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...a recent paper, Reinhart, Rogoff, and Savastano (2003; RRS henceforth) take this evidence one step further. Combining macroeconomic data for the post-1970 period with information about sovereigns' credit histories since the early nineteenth century, they argue that an important subgroup of middle-income countries or "emerging markets" have been systematically afflicted by what they call "debt intolerance." That is, even though their external debt-to-GDP ratios are moderate by international standards and substantially lower than those of several high-income countries, these economies are perceived as riskier and unable to tolerate as much debt. Simply put, their sovereign risk appears to be out of proportion to the size of the respective debt burdens.
To explain this phenomenon, RRS invoke history. Virtually all of these countries have tarnished credit histories, with several of them having defaulted a few times on their public debts. To the extent that those that have defaulted once or more are likely to do so again, the market threshold of what can be considered "safe" borrowing levels for these countries tends to be lower. (1) As a theoretical story, however, this argument raises three questions. The first is whether lenders have, in fact, systematically punished recalcitrant borrowers with higher spreads and more limited market access historically--an issue about which the empirical evidence has been mixed. (2) Second, one is left with the question of what caused serial defaulters to default in the first place. Third, one needs to explain how most of today's advanced economies--which have also defaulted several times in their histories--managed to graduate out of the debt-intolerant "club."
This paper advances a simple but arguably more fundamental explanation for the debt-intolerance phenomenon. We contend that the underlying high volatility of macroeconomic aggregates is a key driver of sovereign risk in developing countries. This volatility can stem from distinct sources, including long-rooted institutional arrangements that tend to foster time-inconsistent policies and procyclical fiscal outcomes, as well as from narrow commodity specialization that induces terms-of-trade (TOT) instability. We argue that this greater volatility is associated with higher default probability and, as a result, these countries face borrowing constraints at lower levels of indebtedness. To the extent that such volatility stems from structural and, hence, slowly evolving factors, the phenomenon can be fairly persistent, even if there is scope for these countries to gradually evolve out of this state. In this sense, we view the debt-intolerance phenomenon as another--and a so far relatively neglected--manifestation of macroeconomic volatility on developing country welfare. The evidence provided in this paper thus bridges a gap between the literature on sovereign debt and that on the adverse effects of macroeconomic volatility on growth and welfare (for example, Mendoza, 1995 and 1997; Ramey and Ramey, 1995; Agenor and Aizenman, 1998; Caballero, 2000; and Acemoglu and others, 2003).
As discussed below, the thrust of our argument does not imply that the relationship between income volatility and default risk is straightforward. On the one hand, greater income volatility suggests a higher probability of large negative income shocks that lead to "nonstrategic" or "excusable" default along the lines of a "capacity-to-pay" argument. On the other hand, Eaton and Gersovitz's (1981) classic model suggests an alternative relationship in which default is punished by permanent exclusion from capital markets; because future exclusion is more costly for borrowers with more volatile incomes, their model suggests that greater volatility tends to decrease the likelihood of strategic default. Yet income volatility also affects the likelihood of default through other channels. First, volatility may affect the level of indebtedness that, in turn, tends to be positively related to default risk. Some models ignore this by assuming either that the level of indebtedness is exogenously given or that the borrower chooses to borrow as much as the lenders will allow (see, for instance, Grossman and Van Huyck, 1988; Grossman and Hahn, 1999; and Alfaro and Kanczuk, 2005). Second, volatility affects the terms on which lenders can borrow, with countries that have more volatile incomes often paying a higher risk premium. It is quite possible that countries that can access capital markets on less-than-advantageous terms care less about maintaining future access to these markets, so they may be more inclined to default in times of crises.
This paper aims to disentangle some of these complex effects in the context of a simple model and by presenting new econometric evidence on the roles of volatility, credit history, and other controls on default probabilities and borrowing capacity. In the model, the optimal level of debt trades off the benefit of borrowing in providing consumption insurance against bad output realization versus the cost of a higher borrowing spread. This spread is shown to be increasing on underlying macroeconomic volatility as well as (possibly) on a poorer credit history. Because greater volatility increases the risk premium for any given level of debt, this tends to dampen borrowing. Conversely, as borrowing is motivated by consumption smoothing, increased volatility increases the incentive to borrow. We find that whereas volatility may have an ambiguous effect on the optimal level of debt, the ex ante probability of default unambiguously increases in volatility.
