Sovereign Debt and Default
Sewon Hur
University of Pittsburgh
February 10, 2015
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 (2009) survey on the existing theories of sovereign
debt/default and the empirical literature
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.
Theories of Sovereign Debt and Default
Sachs and Cohen (1982), Bulow and Rogo (1989), Fernandez and Rosenthal (1990) 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 (2005), Catao and Kapur (2006) 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)
Theories of Sovereign Debt and Default
Mendoza and Yue (2008) assume defaults limit the ability of private agents to obtain private capital - model is consistent with rapid output and TFP collapses
Broner et al. (2006) 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 ine cient 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 e cient (because it allows the country to borrow, by
solving the sovereign risk problem)
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 1990, Cole and Kehoe 1996, 2000)
run on currency (Aghion 2001, 2004, Krugman 1999, Burnside et al. 2004)
sudden stops (Mendoza 2012, Calvo 1998, Hur and Kondo 2013)
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 (2006), Arellano (2008), Benjamin and
Wright (2008), Yue (2006) to name a few...
Empirical Literature
When do countries borrow?
When do countries default?
What are the default costs?
When do Countries Borrow?
Levy-Yeyati (2009) nds that private lending to sovereigns is procylical, while o cial lending is coutercyclical, with a net procyclical eect.
This is in contrast to standard theory where sovereign borrowing
is countercyclical (to smooth consumption)
Why is Borrowing Procylical?
market failure: lack of access to international lending credit during recessions (Gavin and Perotti 1997), incomplete markets (Caballero and Krishnamurthy 2004), limited enforcement (Kehoe and Perri 2002), moral hazard (Atkeson 1991), etc political failure: con ict of interest groups (Tornell and Lane 1999), political pressure for wasteful spending (Talvi and Vegh 2005), corrupt politicians (Alesina et al. 2008)
nature of output shocks: Aguiar and Gopinath (2006) and
Rochet (2006) show that a model with persistent shocks can
generate procyclical borrowing even in the absence of political or
market imperfections
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
Evidence
The evidence is broadly consistent with theory
Levy-Yeyati (2006) nds that defaults tend to follow output contractions (1982-2003)
Tomz and Wright (2007) nd a negative correlation between
output and defaults (1820-2004)
Puzzles Remain..
Still, the theory is inconsistent with several features of default theories underpredict default - Aguiar and Gopinath (2006) generate higher default rates through persistent shocks;
Hatchondo and Martinez (2008) 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
Defaults Happen in Clusters
Defaults tend to happen in clusters, suggesting that defaults are in uenced by the behavior of creditors and international capital markets (interest rate shocks, sudden stops), in addition to debtor country shocks (output or political shocks)
Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 669A third perspective on debt crises, in addi- tion to output shocks and sudden reversals in international capital markets, focuses on the idea that some countries may in fact “over- borrow,” that is, accumulate debt that is too high from a welfare perspective, and at—or perhaps just below—the debt level that competitive creditors will accept.26 Given this high debt, small shocks (of whatever kind) could trigger a default. Debt accumulation
26 Evidence for overborrowing is provided in International Monetary Fund (2003), chapter 3, and
might be excessive because the parties that contract the debt do not bear the full costs of repayment or crises. For example, excessive borrowing could benefit specific groups at the expense of the average domestic taxpayer (Perotti 1996). Moral hazard could also occur at the expense of the foreign taxpayer, if countries in crisis are “bailed out” by institu- tions such as IMF or World Bank, or through bilateral lending.27 Finally, overborrowing
Number of sovereign default episodes
Year in which the country declared default 18
16 14 12 10 8 6 4 2
0
1820 1828 1836 1844 1852 1860 1868 1876 1884 1892 1900 1908 1916 1924 1932 1940 1948 1956 1964 1972 1980 1988 1996 2004
Figure 1. Default Clusters, 1820–2005 Source: Sturzenegger and Zettelmeyer (2007) and Borensztein and Panizza (2008).
