How To Understand The Relationship Between Delay And Haircut In Sovereign Debt

Transcription

1 CENTRE FOR DYNAMIC MACROECONOMIC ANALYSIS WORKING PAPER SERIES CDMA10/15 Delay and Haircut in Sovereign Debt: Recovery and Sutainability * Sayantan Ghoal Marcu Miller Univerity of Warwick Univerity of Warwick and CEPR Kannika Thampanihvong Univerity of St Andrew OCTOBER 010 ABSTRACT One of the triking apect of recent overeign debt retructuring i, conditional on default, delay length i poitively correlated with the ize of haircut. In thi paper, we develop an incomplete information model of debt retructuring where the propect of uncertain economic recovery and the ignalling about utainability concern together generate multi-period delay. The reult from our analyi how that there i a correlation between delay length and ize of haircut. Such reult are upported by evidence. We how that Pareto ranking of equilibria, conditional on default, can be altered once we take into account the e x a nte incentive of overeign debtor. We ue our reult to evaluate propoal advocated to enure orderly reolution of overeign debt crie. JEL Claification: F34, C78. Keyword: Debt retructuring, delay, haircut, growth, utain-ability, information, incentive. * Correpondence: Kannika Thampanihvong, School of Economic and Finance, Univerity of St Andrew, 1 The Score, Catlecliffe, St Andrew, Fife, United Kingdom KY16 9AL, Tel: +44 (0) , Fax: +44 (0) , kt30@t-andrew.ac.uk CASTLECLIFFE, SCHOOL OF ECONOMICS & FINANCE, UNIVERSITY OF ST ANDREWS, KY16 9AL TEL: +44 (0) FAX: +44 (0) cdma@t-and.ac.uk

2 1 Introduction There i coniderable evidence which how that countrie have repeatedly defaulted on their external obligation (Reinhart and Rogo (009)). What are the common feature aociated with default on overeign debt? On everal occaion, debt recheduling or negotiated partial default often involve a reduction of interet rate, if not principal, and typically addle creditor with illiquid aet that may not pay o for an extended period of time (Reinhart and Rogo, 009). Illiquidity and reduction in debt repayment, two triking apect of recent overeign debt negotiation, could impoe a huge cot to invetor. Both Roubini and Seter (004b) and Sturzenegger and Zettlemeyer (007) provide evidence that overeign bond retructuring involve cotly delay and argue that delay in overeign debt retructuring negotiation or lengthy debt renegotiation i widely regarded a ine cient ince the overeign debtor uually u er from loing acce to the international nancial market while the creditor cannot realize their invetment gain. Table 1 ummarize data from both thee paper and provide uggetive evidence that in a number of recent epiode of overeign debt retructuring, delay length and the ize of haircut are poitively correlated. Sovereign Retructuring Delay Face Default? State negotiation - after default value Haircut Ruia 11/1998-7/000 Ye 0 month 1/ month $9.1 69% Ukraine 1/000-4/000 3 month Ye 3 month $.6 40% Pakitan /1999-1/ month No $0.6 30% Ecuador 8/1999-8/000 1 month Ye 1 month $6.5 60% Argentina 9/003-4/005 Ye 19 month 1/ month $ % Uruguay 4/003-5/003 1 month No $3.8 6% Table 1: Sovereign Debt Retructuring during

3 Source: Table 14 and 15 in Sturzenegger and Zettlemeyer (005); Table A.3 in Roubini and Seter (004b) Why i it o di cult for overeign debtor and creditor to retructure overeign debt in an orderly and timely manner? Will fater and more orderly debt retructuring not only help in retoring economic momentum but alo reducing the probability of with which a crii occur in the rt place? From a theoretical perpective, a ingle creditor, complete information bargaining model of overeign debt retructuring (for example, Bulow and Rogo (1989) and Bhattacharya and Detragiache (1994)) cannot account for delay ince, in thi cla of model, an immediate agreement occur along the equilibrium path of play. When the ize of bargaining urplu i determinitic, the defaulting country and it creditor know exactly the future bargaining urplu; thu, both bargaining partie can reach an agreement immediately after the default. In thi paper, our tarting point i the aumption that both the recovery proce and the willingne to undertake maive cal cut (by running a primary budgetary urplu, for example) are uncertain. In a ingle creditor model, we how that multi-period cotly delay will exit in a Perfect Bayeian equilibrium driven by the propect of uncertain economic recovery and the ignalling of utainability concern. In our model, the length of delay i poitively correlated with the ize of creditor loe or haircut. Although one-period delay occur to permit for economic recovery, multi-period delay i eential for the debtor to ignal utainability concern. Relative to the cae with one-period delay, with two-period delay, the creditor alway receive lower payo, which lead to larger haircut although the debtor could either gain or loe. When the debtor gain from two-period delay, conditional on default, the two cenario cannot be interim 1 Pareto ranked. However, when the debtor loe from twoperiod delay, one-period delay interim Pareto dominate two-period delay conditional on default. We ue data from Benjamin and Wright (009) to provide evidence on the poitive correlation between delay length and haircut. 1 At the interim tage, payo are computed conditional on default but before all uncertainty related to the ize of the bargaining urplu and the utainability concern i reolved. 3