Looking at the empirical evidence in light of this theoretical perspective, we examine the extent to which volatility and countries' repayment histories explain default risk over and above other standard controls proposed in the literature. Logit estimates of default probabilities in a cross-country panel spanning the 1970-2001 period clearly indicate that output and TOT volatility are highly significant in explaining sovereign risk--a result that is strikingly robust to the inclusion of the various explanatory variables considered in previous studies. At the same time, our estimates show that once volatility variables are included in the regression, the credit history variable used by RRS is no longer statistically significant. This suggests that countries' credit histories may be, at least in part, proxying for the effects of volatility on sovereign risk not contemplated in the RRS regressions.
We then turn to the issue of how volatility affects sovereign indebtedness. As noted above, a rise in volatility increases loan demand for consumption smoothing purposes, but it also has a supply deterrent effect through higher spreads that may become binding at times; thus, we consider a model that allows for the switch between the two regimes. The respective econometric results indicate that the supply effect predominates most of the time, so that the net effect of volatility on indebtedness tends to be negative. This, in turn, helps explain the second pillar of the debt-intolerance phenomenon documented by RRS--that is, why more volatile countries (which naturally tend to default more often) rarely manage to attain very high levels of sovereign debt relative to income. This explanation is arguably a more fundamental explanation for debt intolerance, in as much as it highlights a mechanism through which certain types of sovereigns default not only once but also repeatedly thereafter. This contrasts with the "virtuous circle" pattern often observed in countries with intrinsically less volatile TOT and income, which can attain higher indebtedness levels without incurring serial default.
I. Model
We assume that sovereign borrowing is motivated by the desire to smooth consumption in the face of domestic income shocks. The sovereign borrower can be viewed as a government that borrows to smooth its own consumption given volatile revenues, or one that borrows on behalf of its citizens to smooth their consumption given the variability of national income. Our benchmark model has two periods. In the first period, the sovereign chooses its level of borrowing; in the second period, after the realization of its random income, the sovereign chooses whether or not to repay its debt. If the debt is not fully repaid, the lender can impose sanctions that cause the borrower to lose a proportion of its period-2 output. We build on this standard framework (see Obstfeld and Rogoff, 1996, chapter 6) to develop the impact of volatility on sovereign risk and optimal borrowing.
We assume that funds borrowed by the sovereign are either held as central bank reserves or invested domestically; however, in each case, they yield the international risk-free interest rate. With debt D > in period 1, total income gross of debt repayment in period 2 is
[Y.sub.2](D) = [bar.Y] + [epsilon] + RD, (1)
where [bar.Y] is mean autarkic output, [epsilon] [member of] [-[[epsilon].sub.m], [[epsilon].sub.m]] is a random shock with zero mean, and R is the gross risk-free interest rate. The debt contract requires the sovereign to repay [R.sub.L]D in period 2. The spread between the contractual rate [R.sub.L] and the risk-free rate R reflects country-specific default risk: the possibility that the sovereign may choose to renege on its repayment obligation.
Lenders have access to an enforcement technology. In the event of default, they can capture a fraction [eta] of the borrower's period-2 income. (3) In this simple two-period context, it is rational for the sovereign to default if and only if the repayment obligation exceeds losses due to enforcement. Repayments are state-contingent:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], (2)
where e([R.sub.L],D) [equivalent to] [[[[R.sub.L] - [eta]R]D]/[eta]] - [bar.Y]. (2)
Thus, there exists a critical value e, such that the borrower repays the debt if and only if the random shock [epsilon] [greater than or equal to] e. In others words, repayment is rational only for relatively high realizations of output.
Effects of Volatility on Loan Supply
Turning to the supply side of the loan market, we depart from the standard formulation (Sachs and Cohen, 1985; and Obstfeld and Rogoff, 1996) in...
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