Persistent gaps, volatility types, and default traps, Issues 2007-2148
International Monetary Fund, 2007 - Business & Economics - 45 pages
We show that cross-country differences in the underlying volatility and persistence of macroeconomic shocks help explain two historical regularities in sovereign borrowing: the existence of "vicious" circles of borrowing-and-default ("default traps"), as well as the fact that recalcitrant sovereigns typically face higher interest spreads on future loans rather than outright market exclusion. We do so in a simple model where output persistence is coupled with asymmetric information between borrowers and lenders about the borrower's output process, implying that a decision to default reveals valuable information to lenders about the borrower's future output path. Using a broad cross-country database spanning over a century, we provide econometric evidence corroborating the model's main predictions-namely, that countries with higher output persistence and conditional volatility of transient shocks face higher spreads and thus fall into default traps more easily, whereas higher volatility of permanent output tends to dampen these effects.
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Persistent Gaps, Volatility Types, and Default Traps
Ana Fostel,Sandeep Kapur,Mr. Luis Catão
Limited preview - 2007
Aiolfi asymmetric information basis points bond financing bondholders borrower's borrowers and lenders Catao coefficients comparative statics constant is included country spreads Debt/GDP Debt/Total Debt decrease default in period default risk default traps Dependent variable Determinants of Sovereign Economic effect emerging markets empirical endogenous equilibrium ex-ante face higher spreads Fostel and Kapur future default future output gain from default hence higher volatility HP-filter measures increase informational asymmetry interest rate investors Non-defaulters Observations R-squared Obstfeld and Taylor output gap output persistence output realizations output shocks output volatility persistence and volatility persistence of output persistent shock positive default premium pre-WWI probability of default Proposition real GDP relative risk aversion Rogoff sample serial default shock persistence shock to trend sovereign bond sovereign borrower sovereign risk sovereign spreads statistically significant stylized facts Table temporary shocks terms of trade theoretical trend gap Venezuela volatility and persistence volatility variable X/GDP