Country risk and political instability

A model of country risk for foreign borrowing is proposed and estimated which incorporates a political instability variable. The model predicts historically high probabilities of default for most of the actual default dates for six countries. This is suggestive of how to understand the phenomenon of foreign debt default.     

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 relevance of supply shocks for inflation: the spanish case

A retrenchment in crossborder credit is under way, the product of both market forces and political pressure on international banks to lend at home (Economist, 2009). In addition, banks, particularly the largest, have also dramatically expanded their retail banking operations over the past few years (Hirtle and Stiroh, 2007). Our goal, in this article, is to study the effects of default risk on equity returns through bank interest margin management under a renewed focus on domestic retail banking, a trend often attributed to the stability of banking activities. Specifically, this article explores the determinants of optimal bank interest margins based on an option-based firm-theoretical model with multiple sources of structural breaks due to political pressure. The model demonstrates how capital regulation and political pressure on foreign lending return and risk conditions jointly determine the optimal bank interest margin decision. We show that a more stringent capital requirement is linked with lower equity return, but higher default risk of the bank in the return to domestic retail banking. An increased focus on the political pressure on foreign lending return is linked with higher equity return and default risk of the bank. It is also showed that an increased focus on the political pressure on foreign lending risk decreases the bank's equity return and default risk. We conclude that the return to domestic retail banking may be a relatively stable activity when the political pressure decision impacts only the expected risk of the bank's foreign lending and not the return.     

Competitive equilibria with limited enforcement

We show how to decentralize constrained efficient allocations that arise from enforcement constraints between sovereign nations. In a pure exchange economy these allocations can be decentralized with private agents acting competitively and taking as given government default decisions on foreign debt. In an economy with capital these allocations can be decentralized if the government can tax capital income as well as default on foreign debt. The tax on capital income is needed to make private agents internalize a subtle externality. The decisions of the government can arise as an equilibrium of a dynamic game between governments.     

Sovereign debt spread and default in a model with self-fulfilling prophecies and asymmetric information

The euro area sovereign debt crisis has renewed interest in government credibility and the risk of default. Recent empirical evidence has shown that the sharp increase in government bond yields cannot be attributed entirely to changes in macroeconomic fundamentals. Contagion effects can occur, and self-fulfilling speculation may arise. In this paper, we develop a theoretical model in the spirit of the second-generation currency crisis models developed by Obstfled (1996). The model describes a strategic game between governments and private investors. Euro area countries face a trade-off as governments may either commit to and implement restrictive fiscal policies or default on debt. The commitment strategy may not be optimal if the fundamentals deteriorate. The policy maker lose part of their credibility, and governments are forced to default. In addition, we introduce uncertainty about the cost of default in the model, which is then able to account for a greater variety of equilibrium. Thus, when the evaluation of the cost of default is asymmetric, prophecies are not always realized and default does not occur. Simulations of the model then show that it offers insights, and can help to account for the situations of Greece and Italy during the sovereign debt crisis.     

The pricing of risk in emerging credit markets: Bonds versus loans

Much of the volatility in emerging markets in the 1990s stems from the fact that the major form of foreign investment is the bond rather than the bank loans which predominated until the debt crisis of the 1980s. Bondholders are too dispersed to negotiate with during a liquidity shortfall. Thus, a shortage of reserves becomes a full-blown crisis. This was not the case in the 1980s when banks, as the major creditors, often lent to countries in arrears. The risk to a loan is therefore rescheduling, while the risk to a bond is default. Empirically pricing loans and bonds as assets reveals that bonds incorporate the greater risk of default into their spreads. Debentures are thus riskier credit than loans. As developing countries now obtain most finance through these risky instruments, the volatility of the 1990s is better understood.     

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.     

