Fiscal policy and default risk in emerging markets

TL;DR: In this paper, the authors developed a quantitative dynamic stochastic small open economy model with incomplete markets, endogenous fiscal policy and sovereign default where public expenditures and tax rates are optimally procyclical.

About: This article is published in Review of Economic Dynamics.The article was published on 2010-04-01 and is currently open access. It has received 127 citations till now. The article focuses on the topics: Fiscal policy & Sovereign default.

Summary

1. Introduction

• The authors study theoretically and quantitatively the links and cyclical behavior of fiscal variables, sovereign interest rate spreads and default risk in emerging market economies.
• A procyclical fiscal policy implies public spending and tax rates in good (bad) times.
• Sovereign debt crises usually take place in bad times, when output growth is low or even negative.
• Section 6 discusses the robustness of the benchmark results to different assumptions regarding the economic environment.
• The impact of the private sector’s access to international credit markets on the behavior of fiscal variables is studied in Section 7, where the authors develop and compute a finite horizon model where both the government and the private sector have access to foreign financing.

2. Link to the Literature

• The empirical regularities for emerging economies addressed in this paper are well documented in the literature.
• Talvi and Vegh (2000) argue that far from being a particular feature of Latin American countries, a procyclical fiscal policy appears to be the norm among developing economies.
• As observed by Vicente and Rial (2007), in the middle of the recession and capital flights the Uruguayan government dramatically increased taxes.
• Riascos and Vegh (2003) develop a neoclassical model of fiscal policy in which public consumption provides direct utility to households.
• They argue that these governments face a loss of access to external credit markets during bad times, which makes it extremely difficult to implement either a countercyclical or an acyclical fiscal policy, and they present some evidence that international credit constraints are more severe during recessions.

3. The Benchmark Model

• The authors consider a small open economy model with three agents: households, government and foreign lenders.
• Households have preferences over private consumption, public 4See Peter (2002) for a survey of econometric studies on the probability of sovereign default.
• They work and consume, taking as given the actions of the government.
• Goods are produced using labor and the production function has constant returns to scale and is subject to technology shocks.
• Foreign lenders charge a premium to account for the probability of not being paid back by the government.

3.1. Households

• There is a representative household with preferences given by the present value of the sum of instantaneous utility functions: E0 ∞X t=0 βtU(Ct, Gt, 1− lt) (3.1).
• The per period utility is concave, strictly increasing and twice differentiable.
• Gt public spending and lt the amount of time allocated to produce goods.
• Output is produced using labor 5Most external debt in developing countries represents government debt.
• From households’ first order conditions the authors get the following equation, describing optimal behavior of the private sector.

3.2. Government

• The benevolent government maximizes the utility of the households in the economy and can borrow and lend in international credit markets.
• When the government borrows, it sells bonds to foreign lenders, so it receives q(B0, A)B0 units of consumption goods from foreign creditors on the current period and promises to pay B0 units next period conditional on not defaulting.
• When the government has access to credit markets it chooses the tax rate, public expenditures and foreign assets in order to maximize households’ utility, taking into account how the private sector will respond to these policies.
• The productivity factor 7The assumption that default reduces output can be rationalized by the fact that after a default episode there is a disruption in foreign trade, Rose (2005), which induces an output loss.
• A0).

3.3. Foreign Lenders

• There is a large number of identical, infinitely lived foreign creditors.
• Each lender can borrow or lend at the risk free rate rf and participates in a perfectly competitive market to lend to the small open economy.
• Next period the lenders may receive the face value of the bond depending on whether the government defaults or not.
• Policy functions for government’s default decision D, optimal asset holdings B0, optimal government expenditures G, Gd and optimal tax rates T , Td, 4.
• Given the government policies and the bond price function, the household policies for consumption and labor solve the household’s problem, 2.

4.2. First Order Conditions from Government’s Problem

• This condition can be interpreted in terms of marginal benefits and marginal costs of changing the tax rate.
• If households react working less hours when the government implements a higher tax rate, then the amount of resources that can be assigned to public expenditures would be reduced.
• The marginal benefits and costs can be described as follows:.
• In terms of effects on current welfare, for each unit of additional borrowing the government could increase the level of public spending by q+B0 ∂q∂B0 − TAFl(l ∗) (1+T ) ∂l ∂B0 units.
• Next period, the government would have to repay its debt, which reduces future government consumption.

