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.     

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 debt as a contingent claim: a quantitative approach

We construct a dynamic equilibrium model with contingent service and adverse selection to quantitatively study sovereign debt. In the model, benefits of defaulting are tempered by higher future interest rates. For a wide set of parameters, the only equilibrium is one in which the sovereign defaults in all states; additional output losses, however, sustain equilibria that resemble the data. We show that due to the adverse selection problem, some countries choose to delay default to reduce loss of reputation. Moreover, although equilibria with no default imply greater welfare levels, they are not sustainable in highly indebted and volatile countries.     

Sovereign default and debt renegotiation

This paper develops a small open economy model to study sovereign default and debt renegotiation for emerging economies. The model features both endogenous default and endogenous debt recovery rates. Sovereign bonds are priced to compensate creditors for the risk of default and the risk of debt restructuring. The model captures the interaction between sovereign default and ex post debt renegotiation. We find that both debt recovery rates and sovereign bond prices decrease with the level of debt. In a quantitative analysis, the model accounts for the debt reduction, volatile and countercyclical bond spreads, countercyclical trade balance, and other empirical regularities of the Argentine economy. The model also replicates the dynamics of bond spreads during the debt crisis in Argentina.     

Sovereign borrowing by developing countries: What determines market access?

What determines the ability of governments from developing countries to access international credit markets? We examine this question using detailed data on sovereign bond issuances and public syndicated bank loans between 1980 and 2000. A key finding of this paper is that the probability of market access is not influenced by a country's frequency of defaults, and that a default, if resolved quickly, does not reduce significantly the probability of tapping the markets. We also find that trade openness, a standard measure of a country's links with the rest of the world, and traditional liquidity and macroeconomic indicators do not help much in explaining market access. However, a country's vulnerability to shocks and the perceived quality of economic policies and institutions appear to influence the government's ability to tap the markets. We also document that the average exclusion from international credit markets following a default declined from four years in the 1980s to two years in the 1990s.     

Long-duration bonds and sovereign defaults

This paper extends the baseline framework used in recent quantitative studies of sovereign default by assuming that the government can borrow using long-duration bonds. This contrasts with previous studies, which assume the government can borrow using bonds that mature after one quarter. We show that, when we assume that the government issues bonds with a duration similar to the average duration of sovereign bonds in emerging economies, the model generates an interest rate that is substantially higher and more volatile than the one obtained assuming one-quarter bonds. This narrows the gap between the predictions of the model and the data, which indicates that the introduction of long-duration bonds may be a useful tool for future research about emerging economies. Our analysis is also relevant for the study of other credit markets.     

Predicting default probabilities and implementing trading strategies for emerging markets bond portfolios

In this paper, we address two main issues: the computation of default probability implicit in emerging markets bond prices and the impact on portfolio risks and returns of expected changes in default probability. Using a reduced-form model, weekly estimates of default probabilities for U.S. Dollar denominated Global bonds of 12 emerging markets are extrapolated for the sample period 1997–2001. The estimation of a logit type econometric model shows that weekly changes of the default probabilities can be explained by means of some capital markets factors. Recursively estimating the logit model using rolling windows of data, out-of-sample forecasts for the dynamics of default probabilities are generated and used to form portfolios of bonds. The practical application provides interesting results, both in terms of testing the ability of a naive trading strategy based on model forecasts to outperform a “customized benchmark”, and in terms of the model ability to actively manage the portfolio risk (evaluated in terms of VaR) with respect to a constant proportion allocation.     

Sovereign default, private sector creditors, and the IFIs

The data reveal that emerging market sovereign borrowing from International Financial Institutions (IFIs) is small, intermittent and countercyclical compared to that from private sector creditors. The IFI loan contracts offered to sovereigns differ from the private ones in that they are more enforceable and have conditionality arrangements attached to them. Taking these contractual differences as given, this paper builds a quantitative model of a sovereign borrower and argues that better enforceability of IFI loan contracts is the main institutional feature that explains the size and cyclicality while conditionality accounts for the intermittency of borrowing from the IFIs.     

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.     

