Earnings Management and Investor Protection: An International Comparison

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Recent sovereign defaults in emerging countries are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output, consumption, and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default occurs in equilibrium because asset markets are incomplete. The model predicts that default incentives and interest rates are higher in recessions, as observed in the data. The reason is that in a recession, a risk averse borrower finds it more costly to repay non-contingent debt and is more likely to default. In a quantitative exercise the model matches various features of the business cycle in Argentina such as: high volatility of interest rates, higher volatility of consumption relative to output, a negative correlation of interest rates and output and a negative correlation of the trade balance and output. The model can also predict the recent default episode in Argentina.

Default risk and income fluctuations in emerging economies

Recent sovereign defaults in emerging countries are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output, consumption, and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default occurs in equilibrium because asset markets are incomplete. The model predicts that default incentives and interest rates are
higher in recessions, as observed in the data. The reason is that in a recession, a risk averse borrower finds it more costly to repay non-contingent debt and is more likely to default. In a quantitative exercise the model matches various features of the business cycle in Argentina
such as: high volatility of interest rates, higher volatility of consumption relative to output, a negative correlation of interest rates and output and a negative correlation of the trade balance and output. The model can also predict the recent default episode in Argentina.

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Default Risk and Income Fluctuations in Emerging Economies

Aggregate and sectoral comovement are central features of business cycles, so the ability to generate comovement is a natural litmus test for macroeconomic models. But it is a test that most models fail. We propose a unified model that generates aggregate and sectoral comovement in response to contemporaneous and news shocks about fundamentals. The fundamentals that we consider are aggregate and sectoral total factor productivity shocks as well as investment specific technical change. The model has three key elements: variable capital utilization, adjustment costs to investment, and preferences that allow us to parameterize the strength of short-run wealth effects on the labor supply. (JEL

/pdf/can-news-about-the-future-drive-the-business-cycle-b482sd6shw.pdf

Can news about the future drive the business cycle

The article studies the role of the assumption that countries can be punished with financial exclusion after a sovereign default. It describes the business cycle properties of a sovereign default model with the exclusion punishment and compares them with those of the same model without the exclusion punishment. Both models build on the framework studied in Aguiar and Gopinath (2006). The article finds that the presence of exclusion punishment is responsible for a high fraction of the sovereign debt that can be sustained in equilibrium. On the other hand, the cyclical behavior of consumption, output, interest rate, and net exports are not fundamentally different in the models with and without exclusion.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2186612_code1851421.pdf?abstractid=2186612&mirid=2

Quantitative Models of Sovereign Default and the Threat of Financial Exclusion

Government support to banks through the provision of explicit or implicit guarantees affects the willingness of banks to take on risk by reducing market discipline or by increasing charter value. We use an international sample of bank data and government support to banks for the periods 2003-2004 and 2009-2010. We find that more government support is associated with more risk taking by banks, especially during the financial crisis (2009-10). We also find that restricting banks' range of activities ameliorates the moral hazard problem. We conclude that strengthening market discipline in the banking sector is needed to address this moral hazard problem.

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International Evidence on Government Support and Risk Taking in the Banking Sector

