Research

Strategic Behavior in Sovereign Debt Restructuring: Impact and Policy Responses

(with Rohan Pitchford)


This draft: November, 2012



[PDF]


Abstract

A prominent feature of recent delays in sovereign debt restructuring has been the presence of a group of "holdout creditors". In this paper we present a simplified version of our recent research on sovereign debt renegotiation (Pitchford and Wright 2012), focusing on the strategic motivations of creditors and with a view to assessing alternative policy responses. We use a two-creditor example to illustrate that a key strategic motivation of creditors in an unstructured negotiation environment is the desire to wait until others have settled, in an attempt to extract a larger settlement and show that this motivation is stronger, and expected delay is increased, as the number of creditors increases. We then use a three player example to demonstrate that collective action eliminates the strategic holdout motivation for delay, while introducing a free-rider motivation: each creditor prefers the others to incur the costs of negotiating for the collective. A perhaps surprising result is that this motivation can be sufficiently strong, that it causes an increase in expected delay. We illustrate the flexibility of our approach by applying the model to secondary markets for creditors and to the issue of "credit vultures".

This paper was prepared for the Round Table on Debt Crises and their Resolution: Analysis and Policies held on August 13th and 14th, 2012 in Buenos Aires, and organized by The International Economic Association, The Argentine Association of Political Economy, and the University of Buenos Aires.




Empirical Research on Sovereign Debt and Default

(with Mike Tomz)


This draft: October, 2012



[PDF]


Abstract

The long history of sovereign debt and associated problems of enforcement have attracted researchers in many fields. In this paper, we survey empirical work by economists, historians, and political scientists. As we review the empirical literature, we emphasize parallel developments in the theory of sovereign debt. One major theme emerges. Although recent research has sought to balance theoretical and empirical considerations, there remains a gap between theories of sovereign debt and the data used to test them. We recommend steps that researchers can take to improve the correspondence between theory and data.

This paper was prepared for the Annual Review of Economics .




Human Capital Risk, Contract Enforcement, and the Macroeconomy

(with Tom Krebs and Moritz Kuhn)


This draft: December 22, 2011



[PDF]


Abstract

We develop a macro-economic model with physical and human capital, idiosyncratic human capital risk, and limited enforcement of credit contracts. Human capital is a non-pledgeable asset with uncertain and age-dependent returns. For a simplified version of the model, we show analytically that an interesting form of under-insurance emerges in equilibrium: young (high-return) households are more exposed to human capital risk and are the least insured relative to their insurance needs. We document this risk-insurance pattern in data drawn from the Survey of Consumer Finance for one of the most important forms of human capital risk – the death of a household member. We show that a calibrated version of the model can quantitatively account for the life-cycle variation of insurance and human capital observed in the US data. Using the calibrated model economy, we estimate the welfare costs of under-insurance for young households to be equal to a 4 percent reduction in lifetime consumption, and show that a policy reform, such as making consumer bankruptcy as costly as defaulting on student loans, leads to a substantial increase in the volume of credit and insurance.


Sovereign Debt Restructuring: Problems and Prospects


This draft: September 20, 2011


[PDF]


Abstract

This paper reviews the history of sovereign debt restructuring operations with private sector creditors with a view to diagnosing the factors that lead to inferior outcomes. The paper also attempts to forecast potential problems that may arise in sovereign debt restructuring negotiations in the future, and reviews possible modifcations of existing institutions. The future potential problems identified include: the role of credit default swaps in discouraging creditor participation in voluntary exchange offers; the potential for manipulation of aggregation clauses; the possibility of de facto sovereign default on state contingent debts through statistical manipulation; more widespread use of appeals to the notion of odious or illegitimate debts; and, the extent to which recent regulatory changes aimed at restricting litigation against sovereigns in default might reduce the incentive for sovereigns to repay their debts in the future.

An early draft of this paper was prepared for the Advisory Group on Dispute Resolution and Sovereign Debt convened by the Netherlands Government and the Permanent Court of Arbitration at the Hague in May 2011.


The Pari Passu Clause in Sovereign Bond Contracts: Evolution or Intelligent Design?