4 Finally, we introduce ex ante debtor moral hazard o that the probability of default i endogenou. We examine the impact of delay in debt retructuring negotiation on the probability of default. We how that the ex ante Pareto ranking of the equilibria with one-period and two-period delay could be di erent from their interim Pareto ranking of equilibria conditional on default. We then examine ome policy intervention that have been advocated to enure more orderly reolution of overeign debt crie. The remainder of the paper i tructured a follow. The next ubection preent a review of related literature. Section preent the model and the reult. Section 3 i devoted for preenting ome upporting evidence. Section 4 i devoted for dicuing the iue related to ex ante overeign debtor incentive. Section 5 preent ome policy recommendation, while Section 6 conclude. The proof and computation underlying ome expreion in the main body of the paper are contained in the appendix. 1.1 Related Literature Our reult that there could be multi-period delay in a ingle-creditor model i complementary to a number of other paper that eek to explain delay in debt retructuring. Some cholar highlight the holdout problem or collective action problem among creditor, whereby an individual creditor i better o if he get paid in full, while other creditor bear the burden of debt retructuring. In Pitchford and Wright (007), delay in debt retructuring negotiation arie from creditor holdout and free-riding on negotiation e ort. In another cla of model, cotly debt retructuring arie from imperfect creditor coordination with multiple creditor (Kletzer, 00; Ghoal and Miller, 003; Haldane et al., 004; Weinchelbaum and Wynne, 005; Ghoal and Thampanihvong, 009), whereby conditional on default, the lack of creditor coordination lead to an ine cient outcome. Merlo and Wilon (1995, 1998) how that immediate ettlement can be ocially uboptimal. Sturzenegger (00) argue that default uually reult in large output loe o that delaying ettlement could bene t both the According to Roubini and Seter (004b), the New York law overeign bond contract give each individual bondholder the right to initiate litigation and allow each bondholder to keep for himelf anything that he recover from the overeign. Roubini and Seter alo pointed out that, in cae of Argentina, it ha to retructure 98 international bond held by a divere group of invetor, including international intitutional invetor, dometic penion fund, and hundred of thouand of retail invetor. 4

5 debtor and the creditor. Dhillon et al. (006) examine the Argentine debt wap in 005 to ee whether bargaining theory in the pirit of Merlo and Wilon (1998) can help explain the Argentine nal debt ettlement a well a the delay in achieving ettlement. Baed on a dynamic model of overeign default in which debt renegotiation i modelled a a tochatic bargaining game along the line of Merlo and Wilon (1995), Bi (008) nd that delay i bene cial a it permit the debtor country economy to recover from a crii. Multi-period delay can arie in Bi (008) but delay length could be negatively correlated with haircut ize. In a related vein, Benjamin and Wright (008) analyze the impact of uncertainty on the renegotiation length. Speci cally, the debtor and the creditor nd it privately optimal to delay retructuring until future default rik (i.e. rik that the debtor will default on the ettlement agreement) i low, even though delay mean ome gain from trade remain unexploited. Bai and Zhang (009) tudy another overeign debt negotiation game with private information about creditor reervation value. The government ue cotly delay a a creening device for the creditor type o delay arie in the equilibrium. The length of delay poitively correlate with the everity of private information and could negatively correlate with haircut ize although they how that the preence of a econdary market on overeign debt could reduce delay length. The Model and the Reult.1 The bargaining model environment In thi ection, we conider a overeign debtor who i already in default. Conditional on default, there i a bargaining between the overeign debtor and the creditor to retructure the defaulted overeign debt. We refer to the bargaining urplu a the additional tax revenue generated to the overeign debtor by gaining acce to the international capital market once the outtanding debt ha been uccefully retructured 3. We uppoe that the 3 In Eaton and Gerovitz (1981), while in default, the debtor cannot acce the international capital market to borrow for conumption moothing. Bi (008) aume that, after a default, the overeign debtor ha no acce to outide nancing and the length of excluion from international capital market depend on the renegotiation proce. The overeign debtor need to repay it defaulted debt in order to regain acce to the capital market. 5

6 overeign debtor ue the tax revenue for one of the two reaon: pending on public good or debt repayment. Thu, debt repayment require a diverion of fund away from expenditure on public good. We interpret the debtor o er to the creditor in the debt retructuring negotiation a the amount of tax revenue diverted from proviion of public good. The total tax revenue available for bargaining i repreented by, where > 0. Since we begin our analyi in thi ection at a point in which the debtor i in default, we aume that the value of in the period immediately after default the initial period i low and i denoted by L. Thi aumption i along the line of the argument put forward by Sturzenegger (00), that i default i aociated with large collape in the economy output thu, following a default, few reource are available in the debtor country for debt repayment. We, however, allow the future value of to be tochatic o that, in the ubequent period, can continue to be low at L with probability p or grow to a higher lever, H, with probability 1 p. A growing can be interpreted a an increae in the tax revenue. It i important to highlight that, if a debt ettlement occur immediately after a default, i.e. in the initial period, in which the bargaining urplu, L, need to be hared between the overeign debtor and the creditor, the cake to be allocated i mall and doing o could mean both partie chooe to give up on the propect of economic growth. A in Dhillon et al. (006), during the debt retructuring negotiation, the overeign debtor could have a trategy for reducing the debt vulnerability uch a the running of cal urplue to reduce the remaining debt ervice. Such utainability contraint eentially retrict the amount available for creditor in the debt negotiation, particularly when the economy of the debtor country i in a receion following a default. In thi paper, the debtor utainability contraint i repreented by, and it denote the minimum fraction of the tax revenue required by the debtor which i conitent with economic and political tability of the debtor country. To implify our analyi, we aume that there are two type of debtor, Optimitic and Cautiou, and the debtor type i determined by the utainability contraint. For the Optimitic debtor, i cloe to zero, while the Cautiou debtor utainability contraint,, i cloe to a level > In the cae of Argentina, even after economic recovery, the ratio of the utainability to the bargaining urplu, =, i 55 percent (Dhillon et al., 006). 6