(ProQuest-CSA LLC: ... denotes formulae omitted.) Sovereign defaults are widespread throughout history. In particular, after Russia defaulted on its sovereign debt in 1998, numerous episodes of sovereign default followed. These recent episodes invigorated the study of sovereign defaults, giving rise to much interesting work that added to the large body of literature on this topic. This article discusses the economics of sovereign defaults, summarizing lessons from existing work on this issue. First, we describe the costs associated with a sovereign default episode. We discuss costs imposed by creditors and those implied by the information revealed by the default decision. Second, we identify circumstances that are likely to lead to a default episode. We explain that sovereign defaults are likely to be observed when resources available to the sovereign are low, borrowing costs are high, or there is a change in political circumstances. Finally, we discuss how understanding sovereign defaults may help to account for distinctive economic features of emerging economies. We conclude that even though there is a large body of literature studying default episodes, there is still a great deal that is not known. 1. SOVEREIGN BORROWING AND DEFAULTS Sovereign debt refers to debt incurred by governments. Sovereign borrowing can be a key policy tool to finance investment or to respond to a cyclical downturn. There are different definitions of a sovereign default. First, from a legal point of view, a default event is an episode in which a scheduled debt service is not paid beyond a grace period specified in the debt contract. Second, credit-rating agencies consider a "technical" default an episode in which the sovereign makes a restructuring offer that contains terms less favorable than the original debt.1 Sovereign defaults do not necessarily imply a total repudiation of outstanding debt. Most default episodes are followed by a settlement between creditors and the debtor government. The settlement may take the form of a debt exchange or debt restructuring. The new stream of payments promised by the government typically involves a combination of lower principal, lower interest payments, and longer maturities. Credit-rating agencies define the duration of a default episode as the amount of time that passes between the default event and when the debt is restructured (even though there may be holdout creditors). Sturzenegger and Zettelmeyer (2005) propose a methodology to compute estimates of debt recovery rates. They also describe recent debt restructurings and estimate the recovery rates for these episodes. Table 1 presents these estimates, which are equal to the market value of the newinstruments obtained by the creditors in the debt exchange plus any cash payment they received divided by the net present value of the remaining contractual payments on the old instruments (inclusive of any principal or interest that remained unpaid after the date of maturity). The present values are discounted using the yield of the new instruments immediately after the results of the exchange offer became public information.2 Sovereign Borrowing Versus Private Borrowing There are some similarities between sovereign borrowing and private sector borrowing. For example, like private agents (households and corporations), governments can borrow to finance long-lived investments. Furthermore, in the same way households borrow to preserve living standards through periods of temporary hardship, governments borrow if they do not want to decrease expenditures when tax revenues are low. In addition to seeking to smooth private consumption, households want to smooth their consumption of services provided by the government (law enforcement, justice, defense, public health, public education, parks, etc.). Consequently, benevolent governments would rather provide a smooth flow of services than have this flow fluctuating with tax revenues. …

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The Economics of Sovereign Defaults

A number of countries have issued sovereign debt instruments indexed to real variables in recent years. This type of contracts could improve risk sharing between debtor countries and international creditors and diminish the probability of occurrence of debt crises. This paper characterizes the optimal features of real indexed sovereign debt contracts in a dynamic stochastic equilibrium framework with incomplete markets. We show that the optimal indexed debt contract should not be studied abstracting from the total portfolio of assets and liabilities of the issuing country. We also show that the optimal contract is similar to an insurance contract, and that a country can replicate it using existing instruments, in particular, a combination of international reserves and GDP-indexed bonds. Calibrating our model to Argentina's economy we find that the welfare gains from introducing indexed debt and allowing asset accumulation could be equivalent to an increase of between 0.1% and 0.5% in certainty equivalent aggregate consumption.

/pdf/indexed-sovereign-debt-an-applied-framework-egd4n8j1c6.pdf

Indexed Sovereign Debt: An Applied Framework

Sovereign debt crises have been recurrent events over the past two centuries. In recent years, the timing of sovereign crises has coincided or has directly followed banking crises. The link between sovereigns and banks tightened as the contingent liability that the banking sector represents for the sovereign grew, as financial “safety nets” became more common. This chapter analyzes the transmission channels between sovereigns and banks, with a focus on the effect of sovereign distress on bank solvency and financing. It then highlights the notable cost to the real economy of the close connection between sovereigns and banks. Breaking the “feedback loop” between these two sectors should be an important policy priority.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2487523_code47767.pdf?abstractid=2487523&mirid=1

Horacio Sapriza

Papers

Quantitative Models of Sovereign Default and the Threat of Financial Exclusion

International Evidence on Government Support and Risk Taking in the Banking Sector

The Economics of Sovereign Defaults

Indexed Sovereign Debt: An Applied Framework

Sovereign Debt Crises