Sovereign Risk and Macroeconomic Fluctuations

Abstract

This dissertation investigates the properties of macroeconomic fluctuations in a small open economy under the presence of sovereign default risk. International borrowing and lending arise from the interaction between a risk averse sovereign representative agent in a small open economy trying to self insure against idiosyncratic shocks and risk neutral international lenders. The credit market is imperfect because the country cannot commit to repay its outstanding debt and chooses to default when it is optimal to do so. The possibility of default induces an endogenous sovereign risk premium on foreign debt and endogenous rationing by foreign creditors.

The second chapter presents a simple model of sovereign risk that explains how default can de triggered by shocks that drive normal business cycles, albeit in the context of an endowment economy. The model features incomplete external financial markets and the inability of the sovereign country to commit to repay debts. These two features coupled with risk neutral international lenders generate an endogenous risk premium and an endogenous borrowing constraint that drive the dynamics of default. The model is calibrated to the Argentine economy. It is able to reproduce counter-cyclical country risk spreads, large capital outflows during Sudden Stops, and default. In a simple experiment conducted here, it is shown that by increasing trade sanctions to the artificial economy, it is possible to deter default but it is not possible to isolate the economy from the occurrence of Sudden Stops. Despite this, the welfare gains from eliminating default are very large: 7\% of steady state consumption. Using numerical methods, this paper also proposes an algorithm for the solution of this family of models that allows to generalize the results of Eaton and Gersovitz (1981) into environments with varying degrees of persistence and volatility in the underlying stochastic income process.

In the third chapter the assumption of an endowment economy is relaxed and the welfare implications of default are studied. Allowing for capital accumulation has a two implications on affecting incentives to repay. The first is that capital increases the likelihood of default because the country has an asset to save if defaults. The second is that, as markets are incomplete and the country engages in precautionary savings, capital serves as a buffer to mitigate consumption falls during recessions. The model is calibrated to the Argentine economy and reproduces the main macroeconomic volatilities and correlations as consumption, investment and output, but fails to reproduce those of trade balance, current account and interest rates. Further research is needed in this direction.

The fourth chapter focuses on monetary policy in small open economies. It presents a dynamic stochastic general equilibrium model of inflation targeting in a small open economy. The model is calibrated to the Colombian economy to study the response of some macroeconomic variables to different types of shocks that are relevant for emerging economies. The sensitivity of those responses to some key parameters is also analyzed. Furthermore, using simulated data from the model, the ability of the model to capture the spectra, the phase and the coherence of observed output and inflation are studied.