Incentive to Sovereign Debt Default in a
Small Open Economy with International
Labor Outflows
Author:
Nguyen Ngoc Cong
Supervisor:
Prof. Mauro Sodini
A thesis submitted in partial fulfillment for
Master of Science in Economics
Department of Economics and Management
I, Nguyen Ngoc Cong, declare that this thesis titled, ’Incentive to Sovereign Debt Default in a Small Open Economy with International Labor Outflows’ and the work presented in it are my own. I confirm that:
This work was done wholly or mainly while in candidature for the master degree
of this University.
Where any part of this thesis has previously been submitted for a degree or any
other qualification at this University or any other institution, this has been clearly stated.
Where I have consulted the published work of others, this is always clearly
at-tributed.
Where I have quoted from the work of others, the source is always given. With
the exception of such quotations, this thesis is entirely my own work.
I have acknowledged all main sources of help.
Signed:
Date:
Abstract
Master of Science in Economics Department of Economics and Management
by Nguyen Ngoc Cong
Over the last few years, the sovereign debt crisis in Puerto Rico has associated with a large number of international labor outflows. To formalize these facts, I develop a simple
to explain how sovereign debt crisis can be affected by international labor outflows. The result shows that given a level of output, higher stock of the labor outflows, higher probability of sovereign debt default.
Firstly, I would like to express my thanks to my supervisor Professor Mauro Sodini who has spent a great amount of time and energy on helping me to complete this master thesis.
Since this thesis is also a product of my studying process at the Master Program of Science in Economics, I would to thanks all of professors in the program. They have paid a lot of attentions to me, but got nothing from me.
Toscana, Italy.
Finally, I would also like to thank my family and my friends who helped me a lot in finalizing this study within the limited time frame.
iii
Declaration of Authorship i Abstract ii Acknowledgements iii List of Figures 1 Symbols 2 1 Introduction 3 2 Literature Review 5
2.1 Why do the sovereign countries repay their debt? . . . 5
2.1.1 Sovereign Immunity, Legal Sanctions and Direct Punishments . . . 5
2.1.2 Restrictions on Financial Market Access . . . 7
2.1.3 Domestic Costs of Default . . . 12
2.2 Policy and Welfare. . . 16
2.2.1 Rollover Risk and Self Fulfilling Debt Crises. . . 17
2.2.2 Debt Dilution and the Maturity of Sovereign Debts. . . 22
2.2.3 Collective Action Problems in Debt Restructuring . . . 24
2.3 Literature review on national competition taxes . . . 26
2.4 Literature review on intranational migration. . . 26
3 The Baseline Models of Sovereign Debt Default 28 3.1 Default Incentives With Non-State-Contingent Contracts; Eaton and Gerso-vitz (1981) and Arellano (2008). . . 28 3.2 Saving and breakdown of reputational contract; (Bulow and Rogoff 1989). 34
4 Extension 38
5 Conclusion 44
48
iv Appendix
1
1 ThenumberofPuertoRicansinUSAandPuertoRico,2005-2015 . . ... 45 2 PuertoRicoGDPGrowthAnnualandEmployedPeople . . . ... 45 3 PuertoRicoDebtRatio . . . .. 46 4 PuertoRicoBond-NationalFreeIndex . . . 47
yt GDP per capita
ct Consumption per capita tbt Trade balance
dt The stock of debt
Introduction
The ongoing debt crisis in Puerto Rico has happened with the out-migration of workers, from domestic labor market to the foreign labor market. Millions of young Puerto Ricans have left the island to USA since 2006 and since 2015 more Puerto Ricans resided in USA than Puerto Rico, most of them moved for job-related reasons [Figure 1]. According to
and the pace has increased in recent years. About 89,000 people moved from Puerto Rico to the mainland United States in 2015, while only around 24,000 moved back to the island. Young people represent a disproportionate share of those who have migrated, leaving behind an older population. The islands natural population growth has also slowed due to declining fertility rates”. In addition, the economy growth rate has been negative for years, corresponding with the number of employed people in the economy has declined [Figure 2]. Since the Puerto Rico government has difficulty to increase its revenue by imposing tax on Puerto Ricans residing in foreign countries, it then massively borrowed from international credit market in order to smooth its consumption, as a result the government ended up with large amount of debt that they were unable to payback later on [Figure 3 and 4].
Sovereign debt defaults have been attracting a great attention from both the economists and policy makers. But the existing literature on this topic often assume that the labour force of a country is fixed and unaffected by the international conditions and no linking between the government finance, international labor outflows, and default decision. However, the observation of large numbers of international labour outflows may have questioned this assumption. The corollary question is how sovereign default probability can response to international labor outflows?
This thesis, therefore, seeks to relate the development of the international labor out-flows to the model of sovereign debt default. In order to do so, the endowment model of
3
sovereign debt default (Eaton and Gersovitz 1981)[2] will be extended by simply adding a representative firm and household. The benchmark model will map the perfect com-petitive economy with an economy of four agents: firm, household, government and foreign creditor. Household’s decision is determined by the incomes from labor supply regardless of abroad or domestic. The firm uses labor as the only input and produces a homogeneous good with constant return to scale technology. The benevolent govern-ment of a small open economy can issue a non-state contingent debt in the international financial market, and in each period it can decide to either repay the debt or not, the international lenders are risk-neutral creditors. In this model, the output (GDP per capita) is actually not affected by the household optimization problem, but the debt (debt per capita) and the government budget constraint are likely to be. If for any reasons, the household chooses to supply more labor to abroad labor market, it will immediately affect the government budget constraint because the government can not tax on the devoted labor abroad to finance its fixed consumption for public goods, but its debt will likely to increase. Consequently, these effects will worsen the sovereign debt credit.
The rest of this thesis is going to be structured as follow: Chapter 2 reviews the most important researches on the default model, Chapter 3 presents the main features of the baseline models (Eaton and Gersovitz 1981), Arellano (2008) and (Bulow and Rogoff 1989), Chapter 4 is an extension of the baseline model, and Chapter 5 concludes the thesis.
Literature Review
This part is highly adopted from the survey of sovereign debt default by Mark LJ Wright (2011)[3] and the review of Mark Aguiar and Manuel Amador (2013)[4]. However, it is also heavily expanded by myself by re-considering some of the fundamental issues and updating the most important results in the recent years.
To understand sovereign risk, it is necessary to understand the incentives for sovereign borrowers to repay their debts, and hence also on the incentives for creditors to lend to sovereigns in the first place To understand sovereign debt default we have to understand why do countries repay their debt and also why do creditors lend to that countries despite of the risk of non-payment.
2.1
Why do the sovereign countries repay their debt?
2.1.1 Sovereign Immunity, Legal Sanctions and Direct Punishments
When a private borrower defaults on a domestic debt contract, the primary costs of default to that borrower are determined by the legal system of the country and its institutions governing bankruptcy. But when a sovereign borrower defaults on a debt contract, however, the availability of legal remedies is originally limited by the doctrine of sovereign immunity, which precludes a law suit against a sovereign without that sovereigns consent. As applied to law suits within the sovereign’s own legal system, this doctrine is based on the intuitive idea, extending back at least to Hobbes’s Leviathan which usually is regarded as one of the earliest and most influential examples of social contract theory [5], that the agent that makes the laws is not bound by those laws.