7 The Optimitic and the Cautiou debtor di er in the utility they obtain from conuming their part of the bargaining urplu. While the utility of the Cautiou debtor i linear in her hare of the bargaining urplu, for the Cautiou debtor, there i a dicontinuity in the utility at a threhold ettlement level,, to re ect her utainability concern on the debt ettlement. Formally, let u i denote the utility of type-i debtor, where i = Optimitic (O), Cautiou (C), and let i denote the type-i debtor hare of the bargaining urplu. It follow that, for the Optimitic debtor, u O = O for all value of O, while for the Cautiou debtor, u C = ( 0 for C < C for C : In thi paper, we capture the debtor concern on utainability of debt ettlement by auming the piecewie linearity of preference. By doing o, it rule out default a a mechanim for rik haring, which would likely a ect welfare computation. We aume that there i an aymmetric information about the utainability contraint. The creditor prior probability over f0; g i fq 0 ; 1 q 0 g. We aume that the uncertainty with repect to and with repect to the utainability contraint are reolved at t =. In our model, bargaining take place over a number of time period, t = 1; ; 3; ::: The bargaining game i peci ed a follow. We aume that the debtor make an o er at t = 1, but, in the ubequent period, the debtor and the creditor have an equal probability of making an o er. An o er i a number greater than or equal to zero and le than or equal to. If the o er i accepted, then the overeign debtor repay the creditor according to the agreement and the game end; otherwie, both player enter the next period. Thi proce continue until the o er i accepted. In any period in which there i diagreement, the debtor i excluded from having acce to the international capital market, which i tranlated into an aumption that the diagreement payo for both player are zero. The timing of event i ummarized in Table. 7

8 Size of Debtor type Propoer Outcome t = 1 L Debtor make an o er t = t = 3; ::: Uncertainty over i reolved. Sutainability contraint i revealed to the debtor. Table : Timing of Event Debtor and creditor make o er 1 with prob. ; 1 Debtor and creditor make o er 1 with prob. ; 1 If o er i accepted, game end. If o er i rejected, game continue: If o er i accepted, game end. If o er i rejected, game continue: If o er i accepted, game end. If o er i rejected, game continue. We olve for the Perfect Bayeian equilibrium of the model. We aume that both creditor and overeign debtor have a common dicount factor = (1 + r) 1, where < 1 and r i the interet rate charged on overeign debt. In order to ditinguih between one-period and two-period delay, we conider two cae: (Cae 1) tochatic bargaining urplu but there i complete information about utainability contraint and the debtor type, and (Cae ) tochatic bargaining urplu and there i aymmetric information about the utainability contraint and the debtor type..1.1 Cae 1: Stochatic bargaining urplu and complete information about the debtor type In thi cae, the debtor type i known at t = o the creditor know whether the debtor i Optimitic or Cautiou. We begin our analyi at t =. We compute the debtor and the creditor econd-period payo when the debtor i Optimitic and Cautiou, repectively. We then calculate the continuation value for each player a we move backward to the rt period. The continuation value would limit the o er that can be made by the debtor at t = 1, when the debtor i a propoer. To capture the point that, at t =, the ize of bargaining urplu i tochatic, we uppoe that E denote the expected ize of tax revenue, where E = p L + (1 p) H. 8

9 Delay occur at t = 1 if the debtor bet o er, which i the exce of the available bargaining urplu at t = 1, L, over the debtor own continuation value, fall below the creditor continuation value. We how that, when the bargaining urplu i tochatic and there i a complete information about the debtor type, delay occur whenever the expected growth rate of the economy, Eg = (E L) L, exceed the rate of dicount, r = 1, regardle of the debtor type, i.e. r < Eg. Thi condition for one-period delay i eentially the ame a that in Merlo and Wilon (1998). Our model predict that, with relatively low growth propect, there will be an immediate agreement between the debtor and the creditor. We ummarize the above dicuion a the following propoition: Propoition 1 When the debtor type i known but there i an uncertainty with repect to, there i one-period delay in overeign debt retructuring whenever the expected growth of the economy exceed the rate of dicount. Proof. See Appendix A..1. Cae : Stochatic bargaining urplu and aymmetric information about the debtor type In thi ubection, we conider the cae in which the bargaining urplu can change over time in a tochatic manner and there i aymmetric information about the debtor type. We olve the model by backward induction, tarting from period t = 3. At t = 3, the creditor poterior belief over the two type of debtor i denoted by q 1. Table 3 preent the creditor o er at extreme value of q 1 and the creditor payo 5. A. Creditor belief a to debtor type q 1 = 1 (Optimit) q 1 = 0 (Cautiou) Creditor o er ( ) ( ) Table 3: Creditor o er with extreme belief Creditor Payo ( ) 5 The detailed computation of creditor o er and payo are preented in Appendix 9

