ENDOGENOUS DEFAULT- WHY AND WHEN DO COUNTRIES WITH FIXED EXCHANGE RATE REGIMES DECIDE TO DEFAULT?
4. Fitting the Model to Data
.
[ . . ] . . ( ) ≤ . ∗ .. . ( ) = ( ).
Consequently: ( = ̅) = ∗ ∗ + (1 − ) ∗ ≤ ∗ + (1 − ) ∗ =
0.777 ( ). Similarly, ( = 0) ≤ ( = ̅) ∗ .. = 0.881 ( ). We can now conclude that ( ; , = 0, , ) ≤ 0.881 ( ).
Thus we conclude ( ; , = 1, , ) > ( ; , = 0, , ),
and the existence of a setting in which defaulting on sovereign debt is the optimal policy is shown.
4. Fitting the Model to Data
Our model suggests that the government’s decision to default is rational and can be explained with credibility considerations. We now confront our assumptions and conclusions with the data and check how well it mimics the reality. Since we have already explained our sample selection we will start with the reality check of our model’s assumptions and predictions by comparing them to data observed in Argentina, Ecuador, Honduras, Russian Federation and Ukraine immediately before and after the default.
27 One will find useful to reread our discussion in the previous section to justify the reasonability of some of our less obvious choices.
28 Associated with ̅ in the case of default ( = 1).
Let us s
1987 1988 1989 1990 1991
domestic pa
1991 1992 1993 1994 1995
ackage of po
2008 2009 2010 2011 2012
gentina
Endogenous Default- Why and When do Countries with Fixed Exchange Rate Regimes Decide to Default?
We could just assume some utility function form which suggests that consumers prefer foreign goods, and in that case we would easily confirm our hypothesis. However, this would be hardly verifiable. Instead, we assumed that our consumers largely rely on imported goods.
This assumption is embodied in our β coefficient, i.e. we assume that ≥ 0.5. We tried to approximate β for our countries, and the results are presented in the following table. While Argentina does not satisfy this criterion, Ecuador and Russian Federation are close. Ukraine and Honduras are definitely above our threshold. In our example = 0.55, which is the average of our sample. We are aware that here presented estimates of consumer’s propensity to imported goods overrate its real value since consumers are not the only demanders of foreign goods. However, we believe that they create the majority of demand.
Table 2: Import/Export to GDP ratio
Country Year
Household final consumption expenditure [%GDP]
Imports of goods and services
[%GDP] Beta
Exports of goods and services [%GDP]
1 2 3 4 6=4/3 7
Argentina
Average
2001-2013 66.45 14.23 0.21 0.18
Ecuador Average
1998/99-2013 66.11 28,76 0.44 0.28
Honduras Average
1989-2013 71.79 59.89 0.83 0.49
Ukraine
Average
1998-2013 57.81 46.35 0.80 0.5
Russian Federation
Average
1998-2013 50.47 22.73 0.45 0.31
Average 0.55 0.35
Source: World Bank, authors’ calculations
On the other hand, we assume that producers can satisfy foreign demand. In our model we assumed that export to GDP share equals 0.35 since it is the average value of export to GDP ratios in our sample countries.
Additionally, we assume that after the default country experiences “autarky”. In this case we should see large import drop at the time of the default. Figure 2 verifies our assumption in most cases. Exports should have the same tendency, and in most cases it really does (see Figure 2).
Figure 2:
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Figure 4
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5. CONCLUDING REMARKS
Our model is kept plain and simple enough to have numerous flaws and omissions. First of all, some of our conclusions rely on approximations of behavioural parameters which makes our model vulnerable to Lucas critique (Snowdon & Vane, 2006). This problem is amplified by the fact that we do not offer a sensitivity analysis of our conclusions in the context of assumed parameters. However, we will leave this shortcoming open to further discussion and future research.
The same goes for omitted dynamics concerns, credit market exclusion costs of default and the statistically non-rigorous (and non-robust) method of fitness of our model to the real world data check. However, eye-introspection based conclusions suggest that we could be on the right track, and that credibility concerns really do matter. We assume that our future work will go towards a more robust check of our conclusions.
Furthermore, we could test the validity of our assumption that governments give more weight to consumers than to producers (α>0.5). This could be easily done by examining whether the ruling governments in sample countries were left or right oriented at the time of default.
Generally, we could use and explore comparative statics possibilities of our model much more than we did in this paper. In addition, there are many other political (political uncertainty, reputation constraints etc.) and economic (e.g. the output cost of default) constrains that our model omits.
Our model could also be expanded with typical producers’ profit maximization and heterogeneous agents’ assumptions. We believe that extension of our model with heterogeneous agents’ assumption could have interesting and important implications for our conclusions. For example, we assumed that there is only one taxation possibility available to the government – taxes on consumption. This is a regressive tax. In that context, our imaginary government is more prone to default as it is proven in Andreasen, Sandleris, & Van der Ghote (2013). Moreover, our ignorance of the income distribution concerns ignores the empirical fact that “all Emerging Economies have levels of income inequality significantly higher than the OECD average” (OECD, 2012). In that context, the imaginary government is more reluctant to default than it would be if we assumed a positively skewed income distribution. However, this is a rather hard task for us at the moment.
We will end this list of shortcomings and recommendations for further research with our assumption that the elasticity of sovereign debt interest rates on expected future debt burden (budget deficit to GDP) is unaffected by sovereign debt to GDP ratio. Future research could include some threshold value of sovereign debt to GDP ratio after which the elasticity of sovereign interest rates to budget deficit to GDP ratio increases, as it is suggested in (Belhocine & Dell’Erba, 2013).
Endogenous Default- Why and When do Countries with Fixed Exchange Rate Regimes Decide to Default?
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