We measure the effects of debt dilution on sovereign default risk and show how these effects can be mitigated with debt contracts promising borrowing-contingent payments. First, we calibrate a baseline modelà la Eaton and Gersovitz (1981) to match features of the data. In this model, bonds' values can be diluted. Second, we present a model in which sovereign bonds contain a covenant promising that after each time the government borrows it pays to the holder of each bond issued in previous periods the difference between the bond market price that would have been observed absent current-period borrowing and the observed market price. This covenant eliminates debt dilution by making the value of each bond independent from future borrowing decisions. We quantify the effects of dilution by comparing the simulations of the model with and without borrowing-contingent payments. We find that dilution accounts for 84% of the default risk in the baseline economy. Similar default risk reductions can be obtained with borrowing-contingent payments that depend only on the bond market price. Using borrowing-contingent payments is welfare enhancing because it reduces the frequency of default episodes.JEL classification: F34, F41.
Episodes of sovereign default feature three key empirical regularities in connection with the banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii) sovereign defaults result in major contractions in bank credit and production. This paper provides a rationale for these phenomena by extending the traditional sovereign default framework to incorporate bankers who lend to both the government and the corporate sector. When these bankers are highly exposed to government debt, a default triggers a banking crisis, which leads to a corporate credit collapse and subsequently to an output decline. When calibrated to the 2001-02 Argentine default episode, the model is able to produce default in equilibrium at observed frequencies, and when defaults occur credit contracts sharply, generating output drops of 7 percentage points, on average. Moreover, the model matches several moments of the data on macroeconomic aggregates, sovereign borrowing, and fiscal policy. The framework presented can also be useful for studying the optimality of fractional defaults. JEL codes: F34, E62
We measure the effects of debt dilution on sovereign default risk and show how these effects can be mitigated with debt contracts promising borrowing-contingent payments. First, we calibrate a baseline modelà la Eaton and Gersovitz (1981) to match features of the data. In this model, bonds' values can be diluted. Second, we present a model in which sovereign bonds contain a covenant promising that after each time the government borrows it pays to the holder of each bond issued in previous periods the difference between the bond market price that would have been observed absent current-period borrowing and the observed market price. This covenant eliminates debt dilution by making the value of each bond independent from future borrowing decisions. We quantify the effects of dilution by comparing the simulations of the model with and without borrowing-contingent payments. We find that dilution accounts for 84% of the default risk in the baseline economy. Similar default risk reductions can be obtained with borrowing-contingent payments that depend only on the bond market price. Using borrowing-contingent payments is welfare enhancing because it reduces the frequency of default episodes.JEL classification: F34, F41.
We show that some recent sovereign debt restructurings were characterized by (i) the absence of missed debt payments prior to the restructurings, (ii) reductions in the government's debt burden, and (iii) increases in the market value of debt claims for holders of the restructured debt. Since both the government and its creditors are likely to benefit from such restructurings, we label these episodes as "voluntary" debt exchanges. We present a model in which voluntary debt exchanges can occur in equilibrium when the debt level takes values above the one that maximizes the market value of debt claims. In contrast to previous studies on debt overhang, in our model opportunities for voluntary exchanges arise because a debt reduction implies a decline of sovereign default risk. This is observed in the absence of any e↵ect of debt reductions on future output levels. Although voluntary exchanges are Pareto improving at the time of the restructuring, we show that eliminating the possibility of conducting voluntary exchanges may improve welfare from an ex-ante perspective. Thus, our results highlight a cost of initiatives that facilitate debt restructurings.
In the past three decades, governments in emerging markets have accumulated large amounts of international reserves, especially those with fixed exchange rates. We propose a theory of reserve accumulation that can account for these facts. Using a model of endogenous sovereign default with nominal rigidities, we show that the interaction between sovereign risk and aggregate demand amplification generates a macroeconomic-stabilization hedging role for international reserves. Reserves increase debt sustainability to such an extent that financing reserves with debt accumulation may not necessarily lead to increases in spreads. We also study simple and implementable rules for reserve accumulation. Our findings suggest that a simple linear rule linked to spreads can achieve significant welfare gains, while those rules currently used in policy studies of reserve adequacy can be counterproductive.
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