Essays in International Finance and Macroeconomics

The way in which governments borrow has changed dramatically over the last decade. The first two chapters of this dissertation study the implications of the rise of local currency sovereign borrowing in emerging markets. Chapter 1 presents a method to measure the credit risk on local currency sovereign debt. Chapter 2 argues that private sector balance sheet mismatch explains why nominal sovereign debt risk is not free from default risk. Chapter 3 studies the costs of sovereign default by exploiting the timing of legal rulings in the case of Republic of Argentina v. NML Capital to identify the causal effect of increases in sovereign default risk on firm performance.Political Economy and Governmen

Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone

Eurozone members are supposedly constrained by the fiscal caps of the Stability and Growth Pact. Yet ever since the birth of the euro, members have postponed painful adjustment. Wishful thinking has played an important role in this failure. We find that governments’ forecasts are biased in the optimistic direction, especially during booms. Eurozone governments are especially over-optimistic when the budget deficit is over the 3 % of GDP ceiling at the time the forecasts are made. Those exceeding this cap systematically but falsely forecast a rapid future improvement. The new fiscal compact among the euro countries is supposed to make budget rules more binding by putting them into laws and constitutions at the national level. But biased forecasts can defeat budget rules. What is the record in Europe with national rules? The bias is less among eurozone countries that have adopted certain rules at the national level, particularly creating an independent fiscal institution that provides independent forecasts

Local Currency Sovereign Risk ∗

Local currency debt represents the bulk of emerging market sovereign borrowing and a rapidly growing share of foreign holding of emerging market debt. We introduce a new measure of sovereign risk based on local currency debt, the local currency credit spread, defined as the yield spread of a local currency bond over the local currency risk-free rate implied from cross currency swaps. From a dollar investor’s perspective, this measure gives the synthetic dollar spread on holding a local currency bond after fully hedging the currency risk of promised cash flows. Compared with the traditional measure of sovereign risk based on credit spreads on foreign currency denominated debt, we find that local currency credit spreads have lower means, are less correlated across countries and less sensitive to global risk factors. We develop a model of partially segmented domestic and external sovereign debt markets and test the model’s differential predictions for the risk premium and the term structure of credit spreads on the two types of debt. We find that imperfect market integration via risky credit arbitrage is important for the differential pricing of local and foreign currency debt

Federal Reserve Board

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