Debt and Default. Costas Arkolakis. February Economics 407, Yale

Transcription

1 Debt and Default Costas Arkolakis Economics 407, Yale February 2011

2 Sovereign Debt Sovereign Debt: Is a contigent claim on a nation s assets. Governments will repay depending on whether it is more bene cial to repay than to default Sovereign Default: Occurs when a sovereign government (i.e one that is autonomous or independent) fails to meet its legal obligations to payments on debt held by foreigners

3 First Recorded Default: Default Episodes

4 Default Episodes First Recorded Default: 4 century BC. (my reading) Hellenic City-States defaulted on loans from Delian league Other episodes: 1343, Edward III of England, Spain 7 times in the 19th century 46 European defaults between US states defaulted in the 1800s

5 Default Episodes First Recorded Default: 4 century BC. (the actual citation) Greek Municipalities defaulted on loans from Delos Other episodes: 1343, Edward III of England, Spain 7 times in the 19th century 46 European defaults between US states defaulted in the 1800s In modern times, Greece has defaulted ve times - in 1826, 1843, 1860, 1893, and 1932 We are no match for the Spanish the last 300 years (but we are getting better at it!)

6 Default Episodes In the past, defaults were sometime leading to con icts Luckily, not in fashion any more Today no particular way to enforce repayment But there are costs to defaulting If there were not, none would lend in the rst place! Costs of Default Financial market penalties: markets do not lend you anymore. Lose consumption smoothing opportunities Macroeconomic implications: disruption in nancial markets may bring economic downturn, export/import declines etc

7 The Latin-American Debt crisis Evolution of Debt to GDP in some emerging economies Figure: The evolution of the debt/gnp ratio in selected countries

8 Interest Payments in Latin American Countries Interest Payments in Latin America Figure: Interest payments in selected Latin American countries. Average

9 Trade Balance in Latin America To repay debts requires running trade surpluses Also implement austerity measures (lower wages, decrease scal de cit) Figure: Trade Balance in the Latin America

10 A Simple Model of Default Assume a country gets a loan L, interest rate r If the country defaults, it loses fraction c of its output Ouput, Y, is stochastic

11 A Simple Model of Default Assume a country gets a loan L, interest rate r If the country defaults, it loses fraction c of its output Ouput, Y, is stochastic Thus, if the country repays next period: Y (1 + r ) L

12 A Simple Model of Default Assume a country gets a loan L, interest rate r If the country defaults, it loses fraction c of its output Ouput, Y, is stochastic Thus, if the country repays next period: Y If the country defaults: Y (1 c) (1 + r ) L

13 A Simple Model of Default Assume a country gets a loan L, interest rate r If the country defaults, it loses fraction c of its output Ouput, Y, is stochastic Thus, if the country repays next period: Y (1 + r ) L If the country defaults: Y (1 c) When does country default? Y (1 + r ) L < Y (1 c)

14 A Simple Model of Default Assume a country gets a loan L, interest rate r If the country defaults, it loses fraction c of its output Ouput, Y, is stochastic Thus, if the country repays next period: Y (1 + r ) L If the country defaults: Y (1 c) When does country default? Y (1 + r ) L < Y (1 c) Solve for Y such that Y (1 + r ) L = Y (1 c)

15 A Simple Model of Default Assume a country gets a loan L, interest rate r If the country defaults, it loses fraction c of its output Ouput, Y, is stochastic Thus, if the country repays next period: Y (1 + r ) L If the country defaults: Y (1 c) When does country default? Y (1 + r ) L < Y (1 c) Solve for Y such that Y (1 + r ) L = Y (1 c) If Y < Y the country defaults (adverse shock may trigger default)

16 A Simple Model of Default Assume a country gets a loan L, interest rate r If the country defaults, it loses fraction c of its output Ouput, Y, is stochastic Thus, if the country repays next period: Y If the country defaults: Y (1 c) (1 + r ) L When does country default? Y (1 + r ) L < Y (1 c) Solve for Y such that Y (1 + r ) L = Y (1 c) If Y < Y the country defaults (adverse shock may trigger default) If r is high Y increases (high interest rates may trigger default)

17 A Simple Model of Default Assume a country gets a loan L, interest rate r If the country defaults, it loses fraction c of its output Ouput, Y, is stochastic Thus, if the country repays next period: Y If the country defaults: Y (1 c) (1 + r ) L When does country default? Y (1 + r ) L < Y (1 c) Solve for Y such that Y (1 + r ) L = Y (1 c) If Y < Y the country defaults (adverse shock may trigger default) If r is high Y increases (high interest rates may trigger default) If L is high Y is high (high L may trigger default)

18 Depreciation and Debt GDP in terms of tradables E ects of a depreciation Q T + P N P T Q N Q T ", P N P T #, Q N # Relative size of tradable sector, and initial exchange rate plays a role If GDP falls in terms of tradables, Debt/GDP ratio rises

19 Debt Reduction Schemes If probability of repayment is low it could be realistic for lenders to adjust the value of the debt Free rider problem: how can you ensure that all the lenders reduce the debt? From an individual lender s point of view, it might be better if he does not forgive the debt Third party buy-backs: maybe too expensive Debt swaps (issuance of new debt that has seniority is served before the old debt) Debt Restructuring

20 Debt Reduction Schemes If probability of repayment is low, it could be realistic for lenders to adjust the value of the debt Unilateral Debt Forgiveness Debt Overhang. Formalization: Forgive some debt to give the chance to the country to recover Let π the probability that the good state occurs, where this probability is a function of the state, π = π (D), and d π(d ) dd < 0. Total expected revenues of the lender are π (D) D + (1 π (D)) ad where a < 1 is the fraction of the money that the country will get if there is a default. There might be an optimal a < 1 (Given that π is a function of D)

21 Debt Reduction Schemes If probability of repayment is low, it could be realistic for lenders to adjust the value of the debt Unilateral Debt Forgiveness Debt Overhang Forgive some debt to give the chance to the country to recover Figure: The Debt La er Curve