Hofstra Law Review, Volume 40, Number 1, Fall 2011, Pages 103-114.


Abstract

In this paper, I review the historical context for the introduction of pari passu clauses into sovereign bond contracts, and the way in which the interpretation of the clauses have evolved over time, in light of Gulati and Scott's (2011) data on sovereign bond contracts and on the interpretation of the clause by creditors' legal representatives. I argue that the introduction of the clause was the rational choice of creditors and debtors at a time in which concerns for fair and equitable treatment of creditors in the event of a sovereign debt restructuring were paramount. I also argue that the growing use of the pari passu clause today, and the drift towards the "risky" version of the clause specifying pro rata repayment, is the rational response to expectations of future contractual and institutional changes that are likely to intensify concerns for inter creditor equity and fairness in the future. I conclude with some reservations about Gulati and Scott's use of qualitative survey evidence to infer the rationality of actions.

Working Paper Version [PDF]



The Stock of External Sovereign Debt: Can We Take the Data At ‘Face Value’?

(with Daniel A. Dias and Christine Richmond)


This draft: August 21, 2011


[PDF]


Abstract

The stock of sovereign debt is typically measured at face value. This is a misleading indicator when debts are issued with different contractual forms. In this paper we construct a new measure of the stock of external sovereign debt for 100 developing countries from 1979 to 2006 that is invariant to contractual form and that illustrates the problems of using debt stocks measured at face value. We emphasize five key findings. First, we show that correcting for differences in the contractual form of debt paints a very different quantitative, and in some cases also qualitative, picture of the stock of developing country external sovereign debt. Second, rankings of indebtedness across countries, which were historically used to define eligibility for debt forgiveness, are sometimes inverted once we correct for differences in contractual form. Third, the empirical performance of the benchmark quantitative model of sovereign debt deteriorates by between 40 to 70 percent once model-consistent measures of debt are used. Fourth, we show how the spread of aggregation clauses in debt contracts which award creditors voting power in proportion to the contractual face value may introduce inefficiencies into the process of restructuring sovereign debts. Fifth, we show how the use of contractual face values gives issuing countries the ability to manipulate their debt stock data, and illustrate the use of these techniques in practice.


Read about this paper in: Lisa Pollack (2011). "What’s in a government debt number?" The Financial Times - Alphaville, November 1st.



The Costs of Financial Crises: Resource Misallocation, Productivity and Welfare in the 2001 Argentine Crisis

(with Guido Sandleris)


This draft: June 29, 2011


[PDF]


Abstract

Financial crises in emerging market countries appear to be very costly: both output and a host of partial welfare indicators decline dramatically. The magnitude of these costs is puzzling both from an accounting perspective -- factor usage does not decline as much as output, resulting in large falls in measured productivity -- and from a theoretical perspective. Towards a resolution of this puzzle, we present a framework that allows us to (i) account for changes in a country's measured productivity during a nancial crises as the result of changes in the underlying technology of the economy, the efficiency with which resources are allocated across sectors, and the efficiency of the resource allocation within sectors driven both by reallocation amongst existing plants and by entry and exit; and (ii) measure the change in the country's welfare resulting from changes in productivity, government spending, the terms of trade, and a country's international investment position. We apply this framework to the Argentine crisis of 2001 using a unique establishment level dataset and nd that more than half of the roughly 10% decline in measured total factor productivity can be accounted for by deteriorations in the allocation of resources both across and within sectors. We measure the decline in welfare to be on the order of one-quarter of one years GDP.

Read about this paper in: Ezequiel Burgo (2011). "Cómo medir los costos de las crisis financieras" Clarin, December 18th.



The Theory of Sovereign Debt and Default


First draft: January 18, 2011


This draft: April 18, 2011


[PDF]


Abstract

This paper provides a relatively non-technical survey of theoretical research on the effect of sovereign risk on the market for sovereign debt, with an emphasis on the way sovereign risk constrains the process of financial globalization. After summarizing the legal environment governing sovereign debt, it discusses the forces that encourage repayment of sovereign debt when legal enforcement is ineffective. It then reviews the recent literature that examines the quantitative importance of these forces. It concludes by discussing a range of institutional changes and policy reforms that might act to further reduce the level of sovereign risk and hence strengthen the process of financial globalization.