As a practical matter, this limits the ability of the sovereign’s creditors to seek enforce-ment of a contract through the courts of the sovereign country itself. With regard to foreign borrowing, this right has typically been extended to foreign governments on the basis of international comity among nations, which as a consequence has limited the ability of foreign creditors to seek redress through their own and other countries’s court. Over time, this so-called absolute doctrine of sovereign immunity has been weakened. In response to increased in government participation in commercial activities in the post war period, driven in part by the rise of socialist and communist countries, a more restrictive doctrine of sovereign immunity was adopted. Codified in the United States with the passage of the Foreign Sovereign Immunity Act of 1976, and in the United Kingdom by the State Immunity Act of 1978, the restrictive doctrine recognizes the immunity of a sovereign with regard to acts of state, but not with respect to its private acts including its commercial activities. With debt issuance widely recognized as a commercial act, foreign creditors now have the ability to bring suit against a sovereign in default on its debts at least in their own and other foreign jurisdictions.
However, this ability is of value only to the extent to which the assets of the sovereign can be attached, and a number of recent court cases have suggested that it is difficult to seize the small stocks of assets held abroad by the average debtor nation. A particularly well known case concerns the mostly unsuccessful efforts of the Swiss company Noga to enforce contracts with Russia by seizing embassy bank accounts, Russian properties in France, naval ships, fighter jets, uranium shipments, and fine art (see Appendix A). In the absence of legal remedies for private creditors, a sovereign debtor in default might be punished directly by a creditor country government. Mitchener and Weidenmeier (2005)[6], for example, present evidence suggesting that capital market participants viewed the threat of military intervention by creditor country governments as an effec-tive deterrent against default by some countries throughout history, ”the supersanctions, instances where military pressure or political control were applied in response to default, were an important and commonly used enforcement mechanism from 1870-1913. Fol-lowing the implementation of supersanctions, on average, ex ante default probabilities on new debt issues fell by more than 60 percent, yield spreads declined approximately 800 basis points, and defaulting countries experienced almost a 100 percent reduction of time spent in default”. Ahmed, Alfaro and Maurer (2007)[7] also argue that military force was an important part of the enforcement of debt contracts in history. Platt (1968) argues that before World War II creditor countries occasionally used force to protect for-eign direct investors, but did not use force to assist holders of soverfor-eign debt. However, these findings are controversial. For example, Tomz (2007)[8] in his study of sovereign borrowing across three centuries finds little evidence for the use of threatened military
intervention to support repayment of debt, although it might have been used to protect the interests of foreign direct investors. Whether or not such punishments were used in the past, there is widespread agreement that they are not significant today.
A recent paper Schumacher, Julian and Trebesch, Christoph and Enderlein, Henrik (2018)[9] shows that defaulting governments were immune from legal action by foreign creditors is no longer the case. Building a dataset covering four decades, they find that creditor lawsuits have become an increasingly common feature of sovereign debt markets. The legal developments have strengthened the hands of creditors and raised the cost of default for debtors. These authors show that legal disputes in the US and the UK disrupt government access to international capital markets, as foreign courts can impose a financial embargo on sovereigns. The findings are consistent with theoretical models with creditor sanctions and suggest that sovereign debt is becoming more enforceable. Despite of these findings, the absence of legal remedies or direct punishments by creditor country governments still a a very important feature of sovereign debt, why do countries ever repay their debts? The costs associated with default are both hard to observe and difficult to quantify. As a consequence, there is a continuing debate about the relative importance of the various costs that we survey in this section.
2.1.2 Restrictions on Financial Market Access
Market participants commonly refer to the loss of normal financial market access as the primary consequence of a country’s decision to default. There are at least three reasons why access to financial markets might be lost or restricted after a default.
One approach emphasizes the role of legal sanctions in blocking credit market access. Although, the ability to seize the assets of a sovereign is limited by the fact that most of these assets are not held in creditor jurisdictions. However, one asset that can be seized are the funds associated with servicing new loans to the country, which inevitably flow through creditor country jurisdictions. Successful lawsuits made it extremely difficult for a defaulting country to issue new credit without paying off old creditors, thereby imposing the kind of credit boycott that short-memoried markets had been unable to impose on their own. This approach has been adopted in two prominent recent court cases, both involving the hedge fund Elliott Associates (see the Appendix A).
Another early paper to study retaliatory loss of credit market access as a punishment for default was Cohen and Sachs (1986)[10]. By analyzing the pattern of growth of a nation which borrows abroad and which has the option of repudiating its foreign debt. They show that the equilibrium strategy of competitive lenders is to make the growth of
the foreign debt contingent on the growth of the borrowing country. The authors give a closed-form solution to a linear version of our model. The economy, in that case, follows a two-stage pattern of growth. During the first stage, the debt grows more rapidly than the economy. During the second stage, both the debt and the economy grow at the same rate, and more slowly than in the first stage. During this second stage, the total interest falling due on the debt is never entirely repaid; only an amount proportional to the difference of the rate of interest and the rate of growth of the economy is repaid each period.
Cole, Dow and English (1995)[11] were amongst the first to argue that the loss of a sovereigns reputation might be a deterrent to default. They develop a simple model of sovereign debt in which defaulting nations are excluded from capital markets and regain access by making partial repayments. This implication of the model is consistent with the historical evidence that defaulting countries return to international loan markets soon after a settlement, but after varying periods of exclusion.
Sandleris (2008)[12] also studies loss of reputation as a punishment for default, although in his model the information revealed is about the creditworthiness of the private sector of the defaulting economy. This paper finds general conditions under which, even in the absence of sanctions, lending to sovereigns can emerge in a single shot game. Further-more, it shows that positive borrowing can be sustained both in pooling and separating equilibria. In this way, it makes clear that neither sanctions nor reputation considera-tions, the two classical explanaconsidera-tions, are necessary to enforce repayment. Information revelation is the crucial mechanism for these results. The repayment/default decision is interpreted as a signal used by the government to communicate information to domestic and foreign agents about the fundamentals of the economy. Governments repay to affect agents’ expectations about them. A default, through its effect on expectations about fundamentals, can generate a decline in foreign and domestic investment and a credit crunch in domestic credit markets. Governments repay to avoid these costs, but may default (in equilibrium) when hit by a negative shock.
Cole and Kehoe (1998)[13] argue that default will spill over to affect the country’s reputation in other areas such as diplomatic relations. In particular, they develop a general model of reputation in which if a government is viewed as untrustworthy in one relationship, this government will be viewed as untrust-worthy in other relationships. These author show that their general model of reputation can support large amounts of debt.