10 For le extreme belief, 0 < q 1 < 1, the creditor expected payo from a high o er of ( ), which i acceptable to both type of debtor, i ( ), while the creditor expected payo from a low o er of, which i only acceptable to the Optimitic debtor i q 1. If q 1 > ( ), the creditor will do better by making a low o er but otherwie for q 1 < ( ). When q1 = ( ), the two o er give the creditor the ame expected payo. Thi condition implie that the poterior belief of the creditor i q 1 =. Since 0 < <, it follow that q 1 < 1. We aume that, if the creditor i indi erent between a low and a high o er, he will chooe to make a high o er. Table 4 how the creditor o er at t = 3 a a function of hi poterior belief. Creditor belief a to debtor type q 1 > (Probably an Optimit) q 1 (Probably Cautiou) Expected payo Creditor o er for creditor q 1 ( ) ( Table 4: Creditor o er at t = 3 for all value of belief If, however, the debtor i the propoer, the Optimitic debtor o er i ( ), while the Cautiou debtor o er i, which are the correponding continuation value of the creditor a computed in Appendix A. Moving to the econd period, the continuation value for the debtor and the creditor, given the common dicount factor,, and the fact that each negotiating party ha an equal probability of being a propoer, are preented in Table 5. 6 ) Creditor belief a to debtor type q 1 > (Probably an Optimit) q 1 (Probably Cautiou) Continuation value for debtor (+) Continuation value for creditor q1 ( ) + 6 In Table 5, when q 1! 1, the creditor continuation value approache, which i the ame a in the cae with complete information about the debtor type. 10

11 Table 5: Continuation value for the debtor and the creditor at t = At t =, there i an aymmetric information about the debtor type. Let u x the creditor poterior belief, q 1, o that the creditor continuation value are a given in Table 5. We denote uch continuation belief by q1 0, where q0 1. Correponding to uch continuation belief of the creditor, the debtor and the creditor continuation value are given by (+) ( ) and, repectively. In what follow, we how that delay in the econd period i neceary for the debtor to ignal about her type and the utainability concern. Lemma 1 Delay occur in the econd period of the bargaining game whenever the creditor prior belief that the debtor i Optimitic, q 0, i u ciently high, i.e. q 0 >, or when the utainability concern i u ciently important, i.e. > (1 q 0). Proof. See Appendix A The detail of the mixed trategy at t = are a follow: if the debtor i choen to be a propoer, the Optimitic debtor o er (~x ; ~x ) with a probability (1 ) and o er (x 0 ; x0 ) with a probability, where ~x = +, x0 > + and = 1 q 0 q 0, while the Cautiou debtor o er (x 0 ; ) with a probability 1. The creditor reject the o er x0 (~x ; ~x ) with a probability (1 ) and reject the o er (x 0 ; x0 ) with a probability 1, where = (~x ) to make an o er at t =, the creditor o er (~x ;. If, intead, the creditor i choen ~x ). The Optimitic debtor accept uch creditor o er with a probability, while the Cautiou debtor reject the creditor o er with a probability 1. Next, at t = 3, the creditor belief a to the debtor type i q 1 =. The creditor payo at t = 3 i ( ), while the debtor payo depend on the debtor o er at t =. If the debtor o er i (~x ; ~x ), the debtor payo at t = 3 i ; however, if the debtor o er at t = i (x0 ; x0 ), her payo at t = 3 i (+). We then move backward to period t = 1 and calculate the continuation value for the creditor and for the debtor. There are two cenario to be conidered: (1) the debtor know her own type and () the debtor doe not know her own type. 11

12 If the debtor know her own type, according to the detailed computation in iappendix B, the continuation value for the Optimitic debtor i i, the continuation value for the Cautiou debtor i and h (+) 4 the continuation value for the creditor i ( ) 1 (1 q 0 ) + h (+) (1 q 0 ) x 0 : On the other hand, if the debtor doe not know her own type, again following the detailed computation in Appendix B, the debtor continuation payo i (+) q0, while the creditor continuation payo i the ame a in the rt cenario. From thee two cenario, it follow from the detailed computation in Appendix B that the expected payo for the creditor from rejecting the debtor o er at t = 1, ^a, i given by (E ^a = ) (E (1 q 0 ) ) (E ) E + Ex 0 ; where Ex 0 > E (E ) ince x 0 > ( ). An alternative interpretation for ^a could be the minimum payo for the creditor to accept the debtor o er. For delay to occur at t = 1, when the debtor i a propoer, it hould be attractive for the the creditor to reject the debtor bet o er at t = 1. Thi happen when the bet o er of the debtor fall below the creditor continuation payo or the expected payo, ^a, computed earlier. Lemma The condition for delay at t = 1 i L (E + ) < ^a; i.e. the exce of the available bargaining urplu over the Cautiou debtor own continuation value fall below the creditor expected payo in the rt period. Proof. In what follow, we derive the condition for delay for each type of debtor at t = 1. For the Optimitic debtor, the bet o er that he can make i the exce of the available bargaining urplu, L, over her own continuation value,, i.e. L. If uch o er fall (E+) 4 1 (E+) 4

13 below the expected payo for the creditor, ^a, the debtor o er will not be accepted ince the creditor doe better by waiting until the next period. Thi reult in a delay in the rt period. Formally, the condition for rt-period delay for the Optimitic debtor i given by L (E + ) < ^a: (1) 4 For the Cautiou debtor, her bet o er i L (E+). If uch o er fall below ^a, the o er will not be accepted. Formally, the condition for delay for the Cautiou debtor i L (E + ) < ^a: () Clearly, when condition () i ati ed, condition (1) will alo be ati ed. Thu, the condition for delay in the rt-period i given by condition (). Therefore, in the cae in which the bargaining urplu i tochatic and there i an aymmetric information about the debtor type and the utainability concern, there i a emi-eparating Perfect Bayeian equilibrium with two-period delay along the equilibrium path of play, initially to permit for economic recovery followed by ignalling about the utainability contraint given that the condition: > (1 q 0) or q 0 > and L (E + ) < ^a are ati ed. E Since 0 < q 0 < 1, > 0 and Ex 0 (E ) > E, by computation, it follow that ^a < E (E ) and ^a <. Therefore, the condition for rtperiod delay both for the Optimitic and Cautiou debtor when therei an aymmetric information about the debtor type, i.e. L (E+) 4 < ^a and L (E+) < ^a, repectively, are more tringent than the condition for delay in the full information cae, i.e. r < Eg. The reaon i that, under the former, there i a poitive rik that the creditor would face a Cautiou debtor, which lower the creditor continuation payo. We ummarize the above dicuion a the following propoition: Propoition When there i an aymmetric information about the debtor 13

