turning the

borrower insolvent (Calvo 2008)


Unlike rollover crises, default need not happen immediately: “slow-

moving” debt crises may occur (Lorenzoni and Werning 2014).

(1) Under what conditions can the feedback loop between interest

rates and debt burden lead to self-fulfilling debt crises?

(2) If default can happen through self-fulfilling spread hikes, how

can policy help avoid the ‘high spread’ outcome?


Simple 2-period model with multiplicity (Ayres et al 2015)

Borrower is a small open economy with preferences

U(c1) + βEU(c2)

Income process:

y1 = 1

y2 = yl with probability p

yh with probability (1 − p)

1 < yl < yh

Continuum of risk-neutral foreign lenders with alternative return R*

The expected return of lending to the country, taking default into

account, has to be equal to R*


Zero initial debt.

Borrow b, at a rate R. At t = 2, two possibilities:

1. pay bR = a.

2. default. If default, output is lost and c2 = 1

Borrower’s choice variable: two possible specifications

1. b, amount received at t = 1 (as in Calvo 2008): the

government decides how much to issue at the lowest bid.

2. a = bR, amount paid at t = 2 (as in Arellano 2008): the

government decides the value of debt at maturity and adjusts

its short-term financing need.


• First period

Creditor i offers limited funds at gross interest rate Ri.

The borrower moves next and borrows from the low-rate creditors:

In equilibrium, Ri = R; let bi = b.

• Second period

Output is realized. The borrower pays only if the cost of paying is

less than the benefit of paying:

bR < y2 − 1


1

0

ib b di

• Supply of debt: given by creditors’ arbitrage condition

R* = R[1 − F (1 + Rb)]. This defines a locus of points (b, R) that

can be interpreted as the supply of funds.

For each b there may be more than one R that satisfies the equation



Debt supply

For high debt demand, there may be 2 equilibria

• Demand for debt: given by utility maximization by the borrower:


1

1

(1 ) (1 ) (1) ( ) ( )

The first-order condition is

'(1 ) '( ) ( )

This defines the demand for debt.

Y

bR

Y

bR

U b F bR U U y bR f y dy

U b R U y bR f y dy


Equilibrium

For high debt demand, there may be 2 equilibria

What is different in the standard model (Arellano (2008) and Aguiar

and Gopinath (2006))?

• Alternative action: does it matter (for multiplicity) whether the choice for the

borrower is b or a = Rb?

1. Calvo (1988). Schedule in b, multiple equilibria.

2. Aguiar and Gopinath (2006), Arellano (2008). Schedule in a, single

equilibrium.

[For lenders, it is clearly inessential]

• Alternative timing:

1. The borrower moves first and chooses b or a = bR (as here)

2. Given the choice b (or a), creditors move next and offer schedule R(b)

[or q(a) = 1 / R(a) as in Arellano 2008]



(conventional case)

66

Rb

For any general density f(y) and CDF F(y),

• If the borrower chooses b, the supply schedule is

R* = R[1 − F (1 + Rb)]

• If the borrower chooses a = Rb, the supply schedule is

R* = R[1 − F (1 + a)]

• Multiplicity results from the possibility of different premia

being charged on a given amount of borrowing

• Picking a amounts to picking the future liability – inclusive of

the premium added by creditors in R.

• If the borrower moves first and chooses a, she is in effect

choosing the spread too – no room for multiplicityKuala Lumpur 2016 -- Luis Servén67

In most configurations there can be multiple equilibria and

self-fulfilling debt crises.

The standard setting assumes the government commits to a given

bond issuance a – regardless of the eventual pricing (amount

raised). In reality, the government will likely issue debt as needed

to raise its target amount b.

With multiplicity, policy may be effective in selecting the

low rate equilibrium:

Design of the policy intervention: a deep-pocket agent offers to

lend large amounts to the country at policy rate RP

The policy would be effective but costless if RP is set just above

the low-level equilibrium R.


Slow-moving self-fulfilling crises

Spread feedback loop with long-term debt (Lorenzoni and Werning

2015).