Paper prepared for the Encyclopedia of Financial Globalization, edited by Gerard Caprio.


Restructuring Sovereign Debts with Private Sector Creditors: Theory and Practice


First draft: May 3, 2010


In Sovereign Debt and the Financial Crisis: Will This Time Be Different?, eds. Carlos A. Primo Braga and Gallina A. Vincelette. 2011, World Bank: Washington, D.C., Pages 295-315.


Abstract

This paper presents new empirical results on the differences in sovereign debt restructuring outcomes across debtor countries in different regions, and at different levels of development. Focusing exclusively on debts owed to private creditors, it finds that both the amount of time taken to complete a restructuring and the size of creditor losses are larger for low income countries, and in particular for Sub Saharan Africa. In addition, these same countries also exit default substantially more indebted than when they entered default. The paper then reviews recent theoretical research on the process of sovereign debt restructuring. It argues that while recent theory is capable of explaining the magnitude of delays observed in the data, it has less to say about which aspects of the the debt restructuring process lead to large increases in indebtedness for low income countries.

This paper was prepared for the conference "Sovereign Debt and the Financial Crisis: Will This Time be Different?" held in Tunisia on 29th and 30th March 2010, organized by the World Bank's Economic Policy and Debt Department in cooperation with the African Development Bank.

Working paper version [PDF]



Capital Flows and Macroeconomic Performance: Lessons from the Golden Era of International Finance

(with Lee Ohanian)


American Economic Review, Volume 100, Number 2, May 2010, Pages 68-72.


Abstract

This paper analyzes the relationship between capital flows and returns during the "golden era" of international flows from 1880 - 1913 and the interwar period from 1918 - 1938. We construct two measures of returns in a country based on, alternatively, the marginal product of capital, and on consumption growth. Our main finding is that flows during the golden era are indeed consistent with standard theory, as capital flows from low to high return countries when returns are measured from consumption growth. However, this relationship breaks down during the interwar period. When returns are measured from the marginal product of capital, there is no tendency for capital to flow from low to high return countries during the golden era, a finding that is quite similar to the main findings in our analysis of the postwar period (Ohanian and Wright 2008).

Working paper version (describes our data sources in greater detail) [PDF]



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

(with Rohan Pitchford)


Review of Economic Studies, Volume 79, Number 2, April 2012, Pages 812-837.


Abstract

Why is it difficult to restructure sovereign debt in a timely manner? In this paper we present a theory of the sovereign debt restructuring process in which delay arises as individual creditors hold-up a settlement in order to extract greater payments from the sovereign. We then use the theory to analyze recent policy proposals aimed at ensuring equal repayment of creditor claims. Strikingly, we show that such collective action policies may increase delay by encouraging free-riding on negotiation costs, even while preventing hold-up and reducing total negotiation costs. A calibrated version of the model can account for observed delays, and finds that free riding is quantitatively relevant: whereas in simple low-cost debt restructuring operations collective mechanisms will reduce delay by more than 60%, in high-cost complicated restructurings the adoption of such mechanisms results in a doubling of delay.


Working paper version June 2011 [PDF]


Ancillary Appendix to Working paper version June 2011 (Contains details on calibration, and on extensions and robustness exercises) [PDF]


Working paper version October 2008 (Contains additional results and alternative presentation of material) [PDF]


Read about this paper in: Joseph Cotterill (2011). "Sovereign debt burden-sharing, and free-riding" The Financial Times - Alphaville, January 5th.



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 The Natural Resources Trap: Private Investment without Public Commitment , eds. William Hogan and Federico Sturzenegger. 2010, Cambridge, MA: MIT Press, Pages 69-110.


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.


Data On Default and Expropriation [Zipped Stata File]




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


American Economic Review P&P, Volume 95, Number 2, May 2005, Pages 388-392.


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.

Working paper version [PDF]



On the Gains from International Financial Integration


Economics Letters, Volume 87, Issue 3, June 2005, Pages 379-386.


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.

Working paper version [PDF]



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 Integration 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.