Sovereign Debt

Question 1

Why does it exist?

Answer 1

Eaton and Gersovitz 1981

• carrot approach: creditors lend because they can deny future access to credit to defaulting debtors
• debtors want to smooth consumption paths - need access to credit in bad and repay in good
• no international court to enforce debt repayments therefore needs incentives to encourage govs to repay debt
• countries repay for reputation all reasons

Question 2

Bulow and rogoffs criticism 1989

Answer 2

• stick approach
• criticise E+G for not being renegotiation proof
• Swiss banker hypothesis
• direct punishment
• borrows in good and repays in bad

Question 3

Swiss banker hypothesis

Answer 3

Assumes countries purchase insurance, store output and invest a portion of wealth abroad to be used in crises

• gov borrows in bad times then good times it defaults and doesn’t repay, instead saves money in Swiss Bank
• • therefore in bad time can use proceeds saved to smooth consumption
• – cheats creditor as no longer needs funds in bad time

Weak model and depends on assumption that S Bank will repay but won’t unless country has technology to impose repayment on S Bank

Question 4

Direct punishment

Answer 4

Lending can only be sustained by direct punishment

• trade sanctions mainly but also military actions therefore debtor can only obtain credit if poss seize assets
• as consequence, debtors should borrow in good times (otherwise can’t pledge anything)

Question 5

Kletzer and Wright 2000

Answer 5

Attempted to rescue idea about reputation
Cheating the Chester mechanism
- if borrower defaults in period 1 on creditor 1 then if creditor 2 lends to that borrow in future, creditor 1 and all other creditors will punish creditor 2 by defaulting on him
- creditor 2 knowing this won’t lend to borrower
– requires that creditors are highly coordinated

Question 6

Original sin

Answer 6

Currency depreciation = increase value of foreign currency denominated debt this aggravating debt crisis
Developing counties - impossibility for them to borrow in their own domestic currency (because lenders fear a depreciation of the currency)
Borrowing in foreign currency –> problems when country has to depreciate currency to run CA surpluses

ORIGINAL SIN IS ONE OF REASONS WHY BALANCE OF PAYMENT CRISIS MAY BECOME DEBT CRISIS

Question 7

Debt crisis 1980s

Answer 7

1980s
2 oil price shocks of 70s boosted assets of oil producing countries. Massive flow of petrodollars has to be invested in world economy 
Belief that countries don't go bankrupt 
Mexico defaulted with deficit = 10% GDP
Baker plan 1985 
Brady plan 1989

Question 8

Debt crisis 1990

Answer 8

4 big crises

1) Mexican tequila crisis 94-95
2) Asian crisis 97-98
3) Russian default 98
4) Argentinian crisis 2001 ($100bn debt)

Balance of payments crises

Question 9

Balance of payments crises

Answer 9

Volatility of debt has lead to authors like CALVC to claim foreign debt should be stopped to avoid sudden stops cause BoP crises

Question 10

Argentina

Answer 10

1991 convertibility law approves - fixing parity of domestic currency to dollar

95-96 interest rates increase due to Mexican crisis

99 Brazil floats currency –> depreciates and A cant follow so loses competitiveness

December 2001 defaults

Dulhade elected Jan 2002 and stops convertibility - peso depreciates 1:1 to 4:1 (devalued by 30%)

Question 11

Excusable default theory

Answer 11

When countries are subject to larger number very -ve shocks have greater excuse for not repaying debts fully and will be granted better terms when restructuring debt

Question 12

Eurozone crisis

Answer 12

Greece and Portugal = increased structured deficits from public debt

Ireland = weak banking sector

Spain = housing bubble

Though Italy = stabilised debt it had high debt level so sensitive to shocks
-1990s debt close to 120%

Question 13

Political economy of debt

Answer 13

1) renters - hold gov bonds. Oppose debt repudiation and inflation prefer tax increases
2) entrepreneurs - hold physical capital. Oppose taxes on capital but not debt repudiation
3) workers - hold human wealth. Prefer taxes on wealth and capital and debt repudiation but oppose indirect taxes

Principal agent problem - institutions give incentives to act in public interest

Question 14

Median voter theorem

Answer 14

50%+1 voter
Look at MV to see if they’d pay more by repaying debt or earn more when debt is repaid

If gov repays debt domestic citizens pay taxes

Median voter compares taxes to pay with share of debt they’d give up if gov didn’t repay debt

E.G. Greece - majority debt 60% held by Eurozone and only 13% by Greek citizens