Research Papers

Holdouts in Sovereign Debt Restructuring: A Theory of Negotiation in a Weak Contractual Environment

(with Rohan Pitchford)


First draft: October 8, 2008


[PDF]


Abstract

Negotiations between a country in default and its international creditors are modeled as a dynamic game in an environment of weak contractual enforcement. The country cannot borrow internationally until it settles with all creditors. Delay arises in equilibrium as creditors engage in strategic hold-up. The model confirms the conventional wisdom that delay increases with more creditors, and with the advent of "vulture" creditors. Contrary to conventional wisdom, putting collective action clauses into bond contracts may increase delay via free-riding on negotiation costs, even while preventing strategic holdup and reducing total negotiation costs. Secondary debt markets consolidate debt with high -- and disperse debt with low -- creditor bargaining power. Whether secondary markets reduce or increase delay depends on the interaction between strategic holdup and debt consolidation effects. The analysis contributes to the theory of multi-player dynamic timing games through a general treatment of the comparative dynamics used to answer key applied questions about sovereign debt negotiation.


Recovery Before Redemption: A Theory of Delays in Sovereign Debt Renegotiations

(with David Benjamin)


First draft: October, 2007


This draft: April, 2008


[PDF]


Abstract

Negotiations to restructure sovereign debts are protracted, taking on average almost 8 years to complete. In this paper we construct a new database (the most extensive of its kind covering ninety recent sovereign defaults) and use it to document that these negotiations are also ineffective in both repaying creditors and reducing the debt burden countries face. Specifically, we find that creditor losses average roughly 40 per-cent, and that the average debtor exits default more highly indebted than when they entered default. To explain this apparent large inefficiency in negotiations, we present a theory of sovereign debt renegotiation in which delay arises from the same commitment problems that lead to default in the first place. A debt restructuring generates surplus for the parties at both the time of settlement and in the future. However, a creditor's ability to share in the future surplus is limited by the risk that the debtor will default on the settlement agreement. Hence, the debtor and creditor find it privately optimal to delay restructuring until future default risk is low, even though delay means some gains from trade remain unexploited. We show that a quantitative version of our theory can account for a number of stylized facts about sovereign default, as well as the new facts about debt restructurings that we document in this paper. Finally, we argue that our findings shed light on the existence of delays in bargaining in a wider range of contexts.


Sovereign Theft: Theory and Evidence about Sovereign Default and Expropriation

(with Mike Tomz)


First draft: October 30, 2007

This draft: June 09, 2008


In Populism and Natural Resources, eds. William Hogan and Federico Sturzenegger. Cambridge, MA: MIT Press, forthcoming 2009.


Abstract

This paper examines two major risks to foreign investors: default on sovereign debt and expropriation of foreign direct investment, which we refer to collectively as "sovereign theft." Using a series of formal models, we analyze how the incentives to engage in sovereign theft vary with the state of the economy, the risk aversion of political leaders, and the nature of punishments for default and expropriation. We then document patterns of sovereign theft and foreign investment across much of the twentieth century. Our research, based on a new data set, reveals a striking asynchronicity: defaults and expropriations have occurred in alternating---rather than coincident---waves. Our findings shed new light on cooperation and conflict in the international economy.

This paper was prepared for the Conference on Populism in Natural Resources, held at the Kennedy School of Government, Harvard University, 1-2 November 2007.


Restructuring the Sovereign Debt Restructuring Mechanism

(with Rohan Pitchford)


First draft: August 20, 2006


[PDF]


Abstract

Sovereign defaults are time consuming and costly to resolve ex post. But these costs also improve borrowing incentives ex ante. What is the optimal tradeoff between efficient borrowing ex ante and the costs of default ex post? What policy reforms, from collective action clauses to an international bankruptcy court, would attain this optimal tradeoff? Towards an answer to these questions, this paper presents a simple incomplete markets model of sovereign borrowing that is coupled with an explicit and flexible model of the sovereign debt restructuring process. We characterize the optimal amount of delay, and explore numerically the effects of various policy options on the amount of delay in renegotiations, and on the efficiency of capital flows.


Do Countries Default in "Bad Times"?

(with Michael Tomz)


Journal of the European Economic Association, Volume 5, Numbers 2-3, April-May 2007, Pages 352-60.


