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Sovereign Default

Paper Session

Sunday, Jan. 7, 2018 10:15 AM - 12:15 PM

Marriott Philadelphia Downtown, Meeting Room 309
Hosted By: American Economic Association
  • Chair: Romain Ranciere, University of Southern California

Optimal Domestic (and External) Sovereign Default

Pablo D'Erasmo
,
Federal Reserve Bank of Philadelphia
Enrique G. Mendoza
,
University of Pennsylvania, NBER and PIER

Abstract

Infrequent but turbulent episodes of outright sovereign default on domestic creditors are considered a “forgotten history” in Macroeconomics. We propose a heterogeneous-agents model in which optimal debt and default on domestic and foreign creditors are driven by distributional incentives and endogenous default costs due to value of debt for self-insurance, liquidity and risk sharing. The government’s aim to redistribute resources across agents and through time in response to uninsurable shocks produces a rich dynamic feedback mechanism linking debt issuance, the distribution of government bond holdings, the default decision, and risk premia. Calibrated to Spanish data, the model is consistent with key cyclical co-movements and features of debt-crisis dynamics. Debt exhibits protracted fluctuations. Defaults have a low frequency of 0.93 percent, are preceded by surging debt and spreads, and occur with relatively low external debt. Default risk limits the sustainable debt and yet spreads are zero most of the time.

Bailout Guarantees, Banking Crises and Sovereign Debt Crises

Javier Bianchi
,
Federal Reserve Bank of Minneapolis
Sandra Lizarazo
,
International Monetary Fund
Horacio Sapriza
,
Federal Reserve Board

Abstract

This paper studies the link between banking crises, sovereign default and government guarantees. A banking crisis can lead to a domestic credit crunch, which can be mitigated by government guarantees. However, the provision of bailout guarantees exposes the government to potentially severe losses from a banking sector failure and a sharp rise in public debt, causing sovereign default risk, and thus sovereign spreads, to increase substantially. As a result, the value of government guarantees deteriorates, deepening the crisis in the financial sector. The recent bailout in Ireland clearly illustrates the relevance of such risk transmission mechanism. An additional important contribution of our paper is to determine under which circumstances it is desirable for the government to provide bailout guarantees to the financial sector of the economy. A calibrated version of our model can mimic some of the interaction dynamics between financial sector risks and sovereign risks observed in Ireland during the crisis.

Sovereign Cocos and the Reprofiling of Debt Payments

Juan Carlos Hatchondo
,
Indiana University
Leonardo Martinez
,
International Monetary Fund
Yasin Kürsat Önder
,
Central Bank of Turkey
Francisco Roch
,
International Monetary Fund

Abstract

We study a model of equilibrium sovereign default in which the government issues cocos (contingent convertible bonds) that stipulate a suspension of debt payments when the government has lost market access. We quantify the effects of such cocos by comparing simulations of the cocos model with the ones obtained when the government issues non-contingent debt. We find that cocos are more likely to mitigate sovereign risk and generate welfare gains when the suspension of payments is triggered by local shocks and accompanied by conditionality, and when cocos are complemented with fiscal rules. We also find that it may be optimal to complement the reprofiling of debt payments with haircuts.

Sovereign Bond Prices, Haircuts and Maturity

Tamon Asonuma
,
International Monetary Fund
Dirk Niepelt
,
Study Center Gerzensee and University of Bern
Romain Ranciere
,
University of Southern California

Abstract

Rejecting a common assumption in the sovereign debt literature, we document that creditor losses (“haircuts”) during sovereign restructuring episodes are asymmetric across debt instruments. We code a comprehensive dataset on instrument-specific haircuts for 28 debt restructurings with private creditors in 1999–2015 and find that haircuts on shorter-term debt are larger than those on debt of longer maturity. In a standard asset pricing model, we show that increasing short-run default risk in the run-up to a restructuring episode can explain the stylized fact. The data confirms the predicted relation between perceived default risk, bond prices, and haircuts by maturity.
Discussant(s)
Sandra Lizarazo
,
International Monetary Fund
Leonardo Martinez
,
International Monetary Fund
Tamon Asonuma
,
International Monetary Fund
Pablo D'Erasmo
,
Federal Reserve Bank of Philadelphia
JEL Classifications
  • F4 - Macroeconomic Aspects of International Trade and Finance
  • H3 - Fiscal Policies and Behavior of Economic Agents