Rose and Spiegel (2009)[14] study empirically the effect of a default on a countries repu-tation in the context of a country’s ability to engage in diplomatic relations in the form
of environmental treaties. They examine the role of non-economic partnerships in pro-moting international economic exchange. Since far-sighted countries are more willing to join costly international partnerships such as environmental treaties, environmental en-gagement tends to encourage international lending. Countries with such non-economic partnerships also find it easier to engage in economic exchanges since they face the possi-bility that debt default might also spill over to hinder their non-economic relationships. The authors present a theoretical model of these ideas, and then verify their empiri-cal importance using a bilateral cross-section of data on international cross-holdings of assets and environmental treaties. Their results support the notion that international environmental cooperation facilitates economic exchange.
The second but the most influential approach was developed in the strategic default model of benevolent government (Eaton and Gersovitz (1981)), in which the authors analyzed the relationship between the default probabilities and output fluctuations and level of debt. The benchmark showed that there can be an equilibrium with debt subject to the default risk in the limited commitment environment, a country makes a repayment in order to keep ”reputation collateral” for future borrowing. If a country defaults, it will be excluded from new loans in the credit market, leading to its loss of a fraction of output as a proxy for total loss. There are two key results of the baseline model; the first is given amount of debt, the default is likely at the lower level of output and the second is given level of output, default is likely at a higher level of debt. These results matched the observed facts on the levels of debt, output and sovereign spreads.
However, this model bases on the exogenous assumption of stationary output, it therefore can not explain why the default always accompany with the ”deep” recession of output. The assumption of fully default implies that the model can not explain the haircut or re-negotiation. The forever exclusion assumption is also impractical due to the fact that many defaulted countries have entered the loan market again. Another weakness of this model is the assumption that creditors are break-even (passive), which prevents the model from giving more details of the boom-bust in credit (most debt crises were followed by boom in credit). Finally, the representative assumption suggests that the model does not address the impact of sovereign default on the different groups of the economy.
Many economist have tried to overcome the mentioned problems as well as make the model fit better the data on emerging market economies in term of borrowing level and corresponded interest rates.
Arellano (2008)[15] studied ”default risk and its interaction with output, consumption, and foreign debt. Default probabilities and interest rates depend on incentives for repay-ment. Default occurs in equilibrium because asset markets are incomplete. The model
predicts that default incentives and interest rates are higher in recessions, as observed in the data. The reason is that in a recession, a risk averse borrower finds it more costly to repay non-contingent debt and is more likely to default”. In this model the author made three important innovations focusing on the cost of default. The first innovation is to allow the possibility of re-entering the loan market of defaulted country, the second is instead of iid of yt, she assumed that it follows a AR − 1, and the third adjustment is higher cost of default corresponding with a higher level of output, but the output is still an exogenous. As a result, this model matched better with the ”deep” recession that has been shown in the data, and it also implies that the ”speed” of probability of default is a strictly increasing and concave function of borrowing.
Another way to weaken the relation between the probability of default and the interest rate is to introduce the longer maturity of the bonds. The bond price and interest rate of today depend not only on the situation of next period but also the expectation of long term future default probabilities. There are some contradictions in increasing bond maturity on the cost and probability of default, which mainly depend on the way of modelling the possibility of re-entering the market and the type of fiscal policy. According to Cole and Kehoe (2000)[16], with longer maturity, the amount of debt rolled over each period is lower, thus benefit of default will decrease, cost of default remains unchanged. Meanwhile, a study of Alfaro (2009)[17] showed that ”both benefit and costs of defaulting decrease with an increase in maturity. Because, the sovereign is not (perpetually) excluded from the market, but rather faces a higher interest rate after defaulting”. Moreover, there are other researchers studying about maturity and default that based on the model of Eaton and Gersovitz (1981), such as Hatchondo and Martinez (2008)[18] and Arellano and Ramanarayanan (2012)[19].
Mendoza and Yue (2012)[20] proposed the first model of both general equilibrium of sovereign debt and default and business cycle which help to explain the deep recession. The authors consider the income fluctuation as an endogenous factor and default risk is also an endogenous variable of the working capital. Some imported inputs for production process required working capital financing. Strategic default causes an efficiency loss because final goods producers cannot operate with the imported input varieties that require credit, substituting them for other imported inputs and domestic inputs, and because labor reallocates from the final goods sector to the sector producing domestic inputs. Default is optimal if after being assessed its effect on economic activity and financial autarky by the decision maker, has higher payoff than debt payment. The model helps to explain the counter-cyclical spread, higher debt ratios, and the dynamic of key economic variables around default. This research also introduces a very interesting way to consider the effect of the private sector structure, financial structure and labor market condition on the default cost.
Nevertheless, the mentioned baseline model as well as its following modifications were faced by a theoretical problem that was first raised by Bulow and Rogoff (1989)[21]. These authors criticized the baseline model for its lack of distinction between the de-faulted country’s cutoff caused by the legal right of outstanding debt and by a loss of reputation, and the ability of creditors to induce their government to do retaliatory ac-tions, especially when the defaulted country has abroad asset. They also established the general condition under which small countries can not establish ”reputation collateral” for payment, and lending to a small developing country is only possible when creditors have enough political or legal right to the debtor country. This model is similar to that of Eaton and Gersovitz (1981), nevertheless Bulow and Rogoff did not make any assumption about the form of consumption utility function but non-satiation behavior, the assumption is not necessary because the proof employed the arbitrage strategy (two identical cash flows always have the same price). A small country can choose either rep-utation contract or cash-advanced contract, the model implicitly assumes that there are international creditors who can make commitments and these commitments are enforced by the legal system in the investors’ countries. Therefore, a small country can hold some kind of valuable asset in the investors’ countries without worrying about attainability of the cash-advanced contracts and is allowed to lend to international credit market. As a result, a country could default their debt by taking the debt obligations it would have made to foreign creditors and invest them with foreign financial institutions to generate a higher level of welfare than they could obtain from future borrowing. Intuitively, any reputation contract cover at least one state of nature that the country will default, be-cause by entering the cash-advanced contract, a country does not need to pay the debt payment but can still enjoy the sequence of consumption at least as under the repay-ment situation. The threat of exclusion from new loans accordingly is not creditable, Bulow and Rogoff proposed the full exclusion from lending and borrowing or stopping the defaulted country from international trade, either which is needed to support the sustainability of reputation contract.
A large literature has established the limits of the Bulow-Rogoff critique of retaliatory punishments. Kletzer and Wright (2000)[22] showed that if creditors cannot commit to repaying deposits, the threat of exclusion from financial markets can work to support borrowing. Wright (2002)[23] shows that even if a group of competitive creditors (in the sense of earning zero profits) can commit to repaying deposits, they can coordinate to credibly exclude a defaulter from access to credit markets. Amador (2004)[24] provides a political economy model of debt which shows that the presence of political uncertainty reduces the ability of a country to save, and hence to replicate the original debt contract after default. In a model where different parties alternate in power, an incumbent party with a low probability of remaining in power has a high short-term discount rate and
is therefore unwilling to save. The current incumbent party realizes that in the future whoever achieves power will be impatient as well, making the accumulation of assets unsustainable. This time-inconsistency is shown to be equivalent to the problem faced by a hyperbolic consumer. Because of their inability to save, politicians demand debt ex-post and the desire to borrow again in the future enforces repayment today.
