Ebook Legal Enforcement, Public Supply of Liquidity and Sovereign Risk
Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises. The conventional view is that such domestic financial turmoil is caused by foreign retaliation, as trade sanctions or exclusion from international financial markets. Yet, this interpretation is controversial. First, there is no clear-cut empirical evidence supporting the application of “classic” penalties. Second, in recent sovereign crises (e.g. Argentina 2001 and Russia 1998) government default had a direct “balance-sheet” effect on domestic financial institutions, since a large fraction of public debt was held domestically (see Mishkin (2006)). In this paper, I study the connection between sovereign defaults and liquidity crises in absence of external penalties.
The model builds on two natural assumptions for emerging markets. First, public debt represents a source of liquidity for the private sector. Indeed, limited enforcement restricts the access to spot credit markets and induces firms to save in government bonds (either directly or indirectly through the banking sector) as a financial buffer that can be drawn in case of unexpected investment opportunities. This is consistent with the negative correlation between creditor rights protection and banks’ holdings of government debt observed in the data. Second, the government cannot discriminate between domestic and foreign bond holders in the event of default. This assumption, which stems from the increasing integration of domestic financial markets, is consistent with the large haircuts suffered by domestic financial institutions on their government debt holdings observed in recent debt crises.
The implications of these two assumptions are clear. The government faces a trade-off which explains sovereign repayment even in absence of foreign penalties. A default, indeed, can be beneficial to domestic welfare because it avoids a transfer to foreign creditors, but on the other hand it triggers a liquidity crisis that lowers domestic investment and production. Eventually, the government repayment choice is determined by the state of aggregate productivity, is procyclical and amplifies output volatility through its effect on private investment.
Two strands of the literature are brought together in this paper. The motivation for holding government bonds is based on the corporate finance approach to liquidity hoarding, e.g. Holmstrom and Tirole (1998), and is extended to the case of open economies. The view in this literature is that agents need to save in government bonds because a lack of collateral dampens both their access to spot credit markets and the size of private financial markets, which cannot provide sufficient saving instruments to hoard liquidity. Simple intuition then suggests that the demand for government bonds declines as the economy integrates with a large foreign markets featuring a virtually infinite financial capacity. Yet, this papers shows that this prediction fails miserably when the government can manipulate returns on public bonds. Indeed, by making returns procyclical, the government could encourage the demand for bonds by domestic agents, who seek to reallocate resources from the least to the most productive state, and ultimately its own ability to issue debt.
The focus on the consequences of default on the domestic private sector, instead, is closely related to a number of recent paper in the sovereign debt literature, e.g. Broner and Ventura (2006, 2008), Guembel and Sussman (2009), Gennaioli et al. (2009). These papers share the assumption of imperfect discrimination among creditors and address respectively the welfare and distributional effects of default, the political process governing sovereign repayment and the interaction between private and public capital flows. My paper instead concentrates on the effects on corporate investment and output.
Having established the link between sovereign defaults and liquidity crises, this paper then analyzes the consequences of a financial reform in this economy. The novel implication is that the reform does not necessarily raise welfare and in some cases it has a backfire effect. Suppose that suddenly domestic firms have access to credit lines that are contingent on each firm’s future need for liquidity. Conventional wisdom suggests that this reform must have unambiguously positive welfare effects since it allows firms to reallocate efficiently liquidity across future states. However, this interpretation considers only one aspect of the reform. The reverse aspect is that domestic firms will stop hoarding liquidity in the form of public bonds and, as the ex-post cost of default will decline, the government will loose access to foreign credit. In general, then, a financial reform might involve a substitution between private and public investment whose outcome in terms of social welfare depends on their relative returns.
Finally, the empirical section documents that sovereign debt crises are associated with domestic liquidity crises. Using sectoral data for a panel of 45 countries over the period 1980-2000, sovereign default appears to have a disproportionate negative impact on the growth rate of financially dependent sectors. The rest of the paper is organized as follows. Section 2 describes the model. Section 3 discusses the implications of institutional reforms. Section 4 presents the empirical evidence. Finally, section 5 concludes.
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