Sovereign Debt without Default Penalties

We develop a theory of sovereign borrowing where default penalties are not implementable. We show that when debt is held by both domestic and foreign agents, the median voter might have an interest in serving it. Our theory has important practical implications regarding (a) the role of financial intermediaries in sovereign lending, (b) the effect of capital flows on price volatility including the possible overvaluation of debt to the point that the median voter is priced out of the market, and (c) debt restructuring where creditors are highly dispersed.     

One reason countries pay their debts: renegotiation and international trade

I estimate the effect of sovereign debt renegotiation on international trade. Sovereigns may fear the trade consequences of default; because creditors deter default, or because trade finance dries up. I use an empirical gravity model of trade and a panel data set covering 50 years, over 150 countries, and other factors that influence bilateral trade. Debt renegotiation is associated with an economically and statistically significant decline in bilateral trade between a debtor and its creditors. The decline in bilateral trade is approximately 8% a year and persists for around 15 years.     

Sovereign defaulters: Do international capital markets punish them?

We empirically study whether countries that default on their debt experience a reduction in their capital inflows, as suggested by the literature. Our data contain information on (i) the defaulter countries and their creditors and (ii) bilateral foreign direct investment (FDI) flows. With these we can study how FDI flows are affected by sovereign default by distinguishing between those flows coming from defaulters' creditor countries and others. According to our estimations, this distinction is crucial since the decline of FDI in flows after default is markedly concentrated on those flows originating in defaulters' creditor countries. The decay in FDI flows is higher in the years closer to the default date and for countries that have defaulted more times. We do not find evidence that countries shut their doors to defaulters' investment abroad, which is also a cost of default suggested in the literature.     

The sovereign spread in Asian emerging economies: The significance of external versus internal factors

This paper investigates the dynamic relations between external factors, domestic macroeconomic factors with sovereign spreads, debt to GDP ratio, etc. in Asian emerging countries. First, we develop a theoretical model that determines the equilibrium debt level, probability of default and sovereign spread and draw empirical implications. We then employ a Structural Vector Autoregression (SVAR) model to investigate empirically how the spread of sovereign debt is influenced over time by both external and domestic factors. The empirical results show that variations in sovereign spreads are mainly driven by external shocks, with the term structure of US interest rate and the global risk aversion having the most important role. The findings also indicate that shocks from the US have a direct effect on sovereign spread and an indirect effect via domestic macroeconomic fundamentals. Finally, the evidence produced validates the presence of some response patterns of sovereign spread to the external shocks.     

Evaluating sovereign risk spillovers on domestic banks during the European debt crisis

Using a Markov-switching model with time-varying probabilities, spillovers from sovereign to domestic bank CDS spreads during the European debt crisis for a set of 14 European countries and 30 European banks are investigated. Our model is able to capture how the increased sovereign risk observed between 2010 and 2013 throughout Europe has impacted i) the probability that banks fall into a crisis regime and ii) the probability that banks stay in the crisis regime. The latter state is characterized by a high volatility and large positive returns of CDS spreads. Different regime-dependent indicators have been computed to assess heterogeneity within the region. The evidence indicates that the intensification of sovereign risk observed during the European debt crisis has positively and significantly driven the regime shifts in volatility of the bank CDS spreads due to increased risk aversion. The results show that the increase in sovereign credit risk seems to have generated second-round effects for some banks that have experienced a deterioration in their funding conditions due to a rise in the domestic sovereign default risk. Overall, our results suggest that sovereign CDS spreads can be considered good forewarning indicators for predicting the evolution of bank CDS spreads. We also find that the effects differ depending on the country and the financial institution. This result suggests that banks are heterogeneously exposed to sovereign credit risk within the same country. One argument relates to the size of these financial institutions and the domestic exposure to sovereign debt.     

European policy and markets: Did policy initiatives stem the sovereign debt crisis in the euro area?

We investigate how European policy initiatives influenced market assessments of sovereign default risk and banking sector fragility during the sovereign debt crisis in four adversely affected countries — Portugal, Ireland, Spain and Italy. We focus on three broad groups of policies: (a) ECB policy actions (monetary and financial support), (b) EU programs (financial and fiscal rules as well as financial support in crisis countries), and (c) domestic austerity programs. We measure immediate market impact effects: what policies changed risk perceptions, using CDS spreads on sovereign bonds and banks in this assessment. We employ dynamic panel and event study methodologies in the empirical work. We find that a number of programs initially stabilized sovereign and bank bond markets (e.g. Outright Monetary Transactions program), although announcement and implementation impacts on markets differed in some cases (e.g. second Covered Market Bond Program). Actions designed to shore up sovereign markets often lowered risk assessments in bank bond markets and policies designed to ensure safety and soundness of the European banking system in some cases significantly impacted sovereign debt markets. Finally, a number of policies designed to stabilize markets had surprisingly little immediate impact on either sovereign or bank bond market risk assessments.     

