What is a debt crisis? The literature has so far paid little attention to the definition of a deb t crisis in the context of foreign lending. Instead, most studies typically assume that sovereign defaults are the most relevant credit events for foreign debt contracts. As a result, a large body of work has focused on the determinants of default risk.
Sovereign defaults are not, however, the only possible outcome of serious foreign- debt-servicing difficulties. For instance, the period starting with the Mexican “crisis” in 1994–95 has been characterized by turbulent sovereign debt markets and substantial IMF assistance to a number of countries. Yet, according to Moody’s (2003) only seven rated sovereign bond issuers have defaulted on their foreign-currency denominated bonds since 1985 and all of those defaults happened between 1998 and 2002. The surprisingly low number of sovereign bond defaults by emerging market sovereign borrowers is in contrast to the numerous defaults on bank loans in the 1980s.
In this paper, we argue that defining debt crises as sovereign defaults overlooks the development of international capital markets and notably the advent of the bond market for emerging market sovereign issuers. We show how sovereign defaults have become a less sensitive indicator of debt-servicing difficulties and suggest an alternative definition of debt crisis which takes into account turbulence in emerging bond markets.
More precisely, we define debt crises as events when either there is a sovereign default or secondary market bond spreads are higher than a critical threshold. In practice, market participants often view sovereign bond spreads above the 1,000 basis points (10 percentage points) mark as signaling a significant probability of default. Using extreme value theory as well as kernel density estimation, we also find that the 1,000 basis points threshold corresponds to significant tail events.
More formally, we assume that foreign-debt-servicing difficulties can be represented by an unobservable latent variable. Indicators such as sovereign defaults or our proposed market based measure can, however, be used to infer the seriousness of such debt-servicing difficulties. Using a definition which incorporates information from sovereign bond markets enables us to overcome the data limitation associated with the dearth of defaults in the 1990s.
We also find that typical determinants of debt-servicing difficulties—solvency and liquidity measures, as well as macroeconomic control variables—explain better our definition of debt crises. In contrast, typical models of debt-servicing problems fail to explain debt crises when they are defined solely as defaults, especially in the period after 1994. In particular, liquidity indicators are significant in explaining our definition of debt crises although they do not play any role in explaining defaults after 1994.
The rest of the paper is organized as follows. We review the literature in Section II and in particular ask the question what exactly are debt crises. In Section III, we propose an alternative model of sovereign debt crises based on secondary bond markets. In particular, we motivate our measure using a theoretical model and a number of statistical methods. In section IV, we estimate our model and compare its out-of-sample performance with models defining debt crises as defaults only. Section V concludes.
Contents
I. Introduction
II. Review of Literature
- A. What Is a Debt Crisis?
III. An Alternative Model of Sovereign Debt Crisis
- A. Psychological/Market Threshold
B. Estimating the Threshold for Bond Spreads Using Extreme Value Theory
C. Estimating the Threshold for Bond Spreads Using a Kernel Density Estimation
IV. Defaults Versus Market-Based Definition of Debt Crises (PesSy)
- A. Baseline Regressions, 1975–2002
B. The 1990s—A New Decade: Sub-Sample Comparisons
C. Out-of-Sample Comparisons
V. Conclusion
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