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Sovereign Debt and Fiscal Policy

Paper Session

Sunday, Jan. 8, 2023 1:00 PM - 3:00 PM (CST)

Hilton Riverside, Kabacoff
Hosted By: American Economic Association
  • Chair: Tamon Asonuma, International Monetary Fund

Political Constraints and Sovereign Default

Marina Azzimonti
,
Stony Brook University and NBER
Nirvana Mitra
,
CAFRAL & Shiv Nadar IoE

Abstract

We study how political constraints, characterized by the degree of flexibility to choose fiscal policy, affect the probability of sovereign default. To that end, we relax the assumption that policymakers always repay their debt in the dynamic model of fiscal policy developed by Battaglini and Coate (2008). In our setup, legislators bargain over taxes, general spending, debt repayment, and a local public good that can be targeted to the region they represent. Under tighter political constraints, more legislators have veto power, implying that local public goods need to be provided to a larger number of regions. The resources that are freed after a default have to be shared with a higher number of individuals, which reduces the benefits from defaulting in per-capita terms. This lowers the incentive to default compared to the case with lax political constraints. The model is calibrated to Argentina and the results conform to robust
empirical evidence. An event study for the 2001/2002 sovereign debt crisis shows that political constraints had an important role in the buildup that led to the crisis.

Constrained Efficient Borrowing with Sovereign Default Risk

Juan Carlos Hatchondo
,
University of Western Ontario
Leonardo Martinez
,
International Monetary Fund
Francisco Roch
,
International Monetary Fund

Abstract

Using a quantitative sovereign default model, we characterize constrained efficient borrowing by a Ramsey government that commits to income-history-contingent borrowing paths taking as given ex-post optimal future default decisions. The Ramsey government improves upon the Markov government because it internalizes the effects of borrowing decisions in period t on borrowing opportunities prior to t. We show the effect of borrowing decisions in t on utility flows prior to t can be encapsulated by two single dimensional variables. Relative to a Markov government, the Ramsey government distorts borrowing decisions more when bond prices are more sensitive to borrowing, and changes in bond prices have a larger effect on past utility. In a quantitative exercise, more than 80% of the default risk is eliminated by a Ramsey government, without decreasing borrowing. The Ramsey government also has a higher probability of completing a successful deleveraging (without defaulting), while smoothing out the fiscal consolidation.

Inflation, Default Risk and Nominal Debt

Carlo Galli
,
University Carlos III of Madrid

Abstract

This paper explores the trade-off between strategic inflation and default for a set of large emerging market economies that borrow mostly in their local currency. Using over-the-counter derivatives data, I find a robust, positive correlation between default risk, inflation risk, and realised inflation. I use these facts to discipline a quantitative sovereign default model where a government issues debt in domestic currency and lacks commitment to both fiscal and monetary policy. I show that simple models of debt dilution via default and inflation have counterfactual implications, as default and inflation are substitutes and co-move negatively. I highlight the role that monetary financing plays to match the data, allowing inflation to serve a second purpose: in bad times, seignorage is especially useful as a flexible source of funding when other margins may be hard to adjust. The model matches the positive correlation between inflation and default risk, and allows to quantitatively evaluate its implication for the trade-off between the insurance benefits of nominal debt and the ex-ante cost of a further source of time inconsistency.

Sovereign Debt and Fiscal Austerity

Tamon Asonuma
,
International Monetary Fund
Hyungseok Joo
,
University of Surrey
Jing Zhang
,
Federal Reserve Bank of Chicago

Abstract

We compile a comprehensive dataset on primary balance, expenditure and revenues in 1975–2020 for 75 countries covering 197 debt restructurings. We document that governments tend to run fiscal deficits during recessions, but they have to implement fiscal consolidation if recessions are accompanied by sovereign debt crises. Moreover, recessions with sovereign debt crises are more severe under expenditure-based consolidation than in revenue-based consolidation. We develop a theoretical model of defaultable debt that embeds endogenous choice of default and fiscal policy, elastic labor supply and nominal wage rigidities. The model shows that when a pre-restructuring revenue level is low, the sovereign has fiscal space to conduct revenue-based consolidation, which results in increases in revenue and expenditure and a moderate output decline.

Discussant(s)
Leonardo Martinez
,
International Monetary Fund
Carlo Galli
,
University Carlos III of Madrid
Jing Zhang
,
Federal Reserve Bank of Chicago
Marina Azzimonti
,
Stony Brook University and NBER
JEL Classifications
  • F3 - International Finance
  • H6 - National Budget, Deficit, and Debt