14 type and a tochatic bargaining urplu, there exit a Perfect Bayeian equilibrium with two-period delay.. Comparion of payo with one-period and two-period delay In what follow, we compare the creditor payo in the cae with oneperiod delay and in the cae with two-period delay in the mixed trategy equilibrium. Thi would allow u to etablih the correlation between delay and ize of haircut in overeign debt. Table 6 provide a ummary for the creditor continuation payo from rejecting the debtor o er at t = 1 in the cae with one-period and two-period delay. Debtor type Creditor payo with one-period delay E Creditor payo with two-period delay Optimitic debtor ^a (E ) Cautiou debtor ^a Table 6: Delay and haircut in overeign debt retructuring (in a mixed trategy) Baing on Table 6, for the creditor expected payo with one-period delay to be greater than the expected payo with two-period delay, it require that E (E q 0 + (1 q 0 ) ) > ^a: Let Ex 0 = E (E ) + ", where " i a trictly poitive number. By computation, the above condition reduce to E (E q 0 + (1 q 0 ) ) (E ) E + (1 q 0 ) > 0; which i equivalent to q 0 E + (1 q 0 ) > 0; a condition which alway hold. 14

15 Thu, conditional on default, relative to one-period delay, the creditor lo i higher under two-period delay o, in the mixed trategy equilibrium, delay i poitively correlated with haircut. In order to undertake the Pareto ranking of equilibria, we need to compute the debtor payo with one-period and two-period delay. With twoperiod delay, the debtor expected payo i (+) q0, where the detailed computation i contained in Appendix B. By computation, it follow that the debtor expected payo with two-period delay i greater than the payo with one-period delay if and only if: E > (1 ) + q 0 (1 ) + q 0 ( ) : (3) The fraction on the RHS of the above inequality i decreaing in q 0 but increaing in, while the fraction on the LHS of the inequality i increaing in. Therefore, the debtor payo with two-period delay i likely to be higher than the payo with one-period delay the higher i the ratio of utainability contraint to the expected value of the bargaining urplu, the lower i the dicount factor and the higher i the creditor prior that the debtor i Optimitic. A poible intuition behind thi condition could be that, both when the dicontinuity in the debtor payo i at a higher ettlement value and when the creditor ha a high prior that the debtor i of an Optimitic type, the value of ignalling about the debtor type and the utainability concern i greater for the debtor. By conidering both the debtor and the creditor payo conditional on default with one-period and two-period delay, our reult how that, relative to one-period delay, two-period delay i interim Pareto dominated only when the direction of the above inequality (3) i revered ince, in thi cae, both the debtor and the creditor payo are lower than with one-period delay. Whenever the above inequality (3) hold, relative to one-period delay, the debtor make a payo gain with two-period delay, while the creditor make a payo lo. In thi cae, the two equilibria cannot be interim Pareto ranked. We ummarize the above dicuion a the following propoition: Propoition 3 Two-period delay never interim Pareto dominate one-period delay although the revere could be true. 15

16 3 Empirical Evidence on Delay in Sovereign Debt Retructuring Negotiation and Haircut In everal tudie on overeign debt retructuring negotiation between a overeign debtor in default and the international creditor, there have been ome documentation that thee negotiating partie have encountered ome di cultie in reaching mutually advantageou ettlement a there i evidence of both delay and haircut. Roubini and Seter (004b) point out that a number of the overeign debt retructuring between 1998 and 005 have been largely characterized by protracted negotiation. With regard to haircut, Sturzenegger and Zettelmeyer (005) nd that there are very large variation in the average level of haircut acro the debt retructuring epiode of 1998 to 005. The preent value haircut 7, according to their calculation, ranged from around 5 to 0 percent for Uruguay (003) to over 50 percent for Ruia (000) and over 70 percent for Argentina (005), with the remaining exchange falling motly in the 0 to 40 percent range. Roubini and Seter (004b) and Sturzenegger and Zettelmeyer (005) have been the two commonly ued ource of data for delay length (default date and date of debt ettlement) and etimate of creditor loe or haircut a cited by everal paper including Dhillon et al. (006), Ghoal and Miller (005), D Eramo (007) and Bi (008). In fact, there exit mall number of etimate of creditor loe produced by di erent reearcher, particularly World Bank (1993), Cline (1995), and Global Committee Argentina Bondholder (004). A recent paper by Benjamin and Wright (009) uncovered di erent etimate of haircut in 7 default contructed by four di erent ource mentioned earlier uing 5 di erent method. Among thee four ource, Benjamin and Wright argue that Sturzenegger and Zettelmeyer (005, 007) provide the mot rigorou meaurement for creditor loe, but the etimate are only available for ix default epiode. Drawn from a variety of ource, the databae on overeign debt retructuring outcome containing data on the occurrence of default and ettlement, the outcome of negotiation a well a meaure of economic performance and indebtedne contructed 7 The loe that default have in icted on creditor are largely baed on the comparion between the (remaining) payment tream that wa originally promied to invetor and the payment tream aociated with the retructured intrument, both dicounted at a common interet rate (Sturzenegger and Zettelmeyer, 007). 16

