News and sovereign default risk in small open economies

This paper builds a unified model of sovereign debt, default risk, and news shocks. News shocks improve the quantitative performance of the sovereign default model in a number of empirically-relevant dimensions. First, with news shocks, not all defaults occur during downturns. Second, the news shocks help account for key differences between developing and more developed economies: as the precision of news improves, the model predicts lower variability of consumption, less countercyclical trade balance and interest rate spreads, as well as a higher level of debt in line with more developed economies. Third, the model captures the hump-shaped relationship between default rates and the precision of news obtained from the data. Finally, the news shocks have a nonmonotonic effect on welfare.     

Sovereign defaults and liquidity crises

Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises. The conventional view is that the domestic turmoil is the consequence of foreign retaliation, although there is no clear empirical evidence on “classic” default penalties. This paper emphasizes, instead, a direct link between sovereign defaults and liquidity crises building on two natural assumptions: (i) government bonds represent a source of liquidity for the domestic private sector and (ii) the government cannot discriminate between domestic and foreign creditors in the event of default. In this context, external debt emerges even in the absence of classic penalties, and government default is countercyclical, triggers a liquidity crunch, and amplifies output volatility. In addition, a reform that involves a substitution of government bonds with privately-sourced liquidity instruments could backfire by restricting governments' access to foreign credit.     

Analytics of sovereign debt restructuring

This paper develops a simple theoretical model to analyse recent proposals on restructuring of sovereign bonds. We find that collective action clauses (CACs) inserted in bonds resolve the inefficiencies caused by intra-creditor coordination problems providing that all parties have complete information about each other's preferences. In such a world, statutory mechanisms, such as international bankruptcy courts, are unnecessary. This is no longer the case when the benefits from reaching a restructuring agreement are private information to the debtor and its creditors due to inefficiencies caused by the debtor-creditor bargaining problem.     

Optimal reserve management and sovereign debt

Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the reserve accumulation does not play a quantitatively important role in this model. In fact, we find the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.     

Renegotiation, collective action clauses and sovereign debt markets

Collective action clauses (CACs) are provisions specifying that a supermajority of bondholders can change the terms of a bond. We study how CACs determine governments' fiscal incentives, sovereign bond prices, and default probabilities in environments with and without contingent debt and IMF presence. We claim that CACs are likely to be an irrelevant dimension of debt contracts in current sovereign debt markets because of the variety of instruments utilized by sovereigns and the implicit IMF guarantee. Nonetheless, under a new international bankruptcy regime like that recently proposed by the IMF, CACs can increase significantly the cost of borrowing for sovereigns, contrary to what is suggested in previous empirical literature.     

Currency mismatches and monetary policy: A tale of two equilibria

We develop a model of a small economy whose residents choose whether to borrow in domestic or foreign currency. The central bank, in turn, chooses fixed or flexible exchange rates, taking the currency denomination of debts as given. We characterize the simultaneous determination of portfolios and exchange rate regime. Both floating and fixed rates can occur as equilibrium outcomes. “Fear of floating” may emerge endogenously and in association with a currency mismatch in assets and liabilities. If equilibria with both fixed rates and floating rates coexist, the latter is Pareto superior. Lessons for current “de-dollarization” proposals are discussed.     

“Rules of thumb” for sovereign debt crises

This paper investigates the economic and political conditions that are associated to the occurrence of a sovereign debt crisis. We use a new statistical approach (Classification and Regression Tree) that allows us to derive a collection of “rules of thumb” that help identify the typical characteristics of defaulters. We find that not all crises are equal: they differ depending on whether the government faces insolvency, illiquidity, or various macroeconomic risks. We also characterize the set of fundamentals that can be associated with a relatively “risk-free” zone. This classification is important for discussing appropriate policy options to prevent crises and improve response time and prediction.     

