Sovereign debt, government myopia and the financial sector Viral V - - PowerPoint PPT Presentation

Sovereign debt, government myopia and the financial sector

Viral V Acharya (NYU Stern, CEPR and NBER) and Raghuram G Rajan (Chicago Booth and NBER)

Why do governments repay sovereign borrowing?

• Fear of exclusion from debt markets, sanctions

– Eaton-Gersovitz (1981), Bulow-Rogoff (1989), …

• But defaulters return to international capital

markets reasonably soon after default

– Eichengreen (1987), Arellano (2009), …

• Governments issuing debt in own currency face

“collateral damage” to their banks

– Broner-Martin-Ventura (2010), Bolton-Jeanne (2011), Gennaioli-Martin-Rossi (2011), … – More applicable to rich, industrialized countries

“Home bias” in govt bond holdings of the European financial sector

.2 .4 .6 .8 1 mean of shareHome CY SI BE AT NL UK LU FR FI SE PT DE IE DK IT MT GR ES HU PL

Source: Acharya, Drechsler and Schnabl (2011)

Why do poor or emerging country governments pay?

• Collateral damage channel not as relevant
• Long-term reputation channel seems to rely on

significantly long-term governments

• Most governments care about short-term

electoral popularity and like to “spend”

• Hence, they care about current cash flows
• They can pass on the burden of repaying debt to

future, possibly rich, governments

• And knowing this, creditors continue to lend

Summary of results

• Government myopia can lead to sustainability of debt

even when poor

– However, this is not necessarily desirable

• Do not default when poor because little gain from

doing so if debt inflows positive; Do not default when rich due to willingness to pay from collateral damage

• Long-term governments more willing to renegotiate

debt to promote growth (or equivalently, have lower interest in, and capacity for, borrowing)

– Net external borrowers grow less

• Rich country defaults = solvency defaults

– Postponing without growth delays messy restructuring

Model

• Country that is emerging from poverty
• Legacy debt held by external creditors
• Private sector (households and corporations)

– Start with some endowment – Can make productive investments – Save in government bonds, some “home bias”

• Short-term government

– Maximize spending on populist schemes – Raise money through taxation and new debt

Model timeline

___________________________________________________________________ Period 1 Period 2 t=0 t=1 t=1+

t=2

(1) Existing foreign debt D0 and corporate endowment E0. (2) Govt decides whether to announce “default” on legacy debt; It announces tax rate t1; Corporate sector makes investment k1 and saves the rest (E0- k1) (3) Short run corporate

• utput f1(k1)

realized; (4) Govt collects taxes t1 f1(k1); Govt repays debt of D0 (1+r) and raises new debt (if no default): Externally financed debt is

1 For

D , domestically financed debt

1 Dom

D . (5) New govt comes in; Govt decides whether to announce “default” on legacy debt; announces tax rate t2; (6) Long run corporate

• utput f2(k1)

realized; Govt collects taxes t2 f2(k1); Govt repays debt of D1 (1+r) (if no default)

Costs of default (in period 1)

• Default disrupts domestic financial sector
• Costs of default equal where
• Several explanations

– Government bonds may be in demand for “safety” – They may serve as collateral in inter-bank flows

• z exogenous for now; endogenized later…

1 1 1 For Dom

D D D = +

1

(1 ), 1

Dom

zD r z + >

Private sector investment

1

1 1 1 2 2 1 1 2

1 1 max (1 ) ( ) (1 ) ( ) . (1 ) (1 )

k

t f k t f k k r r − + − − + +

1 1 1 2 2 1 2

1 1 (1 ) ( ) (1 ) ( ) 1 0. (1 ) (1 ) t f k t f k r r ′ ′ − + − − = + +

Investment is decreasing in tax-rate

Short-term government’s problem

• No-default
• Default

1 1

* 1 1 1 1 1 ,

max (1 ) ( ( ))

D t D

D r t f k t − + +

1

* 1 1 1 1

max ( ( ))

t

t f k t

How much can the future govt repay?

• Constrained by ability to pay
• Constrained by willingness to pay
• Which constraint binds?

1 2 1

(1 ) ( ).

Max

D r t f k + ≤

1 1

(1 ) (1 ).