17 by Benjamin and Wright (009) cover 90 default epiode by 73 countrie during the period of 1989 to 006. Baing on the ummary tatitic they obtained, Benjamin and Wright nd that the length of delay fall within the range of 7.4 to 7.6 year. Benjamin and Wright alo report that the average creditor experienced a haircut of roughly 40 percent of the value of the debt. Lat but not leat, they nd that there i an evidence that longer delay i aociated with larger haircut, with a correlation between the length of the renegotiation proce and the ize of haircut of Figure 1 Delay length and haircut Source: Data on delay length and haircut are from Benjamin and Wright (009) Table 15 in Appendix C 3.1 A cae tudy of Argentina Could Argentina be a cae in point 8? In what follow, we provide a dicuion on why Argentina could be an example of recent debt retructuring, following a default in 001, which involve a ubtantial delay and large haircut. There were di erent factor that could explain why a retructuring of Argentine overeign debt involved a ubtantial delay. We begin by conidering the political factor that militated againt early retructuring. After a default on overeign debt wa declared at the end of 001, there wa a problem of legitimacy a Argentina wa being governed by an interim adminitration led by Preident Duhalde. At that time, ince the Argentine economy wa in a evere receion, the priority of the Preident wa to engineer recovery and not to purue outtanding tructural reform, among which debt reolution wa the mot important (Bruno, 004, p.160). Seriou e ort to retructure Argentine debt did not begin until the interim adminitration wa replaced in the election of 003, but the triking rate of recovery of GDP during Preident Duhalde adminitration ugget that debt retructuring would have been potponed even if there had been no problem of legitimacy (Dhillon et al., 006). 8 Clearly, a key policy iue in the dicuion urrounding the Argentinean debt retructuring i related to iue of debt retructuring. In what follow, we highlight thi apect of the Argentinean experience. Thi i not becaue we do not think creditor coordinator i not important in practice (ee, for intance, Roubini and Seter (004b, p.98)) but to emphaize iue central to thi paper, namely thoe of recovery and utainability. 17

18 It wa in September 003, at the meeting of the IMF and the World Bank in Dubai, that the Argentine government led by Preident Kirchner nally revealed it negotiating tance. The peci c trategy for reducing the debt expoure of the economy involved three principal commitment by the Argentine government, namely to run a primary urplu of 3 percent of GDP, to limit the cot of debt ervice, and to exempt the preferred creditor from the debt retructuring. The three percent GDP ceiling on debt ervice retrict the amount that i available for creditor in the debt wap, particularly when GDP i low. Thu, the rt two commitment by the government of Argentina e ectively determined the overall ize of the debt write-down. The third commitment, which require paying full compenation to the preferred creditor 9 meant there wa little left for other private creditor. Without taking account of pat-due interet, thee contraint left an annual ow of only about a billion dollar on GDP valued at $137 billion a Dubai reidual of le than one percentage point of GDP for private creditor holding debt with a face value of around $80 billion (Dhillon et al., 006). The Dubai propoal articulated by the Argentine government were promptly rejected by creditor group. However, improvement o ered in the coure of 004 together with a decline in the global interet rate meant that a debt wap wa nally accepted by 76 percent of the creditor in 005. To ummarize, in the cae of Argentina, there were clearly two eparate phae leading up to the debt wap in 005. In the rt phae, from end of 001 to mid-003, the Argentine economy wa recovering trongly from a deep receion and there appeared to be a conenu between both partie to await recovery a conenu reinforced by the political di cultie faced by the Duhalde regime. A for the econd phae, one could interpret the meagre Dubai o er made by Argentina in September 003 a driven by utainability concern. In the context of our analyi, thi low o er wa deigned to be rejected by international creditor, leading to delay and a reappraial of the type of debtor i Argentina and nally to a ettlement that repected thee utainability concern. It i intereting to take note of the cloe coincidence of the nal debt wap with the utainability requirement 10 calculated by 9 Thee included both international nancial intitution, uch a the IMF, the World Bank and the IADB, and dometic bondholder who had lent into arrear. 10 A already pointed out in Dhillon et al. (006), the ratio of utainability contraint to the bargaining urplu, =, for Argentina ha a value of 55 percent, while the debt 18

