Abstract
Official lenders provide financial assistance to countries that face sovereign debt crises. The availability of financial assistance has counteracting effects on the default incentives of governments. On the one hand, financial assistance can help to avoid defaults by bridging times of fundamental crises or resolving coordination failures among private investors. On the other hand, the insurance effect of financial assistance lowers borrowing costs, which induces the sovereign to accumulate higher debt levels. To assess the overall effect of financial assistance on the probability of default, we construct a quantitative model of endogenous credit structure and sovereign default that allows for self-fulfilling expectations of default. Calibrating the model to Argentinean data, we find that the availability of financial assistance reduces the number of defaults that occur due to self-fulfilling runs by private investors. However, at the same time, it raises average debt levels causing an overall increase in the probability of default.
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Notes
In the following, the term ‘market debt’ denotes credit provided by private international investors on international debt markets. We use the terms ‘bailout loans’ or ‘financial assistance’ for credit provided by the official lending facility.
A detailed empirical account of default events in several emerging markets economies in the 1990s and early 2000s is provided by Sturzenegger and Zettelmeyer (2006), while Roubini and Setser (2004) examine the crisis events of that time with a special focus on the implications regarding crisis resolution policies.
Dellas and Niepelt (2011) show in a two-period model that a debt agreement with a lending partner that possesses a better enforcement technology can be beneficial both for the lending and the borrowing country and that the bilateral loans are used more during times of crises than in times with good economic conditions and low interest rates on the private market.
One period bonds are also used, e.g., by Arellano (2008) and Boz (2011). Chatterjee and Eyigungor (2012) and Hatchondo and Martinez (2009) analyze long-term loans with a fixed maturity while only considering one type of debt. While our model features bailout loans with a maturity of one period, the country always has the possibility to roll over the previous stock of bailout loans at the same (constant) conditions in every period which is similar to the case of bailout loans with a longer maturity.
See Lizarazo (2013) for a model of sovereign default with risk-averse lenders.
According to the IMF’s lending policies for the so-called ‘stand-by arrangements’, the effective total interest rate demanded from borrowers consists of a number of different fees and charges that are added to the riskless interest rate (International Monetary Fund 2012). Some of the additional charges are independent of the size of the loans (e.g., there is a 50 basis points service charge). Other surcharges on the interest rate are increasing with the size of the demanded IMF loans, as, e.g., the ‘surcharge for large loans’ of 200 basis points for loans sizes above 300 % of the country’s quota.
This problem does not exist when the bond price is determined on the private debt market. In this case, international investors assess the default probability and the bond price falls to zero when the default probability approaches one.
For a discussion of the empirical evidence, see Panizza et al. (2009).
The detailed within-period timing of actions that leads to the potential emergence of self-fulfilling crisis is outlined in Sect. 2.1.
For this illustration, we compute \(V^{c}_\mathrm{run}\left( d,h,y,1\right) \) also for levels of outstanding market debt for which in equilibrium no run occurs. \(V^{c}\left( d,h,y,0\right) \) is always larger or equal to \(V^{c}_\mathrm{run}\left( d,h,y,1\right) \), as a run restricts the options of the government. Without a run, the government could always choose \(d'=0\) and be at least as well off as in the case of a run.
To facilitate the exposition, the condition for the emergence of the crisis zone is only stated for \(V^\mathrm{defD}\left( h,y\right) \). The crisis zone emerges either around \(V^\mathrm{defD}\left( h,y\right) \) or \(V^\mathrm{defDH}\left( y\right) \) depending on which of the two values is the higher one. The position of \(V^\mathrm{defD}\left( h,y\right) \) relative to \(V^\mathrm{defDH}\left( y\right) \) depends on the level of outstanding bailout loans and the respective costs of a default.
The convexity of the cost function can also be generated endogenously in a production economy with working capital loans for foreign intermediate inputs (see Mendoza and Yue 2012).
See Sturzenegger and Zettelmeyer (2008) for an estimate of the size of the haircuts in several default events.
To obtain this estimate, we use the default and rescheduling events documented by Reinhart and Rogoff (2009), which can be clustered to six default episodes from Argentinean independence in 1816 until 2011.
The spread is calculated as the difference between the Argentinean interest rates reported by Neumeyer and Perri (2005) and the rate of a three-month US Treasury bill in the period from 1993Q1 to 2001Q4.
See International Monetary Fund (2003) for actual targets of the Argentinean program. Specifically, allowed deficits for the first 2 years of the program were 2.3 and 1.4 % of GDP. One can transform the deficit targets (measured in percent of GDP) into maximum debt increases by dividing them by the debt-to-GDP level targets for the respective year (which have been 0.477 and 0.473 in 2000 and 2001). Dividing the deficit targets by the actual debt-to-GDP of the respective years or the precrisis debt-to-GDP results in the same value for \(\lambda \).
The mean ratio of IMF loans to GDP in annual data is 0.0132, which implies a quarterly value of approximatively 0.053.
We simulate the model for one million quarters and exclude default and exclusion periods. Additionally, similar to Chatterjee and Eyigungor (2012), we exclude 2 years after redemption as the country counterfactually returns to financial markets with zero debt. We calculate the business cycle statistics over the more than 870,000 remaining periods.
For the welfare comparison, we solve for g in the equation \(g^{1-\sigma } V^\mathrm{FA}\left( d,h,y,\zeta \right) =V^{\mathrm{no\,FA}}\left( d,y,\zeta \right) \), where \(V^\mathrm{FA}\) is the country’s value function of being in the benchmark model with financial assistance and \(V^{\mathrm{no\,FA}}\) the value function of being in the model without financial assistance.
The correspondence between \(\lambda \) and the deficit target is explained in Footnote 19.
As described in Sect. 3 in the benchmark calibration, \(\pi \) is set to match the correlation of output with the change in market debt relative to output, corr(y, \(\Delta d/y\)) which is equal to 0.141.
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Acknowledgments
We thank Gernot Müller, Thomas Hintermaier, Johannes Pfeifer, Almuth Scholl, and participants at the 3rd DFG Workshop on Financial Market Imperfections and Macroeconomic Performance, the 13th SAET Conference on Current Trends in Economics, the 2013 Annual Conference of the Royal Economic Society, the 37th Simposio de la Asociación Española de Economía, the EDP Jamboree 2012, the 2nd Rhineland Workshop, the Annual Meeting of the Verein für Socialpolitik 2012, the 27th Congress of the European Economic Association, the Macro-Workshop (Bonn University), and the 3rd Conference on Recent Developments in Macroeconomics for helpful comments and discussions. Financial support by the Bonn Graduate School of Economics and the German Science Foundation (DFG) under the Priority Program 1578 is gratefully acknowledged. The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Central Bank.
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Appendix
Appendix
See Fig. 8.
Comparison of crisis zones. Notes: black areas: zones overlap, gray areas: crisis only when no financial assistance is available, bright gray areas: crisis zone only in the model with financial assistance
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Kirsch, F., Rühmkorf, R. Sovereign borrowing, financial assistance, and debt repudiation. Econ Theory 64, 777–804 (2017). https://doi.org/10.1007/s00199-015-0945-0
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DOI: https://doi.org/10.1007/s00199-015-0945-0