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Working Paper
Inflation, Debt, and Default
We study how the co-movement of inflation and economic activity affects real interest rates and the likelihood of debt crises. First, we show that for advanced economies, periods with procyclical inflation are associated with lower real interest rates. Procyclical inflation implies that nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. However, such procyclicality also increases sovereign default risk when the economy deteriorates, since the government needs to make larger (real) payments. In order to evaluate both effects, we develop a model of sovereign default on domestic nominal debt with exogenous inflation risk and domestic risk-averse lenders. Countercyclical inflation is a substitute with default, while procyclical inflation is a complement with it, by increasing default incentives. In good times, when default is unlikely, procyclical inflation yields lower real rates. In bad times, as default becomes more material, procyclical inflation can magnify default risk and trigger an increase in real rates.
AUTHORS: Hur, Sewon; Perri, Fabrizio; Kondo, Illenin O.
DATE: 2018-09-28

Working Paper
A model of the Twin Ds: optimal default and devaluation
This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages, thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. In contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have stronger default incentives and therefore support less external debt than economies with optimally floating rates.
AUTHORS: Yue, Vivian Z.; Uribe, Martin; Na, Seunghoon; Schmitt-Grohe, Stephanie
DATE: 2015-04-01

Working Paper
Equilibrium Sovereign Default with Exchange Rate Depreciation
This study proposes and quantitatively assesses a terms-of-trade penalty for defaulting: defaulters must exchange more of their own goods for imports, which causes an adjustment to the equilibrium exchange rate. This penalty can take the place of an ad hoc fall in output: Facing only this penalty and temporary exclusion from debt markets, countries are willing to maintain borrowing obligations up to a realistic level of debt. The terms-of-trade penalty is consistent with the observed relationship between sovereign default and a country's trade flows and prices. The defaulter's currency depreciates while trade volume falls drastically. We demonstrate that a default episode can imply up to a 30% real depreciation, which matches observed crisis events in developing countries.
AUTHORS: Popov, Sergey V.; Wiczer, David
DATE: 2014-11-24

Working Paper
Policy Interventions in Sovereign Debt Restructurings
The wave of sovereign defaults in the early 1980s and the string of debt crises in the decades that followed have fostered proposals involving policy interventions in sovereign debt restructurings. A key question about these proposals that has proved hard to handle is how they in influence the behavior of creditors and debtors. We address such challenge by incorporating these policy proposals into a quantitative model in the tradition of Eaton and Gersovitz (1981) that includes renegotiation in sovereign debt restructurings. Critically, the model also endogenizes the choice of debt maturity, an essential aspect of sovereign defaults and restructurings. We evaluate several policy interventions, and we identify the crucial features that matter to improve the outcome of distressed debt restructurings and reduce the frequency of debt distress events.
AUTHORS: Dvorkin, Maximiliano; Sanchez, Juan M.; Sapriza, Horacio; Yurdagul, Emircan
DATE: 2019-11-15

Working Paper
News, sovereign debt maturity, and default risk
Leading into a debt crisis, interest rate spreads on sovereign debt rise before the economy experiences a decline in productivity, suggesting that news about future economic developments may play an important role in these episodes. In a VAR estimation, a news shock has a larger contemporaneous impact on sovereign credit spreads than a comparable shock to labor productivity. A quantitative model of news and sovereign debt default with endogenous maturity choice generates impulse responses and a variance decomposition similar to the empirical VAR estimates. The dynamics of the economy after a bad news shock share some features of a productivity shock and others of sudden stop events. However, unlike episodes of sudden stops, long-term debt does not shield the country from bad news shocks, and it may even exacerbate default risk. Finally, an increase in the precision of news allows the government to improve its debt maturity management, especially during periods of high stress in credit markets, and thus face lower yield spreads while increasing the amount of debt.
AUTHORS: Dvorkin, Maximiliano; Sanchez, Juan M.; Sapriza, Horacio; Yurdagul, Emircan
DATE: 2018-10-31

Working Paper
Resource Curse or Blessing? Sovereign Risk in Resource-Rich Emerging Economies
In this paper we document the stylized facts about the relationship between international oil price swings, sovereign risk and macroeconomic performance of oil-exporting economies. We show that even though being a bigger oil producer decreases sovereign risk?because it increases a country?s ability to repay?having more oil reserves increases sovereign risk by making autarky more attractive. We develop a small open economy model of sovereign risk with incomplete international financial markets, in which optimal oil extraction and sovereign default interact. We use the model to understand the mechanisms behind the empirical facts, and show that it supports them.
AUTHORS: Hamann, Franz; Mendoza, Enrique G.; Restrepo-Echavarria, Paulina
DATE: 2018-10-01

Working Paper
Sovereign Debt Restructurings
Sovereign debt crises involve debt restructurings characterized by a mix of face-value haircuts and maturity extensions. The prevalence of maturity extensions has been hard to reconcile with economic theory. We develop a model of endogenous debt restructuring that captures key facts of sovereign debt and restructuring episodes. While debt dilution pushes for negative maturity extensions, three factors are important in overcoming the effects of dilution and generating maturity extensions upon restructurings: income recovery after default, credit exclusion after restructuring, and regulatory costs of book-value haircuts. We employ dynamic discrete choice methods that allow for smoother decision rules, rendering the problem tractable.
AUTHORS: Sanchez, Juan M.; Dvorkin, Maximiliano; Yurdagul, Emircan; Sapriza, Horacio
DATE: 2018-06-25

Working Paper
Sovereign Default and the Choice of Maturity
This study develops a novel model of endogenous sovereign debt maturity choice that rationalizes various stylized facts about debt maturity and the yield spread curve: first, sovereign debt duration and maturity generally exceed one year, and co-move positively with the business cycle. Second, sovereign yield spread curves are usually non-linear and upward-sloped, and may become non-monotonic and inverted during a period of high credit market stress, such as a default episode. Finally, output volatility, sudden stops, impatience and risk aversion are key determinants of maturity, both in our model and in the data.
AUTHORS: Sanchez, Juan M.; Sapriza, Horacio; Yurdagul, Emircan
DATE: 2014-10-27

Working Paper
History Remembered: Optimal Sovereign Default on Domestic and External Debt
Infrequent but turbulent overt sovereign defaults on domestic creditors are a ?for- gotten history? in macroeconomics. We propose a heterogeneous-agents model in which the government chooses optimal debt and default on domestic and foreign creditors by balancing distributional incentives versus the social value of debt for self-insurance, liquidity, and risk-sharing. A rich feedback mechanism links debt issuance, the distribution of debt holdings, the default decision, and risk premia. Calibrated to Eurozone data, the model is consistent with key long-run and debt-crisis statistics. Defaults are rare (1.2 percent frequency) and preceded by surging debt and spreads. Debt sells at the risk-free price most of the time, but the government?s lack of commitment reduces sustainable debt sharply.
AUTHORS: D'Erasmo, Pablo; Mendoza, Enrique G.
DATE: 2019-07-22

Working Paper
Optimal Domestic (and External) Sovereign Default
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 comovements 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.
AUTHORS: Mendoza, Enrique G.; D'Erasmo, Pablo
DATE: 2017-02-10

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