(Simplified) setting: long-term debt as a perpetuity with coupon

payments that decay geometrically at rate 0 < δ < 1:

κ, κ (1-δ), κ (1-δ)2…

So a bond issued at t-s corresponds to (1-δ)s bonds issued at time t

[avoids having to keep track of how much debt was issued when]

Investors’ discount rate is R = 1+r

Smaller δ = longer maturity. Assume κ = δ+r


• Budget constraint if no default: st + qt[bt+1 - (1-δ) bt] = κbt

The surplus s is uncertain. To simplify, assume all uncertainty

is concentrated at t = T.

Before T, the surplus follows

(a debt-responsive fiscal rule)

From T onward, the surplus forever equals s = rS, where S is

uncertain with CDF F(S)

Default happens at T if s < rbT. This happens with prob F(bT)

Under default, there is a recovery value ϕ


1 0 1(1 ) ( )t t ts s b

• Investors’ arbitrage equation for t < T – 1:

qt = [(1-δ) qt+1+κ] / (1+r)

• Arbitrage equation at T – 1:

Multiplying both sides by bT we get a Laffer curve.

In general it is not monotonic because as bT

increases the probability of default also rises


1

0

11 ( ) ( )

1

Tb

T T

T

q F b SdF Sr b


A numerical example

Blue = Laffer curve

Green = qT and bT obtained solving the model for all possible values of q0

Here there are three equilibria (two stable)


A numerical example: dynamics

A jump from the good to the bad equilibrium leads to a growing difference in debt

dynamics as a larger fraction of debt is issued at distressed prices


More activist surplus rule increases the good-equilibrium uniqueness region (lower

red region). With passive surplus, high debt leads to immediate default.

Longer maturities also expand the good-equilibrium uniqueness region. Very low

maturities require more refinancing and expand the immediate default region.

Was this mechanism at work in the Euro crisis?

Not clear: short–run spreads jumped even more than long-run spreads.


Other possible explanations

Rollover risk (Corsetti and Dedola 2014)

Currency risk (Euro exit)

Can policy help avoid self-fulfilling debt crises?

Monetary policy might help rule out the bad equilibrium – by inflating

away the debt. This is relevant with long-term debt – not for runs on

short-term debt.

This is analyzed by Bacchetta, Perazzi and van Wincoop (2015): long-

term debt in a NK model of monetary policy.

Result: Aggressive monetary policy does work – but at the cost of very

high inflation (e.g., 25% for b/y around 100%).



The maturity of sovereign borrowing

Borrowers can issue debt at short and long maturities. What

drives the maturity structure of public debt?

Short-term debt provides a commitment device for the debtor – it

reduces the incentive to default or inflate away (because the

penalty comes right away).

Long-term debt can be diluted by further debt issuance.

This difference is reflected in the returns required by debt

holders. Thus it is cheaper for debtors to raise short-term loans.

But also: long-term debt avoids the risk of rollover crises.


The equilibrium maturity composition of debt reflects these

ingredients.

Some recent perspectives:

• Lender risk aversion: Asset holders may need to liquidate

their holdings of long-term debt prior to maturity at an

uncertain price, so they charge a risk premium to hold them

(Broner et al 2011)

The secondary-market price of long term debt is volatile

because future government revenues are uncertain.


• Hedging benefit of long-term debt for (risk-neutral)

borrowers: debtors can hedge against the risk of having to

issue debt in bad times – e.g., having to roll over the debt

at high rates (Arellano and Ramanarayanan 2012).

• Optimal choice of maturity under dilution and rollover

risk (Chatterjee and Eyigungor 2012)


Consider the case of risk-averse lenders who want to hedge the

risk of lending long term. (Broner et al 2011)

The government transfers part of the rollover risk to investors by

issuing some long-term debt.

The optimal maturity composition of debt results from risk-

sharing equilibrium between lenders and borrowers.

Funds supply shocks: the higher investor risk-aversion, the

higher the term premium and the shorter the maturity of debt.

Funds demand shocks: the lower expected future fiscal revenues,

the higher the term premium.

These model predictions are tested using foreign-currency bond

price and quantity data for 8 emerging markets, 1990-2003.