An alternative reason for the loss of credit market access following a default is that the decision to default reveals something about the country’s credit worthiness leading creditors to reduce or cut-off lending to them. We refer to this cost of default as the loss of a country’s reputation, noting that the literature often uses the term to also describe retaliatory punishments for default. For example, if there is incomplete information about the gains from sovereign borrowing - perhaps because the country’s value of future lending or the costs of default are unknown - a default will lead foreigners to infer that the country is a ”bad type”. Future loans will not be forthcoming because creditors believe those loans will lose money, and not as the result of a coordinated retaliatory embargo on loans. Other variants of this approach postulate that default reveals information about underlying investment opportunities in the country, or the likelihood that the country will cooperate in other areas such as diplomatic relations.
2.1.3 Domestic Costs of Default
A final class of costs of default identified by the literature concern the impact of a default on the domestic economy and political system of the country. There are numerous mechanisms through which this might occur. As noted above, the primary benefit from default is that a country can keep resources that it would have otherwise paid to foreigners. If, however, a country cannot discriminate between debts owned by foreigners and debts owned by its own citizens, a default will impose costs on the country’s citizens. Broner, Martin and Ventura (2014)[25] argue that secondary markets may serve to reallocate bond holdings in such a way as to deter default by making the costs of default fall primarily on domestic residents.
A default may also impose direct costs of the economy of the defaulting country. For example, if default damages the domestic financial system by inducing a domestic bank-ing crisis, domestic output will fall. Another mechanism through which the domestic economy may be affected by a default is through its effects on international trade. There is some empirical evidence that countries in default experience a significant decline in foreign trade, which may indicate the imposition of trade sanctions, either explicitly or sub rosa, or the loss of access to trade credit facilities. Once again, this view remains controversial: other authors have argued that these trade declines are unrelated to the
pattern of debt holdings, and hence might be due to forces other than trade sanctions by creditor country governments.
McGillivray and Smith (2008)[26] argue that in political systems in which citizens can replace leaders at low cost broadly, democracies sovereign default will be rare. Since a reputation for good behaviour is likely to be among the most important reasons why sovereign governments can borrow from creditors, citizens will have strong incentives to replace a political leader who defaults so as to restore the countrys reputation as a trustworthy borrower. This will be true even if citizens generally favour default, as the benefits accrued from betraying a defaulting leader should trump congruence in beliefs about the appropriateness of default. The implication is that if the primary objective of incumbent governments is to retain power, democracy acts as a powerful institutional mechanism that ensures a credible political commitment to repay loans and thus makes default very rare.
Kaletsky (1985)[27] argues that the threatened loss of short term trade credit, rather than the loss of credit market access more generally, that deters default.
Rose (2005)[28] finds evidence of substantial trade declines following a sovereign default. The author estimates the effect of sovereign debt renegotiation on international trade. Sovereigns may fear the trade consequences of default; because creditors deter default, or because trade finance dries up. The paper an empirical gravity model of trade and a panel data set covering 50 years, over 150 countries, and other factors that influence bilateral trade. Debt renegotiation is associated with an economically and statistically significant decline in bilateral trade between a debtor and its creditors. The decline in bilateral trade is approximately 8 percent a year and persists for around 15 years. Although, sovereign defaults are associated with declines in defaulting countries trade, Martinez and Sandleris (2011)[29] argue that the trade declines identified by Rose are unrelated to the pattern of debt holdings, and hence might be due to forces other than trade sanctions by creditor country governments. In this paper, they devise an empirical strategy to evaluate the question ”Are these declines the result of trade sanctions as the trade sanctions argument of sovereign borrowing would suggest?” based on the idea that if trade sanctions are causing the declines, bilateral trade with creditor countries should fall more than trade with other countries. They find that this is not the case. The analysis does not yield much evidence of broader punishment strategies including a league of major creditors either. These results contradict the predictions of the trade sanctions theory of sovereign borrowing.
Gennaioli, Nicola and Martin, Alberto and Rossi, Stefano (2014)[30] present a model of sovereign debt in which, contrary to conventional wisdom, government defaults are
costly because they destroy the balance sheets of domestic banks. In thei model, better financial institutions allow banks to be more leveraged, thereby making them more vulnerable to sovereign defaults. Their predictions: government defaults should lead to declines in private credit, and these declines should be larger in countries where financial institutions are more developed and banks hold more government bonds. In these same countries, government defaults should be less likely. Using a large panel of countries, they find evidence consistent with these predictions.
The internal cost of default, an important driver of sovereign debt repayment, increases with domestic portfolios’ home bias. And so, when using capital controls or other instruments to steer these portfolios, a country faces a trade-off between commitment to repay and diversification. But why does a borrowing country not eschew the internal cost of default through domestic sector bailouts? And why does their sovereign not intermediate the diversification through swaps and other hedging devices? Answering these two questions is key to fathom the nature of internal costs of default. Mengus, Eri (2014)[31] investigate sovereign debt sustainability in a model where domestic and foreign investors optimally select their portfolios and the sovereign optimizes over its debt, default and bailout policies. It derives conditions under which internal bailouts do not preclude sovereign borrowing and establishes when, despite their disciplining benefits, capital controls are undesirable.
Sovereign defaults are associated with declines in foreign and domestic credit to the do-mestic private sector. Sandleris Guido (2014)[32] analyzes theoretically whether sovereign defaults can lead to this decline, even if domestic agents do not hold sovereign debt. It also studies whether the quality of domestic financial institutions affect the magnitude of this effect. In order to address these issues, the paper embeds the traditional sovereign borrower/foreign creditors relationship of the sovereign debt literature in a macro-model where widespread individual financial constraints limit a country’s ability to reallocate resources. The paper finds that sovereign defaults can indeed generate a decline in for-eign and domestic credit even if domestic agents do not hold soverfor-eign debt, and that stronger domestic financial institutions can amplify this effect.
Economic policymakers sometimes perceive a sovereign default as a jump into the un-known. The main piece of information missing is what the costs of the default are going to be. Assessing these costs correctly is crucial for evaluating how far a country should go to avoid a default. Sandleris Guido (2016)[33] analyzes the main sources of the costs of default discussed in the theoretical literature and evaluates the empirical evidence on the matter. This paper classify these potential sources in three groups: (1) sanc-tions imposed as penalties by creditors; (2) costs related to the information content of default; and (3) costs related to domestic agents sovereign bond holdings. The author
then presents a simple model that captures the main intuition behind each of them. A review of the empirical evidence suggests that while the costs generated in the aftermath of defaults by traditional mechanisms, such as trade sanctions or exclusion from credit markets, have not been significant in recent decades, costs deriving from information revelation and the impact on domestic bondholders, particularly the banking system, have become major consequences of sovereign defaults.