Increase in home bias in the Eurozone debt crisis: The role of domestic shocks

One of the most striking consequences of the recent episode of sovereign debt market stress in the Eurozone has been the increase in the share of public debt held by the domestic sector in fragile economies. However, the causes and potential consequences of this increase were only given scarce attention in the literature on the Euro area sovereign debt crisis. In order to fill this gap, we first determine the shocks that impact the variation in the share of sovereign debt held at home in an SVAR model on a sample of Eurozone countries between 2002 and 2014, distinguishing between external and domestic shocks. Thanks to several alternative tests, we show that home bias in sovereign debt responds positively to country-specific fundamentals and expectation shocks but we find no evidence that the increase in home bias is destabilizing per se in the short-run. Second, a stylized theoretical model backed by the empirical results predicts that the consequences for sovereign debt crisis depend on the relative impact of domestic initial destabilizing shocks and increased home bias. The analysis suggests that an increase in home bias in times of sovereign debt stress, despite reflecting deteriorating fiscal conditions, may make default less likely.     

Fiscal limits and monetary policy: default vs. inflation

This paper studies the monetary policy trade-off between low inflation and low sovereign risk in the environment where fiscal authorities fail to fully ensure the sustainability of government debt. Building on the Fiscal Theory of Price Level (FTPL) and the Fiscal Theory of Sovereign Risk (FTSR), this paper differs in its baseline assumption about the monetary policy objective, which is neither to rule out defaults regardless of inflation costs (as in FTPL), nor to follow inflation targeting regardless of associated sovereign risk (as in FTSR). Instead, we study the case in which the central bank controls the risky interest rate to minimize the probability of default while ruling out large inflation hikes. We show that this policy regime can mitigate default risks only when the central bank is expected to allow sufficient increases in inflation. When agents believe that the central bank's tolerance toward inflation hikes has increased, equilibrium risk premium goes down, suggesting that information concerning changes in the central bank's preferences over inflation directly impacts default risks.     

Modeling Guarantees,Over-Indebtedness and Financial Crises in an Open Economy

This work develops a simple framework to analyse how financial intermediaries’ balance sheet problems combined with financial guarantees make an economy more vulnerable to financial crises. A ‘double default’ problem – that is, the default of financial intermediaries on their debt repayments and of the government on its guarantees to bailout intermediaries’ losses – is modelled in this study. The possibility of multiple equilibria, including a crisis equilibrium where the government is not able or willing to honor its guarantees towards the domestic financial sector, arises from the interplay of all the above elements: financial intermediaries’ level of indebtedness, government implicit guarantees and high-risk creditors’ lending. This work also produces predictions concerning the vulnerability to a financial crisis: multiple equilibria are possible only in certain ranges of the fundamentals.     

Sovereign default risk and decentralization: Evidence for emerging markets

We study the impact of decentralization on sovereign default risk. Theory predicts that decentralization deteriorates fiscal discipline since subnational governments undertax/overspend, anticipating that, in the case of overindebtedness, the federal government will bail them out. We analyze whether investors account for this common pool problem by attaching higher sovereign yield spreads to more decentralized countries. Using panel data on up to 30 emerging markets in the period 1993–2008 we confirm this hypothesis. Higher levels of fiscal and political decentralization increase sovereign default risk. Moreover, higher levels of intergovernmental transfers and a larger number of veto players aggravate the common pool problem.     

Sovereign Liquidity Crises: The Strategic Case For a Payments Standstill

Is sovereign borrowing so different from corporate debt that there is no need for bankruptcy-style procedures to protect debtors? With the waiver of immunity, sovereign debtors who already face severe disruption from short-term creditors grabbing their currency reserves are also exposed to litigious creditors trying to seize what assets they can in a 'race of the vultures'.
The lack of an orderly procedure for resolving sovereign liquidity crises means that the IMF is de facto forced to bail out countries in trouble. The strategic case for legalising standstills is to rescue the international financial system from this 'time consistency' trap.     

Exchange rate policy under sovereign default risk

We examine monetary policy options for a small open economy where sovereign default might occur due to intertemporal insolvency. Under interest rate policy and floating exchange rates the equilibrium is indetermined. Under a fixed exchange rate the equilibrium is uniquely determined and independent of sovereign default.     

CREDIT RATING AND DEBT CRISES

We develop an equilibrium theory of credit rating in the presence of rollover risk. By influencing rational creditors, ratings affect sovereigns' probability of default, which in turn affects ratings. Our analysis reveals a pro‐cyclical impact of credit rating: In equilibrium the presence of a rating agency increases default risk when it is high and decreases default risk when it is low.     

