Research

"Sovereign Default and Cheap Talk" (Job Market Paper)

Abstract: It is puzzling that advanced economies often have access to cheap borrowing even when they hold huge levels of debt, whereas emerging economies typically suffer from higher spreads even when they hold relatively low levels of debt. Standard sovereign debt models typically fail to explain both the "debt intolerance" that emerging countries inherit, and the “graduation” to cheaper rates that characterize developed countries. I address this puzzle by developing a small open economy model with an embedded cheap talk game. Information revelation is the key mechanism for these results. A competent government wishes to transmit private information about its current income to uninformed lenders who, in turn, update their beliefs about the government’s reputation for transparency. When times are bad, governments gain in the short run from misrepresenting the health of their economy, but suffer the long run cost of a lower reputation by doing so. The government cares about its reputation only indirectly because bond markets respond favorably to high reputation countries in equilibrium.  The model generates a separating equilibrium in which (i) governments with a lower-than-threshold reputation are trapped in a "debt intolerant'' state even though they hold low levels of debt and (ii) governments with higher reputation are able borrow at lower interest rates even when they hold higher levels of debt. Click here to read the paper.

Key Words: sovereign default, sovereign debt, serial defaulters, debt intolerance, cheap talk, reputation

JEL Codes: F34, D4, F30, G15

"Common Euro Area Sovereign Bonds in a Model of Equilibrium Default", joint with Juan Carlos Hatchondo and Leonardo Martinez

Abstract: We evaluate recent proposals of introducing common euro area sovereign securities (Eurobonds). We focus on proposals that include the introduction of guarantees with the objective of reducing the risk of default for Eurobonds, making them virtually default-free. If these proposals were implemented, Eurobonds would be a new source of financing for European governments in addition to traditional defaultable bonds. Proposals differ on the amount of financing a government could access through Eurobonds and on the circumstances in which these bonds could be issued. We evaluate these proposals using a model of equilibrium sovereign default augmented to allow for both defaultable and non-defaultable debt. Preliminary simulation results indicate that introducing Eurobonds may reduce the spread on defaultable sovereign bonds significantly. However, without restrictions to defaultable debt issuances, this spread reduction is only temporal. The government first uses the newly available Eurobond financing to reduce the level of its defaultable debt. But after exhausting its new source of financing, the government increases the level of defaultable debt. In the long-run, Eurobonds do not change significantly the government's willingness to issue defaultable debt and face default risk.

Key Words: sovereign default, sovereign debt, Eurobonds, blue bonds, red bonds

JEL Codes: F34, F30

"Inflation and Domestic Debt Default"

Abstract: Recent European crisis have brought attention to the idea of inflating away debt burdens. Countries that have independent monetary policies are able to create inflation and bring down the cost of holding domestic debt. The benevolent government maximizes the utility of the representative agent and the central bank can respond to a debt crisis by letting inflation to increase. My paper contributes to the literature with a simultaneous analysis of domestic debt default and inflation by extending the noble framework of Eaton and Gersovitz (1981).

Key Words: sovereign default, domestic debt, inflation, monetary policy

JEL Codes: F34, F30, E52, E61

"Fiscal Discipline in West African Economic and Monetary Union", joint with Ermal Hitaj (Revise and Resubmit)

Abstract: This paper explores the extent to which rules and market discipline are effective in ensuring fiscal sustainability in the West African Economic and Monetary Union (WAEMU). After evaluating the responsiveness of sovereign interest rates to governments' fiscal behavior, the paper finds that an improvement of the effectiveness of market discipline in WAEMU would necessitate further development of the regional financial market. In addition, fiscal aspects of the WAEMU's regional surveillance framework could be reconsidered to improve both design and enforceability. Click here to read the paper.

Key Words: fiscal rules, sovereign debt, WAEMU, market discipline

JEL Codes: E43, E62, G12, H60, H63