REENTERING CAPITAL MARKETS AFTER SELF-FULFILLING
SOVEREIGN DEBT CRISIS
Elena Savushkina
Institute of Economic Studies, Charles University in Prague
Velvarská 29, 160 00 Prague, Czech Republic
Phone: +(420) 776 355 641
E-mail: [email protected]
Oleksiy Skorokhod
PFČP, risk manager
Truhlářská 1106/9, 110 00 Prague, Czech Republic
E-mail: [email protected]
In recent years the majority of the emerging market financial crises were caused by debt
problems. Most of them were driven by the loss of confidence in the government and resulted in
sudden reversals of capital flows. The analysis of the processes which lead to these crises should help
government policymakers and international financial institutions in building crisis evasion strategy.
Mostly used technique to capture the investors’ panic is the model with self-fulfilling beliefs.
However, the analysis is complicated with the deficiencies of existing methods. Most of publications
on self-fulfilling debt crises do not analyze the possibility for a country to reenter the international
capital markets after default, which leads to undervaluation of the country’s liabilities and
overestimation of the credit risk.
Accordingly, this paper studies the effect of potential coming back to capital market on the
self-fulfilling behavior of investors in comparison with their behavior in models without reentering. In
other words we extend the scope of research and study the behavior of economy after the default
declaration. Within the framework we examine the relationship between government and foreign
investors in the stochastic recursive general equilibrium setup. On the one hand such analysis can aid
investors in more adequate pricing of the sovereign obligations. On the other hand government can
strategically default (with the intention to come back later) in order to smooth consumption and avoid
social crisis.
The analytical framework developed in the paper gives insight about the impact of various
investors’ beliefs on the mechanism of sovereign default. Therefore it underlines the role of mediatory
agents in near crises situations as they are able to influence investors’ beliefs by both insuring risky
debts and participation in the negotiations on debt rescheduling.
JEL Classification: F30, F34, G13
Key words:
equilibrium
self-fulfilling debt crises, sovereign bond pricing, dynamic stochastic general
2
Introduction
In recent years the majority of the emerging market financial crises were driven by debt
problems. Most of them were caused by concerns about the government’s credibility and
resulted in sudden reversals of capital flows. The analysis of the processes which lead to these
crises should help government policymakers and international financial institutions in
building crisis evasion strategy. In order to perform this task we will examine the relationship
between government and foreign investors in a stochastic recursive general equilibrium setup
in which a self-fulfilling crisis may occur.
Similar to Cole&Kehoe (1996, 2000), in the proposed research the origin of the selffulfilling behavior of investors is debt rollover. Such behavior arises in the situations when
the country is heavily indebted hence it can only serve the debt but not repay it immediately.
Thus in order to obey its obligations on the previously issued debt instruments the
government should be able to sell new period bonds. Supposing that there is a coordination
failure among investors the potential liquidity problem provokes the self-fulfilling default. In
other words, if every investor expects other investors not to lend new funds to the country and
if such decision causes default, then no investor will lend. Accordingly the pessimistic
expectations of investors in the absence of coordination facilitate otherwise potential crisis
event. In our research, in order to reflect such self-fulfilling behavior of investors the price of
debt in the international credit market is made explicitly dependent on the probability of
strategic default in future.
Furthermore it is also assumed that if a country is not able to issue new debt it will reject
to repay the previous debt as repayment would result in a severe consumption rationing.
Therefore the government will be better off by choosing to default and be punished rather
than to service the debt in a near panic situation. At the same time, most of the publications on
self-fulfilling debt crisis focus their attention only on default decision and do not analyze the
possibility for the country to reenter the international capital markets. Hence it is considered
there that the state of autarky remains for an infinite number of periods. However, such
assumption leads to underpricing of the country’s debt instruments (no recovery rate) and
overestimation of the credit risk that eventually leads to a self-fulfilling panic.
In order to reckon the value of the debt more adequately the suggested setup models the
possibility for a country to come back to the international capital market. At the same time
this change in our model complicates the analysis of the relationship between government and
investors in the following way. On the one hand the government may percept the default
event (accompanied by reduction of the principle) as a potential remedy for its debt problems.
3
Accordingly, investors would expect higher probability of the government strategic default.
On the other hand investors play the leading role during negotiations which regulate the
conditions on debt reduction and assignment of the new interest rate (interest rate policy) after
default event. Hence they may expect positive recovery rate on the defaulted obligations.
Consequently, the aim of the research is to study the effect of potential capital market
reentering on the self-fulfilling behavior of investors compared to the original model without
reentering. This investigation should give insight into different consequences of sovereign
defaults (for borrowers and lenders) depending on the type of investors’ behavior. Therefore,
it underlines the role of international financial institutions in near-crisis situations as they are
able to influence investors’ beliefs by both insuring risky debt and participating in the