Infrequent but turbulent episodes of outright sovereign default on domestic creditors are considered a forgotten history in Macroeconomics. D’Erasmo, Pablo and Mendoza, Enrique G (2016)[34] propose a heterogeneous-agents model in which optimal debt and default on domestic and foreign creditors are driven by distributional incentives and endogenous default costs due to the value of debt for self-insurance, liquidity and risk-sharing. The government’s aim to redistribute resources across agents and through time in response to uninsurable shocks produces a rich dynamic feedback mechanism linking debt issuance, the distribution of government bond holdings, the default decision, and risk premia. Calibrated to Spanish data, the model is consistent with key cyclical co-movements and features of debt-crisis dynamics. Debt exhibits protracted fluctuations. Defaults have a low frequency of 0.93 percent, are preceded by surging debt and spreads, and occur with relatively low external debt. Default risk limits the sustainable debt and yet spreads are zero most of the time.
Perez, Diego and others (2015)[35] explore two mechanisms through which a sovereign default can disrupt the domestic economy via its banking system. First, a sovereign default creates a negative balance-sheet effect on banks, which reduces their ability to raise funds and prevents the flow of resources to productive investments. Second, default undermines internal liquidity as banks replace government securities with less productive investments. I quantify the model using Argentinean data and find that these two mechanisms can generate a deep and persistent fall in output post-default, which accounts for the governments commitment necessary to explain observed levels of external public debt. The balance-sheet effect is more important because it generates a larger output cost of default and a stronger ex-ante commitment for the government. Post-default bailouts of the banking system, although desirable ex-post, are welfare reducing ex-ante since they weaken governments commitment. Imposing a minimum public debt requirement on banks is welfare improving as it enhances commitment by increasing the output cost of default.
Although the source of such domestic costs remains controversial, the perception that such costs exist is sufficiently widely accepted that the quantitative theoretical literature typically combines an ad-hoc output loss with the loss of market access when modeling the costs of default.
Recently, another line of non-strategic sovereign debt model default which is a contra-diction to model of Eaton and Gersovitz on the philosophy issues that a ”Sovereign” default because it does not have ability not because of unwilling to pay. The paper of (Farhi, Emmanuel and Tirole, Jean (2017)) [36] formalized on this idea, ”The recent unravelling of the Eurozone’s financial integration raised concerns about feedback loops between sovereign and banking insolvency. This article provides a theory of the feed-back loop that allows for both domestic bailouts of the banking system and sovereign debt forgiveness by international creditors or solidarity by other countries. Our theory has important implications for the re-nationalization of sovereign debt, macroprudential regulation, and the rationale for banking unions”. The research leaves open a num-ber of fascinating questions. First, authors have assumed that the bailouts take the fiscal route. As observed recently in many countries, central banks may participate in the bailout, perhaps risking inflation and devaluation. While the analysis is consistent with the central bank participating in the bailout, it assumes that the cost of such non-conventional intervention is a fiscal one rather than inflation or devaluation. Second, the authors have assumed that sovereign defaults are not strategic (the Sovereign defaults only if it cannot repay). If defaults are strategic, domestic exposure choices by domestic banks influence the incentives to default (the Sovereign is less likely to default if its debt is held domestically), opening up the possibility of complex strategic interactions between banks and sovereigns, and conferring a benefit (disciplining the Sovereign) upon debt re-nationalization. Finally, further research should be devoted to the governance of the banking union, and in particular to the interactions between prudential and fiscal integration.
2.2
Policy and Welfare
The quantitative theoretical literature has shown that sovereign risk alone can act as a very severe constraint on the amount of sovereign debt that can be issued. In this section, we briefly discuss the potential for self-fulfilling debt crises to arise as a further limitation on the market for sovereign debt, before turning to two policy debates that have recently been studied by the theoretical literature: the desirability of issuing longer maturity debts; and, the need for a mechanism to coordinate creditors in negotiations to restructure defaulted debts, before turning to two policy debates that have recently been studied by the theoretical literature: the desirability of issuing longer maturity debts; and, the need for a mechanism to coordinate creditors in negotiations to restructure defaulted debts.
Before proceeding, we stress two important caveats. First, an understanding of the costs of default, and hence of the incentives of a country to borrow appropriately and avoid default, is essential to any discussion of policy and welfare. For without an understanding of these incentives, any proposed policy for changing the market for sovereign debt may be either infeasible or undesirable for the very same reasons that prevented market institutions from implementing the change in the first place. As a consequence of the ongoing debate as to the precise costs of default, policy proposals that rely on a specific interpretation of these costs should be treated with caution. Second, it is important to acknowledge the welfare trade-off between minimizing the costs of default ex-post, with the need to give countries an incentive to borrow appropriately and avoid default ex-ante.
2.2.1 Rollover Risk and Self Fulfilling Debt Crises
The possibility that debt crises could be self fulfilling has been acknowledged for a long time and derives from the following logic: If investors believe a default to be an unlikely, they will demand a small default risk premium and debtors, faced with a low interest rate, will have little incentive to default; Conversely, if investors think a default is likely, they will demand higher interest rates perversely giving the country a greater incentive to default. The possibility of such a self fulfilling debt crisis is further strengthened when a country has a large amount of short-term debt falling due that it would like to roll-over: that is, it would like to repay these debts by issuing new debts. In such a world, a debtor may be willing to repay that portion of the debt that is falling due if it knows it can roll over these debts by issuing new ones, and unwilling otherwise. As a result, if creditors believe that other creditors will not purchase new debt issued by the sovereign, they themselves will not purchase these debts leading to a self-confirming default
Obstfeld (1996)[37] presents a model motivated by the discomfort a government suffers from speculation against its currency determines the strategic incentives of speculators and the scope for multiple currency-market equilibria. After describing an illustrative model in which high unemployment may cause an exchange-rate crisis with self-fulfilling features, this paper reviews some other self-reinforcing mechanisms. While Krugman (1996)[38] shows that the recent literature’s result that expectations of crisis can be self-fulfilling is due less to the new assumption of endogeneity of government policy than to the dropping of the classical assumption that fundamentals are deteriorating. When ob-jective economic conditions are steadily deteriorating, these fundamentals can be shown to determine uniquely the timing of a currency crisis, even if policy is endogenous and even if people are uncertain about the government’s objective function. If fundamentals
evolve randomly and are not certain to deteriorate, then self-fulfilling expectations can play a role, though even here this role may be tempered by the presence of well-financed speculators. This paper also argues that, as an empirical matter, the actual currency experience of the 1990s does not make as strong a case for self-fulfilling crises as has been claimed by some researchers. In general, it is very difficult to distinguish between currency crises that need not have happened and those that were made inevitable by concerns about future viability that seemed reasonable at the time.
A number of authors have argued that such self fulfilling roll-over risk played an im-portant role in the Mexican crisis of 1994-1995. Sachs, Tornell and Velasco (1996)[39] examine closely the financial events following the Mexican peso devaluation to uncover new lessons about the nature of financial crises. This paper explore the question of why, during 1995, some emerging markets were hit by financial crises while others were not. To this end, they ask whether there are some fundamentals that help explain the varia-tion in financial crises across countries or whether the variavaria-tion just reflects contagion. They present a simple model identifying three factors that determine whether a country is more vulnerable to suffer a financial crisis: a high real exchange rate appreciation, a recent lending boom, and low reserves. They find that for a set of 20 emerging markets, differences in these fundamentals go far in explaining why during 1995 some emerging markets were hit by financial crises while others were not. The authors also find that alternative hypotheses that have been put forth to explain such crises often do not seem to be supported by the data, such as high current account deficits, excessive capital inflows and loose fiscal policies.