What explains default risk premium during the financial crisis? Evidence from Japan

As is well documented, subprime mortgage markets carried significant default risk. This paper investigates the relationship between default risk premium, stock market conditions and macroeconomic variables during the financial crisis. Using iTraxx Japan Credit Default Swap (CDS) index spreads covering the period from March 2006 to November 2009, we employ a time-varying dynamic factor model with Markov regime switching to generate regime probabilities for default risk. We analyze the sensitivity of default risk premium changes to stock market conditions and macroeconomic variables by using two-state Markov switching models: a crisis regime sparked by rising loan defaults in the sub-prime mortgage market, and a non-crisis regime. We found strong evidence that the relationship between default risk premium changes, stock market and macroeconomic variables is regime-dependent. Our results suggest that during periods of crisis, CDS indices behave as a higher-risk indicator and become more sensitive to stock market conditions and macroeconomic variables. This paper examines the effects of the financial crisis in explaining the default risk premium. Understanding the determinants of default risk premium is important for financial analysts, economic policy makers and credit risk management.     

Zero‐interest Rate Policy and Unintended Consequences in Emerging Markets

Since 2009, central banks in the major advanced economies have held interest rates at very low levels to stabilise financial markets and support the recovery of their economies. This paper outlines the unintended consequences of the prolonged period of very low world funding interest rates in emerging markets. The paper is informed by a Mises–Hayek‐BIS view on credit booms and Mises' law of unintended consequences. Consistent with the presented credit boom view, I provide evidence that the very low world funding interest rates are associated with a rise in volatile capital flows and asset market bubbles in fast‐growing emerging markets. In line with Mises' law, I further show that these unintended consequences give rise to a new wave of interventionism as policymakers in emerging markets increasingly reintroduce financially repressive measures to isolate the economies from foreign capital inflows.     

Market power in banking,countercyclical margins and the international transmission of business cycles

By introducing an imperfectly competitive banking sector into a standard two-country, two-good RBC model with complete asset markets, we study the international transmission of aggregate TFP shocks in an environment with noncompetitive financial intermediation. In this model, price-cost margins in a global loan market are endogenous and countercyclical. As a result, a positive TFP shock in one country spills over to another through a reduction in the global cost of both credit and externally financed investment. The quantitative analysis shows that countercyclical margins on loans play a key role in bringing the predictions of the theory closer to the observed cross-country cyclical co-movements of consumption, employment, investment and output. Recessions are deeper when the cost of credit rises during these economic downturns. Thus, a financial accelerator arises in our framework, unveiling the increased importance of stabilization policies in economies where margins in credit markets are countercyclical.     

CORRELATED DEFAULTS IN INTENSITY-BASED MODELS

This paper presents an intensity-based model of correlated defaults with application to the valuation of defaultable securities. The model assumes that the intensities of the default times are driven by common factors as well as other defaults in the system. A recursive procedure called the "total hazard construction" is used to generate default times with a broad class of correlation structures. This approach is compared to standard reduced-form models based on conditional independence as well as alternative approaches involving copula functions. Examples are given for the pricing of defaultable bonds and credit default swaps of the regular and basket type.     

Financial liberalization, structural change, and real exchange rate appreciations

The last twenty years have witnessed periods of sustained appreciations of the real exchange rate in emerging economies. The case of Mexico between 1988 and 2002 is representative of several episodes in Latin America and Central and Eastern Europe in which countries opening to capital flows experienced large appreciations accompanied by a significant reallocation of workers towards the non-tradable sector. We account for these facts using a two sector dynamic general equilibrium model of a small open economy with frictions to labor reallocation and two driving forces: (i) A decline in the cost of borrowing in foreign markets, and (ii) differential productivity growth across sectors. These two mechanisms account together for 60% of the decline in the domestic relative price of tradables in Mexico and for a large fraction of the observed reallocation of labor across sectors. The decline in the interest rate faced by Mexico in international markets is quantitatively the most important channel. Our results are robust to the inclusion of terms of trade into the model.     

