Recent developments in Europe have once again brought sovereign debt and default to the top of the global economic agenda. Studying sovereigns’ decisions to repay or repudiate requires an understanding of the costs of default, the process of renegotiation during default, and the contractual features of available instruments such as private sector credit and IMF debt. This article describes the theoretical research conducted at the IMF on sovereign debt and default.
While public attention has focused on when and why sovereigns default, the academic literature has analyzed a seemingly different question: why do sovereigns repay their debt? Since—unlike with corporate defaults—lenders do not have the legal right to seize the assets of sovereigns and the enforcement of any penalty is difficult, it has been hard to reconcile why sovereigns repay their debt. If sovereigns’ assets cannot be seized, default may be costless for them, so rational lenders would optimally choose not to lend, and in equilibrium there would be no debt or default. This argument, however, does not help explain the empirical facts because the data reveal positive levels of debt—in some cases high levels of debt compared to the country’s GDP—along with several episodes of default, suggesting that there must be costs associated with default. Hence, researchers have aimed at understanding potential costs of default.
The sovereign debt literature considers two main costs of default: reputational costs and direct sanctions. Reputational costs operate through loss of access to international capital markets (autarky) and hence inability to smooth consumption over time. Direct sanctions refer to trade sanctions that are likely to lead to a disruption in trade and therefore a reduction in output. The empirical relevance and relative importance of these costs have been disputed and the recent sovereign debt literature has modeled the reputational costs rigorously but has captured the other direct sanctions simply as a decline in output during default.
On the modeling of reputational costs, Eaton and Gerso-vitz (1981) provide a tractable, incomplete markets framework. They model a sovereign that optimally chooses to default or to repay. If the sovereign chooses to repay, it also chooses how much to borrow. There is a single lender that represents perfectly competitive private sector creditors. The punishment for default is permanent exclusion from international capital markets. The endogenous default probability of the sovereign pins down the equilibrium interest rate.
More recently, Arellano (2008) studied the quantitative implications of Eaton and Gersovitz’s setup by introducing stochastic output and exclusion from capital markets for a period with stochastic length and direct output losses to capture direct sanctions during default. This model delivers many of the observed patterns in emerging markets’ data such as high volatility of interest rates, higher volatility of consumption relative to output, a negative correlation of interest rates and output, and a negative correlation of the trade balance and output. Most importantly, in line with the data, the model implies that the sovereign finds it optimal to default in bad times, that is, when output is below its trend. Intuitively, to avoid low levels of consumption, the sovereign is more likely to choose default when faced with lower output—an important implication not present in earlier studies of sovereign debt featuring a complete asset market.
Following Arellano (2008), several studies have extended this basic setup to include other relevant features of debt and default such as renegotiation of debt, international reserve holdings, long maturity bonds, and political-economy-related ingredients. For example, Bi (2008) enriches Arellano’s setup to incorporate a stochastic bargaining game to model debt renegotiation. In a related paper, Hatchondo, Martinez, and Sapriza (2010) highlight the impact of solution-method choice on the quantitative results of models with default.
Boz (2009) introduces an international financial institution (IFI) to the canonical setting of Arellano (2008), which had modeled the private sector creditors as the only type of lender, and documents the business-cycle properties of IFI debt. She examines the sovereign’s allocation of its financing needs between private sector creditors and the IFI to account for the cyclical properties of IFI lending, and to map the features of these different types of debt contracts to various patterns in observed flows. The theoretical framework features a sovereign, private sector creditors, and an IFI. The sovereign cannot commit to repay its debt to private sector creditors and thereby strategically defaults depending on the level of its commercial debt, official debt, and output. Similar to Arellano (2008), the interest rate charged by private creditors is determined by endogenous default probabilities, and the punishment for default is exclusion from the commercial credit markets and direct output losses.
