IMF Sep-10 Research Bulletin has interesting discussions as always.
The one on sovereign debt and default is very interesting. It is written by Emine Boz of IMF.
While public attention has focused on when and why sovereigns default, the academic literature has analyzed a seemingly different question: why do sovereigns repay their debt? Since—unlike with corporate defaults—lenders do not have the legal right to seize the assets of sovereigns and the enforcement of any penalty is difficult, it has been hard to reconcile why sovereigns repay their debt. If sovereigns’ assets cannot be seized, default may be costless for them, so rational lenders would optimally choose not to lend, and in equilibrium there would be no debt or default.
This argument, however, does not help explain the empirical facts because the data reveal positive levels of debt—in some cases high levels of debt compared to the country’s GDP—along with several episodes of default, suggesting that there must be costs associated with default.
So what are the costs of default — One, reputation costs. Two, there could be sanctions:
The sovereign debt literature considers two main costs of default: reputational costs and direct sanctions. Reputational costs operate through loss of access to international capital markets (autarky) and hence inability to smooth consumption over time. Direct sanctions refer to trade sanctions that are likely to lead to a disruption in trade and therefore a reduction in output. The empirical relevance and relative importance of these costs have been disputed and the recent sovereign debt literature has modeled the reputational costs rigorously but has captured the other direct sanctions simply as a decline in output during default.
She points to research which has looked at modeling reputation costs. One such study looks at how sovereigns behave differently while borrowing from private sector vs borrowing from international finance institutions (IFI) like IMF, World Bank etc. There are some interesting findings.
Using the IMF’s Stand-By Arrangements, Boz (2009) shows that in emerging markets, the cyclical properties of lending by IFIs are in stark contrast to those of lending by private sector creditors. The average correlation of IMF debt flows with output for a group of emerging-market economies is –0.19, while the same correlation in the case of commercial debt flows is 0.37. In addition, the variability of commercial debt flows is about four times as large as that of IMF debt (0.82 versus 3.91 percent). Finally, borrowing from the IMF is intermittent; the unconditional probability of the use of IMF credit is around 50 percent. This pattern also contrasts with commercial debt as most emerging-market economies are indebted to private sector creditors at all times.
The reason is IMF has a different contract with sovereigns:
The IFI offers a different type of contract than the private sector creditors. First, contracts with the IFI are enforceable, while those with commercial creditors are not. Boz (2009) considers this to be loosely implied by the IFI having a preferred creditor status and also the fact that the IMF has almost always been repaid, particularly by emerging-market economies. Second, the interest rate associated with IFI lending is assumed to be the sum of the risk-free rate and a charge that increases with the amount borrowed from the IFI. This specification for the IFI interest rate captures the surcharges that may apply in the case of Stand-By Arrangements, depending on the amount borrowed. This specification is significantly different from commercial interest rates that depend on the endogenous default probability determined by the “riskiness” of the sovereign. Finally, conditionality associated with IFI debt is accounted for by a higher discount factor in periods when the sovereign is indebted to the IFI. In this setting, a higher discount factor tilts the consumption profile by shifting consumption from the present to the future, thereby lowering debt levels and default probabilities. This can be interpreted as similar to implementation of tighter fiscal policies that traditionally have been part of IMF conditionality.
Plus, there are two additional topics.
- How advanced economies concerns were transmitted to developing economies
The global financial crisis of 2008–09 has spurred researchers to examine how the associated recession was transmitted from advanced to emerging economies. Recent IMF studies have found that pre-crisis vulnerabilities such as large current account deficits, rapid credit growth, and high levels of short-term debt were strongly associated with the magnitude of spillovers. Trade, bank lending, and financial markets served as key transmission channels.
Then there are Q&A prepared by Bernardin Akitoby of IMF. He looks at following issues:
How do institutions shape financial markets? The question is highly relevant in the context of the global financial crisis. This article reviews recent studies on the effect of institutions on financial markets, focusing on the “Lucas paradox” of capital inflows, the pricing of risk, and access to capital markets. There is strong empirical evidence to support the hypothesis that institutions, in various forms, are important determinants of financial market development
Both very interesting.