27 For this argument to make sense, official loans must contain a subsidy, either by carrying an interest rate that does not reflect the riskiness of the loan for the official
International Finance (Sewon Hur) Lecture 6 February 10, 2015 14 / 22
Costs of Default
Capital market exclusion
Sandleris et al. (2004) nd that countries were excluded for an average of four years after defaults ended (1980s) and 0-2 years since then
Richmond and Dias (2008) using a stronger de nition of exclusion (positive net transfers) nd exclusions of 5.5 years (1980s), 4.1 years (1990s) 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 2005,
Arellano 2008, Aguiar and Gopinath 2006, Benjamin and Wright
2008)
Costs of Default
Higher borrowing costs
Borendztein and Panizza (2010) nd that spreads are 400 basis points higher in the year after default, 250 higher in second year, and loses statistical signi cance thereafter (1997-2004)
Flandreau and Zumer (2004) nd that spreads are 90 basis points higher in the year after, but the eect dies out rapidly (1880-1914)
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 2005)
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 (2004): defaults are associated with a reduction in growth of 0.6 percent (2.2 percent if default comes with banking crisis)
De Paoli et al. (2006): output losses are correlated with defaults and increase with duration of default
Levy-Yeyati and Panizza (2006): defaults tend to happen in trough, and often mark beginning of recovery
suer from endogeneity biases
Recent Default Episodes
Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 683restructuring with basically no haircut (the Dominican Republic). Finally, about half of the restructurings listed in table 4 were preemptive (i.e., they took place before the country missed any payment on its existing debt) while the other half were postdefault restructurings.49
Consider first whether there is any evi- dence of capital market exclusion. Figure 4, based on a regression that includes all developing countries with an income per
49 For detail on these restructurings, see Sturzenegger
capita of at least US$500 and controls for both country and year fixed effects, sug- gests not. In the year of the default episode, private capital flows to the defaulting coun- tries were slightly below trend but started to recover immediately thereafter and, within three years of the episode, they were already above trend. Argentina, Russia, and Ecuador observed a collapse of capital flows one or two years before the default. In these countries, capital inflows reached a trough in the year after the default but then recov- ered quickly. The case of Argentina is par- ticularly interesting. This country had by far TABLE 4
Characteristics of Recent Debt Restructurings
Country Year
Total amount restructured1
(bill US$) Haircut
(%) Type of restructuring
Russia 1998–2000 38.7 52.6 Postdefault
Ukraine 1998–2000 7.8 28.9 Predefault
Pakistan 1999 0.61 31 Predefault
Ecuador 1999–2000 6.5 28.6 Postdefault
Argentina 2001–2005 145 75 Pre- and postdefault
Uruguay 2003 5.4 13.3 Predefault
Moldova 2002 0.08 37 Pre- and postdefault
Dominican Republic 2005 1.5 2 Predefault
1 Domestic and external debt with private creditors.
Source: Sturzenegger and Zettelmeyer (2007, 2008).
International Finance (Sewon Hur) Lecture 6 February 10, 2015 18 / 22
Some Evidence of Temporary Exclusion
684 Journal of Economic Literature, Vol. XLVII (September 2009)the country had to impose capital controls on inflows. Profit opportunities—perhaps linked to the behavior of the real exchange rate—seemed to have dominated any rep- utational considerations. This is not to say that the restructuring strategy may not have had an impact on the behavior of capital flows around the time of the restructuring.
Countries that opted for a preemptive strat- egy (Dominican Republic and Uruguay) seemed to enjoy a recovery of private inflows even before the restructuring. However, the evidence suggests that effects on the volume of capital flows were at best transitory.
Figure 5 examines whether there is any
costs, based again on a large panel regres- sion that controls for country and time fixed effects, and excludes the months in which a country is in default. The main result is that—controlling for changes in global financial conditions (via time dummies)—
postdefault spreads return to predefault levels within twenty-four months or less.
However, figure 4 does not control for changes in the fundamentals of defaulting countries. If these improve as a result of the restructuring, the rapid convergence shown in the figure could still be consistent with the idea that defaulters pay higher spreads than nondefaulters with similar Ecuador Moldova Pakistan .1
0
−.1
−.2
All countries Argentina Dominican Republic
Russia Ukraine Uruguay Event time Event time Event time
Event time Event time Event time
Event time Event time Event time .05
0
−.05
−.1
.020
−.02−.04
−.06
.020
−.02−.04
−.06−.08 .15.2
.05.1
−.050 .1
.05 0
−.05
.05 0
−.05
−.1
.05 0
−.05
−.1
.1
−.10
−.2
−.3
−5 −4−3 −2−1 0 1 2 3 4 5 −5 −4 −3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5
−5 −4−3 −2 −1 0 1 2 3 4 5 −5 −4 −3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5
−5 −4−3 −2 −1 0 1 2 3 4 5 −5 −4 −3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5
Figure 4. Recent Defaults and Private Capital Flows
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$500 in the year 2000.
