Sovereign Default, Interest Rates and Political Uncertainty in Emerging Markets

Emerging economies tend to experience larger political uncertainty and more default episodes than developed countries. This paper studies the effect of political uncertainty on sovereign default and interest rate spreads in emerging markets. The paper develops a quantitative model of sovereign debt and default under political uncertainty in a small open economy. Consistent with empirical evidence, the quantitative analysis shows that higher levels of political uncertainty significantly raise the default frequency and both the level and volatility of the spreads. When parties borrow from international credit markets, the presence of political uncertainty induces a short-sight behavior in politicians.Default, Sovereign Debt, Political Risk

Fiscal Policy and Default Risk in Emerging Markets.

Emerging economies usually experience procyclical public expenditures, tax rates and private consumption, countercyclical default risk, interest rate spreads and current account and higher volatility in consumption than in output. In this article we develop a dynamic stochastic equilibrium model of a small open economy with endogenous fiscal policy, endogenous default risk and country interest rate spreads in an incomplete credit markets framework that rationalizes these empirical findings.Procyclical fiscal policy, Sovereign default

Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets

Emerging economies tend to experience larger fluctuations in their terms of trade, countercyclical interest rates and more default episodes than developed countries. These structural features might suggest a relevant role for world prices in driving country spreads. This paper studies the role of terms of trade shocks in inducing output fluctuations and countercyclical spreads using a stochastic dynamic general equilibrium model of a small open economy. The model predicts that default incentives and default premia are higher in recessions, as observed in the data. In a quantitative exercise, the model matches various features of emerging economies and can account for the dynamics of default episodes in these markets.Default, Terms of Trade, Sovereign Debt

Indexed Sovereign Debt: An Applied Framework

In recent years, some countries have issued sovereign bonds indexed to real variables such as GDP. Moreover, there has been discussions about this issue during the European crisis. This paper analyzes the effects of introducing this type of contracts in a standard DSGE model with sovereign default risk. We solved the model numerically calibrating it to the Argentine economy and show that the introduction of GDP-indexed sovereign debt contracts reduces the probability of default and makes the government willing to hold non-contingent assets and issue real-indexed bonds at the same time. The magnitude of the welfare effect that this type of instruments could generate is equivalent to an increase of approximately half a percentage point per year in certainty equivalent aggregate consumption.

Financially Constrained Stock Returns

More financially constrained firms are riskier and earn higher expected returns than less financially constrained firms, although this effect can be subsumed by size and book-to-market. Further, because the stochastic discount factor makes capital investment more procyclical, financial constraints are more binding in economic booms. These insights arise from two dynamic models. In Model 1, firms face dividend nonnegativity constraints without any access to external funds. In Model 2, firms can retain earnings, raise debt and equity, but face collateral constraints on debt capacity. Despite their diverse structures, the two models share largely similar predictions.

Online Appendix to "Quantitative properties of sovereign default models: solution methods"

This document describes how we evaluate the accuracy of the solution of the baseline sovereign default model using the test proposed by den Haan and Marcet (1994). We show that the solutions obtained using Chebyshev collocation and cubic spline interpolation approximate the equilibrium with reasonable accuracy and illustrate the challenges that arise when the test is applied to the solution obtained using the discrete state space technique.

Quantitative models of sovereign default and the threat of financial exclusion

Business cycles ; Debt ; Default (Finance)

Sovereign default risk with heterogenous borrowers

We study a standard quantitative model of sovereign default in which the government in a small open economy (SMO) decides how much to save and whether to default on its debt. In contrast with previous quantitative studies, we do not assume that a defaulting country is exogenously excluded from capital markets, and we assume that political parties with different discount factors alternate in power. Preliminary quantitative results indicate that even without assuming exogenous exclusion, after a default episode, the model generates difficulties in market access---in average, for the same level of debt, spreads are higher after default; due to this increase in borrowing costs, capital inflows are initially decreased, and recover slowly after that. We also describe the strategic interaction of governments with different patienceSovereign Default, Strategic Behavior; Endogenous Borrowing Constraints; Markov Perfect Equilibrium.

Sovereign Debt Restructurings

Sovereign debt crises involve debt restructurings characterized by a mix of face value haircuts and maturity extensions. The prevalence of maturity extensions has been hard to reconcile with economic theory. We develop a model of endogenous debt restructuring that captures key facts of sovereign debt and restructuring episodes. While debt dilution pushes for negative maturity extensions, three factors are important in overcoming the effects of dilution and generating maturity extensions upon restructurings: income recovery after default, credit exclusion after restructuring, and regulatory costs of book value haircuts. We employ dynamic discrete choice methods that allow for smoother decision rules, rendering the problem tractable.Yurdagul gratefully acknowledges the support from the Ministerio de Economía y Competitividad (Spain) (ECO2015-68615-P), María de Maeztu grant (MDM 2014-0431), and from Comunidad de Madrid, MadEco-CM(S2015/HUM-3444)

News, sovereign debt maturity, and default risk

Leading into a debt crisis, interest rate spreads on sovereign debt rise before the economy experiences a decline in productivity, suggesting that news about future economic developments may play an important role in these episodes. An empirical VAR estimation shows that a news shock has a larger contemporaneous impact on sovereign credit spreads than a comparable shock to labor productivity. A quantitative model of news and sovereign debt default with endogenous maturity choice generates impulse responses and a variance decomposition similar to the empirical VAR estimates. The dynamics of the economy after a bad news shock share some features of a productivity shock and some features of sudden stop events. However, unlike during sudden stop episodes, long-term debt does not shield the country from bad news shocks, and it may even exacerbate default risk. Finally, an increase in the precision of news allows the government to improve its debt maturity management, especially during periods of high stress in credit markets, and thus face lower yield spreads while increasing the amount of debt.Yurdagul gratefully acknowledges the support from the Ministerio de Economía y Competitividad (Spain) (ECO2015-68615-P), María de Maeztu grant (MDM 2014-0431), and from Comunidad de Madrid, MadEco-CM (S2015/HUM-3444)