5. Quantitative Analysis

• The benchmark model is solved numerically and the parameters are based on existing data.
• Given the availability of time series of data, Mexico is used as a benchmark and their period of study is 1980-2007.
• Many of the business cycles features observed in Mexico are shared by other emerging market economies.

5.1. Data

• The data are seasonally adjusted quarterly real series obtained from Banco de Mexico.
• Output, private consumption and public consumption are in logs and the trade balance is presented as a percentage of GDP.
• An effective tax rate was computed for the consumption tax using the methodology of Mendoza, Razin and Tesar (1994).
• The interest rate spreads corresponds to the EMBI for 1994-2007.
• All series are filtered with the Hodrick-Prescott filter.

5.2. Calibration

• The calibration involves choosing the functional forms and the parameter values.
• The household’s labor supply depends on the productivity factor, the tax rate and the parameter Ψ of the per period utility.
• Some of the parameter values that are used are standard for business cycles models in emerging markets.
• The parameter σ, the coefficient of relative risk aversion, is set equal to 2, a standard value (see Aguiar and Gopinath 2006).
• This value implies that a defaulting country will return to financial markets in about 10 quarters after defaulting on its foreign debt.

5.3. Results

• This section presents the simulation results and the statistical properties of the benchmark model.
• Figure 1 plots the discount bond price schedule as a function of assets for two values of the productivity shock.
• Therefore, in the middle of a recession, a highly indebted govern- 26 ment losses access to credit markets and it has to finance its expenditures with taxes.
• When the amount of foreign debt is low and the government always pays back its debt, the country faces the risk free interest rate and the optimal tax rate increases with A.
• Therefore, in this region the economy borrows more in recessions and less in expansions as in standard insurance models with borrowing constraints a la Hugget (1993).

6. Discussion

• In this section the authors conduct a robustness check of the benchmark results.
• The authors first analyze the role of default in the model.
• Now, the optimal cyclical pattern for borrowing and tax rates, imply a slightly positive correlation of these variables with GDP.
• As the numbers in the table show, the qualitative results stand and overall results do not change significantly.
• As the goods become more complements the government tends to implement a larger tax to redistribute the resources according to the optimal allocation between C and G.

7. The Model with private foreign borrowing

• The assumption that households cannot borrow directly from credit markets is in conflict with the increased participation of the private sector’s debt in the overall bond issuance by emerging markets documented by the IMF (IMF Financial Stability Report (2007), Copelman (1996)).
• At the same time, the aggregate figures on private foreign borrowing conceal a significant cross country heterogeneity: while private foreign borrowing in countries like Estonia or Thailand is significant relative to public foreign borrowing, for a large number of developing countries it is almost exclusively the government that has access to international credit markets.
• Lahiri, Singh and Vegh (2007) observe that in general, access to asset markets is limited to a fraction of the population, and even in the US the degree of segmentation in asset markets is remarkably high.
• They point out that as of 1989, almost 60% of US households did not hold any interest bearing assets (defined as money market accounts, certificates of deposit, bonds, mutual funds, and equities) and 25% did not even have a checking account.
• This stylized fact is analyzed in numerous empirical studies such as Durbin and Ng (2005), Borensztein, Cowan and Valenzuela (2007) and Peter and Grandes (2005) among others.

7.1. Results

• The government does not have commitment to long-run plans and chooses taxes (τ), debt (B) and default (D) before the private sector decides on debt (b), and default (d).
• Therefore, the authors first present the last period problem.
• Likewise, suppose in the second period the government decided to default on its debt and to set taxes at τ .
• Additionally, the term I(d=0)qg(b,B, y)B0 indicates that in case of default in the private sector, the government is also excluded from credit markets.
• The policy functions used in the simulations below are those that solve the first period problem.

7.2. Simulations

• The value for the common parameters, stochastic processes and functional forms are taken from the benchmark model.
• Different values of the parameters determining the output loss after default must be considered.
• To follow the concept of “sovereign credit ceiling” observed in the data, the authors set λp slightly higher than λg.13 Last, if both sectors default, they assume the punishment is harder, λb = 0.97.
• In the last column, the correlations were computed from time series simulated using the policy functions defined above.
• At the same time, since the cost of private borrowing also increases in recessions due to countercyclical credit risk, the private sector also faces procyclical borrowing and is constrained in bad times, so private debt is not a good instrument to smooth consumption.