The term premium is usually positive


The term premium usually rises in crisis periods


But with extreme turbulence there are reversals…


…with extreme turbulence there are reversals…

Selected Euro Area countries 10-year

government bond spread vs Bund (basis points)

Source: Bloomberg

-500

0

500

1,000

1,500

2,000

Jan-9

5

Aug-9

5

Mar

-96

Oct

-96

May

-97

Dec

-97

Jul-

98

Feb

-99

Sep

-99

Apr-

00

Nov-0

0

Jun-0

1

Jan-0

2

Aug-0

2

Mar

-03

Oct

-03

May

-04

Dec

-04

Jul-

05

Feb

-06

Sep

-06

Apr-

07

Nov-0

7

Jun

-08

Jan-0

9

Aug-0

9

Mar

-10

Oct

-10

May

-11

Dec

-11

Jul-

12

Feb

-13

Portugal Ireland Italy Greece Spain


Selected Euro Area countries 2-year

government bond spread vs Bund (basis points)

Source: Bloomberg

-500

0

500

1,000

1,500

2,000

Jul-

97

Jan-9

8

Jul-

98

Jan-9

9

Jul-

99

Jan-0

0

Jul-

00

Jan-0

1

Jul-

01

Jan

-02

Jul-

02

Jan-0

3

Jul-

03

Jan-0

4

Jul-

04

Jan-0

5

Jul-

05

Jan-0

6

Jul-

06

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Jul-

13

Portugal Ireland Italy Greece Spain



Crises make a significant difference for the term premium – in

all cases and crisis definitions.


Adding some standard controls does not change the result


In turbulent periods countries issue less long-term debt (but

there is no significant effect on short-term)


Borrower hedging: alternative perspective highlighting the

hedging benefit of long-term borrowing for debtors

(Arellano and Ramanarayanan 2012).

Lenders are risk-neutral, and borrowers hedge against the

risk of having to issue debt at high rates in bad times.


Setup: to keep thinks tractable, model long-term debt as a

perpetuity with coupon payments that decay geometrically

at rate 0 < δ < 1.

[This helps avoid having to keep track of how much debt

was issued when]

1

1

1

1

price of the perpetuity at issue

what the borrower collects

payment due in period

total payment due (=long-term debt stock) at time t

law of motion

t

t t

n

t

tj

Lt t j

j

Lt Lt t

q

q

t n

b

b b

of long-term debt


The rest of the setup is similar to Arellano (2008):

'

'

( , , ) max ( , , ), ( )

( ) ( ) (0,0, ') (1 ) ( ') ( , ') ' default value

( , , ) max ( ) ( , , ) ( , ') ' continuation value

( ' , '

o c d

S L S L

d def o d

y

c c

S L S L

y

S L S S L

v b b y v b b y v y

v y u y v y v y f y y dy

v b b y u c v b b y f y y dy

c y b b q b b

, ) ' ( ' , ' , ) ' consumption

( , ) : ( , , ) ( ) default set

( , ) : ( , , ) ( ) repayment set

S L S L L

c d

S L S L

c d

S L S L

y b q b b y b

D b b y Y v b b y v y

R b b y Y v b b y v y


( ' , ' )

( ' , ' )

1 Pr[ ]( ' , ' , ) ( , ') '

1 * 1 *

1( ' , ' , ) 1 ( ' , ' , '), ( ' , ' , '), ' ( , ') '

1 *

where are the policy functions characterizing debt

S L

S L

S S L

R b b

L S L L S S L L S L

R b b

j

repaymentq b b y f y y dy

r r

q b b y q b b b y b b b y y f y y dyr

b

issuance.

The pricing of debt by risk-neutral competitive lenders is :

The important thing to note is the extra item in the long-term

debt price: purchasing long debt today yields a payment of 1

tomorrow, plus remaining debt worth δq’L.

Facing these prices, the borrower’s optimal decision regarding

short- and long-term borrowing yields first-order conditions:


1 ' '( ') '

1 ' ' '( ') '

'''( ) 1 (1 *) '( ') '

' '

'''( ) 1

' '

(1 *) '( ') ' L

L

L LS S L

S S S S

L LS S L

L L L L

E q u c R

E q R E u c R

b bb q qu c r E u c R

q b q b

b bb q qu c

q b q b

r E u c R

The LHS of both first order conditions captures the effects of

issuing debt on the incentives to repay.

• the price of S-T debt depends on incentive to repay tomorrow

• the price of L-T debt depends also on the decision to borrow again

tomorrow: if it is positively related to today’s debt, then the price of L-

T debt is more sensitive to debt volumes than the S-T price – so S-T

debt provides a stronger incentive to repay.

