Three Essays on Sovereign Risk

Armella Olazabal, Sergio

doi:https://doi.org/10.21985/n2-78yn-1737

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Three Essays on Sovereign Risk

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In this dissertation I examine how the government should respond to sovereign risk and show that it has implications on the optimal behavior of the government. In Chapter 1, I look into international reserve management. In Chapter 2, I analyze the effects of sovereign risk on the size of fiscal multiplier and its implications on the cyclicality of fiscal policy. In Chapter 3, I present co-authored work with Giacomo Magistretti. We study the effects of imperfect information and political uncertainty on sovereign risk. Emerging market economies hold substantial amounts of international reserves. In Chapter1, I study how a government should optimally manage these reserves when facing a debt crisis. The main contribution is to show that the answer depends on the nature of the crisis. I build a model of sovereign debt and default in which multiple equilibria are possible. In the model, government borrowing costs can increase for two reasons: a productivity shock that leads to a transitory contraction in output or a shock to lenders' beliefs that increases the possibility of a rollover crisis in the next period. The optimal reserve management policy for the government is to run down reserves in response to the first type of shock, and to accumulate reserves in response to the second. This is because reserves both help the government smooth spending when borrowing costs are high and reduce the effect that lenders' beliefs have on the possibility of a rollover crisis. I fit the model to match Argentine data and find that lenders' beliefs about the possibility of a rollover crisis are important for understanding the behavior of international reserves during the 2018 crisis. The data shows that fiscal policy is mostly pro-cyclical in emerging market economies and counter-cyclical in advanced economies. In Chapter 2, I portray sovereign risk as the explanation. My model results from the combination of a simple model of a small open economy with nominal rigidities with the canonical quantitative sovereign default model. Importantly, I incorporate the passthrough of sovereign risk to the private sector. In equilibrium, the quantitative model features an inverse relation between spreads and the size of the fiscal multiplier. Hence, the cyclicality of fiscal policy is optimally state dependent. In particular, countries that experience a sharp increase in sovereign spreads after a shock, optimally prefer to follow a pro-cyclical fiscal policy as borrowing conditions deteriorate and the fiscal multiplier diminishes in size. In contrast, governments that continue to face good borrowing terms after a shock, are able to expand government spending, finance it with more debt, and have small movements in sovereign spreads, which creates little to no distortion on the private sector and has a larger impact on output. In Chapter 3 we rationalize the observation that sovereign debt spreads are very responsive to political uncertainty. We do this in a model where creditors learn the hidden propensity to honor debt obligations from government actions over time. We assume alternation in power of two types of government facing different costs of default on debt. Market participants do not know which type they are facing in each period. They form beliefs about it, which are updated according to observed fiscal policy decisions and political transition probabilities. We derive the conditions for the existence of pooling and separating equilibria on default and borrowing choices. As lenders beliefs about facing a government with low default costs strengthen, sovereign spreads increase, causing a contraction in public borrowing and spending. A version of our model calibrated to the Italian economy shows that the asymmetric information amplifies the increase in the level and the volatility of spreads stemming from political turnover, with negative implications for welfare.

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