Gunboats, reputation, and sovereign repayment: lessons from the Southern Confederacy

Many states that formed the Southern Confederacy defaulted on sovereign debt sold in international capital markets during the 1840s. The Confederacy also elected President Jefferson Davis, who openly advocated the repudiation of U.S. states' debts while a member of Congress. Despite its poor credit record, the Confederate government managed to float cotton bonds in England that constituted under 2% of its expenditures. The bonds were largely issued to settle overdue debts with gun contractors who had cut off trade credit. The South serviced the bonds as late as March 1865, a time of domestic hyperinflation and weeks before the fall of Richmond. Although the Confederate experience shows that trade sanctions can promote debt repayment, the gunboat model can only account for a small amount of lending. A reputation or another type of sanction would be necessary to support higher levels of lending in international capital markets.     

Private capital flows, capital controls, and default risk

What has been the effect of the shift in emerging market capital flows toward private sector borrowers? Are emerging market capital flows more efficient? If not, can controls on capital flows improve welfare? This paper shows that the answers depend on the form of default risk. When private loans are enforceable, but there is the risk that the government will default on behalf of all residents, private lending is inefficient and capital controls are potentially Pareto-improving. However, when private agents may individually default, capital flow subsidies are potentially Pareto-improving.     

Relative price volatility under Sudden Stops: The relevance of balance sheet effects

Sudden Stops are associated with increased volatility in relative prices. We introduce a model based on information acquisition to rationalize this increased volatility. An empirical analysis of the conditional variance of the wholesale price to consumer price ratio using panel ARCH techniques confirms the relevance of Sudden Stops and potential balance sheet effects as key determinants of relative price volatility, where balance sheet effects are captured by the interaction of a proxy for potential changes in the real exchange rate (linked to the degree of external leverage of the absorption of tradable goods) and a measure of domestic liability dollarization.     

Currency depreciations, financial transfers, and firm heterogeneity

The present paper investigates five episodes of currency collapse from the perspective of non-financial firms operating in Argentina, Brazil and Mexico. We focus on two aspects: wealth and income transfers from borrowing firms to lenders and firm heterogeneity. At the firm level, we find that the currency collapses are preceded and associated with sharply rising financial transfers from firms to lenders. The debt and income structure is central in explaining the asymmetric firm dynamics. Most affected are firms with high levels of unhedged foreign-currency debt. At the country level, Argentina, Brazil, and Mexico display three contrasting examples. Argentina has a large currency mismatch, Brazil balances the currency denomination of debt and income (natural hedge), and Mexico occupies an intermediate position.     

Debt deleveraging and the exchange rate

Deleveraging from high debt can provoke deep recession with significant international side effects. Swings in the nominal exchange rate and large variations in consumption, output, and terms of trade can happen during the adjustment. All these movements are inefficient and interesting trade-offs emerge from the perspective of global welfare. The optimal adjustment to global imbalances should not necessarily require large movements in the nominal exchange rate. A global liquidity trap can be desirable when countries are more open to trade.     

Hares and stags in Argentinean debt restructuring

The latest Argentinean debt restructuring was the first time the resolution of a modern financial crisis was completely handed over to the private financial markets without official intervention by public institutions. We argue that the resulting harshest haircut for private creditors in history can be at least partially related to a stag-hunt game played by creditors. We show that incentive schemes provided by the Argentinean government were factors facilitating this haircut. The analysis suggests that, contrary to the recognition in the literature, the effects of Collective Action Clauses and Exit Consents within a restructuring process are not equal. In the case of Argentina, the inclusion of Collective Action Clauses in the defaulted bonds could have benefited the holdout creditors.     

Oil shocks and external adjustment

We examine the effects of endogenously determined oil price fluctuations in a two-country DSGE model. Under incomplete financial markets, an oil market-specific shock that boosts the oil price results in a wealth transfer toward oil exporters, depresses the oil importer's consumption, and causes the oil importer's real exchange rate to depreciate. Although the oil importer experiences a deterioration in the oil component of its trade balance, an improvement in the nonoil balance substantially dampens the effects on the overall trade balance.     

