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Working Paper
The (Unintended?) Consequences of the Largest Liquidity Injection Ever
We study the design of lender of last resort interventions and show that the provision of long-term liquidity incentivizes purchases of high-yield short-term securities by banks. Using a unique security-level data set, we find that the European Central Bank?s three-year Long-Term Refinancing Operation incentivized Portuguese banks to purchase short-term domestic government bonds that could be pledged to obtain central bank liquidity. This "collateral trade" effect is large, as banks purchased short-term bonds equivalent to 8.4% of amount outstanding. The resumption of public debt issuance ...
Working Paper
Improving Sovereign Debt Restructurings
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, and the recent global pandemic crisis has further reignited this discussion. 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: maturity choice and debt ...
Working Paper
Sovereign Debt and Credit Default Swaps
ow do credit default swaps (CDS) affect sovereign debt markets? The answer depends crucially on trading frictions, risk-sharing, arbitrage violations, and spillovers from secondary to primary markets. We propose a sovereign default model where investors trade bonds and CDS over the counter via directed search. CDS affect bond prices through several channels. First, CDS act as a synthetic bond. Second, CDS reduce bond-investing risks, allowing exposure to be unwound. Third, CDS availability increases trading profitability, which induces entry and reduces trading costs. Last, these direct ...
Working Paper
International Reserve Management under Rollover Crises
This paper investigates how a government should manage international reserves when it faces the risk of a rollover crisis. We ask, should the government accumulate reserves or reduce debt to make itself less vulnerable? We show that the optimal policy entails initially reducing debt, followed by a subsequent increase in both debt and reserves as the government approaches a safe zone. Furthermore, we uncover that issuing additional debt to accumulate reserves can lead to a reduction in sovereign spreads.
Working Paper
Seigniorage and Sovereign Default: The Response of Emerging Markets to COVID-19
Monetary policy affects the tradeoffs faced by governments in sovereign default models. In the absence of lump-sum taxation, governments rely on both distortionary taxes and seigniorage to finance expenditure. Furthermore, monetary policy adds a time-consistency problem in debt choice, which may mitigate or exacerbate the incentives to accumulate debt. A deterioration of the terms-of-trade leads to an increase in sovereign-default risk and inflation, and a reduction in growth, which are consistent with the empirical evidence for emerging economies. An unanticipated shock resembling the ...
Report
Fiscal Policy in Debt Constrained Economies
We study optimal fiscal policy in a small open economy (SOE) with sovereign and private default risk and limited commitment to tax plans. The SOE's government uses linear taxation to fund exogenous expenditures and uses public debt to inter-temporally allocate tax distortions. We characterize a class of environments in which the tax on labor goes to zero in the long run, while the tax on capital income may be non-zero, reversing the standard prediction of the Ramsey tax literature. The zero labor tax is an optimal long run outcome if the economy is subject to sovereign debt constraints and ...
Working Paper
Domestic Policies and Sovereign Default
A model with two essential elements, sovereign default and distortionary fiscal and monetary policies, explains the interaction between sovereign debt, default risk and inflation in emerging countries. We derive conditions under which monetary policy is actively used to support fiscal policy and characterize the intertemporal tradeoffs that determine the choice of debt. We show that in response to adverse shocks to the terms of trade or productivity, governments reduce debt and deficits, and increase inflation and currency depreciation rates, matching the patterns observed in the data for ...
Working Paper
Domestic Policies and Sovereign Default
This paper incorporates fiscal and monetary policies into a model of sovereign default. In addition to the standard present-bias vs default-risk tradeoff faced by governments when choosing debt, distortionary policy instruments introduce an intertemporal tradeoff, which may mitigate or exacerbate the incentives to accumulate debt. Taxation, the money growth rate and currency depreciation all increase with the level of debt. The model reproduces standard business cycle statistics, the response of spreads, inflation and growth to terms-of-trade shocks, and the cyclical properties of fiscal and ...
Report
Is It Too Late to Bail Out the Troubled Countries in the Eurozone?
In January 1995, U.S. President Bill Clinton organized a bailout for Mexico that imposed penalty interest rates and induced the Mexican government to reduce its debt, ending the debt crisis. Can the Troika (European Commission, European Central Bank, and International Monetary Fund) organize similar bailouts for the troubled countries in the Eurozone? Our analysis suggests that debt levels are so high that bailouts with penalty interest rates could induce the Eurozone governments to default rather than reduce their debt. A resumption of economic growth is one of the few ways that the Eurozone ...