Reputational Effects in Sovereign Default

Transcription

1 Reputational Effects in Sovereign Default Konstantin Egorov 1 Michal Fabinger 2 1 Pennsylvania State University 2 University of Tokyo OAP-PRI Economic Workshop Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 1 / 22

2 Outlines Outline of the Talk 1 Motivation 2 Model 3 Results Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 2 / 22

3 Motivation Motivation Argentina Sources: EMBI spread data, BIS debt data, OECD gdp data Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 3 / 22

4 Motivation Motivation Barrett (2016): Data on 27 defaults between 1980 and 2013 Conditional on observables, spreads are higher for at least two years after default Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 4 / 22

5 Motivation Motivation Graduation from default Countries with low default risk today went through long periods of high default risk in the past Qian, Reinhart, and Rogoff (2010) report that 2 decades without a relapse (falling into crisis) is an important marker... However, crisis recidivism distributions have very fat tails, so that it takes at least 50 and perhaps 100 years to meaningfully speak of graduation. Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 5 / 22

6 Motivation Research Question History dependence in sovereign default Past repayment lowers current spread Graduation from default Explain and quantify with reputation model Imperfect information about cost of default Investors infer unobserved types based on history of observable actions Debt repayment as a signal of good type Country needs to earn reputation to graduate from default Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 6 / 22

7 Motivation Related Literature Default with imperfect information Kletzer (1984), Atkeson (1991), Cole, Dow, and English (1995), Alfaro, Kanczuk (2005), Sandleris (2008, 2010), Catao, Fostel, Kapur (2009), Cata, Fostel, Ranciere (2011), Dovis (2014), Phan (2014), Chatterjee et al. (2015)... D Erasmo (2011) Two types of government (high and low discount rate) Government with low β mimic the behavior of government with high β Beliefs are updated in Bayesian fashion based on observable history Explains frequency of default and debt-to-gdp ratio Barrett (2016) Continuum of types Exogenous consumption decision Explains high spread after default and low frequency of default Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 7 / 22

8 Model Utility; GDP without default Small open economy, single aggregate good U = t=0 β t u (c t ), u (c t ) = 1 1 γ c1 γ t Only one-period bonds traded internationally: asset level a Risk-neutral creditors (~ idiosyncratic country GDP risk ) If not in default, GDP process y t = e zt with AR(1) z t : z t = ρ z z t 1 + ε t, ρ z (0, 1), ε t N(0, σ 2 z ) Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 8 / 22

9 Model Good credit, bad credit The country may have a good credit (G), or following default bad credit (B) A country with bad credit can regain good credit with exogenous probability λ Country with bad credit is considered in default Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 9 / 22

10 Model Default The government optimally decides each period whether to default If in default, exclusion from international financial markets In addition, if in default, GDP reduced to (1 x) y t where x (0, 1) represents an explicit cost of default, loosely interpreted as the level of government responsibility Before default, only the government knows x unlike in the baseline models of Aguiar and Gopinath (JIE 2006) and Arellano (AER 2008) Note: D Erasmo (2011) considers information asymmetry regarding the government s discount rate. But since the hidden state can take only two values, in equilibrium information asymmetry disappears very quickly, and effectively we get a complete information model Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 10 / 22

11 Model Default cost determination The cost of default x is known only to the government It does not change over time unless the country defaults Following a default, new political elite comes to power and draws a new value of x from a known distribution with pdf ϕ(x) and support [x min, x max ] Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 11 / 22

12 Model Pooling equilibrium Pooling equilibrium Creditors update their beliefs about x in a Bayesian fashion each period Equilibrium selection criterion: choose the equilibrium that maximizes welfare of the pool of countries (with good credit) This eliminates unnatural equilibria In the limit of no information asymmetry, one recovers the usual Euler equation Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 12 / 22

13 Model Reputation mechanism If the country goes through a severe recession without defaulting, creditors infer that the government s cost of default must be high the government is responsible The lowest possible reputation level (denoted x b ) consistent with past behavior goes up The country can borrow at lower interest rates Investors know the country better, so they know how much to lend without triggering a default Eventually, the country may graduate from default Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 13 / 22

14 Model Solution to the model Four state variables: a... asset level z... (potential) log GDP; or equivalently y... (potential) GDP x... cost of default x b... minimum cost of default consistent with past behavior Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 14 / 22

15 Model Solution to the model One value function for good credit, one value function for bad credit Set of Bellman equations Solved numerically by: discretizing dimensions a and z, and using Chebyshev polynomials for dimensions x and x b Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 15 / 22

16 Model Solution to the model: value functions Value function for a country having the choice to default or not: { } V (a, y, x, x b ) = max V G (a, y, x, x b ), V B (y, x) Value function for a country with good credit: ( V G (a, y, x, x b ) = max u (c) + βe y c,a yv ( a, y, x, x b ) ) s.t. c = y + a q ( a, a, y, x b ) a q (a, a, y, x b ) is the bond price x b are updated beliefs of investors: x b = x b (a, y, x b) Value function for a country with bad credit: V B (y, x) = u ((1 x) y) + β (1 λ) E y yv B (y, x) + βλe y,x yv ( 0, y, x, x min ) Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 16 / 22

17 Model Solution to the model: investors beliefs Define x = x(a, y, x b ) as V G (a, y, x, x b ) = V B (y, x) Updated investors beliefs: x b (a, y, x b ) = max {x b, x(a, y, x b )} Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 17 / 22

18 Model Solution to the model: pooling equilibrium Welfare maximizing pooling equilibrium a (a, y, x b ) = arg max a xmax x b (a,y,x b) [ u ( y + a q ( a, a, y, x b ) a ) +βe y yv ( a, y, x, x b (a, y, x b ) )] ϕ(x)dx Incentive-compatibility constraint { ( V G (a, y, x, x b ) max a Bond price q ( a, a, y, x b ) = xmax x b (a,y,x b) u y + a 1 E y y D (a, y ), x min ) a 1 + r +βe y yv ( a, y, x, x = x min ) } [ ] 1 E y yd (a, y, x, x b (a, y, x b)) ϕ(x)dx (1 + r) x max x b (a,y,x b) ϕ(x)dx Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 18 / 22

19 Results Parameter values Risk aversion γ 2 Probability of redemption λ 10% Persistence of income ρ z 0.9 Standard deviation of income σ z 3.4% Discount factor β 0.8 Risk-free interest rate r 1% Support of distribution of cost of default [x min, x max ] [0.5%, 8%] Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 19 / 22

20 Results Simulation Debt, % of annual GDP GDP Interest Rate Spread, % Reputation x b, % Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 20 / 22

21 Results Defaults and business cycle moments Moment Data Model with imperfect information Aguiar-Gopinath (JIE 2006) - Model I σ(y) σ(c) σ(tb/y) σ(r) corr(c, y) corr(tb/y, y) corr(r, y) corr(r, TB/y) Defaults (per quarters) Debt/GDP (%) Max R (bp) Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 21 / 22

22 Results Conclusions In the real world, creditors have to form expectations about the nature of the debtor country government We build a model of sovereign default that incorporates this feature Past behavior is reflected in today s interest rates Graduation from default Realistic interest rate schedule, realistic default rate under natural assumptions about the GDP process Konstantin Egorov, Michal Fabinger Reputational Effects in Sovereign Default OAP-PRI Economic Workshop 22 / 22