Expectations and exchange rate dynamics: A state-dependent pricing approach

This paper presents a two-country DSGE model with state-dependent pricing as in Dotsey et al. [Dotsey, M., King, R.G., and Wolman, A.L., 1999. State-dependent pricing and the general equilibrium dynamics of money and output. Quarterly Journal of Economics 114, 655-690] and variable demand elasticity as in Kimball [Kimball, M.S., 1995. The quantitative analytics of the basis neomonetarist model. Journal of Money, Credit, and Banking 27, 1241-1277]. Following a domestic monetary expansion, the model predicts: (i) positive hump-shaped responses of domestic output and consumption, (ii) positive spillover effects on foreign output and consumption, (iii) a high international output correlation relative to consumption correlation, (iv) a delayed increase in domestic and foreign inflation, (v) a delayed nominal exchange rate overshooting, (vi) a deterioration in the terms of trade, and (vii) a J-curve in the trade balance. The model matches the impulse responses from an identified VAR more closely than an otherwise identical model with time-dependent pricing.     

Nominal rigidity, desired markup variations, and real exchange rate persistence

This paper develops and estimates a dynamic general-equilibrium sticky-price model that accounts for real exchange rate persistence. The key feature of the model is the dependence of the firm's desired markup on its relative price. Desired markup variations exacerbate the nominal rigidity that results from the exogenously imposed frictions in the goods market. The model is estimated by the maximum-likelihood method using Canadian and U.S. data. The estimated model successfully replicates the properties of the Canada-U.S. bilateral real exchange rate. In particular, the model closely matches the persistence found in the real exchange rate series. More importantly, this is achieved with a plausible duration of price contracts and a moderate convexity of the demand function.     

How do trade and financial integration affect the relationship between growth and volatility?

The influential work of Ramey and Ramey [Ramey, G., Ramey, V.A., 1995. Cross-country evidence on the link between volatility and growth. American Economic Review 85, 1138-1151 (December).] highlighted an empirical relationship that has now come to be regarded as conventional wisdom—that output volatility and growth are negatively correlated. We reexamine this relationship in the context of globalization—a term typically used to describe the phenomenon of growing international trade and financial integration that has intensified since the mid-1980s. Using a comprehensive new data set, we document that, while the basic negative association between growth and volatility has been preserved during the 1990s, both trade and financial integration significantly weaken this negative relationship. Specifically, we find that, in a regression of growth on volatility and other controls, the estimated coefficient on the interaction between volatility and trade integration is significantly positive. We find a similar, although less robust, result for the interaction of financial integration with volatility.     

On the unstable relationship between exchange rates and macroeconomic fundamentals

Survey evidence shows that the relationship between the exchange rate and macro fundamentals is perceived to be highly unstable. We argue that this unstable relationship naturally develops when structural parameters in the economy are unknown. We show that the reduced form relationship between exchange rates and fundamentals is then driven not by the structural parameters themselves, but rather by expectations of these parameters. These expectations can vary significantly over time as a result of perfectly rational “scapegoat” effects. These effects can be expected to hold more broadly in macro and finance beyond the application to exchange rates in this paper.     

Valuation effects and the dynamics of net external assets

‘Valuation effects’ can imply that the traditional current account is an inaccurate measure of the change in the net foreign asset (NFA) position. This paper uses new developments in the analysis of portfolio choice in general equilibrium to investigate valuation effects in a two-country model. Broadly speaking, the valuation effects in the model correspond to those observed in the data. But there is a key distinction between ‘unanticipated’ and ‘anticipated’ valuation effects. Unanticipated effects can be large, dominating the movement in NFA, but anticipated effects arise only at higher orders of approximation and are small for reasonable parameterizations.     

The role of multinational production in a risky environment

This paper explores the aggregate consequences of Foreign Direct Investment (FDI) on the opportunities for risk diversification available to consumers. The crucial difference between FDI and other international financial flows is that the former involves technology flows across countries. We present a model where firm-embedded productivity can be transferred costly across countries through the activity of multinational firms. We find that risk patterns affect multinationals' location decisions and, in turn, these decisions change the scope for international risk diversification even in a world with complete financial markets.