The RHS of the L-T FOC captures its hedging benefit.


1 ' , '( ') ' 0LCov q u c R

The hedging benefit arises when

i.e., when across repayment states low consumption is

accompanied by low debt prices – L-T bonds are then a good

hedge because their value falls in bad times.

This does not apply to S-T debt because its future value does

not change across states.

Hence a risk-averse borrower will generally issue both types of

debt.

The optimal maturity structure of borrowing is achieved by

equating the incentive to repay of L-T debt, relative to that of

ST debt, to the hedging benefit of L-T debt.

The relative incentive benefit (higher incentive to repay) of

short-term debt reflects the fact that it cannot be ‘diluted’ by

more borrowing. In contrast, the price of L-T depends on

future borrowing.

Short-term debt has a disciplining effect – lenders can liquidate

it early in bad states, so they are willing to lend larger amounts,

at lower spreads, than L-T debt.

L-T debt allows hedging future fluctuations in consumption

coming from changes in default risk.


The paper performs some numerical exercises calibrated to

Brazil to test its ability to replicate the maturity structure of

debt and spreads.


The model underpredicts the average slope of the spread curve,

as well as the average level of spreads at times of high short

spreads (= turbulence).


The model matches the comovement of duration and spreads,

but underpredicts the average duration of new debt


In the model, the relative incentive of ST debt is higher when

spreads rise. Maturity shortens when short spreads rise more

than long spreads – same as in the data.


Other simulations adding risk-averse lenders improve the fit of

spreads but worsen the fit of debt quantitites.

Optimal maturity choice: Chatterjee and Eyigungor (2012)

• Framework similar to Arellano and Ramanarayanan (2012).

Long-term debt is a better hedge against output shocks, but

more expensive than ST debt due to debt dilution.

In baseline model, dilution effect dominates and welfare is

decreasing in maturity!

Adding a small probability of self-fulfilling rollover crises

changes the result.

• Long-term debt limits vulnerability

• With short-term debt only, government must reduce borrowing to

limit vulnerability, and this turns around the welfare result.



Sovereign theft

Why limit the focus to sovereign debt default? Think also of

sovereign expropriation of foreign investment: more

broadly, “sovereign theft” (Tomz and Wright 2010).

Expropriation risk affects all investments – but especially

foreign investment due to the lack of strong supranational

institutions.

Define expropriation as any of “nationalization, coerced

sale to government, intervention or requisition, or unilateral

contract renegotiation”.

Problem: data available only for countries with U.S. FDI

positions.


Some stylized facts:

-- Like default, expropriation has tended to occur in waves.

-- Waves of default and expropriation have not coincided.

Expropriations were most common in the 1970s, and at

the end of the sample.

-- Since the 1970s were a period of boom for LDCs, this

means that expropriation does not happen more often in

bad times, unlike default (consistent with theory)

-- Across developing countries, most have either defaulted

and expropriated, or neither.


What are the determinants of expropriation?

• Since traditional debt stipulates fixed payments, the

incentive to default is highest when resources are most

limited – in bad times.

• Equity involves payments that correlate with the

business cycle. The incentive to expropriate depends on

the relative value placed on resources at bad times:

-- if it is very high, it still leads to expropriation (out of

“desperation”) even though payments are low

-- if it is about the same as in booms, then the incentive

is to expropriate in good times when payments are

large (“opportunism”)


Analytically, assume the foreign investor has the right to a

share α of total output, itself subject to a stochastic

shock θ. The capital stock k is chosen before the shock

is realized. Then default is optimal if

Here PE is an additional benefit (“prize”) of not defaulting –

e.g., continued access to future investment, avoidance of

sanctions, etc. Let


Then expropriation occurs when

If the elasticity of substitution is greater than 1, the LHS

rises with the productivity shock, so expropriation is

more likely in good times (“opportunism”). The

opposite happens if it is less than 1 (“desperation”).

How does this work in practice ? Numerical simulations

comparing the expropriation model with an Arellano-

like sovereign default model.


The probability of expropriation in bad times is lower than that of

default because of the better risk-sharing that equity provides.