Cole, Harold L and Kehoe, Timothy J (1996)[40] explore the extent to which the Mexican government’s inability to roll over its debt during December 1994 and January 1995 can be modeled as a self-fulfilling debt crisis. In the model there is a crucial interval of debt for which the government, although it finds it optimal to repay old debt if it can sell new debt, finds it optimal to default if it cannot sell new debt. If government debt is in this interval, which they call the crisis zone, then they can construct equilibria in which a crisis can occur stochastically, depending on the realization of a sunspot variable. The size of this zone depends on the average length of maturity of government debt. Their analysis suggests that for a country, like Mexico, with a very short maturity structure of debt, the crisis zone is large and includes levels of debt as low as those in Mexico before the crisis.
An other model of this phenomenon has been also presented by Cole and Kehoe (2000)[16]. They characterize the values of government debt and the debt’s maturity structure un-der which financial crises brought on by a loss of confidence in the government can arise
within a dynamic, stochastic general equilibrium model. They also characterize the op-timal policy response of the government to the threat of such a crisis. They show that when the country’s fundamentals place it inside the crisis zone, the government may be motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the government’s debt. They show that this reduction can be gradual if debt is high or the probability of a crisis is low. The author also sow that, while lengthening the maturity of the debt can shrink the crisis zone, credibility-inducing policies can have perverse effects.
Alesina Prati, and Tabellini (1989)[41] show that if the public expects that in the future the government will be unable to roll over the maturing debt, they may refuse to buy debt today and choose to hold foreign assets. This lack of confidence may then be self-fulfilling. They argue that under certain conditions, the occurrence of a confidence crisis is more likely if the average maturity of the debt is short. In the contrary, a long and evenly distributed maturity structure may reduce such a risk. They consider the recent Italian experience from this perspective. In particular they ask whether recent developments in the market for government debt showy signs of unstable public confidence, and of a risk premium.
Conesa Juan Carlos and Timothy J. Kehoe. (2017)[42] introduce this feature in models with income shocks. They develop a model for analyzing the sovereign debt crises of 20102013 in the Eurozone. The government sets its expendituredebt policy optimally. The need to sell large quantities of bonds every period leaves the government vulnerable to self-fulfilling crises in which investors, anticipating a crisis, are unwilling to buy the bonds, thereby provoking the crisis. In this situation, the optimal policy of the gov-ernment is to reduce its debt to a level where crises are not possible. If, however, the economy is in a recession where there is a positive probability of recovery in fiscal rev-enues, the government also has an incentive to smooth consumption and increase debt. Their exercise identifies conditions on fundamentals for which the incentive to smooth consumption dominates, giving rise to a situation where governments optimally gamble for redemption, running fiscal deficits and increasing their debt, thereby increasing their vulnerability to crises
Stangebye Zachary and Chatterjee Satyajit and Cole Harold and Aguiar (2016)[43] found that sovereign debt spreads occasionally exhibit sharp, large spikes in spreads over risk-free bonds but only weakly correlated with movements in domestic output and are frequently followed by reductions in the face value of debt outstanding. Motivated by this evidence, they propose a quantitative model with long-term bonds and three sources of risk: fluctuations in the growth of domestic income; movements in the risk premia associated with default risk; and shifts in creditor “beliefs” regarding the actions of
other creditors. They show that the shifts in creditor beliefs directly play an important role in generating default risk, but also amplify the impact of shocks to fundamentals. Interestingly, persistent changes to risk premia have a negligible impact on spreads, and an increase in risk premium may even lead to a decline in spreads. The latter reflects that a higher risk premium provides discipline regarding future debt issuances. More generally, the sovereign borrowing decisions are quantitatively sensitive to equilibrium bond prices. Even large, relatively unexpected shocks to creditor beliefs have only a modest effect on spreads as the government responds by aggressively deleveraging. Bocola, Luigi and Dovis, Alessandro (2016)[44] use the information contained in the joint dynamics of governments debt maturity choices and interest rate spreads to quantify the importance of self-fulfilling expectations in sovereign bond markets. The paper considers a model of sovereign borrowing featuring endogenous debt maturity, risk averse lenders and self-fulfilling rollover crises la Cole and Kehoe (2000). In this environment, interest rate spreads are driven by economic fundamentals and by expectations of future self-fulfilling defaults. These two sources of default risk have contrasting implications for the debt maturity choices of the government. Therefore, they can be indirectly inferred by tracking the evolution of the maturity structure of debt during a crisis. They fit the model to the Italian debt crisis of 2008-2012, finding that 12 percent of the spreads over this episode were due to rollover risk. Their results have implications for the effects of the liquidity provisions established by the European Central Bank during the summer of 2012.
Aguiar, Mark and Chatterjee, Satyajit and Cole, Harold and Stangebye, Zachary (2017)[45] revisit self-fulfilling rollover crises by introducing an alternative equilibrium selection that involves bond auctions at depressed but strictly positive equilibrium prices, a sce-nario in line with observed sovereign debt crises. They refer to these auctions as desper-ate deals, the defining feature of which is a price schedule that makes the government indifferent to default or repayment. The government randomizes at the time of repay-ment, which they show can be implemented in pure strategies by introducing stochastic political payoffs or external bailouts. Quantitatively, auctions at fire-sale prices are crucial for generating realistic spread volatility.
Does monetary sovereignty reduce the likelihood of default conditional on weak fun-damentals and/or shield government debt markets from self-fulfilling speculative runs? Building on Calvo (1988)[46], Corsetti, Giancarlo and Dedola, Luca (2013)[47] specify a stochastic monetary economy where discretionary policymakers can default on debt holders through surprise inflation or by imposing discrete haircuts, at the cost of both output and budgetary losses. They show that the resort to the printing press to inflate away nominal debt per se rules out neither fundamental outright default nor confidence
crisis. What matters is the ability of the central bank to swap government debt for monetary liabilities (e.g. cash and reserves), whose demand is not undermined by fears of default. The scope for successful central bank interventions in the debt market is how-ever not unconstrained. They characterize conditions that must be met for alternative intervention strategies to be credible, i.e. feasible and welfare improving.