negotiations on debt rescheduling.
The paper is organized in the following way. The introduction is continued by a brief
literature review. After examination of key achievements in the relevant publications we
continue with the description of the model. The discussion of the setup is divided into several
parts. The first one discusses the original setup, developed by Chamon (2004). The second
one is devoted to the modified version created by authors. After presenting the formal
framework we proceed with the numerical section. There we provide setup parameters and
output of the model which consists of numerical outcome and relevant graphs obtained
through numerical simulations. The paper is finalized with conclusion and appendices.
Literature review
The issue of debt sustainability can be studied from the perspective of agents’ behavior
in near-crisis situations. One of the first papers in this field was published by Sachs (1985).
He argues that debt crisis can be caused by self-fulfilling expectations. According to the setup
creditors will not roll over the debt in case they expect other creditors will not borrow as well.
Among later publications it is worth mentioning Cole&Kehoe (1996, 2000) who extend the
analysis to future periods as well as model the phenomena of temporarily rolling over debt
due to coordination failure. A brief survey of the debt crises models with self-fulfilling
behavior can be found in Chamon (2004) who also develops his own model and provides
rigorous analysis of the situations in which self-fulfilling expectations would not lead to the
creditors’ panic. However, he does not solve his model.
In the proposed setup the maximization problem of the government extends the
framework initially specified in Sachs (1985) and later complemented by Chamon (2004).
4
However, in contrast with the original publications the country takes into account the
possibility of reentering international capital markets. Additional attention is also paid to
investors’ behavior, more precisely to the role of investors’ expectations in foreign capital
price formation and the role of liquidity constraints in country’s default.
Methodology section: the original setup
The original setup developed by Chamon (2004) considers the small open economy with
one representative consumer with infinite lifetime. Its preferences are characterized by utility
function u(C). It is further assumed that u(C) is twice continuously differentiable, strictly
concave and monotonically increasing. It is also supposed that u(C) follows Inada conditions
and the government discounts future at the rate  .
The state variables of economy are the stock of capital Kt and amount of foreign debt Bt.
All decision-making processes including investment and debt policies are performed by
government, which acts as a benevolent social planner. If the country has access to
international credit market the production process in period t is specified as
Y  st , Kt   st  f  Kt 
(1.1)
Here st corresponds to stochastic productivity shock, which is distributed i.i.d. and
follows Markov chain properties and Kt is the amount of capital invested in t-1 period. At the
end of each period capital stock depreciates at rate  . The production function is considered
to exhibit the decreasing return to scale feature: f '  0, f "  0 . However, the output also
depends on whether country ever defaulted before. After default declaration, the economy is
suffering permanent productivity penalty.
This effect of decrease in productivity may be explained by the disruption of foreign
trade relations, which affects the value of output. The broader discussion of this aspect may be
found in Obstfeld&Rogoff (1996). Another explanation suggests negative consequences
associated with the loss of reputation caused by default decision. This topic is elaborated by
Cole&Kehoe (1997).
According to the original setup the country may operate in two states: “repaying” and
“default”. These states will be further denoted with “R” and “D” superscripts. In the
“repaying” state the country has access to international capital markets but also has option to
abandon it. The authorities may either decide to service the debt or declare default and switch
to autarky. In turn in the “default” state the government cannot use the external borrowing and
remains in this state forever.
To be more precise the timing of the model is the following. At the beginning of period t
the productivity shock st is realized. All information related to state variables and shocks is
known to both government and investors. Consequently after the realization of productivity
shock all actions during period t are predefined as a result of optimization. If the country has
access to international capital markets the government decides whether to service debt in the
current period or declare default (in other words, whether to remain in the “repaying” state or
switch to autarky). In case of the latter choice the default declaration happens after realization
of the shock and affects production in all subsequent periods including the period of
announcement. It is worth stressing that switching to default state results in the loss of access
to international capital markets.
Afterwards, the government makes its choice regarding stock of the next period capital
Kt+1. In case the country preserves access to international credit in the subsequent period it
also has to decide on the amount of next period debt Bt+1, which it offers to investors at
equilibrium price pt1. In the described model debt instruments exist in the form of one-period
zero coupon bonds. After receiving an offer from the government investors decide whether to
buy new claims. As all agents are rational and information is complete, the government
assigns price pt such that investors buy the offered bonds. At the end of the period the
production process takes place and government distributes the generated wealth between next
period capital, consumption and repayment of the debt issued at the beginning of the previous
period.
Being more specific the objective function for the “defaulted” state is described by the
following:


V D  st , Kt   max u  Ct    Et V D  st 1 , K t 1 
Kt 1
Ct  Y  st , Kt   Kt 1   Kt
s.t. 
Ct  0
(1.2)
Following this notation the country in financial autarky has no opportunity of gaining
back access to capital markets. Thus, the government maximizes social utility by optimizing
solely the investment policy.
Besides inability to access international credit markets, the country in default state
suffers decline in productivity, which corresponds to trade isolation and bank system crisis.
This effect is captured by lower values of st (the exact values are specified in numerical
section).
As opposed to “default” state, in “repaying” state the social planner is responsible for
pursuing both investment and debt policy. Besides that, it also has a possibility to declare
default if it foresees that further operations with foreign debt will lead to lower expected
future consumption compared to the predicted future consumption in “defaulted” state.
1
The price of the debt pt includes risk-free interest rate valid in international markets and a risk premium
associated with expected possibility of default


V R  st , K t , Bt   max u  Ct    Et  max V R  st 1 , K t 1 , Bt 1  ,V D  st 1 , K t 1 
Bt 1 , Kt 1
Ct  Y  st , K t   p  st , K t , Bt  Bt 1  K t 1  Bt   K t
s.t. 
Ct  0
(1.3)
Here Bt stands for the amount of foreign debt denominated in one-period maturity bonds,
which the country has to repay in period t. In turn, pt corresponds to equilibrium price of the
capital. It is determined as:
pt  p  st , K t , Bt    * Pr V R  st 1 , K t 1 , Bt 1   V D  st 1 , K t 1  
(1.4)
where investors discount future at the rate  * which corresponds to international market rate
(unlike government, which uses domestic rate  as a discount factor).
Another important restriction is a transversality condition, which should prevent
government from infinitely increasing debt stock:
lim  s  t Et  Bs   0
s 
(1.5)
Unfortunately Chamon does not provide solution of his model so we provide our own in
the numerical section.
.
Methodology section: the setup with introduced changes
The previous section described the setup developed by Chamon where government has
no option to come back to capital markets if it has ever defaulted. This section discusses the
suggested modifications which are added to the setup in order to capture the possibility for the
government to regain access to the international credit markets.
In terms of new model whenever the government declares its inability to serve foreign
debt the total value of its obligations is not equal to zero. Unlike previous section, where
defaulted sovereign bonds have zero value, in the modified setup there is still a chance that
the government will meet its commitments at least partially. Thus it is rationally to anticipate
the obligations to have non-zero expected value. In terms of real economic environment it
corresponds to the mechanisms of reselling the defaulted sovereign bonds. Consequently, the
setup alteration leads to more adequate pricing of the debt instrument.
Later on in this section it is shown which adjustments should be made in order to allow
the country to reenter the capital market. Beside the modifications of the government’s
objective function, certain changes should be made in the pricing of the sovereign bonds.
Now we start with the introduction of adjustments made in the government’s value
functions. The expression for the “repaying” state is nearly the same as in the original setup.
The only difference is the change in arguments of VR


V R  st , K t , Bt   max u  Ct    Et  max V R  st 1 , K t 1 , Bt 1  ,V D  st 1 , K t 1 , Bt 1 
Bt 1 , K t 1
Ct  Y  st , K t   p  st , K t , Bt  Bt 1  K t 1  Bt   K t
s.t. 
Ct  0
(2.1)
While modifying the value function of defaulted economy it is necessary to control for
the amount of sovereign debt.