Sovereign default risk and state-owned bank fragility in emerging markets: evidence from China and Russia

In this paper we investigate the interdependence of the sovereign default risk and banking system fragility in two major emerging markets, China and Russia, using credit default swaps as a proxy for default risk. Both countries’ banking industries have strong ties with their governments and public sector, even after a series of significant reforms in the last two decades. Our analysis is built on the case studies of each country’s two biggest banks. We employ a bivariate vector autoregressive (VAR) and vector error correction (VECM) framework to analyse the short- and long-run dynamics of the chosen CDS prices. We use Granger causality to describe the direction of the discovered dynamics. We find evidence of a stable long-run relationship between sovereign and bank CDS spreads in the chosen time period. The more stable relationship is found in cases where the biggest state-owned universal banks in emerging markets are closely managed by the government. But the fragility of those banks does not directly affect the state of public finances. However, in cases where state-owned banks directly participate in large governmental projects, banking fragility may result in the deterioration of state funds, while raising the risk of sovereign default.     

Sovereign default risk and volatility

In a model of sovereign debt with endogenous default, we find a non-monotonic relationship between default risk and volatility, reflecting a trade-off between prudence and the insurance value of default. We show that this feature also holds in the data.     

Sudden Stops,Time Inconsistency,and the Duration of Sovereign Debt

We study the sovereign debt duration chosen by the government in the context of a standard model of sovereign default. The government balances off increasing the duration of its debt to mitigate rollover risk and lowering duration to mitigate the debt dilution problem. We present two main results. First, when the government decides the debt duration on a sequential basis, sudden stop risk increases the average duration by 1 year. Second, we illustrate the time inconsistency problem in the choice of sovereign debt duration: governments would like to commit to a duration that is 1.7 years shorter than the one they choose when decisions are made sequentially.     

Sovereign Default Risk and Recovery Rates: What Government Bond Markets Expect for Greece

Bond market data on sovereign bond yields is used to estimate sovereign default risk and the amount of the expected “hair‐cut” for Greece between 2008 and 2011. Using a structural pricing model that relies on compound option theory short‐term and long‐term default probabilities and their dependencies can be inferred. Thereby bond yield spreads for different maturities are integrated. In addition, a reduced form model is applied to infer the recovery rate expected by bond market participants. The paper shows that sovereign default risk and recovery rate dynamics reflect events that are important for Greece's repayment capacity.     

Sovereign credit ratings,growth volatility and the global financial crisis

Using monthly data from January 1996 to May 2010 for a panel of 76 developed and emerging economies and adopting an instrumental variable (IV) estimation technique by correcting for both heterogeneity and endogeneity with the generalized two-stage least squares (G2SLS, EC2SLS) procedure method suggested by Balestra and Varadharajan-Krishnakumar (1987) and Baltagi and Li (1995), this article provides empirical evidence that volatility of per capita GDP growth is reduced when there are positive changes in credit ratings; in other words when sovereign credit risk improves. To deal with potential simultaneity between sovereign credit ratings and output volatility, a system (3SLS) approach is undertaken, and our findings remain robust. By weakening the volatility dampening effects of ratings changes, it is found that the global financial crisis (GFC) has enhanced macroeconomic volatility. One of the channels via which sovereign rating changes affect growth volatility is the financial markets’ repricing of sovereign default risk that is reflected in sovereign credit default swap (CDS) spreads and its volatility.     

PIGS or Lambs? The European Sovereign Debt Crisis and the Role of Rating Agencies

This paper asks whether rating agencies played a passive role or were an active driving force during Europe??s sovereign debt crisis. We address this by estimating relationships between sovereign debt ratings and macroeconomic and structural variables. We then use these equations to decompose actual ratings into systematic and arbitrary components that are not explained by previously observed procedures of rating agencies. Finally, we check whether systematic, as well as arbitrary, parts of credit ratings affect credit spreads. We find that both do affect credit spreads, which opens the possibility that arbitrary rating downgrades trigger processes of self-fulfilling prophecies that may drive even relatively healthy countries towards default.     

The effect of political factors on sovereign default

This aricle examines the effect of political factors on sovereign default. Using a theoretical model, we find that political instability increases the likelihood of default. To test this theoretical implication, we use a panel logit model to estimate the effect of long- and short-run political factors, along with other macroeconomic variables, on the probability of default. Data from 68 developed and developing countries between 1970 and 2010 is used to conduct the study. Our findings suggest that a country is more likely to default when (i) it has a relatively younger political regime in place; (ii) it faces a higher chance of political turnover; and (iii) it has a less democratic political system. Economic factors are also vital; a country with stronger growth and less external debt is less likely to experience sovereign default. Robustness tests using alternative measures of political risk, trade balance and EMBI sovereign bond spreads also support the baseline findings.