Sovereign Debt and Default

Sovereign Debt and Default Sewon Hur University of Pittsburgh February 1, 215 International Finance (Sewon Hur) Lecture 6 February 1, 215 1 / 22

Introduction Sovereign debt diers from corporate debt because of the lack of a legal mechanism to enforcement repayment In this lecture, we consider the Panizza, Sturzenegger, Zettelmeyer (29) survey on the existing theories of sovereign debt/default and the empirical literature International Finance (Sewon Hur) Lecture 6 February 1, 215 2 / 22

Theories of Sovereign Debt and Default Can a sovereign debt market exist if repayment cannot be enforced? Eaton and Gersovitz (1981) - yes, with the threat of permanent exclusion from credit However, Bulow and Rogo (1989) show that even with the threat of exclusion from credit, if there exist other methods to smooth consumption such as savings or insurance, then borrowing is impossible. International Finance (Sewon Hur) Lecture 6 February 1, 215 3 / 22

Theories of Sovereign Debt and Default Sachs and Cohen (1982), Bulow and Rogo (1989), Fernandez and Rosenthal (199) focus on direct punishment for reasons to repay (interference with a country's current transactions such as seizure of trade and payments) Cole and Kehoe (1998) - if default can damage government reputation, for instance, with the government's domestic partners, then debt can be sustained Sandleris (25), Catao and Kapur (26) focus on information revealed by default. If default signals, for instance, that government nancial position is weaker than previously thought, then future output may be reduced (perhaps due to increase in expected taxation) International Finance (Sewon Hur) Lecture 6 February 1, 215 4 / 22

Theories of Sovereign Debt and Default Mendoza and Yue (28) assume defaults limit the ability of private agents to obtain private capital - model is consistent with rapid output and TFP collapses Broner et al. (26) highlight the role of secondary markets in limiting sovereign risk. if foreigners can sell debt to domestic residents in secondary markets, then debt will always be repaid back, even in the absence of punishments. this result is ex-post inecient for the borrower (because if domestic agents could coordinate and not buy back debt, the government could default and be better o) but ex-ante ecient (because it allows the country to borrow, by solving the sovereign risk problem) International Finance (Sewon Hur) Lecture 6 February 1, 215 5 / 22

Theories of Sovereign Debt and Default A strand of the literature takes the existence of sovereign debt as given, and explore the eect of investor behavior or expectations run on debt (Sachs 1984, Alesina 199, Cole and Kehoe 1996, 2) run on currency (Aghion 21, 24, Krugman 1999, Burnside et al. 24) sudden stops (Mendoza 212, Calvo 1998, Hur and Kondo 213) International Finance (Sewon Hur) Lecture 6 February 1, 215 6 / 22

Theories of Sovereign Debt and Default Many recent papers have gone back to Eaton and Gersovitz's (1981) implicit assumption that countries do not have a savings opportunity after defaulting Aguiar and Gopinath (26), Arellano (28), Benjamin and Wright (28), Yue (26) to name a few... International Finance (Sewon Hur) Lecture 6 February 1, 215 7 / 22

Empirical Literature When do countries borrow? When do countries default? What are the default costs? International Finance (Sewon Hur) Lecture 6 February 1, 215 8 / 22

When do Countries Borrow? Levy-Yeyati (29) nds that private lending to sovereigns is procylical, while ocial lending is coutercyclical, with a net procyclical eect. This is in contrast to standard theory where sovereign borrowing is countercyclical (to smooth consumption) International Finance (Sewon Hur) Lecture 6 February 1, 215 9 / 22

Why is Borrowing Procylical? market failure: lack of access to international lending credit during recessions (Gavin and Perotti 1997), incomplete markets (Caballero and Krishnamurthy 24), limited enforcement (Kehoe and Perri 22), moral hazard (Atkeson 1991), etc political failure: conict of interest groups (Tornell and Lane 1999), political pressure for wasteful spending (Talvi and Vegh 25), corrupt politicians (Alesina et al. 28) nature of output shocks: Aguiar and Gopinath (26) and Rochet (26) show that a model with persistent shocks can generate procyclical borrowing even in the absence of political or market imperfections International Finance (Sewon Hur) Lecture 6 February 1, 215 1 / 22

When do Countries Default? In standard sovereign debt models, countries borrow during bad times and repay during good times. countries might be tempted to default, but anticipating this, creditors will not lend beyond a threshold level of debt at which defaulting is preferable to repaying. as a result, in the simplest models, defaults never happen. Defaults can arise in equilibrium in sovereign debt models with output uncertainty and incomplete contracts. countries default in bad states International Finance (Sewon Hur) Lecture 6 February 1, 215 11 / 22

Evidence The evidence is broadly consistent with theory Levy-Yeyati (26) nds that defaults tend to follow output contractions (1982-23) Tomz and Wright (27) nd a negative correlation between output and defaults (182-24) International Finance (Sewon Hur) Lecture 6 February 1, 215 12 / 22

Puzzles Remain.. Still, the theory is inconsistent with several features of default theories underpredict default - Aguiar and Gopinath (26) generate higher default rates through persistent shocks; Hatchondo and Martinez (28) with long-duration bonds. Still default probabilities are lower than observed. empirical relationship between bad output and defaults is not as tight - Tomz and Wright show that only 62 percent of defaults occur when output is below trend. This could be due to other shocks such as political shocks, credit shocks, interest rate shocks International Finance (Sewon Hur) Lecture 6 February 1, 215 13 / 22