V D  st , Kt , Bt   max u  Ct    Et  max V R  st 1 , K t 1 , Bt 1  ,V D  st 1 , K t 1 , Bt 1 
Kt 1
Ct  Y  st , K t   K t 1   K t , Ct  0
s.t. 
D
 Bt 1  1  r  1  1    I RD  Bt
(2.2)
1, st  st 1 , K t 1 , Bt 1   R and st  st , K t , Bt   D
where I RD  
0, otherwise
The stock of debt in the default state is growing with the constant rate rD. The values of
both interest rate rD and share of debt obligations remaining after negotiations  are obtained
as a result of optimization in (2.5).
Using the notation of the original setup pt in (2.1) measures the price of Bt+1 bonds and
each bond pays one unit of the consumption good at the end of period t+1. According to
Chamon this price equals to the probability for the economy to remain in the “repaying” state
over the infinite future multiplied by  * . This approach is also used in the modified version of
setup. However, there is an important difference. Due to nonzero recovery rate of defaulted
bonds the interpretation of price pt is extended to the probability of returning funds, invested
into government’s obligations over the infinite future times  *
pt  p  st , Kt , Bt    *  P  1  P  RR  st 1 , Kt 1 , Bt 1  
P  Pr V R  st 1 , Kt 1 , Bt 1   V D  st 1 , Kt 1 , Bt 1  
(2.3)
Here P stands for the probability of remaining in “repaying” state and RR corresponds to
expected recovery rate of the investments in case of default. pt can be interpreted as a liner
combination of “1” and RR times  * . Thus, if the probability of default is low (and
accordingly P is approaching 1) then pt is close to  * which corresponds to the risk-free rate.
Consequently, if the sovereign default hazard is high, P has a near zero value and pt is
approaching  * RR . which represent the price of defaulted obligations.
To be more precise recovery rate RR corresponds to the expected share of invested funds
which will be returned in case country comes back to the repaying state after default
declaration.
More formally it is expressed as
RR  st , K t , Bt  
PV D  st , K t , Bt 
Bt
(2.4)
where PVD denotes the expected present value of the debt obligations if government declares
inability to fulfill its obligations. The model tracks down all possible paths of county’s
development (for given r D and  ) over infinite future. The calculation of PVD is described
later in (2.5).
Using the terms exploited in game theory investors and government play a leaderfollower game after default declaration. On the first stage investors maximize the present
value of expected returns on defaulted obligations (2.5) with respect to r D and  taking into
account the response function of the government. Here r D stands for the interest rate
associated with the part of debt which will be subject to repayment in the future. In turn
( 1   ) corresponds to the fraction of debt stock which will be forgiven2. During the second
stage the government optimizes its policy function in autarky subject to constraints imposed
by investors. In other words r D and  are the exogenous parameters for the government.
Furthermore, it is presumed that while country stays in autarky it does not repay the
remaining debt which grows at the previously agreed fixed rate r D .
As a result of negotiations investors maximize the present value of the expected cash
flows at the moment of default declaration (PVD), which will be generated by the government
after reentering the capital market.
However, by assigning a high interest rate on the remaining debt investors decrease the
probability that the country will come back from the default state in the future. The same
tradeoff investors face while choosing between the share of debt which will be forgiven
( 1   ) and the probability of recovering from default in future.
Consequently, investor’s problem during the default negotiations is the following:

PV D  sT , KT , BT   max ,r D   * I DR  sT t sT  PV R  sT t , KT t , BT t 
t 1 sT  t
2
Should be added the reference to example of Argentina
t
(2.5)
subject to 0    1 and r D  0
where BT  t  BT  1  r D 
t
1, st  sT t 1 , KT t 1 , BT t 1   D and st  sT t , KT t , BT t   R
I DR  
0, otherwise
 R, V R  st , K t , Bt   V D  st , K t , Bt 
and st  st , K t , Bt   
 D, otherwise
here BT represents the amount of debt obligations in possession of investors at the moment of
default declaration (time T), in turn  stands for the share of the debt which remains in the
liabilities of the country. Consequently, BT  1  r D  corresponds to the amount of debt at the
t
time T+t in case country still remains in the default state. Naturally r D and  are assigned
new each time the default negotiations occur. However, in order to avoid over-complication
of formulas the time indices for r D and  are omitted.
PV R  st , Kt , Bt  is the present value of the debt obligations of a country, which operates
in the “repaying” state. It is equal to present value of the expected cash flows that will be
generated by the government as a result of debt service. Function st  st , Kt , Bt  denotes the
optimal state of the economy for a given capital and debt.
Expression   s t s0  in (2.5) reflects conditional probability of having a sequence of
shocks s t   st , st 1 ,
, s0  at time t, given the initial shock s0 at time 0. As was mentioned
earlier, productivity shock st in (1.1) follows the Markov chain properties. According to
Ljungqvist (2000) in one-period-ahead framework the  . .  function is defined as
  s ' s   Pr  st 1  s ' st  s  . At the same time, the probability of having the history of shocks
s t is conditional on initial shock s0 . To be more precise the probability of shock st at time t
can
be
written
recursively
over
the
history
of
shocks
  s t s0     st st 1    st 1 st  2    s1 s0  . Thus, according to expression (2.5) the present
value of debt obligations at the moment of default declaration equals to the sum of present
values of accumulated debt stock by the time of returning to capital markets (weighted by the
probability of these events and discounted at rate  * ).
Numerical section
This section mostly deals with the issues related to obtaining numerical solution of the
model. These topics include the description of the setup parameters continued by the
explanation of algorithm. After brief discussion of implementation of the programming the
section ends with the analysis of results. The code is created mainly in C++ and partially in
Matlab and is available upon request.
Model setup parameters
The exogenous parameters of the model are divided into two groups. The first covers the
utility function and production function characteristics. In turn the second group reflects the
Markov chain structure.
To be more precise the production function Y  st , Kt   st  f  Kt  previously described
in (1.1) is represented by Cobb-Douglas production function f  Kt   Kt , where  indicates
productivity of capital. In order to satisfy the decreasing returns to scale criteria  should be
belong to    0;1 interval.
For the numerical simulations the following parameters were chosen:
 = 0.25,  = 0.95,  * = 0.9,  = 10%
The Markov chain transition matrix:
The realization of st depends on state:
Pr  st 1 st 
st 1  good
st 1  bad
Shock, st
In repaying state
In default state
st  good
.80
.20
st  good
1.0
0.4
st  bad
.30
.70
st  bad
0.3
0.3
The condition  *   implies that it is relatively costly to borrow as the external
interest rate associated with  * is higher than the domestic interest rate (in case the economy
is far from switching to default state and thus the lending risk is negligible).
Another important issue is the calculation of the expectation of next period economy’s
value. Due to the timing of the model, country has to make decision concerning the next
period state before the corresponding shock is realized. Thus it considers the average of next
period value functions weighted by the probability. Formally it is expressed as
EtV i  st 1 Kt 1 , Bt 1   V i  st 1 , Kt 1 , Bt 1   Pr  st 1 st , i R, D
st 1
Description of solution
The implementation of the model was not trivial due to the self-fulfilling properties of
agents’ behavior. Thus the equilibrium of original model is based on the price system (which
is the system of investor’s beliefs) and the policy of the government in repaying state. The
modified setup has one more category: government’s policy in default state, which is
mutually dependent with previous two.
For all stages except for recovery rate calculation the software used linear discrete space
for both capital and debt. The domain was divided into 50x50 combinations of K and B for
each state of government’s policy (repaying and default).
Thus, the first (the original setup) stage aims to solve the equation (1.2), which reflects
the behavior of the government in default state in the original setup. The numerical solution is
straightforward as it does not involve any self-fulfilling features. The value function VD is
used during later stages of calculation.
The second stage (the original setup) solves the equation (1.3), which requires formation
of the price system pt, according to conditions provided in (1.4). Thus, after initializing pt
with  * (which corresponds to 100% probability of remaining in repaying state) the iteration
cycle is constructed in the following way:
a)
Initialize/update
policy
functions
Kt 1  K  st , Kt , Bt  , Bt 1  B  st , Kt , Bt  ,
policy function which indicates whether country will be in repaying or default
state
in
t+1
period
Wt 1  W  st , Kt , Bt  {R, D}
and
value
function
V R  st , Kt , Bt  .
b)
Find locations
 st , Kt , Bt  ,
for which V R  st , Kt , Bt   V D  st , Kt , Bt  . Assign
initial p  st , Kt , Bt  with  * for these locations.
c)
Using policy functions K, B, W, obtained in step a) it is possible to track the
potential paths of economies evolution. Thus we can calculate the default
probability over more than one period ahead. By recursive iterations we obtain
the invariant system of prices (which corresponds to the equation (1.4)).
d)
If the computed set of prices or value functions are significantly different from
those used in step a) then we need to start over the cycle from step a).
After a number of iterations the model converges to equilibrium, for which the
following conditions are held:

Both country and investors maximize their utility and profit respectively.

Government’s policy functions K, B and W are the best response to the calculated
price system p.

The price system p achieved as a result of iterations is the best reaction to the obtained
government’s policy functions K, B and W.