private capital ows (residuals of regression with country and year
xed eects)
International Finance (Sewon Hur) Lecture 6 February 10, 2015 19 / 22
Limited Evidence of High Spreads Post-Default
685 Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default
To deal with this objection, we regress average spreads in year t on economic fun- damentals measured in year t − 1, in addi- tion to year fixed effects, in a 1994–2008 sample (that is, centered on the recent default episodes).50 Our variables of interest are three dummies that take value 1 in each of the three years after the resolution of the default episode (DEFt+1, DEFt+2, and DEFt+3) and a dummy that takes value
50 We measure fundamentals with the log of GDP per
one in each year after the third year of the default episode (D > t+3).51 Column 1 of table 5 reports the results of the model esti- mated controlling for both credit ratings and economic fundamentals. We find a positive but statistically insignificant effect of default on spreads in the first two years, while the coefficients on (Dt+3) and (D > t+3) are statistically significant and negative. When we repeat the regression without controlling
51 Thus, if a country defaulted in 1998 and concluded the episode in 2000, Dt+1 takes value one in the year
bps
bpsbpsbps bps bpsbps
3000
−1000
All countries Argentina Dominican Republic
Event time, months Event time, months Event time, months
−36 −24 −12 0 12 24 36 −36 −24 −12 0 12 24 36 −36 −24 −12 0 12 24 36 Ecuador Pakistan Russia
Ukraine Uruguay 3000
0
2000
0
2000
0
5000
0 2000
0
2000
0
2000
0
Event time, months Event time, months Event time, months
Event time, months Event time, months
−36 −24 −12 0 12 24 36 −36 −24 −12 0 12 24 36 −36 −24 −12 0 12 24 36
−36 −24 −12 0 12 24 36 −36 −24 −12 0 12 24 36
Figure 5. Spreads Before and After Defaults
Notes: The figure plots the residuals of a regression that controls for country and year fixed effects and that includes all countries that are included in the JP Morgan EMBI+ Global.
spreads (residuals of regression with country and year xed eects)
International Finance (Sewon Hur) Lecture 6 February 10, 2015 20 / 22
Mixed Evidence of Output Costs
Panizza, Sturzenegger, and Zettelmeyer: Sovereign Debt and Default 689output declines, financial sector disruptions and generally a period of capital market exclusion while debt is renegotiated. This fact motivated a set of proposals, beginning in the 1980s and particularly following the 1995 Mexican and 1998 Russian crises, to reform the institutions and/or contracts gov- erning debt flows and debt renegotiation in order to reduce the cost of crises.55 For the most part, these proposals—which climaxed in the proposal by management and staff of the IMF, in 2001, to create a bankruptcy-type
“sovereign debt restructuring mechanism”
(SDRM) for countries—focused on making the debt renegotiation process smoother and faster, in particular, by mitigating credi- tor coordination failures (see Rogoff and Zettelmeyer 2002 for a history).
As argued in the previous section, pro- posals in this class can perhaps be criticized (with the benefit of hindsight) for having barked up the wrong tree—creditor coordi- nation failures did not, in the end, turn out to be a significant impediment to the debt rene- gotiations of the 1998–2005 period. Beyond questions of empirical relevance, however, proposals that aim to reduce the costs of debt crises raise a deeper issue (Michael P. Dooley Ecuador Moldova Pakistan All countries Argentina Dominican Republic
Russia Ukraine Uruguay .05.1
−.050
−.15−.1
.05
−.050
−.15−.1
.05 0
−.05
−.1
Event time Event time Event time
.02 0
−.02−.04
−.06 .05
−.050
−.1
−.15 .05
0
−.05
−.1
.05.1
−.050
−.15−.1
.1 0
−.1
−.2
.05
−.050
−.1
−.15
Event time Event time Event time
Event time Event time Event time
−5 −4−3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5
−5 −4−3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5
−5 −4−3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5 −5 −4−3 −2 −1 0 1 2 3 4 5
Figure 7. Recent Defaults and GDP Growth
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$500 in the year 2000.
GDP growth (residuals of regression with country and year xed eects)
International Finance (Sewon Hur) Lecture 6 February 10, 2015 21 / 22