Using the IMF’s Stand-By Arrangements, Boz (2009) shows that in emerging markets, the cyclical properties of lending by IFIs are in stark contrast to those of lending by private sector creditors. The average correlation of IMF debt flows with output for a group of emerging-market economies is -0.19, while the same correlation in the case of commercial debt flows is 0.37. In addition, the variability of commercial debt flows is about four times as large as that of IMF debt (0.82 versus 3.91 percent). Finally, borrowing from the IMF is intermittent; the unconditional probability of the use of IMF credit is around 50 percent. This pattern also contrasts with commercial debt as most emerging-market economies are indebted to private sector creditors at all times.
The IFI offers a different type of contract than the private sector creditors. First, contracts with the IFI are enforceable, while those with commercial creditors are not. Boz (2009) considers this to be loosely implied by the IFI having a preferred creditor status and also the fact that the IMF has almost always been repaid, particularly by emerging-market economies. Second, the interest rate associated with IFI lending is assumed to be the sum of the risk-free rate and a charge that increases with the amount borrowed from the IFI. This specification for the IFI interest rate captures the surcharges that may apply in the case of Stand-By Arrangements, depending on the amount borrowed. This specification is significantly different from commercial interest rates that depend on the endogenous default probability determined by the “riskiness” of the sovereign. Finally, condition-ality associated with IFI debt is accounted for by a higher discount factor in periods when the sovereign is indebted to the IFI. In this setting, a higher discount factor tilts the consumption profile by shifting consumption from the present to the future, thereby lowering debt levels and default probabilities. This can be interpreted as similar to implementation of tighter fiscal policies that traditionally have been part of IMF conditionality.
In line with the data, Boz’s model generates procyclical commercial debt as well as countercyclical IFI debt. This is driven by two intertwined features of the model. First, the fact that IFI debt contracts are enforceable leads to a canonical consumption-savings type prediction for the cyclical properties of the sovereign’s borrowing from the IFI. With commitment, consumption-savings models predict more borrowing in bad times and less in good times, hence countercyclical debt flows. On the contrary, default-able commercial debt is procyclical, highlighting the role of lack of commitment to account for the cyclical characteristics of this kind of debt flow. Second, the inelasticity of the IFI interest rates with respect to country characteristics leads the sovereign to find it optimal to borrow more commercially at relatively lower rates in good times with lower default probability and without incurring the costs associated with borrowing from the IFI. However, in bad times, in order to avoid the high risk premia charged by private sector creditors, the sovereign reallocates its portfolio by giving more weight to borrowing from the IFI.
Utilizing this theoretical framework, Boz (2009) concludes that conditionality explains the intermittent nature of borrowing from the IFI. In other words, unlike commercial debt that the sovereign holds at all times except when in default, IFI debt holdings in general are positive in relatively bad times. The fact that IFI debt contracts are enforceable and the price of IFI debt, that is, the surcharge, does not depend on the level of commercial debt helps explain the countercyclicality of IFI debt.
Visiting Scholars, July-September 2010
Kevin Clinton; 4/29/10-4/29/11
Donald R. Davis; Columbia University; 6/11/10-8/31/10
Arellano, Cristina, 2008, “Default Risk, the Real Exchange Rate and Income Fluctuations in Emerging Economies,” American Economic Review, Vol. 98, No. 3, pp. 690–712.
Bi, Ran, 2008, “Beneficial Delays in Debt Restructuring Process,” IMF Working Paper 08/38.
Boz, Emine, 2009, “Sovereign Default, Private Sector Creditors and the IFIs,” IMF Working Paper 09/46.
Eaton, Jonathan, and MarkGersovitz, 1981, “Debt with Potential Repudiation,” Review of Economic Studies, Vol. 48, No. 2, pp. 289–309.
Hatchondo, JuanCarlos, Leonardo Martinez, and HoracioSapriza, 2010, “Quantitative Properties of Sovereign Default Models: Solution Methods Matter,” IMF Working Paper 10/100.