sovereign default, exit and contagion in a monetary union

Sovereign Default, Exit and Contagionin a Monetary Union

Sylvester Eijffinger, Michal Kobielarz and Burak Uras(Tilburg University)

Belgian Macro WorkshopNamur, 12th September 2017

Michal Kobielarz (Tilburg) Sovereign Default, Exit & Contagion in MU Namur, 12.09.2017 1 / 17

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Introduction

Crisis and Contagion in the Eurozone

2006 2008 2010 2012 2014 2016

0

5

10

15

20

25

30

35

GreecePortugalSpainItaly

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Introduction

This paper

1 A theoretical framework for analyzing two sovereign decisions:

default on external debt,

exit from a monetary union.

2 Explain contagion within a monetary union:

risk of one country exiting triggers sovereign debt problems in othercountries.

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Introduction

This paper - setup

Small Open Economy dynamic macro model,

SOE issues debt on international financial markets,

SOE is a member of a monetary union.

Decisions in the Model

Sovereign Default

Government issues bonds on international financial markets,

Each period decision whether to repay debt:

repay - it can issue new bonds,

default - cannot issue:

is banned from international financial markets,suffers an output loss (default penalty).

Government makes the optimal long-run decision, which depends onpast debt and current conditions.

Sovereign Default

Monetary Union Exit

There is a nominal friction (wage rigidity) - beneficial to devalue inrecession,

The country is a member of a MU ⇒ fixed exchange rate,

Government may exit the MU and devalue,

but exit is costly, C .

Optimal decision: exit iff

Benefits > Cost

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Monetary Union Exit

Benefits > Cost

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Monetary Union Exit

Benefits > Cost

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Monetary Union Exit

Benefits > Cost

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Exit cost & benefits

Exit benefits:

relax nominal friction,

debt reduction.

Exit cost in reality - examples:

losses in trade and production,

liquidity issues during transition, potential (domestic andinternational) bank runs,

EMU vs EU membership.

Conclusion: exit cost is unknown!

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Exit benefits:

debt reduction.

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Exit benefits:

debt reduction.

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Main mechanism - Contagion

Cost of exiting are unknown, C ∈ {CL,CH},

First country exiting reveals the true exit cost,

Exit decisions depend on information available:

With uncertainty ⇒ exit decision against expected cost C e ,After cost revealed ⇒ exit decision with true cost, CL or CH ,

Assumption:CH > C e > Benefits > CL

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Cost of exiting are unknown, C ∈ {CL,CH},

First country exiting reveals the true exit cost,

Exit decisions depend on information available:

With uncertainty ⇒ exit decision against expected cost C e ,After cost revealed ⇒ exit decision with true cost, CL or CH ,

Assumption:CH > C e > Benefits > CL

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Rumors about a future exit (of Greece) influence today’s interest rates (forPortugal):

risk of Grexit ⇒ true C revealed before next period decisions,

if C = CL Portugal might exit and devalue,

re-denomination + devaluation = partial default,

investors price it in (today) ⇒ increase in interest rates.

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Model overview & Analysis

Model overview

SOE model a la Schmitt-Grohe & Uribe (JPE, 2016), Na et al. (2017):

SOE issues bonds on international financial markets,

may default on the debt,

downward nominal wage rigidity,

the rigidity may cause involuntary unemployment.

We extend the model with:

SOE is member of a monetary union - fixed exchange rate,

possibility of (costly) exit from the union,

exit allows devaluation and debt reduction.

Page 24: Sovereign Default, Exit and Contagion in a Monetary Union

Model overview

SOE model a la Schmitt-Grohe & Uribe (JPE, 2016), Na et al. (2017):

SOE issues bonds on international financial markets,

may default on the debt,

downward nominal wage rigidity,

the rigidity may cause involuntary unemployment.

We extend the model with:

SOE is member of a monetary union - fixed exchange rate,

possibility of (costly) exit from the union,

exit allows devaluation and debt reduction.

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Quantitative analysis

Benchmark analysis:

Standard calibration - Argentina, calibration

Simulation: 1000 series x 5000 periods,

1 period = 1 quarter

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Simulation results more switches

Expectedexit cost

Fraction of simulation serieswith regime switch

EXIT DEFAULT

0.7 99.7% 100%0.8 93.9% 100%1.1 33.0% 100%1.5 3.9% 100%1.9 0.1% 100%2.2 0.0% 100%2.3 0.0% 100%

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Quantitative analysis

Benchmark analysis:

Standard calibration - Argentina, calibration

Simulation: 1000 series x 5000 periods,

Contagion experiment:

Take benchmark simulation periods without default/exit,

Introduce a rumors shock - probability that Greece exits before nextperiod (information revelation),

Compare with benchmark simulation.