Dom

D r zD r + ≤ +

* * 2 2 1 1 1 1

1 ( ( )) ( ( )). (1 ) t f k t z E k t r ≤ − +

Short-term govt’s tax policy

• In ability-to-pay region
• In willingness-to-pay region
• Debt capacity

1

* * 2 2 1 1 1 1 1 1

1 max ( ( )) ( ( )). (1 )

t

t f k t t f k t r + +

1

* * 1 1 1 1 1 1

max ( ( )) ( ( ))

t t f k t

z E k t + −

( )

* * * * * 1 2 2 1 1 1 1

1 min ( ( )), ( ) , (1 ) D t f k t z E k t r   = −   +  

Example: Effect of endowment

0.5 1 1.5 2 2.5 3 3.5 4 4.5 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 E0 t1 w.r.t. change of E0 t1

A

t1

• t1

w (β)

t1* t1**

Short-term govt’s default decision

• Default if and only if
• Threshold default point is increasing in

endowment and deadweight cost of default

** * ** * * * * 1 1 1 1 1 1 1 1 1

( ( ) (1 ) ( ( )). t f k t D D r t f k t ≥ − + +

Example: Effect of endowment

0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

• 1
• 0.5

0.5 1 1.5 E0 D w.r.t. change of E0 D1* D0

max

Effect of productivity ( )

1 2

( ) , ( ) (1 ) , f k k f k k

γ γ

αθ α θ = = −

1 2 3 4 5 6 7 8 9 10 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

θ

t1 w.r.t. change of θ t1

A

t1

• t1

w (β)

t1* t1**

Effect of productivity ( )

1 2

( ) , ( ) (1 ) , f k k f k k

γ γ

αθ α θ = = −

1 2 3 4 5 6 7 8 9 10 0.1 0.2 0.3 0.4 0.5 0.6 0.7

θ

D w.r.t. change of θ D1* D0

max

Long-term government

• More generally, consider a government that

discounts future spending at rate

• Objective function:
• If then no value to bringing spending

forward by borrowing, so it always defaults on legacy debt

• Debt capacity is declining in

1

(1 ) r β

−

≤ +

1

(1 ) r β

−

= + β

[ ] ( ) ( )

1 1 1 1 1 1 2 2 1 1

(1 ) (1 ) ( ) ( ) D D r D r t f k t t f k t β β − + − + + +

Choice of financial sophistication

• Countries choose the extent of “entanglement”
• f financial sector with govt bond markets
• Government-sponsored enterprises (GSEs)

– Fannie Mae privatized in 1968 – But “agency” debt maintained special status, e.g., as OMO collateral at the Fed – Over 50% of debt held by financial firms – This commitment allowed agencies to borrow – Commitment was upheld ex post

Entanglement of GSE debt

Holders of GSE Debt: 4Q10 Rest of the world 16% Household sector 1% Government 28% Finance Sector 55%

Source: Federal Reserve, Credit Sights

Choosing z

• We need to introduce uncertainty in second-

period output: high w.p. q ; 0 otherwise

• Constraints:

[ ] ( ) ( )

1 1

, , 1 1 1 1 1 1 1 2 2 1 1

max (1 ) (1 ) (1 ) (1 ) ( ) ( )

dom H t z D

qD D r qD r q zD r t f k t qt f k t β β β − + − + − − + + +

1 2 2 1

(1 ) min[ , (1 )]

H dom

D r t f zD r + ≤ +

1 1 1

[ ( )].

dom

D E k t ≤ −

Bond markets for “wrong” reasons

• Sufficiently long-term govt

sees no value to investment in z

• Else, boost debt capacity to the fullest so as to

borrow and spend today up to ability to pay

• Greater is q, the greater the desire to borrow

today (lower tax rate), and the greater is z to commit to repay

1 q r β ≤ +

2 2 1 1

1

H dom

t f D zD r = = +

GSEs as (govt’s) “shadow banks”

• The United States government created

substantial “z” through creation of agency debt within a sophisticated financial sector

• Willingness to pay external creditors
• Substantial debt capacity for GSEs
• Ostensible goal to boost short-run

consumption through housing subsidies

• Excessive future risk to housing sector collapse
• Resulted in substantial fragility, mop-up costs

Implications for European situation

• As “others” help roll over debt, myopic governments

see little value to debt restructuring

• Industrialized countries with developed banking

sectors are willing to pay; where is ability to pay?

– Better to restructure debt and promote growth

• Bruegel proposal:

– “Blue” bonds held by domestic banks and guaranteed by Euro area; – “Red” bonds guaranteed by issuing country and domestic banks prohibited from holding – Lack of commitment to repay Red bonds? – Can help limit excessive borrowing by short-term govts

Implications for debt restructuring

• Reputation and sanctions-based models imply

full defaults – “in for a penny, in for a pound”

• In practice, debt restructurings generally

involve substantial repayments

• Suggests primary objective might be setting

debt levels to mutually agreeable levels so that future ability to repay is restored

• Lack of market access can thus be only

temporary as commonly observed