If default on one asset makes you lose both prizes, you tend to

default on both or none. But this is not what we see in the data.


What does all this imply for the structure of foreign asset

positions ?

Because equity contracts are state-contingent, theory

implies that they should face lower probabilities of

sovereign theft by risk-averse borrowers.

Hence we should see a predominance of equity and FDI

finance over debt in international markets – which was

not the case in the past, but is changing now…


The timing of default

Theoretical models predict that defaults should happen in

‘bad times’, and conversely for expropriation – is this right?

Tomz and Wright 2008: look at episodes of sovereign

default over 1820-2004 in 175 countries.

Defaults are taken to include reschedulings and

renegotiations, and are assumed to last until there is

agreement with a majority of creditors.

This yields 169 default episodes. Bunching especially

around the 1980s.

H-P filter to define good and bad times.


In Argentina and Chile, bad times are neither necessary nor

sufficient for default to occur.


Overall, default occurs more frequently in bad times – but the relationship is

not strong: more than 1/3 of defaults begin in good times.

Severe downturns are more closely tied to defaults – these are twice more

likely when output is 7% or more below trend.


They also simulate the Aguiar-Gopinath (2006) model to

check its predictions about the timing of default.

The two versions of the model (temporary and permanent

shocks) yield a much tighter relation of default with output:

With temporary shocks, default begins with output below trend

100% of the time.

With permanent shocks, 85% of the time

In reality, it is only 62 percent.

The predicted magnitude of the output shortfall at the onset of

default is also much bigger than the 1.4% observed.

One possible reason for these discrepancies is that other

factors besides output (e.g., political conditions, world

interest rates…) also matter for default.


Eden et al (2013): look at the correlates and timing of both

default and expropriation.

They use a large dataset covering 192 countries over 1970-

2004.

Both kinds of events tend to happen in the same countries,

but they rarely happen at (or around) the same time.


Summarizing:

In the short run, default tends to be preceded by rapid debt

accumulation (like in Reinhart-Rogoff).

• It also tends to be preceded by slow growth.

• Defaults are not very persistent over time – i.e., (recent)

past default is not a good predictor of upcoming default.

In contrast, expropriation does not appear to be related to

the existing FDI stock.

• Nor is it systematically preceded by slow growth.

• But expropriation is strongly persistent – the best

predictor is an earlier expropriation occurring in the past

5 years.


The cost of sovereign default

Theoretical models typically assume that default is punished

by subsequently higher borrowing costs, up to full exclusion

from financial markets.

But casual evidence suggests that countries typically regain

access to credit fairly quickly – as quickly as a couple of years

after default.

What does the less-casual evidence show?


Cruces and Trebesch (2012): detailed analysis of a large

dataset on creditor losses (‘haircuts’) from default /

restructuring episodes.

Sovereign default is in fact a robust predictor of subsequent

borrowing conditions – once the extent of haircuts is taken

into account.

Data: all sovereign debt restructurings 1970-2010.

Haircut defined by the percentage difference between the old

and new (if any) debt obligations.


The simplest haircut measure at the time of a restructuring is

HF = 1 – (Face value of new debt / Face value of old debt)

But this is a poor indicator because it does not capture the

haircut implied by, e.g., a lengthening of maturity.

The most common haircut measure is

HM = 1 – (PV of new debt / Face value of old debt)

with the PV computed at the post-default market rate.

This overstates haircuts by assuming the old debt was due in

full on the date of debt exchange. A better measure (used

in the paper) is

HSZ = 1 – (PV of new debt / PV of old debt)


Haircuts show large and increasing dispersion.


Face-value reduction has become increasingly common, and it

usually leads to larger haircuts than pure restructuring.


Theoretical models of default typically assume 100% haircuts.

– seldom seen in reality.

To assess the effects of default, examine two questions:

(1) Do larger haircuts lead to larger yield spreads after

restructuring?

(2) Do larger haircuts lead to longer periods of exclusion from

credit markets?

For (1), look at EMBI Global spreads (relative to those of non-

defaulters). Break into two groups (haircut above and below

the median of 37%).

There is a clear difference between the spreads after low and

high haircuts – especially after 3+ years.


Also, run regressions of EMBIG spreads on haircut size and

other variables.