The democratic (dis)advantage: The conditional impact of democracy on credit risk and sovereign default

Many have argued that democracies are able to make credible commitments to repay their debts and consequently enjoy higher sovereign credit ratings. In contrast to this expectation, I argue that the advantage of democracies in credit ratings is conditional on the countries' level of financial vulnerability and adjustment needs. Because democracies have more diffuse decision-making and are more accountable to the public, they encounter greater difficulty than autocracies in passing unpopular economic adjustment measures. Thus, I argue that democracies with high debt levels and low foreign reserve assets experience worse credit outcomes, whereas democracies with low vulnerability experience more positive outcomes. In a sample of up to 96 developing countries, I show that democracies have worse credit ratings and CDS Spreads and are more likely to default than their autocratic counterparts when foreign reserves are low relative to external debt. Notably, I also show that large debt burdens increase credit risk mainly in more democratic countries. I further test the causal pathway of the democratic advantage by constructing democracy scores of “market-friendly” and “adjustment-difficulty” democracy, finding that democracy worsens debt outcomes due to adjustment difficulty. These findings help to revise and clarify the causal logic surrounding the democratic advantage hypothesis.     

Dollarization and financial integration

How does a country's exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government responds to shocks by adjusting monetary policy and foreign borrowing. Sovereign borrowing is subject to endogenous limits, which ensure repayment when the default punishment corresponds to financial autarky. Dollarizing implies renouncing monetary policy, but can make access to international debt markets more valuable, thereby loosening borrowing constraints. This mechanism linking dollarization to financial integration is consistent with observed declines in spreads on foreign-currency debt in countries adopting the dollar or the euro.     

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.     

OPTIMAL DEBT AND ENDOGENOUS GROWTH IN MODELS OF INTERNATIONAL FINANCE

The International Monetary Fund, the World Bank and the bond rating agencies did not anticipate the crises in Asia 1997–98 and in Argentina 2001 . With this statement in mind, we consider some multi-stage inter-temporal stochastic optimisation models in international finance that imply theoretically founded and empirically measurable Early Warning Signals. The mathematical technique is dynamic programming/stochastic optimal control (DP/SOC).
The variables of interest are the optimal foreign debt, consumption, capital and the growth rate of GDP. They are used as benchmarks of economic performance. By comparing the actual debt to the optimal debt we derive a measure of the sustainability of the debt and vulnerability to default problems. The two sources of uncertainty – the productivity of capital and the real interest rate on the foreign debt – are modeled as stochastic processes. Specific applications of the DP/SOC techniques are given for country defaults in Asia and Latin America, and the US current account deficits.     

Household’s optimal mortgage and unsecured loan default decision

How do households make optimal borrowing and default decisions when they have the option to borrow in multiple ways? In this paper, I analyze households’ optimal mortgage and unsecured loan borrowing and default decisions in the context of the recent recession. I model households as able to default on mortgage debt to walk away from capital losses, at the price of foreclosure. However, a household can also default on unsecured debt to maintain its home, in exchange for a longer exclusion from credit markets following default. Depending on the costs of each alternative, financially constrained households exhibit heterogeneity in optimal default decisions.Next, I analyze how mortgage loan modification policies, after a sudden drop in house prices, affect household choices in the mortgage and unsecured loan markets. The quantitative exercise shows that the government-driven mortgage modification program, initiated in 2009, reduces the mortgage default rate by 0.27% points. However, this increases the unsecured loan charge-off rate by 0.66% points.     

Domestic versus External Borrowing and Fiscal Policy in Emerging Markets

This paper presents a model of an emerging market sovereign that can selectively default on its domestic or external creditors. The two classes of creditors have different ways of punishing the government in the event of default, which in turn creates a differential in the sovereign's incentives to default on its domestic versus foreign creditors. We explore the extent to which the possibility of differential treatment of creditors affects the composition of debt. We find that a country characterized by volatile output, sovereign risk, and costly tax collection will want to borrow in domestic as well as in international markets.     

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.     

Financial Instability under a Flexible Exchange Rate*

Many governments in developing countries contemplate the possibility of increasing the flexibility of their exchange rates despite having accumulated substantial dollar‐denominated debt. Using a model of corporate dollar debt in which the future exchange rate is uncertain, this paper studies the financial risks that might arise as a consequence of increased exchange rate flexibility. Since a firm may default on its debt either because its dollar income is too low or because investors refuse to roll over its debt, the measure of the overall risk of default should take into account both factors, as well as their interaction. Solving the model for the no‐default rational expectations equilibrium, we find that a small risk of insolvency may bring about a substantial risk of illiquidity.     

