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 1 .8 mean of shareHome .6 .4 .2 0 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=1 + t=2 t=0 t=1 (1) Existing (2) Govt (3) Short (4) Govt (5) New govt (6) Long run foreign debt decides run collects taxes comes in; corporate D 0 and whether to corporate t 1 f 1 (k 1 ) ; Govt decides output f 2 (k 1 ) corporate announce output f 1 (k 1 ) Govt repays whether to realized; Govt endowment “default” on realized; debt of announce collects taxes E 0 . legacy debt; D 0 (1+r) and “default” on t 2 f 2 (k 1 ) ; It announces raises new legacy debt; Govt repays tax rate t 1 ; debt (if no announces debt of Corporate default): tax rate t 2 ; D 1 (1+r) sector makes Externally (if no default) investment financed debt k 1 and saves For is D , 1 the rest (E 0 - domestically k 1 ) financed Dom debt D . 1

Costs of default (in period 1) • Default disrupts domestic financial sector + > Dom • Costs of default equal where (1 ), 1 zD r z 1 = + For Dom D D D 1 1 1 • 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…

Private sector investment 1 1 − + − − max (1 t ) ( ) f k (1 t ) f k ( ) k . + + k 1 1 1 2 2 1 1 2 1 (1 r ) (1 r ) 1 1 ′ ′ − + − − = (1 t ) f ( ) k (1 t ) f ( ) 1 k 0. + + 1 1 1 2 2 1 2 (1 r ) (1 r ) Investment is decreasing in tax-rate

Short-term government’s problem • No-default − + + * max t D D (1 r ) t f k ( ( )) t 1 0 1 1 1 1 D , 1 1 • Default * max t f k ( ( )) t t 1 1 1 1 1

How much can the future govt repay? • Constrained by ability to pay + ≤ Max (1 ) ( ). D r t f k 1 2 1 • Constrained by willingness to pay + ≤ + Dom D (1 r ) zD (1 r ). 1 1 • Which constraint binds? 1 ≤ − * * ) t f ( k t ( )) z E ( k t ( )). + 2 2 1 1 0 1 1 (1 r

Short-term govt’s tax policy • In ability-to-pay region 1 + * * max t f k t ( ( )) t f k t ( ( )). + 2 2 1 1 1 1 1 1 t (1 r ) 1 • In willingness-to-pay region + − * * max t t f k t ( ( )) z E ( k t ( )) 1 1 1 1 0 1 1 1 • Debt capacity   ( ) 1 = − * * * * * D min  t f k t ( ( )), z E k t ( )  , + 1 2 2 1 1 0 1 1   (1 r )

Example: Effect of endowment w.r.t. change of E0 1 A t 1 0.9 - t 1 0.8 w ( β ) t 1 0.7 t 1 * t 1 ** 0.6 0.5 t 1 0.4 0.3 0.2 0.1 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 E0

Short-term govt’s default decision • Default if and only if ≥ − + + ** * ** * * * * t f k t ( ( ) D D (1 r ) t f k t ( ( )). 1 1 1 1 1 0 1 1 1 1 • Threshold default point is increasing in endowment and deadweight cost of default

Example: Effect of endowment w.r.t. change of E0 1.5 D 1 * max D 0 1 0.5 D 0 -0.5 -1 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 E0

Effect of productivity γ γ ( ) = αθ = − α θ f k ( ) k , f k ( ) (1 ) k , 1 2 w.r.t. change of θ 1 0.9 0.8 0.7 0.6 0.5 t 1 0.4 A t 1 - 0.3 t 1 w ( β ) t 1 0.2 t 1 * 0.1 t 1 ** 0 0 1 2 3 4 5 6 7 8 9 10 θ

Effect of productivity γ γ ( ) = αθ = − α θ f k ( ) k , f k ( ) (1 ) k , 1 2 w.r.t. change of θ 0.7 D 1 * max 0.6 D 0 0.5 0.4 D 0.3 0.2 0.1 0 0 1 2 3 4 5 6 7 8 9 10 θ

Long-term government • More generally, consider a government that − β ≤ + discounts future spending at rate 1 (1 r ) • Objective function: [ ] ( ) ( ) − + − β + + + β (1 ) (1 ) ( ) ( ) D D r D r t f k t t f k t 1 0 1 1 1 1 1 2 2 1 1 − β = + • If then no value to bringing spending 1 (1 r ) forward by borrowing, so it always defaults on legacy debt β • Debt capacity is declining in

Choice of financial sophistication • Countries choose the extent of “entanglement” of 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 Household Rest of the sector world 1% 16% Finance Government Sector 28% 55% Source: Federal Reserve, Credit Sights

Choosing z • We need to introduce uncertainty in second- period output: high w.p. q ; 0 otherwise [ ] ( ) ( ) − + − β + − β − + + + β dom H max qD D (1 r ) qD (1 r ) (1 q zD ) (1 r ) t f k t ( ) qt f k t ( ) t z D , , 1 0 1 1 1 1 1 1 2 2 1 1 1 1 • Constraints: + ≤ + H dom (1 ) min[ , (1 )] D r t f zD r 1 2 2 1 ≤ − dom [ ( )]. D E k t 1 0 1 1

Bond markets for “wrong” reasons q • Sufficiently long-term govt sees no β ≤ + 1 r value to investment in z • Else, boost debt capacity to the fullest so as to borrow and spend today up to ability to pay H t f = = dom 2 2 D zD + 1 1 1 r • Greater is q, the greater the desire to borrow today (lower tax rate), and the greater is z to commit to repay

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