A fiscal theory of sovereign risk

This paper presents a fiscal theory of sovereign risk and default. Under certain monetary-fiscal regimes, the risk of default, and thus the emergence of sovereign risk premia, are inevitable. The paper characterizes the equilibrium processes of the sovereign risk premium and the default rate under a number of alternative monetary policy arrangements. It is argued that, given the fiscal stance, monetary policy plays a crucial role in shaping the equilibrium behaviour of the country risk premium and the default rate. For instance, under some of the monetary policy rules considered, the expected default rate and the sovereign risk premium are zero (and therefore unforecastable) although the government defaults regularly. Under other monetary regimes the default rate and the sovereign risk premium are serially correlated (and therefore forecastable). In addition, environments are characterized under which delaying default is counterproductive. JEL Classification: E6, F4

A Fiscal Theory of Sovereign Risk

This paper presents a fiscal theory of sovereign risk and default. Under certain monetary-fiscal regimes, the risk of default, and thus the emergence of sovereign risk premia, are inevitable. The paper characterizes the equilibrium processes of the sovereign risk premium and the default rate under a number of alternative monetary policy arrangements. Under some of the policy environments considered, the expected default rate and the sovereign risk premium are zero although the government defaults regularly. Under other monetary regimes the default rate and the sovereign risk premium are serially correlated and therefore forecastable. Environments are characterized under which delaying default is counterproductive.

Essays in Macroeconomics and Sovereign Default

This thesis studies government fiscal, monetary and debt policy, with a particular focus on debt crises and the pricing of default risk. The first chapter studies the circular relationship between sovereign credit risk, government fiscal and debt policy, and output. I show that, when fiscal policy responds to borrowing conditions in the sovereign debt market, multiple equilibria exist where the expectations of lenders are self-fulfilling. This result is reminiscent of the European debt crisis of 2010-12: while recessionary, fiscal austerity may be the government best response to excessive borrowing costs during a confidence crisis. The second chapter studies the information sensitivity of government debt denominated in domestic vs. foreign currency: the former is subject to inflation risk and the latter to default. Default only affects sophisticated bond traders, whereas inflation concerns a larger and less informed group. Within a two-period Bayesian trading game, we display conditions under which debt prices are more resilient to bad news. Our results can explain debt prices across countries following the 2008 financial crisis, and also provide a theory of ``original sin." The third chapter explores the trade-off between strategic inflation and default for a set of large emerging market economies that borrow mostly in their local currency. Using derivatives data, I find a robust, positive correlation between default risk, expected and realised inflation. I use these facts to discipline a quantitative sovereign default model where a government issues debt in domestic currency and lacks commitment to fiscal and monetary policy. I show that simple models of debt dilution via default and inflation have counterfactual implications. I highlight the role of monetary financing in matching the data, allowing inflation to serve a second purpose: in bad times, seigniorage is especially useful as a flexible source of funding when other margins are hard to adjust

Sovereign default and monetary policy tradeoffs

The paper is organized around the following question: when the economy moves from a debt-GDP level where the probability of default is nil to a higher level—the “fiscal limit”—where the default probability is non-negligible, how do the effects of routine monetary operations designed to achieve macroeconomic stabilization change? We find that the specification of the monetary policy rule plays a critical role. Consider a central bank that targets the risky rate. When the economy is near its fiscal limit, a transitory monetary policy contraction leads to a sustained rise in inflation, even though monetary policy actively targets inflation and fiscal policy passively adjusts taxes to stabilize debt. If the central bank targets the riskfree rate, on the other hand, the same transitory monetary contraction keeps inflation under control but leads output to contract for a prolonged period of time. The comparison shows that sovereign default risk puts into sharp relief the tradeoff between inflation and output stabilization

Preparedness, crisis management and policy change : EMU at the critical juncture of 2008-2013

Focusing on the role of the European Central Bank during the recent banking and sovereign debt crisis in the euro area, this article contributes to the literature on ideational and institu-tional change at critical junctures. In line with recent calls to take the temporal dimension of political change seriously, the article argues that in the context of explosive economic crises a phase of emergency crisis management precedes the phase of purposeful institution building. What happens during this phase is crucial, for in spite of their improvised charac-ter emergency crisis management measures create their own path dependencies. This, how-ever, raises the question of why crisis managers act the way they do. While it is true that crisis managers act as bricoleurs who use whichever tools they find at their disposal, the question of why certain tools are available rather than others calls for a historicisation of crisis management. The article therefore introduces the variable of preparedness, which measures the extent to which the pre-crisis policy paradigm was prepared for the occur-rence of, in this case, the combination of a systemic banking crisis and a sovereign debt cri-sis. The empirical section then compares pre-crisis contingency planning and in-crisis contingency acting, revealing several inconsistencies in the pre-crisis crisis paradigm. The analysis matters for our understanding of political change because these inconsistencies caused the ECB to assume a dominant position in the euro area during the emergency phase of the crisis. This windfall gain in power for the ECB has already begun to shape the future ideational and institutional order of the euro area