Defaults Happen in Clusters Defaults tend to happen in clusters, suggesting that defaults are inuenced by the behavior of creditors and international capital markets (interest rate shocks, sudden stops), in addition to debtor country Panizza, shocks Sturzenegger, (output and Zettelmeyer: orsovereign political Debt and Default shocks) 669 18 16 Number of sovereign default episodes 14 12 1 8 6 4 2 182 1828 1836 1844 1852 186 1868 1876 1884 1892 19 198 1916 1924 1932 194 1948 1956 1964 1972 198 1988 1996 24 Year in which the country declared default Figure 1. Default Clusters, 182 25 International Finance (Sewon Hur) Lecture 6 February 1, 215 14 / 22

Costs of Default Capital market exclusion Sandleris et al. (24) nd that countries were excluded for an average of four years after defaults ended (198s) and -2 years since then Richmond and Dias (28) using a stronger denition of exclusion (positive net transfers) nd exclusions of 5.5 years (198s), 4.1 years (199s) and 2.5 since bottom line: calibrated models with exclusion alone cannot generate debt levels and default frequencies, many assume additional exogenous output costs (Alfaro and Kanzcuk 25, Arellano 28, Aguiar and Gopinath 26, Benjamin and Wright 28) International Finance (Sewon Hur) Lecture 6 February 1, 215 15 / 22

Costs of Default Higher borrowing costs Borendztein and Panizza (21) nd that spreads are 4 basis points higher in the year after default, 25 higher in second year, and loses statistical signicance thereafter (1997-24) Flandreau and Zumer (24) nd that spreads are 9 basis points higher in the year after, but the eect dies out rapidly (188-1914) bottom line: calibrated models with borrowing costs alone cannot generate debt levels and default frequencies, unless for instance output costs are assumed (Alfaro and Kanzcuk 25) International Finance (Sewon Hur) Lecture 6 February 1, 215 16 / 22

Costs of Default Domestic costs models predict defaults happen in bad states. Do defaults cause output drops, or make already bad states worse? evidence is mixed Sturzenegger (24): defaults are associated with a reduction in growth of.6 percent (2.2 percent if default comes with banking crisis) De Paoli et al. (26): output losses are correlated with defaults and increase with duration of default Levy-Yeyati and Panizza (26): defaults tend to happen in trough, and often mark beginning of recovery suer from endogeneity biases International Finance (Sewon Hur) Lecture 6 February 1, 215 17 / 22

Recent Default Episodes Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 683 Table 4 Characteristics of Recent Debt Restructurings Country Year Total amount restructured 1 (bill US$) Haircut (%) Type of restructuring Russia 1998 2 38.7 52.6 Postdefault Ukraine 1998 2 7.8 28.9 Predefault Pakistan 1999.61 31 Predefault Ecuador 1999 2 6.5 28.6 Postdefault Argentina 21 25 145 75 Pre- and postdefault Uruguay 23 5.4 13.3 Predefault Moldova 22.8 37 Pre- and postdefault Dominican Republic 25 1.5 2 Predefault 1 Domestic and external debt with private creditors. Source: Sturzenegger and Zettelmeyer (27, 28). restructuring with basically no haircut (the capita of at least US$5 and controls for International Finance Dominican (Sewon Republic). Hur) Finally, about half Lecture both 6 country and year fixed February effects, sug- 1, 215 18 / 22

Some Evidence of Temporary Exclusion Journal of Economic Literature, Vol. XLVII (September 29) 684 All countries Argentina Dominican Republic.1.2.5.5.2.2.4.6 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 Event time Event time Event time.1.5.5 Ecuador Moldova Pakistan.2.15.1.5.5.2.2.4.6.8 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 Event time Event time Event time Russia Ukraine Uruguay.5.5.1.5.5.2.3 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 Event time Event time Event time Figure 4. Recent Defaults and Private Capital Flows private capital ows (residuals of regression with country and year Notes: The figure plots the residuals of a regression that controls for country and year fixed effects and that includes all developing countries that had an income per capita greater than US$5 in the year 2. xed eects) International Finance (Sewon Hur) Lecture 6 February 1, 215 19 / 22

Limited Evidence of High Spreads Post-Default Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 685 3 All countries Argentina Dominican Republic 3 2 1 bps 36 24 12 12 24 36 36 24 12 12 24 36 36 24 12 12 24 36 Event time, months Event time, months Event time, months bps 2 Ecuador Pakistan Russia 2 5 bps bps bps 36 24 12 12 24 36 36 24 12 12 24 36 36 24 12 12 24 36 Event time, months Event time, months Event time, months 2 Ukraine 2 Uruguay bps bps 36 24 12 12 24 36 36 24 12 12 24 36 Event time, months Event time, months Figure 5. Spreads Before and After Defaults Notes: The figure plots the residuals of a that controls for year fixed effects and that spreads (residuals includes all countries of that are regression included in the JP Morgan withembi+ country Global. and year xed eects) International Finance (Sewon Hur) Lecture 6 February 1, 215 2 / 22

Mixed Evidence of Output Costs Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 689.1.5.5 5 All countries Argentina Dominican Republic.5.5 5 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 Event time Event time Event time Ecuador Moldova Pakistan.5.5.2.5.2.5.4 5.6 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 Event time Event time Event time Russia Ukraine Uruguay.1.1.5.5.5.5 5.2 5 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 5 4 3 2 1 1 2 3 4 5 Event time Event time Event time Figure 7. Recent Defaults and GDP Growth GDP growth (residuals of regression with country and year xed Notes: The figure plots the residuals of a regression that controls for country and year fixed effects and that includes all developing countries that had an income per capita greater than US$5 in the year 2. eects).5.5 International Finance (Sewon Hur) Lecture 6 February 1, 215 21 / 22

Costs of Default Sovereign defaults are typically associated with output declines, nancial sector declines, and a temporary period of capital market exclusion Evidence for persistent eects of default is limited International Finance (Sewon Hur) Lecture 6 February 1, 215 22 / 22