Abstract

This paper uses a new dataset to study the relationship between economic output and sovereign default for the period 1820-2004. We find a negative but surprisingly weak relationship between output and default. Throughout history, countries have indeed defaulted during bad times (when output was relatively low), but they have also maintained debt service in the face of severe adverse shocks, and they have defaulted when domestic economic conditons were favorable. We show that this constitutes a puzzle for standard theories, which predict a much tighter negative relationship as default provides partial insurance against declines in output.

This paper was prepared for the Annual Congress of the European Economic Association held in Vienna, 24th to 28th August 2006

Working paper version (describes our data sources, empirical results, and numerical methods in greater detail) [PDF]


Slides [PDF]



Sovereign Debt, Default, and Bailouts

(with David Miller and Michael Tomz)


First draft: January 20, 2006


[PDF]


Abstract

Governments default on their foreign debts with surprising regularity. Given the costs of default, to both creditors and to the defaulting country, is it possible to reform the international financial system to minimize the incidence and severity of debt crises while still promoting efficient capital flows? This paper uses evidence from a new historical dataset on the relationship between sovereign borrowing and defaults to discipline the development of a model in which defaults occur in equilibrium. In the context of this model, the optimal form of supra-national intervention ("bailouts") is derived.


Coordinating Creditors

First draft: December 23, 2004


[PDF]


Abstract

The market for developing country sovereign debt has become increasingly competitive. Is this necessarily good for welfare? Or, is there scope for beneficial government intervention to reduce competition, and promote coordination, among creditors? This note reviews recent theoretical work on the market for developing country sovereign debt that shows that competition can reduce welfare. Further, it argues that while private sector creditor organizations have been successful at coordinating existing creditors in history, government intervention to discourage entry by new creditors may be welfare improving today.


On the Gains from International Financial Integration

This version: January 16, 2005


[PDF]


Abstract

Are there large unexploited gains from international financial integration? Why do they remain unexploited? This paper shows that when market incompleteness leads foreigners and residents to value firms differently, multiple equilibria arise where domestic residents purchase inefficient domestic-owned firms.


Establishment Size Dynamics in the Aggregate Economy

(with Esteban Rossi-Hansberg)


American Economic Review, Volume 97, Number 5, December 2007, Pages 1639-1666.


Abstract

Why do growth and net exit rates of establishments decline with size? What determines the size distribution of establishments? This paper presents a theory of establishment dynamics that simultaneously rationalizes the basic facts on economy-wide establishment growth, net exit, and size distributions. The theory emphasizes the accumulation of industry specific human capital in response to industry specific productivity shocks. It implies that establishment growth and net exit rates should decline faster with size, and that their size distribution should have thinner tails, in sectors that use human capital less intensively, or correspondingly, physical capital more intensively. In line with the theory, we document substantial sectoral heterogeneity in US establishment dynamics and establishments size distributions, which is well explained by variation in physical capital intensities.


Working Paper Version [PDF]


Data and Programs [ZIP]


Slides [PDF]

This paper previously circulated with the title “Firm Size Dynamics in the Aggregate Economy”, and is available as National Bureau of Economic Research Working Paper No. 11261.



Urban Structure and Growth

(with Esteban Rossi-Hansberg)


Review of Economic Studies, Volume 74, Number 2, April 2007, Pages 597-624.


Abstract

Most economic activity occurs in cities. This creates a tension between local increasing returns, implied by the existence of cities, and aggregate constant returns, implied by balanced growth. To address this tension, we develop a theory of economic growth in an urban environment. We show how the urban structure is the margin that eliminates local increasing returns to yield constant returns to scale in the aggregate, thereby implying a city size distribution that is well described by a power distribution with coefficient one: Zipf's Law. Under strong assumptions our theory produces Zipf's Law exactly. More generally, it produces the systematic deviations from Zipf's Law observed in the data, namely the under-representation of small cities and the absence of very large ones. In these cases, the model identifies the standard deviation of industry productivity shocks as the key parameter determining dispersion in the city size distribution. We present evidence that the dispersion of city sizes is consistent with the dispersion of productivity shocks in the data.


Working Paper Version [PDF]


Technical Appendix [PDF]


Slides [PDF]


Read about this paper in: Douglas Clement (2004). "Sets and the City." The Region, September.