I'll have what she's having: (Social) Perceptions of default options and implications for marketing and decision making

The power that default options have in shaping choice has been well established, yet relatively little is known about how decision makers experience and interpret such preselected options. Research suggests that individuals assume defaults represent a recommended course of action, yet the basis for this recommendation is unclear. Across two experimental studies, we explored consumer theories of default recommendations, examining spontaneous and experimentally manipulated perceptions of the basis of the default, and the impact on decision making across different contexts. Evidence across diverse populations and tasks shows that options were retained to a greater extent when represented as the default, consistent with classic default effects. Furthermore, a significant default effect emerged when the decision context was framed as complex. In line with research on social influence, defaults were most effective when they were presumed to reflect the most popular option (regardless of context). Interestingly, participants rated defaults as being more likely to represent the most popular option, regardless of decision context or default explanation provided to them. These findings highlight the importance of understanding the contexts in which default choices are relied upon and how those defaults are perceived by decision makers.     

The effect of default options on choice—Evidence from online product configurators

Many firms use product configurators to enable customers to specify their desired products online. In such systems, defaults are pre-specified for levels of product features by the manufacturer or dealer. For example, when configuring a racing bike online, a default is predefined (e.g., the Shimano Ultegra model) for all required features (e.g., the gearshift levers). Such defaults, which may even adapt to previous choices, ensure that a functional and fully defined product emerges at the end of the configuration process. However, when designing sales systems, companies often fail to realize that these defaults also affect customer decision-making. We demonstrate the effect by a study that makes use of a fully simulated racing bike configurator. We find the following results: Moving the default of one feature (e.g. wheels) from the lowest to the highest level results in an increase in sales. In addition, the feature level defined as the default also acts as a reference point by increasing the sales of levels near to it. In order to maximize sales, the default should be set at the level of a feature that is between the medium and the highest price level. To conclude we discuss how manufacturers and dealers subtly yet powerfully influence the decision-making process with their sales systems.     

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.     

Regional financial integration in the GCC

We investigate the extent of regional financial integration in the member countries of the Gulf Cooperation Council. Interest rate data show that convergence exists and that interest rate differentials are relatively short-lived—especially relative to other unified currency area and comparable to those of the Euro Area post 1999. Equity data using cross-listed stocks confirm that stock markets are fairly integrated compared to other emerging market regions, although price equalization is hampered by market illiquidity. The limited volume data available suggests that intra-GCC capital flows are sizeable.     

Encouraging Entrepreneurship: Microfinance,Knowledge Support,and the Costs of Operating in Institutional Voids

This study focuses on the supplemented strategies of microfinance institutions (MFIs), in which the MFI offers nonfinancial services, such as entrepreneurship related knowledge, in addition to financial services to impoverished borrowers at the bottom of the pyramid (BoP). We examine two contextual factors–foreign direct investment (FDI) and loan defaults–to better understand the relationship between providing knowledge support to encourage entrepreneurship and costs of operating at the BoP for MFIs. In contexts where FDI is low and loan defaults are high, providing knowledge support to encourage entrepreneurship aggravates the MFI's costs of operating at the BoP. However, in contexts where FDI is high and loan defaults are low, providing knowledge support to encourage entrepreneurship among impoverished borrowers does not aggravate the MFI's costs of operating at the BoP. Hence, in emerging markets where governments welcome FDI and curb loan defaults, MFIs can viably support entrepreneurship among the poor. © 2013 Wiley Periodicals, Inc.     

Are asset price guarantees useful for preventing Sudden Stops?: A quantitative investigation of the globalization hazard-moral hazard tradeoff

An implication of the globalization hazard hypothesis is that ‘Sudden Stops’ caused by global financial frictions could be prevented by offering foreign investors price guarantees on emerging markets assets. These guarantees create a tradeoff, however, because they weaken globalization hazard while creating international moral hazard. We study this tradeoff using a quantitative, equilibrium asset-pricing model. Without guarantees, margin calls and trading costs cause Sudden Stops driven by a Fisherian deflation. Price guarantees prevent this deflation by propping up foreign demand for assets. The effectiveness of price guarantees, their distortions on asset markets, and their welfare implications depend critically on whether the guarantees are contingent on debt levels and on the price elasticity of foreign demand for domestic assets.