This paper develops a small open economy model to study sovereign default and debt renegotiation for emerging economies. The model features both endogenous default and endogenous debt recovery rates. ...Sovereign bonds are priced to compensate creditors for the risk of default and the risk of debt restructuring. The model captures the interaction between sovereign default and
ex post debt renegotiation. We find that both debt recovery rates and sovereign bond prices decrease with the level of debt. In a quantitative analysis, the model accounts for the debt reduction, volatile and countercyclical bond spreads, countercyclical trade balance, and other empirical regularities of the Argentine economy. The model also replicates the dynamics of bond spreads during the debt crisis in Argentina.
Why are episodes of sovereign default accompanied by deep recessions? The existing literature cannot answer this question. On one hand, sovereign default models treat income fluctuations as an ...exogenous endowment process with ad hoc default costs. On the other hand, emerging markets business cycle models abstract from modeling default and treat default risk as part of an exogenous interest rate on working capital. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing, and default triggers an efficiency loss as these inputs are replaced by imperfect substitutes, because both firms and the government are excluded from credit markets. Default is an optimal decision of a benevolent planner for whom, even after internalizing the adverse effects of default on economic activity, financial autarky has a higher payoff than debt repayment. The model explains the main features of observed cyclical dynamics around defaults, countercyclical spreads, high debt ratios, and key long-run business cycle moments.
The popular Nelson–Siegel Nelson, C.R., Siegel, A.F., 1987. Parsimonious modeling of yield curves. Journal of Business 60, 473–489 yield curve is routinely fit to cross sections of intra-country bond ...yields, and Diebold–Li Diebold, F.X., Li, C., 2006. Forecasting the term structure of government bond yields. Journal of Econometrics 130, 337–364 have recently proposed a dynamized version. In this paper we extend Diebold–Li to a global context, modeling a potentially large
set of country yield curves in a framework that allows for both global and country-specific factors. In an empirical analysis of term structures of government bond yields for the Germany, Japan, the UK and the US, we find that global yield factors do indeed exist and are economically important, generally explaining significant fractions of country yield curve dynamics, with interesting differences across countries.
The Two‐Pillar Policy for the RMB JERMANN, URBAN J.; WEI, BIN; YUE, VIVIAN Z.
The Journal of finance (New York),
December 2022, Volume:
77, Issue:
6
Journal Article
Peer reviewed
ABSTRACT
This paper studies China's recent exchange rate policy for the renminbi (RMB). We demonstrate empirically that a two‐pillar policy is in place, aiming to balance exchange rate flexibility ...and RMB index stability via market and basket pillars. We further extend and validate the formulation that incorporates the so‐called countercyclical factor. Theoretically, we develop a flexible‐price monetary model for the RMB in which the two‐pillar policy arises endogenously as an optimal response of the government. We estimate the model by generalized method of moments and quantitatively assess various policy trade‐offs.
This paper attempts to disentangle the intricate relation linking the world interest rate, country spreads, and emerging-market fundamentals. It does so by using a methodology that combines empirical ...and theoretical elements. The main findings are: (1) US interest rate shocks explain about 20% of movements in aggregate activity in emerging economies. (2) Country spread shocks explain about 12% of business cycles in emerging economies. (3) In response to an increase in US interest rates, country spreads first fall and then display a large, delayed overshooting; (4) US-interest-rate shocks affect domestic variables mostly through their effects on country spreads; (5) The feedback from emerging-market fundamentals to country spreads significantly exacerbates business-cycle fluctuations.
Sovereign risk and financial risk Gilchrist, Simon; Wei, Bin; Yue, Vivian Z. ...
Journal of international economics,
20/May , Volume:
136
Journal Article
Peer reviewed
Open access
In this paper, we study the interplay between sovereign risk and global financial risk. We show that a substantial portion of the comovement among sovereign spreads is accounted for by changes in ...global financial risk. We construct bond-level sovereign spreads for dollar-denominated bonds issued by over 50 countries from 1995 to 2020 and use various indicators to measure global financial risk. Through panel regressions and local projection analysis, we find that an increase in global financial risk causes a large and persistent widening of sovereign bond spreads. These effects are strongest when measuring global risk using the excess bond premium – a measure of the risk-bearing capacity of U.S. financial intermediaries. The spillover effects of global financial risk are more pronounced for speculative-grade sovereign bonds.
Liquidity backstops can mitigate runs. In this paper we develop a dynamic model of debt runs based on He and Xiong (2012) to identify, both conceptually and quantitatively, the value of a liquidity ...backstop for its run-mitigating role. For the purpose of identification, we focus on the municipal bond markets for variable rate demand obligations and auction rate securities. Based on the run episodes in these markets during the financial crisis of 2007-09 and the calibrated model, we find that the value of a liquidity backstop is about 14.5 basis points per annum. Our findings have important policy implications regarding the effectiveness of liquidity backstops in ameliorating problems of financial instability.
This paper studies firms’ usage of interest rate swaps in a model economy driven by aggregate productivity shocks, inflation shocks, and counter-cyclical idiosyncratic productivity risk. Consistent ...with empirical evidence, firms in the model are fixed-rate payers. Counter-cyclical productivity risk is key for this finding; inflation risk contributes to producing the opposite outcome. Also consistent with empirical evidence, swap positions are negatively correlated with the term spread, so that firms appear to be timing the market. In the model, swaps generate only small economic gains for the typical firm.
This article is part of a Special Issue entitled “Fiscal and Monetary Policies”.
This paper evaluates the efficacy of the Secondary Market Corporate Credit Facility, a program designed to stabilize the U.S. corporate bond market during the COVID-19 pandemic. The program ...announcements on March 23 and April 9, 2020, significantly reduced investment-grade credit spreads across the maturity spectrum – irrespective of the program’s maturity-eligibility criterion – and ultimately restored the normal upward-sloping term structure of credit spreads. The Federal Reserve’s actual purchases reduced credit spreads of eligible bonds 3 basis points more than those of ineligible bonds, a sizable effect given the modest volume of purchases. A calibrated variant of the preferred habit model shows that a “dash for cash” – a selloff of shorter-term lowest-risk investment-grade bonds – combined with a spike in the arbitrageurs’ risk aversion, can account for the inversion of the investment-grade credit curve during the height of turmoil in the market. Consistent with the empirical findings, the Fed’s announcements, by reducing risk aversion and alleviating market segmentation, helped restore the upward-sloping credit curve in the investment-grade segment of the market.
•We evaluate the efficacy of the SMCCF, the Federal Reserve’s corporate bond-buying program.•The Fed’s announcements restored the normal upward-sloping term structure of credit spreads and had little to do with the program’s eligibility criteria.•The narrowing of credit spreads was due to a reduction in credit risk premiums.•Actual purchases had significant effects on credit spreads of program-eligible bonds.
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