If haircut size is ignored, spreads only seem to be affected for

a couple of years after restructuring – the standard finding

that ‘all is quickly forgotten’.

Putting in haircut size makes a big difference: a 1% extra

haircut raises spreads 6.75 bp after 1 year, and still 3 bp in

years 4-5.

A haircut of 40% (close to the mean) raises spreads by 140 bp

the first year and 127 bp 4-5 years after.

Adding restructuring dummies and controls does not take

away the significance of haircut size.


For the effect of haircut size on market exclusion, define

‘reaccess’ as the first year with an international loan or

bond placement and/or international credit flows to the

public sector.

Bigger haircuts lead to longer periods of exclusion.


A Cox hazard model confirms the adverse effect of haircut

size on reaccess.


The cost of sovereign default and the financial system

The conventional assumption is that the defaulted sovereign

debt is held by outsiders (foreigners) whose welfare does

not matter.

In reality, much debt is held by domestic agents, and

‘discriminatory default’ is in most cases not feasible – so

default also imposes a welfare cost on them.

Locals may end up holding the debt through secondary

market transactions, in which case default hurts primarily

domestic savers (Broner et al 2010).


Source: Broner et al (2014)


Government debt held by banks, 2010

In reality, much of the outstanding sovereign debt is

typically held by banks.


Sovereign debt holdings, by sector (% of total)


Argentine banks' exposure to a default


Greek banks' exposure to a default


Peripheral European Banking System Exposure to their

Own Government and Private Sector, 2011 Q1(in percent of banking system equity)

0 200 400 600 800 1000 1200

Greece

Ireland

Portugal

Own Government

Own Private Sector

Kuala Lumpur 2016 --

Luis Servén

155


When domestic banks hold much of the debt, sovereign

default weakens bank balance sheets and leads to a credit

crunch – and a growth decline.

Gennaioli, Martin and Rossi (2014): these domestic costs of

default encourage debt repayment, quite aside of reputation

and/or market exclusion effects.


Two issues to explore:

(1) The cost of default

(2) The frequency of default

Two potential drivers:

-- Banks’ public debt holdings

-- The quality of financial institutions (higher quality allows

greater leverage and a bigger role for bank credit)

Panel data of emerging and developed countries over 1980 -

2005


Bigger holdings of public debt worsen the post-default

credit crunch

Subsequent work using bank-level data (Gennaioli et al 2016) yields

similar results.

Stronger financial institutions also worsen the crunch

because they typically result in higher leverage.

Once institutional quality and bank debt holdings are taken into account

(in interaction terms), default alone is not a significant predictor of

credit crunches.

Other regressions show that larger bank debt holdings (and better

financial institutions) ceteris paribus reduce the likelihood of sovereign

default – in line with the arguments on the cost of default.

All this is quite consistent with what we currently see in Europe…


Bigger bank holdings of debt reduce the frequency of default


Financial repression

Default (or restructuring) is only one way to reduce high

sovereign debt/GDP ratios. Historically there have

been others:

(1) Growth

(2) Fiscal adjustment

(3) Surprise inflation

(4) Financial repression, often along with steady

inflation

The various options are usually found in combination

But (4) and (5) only work for domestic-currency debt


Financial repression involves the payment of below-

market rates on public debt, allowed by

– mandatory holdings of public debt by major

lenders (e.g., pension funds, banks…) often

imposed by ‘prudential regulation’

– interest rate ceilings or controls

…in general, a tight connection between government

and lenders

It played a big role to reduce the large debt stocks of rich

countries post-WWII (in contrast with the defaults

that help reduce post-WWI debts).


Financial repression combined with inflation can lead to

negative real interest rates and ‘debt liquidation’

A transfer from lenders to borrowers (the government)

Over 1945-80 real interest rates were negative on

average in both advanced and emerging countries.


How big was the liquidation effect of financial

repression? Think of it as an implicit tax revenue.

Source: Reinhart and Sbrancia (2011)


Financial repression is likely to be very tempting to rich-

country governments facing massive debt stocks.

Repression may re-emerge disguised as ‘prudential

regulation’ of banks, pension funds and other

intermediaries forcing them to hold public debt.

Some argue that the decoupling of public debt prices (or

interest rates) and risk is already happening through

intervention of Central Banks and other non-market

players across the world…

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