Debt Dilution and Sovereign Default Risk

Policy Research Working Papers, 2010

2013

In this chapter, we use a benchmark limited-commitment model to explore key issues in the economics of sovereign debt. After highlighting conceptual issues that distinguish sovereign debt as well as reviewing a number of empirical facts, we use the model to discuss debt overhang, risk sharing, and capital flows in an environment of limited enforcement. We also discuss recent progress on default and renegotiation; self-fulfilling debt crises; and incomplete markets and their quantitative implications. We conclude with a brief assessment of the current state of the literature and highlight some directions for future research.

Economics Letters, 2012

This paper analyzes the effects of volatility on sovereign default risk. Empirically, the paper establishes a concave relationship between spreads and volatility. While for low levels of volatility an increase in volatility is associated with an increase in the sovereign risk premium, the risk premium increases at a decreasing rate. This empirical relationship is robust to different estimation methods, samples and control variables. Furthermore, the relationship between volatility and risk premia is non-monotonic: while at low levels of volatility an increase in volatility implies an increase also in spreads, for sufficiently high levels of volatility this relationship turns negative. The paper also presents a quantitative model of sovereign debt with default risk consistent with this feature and other characteristics of EME debt. The intuition for this result is the existence of a trade-off between prudential behavior in order to avoid large consumption fluctuations under autarky and the increased likelihood of a default, given that default provides some short-run relief under a very bad realization of shocks. JEL classification: F34; E62 for sharing generously their data. All remaining errors are my exclusive responsibility.

2011

This dissertation analyzes different aspects of the actions of borrowing and repaying debts by governments in both domestic and international financial markets. In Chapter 1, which is co-authored with Guido Sandleris and Alejandro Van der Ghote, we use a unique dataset on sovereign bond issuances and syndicated bank loans to study the duration and determinants of the periods of exclusion from international credit markets that usually follow governments' defaults. Among other results, we find that countries either reaccess the markets in the first years after a default or have to wait much longer to do it, and that political stability significantly increases the chances of reaccessing the market. We present a political economy model of endogenous sovereign borrowing and market reaccess that matches these two features of the data. In Chapter 2, 1 study the relation between the domestic financial system's market structure, the allocation of government debt and the cost of credit for the government. The fact that governments are less likely to repudiate their debts when there are more domestic agents among their creditors creates an externality: when domestic investors demand government bonds, they reduce the probability of default and improve the situation of every other bondholder. The concentration of investment decisions in fewer financial institutions increases the degree of internalization of this effect, expands the demand for government bonds by domestic agents and reduces the cost of credit for the government. In Chapter 3, I propose a mechanism that can explain the observed positive correlation between public and private spreads, taking into account that domestic banks tend to be heavily exposed to sovereign debt. Firms have private information about the results of their projects, information that can be obtained by domestic banks, as long as they pay a verification cost, but not by foreign creditors. A sovereign default has a negative impact on domestic banks, reduces their verification capacity and increases the incentives for firms to declare themselves insolvent. Consequently, risks of sovereign and private defaults are positively correlated.

2019

We quantitatively explore the implications of the partial default mechanism for the dynamics of sovereign debt and default in a small open economy. The model features endogenous partial default and preemptive recovery on the defaulted amount with direct utility cost of default, instead of the exclusion from international financial markets. The model is calibrated to Argentina and compared to the traditional full default models. We show that with our partial default framework, (1) the model with endowment not only matches the mean spread on debt and the debt-to-output ratio, like the traditional models, but also matches both the default frequency and the default rate; (2) the model with production, with investment as another margin to smooth consumption, improves the fit with data for the volatilities of consumption and spread on debt as well as the debt service-to-output ratio (without significant change in other moments), partially o setting the weak performance of the endowment mo...

Journal of International Money and Finance, 2021

Economic vulnerabilities may remain latent for long periods and may only reveal their full impact on a country's fiscal sustainability when the economy undergoes a significant shock. This could lead researchers to understate the impact of such vulnerabilities on a country's probability of sovereign default, particularly at times of global or local financial stress. We analyze data from a panel of 113 countries over the period 1990-2014 to examine the impact of debt burden indicators and macro fundamentals on risk of sovereign default in emerging markets and advanced economies. We test whether economic fundamentals and fiscal vulnerabilities have a stronger impact on the risk of sovereign default during periods of financial distress than during tranquil times. We find that financial stress significantly amplifies the impact of the debt-to-GDP ratio, the stock of international reserves, and GDP per capita on the probability of sovereign default.

Journal of Development Economics, 2011

Few would dispute that sovereign defaults entail significant economic costs, including, most notably, important output losses. However, most of the evidence supporting this conventional wisdom, based on annual observations, suffers from serious measurement and identification problems. To address these drawbacks, we examine the impact of default on growth by looking at quarterly data for emerging economies. We find that, contrary to what is typically assumed, output contractions precede defaults. Moreover, we find that the trough of the contraction coincides with the quarter of default, and that output starts to grow thereafter, indicating that default episode seems to mark the beginning of the economic recovery rather than a further decline. This suggests that, whatever negative effects a default may have on output, those effects result from anticipation of a default rather than the default itself. * We would like to thank Eduardo Cavallo and other participants in the December 2005 IPES pre-conference, and we wish to thank Mariano Alvarez for excellent research assistance. The views expressed in this paper are the authors' and do not necessarily reflect those of the Inter-American Development Bank.

Central European Economic Journal, 2018

While the literature on determinants of sovereign default is voluminous, the links between private indebtedness and the probability of public bankruptcy have not been studied extensively. In this paper we aim to fill this gap and to shed more light on the influence of the size and structure of private debt on sovereign default probability. We focus on developing and emerging market economies over the years 1970-2012. The main conclusions are that both the size and the structure of private borrowings affect the probability of a sovereign default.

2010

This paper uses model averaging techniques to identify robust predictors of sovereign default episodes on a pooled database for 46 emerging economies over the period 1980-2004. Sovereign default episodes are defined according to Standard & Poor s or by non-concessional International Monetary Fund loans in excess of 100 percent of the country s quota. The authors find that, in addition to the level of indebtedness, the quality of policies and institutions is the best predictor of default episodes in emerging market countries with relatively low levels of external debt. For emerging market countries with a higher level of debt, macroeconomic stability plays a robust role in explaining differences in default probabilities. The paper provides evidence that model averaging can improve out-of-sample prediction of sovereign defaults, and draws policy conclusions for the current crisis based on the results.

Oxford Review of Economic Policy, 2013

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