Ebook Persistent Gaps, Volatility Types and Default Traps
Two main stylized facts permeate the history of sovereign borrowing. The first is serial default. Lindert and Morton (1989) find that countries that defaulted over the 1820-1929 period were, on average, 69 percent more likely to default in the 1930s, and that those that incurred arrears and concessionary schedulings during 1940-79 were 70 percent more likely to default in the 1980s. While these estimates are not conditioned on countries’ fundamentals, evidence provided by Reinhart, Rogoff and Savastano (2003) indicates that serial default is only loosely related to countries’ indebtedness levels and other fundamentals. They show that such serial defaulters have lower credit ratings and face higher spreads at relatively low indebtedness levels a phenomenon they call “debt intolerance”. The experience of such debt intolerant countries which embark upon a “vicious circle” of borrowing, defaulting and being penalized with higher interest rates stands in sharp contrast with that of countries that manage to undergo a “virtuous circle” of borrowing and repayment with declining sovereign spreads.
A second notable empirical regularity is that default rarely entails permanent exclusion from international capital markets but mainly a re-pricing of country risk (higher spreads), at least for sometime. This regularity is at odds with much of the theoretical literature: in early models (notably Eaton and Gersovitz, 1981) it is the threat of permanent exclusion from capital markets which is crucial to sustain sovereign lending; later models allowed for this exclusion to be temporary but with random re-entry rules which are not price-dependent (Aguiar and Gopinath, 2005; Arellano, 2006). In practice, default is often “punished” not through outright denial of credit or fixed re-entry rules but a worsening of the terms on which the country can borrow again. Provided that borrowing needs are not too price elastic, the sovereign will continue to tap the market – absolute exclusion representing only the limiting case in which lenders’ “capture technology” is so weak that country spreads may become prohibitively large for any borrowing to take place.
This paper argues that two structural features which are typically found in emerging markets help explain both stylized facts. These structural features are that output shocks are not only typically large, thus producing high cyclical variability about trend growth, but also highly persistent.
That output volatility is generally high among emerging markets is a well documented phenomenon (see, for instance, Kose et al., 2006). Recent work has related such volatility to a number of long-lasting structural features, ranging from domestic institutions (Acemoglu et al., 2004), commodity specialization (Blattman et al., 2006) to imperfections in international capital markets that limit these countries’ ability to issue domestic-currency denominated sovereign debt, thus rendering them more vulnerable to currency fluctuations (Eichengreen et al., 2003).
What has received less attention in the literature, however, is the fact that such output volatility is often coupled with considerable persistence of output shocks. For a given dispersion of shocks (conditional output volatility), higher persistence implies that associated output fluctuations will be larger; so, the same unconditional output volatility may be generated by different combinations of persistence and dispersion of shocks. Yet, as we how below, it is important to disentangle the effects of these distinct parameters on sovereign risk. On a broader analytical level, such a separation is important as well because there are distinctive macroeconomic mechanisms behind shock persistence in emerging-market economies. One is the presence of short-run supply-side inelasticities which make primary commodity price shocks long-lasting; to the extent that primary commodities remain key export items for many such countries, sizeable persistence in output and terms-of-trade is not surprising. Second, various frictions, political as well as economic, make fiscal policy more procyclical in these countries than others. In a recession, a contractionary fiscal stance tends to delay recovery, which exacerbates shock persistence. Third, financial and institutional frictions in emerging markets typically magnify the sensitivity of domestic credit to loan collateral values. As a result, the credit-transmission mechanism can induce more prolonged spirals of output contraction or expansion, including painful episodes of debt deflation. Insofar as such frictions are often coupled with protracted balance-sheet adjustments stemming from currency-denomination mismatches (see, e.g., Calvo, 1998; Mendoza, 2005), they also help explain higher shock persistence in those economies.
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