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)| false Mendoza, Enrique G., and P. Marcelo Oviedo, 2004, “ Public Debt, Fiscal Solvency and Macroeconomic Uncertainty in Latin America: The Cases of Brazil, Colombia, Costa Rica and Mexico,” NBER Working Paper No. 10637 ( Cambridge, Massachusetts: National Bureau of Economic Research).
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)| false Obstfeld, Maurice, and Giovanni Peri, 1998, “ Regional Nonadjustment and Fiscal Policy,” in EMU: Prospects and Challenges for the Euroed. by David Begg, Jürgen von Hagen, Charles Wyplosz, and Klaus F. Zimmermann, Economic Policy, Vol. 26, No. 2, pp. 205– 59.
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The authors are grateful to Eduardo Borensztein, Olivier Jeanne, and Jeromin Zettelmeyer for insightful suggestions, and earlier collaboration on related topics. They also thank Charles R. Blitzer, Jun I1 Kim, as well as our discussant Maroje Lang and other participants in the 11th Dubrovnik Economic Conference for helpful comments.
For the purposes of this paper, default is defined to include instances of debt restructuring below net present value at market prices.
Another reason why issuing growth-indexed bonds may be more attractive for emerging markets is that their growth risks are more easily diversifiable in a portfolio held by international investors. The comovement between GDP growth in an emerging market and different measures of the “market portfolio” is typically very small: CAPM-type regressions yield low estimates for β and R2 coefficients (Borensztein and Mauro, 2004).
The assumption of risk-neutrality is for simplicity. A risk premium could be introduced with essentially no impact on the main messages of the paper.
While our simplifying assumption that default occurs if and only if the debt/GDP ratio exceeds an estimated trigger level may not do full justice to defaults triggered by illiquidity, distinctions between illiquidity and solvency, or the role of the maturity composition of the debt, our approach seems to be based on an empirically relevant and observable variable.
Growth surprises that lower the average growth path will disproportionately harm growth-indexed bond returns. But even then, part of the effect is attenuated by the lower prevalence of defaults. Of course, growth surprises that raise the average growth path will disproportionately benefit growth-indexed bond holders.
Furthermore, the wide cross-country variation in the use of and types of indexation, with no obvious regular patterns, is consistent with the view that policy makers can play a significant role in fostering financial innovation (see also Borensztein and Mauro, 2004; and Borensztein and others, 2004).
Value Recovery Rights linked to commodity prices were somewhat more common, particularly in the context of the Brady deals. An interesting precedent is also provided by a small restructuring by the city of Buenos Aires, which included indexation to tax revenues. Closer to the notion of pure “Shiller” securities, a small market for options on economic statistics such as U.S. nonfarm payroll has occasionally operated in the past few years under the auspices of Deutsche Bank and Goldman Sachs.
Note also that mismeasurement concerns would apply even more strongly to inflation-indexed bonds, where the political and financial incentives are aligned: underestimating inflation would both yield political benefits and reduce the interest burden. Nevertheless, inflation-indexed bonds are widely used in many countries.
de la Vega lived in Amsterdam but wrote in Spanish as was customary for a Sephardic Jew at the time.
See, for example, Deutsche Bank’s “calculator” on their web site.
The approach based on a default-trigger rule for the debt/GDP ratio is primarily for analytical simplicity, but is also broadly in the spirit of Reinhart, Rogoff, and Savastano (2003), who note a tendency for emerging markets to be “debt-intolerant” and default when their debt/GDP ratio exceeds a certain value.
Setting a, the share of dollar debt, to zero yields a debt equation that is even more standard and familiar.
Since we assume the real interest rates are the same in dollar and local currency terms, the corresponding nominal interest rates in local currency are ipv and iind multiplied by (1 + π)/(1 + π*).
Data coverage for the primary balance begins in 1986 for Turkey and 1990 for Brazil.
Although the real exchange rate depreciated on average by 1.4 percent a year in the historical sample, a zero expected real depreciation seems more reasonable going forward, owing to factors (such as those envisaged by Balassa-Samuelson reasoning) that would even point to a long-run real exchange rate appreciation for emerging markets.
The standard deviations (in percentage points) are: σg=3.8, σε=16.1 and σpb=3.3. The correlations are: ρg,ε=-0.63, ρg, pb=-0.34 and ρε, pb=0.16.
One could extend the model to allow for serial correlation in these variables, for example by computing conditional means and covariances. VAR estimates for these variables yield very noisy and implausible results (probably owing to crisis episodes in the sample which may alter some of the relationships between these variables). Since the focus of our paper is on illustrating our pricing algorithim, we chose, for simplicity, to use the unconditional means and convariance matrix. Similarly, one could consider policy response rules—for example, a potential relationship between the lagged debt ratio and the primary surplus. Again, historical relationships are difficult to estimate in a reliable manner; as a result, one might argue that investors are unlikely to take such response rules into consideration.
In this paper, we focus on pricing the bonds given
In practice, other factors—notably liquidity and rollover difficulties—also contribute to determining defaults. Such factors, especially those related to investor expectations and multiple equilibria would be far more difficult to model. Our simplifying strategy is to focus on the debt/GDP ratio as a key fundamental variable that is both observable and empirically tractable. Yet another approach would be to use models that relate default probabilities to economic fundamentals (for example, Detragiache and Spilimbergo, 2001; Manasse and Roubini, 2005). However, the predictive power of these models is limited.