Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Quantitative Models of Sovereign Default and the Threat of Financial Exclusion

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Quantitative Models of Sovereign Default and the Threat of Financial Exclusion

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Business cycles in small emerging economies differ from those in developed economies. Emerging economies feature interest rates that are higher, more volatile, and countercyclical (interest rates are usually acyclical in developed economies). These economies also feature higher output volatility, higher volatility of consumption relative to income, and more countercyclical net exports.1 Recent research is trying to develop a better understanding of these facts, as has been done for U.S. business cycles.

Because of the high volatility and countercyclicality of the interest rate, the (state-dependent) borrowing-interest rate menu is a key ingredient in any model designed to explain the cyclical behavior of quantities and prices in emerging economies. Some studies assume an exogenous interest rate.2 Others provide microfoundations for the interest rate based on the risk of default.3 This is the approach taken by recent quantitative models of sovereign default, which are based on the framework proposed by Eaton and Gersovitz (1981).4 These articles build on the assumption that lenders can punish defaulting countries by excluding them from international financial markets. The assumption is controversial on several grounds. First, it appears to be at odds with the existence of competitive international capital markets (which is assumed in these models). It is not obvious that competitive creditors would be able to coordinate cutting off credit to a country after a default episode.5 Second, empirical studies suggest that once other variables are used as controls, market access is not significantly influenced by previous default decisions (see, for example, Gelos, Sahay, and Sandleris 2004, Eichengreen and Portes 2000, and Meyersson 2006).6

1. SUMMARY OF RESULTS

This article studies the role of the exclusion assumption for business cycle properties of emerging economies. It first describes the business cycle properties of a sovereign default model with exclusion and compares them with those of the same model without exclusion. The article finds that the presence of exclusion punishment is responsible for a high fraction of the sovereign debt that can be sustained in equilibrium. It also finds that the business cycle statistics of the model are not significantly affected by the exclusion punishment. The model without exclusion generates annual debt-output ratios of less than 2 percent. Whereas, the model with exclusion generates debt-output ratios between 4.8 and 6.3 percent. On the other hand, the cyclical behavior of consumption, output, interest rate, and net exports are not fundamentally different in the models with and without exclusion. An additional limitation shared by both model environments is that the volatility of the interest rate and (to a lesser extent) of the trade balance are too low compared to the data. This suggests that the exclusion assumption does not play an important role in these dimensions, and therefore future studies that do not rely on the threat of financial exclusion will not necessarily be handicapped in explaining the business cycle in emerging economies.

The model studied in this article builds on the framework studied inAguiar and Gopinath (2006), which in turn, quantifies the model presented by Eaton and Gersovitz (1981). The most appealing feature about this setup is that it reduces the default decision to a simple tradeoff between current and future consumption without a major departure from the workhorse model used for real business cycle analysis in the last decades. Recent quantitative studies on sovereign default have shown that this environment can potentially account for important business cycle features in emerging economies and that it can be extended to address other issues (such as the optimal maturity structure of sovereign debt).7 The framework studied in Aguiar and Gopinath (2006) is the simplest among the ones presented in recent studies. …

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