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References

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1/

The author thanks Morris Goldstein for helpful suggestions and comments. Any remaining errors are the author’s responsibility.

2/

This rules out, in particular, a situation in which a borrower follows a Ponzi game; see e.g., Bartolini and Cottarelli, 1991. It does not require that default never occurs—it may still occur if the debtor is hit by unusually large adverse stocks.

3/

In Kenen’s (1992) terminology, market discipline can only address the solvency problem, and not the stabilization and the policy mix problems.

4/

The upper part of the backward-bending curve reflects the fact that, if the interest rate were at a level higher than rmax, this would further increase the default risk and further reduce the amount that lenders would be prepared to provide at that rate. This part of the curve is economically irrelevant, though, since the corresponding points on the lower part of the curve offer the same return to the lender at a lower cost to the borrower.

5/

Nominal rather than real interest rate spreads are shown because, within the EMS, the former reflect the risks of realignment that might be associated with divergent fiscal positions.

6/

Corsetti and Roubini (1991) suggest that Italy, Belgium, Ireland, and Greece might fall into this category.

7/

Governments’ ability to follow through may also be limited. For example, anecdotal evidence from Poland suggests that in some cases the courts may be unwilling to enforce debt contracts, even though the government itself had stated the intention of making bankruptcy possible.

8/

A contrary idea, of “constructive ambiguity”—deliberately creating uncertainty about the scope of possible bailout—is sometimes expressed (see Leipold et al., 1991a). The point is debatable, but it would appear to be more difficult to establish credibility for an ambiguous commitment.

9/

Spreads shown in Chart 5 are for bonds whose term to maturity is eight or nine years; this range was chosen because of the availability of comparable data for all ten provinces.

10/

Another typical aspect of many federal systems is an elaborate structure of conditional and unconditional intergovernmental transfers. This, however, may also tend, if anything, to undermine fiscal discipline, since it dissociates the collection of taxes from the provision of services, and, in the case of conditional grants, subsidizes expenditures by the lower levels of government.

11/

For a discussion of these issues, see also Frenkel and Goldstein, 1991.

12/

Moreover, in the 1970s there was not yet a wide range of market-based hedging instruments with which indebted developing countries could hedge against such shocks; see Mathieson et al., 1989.

13/

This, of course, applies to any bank lending, not just sovereign lending.

Market Discipline
Author: Mr. Timothy D. Lane