Ebook Default risk premia on government bonds in a quantitative macroeconomic model
Recent fiscal policy measures that aim to reduce the macroeconomic impact of the financial crisis have boosted public deficits in almost all industrialized countries. According to the International Monetary Fund (IMF, 2009) gross public debt in the G20 countries will surge to 106% of GDP by 2010. As a consequence, concerns about future government default on debt obligations have become a topic widely discussed in the financial press, as well as the possibility of interest rates on government bonds rising as a reflection of default risk. Indeed, sizeable yield spreads between government bonds of member countries of the European Monetary Union have been observed over the course of recent years, even before the current crisis.
For example, in mid 2007 the interest rates on one year government obligations in the highly indebted countries Belgium and Greece (who had debt to gdp ratios of 88.7 and 96.5 percent) were 23.7 and 113.9 basis points, respectively, above the interest rates on comparable German government bonds. For longer term government securities of Eurozone members, there is a well documented empirical pattern showing that interest rate spreads exist and are increasing in the level of a countryjs indebtedness (see e.g. Manganelli and Wolswijk, 2009). Since, within a currency union, government bonds of all member countries are subject to the same amount of inflation risk and there is no differential exchange rate risk, this divergence in interest rates could be interpreted as reflecting the risk of governments defaulting on their debt obligations. One obvious policy concern would be that higher interest rates on sovereign debt instruments due to default risk premia additionally worsen the fiscal position of indebted governments.
The present paper analyzes government default risk and its reflection in public bond interest rates within a quantitative macroeconomic model, where default is modelled similar to Uribejs (2006) Fiscal Theory of Sovereign Default. The question is whether size able risk premia on short term debt amounting from several tens to over a hundred basis points can be rationalized when interest rates are equilibrium outcomes reflecting the principles of consumption based asset pricing. While the empirical literature has documented the existence of spreads that may be interpreted as risk premia (see e.g. Codogno et al., 2003, Bernoth et al., 2006, Akitobi and Stratmann, 2008), it is presently unclear in how far the emergence of sovereign default risk premia for countries without recent default experiences can be explained within a dynamic general equilibrium framework that is the standard workhorse of contemporary macroeconomics. The present paper addresses this question.
There is, of course, a large theoretical literature on sovereign default that focuses on external debt in open economies. In this literature, default is modelled as a deliberate strategic decision of the government that reflects the outcome of an optimization problem (see Eaton and Gersovitz, 1981, or Arellano, 2008, among others). While this assumption is certainly useful for the case where it has been applied to in the literature, namely external debt of emerging market economies, we view it as less suited to explain risk premia in developed economies where governments have not been observed defaulting on their debt in the recent past.
Since sovereign default has not occurred in, for example, member countries of the European Union in the postwar period, yet public bonds issued by these countries governments are priced differently from each other, we decide not to model default as a purposefully chosen action of the government. Instead, our approach is complementary to the existing literature in that we analyze default risk based on a non optimizing government issuing short term debt while facing a maximum debt repayment capacity. In our framework, the government honors its debt obligations as far as possible, but default inevitably occurs if lenders stop rolling over public debt, which will be the case when the government becomes unable to avoid a Ponzi game (even for the maximum present value of future government surpluses). As a consequence, while government default may occur in equilibrium, it is a rare event in our model. We use this setup to infer the pricing of default risk.
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