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For comments and suggestions, we thank Gaston Gelos, Jorge Roldos and seminar participants at the IMF Institute and the 2011 European Economic Association and Econometric Society Meeting. Remaining mistakes are our own. The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management, the Federal Reserve Bank of Richmond, or the Federal Reserve System. For the latest version of this paper, please visit http://works.bepress.com/leonardo_martinez.
Fiscal crises occur in countries with fiscal rules in part because of the lack of enforcement of these rules. However, countries have been able to overcome enforcement issues, for instance, giving stability to their rules by making them part of their constitutions (see IMF (2009)).
For instance, in an IMF Staff Position Note, Blanchard et al. (2010) argue that “A key lesson from the crisis is the desirability of fiscal space to run larger fiscal deficits when needed.” They also note that “Medium-term fiscal frameworks, credible commitments to reducing debt-to-GDP ratios, and fiscal rules (with escape clauses for recessions) can all help in this regard.”
Chatterjee and Eyigungor (forthcoming) and Hatchondo and Martinez (2009) show that long-term debt is essential for accounting for interest rate spread dynamics with a sovereign default framework.
See, for instance, Aguiar and Gopinath (2006), Arellano (2008), Benjamin and Wright (2008), Boz (2011), Lizarazo (2005, 2006), and Yue (2010). These models share blueprints with the models used in studies of household bankruptcy—see, for example, Athreya et al. (2007), Chatterjee et al. (2007), Li and Sarte (2006), Livshits et al. (2008), and Sanchez (2010).
This is consistent with evidence for emerging economies (that pay a high and volatile interest rate), as documented by Gavin and Perotti (1997), Ilzetzki and Vegh (2008), Kaminsky et al. (2004), Talvi and Vegh (2009), and Vegh and Vuletin (2011).
Hatchondo et al. (2007) solve a baseline model of sovereign default with and without the exclusion cost and show that eliminating this cost affects significantly only the debt level generated by the model.
We use linear interpolation for endowment levels and spline interpolation for asset positions. The algorithm finds two value functions, V1 and V0. Convergence in the equilibrium price function q is also assured.
We use the Macaulay definition of duration. Thus, with the coupon structure in this paper, duration is given by
where r* denotes the constant per-period yield delivered by the bond.
Hatchondo et al. (2010b) show that the effects of debt dilution are similar in model economies with three and six defaults per 100 years. The discount factor value we obtain is relatively low but higher than the ones assumed in previous studies (for instance, Aguiar and Gopinath (2006) assume β = 0.8). Low discount factors may be a result of political polarization in emerging economies (see Amador (2003) and Cuadra and Sapriza (2008)).
The data for income and consumption is taken from the Argentinean Finance Ministry. The spread before the first quarter of 1998 is taken from Neumeyer and Perri (2005), and from the EMBI Global after that. For the default frequency, we report the value we targeted, as discussed in Section III.
The qualitative features of this data are also observed in other sample periods and in other emerging markets (see, for example, Aguiar and Gopinath (2007), Alvarez et al. (2011), Boz et al. (2011), Neumeyer and Perri (2005), and Uribe and Yue (2006)). The only exception is that in the data we consider, the volatility of consumption is slightly lower than the volatility of income, while emerging market economies tend to display a higher volatility of consumption relative to income.
Analyzing the difficulties of implementing a voluntary debt exchange is beyond the scope of this paper (see, for instance, Gulati and Zettelmeyer (2012)).
If one allows the government to choose a different duration of sovereign bonds each period, one would have to keep track of how many bonds the government has issued for each possible value of duration to determine government’s liabilities (see Arellano and Ramanarayanan (2010)). The computation cost of including additional state variables may be significant (Hatchondo et al. (2010a) show that the computation cost of obtaining accurate solutions in default models may be significant, and Chatterjee and Eyigungor (forthcoming) explain how the cost increases when long-duration bonds are assumed).
We follow the most common approach of assuming that GDP shocks are the only shocks in the economy and that sovereign debt contracts are not GDP indexed. The overwhelming majority of sovereign debts are not GDP-indexed (see Bolton and Jeanne (2009), Borensztein and Mauro (2004), Durdu (2009), and Sandleris et al. (2009)). Furthermore, sovereigns’ willingness to repay has many other determinants besides domestic GDP. Tomz and Wright (2007) argue that these other determinants (e.g., political shocks) play an important role as predictors of sovereign defaults. Richer models that incorporate determinants of sovereign default other than GDP would feature market incompleteness even with GDP-indexed bonds.