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Simulation results - Contagion more

Experiment setup Exit Prob. Additional defaults(%) as % of no-default periods

C e CL CH all periods periods with recessionspositive debt

2.3 0.8 3.8 0 0.78 1.44 4.43

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Simulation results - Contagion more

2.3 0.8 3.8 0 0.78 1.44 4.43

0.78+0.380.38 = 1.44+0.70

0.70 = 4.43+1.001.00 =

Default multipliers: 3.05 3.05 5.43

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Simulations - bond prices

-8 -4 0 4 8 120.999

1

1.001

1.002

1.003

1.004Tradable output

-8 -4 0 4 8 120.994

0.996

0.998

1

1.002

1.004

1.006Tradable consumption

-8 -4 0 4 8 12-0.04

-0.035

-0.03

-0.025

-0.02

-0.015Debt level

-8 -4 0 4 8 120.972

0.974

0.976

0.978

0.98

0.982

0.984

0.986Bond prices

baseline simulationsimulation with rumor shockcounterfactual (bond price)

-8 -4 0 4 8 122.1

2.15

2.2

2.25

2.3Nominal Wages

optimal wage (baseline)optimal wage (with shock)

-8 -4 0 4 8 120.074

0.076

0.078

0.08

0.082

0.084Unemployment

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Simulations - consumption more

-8 -4 0 4 8 120.999

1

1.001

1.002

1.003

-8 -4 0 4 8 120.994

0.996

0.998

1

1.002

1.004

-8 -4 0 4 8 12-0.04

-0.035

-0.03

-0.025

-0.02

-0.015Debt level

-8 -4 0 4 8 120.972

0.974

0.976

0.978

0.98

0.982

0.984

0.986Bond prices

-8 -4 0 4 8 122.1

2.15

2.2

2.25

2.3Nominal Wages

-8 -4 0 4 8 120.074

0.076

0.078

0.08

0.082

0.084Unemployment

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Conclusions

Model explaining contagion in a monetary union,

Rumors of a first exit cause debt problems in other countries,

Information friction (uncertainty) generates fragility,

Limiting uncertainty limits space for contagion,

but (potentially) at the cost of more exits.

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Appendix

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Appendix

Calibration back

Parameter Value Descriptionβ 0.87 Quarterly discount factorr∗ 0.01 Quarterly net world interest rateγ 0.99 Degree of downward nominal wage rigidityδ1 -0.25 Parameters of the output loss functionδ2 0.27CL 0.8 Low exit costCH 3.8 High exit costC e 2.3 Expected cost of exit

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Appendix

Calibration back

Parameter Value Descriptionσ 2 Inverse of intertemporal elasticity of consumptiona 0.28 Share of tradablesε 0.44 Elasticity of substitution between T and NTα 0.59 Labor share in the non-traded sectorρ 0.932 Serial correlation of ln yT

t

σy 0.037 Standard deviation of innovation to yTt

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Appendix

Benchmark simulation results back

Expectedexit cost

Consumptionequivalent

Fraction of simulationswith regime switch

EXIT DEFAULT

0.7 8.3% 99.7% 100%0.8 9.4% 93.9% 100%1.1 12.5% 33.0% 100%1.5 16.3% 3.9% 100%1.9 19.8% 0.1% 100%2.2 22.2% 0.0% 100%2.3 23.0% 0.0% 100%

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Appendix

Benchmark simulation results back

Expectedexit cost

First regime switch

EXIT DEFAULT BOTH

0.7 66.2 33.2 0.60.8 53.5 46.1 0.41.1 22.8 77.1 0.11.5 3.5 96.5 01.9 0 100 02.2 0 100 02.3 0 100 0

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Appendix

Regime switches in the model

UNION DEFAULT

EXIT AUTARKY

default

exit

default &exit

Appendix

Simulation results - Contagion back

2.3 0.8 3.8 0 0.78 1.44 4.43

2.3 0.7 3.9 0 1.20 2.21 6.202.3 1.1 3.5 0 0.42 0.78 1.922.3 1.9 2.7 0 0.25 0.46 0.38

1.5 0.7 2.3 0.00 0.75 1.38 5.061.5 0.8 2.2 0.00 0.43 0.79 4.081.5 1.1 1.9 0.00 0.16 0.30 1.52

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Appendix

Simulations - unemployment back

-8 -4 0 4 8 120.999

1

1.001

1.002

1.003

-8 -4 0 4 8 120.994

0.996

0.998

1

1.002

1.004

-8 -4 0 4 8 12-0.04

-0.035

-0.03

-0.025

-0.02

-0.015Debt level

-8 -4 0 4 8 120.972

0.974

0.976

0.978

0.98

0.982

0.984

0.986Bond prices

-8 -4 0 4 8 122.1

2.15

2.2

2.25

2.3Nominal Wages

-8 -4 0 4 8 120.074

0.076

0.078

0.08

0.082

0.084Unemployment

sovereign default, exit and contagion in a monetary union

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