8. Conclusions

• In this paper the authors help rationalize the observed procyclicality of fiscal policy in emerging economies as the outcome of optimal public policy.
• The results are also consistent with other key stylized facts present in emerging market 14 In computing those correlations, each point y was weighted by the measure of y in the stationary distribution of income.
• Since non-contingent debt is not a good instrument for consumption smoothing, public expenditures fluctuate.
• When the economy faces a fall in output but the government does not default, it has the option to borrow from abroad but at a high interest rate.
• Therefore, complementing the previous literature that focused on the loss of market access, the authors find that the possibility of sovereign default and the associated risk premium play an important role in inducing the procyclical fiscal policy observed in emerging economies.

Figures

Table 2.

Figure 1 Bond Price

Table 6. The economy with private foreign borrowing

Table 5. Public and private foreign debt in developing countries

Figure 4 Tax Rate Policy T(B,A)

Figure 5 Borrowing Function B'(B,A)

Table 1. Parameter Values

Figure 3 Dynamics of GDP and Tax Rate

Figure 2 Dynamics of GDP and Spread

Table 4.

Table 3. Simulation Results Benchmark Model Model Model Without Default With Labor tax

Frequently asked questions

Q1. What contributions have the authors mentioned in the paper "Fiscal policy and default risk in emerging markets∗" ?

In this paper the authors develop a quantitative dynamic stochastic small open economy model with incomplete markets, endogenous fiscal policy and sovereign default where public expenditures and tax rates are optimally procyclical. 

Q2. What have the authors stated for future works in "Fiscal policy and default risk in emerging markets∗" ?

Therefore, complementing the previous literature that focused on the loss of market access, the authors find that the possibility of sovereign default and the associated risk premium play an important role in inducing the procyclical fiscal policy observed in emerging economies. 

Q3. What is the effect of the low income state on the trade balance?

In low income states, borrowing is relatively expensive so the government is constrained and tax rates are raised, thus consumption decreases similarly to output and the trade balance tends to be positive. 

Q4. What is the effect of incomplete markets on the economy?

With incomplete markets the government is less able to smooth its consumption and the correlation between output and public consumption becomes positive. 

Q5. What is the effect of a marginal increase in the tax rate on today’s utility?

In terms of effects on today’s utility, a marginal increase in the tax rate affects private consumption, public spending and labor effort. 

Q6. What is the effect of a series of adverse shocks on the cost of borrowing?

In the presence of a series of adverse shocks, the cost of rolling over debt and financing public expenditures increases and it becomes optimal to increase consumption taxes. 

Q7. What is the rationale for the assumption that default reduces output?

The assumption that default reduces output can be rationalized by the fact that after a default episode there is a disruption in foreign trade, Rose (2005), which induces an output loss. 

Q8. What makes the government more attractive in recessions?

A key feature of the model to understand why the government relies more on taxes in recessions is the asset structure of the model that makes default more tempting in recessions. 

Q9. What is the probability that the government defaults on its sovereign debt?

When it defaults, creditors get 0 units of the consumption good, where λ(B0, A) is the endogenous probability that the government defaults on its sovereign debt. 

Q10. What is the borrowing policy function for the output shock?

Figure 5 shows the borrowing policy function B0(B,A) conditional on not defaulting, as a function of B for two values of the productivity shock. 

Q11. What are the parameters that determine the output loss after default?

The parameters λb, λg, and λp represent the punishment if both default, if only the government defaults, and if only the private sector defaults, respectively. 

Q12. How long does a country return to financial markets after defaulting?

This value implies that a defaulting country will return to financial markets in about 10 quarters after defaulting on its foreign debt. 

Q13. What is the purpose of V 2(b,B, y)?

Notice that V 2(b,B, y) is useful because this is the function used in the first period to compute the effect of borrowing on the utility in the second period. 

Q14. What is the effect of the private sector borrowing from abroad?

Since the private sector may borrow somewhat from abroad, it might avoid an otherwise even more drastic fall in consumption, making it less costly to tax for the government. 

Q15. What is the probability that the economy will return to the financial markets?

The economy is excluded from credit markets in the current period but in the next one the country may regain access to external markets with an exogenous probability μ.