Default Risk and Income Fluctuations in Emerging Economies

The paper is motivated by a set of emerging-market facts that the existing theory got backwards. Emerging economies “face volatile and highly countercyclical interest rates, usually attributed to countercyclical default risk,” and when Argentina defaulted in December 2001 “consumption and output collapsed, interest rates increased, and the trade balance experienced a sharp reversal.” The model is a small open economy whose benevolent government trades one-period discount bonds with risk-neutral competitive foreign creditors, can default at any time, and if it does is excluded from financial markets for a stochastic number of periods and suffers a direct output loss; bond prices are set so lenders break even, which makes the interest rate an endogenous function of the size of the loan and the current shock. The analytical core is a reversal. In participation-constraint models with a complete set of state-contingent claims, the temptation to walk away is strongest in good states, because that is when efficiency says to repay; here the opposite holds. Proposition 2 establishes that default can occur only when no available contract lets the government roll the debt over – “if the borrower could roll over the current debt, then he would simply consume more today and default tomorrow on a higher debt” – so default coincides with a required net capital outflow, and Proposition 3 then shows that because utility is concave, “net repayment is more costly when income is low,” making default a recession phenomenon. Proposition 1 adds that default sets shrink in assets, so a default threshold in income falls as the country gets richer, and the bond price schedule is increasing in assets and, with persistent shocks, more generous in booms – delivering countercyclical borrowing limits. Quantitatively the model is calibrated to Argentina with σ = 2, r = 1.7% quarterly, an AR(1) log output process with ρ = 0.945 and η = 0.025 discretised to 21 states, and three free parameters (β = 0.953, re-entry probability θ = 0.282, output-cost threshold 0.969 E(y)) matched to a 3% default probability, a 5.53% debt-service-to-GDP ratio and the trade balance volatility. Matching the historical default frequency requires an output cost of default that is disproportionately large in booms, a specification the author justifies partly on evidence that default collapses private credit but presents openly as reduced form. The calibrated model produces a spread standard deviation of 6.36 against 5.58 in the data, consumption more volatile than output (6.38 versus 5.81), spreads negatively correlated with output (-0.29 against -0.88 in the data), a countercyclical trade balance (-0.25 against -0.64), mean debt of 5.95% of output, and a mean output deviation of -8.13% while in default against -7.3% in Argentina; fed Argentina’s actual GDP series from 1993, it predicts default in the fourth quarter of 2001. The acknowledged failure is the level of the spread: risk-neutral pricing ties the mean spread mechanically to the default probability, so the model yields 3.58% against Argentina’s 10.25%, and closing the gap requires a lender pricing kernel that is high in default states with a sensitivity the author characterises as implying a high degree of lender risk aversion.

Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default)

This paper develops a New Keynesian small open economy model with endogenous sovereign default — the NK-Default framework — and uses it to study the interplay between monetary policy and sovereign risk in emerging markets. The core finding is that sovereign default risk amplifies inflation volatility through an expectations channel: when default risk rises, forward-looking firms increase prices in expectation of high future inflation and depressed consumption during a potential default, so that current inflation rises even before any default occurs. Conversely, tight monetary policy disciplines government overborrowing by raising the cost of domestic monetary distortions, which the government internalizes by reducing its borrowing. Calibrated to eight emerging-market inflation targeters (Brazil, Chile, Colombia, Mexico, Peru, Philippines, Poland, South Africa) over 2004–2019, the model quantitatively matches the positive comovement of spreads with inflation and nominal rates, and the temporary nature of inflation events (approximately 4.5% inflation spike, 2.3% spread increase, resolved within roughly a year). Counterfactual experiments find that default risk accounts for approximately 50% of both inflation business-cycle volatility and the inflation increase during these events, and that a 1% tighter monetary policy would reduce spreads by about 0.3% during inflation events. An interest rate rule augmented to respond to default risk dominates strict inflation targeting in welfare and reduces mean spreads by 2.2 percentage points; strict inflation targeting is not the optimal monetary regime when sovereign risk is present.

Cristina Arellano | Macro Paper Warehouse

Default Risk and Income Fluctuations in Emerging Economies

Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default)