On the role of lenders in sovereign debt crises

Abstract

This thesis emphasizes the role of lenders in the analysis of sovereign debt crises, whereas the existing literature on sovereign debt has mostly focused on the borrower’s default decision. In particular, it investigates two main dimensions of sovereign lending: coordination and heterogeneity among lenders. The first two chapters of the thesis apply the theory of optimal contracts and analyze the role of coordination among lenders. The third chapter builds on the standard approach of exogenous incomplete markets. Like the first chapter, it focuses on emerging economies. Like the second chapter, it analyzes the interaction between official and private lenders. In the first chapter, I analyze the sovereign debt management of emerging economies. I consider a market economy in which a sovereign borrower trades non-contingent bonds of different maturities with two foreign lenders. The borrower is impatient and lacks commitment. I show that the market economy can implement the Planner’s constrained efficient allocation through changes in maturity and costly debt buybacks. Defaults cannot substitute for such buybacks. Nevertheless, the market economy may fail to implement the Planner’s allocation for the following reasons. First, market participants rely on Markov strategies; an assumption that I rationalize in the context of emerging economies. Second, there are multiple Markov equilibria owing to the strategic interaction of the lenders. I relate these equilibria to the experience of Argentina and Brazil since 1995. In particular, conducting buybacks and avoiding defaults, I find that Brazil has a more efficient sovereign debt management than Argentina. In the second chapter, joined with Yan Liu and Ramon Marimon, we develop the optimal design of a Financial Stability Fund to overcome sovereign debt overhang issues. Similar to the previous chapter, we derive an optimal contract that we use as a normative benchmark with positive implications. We consider an environment in which a sovereign country can borrow long-term defaultable bonds on the private international market, while having access to a Fund, which provides insurance and credit. We interpret the Fund as the outcome of long-term contingent contract subject to limited enforcement constraints. Our main theoretical result is to characterize the Nash equilibrium between a sovereign country, the Fund and private competitive lenders. The Fund is only required minimal absorption of the sovereign debt to achieve the constrained efficient allocation. The Fund and its lending policy are essential as private lenders alone may not attain such allocation as shown in Chapter 1. Quantitatively, we find that Italy would have had important welfare gains and a more efficient path of debt accumulation with the Fund. In my final chapter, I study existing official multilateral lending institutions. This complements the previous chapter which derives the optimal design of an official lender. I first present new empirical facts on defaults involving the International Monetary Fund and the World Bank. In particular, defaults on such institutions are infrequent, last relatively longer and are associated with greater private creditors’ losses. I subsequently build a theoretical model to rationalize those findings. I consider an incomplete markets model with heterogenous lenders and endogenous renegotiation. The key assumption is the greater enforcement power of multilateral lenders relative to private lenders emanating from a non-toleration of arrears combined with a greater output penalty upon default. This generates an important pecuniary spillover on private lending and rationalizes the aforementioned empirical facts.