Constrained Efficient Borrowing with Sovereign Default Risk

Abstract

Using a quantitative sovereign default model, we characterize constrained efficient borrowing by a Ramsey government that commits to income-history-contingent borrowing paths taking as given ex-post optimal future default decisions. The Ramsey government improves upon the Markov government because it internalizes the effects of borrowing decisions in period t on borrowing opportunities prior to t. We show the effect of borrowing decisions in t on utility flows prior to t can be encapsulated by two single dimensional variables. Relative to a Markov government, the Ramsey government distorts borrowing decisions more when bond prices are more sensitive to borrowing, and changes in bond prices have a larger effect on past utility. In a quantitative exercise, more than 80% of the default risk is eliminated by a Ramsey government, without decreasing borrowing. The Ramsey government also has a higher probability of completing a successful deleveraging (without defaulting), while smoothing out the fiscal consolidation.

Numerical Fiscal Rules for Economic Unions: the Role of Sovereign Spreads

“…This is a standard feature of default models and is also consistent with existing empirical evidence(Jaramillo and Tejada, 2011;David et al, 2019;Hatchondo et al, 2020).8©International Monetary Fund. Not for Redistribution…”

“…Note that b R 2 is the level of borrowing in period 2 that the government in period 1 would like to commit to, if it cannot commit to a period 3 default decision. InHatchondo et al (2020), we characterize such policies in a quantitative default model.6©International Monetary Fund. Not for Redistribution…”

“…While in this stylized model it would be optimal to issue one-period debt, this is not true in models with a plausible calibration of the volatility of the borrowing cost (e.g.,Hatchondo et al, 2020).5 A third-party international organization could work as a commitment device as discussed inGoncalves and Guimaraes (2015).7©International Monetary Fund. Not for Redistribution…”

Fiscal Stimulus under Sovereign Risk

“…29 Like other contributions to the large literature on fiscal rules (see, e.g., Hatchondo, Martinez and Roch, 2021;Chatterjee and Eyigungor, 2015;Hatchondo, Martinez and Sosa-Padilla, 2016;Hatchondo, Roch and Martinez, 2019), we assume that these rules are enforced by either some legal mandate or a supra-national institution. Halac and Yared (2017) and Dovis and Kirpalani (2020) study reputation mechanisms.…”

Sovereign Debt

“…Hatchondo et al (2021) compute the borrowing path that a government with commitment to future borrowing would choose and find that a simple debt brake rule can achieve 60 percent of the welfare gains obtained with the optimal borrowing path. 22 IMF (2021b) argue that fiscal frameworks provide the set of rules and institutions that allow countries to signal such commitments and to comply with them.…”