Bacchetta, Philippe and Perazzi, Elena and Van Wincoop, Eric (2015)[48] examine quan-titatively the potential for monetary policy to avoid self-fulfilling sovereign debt crises. They combine a version of the slow-moving debt crisis model proposed by Lorenzoni and Werning (2013)[49] with a standard New Keynesian model. They consider both conventional and unconventional monetary policy. Under conventional policy the cen-tral bank can preclude a debt crisis through inflation, lowering the real interest rate and raising output. These reduce the real value of the outstanding debt and the cost of new borrowing, and increase tax revenues and seigniorage. Unconventional policies take the form of liquidity support or debt buyback policies that raise the monetary base beyond the satiation level. They find that generally the central bank cannot credibly avoid a self-fulfilling debt crisis. Conventional policies needed to avert a crisis require excessive inflation for a sustained period of time. Unconventional monetary policy can only be effective when the economy is at a structural ZLB for a sustained length of time. What circumstances or policies leave sovereign borrowers at the mercy of self-fulfilling increases in interest rates? To answer this question, Lorenzoni, Guido and Werning, Ivan (2013)[49] study the dynamics of debt and interest rates in a model where default is driven by insolvency. Fiscal deficits and surpluses are subject to shocks but influenced by a fiscal policy rule. Whenever possible the government issues debt to meet its current obligations and defaults otherwise. They show that low and high interest rate equilibria may coexist. Higher interest rates, prompted by fears of default, lead to faster debt accumulation, validating default fears. They call such an equilibrium a slow moving crisis, in contrast to rollover crises where investor runs precipitate immediate default. They also investigate how the existence of multiple equilibria is affected by the fiscal policy rule, the maturity of debt, and the level of debt.
De Grauwe, Paul and Ji, Yuemei (2013)[50] test the hypothesis that the government bond markets in the Eurozone are more fragile and more susceptible to self-fulfilling liquidity crises than in stand-alone countries. They find evidence that a significant part of the surge in the spreads of the peripheral Eurozone countries during 201011 was disconnected from underlying increases in the debt to GDP ratios and fiscal space variables, and was associated with negative self-fulfilling market sentiments that became very strong since the end of 2010. They argue that this can drive member countries of the Eurozone into bad equilibria. They also find evidence that after years of neglecting
high government debt, investors became increasingly worried about this in the Eurozone, and reacted by raising the spreads. No such worries developed in stand-alone countries despite the fact that debt to GDP ratios and fiscal space variables were equally high and increasing in these countries.
Chamon (2007)[51] shows that the roll-over coordination problem can be eliminated by a combination of state-contingent securities and a mechanism that allows investors to promise to lend only if enough other investors do so as well. This suggests that runs on the debt of a single borrower (such as the government) can be eliminated and that self-fulfilling features are more plausible when externalities among many decentralized borrowers allow for economy-wide debt runs to occur.
2.2.2 Debt Dilution and the Maturity of Sovereign Debts
Work on self-fulfilling debt crises has pointed to a possible over-reliance on short term borrowing by developing countries, without explaining why short term lending is so predominant in the first place. One explanation for inefficiently short maturities lies in the lack of an explicit and enforceable seniority structure among sovereign debts. For example, if there is no seniority so that all debt holders expect to be treated equally in the event of a debt restructuring, and if the total amount to be paid to creditors is relatively fixed, new debt issues have the effect of reducing the amount that existing debt holders expect to recover, and hence reduce the value of existing debt claims. This phenomenon, a form of the debt dilution problem studied with regard to domestic corporate debt by Fama and Miller (1972)[52], has been applied to sovereign debt by a number of recent authors.
In an environment characterized by weak contractual enforcement, sovereign lenders can enhance the likelihood of repayment by making their claims more difficult to restructure ex post. Bolton and Jeanne (2007)[53] show, however, that competition for repayment between lenders may result in a sovereign debt that is excessively difficult to restructure in equilibrium. This inefficiency may be alleviated by a suitably designed bankruptcy regime that facilitates debt restructuring.
Bi Ran (2006)[54] develops a dynamic model of sovereign default and renegotiation to study how expectations of default and debt restructuring in the near future affect the ex ante maturity structure of sovereign debts. This paper argues that the average maturity is shorter when a country is approaching financial distress due to two risks: default risk and debt dilution risk. Long-term yield is generally higher than short-term yield to reflect the higher default risk incorporated in long-term debts. When default risk is high and long-term debt is too expensive to afford, the country near default has to rely
on short-term debt. The second risk, debt dilution risk, is the focus of this paper. It arises because there is no explicit seniority structure among different sovereign debts, and all debt holders are legally equal and expect to get the same haircut rate in the post-default debt restructuring. Therefore, new debt issuances around crisis reduce the amount.
Bolton, Patrick and Jeanne, Olivier (2009)[55] show how the willingness-to-pay problem and lack of exclusivity in sovereign lending may result in an equilibrium sovereign debt structure that is excessively difficult to restructure. A bankruptcy regime for sovereigns can alleviate this inefficiency but only if it is endowed with far-reaching powers to enforce seniority and subordination clauses in debt contracts. A bankruptcy regime that makes sovereign debt easier to restructure without enforcing seniority may decrease welfare. An important ineffciency in sovereign debt markets is debt dilution, wherein sovereigns ignore the adverse impact of new debt on the value of existing debt and, consequently, borrow too much and default too frequently. A widely proposed remedy is the inclusion of seniority clause in sovereign debt contracts: Creditors who lent first have priority in any restructuring proceedings. Chatterjee Satyajit and Eyigungor Burcu (2013)[56] incorporate seniority in a quantitatively realistic model of sovereign debt and find that seniority is quite effective in mitigating the dilution problem. They also show theoret-ically that seniority cannot be fully effective unless the costs of debt restructuring are zero.
Raquel Fernndez, Alberto Martin (2014)[57] present a simple model of sovereign debt crises in which a country chooses its optimal mix of short and long-term bonds subject to standard contracting frictions: the country cannot commit to repay its debts nor to a specific path of future debt issues, and contracts cannot be made state contingent nor renegotiated. They show that, in order to reduce incentives to engage in debt dilution, the country must issue short-term debt. This exposes it to roll-over crises and inefficient repayments. They examine the effects of alternative restructuring regimes, which either write-down debt or extend its maturity in the event of crises, and show that both necessarily improve ex ante welfare if they do not decrease expected payments to creditors during crises. In particular, they show that the way in which these regimes redistribute payments between short- and long-term creditors, which has been a central point in recent policy debates, is inconsequential.
A sovereign’s inability to commit to a course of action regarding future borrowing and default behavior makes long-term debt costly (the problem of debt dilution). One mech-anism to mitigate this problem is the inclusion of a seniority clause in debt contracts. In the event of default, creditors are to be paid off in the order in which they lent (the ”absolute priority” or ”first-in-time” rule). Chatterjee Satyajit and Eyigungor Burcu
(2015)[58] propose a modification of the absolute priority rule suited to sovereign debts contracts and analyze its positive and normative implications within a quantitatively realistic model of sovereign debt and default.
Dovis Alessandro (2018)[59] shows that the key aspects of sovereign debt crises can be rationalized as part of the efficient risk-sharing arrangement between a sovereign borrower and foreign lenders in a production economy with informational and commit-ment frictions. The constrained efficient allocation involves ex-post inefficient outcomes that resemble sovereign default episodes in the data and can be implemented with non-contingent defaultable bonds and active maturity management. Defaults and periods of temporary exclusion from international credit markets happen along the equilibrium path and are essential to supporting the efficient allocation. Furthermore, during debt crises, the maturity composition of debt shifts towards short-term debt and the term premium inverts as in the data.
