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Sovereign Debt and Financial Development

Paper Session

Friday, Jan. 6, 2023 10:15 AM - 12:15 PM (CST)

Hilton Riverside, Norwich
Hosted By: Econometric Society
  • Chair: Givi Melkadze, Georgia State University

Sovereign Risk and Economic Activity: The Role of Firm Entry and Exit

Gaston Rene Chaumont
,
University of Rochester
Givi Melkadze
,
Georgia State University
Ia Vardishvili
,
Auburn University

Abstract

This paper quantifies the role of firm entry and exit in propagating the sovereign default risk on the real economy. Using annual industry-level data from European countries, we document that an increased sovereign default risk is associated with a decline in firm entry and an increase in firm exits. We find strong evidence in favor of the sovereign–bank lending channel in explaining the observed negative relationship between sovereign risk and firm entry, while this channel plays a minor role in sovereign risk - exit relationship. Using the firm-level data from Portugal, we additionally document the persistent effects of the sovereign crisis on the entrant cohorts’ life-cycle dynamics. Motivated by the empirical facts, we develop a heterogeneous firm dynamics model with endogenous entry and exit, sovereign default risk, and financial frictions. The calibrated model generates a close match to firms’ life-cycle dynamics in Portugal. We find that the sovereign–bank lending channel plays an important role in the observed dynamics of entry, which, in turn, has a long-lasting negative effect on the dynamics of the economic aggregates.

Improving Sovereign Debt Restructurings

Maximiliano Dvorkin
,
Federal Reserve Bank of St. Louis
Juan M. Sanchez
,
Federal Reserve Bank of St. Louis
Horacio Sapriza
,
Federal Reserve Bank of Richmond
Emircan Yurdagul
,
Charles III University of Madrid

Abstract

The wave of sovereign defaults in the early 1980s and the string of debt crises in subsequent decades have fostered proposals involving policy interventions in sovereign debt restructurings. The global financial crisis and the recent global pandemic have further reignited this discussion among academics and policymakers. A key question about these policy proposals for debt restructurings that has proved hard to handle is how they influence the behavior of creditors and debtors. We address this challenge by evaluating policy proposals in a quantitative sovereign default model that incorporates two essential features of debt: maturity choice and debt renegotiation in default. We find, first, that a rule that tilts the distribution of creditor losses during restructurings toward holders of long-maturity bonds reduces short-term yield spreads, lowering the probability of a sovereign default by 25 percent. Second, issuing GDP-indexed bonds exclusively during restructurings also reduces the probability of default, especially of defaults in the five years following a debt restructuring. The policies lead to welfare improvements and reductions in haircuts of similar magnitude when implemented separately. When jointly implemented, they reinforce each other's welfare gains, suggesting good complementarity.

Expenditure Consolidation and Sovereign Debt Restructurings: Front- or Back-loaded

Tamon Asonuma
,
International Monetary Fund
Hyungseok Joo
,
University of Surrey

Abstract

Sovereigns implement expenditure consolidation prior to debt crisis—“front-loaded”. We compile a dataset on strategies of expenditure consolidation and restructurings in 1975–2020. We find that (i) expenditure consolidation precedes—front-loaded—preemptive restructuring, while occurs upon post-default restructurings—back-loaded—; and (ii) public investment and duration differ between preemptive and post-default restructurings. We construct a theoretical sovereign debt model that embeds endogenous choice of preemptive and post-default renegotiations, public capital accumulation, and expenditure composition. The model quantitatively shows the sovereign’s choice of front-loaded consolidation and preemptive restructuring results in quick public investment recovery and debt settlement. Data support theoretical predictions.

Financial Development, Trade, and Misallocation

David Perez-Reyna
,
University of the Andes
Filippo Rebessi
,
California State University-East Bay

Abstract

We analyze the interaction of financial development and trade in a small open economy. In a benchmark economy with full financial development, there is no misallocation. When financial development is imperfect, access to borrowing in local currency is expensive. This causes misallocation to arise among the most productive firms. Productive firms with small initial capital access the international credit market by paying a fixed cost. By borrowing in foreign currency, they scale up close to their benchmark size. Larger firms borrow from domestic credit markets and are smaller than their benchmark counterparts. More expensive borrowing hinders firms to pay the fixed cost to export. Therefore, lower financial development causes firms to be worse off during devaluations, relative to the benchmark.
JEL Classifications
  • F3 - International Finance