19 the Argentine government Debtor Ex Ante Incentive and E ciency In Section, we have een that multi-period cotly delay arie in a Perfect Bayeian equilibrium driven by propect of uncertain economic recovery and ignalling about the utainability concern. What are the implication of delay on the overeign debtor ex ante incentive? In order to anwer thi quetion, we tudy a very imple model of ex ante debtor moral hazard and, by endogenizing the probability of default, examine the impact of delay on the probability of default, i.e. under what condition would two-period delay, relative to one-period delay, increae the probability of default? We aume that the overeign debtor iue a bond 1 at t = 0, which promie an interet coupon, r, in perpetuity. At t = 0, the overeign debtor ha to chooe the level of e ort 13, e [0; 1], at a cot (e), where 0 (e) > 0 and 00 (e) > 0, o that it i more cotly for the debtor to exert high e ort relative to low e ort. At the beginning of t = 1, the overeign debtor face an advere hock 14 with probability h. Conditional on the advere hock, there i a default by overeign debtor with probability 1 e due to a lack of available fund to cover outtanding debt payment. Thi ugget that a wap itelf i etimated to repreent a payo of about 53 percent. 11 Anecdotal upport for thi interpretation i provided in Liacovich (005, pp. 6-7) in hi biography of Mr. Lavagna, who wa the Argentine Finance Miniter at the time. Hi writing on the low Dubai o er and the utainability concern lying behind it i a follow: ome time before the o er [at Dubai], Lavagna wa already preparing the eld: he realized that after the o er, there are going to be ad face everywhere. And indeed the rt reaction of the creditor wa of rejection...but the Argentine o enive wa not retricted to Dubai. [Preident] Kirchner in New York, one day after the o er, had an interview with Preident George W. Buh, who aid, Keep on negotiating rmly with the creditor. And the Argentine Preident ued the auditorium of UN General Aembly to criticize the international nancial organization for upporting debt reduction and [promoting] growth. It i never been known to recover debt from the dead, he aid in hi peech. 1 It i important to explicitly tate that, in thi model of ex ante debtor moral hazard, ince the debtor doe not decide how much to borrow, there i no room for default to improve rik haring, and there i no intenive margin along which borrowing can be adjuted to change in the cot of borrowing. 13 In thi context, high e ort could correpond to a ituation where money i borrowed and ued to promote R&D in the export ector and low e ort could correpond to tranferring borrowed money to local elite who are then free to put it in tax haven overea (ee Ghoal and Miller (003) for more example of ex ante debtor moral hazard and other relevant reult). 14 An example of uch advere hock could be a hock to world oil price. 19

20 low e ort implie that the debtor economy i more likely to be vulnerable to an advere external hock. The advere hock occur with a poitive probability only at the beginning of t = 1, and the probability of the advere hock i zero in all ubequent period. In the abence of the advere hock, the debtor continue to make any contracted repayment and obtain a continuation, noncontractible payo 15 (meaured in t = 0 payo unit) of D > 0. The fact that the debtor payo, D, i non-contractible mean that D cannot be attached by the private creditor in the ettlement of their claim nor can the overeign debtor make a credible commitment to tranfer uch payo to the private creditor. If there i a default, the payo of the debtor i decribed a in Section and will depend on whether there i one-period or two-period delay in the retructuring of defaulted debt. A a function of the equilibrium prevailing in the pot-default debt retructuring game, let K denote the debtor expected payo conditional on default, meaured in t = 0 payo unit, where K < D. The debtor face the following maximization problem: max h [ed + (1 e) K] + (1 h) D (e): e[0;1] The rt-order condition characterizing an interior olution i: 0 (e ) = h (D K) : Oberve that, ince 00 (e) > 0, it follow that the optimal level of ex ante e ort, e (and hence the probability of default, (1 e )) i increaing (decreaing) in the probability of advere hock, h, and the debtor noncontractible payo, D, but i decreaing (increaing) in the expected payo, conditional on default, for the debtor, K. In the interim debt retructuring negotiation, conditional on default, one ha een that whether or not the length of delay adverely impact the debtor payo depend on whether or not condition (3) hold, i.e. whether or not the debtor expected payo with two-period delay i greater than the payo with one-period delay. When two-period delay give the debtor 15 Following Eaton and Gerovitz (1981), we interpret thi non-contractible payo a the bene t at t = 1 of a future gain in national output when a debt crii i prevented at t = 1. 0

21 higher expected payo than one-period delay in the interim debt negotiation game, the debtor payo conditional on default, K, with two-period delay increae relative to the one-period delay, while the correponding ex ante choice of e ort of the debtor, e, goe down. It follow that, relative to oneperiod delay, two-period delay increae the ex ante probability of default, making the debt crie more likely in the rt place. Sovereign pread, S, could be calculated by uing the formula introduced in Ghoal and Miller (003) a follow: S = z (1 R) ; where z i the probability of default, and R i the recovery rate. Applying thi formula to the context of our analyi, the probability of default i z = (1 e ) h and the recovery rate, R, i inverely related to the creditor lo or the ize of the haircut. Whenever the two-period delay give the debtor higher expected payo than the one-period delay in the interim debt negotiation game (i.e. whenever condition (3) hold), it follow that, relative to one-period delay, overeign pread with two-period delay i higher ince both z i higher (a e i lower with two-period delay) and R i lower (a the ize of the haircut i higher with two-period delay). Although, when condition (3) hold, the equilibrium payo conditional on default with oneperiod delay cannot be e ciency ranked relative to the equilibrium payo with two-period delay ince the debtor gain while the creditor loe, the ex ante payo with two-period delay could be lower relative to with one-period delay. Moreover, with an appropriate adjutment of the overeign pread, the ex ante creditor payo will be una ected by the delay length. Formally, let e t (repectively, K t ) denote the e ort choice of the debtor (repectively, the debtor expected payo conditional on default) with delay length t, where t = 1;. A long a (1 e 1 ) K 1 ' (1 e ) K and h (e 1 e ) D > (e 1 ) (e ), then the overeign debtor payo are higher with one-period delay relative to two-period delay 16. By Propoition 3, relative to one-period delay, two-period delay i ine cient whenever it give the debtor lower expected payo at the interim period (conditional on default) than the one-period delay, i.e. when the direction of the inequality in condition (3) i revered, a in thi cae, both 16 The latter condition came from he 1D (e 1) > he D (e ). 1

