Essays on Sovereign Debt Crises
Sosa Padilla Araujo, Cesar
Mendoza, Enrique G
Reinhart, Carmen M
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This study analyzes two aspects of sovereign debt crises: first, the relationship between banking crises and sovereign defaults, second, how the debt dilution phenomenon affects sovereign default risk. Episodes of sovereign default feature three key empirical regularities in connection with the banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii) sovereign defaults result in major contractions in bank credit and production. The first essay provides a rationale for these phenomena by extending the traditional sovereign default framework to incorporate bankers that lend to both the government and the corporate sector. When these bankers are highly exposed to government debt a default triggers a banking crisis which leads to a corporate credit collapse and subsequently to an output decline. When calibrated to Argentina's 2001 default episode the model produces default on equilibrium with a frequency in line with actual default frequencies, and when it happens credit experiences a sharp contraction which generates an output drop similar in magnitude to the one observed in the data. Moreover, the model also matches several moments of the cyclical dynamics of macroeconomic aggregates. In the second essay we measure the effects of debt dilution on sovereign default risk and show how these effects can be mitigated with debt contracts promising borrowing-contingent payments. First, we calibrate a baseline model <italic>a la</italic> Eaton and Gersovitz (1981) to match features of the data. In this model, bonds' values can be diluted. Second, we present a model in which sovereign bonds contain a covenant promising that after each time the government borrows it pays to the holder of each bond issued in previous periods the difference between the bond market price that would have been observed absent current-period borrowing and the observed market price. This covenant eliminates debt dilution by making the value of each bond independent from future borrowing decisions. We quantify the effects of dilution by comparing the simulations of the model with and without borrowing-contingent payments. We find that dilution accounts for 84% of the default risk in the baseline economy. Similar default risk reductions can be obtained with borrowing-contingent payments that depend only on the bond market price. Using borrowing-contingent payments is welfare enhancing because it reduces the frequency of default episodes.