Debt sustainability in emerging market countries: Some policy guidelines from a fan-chart approach

This paper uses a probabilistic approach to simulate the medium-term public debt trajectories of several major emerging market countries. We extend the standard debt sustainability analysis framework so as to more faithfully reproduce these countries’ economic reality in two aspects. First, we allow them to differ in the cyclical stance of their fiscal policy and in their degree of fiscal responsiveness to debt. Second, we explicitly integrate the specific risk premium paid by each country when borrowing in foreign currency. It allows us to evaluate the impact of alternative policies that the government may consider to improve sustainability. The results lead to three policy recommendations: i) a country should consider decreasing its exposure to currency risk only in extreme cases (like Argentina); ii) on the contrary, greater fiscal responsiveness (i.e. stronger fiscal tightening whenever there is a debt increase) could enhance sustainability to a much greater extent; iii) countries with low responsiveness to debt or a poor fiscal consolidation track record should be cautious with countercyclical fiscal policies, as they may trigger an unsustainable debt trajectory in the trough of the economic cycle.     

The perils of debt deflation in the Euro area: a multi regime model

Academic research and policy makers in the Euro area are currently concerned with the threat of debt deflation and secular stagnation in Europe. Empirical evidence seems to suggest that secular stagnation and debt deflation in the Euro area may be rather slowly developing. Yet what appears as major peril is that debt deflation with a lack of economic growth, rising real interest rates and further rising debt may trigger household defaults, defaults of firms and banks, rise of risk premia, and default risk of certain sectors of the economy or sovereign defaults. It is this rising default and financial risk that may lead to a regime change to a slowly moving debt crisis with high financial risk and high financial stress. In order to explore those issues, a macro policy model of Svensson type is introduced, exhibiting a regime of low and high financial stress. Then, a four dimensional multi-regime VAR is employed to an Euro area data set to support the theoretical model and the claim that in particular Southern Euro area countries are affected by debt deflation and financial market stress.     

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.     

Commodity Price Instability and Debt-linking by Developing Countries

Most developing countries borrow in world capital markets. Typically this borrowing is denominated in one of the major currencies and requires periodic servicing. The foreign exchange required to meet the service obligation is often dependent on the export of one or a small number of commodities. This demand usually competes with a number of other claims on export earnings, including both consumption and capital goods imports. This paper investigates the use of commodity-linked borrowing by developing countries. If the interest and/or principal payments on external debt are linked to the price of a country's principal exports, the risk of default can be shifted to better-diversified lenders. The social cost of linking is much smaller than that of other compensating arrangements. In addition, commodity-linked debt may reduce the borrower's direct lending costs. This will depend on the quantity of linked debt supplied and the dispersion of expectations about the future price of the commodity. If the supply is small relative to the demand among investors who expect the commodity price to increase, the resulting reduction in the cost of borrowing may be sufficient to offset the premium for bearing the risk associated with the commodity's future price.     

Counterparty effects on capital structure decision in incomplete market

This paper builds a static contingent-claim model that allows for examining the optimal capital structure with the joint arguments of counterparty default risk and market incompleteness. A first-passage-time model with jump default barrier is adopted to capture the counterparty effects on the pricing of defaultable claims. Following the framework of Jarrow and Yu (2001), the jump in primary firm's bankruptcy barrier is designed as the loss on capital resulted from secondary firm's bankruptcy. The relevance of market incompleteness in the context of claim-pricing is considered using “good-deal asset price bound” method by Cochrane and Saa-Requejo (2000). We show that the effects of counterparty's default clearly diminish the uses of debt, which indirectly explains the so-called under-leveraged puzzle. We further find that counterparty effects on capital structure are sensitive to market incompleteness and firm's characteristics, such as tax rate and bankruptcy cost rate.