Abstract
According to reputation models of sovereign debt, the incentives to repay are proportional to the income insurance benefits provided by the access to international markets. This paper, however, documents that private net lending to developing countries exhibits a procyclical or acyclical pattern, contradicting this premise. By contrast, official debt net flows exhibit a countercyclical patter. In addition, the paper shows that (both current and past) defaults are associated with lower net debt flows. The findings suggest that, while reputation models may explain the preferred creditor status enjoyed by official lenders, they cannot account for the presence of sovereign debt markets in developing countries.
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Notes
Both the historical record on the workings of creditor clubs, and the evidence that defaulters are excluded from international capital markets tend to support this view.
A related argument is made by Cole and Kehoe (1996), where the cost of default is due to negative externalities (e.g., the reputation costs on other relationships that cannot be readily insured). Guido…makes a similar argument, where these externalities are associated with the real impact of higher borrowing costs by private corporations as a result of the sovereign’s default.
In this context, it is easy to see the distinction between willingness and ability to pay, since defaults are, by assumption, positively correlated with the latter. The more frequent case of a default during a recession calls for a more nuanced definition of those terms. We come back to this below.
Trivially, the insurance view would entail a positive transfer in this case. As will be seen, due to the preferred creditor status of multilateral financial institutions, transfers are often negative even under default.
In fact, borrowing costs may work in the context of a standard debt contract as a potential channel to distribute consumption between states, by borrowing more costly in bad times at the expense of a taller bill in good times.
The Fund, built as an insurance mechanism against temporary balance of payment imbalances, should behave countercyclically.
See Obstfeld and Rogoff (1996), chapter 6, for a discussion along these lines. Other characteristic of the original model, the fact that the supply of loans is bounded and upward sloping as the probability of default increases monotonically with debt service, is typically verified in practice.
Official flows comprise four sub-categories: IMF lending, non-IMF multilateral lending (concessional and non-concessional), and bilateral lending. The last three sub-categories behave in line with aggregate non-IMF official flows and, for the sake of brevity, are not reported in the tables (the results are available from the author on request).
Variable definitions and sources are detailed in Appendix.
Results using the HP-filtered gap are reported in Levy Yeyati (2006). While results are not significantly altered when zero-flow countries are not excluded, failing to do so may introduce an important bias in the coefficients when a large fraction of countries do not have access to a specific flow type, as is the case for bonded debt.
It needs to be noted, however, that bonded debt ratios within this group are highly diverse, with very small numbers but for a few emerging economies that have only recently gained access to international capital markets. I come back to this point in the robustness section below.
Possible explanations include the incidence of consessional loans as last resort lending in low income economies, and the growing participation of multilateral agencies in IMF-led rescue packages.
As the timing of defaults and their financial effects is sometimes controversial, I prefer to use last year as the cutoff date between what is considered past and current defaults to avoid associating immediate effects to reputation aspects. However, tests controlling using the current year as cutoff date yield similar results.
See, among others, Calvo et al. (2003) and Edwards (2005) for evidence on the link between capital account reversals and economic performance, and Gavin and Perotti (1997) for an early account on the asymmetric behavior of capital flows, where sudden reversal are sharper and more procyclical than inflows.
For all the tests reported in the paper, similar results are obtained when the cycle is computed based on the HP-filtered trend. These results, omitted here for brevity, are available on request.
By contrast, private bank flows in the 90s played a minor relative to bonded debt (for emerging economies) and official lending (for non-emerging economies).
See, among others, Cowan et al. (2006).
See Hausmann and Fernández Arias (2000).
This simply confirms results reported by Borensztein et al. (2007).
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The author wishes to thank Jorge Morgenstern for excellent research assistance.
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Levy Yeyati, E. Optimal Debt? On the Insurance Value of International Debt Flows to Developing Countries. Open Econ Rev 20, 489–507 (2009). https://doi.org/10.1007/s11079-008-9086-4
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DOI: https://doi.org/10.1007/s11079-008-9086-4