No counterpart may deviate from chosen strategy without reducing its gains.
The price system looks as follows. On the horizontal axes debt/GDP is counted whereas
vertical axes reflects the probability of VR>VD for corresponding debt/GDP observations.
1
R
D
Prob(V > V )
Good shock
Default state
Repaying state
0.5
0
30
40
50
60
debt/GDP
Bad shock
70
80
90
100
50
60
debt/GDP
70
80
90
100
1
R
D
Prob(V > V )
20
Default state
Repaying state
0.5
0
20
30
40
On the third stage of calculations the task is to compute the policy functions and price
system associated with the modified setup.
a)
Initialize/update
policy
functions
Kt 1  K  st , Kt , Bt  , Bt 1  B  st , Kt , Bt  ,
policy function which indicates whether country will be in repaying or default
state
in
t+1
period
Wt 1  W  st , Kt , Bt  {R, D}
and
value
function
V R  st , Kt , Bt 
b)
Find locations
 st , Kt , Bt  ,
for which V R  st , Kt , Bt   V D  st , Kt , Bt  . Assign
initial p  st , Kt , Bt  with  * for these locations. Keep already calculated
recovery rates.
c)
Compute NPV for investors for each possible combination of Kt and Bt.
d)
Find the RR by solving optimization problem for government in exponential
space (as opposed to usual linear presentation).
e)
Using policy functions K, B, W, obtained in step a) it is possible to track the
potential paths of economies evolution. Thus one can estimate the default
probability over more than one period ahead. By recursive iterations we obtain
the invariant system of prices (which corresponds to the equation (2.3)).
f)
If the computed set of prices or value functions are significantly different from
those used in step a) then we need to start over the cycle from step a).
The following graph represents the distribution of recovery rates as a function of (K,B)
pair. The graph has similar notations except for the meaning of the red line. It stands for the
recovery rate instead of the probability of remaining in the repaying state.
1
R
D
Prob(V > V )
Good shock
0.5
Default state
Repaying state
40
50
60
70
debt/GDP
Bad shock
80
90
100
60
70
debt/GDP
80
90
100
1
R
D
Prob(V > V )
0
30
0.5
Default state
Repaying state
0
30
40
50
After extensive computations the model converges to equilibrium, for which the following
conditions are held:

Both country and investors maximize their utility and profit respectively.

Government’s policy functions K, B and W are the best response to the computed price
system p.

The price system p achieved as a result of iterations is the best reaction to the obtained
government’s policy functions K, B and W.

No counterpart may deviate from chosen strategy without reducing its gains.
In order to examine the welfare effect of exhibiting different types of shock we proceed
with the simulations of country’s behavior. Let’s assume that the country has equal chances of
starting at any combination of K and B (the probability is uniformly distributed over domain).
Then the probability that after substantially large number of periods the economy will have
certain value is the following:
Good shock
15
Modified setup
Original setup
10
Lambda
5
0
28
15
29
30
31
32
33
Value fn
bad shock
34
35
36
37
32
33
Value fn
34
35
36
37
Modified setup
Original setup
10
Lambda
5
0
28
29
30
31
As we see on the graph, the shape of the distribution does not differ significantly in
original comparing with modified model (average consumption increased by approximately
7% for both realizations of shock). However, for provided setup parameters and size of
domain the number of (K,B) states which has access to international market has virtually
doubled. Although the precise number is the function of the parameters, this outcome
supports the importance of reducing coordination failure among investors through e.g.
providing guarantees of repurchasing defaulted bonds or aiding in debt restructuring. Another
inference from the obtained result is importance of international financial organizations in
reducing the possibility of investors’ panic by facilitating negotiation processes between the
government and investors in near crisis situations.
Concluding remarks
Our setup provides analytical framework for analysis of investors’ self-fulfilling
behavior in the case government has a possibility of coming back to capital markets after
default declaration. The recent example of Russia (1998) proves that the country may return
quite soon. We show that the phenomenon of returning can be modeled using stochastic
recursive general equilibrium setup. On the one hand such analysis can aid investors in more
adequate pricing of the sovereign obligations. On the other hand government may adjust its
policy using the inferences of the provided framework. Thus based on the outcomes of our
model investors should perceive wider range of economy states as those which are not leading
to default. However, at the same time taking into account the opportunity to reenter the
international capital markets government can strategically default (with the intention to come
back later) in order to smooth consumption and avoid social crisis. Moreover, our results
underline the role of international financial institutions. In near crises situations they are able
to influence investors’ beliefs by both insuring risky debts and participation in the
negotiations on debt rescheduling.
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