These theoretical papers have contributed to a policy debate on the desirability of a procedure to enforce seniority in the event of a default to solve these problems. However, the precise details as to how such a system could be implemented, given the nature of sovereign risk and the difficulty of enforcing any sovereign debt contract, is still unclear.
2.2.3 Collective Action Problems in Debt Restructuring
Both of the above sets of reforms are associated with particular problems in the way in which creditors coordinate to purchase bonds or extend loans. There also exists a substantial literature advocated mechanisms to coordinate creditors after a default as debts are restructured. During the debt crisis of the 1980s, much of the focus of this literature was on the possibility of free riding by creditors in regard to the debt overhang problem, which is modeled by Krugman (1988)[60] among others. A debt overhang refers to a situation in which a country’s debt level is too large to be repaid in full, which can lead to suboptimal decisions by both the country and its creditors. From the perspective of the country, if creditors are able to extract the bulk of any future increase in revenues, the country will have no incentive to make investments that increase its future income, and hence also the value of the creditors claims. This problem can be removed if creditors write down their debt to the level where the country retains enough of the extra income to be persuaded to make the investment, but still leaves creditors with a more valuable settlement. However, if creditors cannot coordinate in writing own their debts, then individual creditors have an incentive to free ride on the write downs of other creditors. This has been interpreted as an argument in favor of some sort of centralized debt restructuring mechanism.
More recently, in the aftermath of successful litigation by minority creditors against sovereigns in default such as the Elliott Associates case studied above, recent research has focused on the incentive of some creditors to engage in what has been termed strategic holdout in which a subset of creditors does not participate in a restructuring agreement in order to engage in later litigation. If such litigation is able to hold up the restructuring, such creditors might be able to extract more generous terms from the creditor, which is likely to slow down the restructuring process more generally.
Formal models of the strategic holdout incentive have been developed by Pitchford and Wright (2011)[61] who use the model to study the effect of changes in the contractual form of sovereign debts, including the introduction of collective action clauses in interna-tional bonds designed to bind holdout creditors to accept a majority settlement. They end that the implementation of such clauses reduces the cost of default ex-post, but may nonetheless raise the welfare of borrowing countries ex ante despite these adverse effects on the incentive of a country to default by reducing the socially wasteful costs of default.
The emerging market crises have prompted debate over the costs and benefits of col-lective action clauses (CACs) in bond contracts. CACs may facilitate the restructuring of repayment terms in the event of financial distress. Proponents of CACs argue they should lower borrowing costs, while opponents contend that they lead to moral hazard and increased borrowing costs. Becker Torbjorn and Richards Anthony and Thaicharoen Yunyong (2003)[62] examines the pricing of bonds with and without CACs using data for both primary and secondary market yields and finds no evidence that the presence of CACs has increased yields for either higher- or lower-rated issuers
An early paper by Barry Eichengreen, Ashoka Mody (2000)[63] examines the implica-tions for borrowing costs of including collective-action clauses in loan contracts. For a sample of some 2,000 international bonds, they compare the spreads on bonds subject to UK governing law, which typically include collective-action clauses, with spreads on bonds subject to US law, which do not. Contrary to the assertions of some market par-ticipants, they find that collective-action clauses in fact reduce the cost of borrowing for more credit-worthy issuers, who appear to benefit from the ability to avail themselves of an orderly restructuring process. In contrast, less credit-worthy issuers pay, if anything, higher spreads. They conjecture that for less credit-worthy borrowers the advantages of orderly restructuring are offset by the moral hazard and default risk associated with the presence of renegotiation-friendly loan provisions.
2.3
Literature review on national competition taxes
A central message of the tax competition literature is that independent governments engage in wasteful competition for scarce capital through reductions in tax rates and public expenditure levels. Wilson (1999)[64] discusses many of the contributions to this literature, ranging from early demonstrations of wasteful tax competition to more recent contributions that identify efficiency-enhancing roles for competition among gov-ernments. Such roles involve considerations not present in earlier models, including imperfectly-competitive market structures, government commitment problems, and po-litical economy considerations.
Its also relates to the survey of Weingast (2009)[65] on fiscal federalism in which the author focuses on three aspects of second generation fiscal federalism (SGFF). First, it considers the design of intergovernmental transfers. While first generation fiscal federal-ism (FGFF) emphasizes correcting vertical and horizontal equity, SGFF emphasizes the importance of fiscal incentives for producing local economic prosperity. SGFF extends FGFF approaches by showing how non-linear transfer systems can produce both equal-ization and high marginal fiscal incentives to produce local economic growth. Second, the paper raises the fiscal incentive approach, showing how different tax systems pro-duce different fiscal incentives for political officials to choose policies. Third, the paper discusses the interaction of democracy and fiscal federalism.
Inside a single nation, Tiebout (1956)[66] showed the competition of local governments can lead to efficiency.
2.4
Literature review on intranational migration
As mentioned above, this research also relates to intranational migration and labor mo-bility. Therefore, the following literature would be in hand for this proposal.
As noted in Gordon and Pablo (2018)[67], Rosen (1979)[68] and Roback (1982)[69] em-ploy a static model with perfectly mobile labor. This implies every region must provide individuals with the same utility. While this indifference condition allows for elegant characterizations of equilibrium prices and rents, it also means government policies are
completely indeterminate: Every debt, service, or tax choice results in the same utility.
With a focus on migration in European, Emmanuel Farhi, Ivn Werning (2014)[70] study the effects of labor mobility within a currency union suffering from nominal rigidities. When the demand shortfall in depressed region is mostly internal, migration may not help regional macroeconomic adjustment. When external demand is also at the root of the problem, migration out of depressed regions may produce a positive spillover for stayers. They consider a planning problem and compare its solution to the equilibrium. They find that the equilibrium is generally constrained inefficient, although the welfare losses may be small if the economy suffers mainly from internal demand imbalances.
The Baseline Models of Sovereign
Debt Default
The following models of sovereign debt default mainly follow the resembled models by Uribe, Martin and Schmitt-Grohe (2017) [71].
3.1
Default Incentives With Non-State-Contingent
Con-tracts; Eaton and Gersovitz (1981) and Arellano (2008).
In particular, in the model of Eaton and Gersovitz (1981), the decision maker is a benevolent government of a small open economy and maximizes increasing concave util-ity consumption function of a representative agent: The world interest rate is r*.
E0 ∞ X
0
βtu(ct)
Where E0 denotes the expectation operator at the time t0, β ∈ (0, 1) is a parameter subjecting to discount factor, ct denotes the consumption at period t.
The output of the economy yt (GDP per capita) is assumed to be exogenous and iden-tically independent distributed and the distribution featuring with bounded support [y, y]. To smooth its consumption, the sovereign can borrow internationally by issuing zero coupon bonds that mature in one period. The bonds, with face value dt (debt per capita) with above bounded support dt≤ d to prevent the government from playing the Ponzi game. The bond sells at a discount a q(dt, yt), as function of the borrowing d and the output yt. In each period, if government has an outstanding debt, government can