22 the debtor and creditor payo with two-period delay are lower than with one-period delay. However, when the two-period delay give the debtor lower expected payo at the interim tage (conditional on default) relative to the one-period delay, with two-period delay, the debtor ex ante level of e ort, e, i higher and the probability of default, (1 e ) h, i lower than with one-period delay. Even though, relative to one-period delay,the recovery rate, R, i lower with two-period delay due to larger ize of haircut, the creditor ex ante payo will not be a ected a the overeign pread will be adjuted upward. However, the debtor ex ante payo could actually go up a long a (1 e 1 ) K 1 ' (1 e ) K and h (e 1 e ) D > (e 1 ) (e ). Therefore, the ex ante Pareto ranking of equilibria with one-period delay and two-period delay could be di erent from the interim Pareto ranking of equilibria conditional on default. We ummarize the above dicuion a the following propoition: Propoition 4 The ex ante Pareto ranking of equilibria with one-period delay and two-period delay could be di erent from the interim Pareto ranking of equilibria. 5 Policy Dicuion Drawing on the reult that we have obtained o far, in what follow, we provide a brief evaluation of a number of policy initiative that are in relation to the overeign debt retructuring, abtracting away from the iue of creditor coordination but focuing on delay generated by uncertain economic recovery and ignalling about the utainability concern. In principle, avoiding e cient delay due to waiting for economic recovery can be achieved by the tate-contingent bond contract 17. With tatecontingent bond contract, ince the debtor and the creditor agree ex ante how to adjut payment if advere hock occur, there i, therefore, no need for both partie to renegotiate the contract ex pot hould a negative hock take place. Payment on overeign debt would then be automatically adjuted upward in good tate (i.e. when output and economic growth are high), and adjuted downward in bad tate (i.e. during an economic receion and low growth). However, there are ome broad problem aociated 17 See Shiller (003), Caballero (003), Borenztein and Mauro (00) and Roubini and Seter (004b) for further dicuion on tate-contingent debt contract.

23 with thi type of debt contract. Firt, it i di cult to pecify all potential hock and contingencie in the contract and, econd, ince thi type of contract provide overeign debtor with inurance againt peci c contingencie, it could adverely a ect the debtor incentive and reult in the problem of debtor moral hazard. Thee problem could perhap explain why tate-contingent bond contract could be illiquid. Argentina did nally iue GDP-linked bond a a part of the debt wap. Thee bond were initially greatly undervalued by the market at the time of iue but have ubequently been priced much more favorably. Could thi be a good augury for future debt retructuring 18? In the model we propoe in thi paper, the IMF could help by providing information. When the growth propect are not common knowledge, for example, the IMF could reolve uncertainty about the future growth. Likewie, when utainability concern are in dipute, the IMF could publih it own bet etimate, which hould remove the need for a Cautiou debtor to ue delay a a ignal for utainability conideration 19. Viewed from the perpective of our model, clearly both of thee intervention directly addre concern relating to e ciency of debt retructuring conditional on default. However, their ue could be limited by concern relating to debtor moral hazard epecially when the Pareto ranking of equilibria i altered ex ante relative to their interim Pareto ranking conditional on default. Neverthele, in ome ituation, namely thoe where debtor payo are lower in the cae of one-period delay relative to two-period delay, the information role of the IMF could improve ex ante e ciency. A potentially eriou challenge to carrying out thi informational role i that the IMF face a con ict of interet: a a enior creditor, it preumably ha an incentive to exaggerate utainability requirement in favour of the debtor to minimize other claim on the debtor reource. Would uch induced compaion for the debtor not be checked by it creditor-dominated Executive Board? If not, thi informational tak could be delegated elewhere, perhap to the Inter-American Development Bank for cae of Latin American debt retruc- 18 In thi paper, we however, conider a non-contingent debt contract; thu the delay in the initial period i needed to permit the defaulted debtor economy to recover from the receion and o that more reource could be available for debt ettlement. 19 Blutein (005) provide dicuion on the o cial utainability aement of Argentina made by the IMF but kept con dential. 3

24 turing, for example. Moreover, conditional on default, the debtor may have an incentive to manipulate the information available to, and ubequently made public by, the IMF. 6 Concluion One of the triking apect of the recent overeign debt retructuring i that, conditional on default, long delay i poitively correlated with ize of haircut. In thi paper, abtracting away from the iue of creditor coordination, we develop a bargaining model to account for thi, highlighting the economic recovery and utainability conideration a complementary reaon for delay. With tochatic bargaining urplu and aymmetric information about the debtor utainability concern, we how that multi-period cotly delay arie in a Perfect Bayeian equilibrium, initially re ecting economic recovery followed by ignalling about utainability. A key reult of the model how that prolonged delay i poitively correlated with a large haircut. Thi reult i upported by empirical evidence. We, then, examine the ex ante incentive of the overeign debtor and nd that the Pareto ranking of equilibria, conditional on default, can be altered once ex ante incentive are taken into account. Finally, we ue our reult for examining a number of policy propoal put forward to enure an orderly retructuring of overeign debt. We argue that the IMF could help by providing information on future growth propect of the debtor country a well a publihing it bet etimate on the overeign debtor debt utainability. Combining the reaon for delay examined in thi paper with thoe driven by creditor coordination and creditor moral hazard remain a topic for future reearch. Acknowledgement The author are grateful to the ESRC under Project RES and RES We thank Javier García-Fronti, Daniel Heymann and participant at RES Conference 010 and eminar in the Bank of Spain and the Univerity of San Andre for helpful comment. 4

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