Reputations and Sovereign Debt

First draft: July, 2001

This version: September, 2002

Abstract

Why do countries repay their debts? If countries in default have suffcient opportunities to save, Bulow and Rogoff (1989) have shown that the answer cannot stem from a country’s desire to preserve a reputation for repayment. As a result, researchers have explained the existence of sovereign debt by either placing restrictions on the deposit contracts banks can other, or by looking outside the credit market for alternative means of enforcement, including the imposition of trade embargoes, or spillovers to other reputational relationships of the country. In contrast, in this paper we demonstrate that a country’s concern for it’s reputation can work to enforce repayment without placing any technological restrictions on the ability of banks to other contracts, and without appealing to any mechanisms outside of the credit market itself, as long as there are incentives for banks to tacitly collude in punishing a country in default. Such incentives exist as long as the number of banks is not too large, even if banks make zero profits.



Private Capital Flows, Capital Controls and Default Risk


Journal of International Economics, Volume 69, Number 1, June 2006, Pages 120-149.


Abstract

What has been the effect of the shift in emerging market capital flows toward private sector borrowers? Are emerging market capital flows more efficient? If not, can controls on capital flows improve welfare? This paper shows that the answers depend on the form of default risk. When private loans are enforceable, but there is the risk that the government will default on behalf of all residents, private lending is inefficient and capital controls are potentially Pareto-improving. However, when private agents may individually default, capital flow subsidies are potentially Pareto-improving.

Working Paper Version [PDF]


Creditor Coordination and Sovereign Risk

This version: 2002

Abstract

The shift in emerging market debt towards bonds has prompted a number of proposals for reform of the international financial system with a view to facilitating coordination among a dispersed body of creditors. These proposals vary in the extent to which they advocate a return to the institutional framework that governed the 19th Century experience with bond financing, and the adoption of measures designed to compel agreement amongst creditors. This paper first examines the history of bondholder councils in the 19th Century and argues, contrary to the existing literature, that their most important function was to circulate information concerning which debtors were in default and under embargo, and just as importantly, which creditors were in violation of these embargos. That is, bondholder councils acted to influence both a debtors and a creditors reputation for cooperation. The paper then presents a model of a bondholder council that rationalizes these observations. Like the model of Greif, Milgrom and Weingast (1994), the model emphasizes the role of institutions in providing information sufficient to support cooperation. Unlike that model, the focus is on providing information sufficient to support equilibria that are proof to renegotiation. The paper then examines changes in the legal environment since this earlier era of bond finance and argues that they are likely to have reduced the efficacy of private, wholly voluntary, mechanisms for dealing with default. As these changes are unlikely to be repealed, this may constitute a case for involuntary mechanisms.



Investment and Growth with Limited Commitment

This version: 2001

Abstract

This paper studies risk sharing and growth in a large linear-isoelastic economy in which agents cannot commit to honoring their contracts. Although information is perfect, limited commitment reduces the ability of agents to insure against idiosynchratic production risk. We make three methodological and two substantive contributions. Methodologically, first we characterize stationary efficient allocations by extending techniques developed by Atkeson and Lucas (1993) and (1996) for large private information endowment economies to limited commitment production economies with an unbounded state space. Second, we circumvent the non-convexity inherent in limited commitment production economies with risk averse agents in a direct fashion and provide closed form solutions for agents' consumption and savings functions. Third, we decentralize these allocations in a competitive equilibrium with solvency constraints in the sense of Alvarez and Jermann (2000). These constraints take a pseudo-collateralized form: borrowing limits are linear in accumulated capital, even when capital cannot be seized in lieu of repayment. These techniques are then applied to two substantive issues. First, we show that the effect of limited commitment on investment is ambiguous: agents may accumulate either more or less capital than under full insurance. This conflicts with a number of conjectures in the literature, as well as with the results of similar models with private information. Second, we establish a form of observational equivalence between allocations supported by an agent’s reputation for repayment and those supported by the threat of direct sanctions against defaulters.



Internationalisation, Firm Conduct, and Productivity

(with Henry Ergas)


in International Intergration of the Australian Economy. Philip Lowe and Jacqueline Dwyer eds. Sydney: Reserve Bank of Australia, pp. 51-105.


Read about this paper in: Ross Gittins (1994). "It could be that we are trading more but enjoying it less." The Sydney Morning Herald, September 17th, Page 42.