lecture 5 sovereign risk

8/12/2019 Lecture 5 Sovereign Risk

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Topic 2

Sovereign Debt

and the Pattern of Capital Flows



• The sanctions available to foreign creditors are

limited.

– Gunboat diplomacy is difficult

– Sanctions (eg seizure of the national airline) also

hard to enforce in courts. But (New York) law does

cover sovereign bonds.

• Big informational asymmetries – privatelenders do not know how reliable a sovereign

is



• Limits on sovereign debt contracts impinge on

ability to smooth consumption optimally

• The extent to which optimal contracts are

limited will depend on how creditors can

penalise the debtor – implicitly or explicitly

• We need to draw a critical distinction between

the “ability to pay” and “willingness to pay”,

i.e allow for strategic default .



Default in History

• An early default – England in 1340 (Edward III),1472, 1594

• Spain 1557, 1560, 1575, 1596 (Philip II), 1607, 1627, 1647

•

Greece – number of years in default since 1800 = 50!

• France – “countries should default every 100 years or so to restoreequilibrium”. 1558, 1624, 1648, 1661, 1701,1715, 1770, 1788, 1812.French Kings executed creditors…

• China – 1921, 1939; Argentina – 1951, 1956, 1982, 1989, 2001

• Why do some countries default and not others? Australia, Canada,New Zealand…..



A very simple model

• Two periods.

• Loan of size B is made to the country at start

of period 1.

• Country repays R(B) in period 2.

• If it defaults, it pays a penalty, P

•

Suppose utility is U(B,x), increasing in amountborrowed (B) and decreasing in size of the

obligation (x).



• The country repays only if utility from repaying is

at least as great as utility from defaulting

• Let R=(1+i)B, then repayment occurs if



• Some observations follow:

– Credit can be rationed. The borrower does notget more than P/1+i

– The bigger the penalty, the more we can borrow – If P=0, then international lending does not occur

•

Note: the size of the penalty is exogenous tothe model. It does not depend ondebtor/creditor characteristics.



Carrots or Sticks?

• Should creditors offer debtors the “carrot” of

continued capital market access in return for debtrepayment?

–

In this case, a defaulter faces costly financial autarky – And the debtor has an incentive to maintain a

reputation as a good borrower

• Or should they use the “stick” of sanctions?

– Seize assets and take debtor to courts in creditorcountries (eg US)

– Impose costly trade sanctions



A “carrot” model

• A small country borrows L to produce f(L)

• It has to repay (1+r)L

• Per period payoff:

• Maximising the payoff gives demand for foreign capital

• Let the country default at time t=0. If it does, then let itsuffer the loss of access to foreign credit forever after.



• This is a “trigger strategy” played by creditors

• Across an infinite horizon, if default occurs at t=0, then presentvalue of foregone profits from t=1 is

• Again, for a country to repay, it must have the incentive to do so.



• If ruler is impatient and does not care about the

future too much, then credit will be rationed.

• Model shows that the threat of a cutoff of capital

may support international lending – not that itwill.

• Folk Theorem: many possible equilibria are

possible.• Model does not allow for subtleties like debt

renegotiation



Explicit penalties for default

[O&R ch 6.1]

• Small open economy; two periods

• Date 1 endowment = 0, no date 1 consumption

(so no savings at date 1)

• At date 1, country can enter into insurancecontracts to deal with uncertain date 2 output

• Lifetime utility is the date 1 expected utility ofconsumption



• Date 2 output uncertain and given by

•The country can buy insurance abroad and theinsurance contract has a (state contingent) paymentschedule to the insurer, P(e) to be paid at date 2.

• Everyone observes the shock in date 2. If P(e)<0,then the country receives a payment in state e.P(e)>0 is the premium the country pays



• Insurance firms are risk neutral and perfectly

competitive. So in equilibrium, contracts must

have zero expected profits

• Renegotiation of contracts is not possible, i.e

can’t reschedule debts.



Optimal incentive compatible contract

• Suppose sanctions cost a fraction, 0<h<1 of

output

• Incentive compatibility implies that the

insurance contract cannot make the country

pay in excess of the sanction cost:



• The optimal insurance contract is the solution

to the problem:

•

The associated Lagrangian is



• The first order conditions are

• For low states of the world, incentive compatibility

constraint does not bind. These are states where

insurers make payments or where the country’s

repayment is lower than the punishment cost



• Implication: consumption is constant and

independent of the state of the world when

the IC constraint does not bind.

• So consider repayment schedules of the form

P(e)=P0+e, which make consumption

independent of e.



• To solve for the critical state, e, note that



• The optimal incentive compatible insurance

contract is thus



• And since insurers must earn zero expected

profits, the triangle abc and quadrilateral cdfg

are equal in area



• For low states of the world, there are no

incentive compatibility issues, so fullconsumption smoothing can be achieved.

• For high states of the world, the temptation to

default is too great under full insurance, so theoptimal contract requires only a portion of theoutput be transferred to creditors

• But the limitation on how much a country can berequired to transfer in a good state in order notto be tempted by default reduces the level ofconsumption that insurers can transfer in bad

states – since we have a zero profit condition



• Note that, in equilibrium, default never takes place inany state of the world.

•The severity of the punishment is crucial indetermining the nature of the equilibrium. The moresevere the punishment, the larger the set of states overwhich the country can smooth consumption.

• Note default is only a potential problem in “good”times. In actuality, default occurs during “bad” times.Harsh punishments are useful if credibility of theborrower is an issue, but can be harmful if severe

negative shocks strike.

• When default actually occurs, creditors find it optimalto renegotiate the contract rather than enforcesanctions. So carrying out the threat is not “subgameperfect”.



The Bulow-Rogoff Critique

• The carrot approach seems appealing – it is“institution-free”. We do not have to worry aboutthe particulars of government or politico-legalstructures.

• But, if institutions do not matter, then why go tothe trouble of insisting that debts are in foreign

currency ($US, not peso) and why write contractsso that they are adjudictated in foreign courts(Nomura and Sweden; NY law)?



• Bulow and Rogoff suggest that – in principle – acountry can default, and use the money saved topurchase an insurance contract to achieve the samelevel of intended consumption smoothing at less cost.

• Brazil defaults on Citi and approach Lloyds for aninsurance contract to help hedge future exportfluctuations….

• Reputation therefore requires some discipline.Institutions (especially legal) will matter. Sanctions (orsticks) cannot be totally ignored.



• Imagine a good state occurs. Rather than repaying thecreditor, the country defaults and invests in a riskless bondpaying r.

• Now the country approaches a new set of foreign insurersto replicate the original (reputation) contract.

• Critically, it can post its bond as collateral, so new investorsare reassured. And the country does not rely on its(defunct) reputation.

• Country comes out in front. It has replicated its contract,and can consume the interest payments on the bond it hasposted as collateral. Pure reputation alone cannot sustainforeign debt

lecture 5 sovereign risk

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