Sovereign Default Risk in a Monetary Union

A country entering a monetary union gives up the right to determine its own monetary policy, thereby relinquishing monetary instruments to assure fiscal solvency. In this paper, we develop a new theoretical model to address fiscal solvency risk. We show that when debt is subject to an upper bound and policy faces stochastic shocks, a government can find itself in a position for which the expected present value of future surpluses under current policy is less than debt. Agents refuse to lend into such a position, and the sudden stop of capital flows defines a fiscal solvency crisis. We model the dynamics of a fiscal solvency crisis in a monetary union under the assumption that the fiscal authority will respond to the crisis using default to reduce the value of debt. We simulate the model to estimate fiscal solvency risk in the European Monetary Union. We find that countries adhering to the Stability and Growth Pack limits are perfectly safe, while countries like Greece and Italy, whose debt relative to GDP has strayed far above the 60 percent limit, are not.European Monetary Union, sovereign default, financial crisis

Determinants of Sovereign Bond Yield Spreads in the EMU. An Optimal Currency Area Perspective

In the light of the recent financial crisis, we take a panel cointegration approach that allows for structural breaks to the analysis of the determinants of sovereign bond yield spreads in nine economies of the European Monetary Union. While we find evidence for a level break in the cointegrating relationship, we do not find empirical support for a regime shift and hence for a change in the pricing of the determinants of sovereign spreads. Moreover, results show that (i) fiscal imbalances (namely expected government debt-to-GDP differentials) are the main long-run drivers of sovereign spreads; (ii) liquidity risks and cumulated inflation differentials have non-negligible weights; but (iii) all conclusions are ultimately connected to whether or not the sample of countries is composed of members of an Optimal Currency Area (OCA). In particular, we establish (i) that results are overall driven by those countries not passing the OCA test; and (ii) that investors closely monitor and severely punish the deterioration of expected debt positions of those economies exhibiting significant gaps in competitiveness

International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

This paper considers the consequences of international financial market integration for national fiscal and monetary policies that derive from the absence of an international sovereign authority to define and enforce contractual obligations across borders. The sovereign immunity of national governments serves as a fundamental constraint on international finance and is used to derive intertemporal budget constraints for sovereign nations and their governments. It is shown that the appropriate debt limit for a country allows for state-contingent repayment. With non-contingent debt instruments, debt renegotiation occurs in equilibrium with positive probability. A model of tax smoothing is adopted to show how information imperfections lead to conventional bond contracts that are renegotiated when a critical level of indebtedness is reached. Renegotiation is interpreted in terms of nominal and real denominated bonds drawing implications for the intertemporal borrowing constraint for monetary policies, the accumulation of reserve assets, and current account sustainability.

Inflation and Sovereign Default

Recent research has highlighted the role that the government budget constraint plays in determining the consumer price level. According to the fiscal approach to price determination, prices adjust so that the discounted value of future real government primary surpluses equals the current real value of public debt. An important implication is that the probability of a crisis involving default on public debt may directly affect consumer prices. This paper examines the interaction of prices and sovereign insolvency crises using simple, continuous-time models of the government budget constraint. Copyright 2001, International Monetary Fund

Monetary Union Stability: The Need for a Government Banker and the Case for a European Public Finance Authority

This paper argues monetary union stability requires a government banker that manages the bond market and it offers a specific proposal for stabilizing the euro that does not violate the “no country bail-out” clause. There is accumulating evidence that the euro’s current architecture is unstable. The source of instability is high interest rates on highly indebted countries which creates unsustainable debt burdens. Remedying this problem requires a central bank that acts as government banker and pushes down government bond interest rates to sustainable levels. That can be accomplished by creation of a European Public Finance Authority (EPFA) that issues public debt which the European Central Bank (ECB) is allowed to trade. The debate over the euro’s financial architecture also has significant political implications. That is because the current neoliberal inspired architecture, which imposes a complete separation between the central bank and public finances, puts governments under continuous financial pressures. Over time, that pressure makes it difficult to maintain the European social democratic welfare state. This gives a political reason for reforming the euro and creating an EPFA that supplements the economic case for reform.monetary union, stability, government banker, euro.