Essays on Sovereign Default

Abstract

This dissertation consists of three chapters on sovereign default. Thematically, they are linked by their examination of how sovereign risk influences government policy, equilibrium allocations, and welfare. Chapter 1 investigates the optimal currency denomination in sovereign bonds. Chapter 2 and 3 delve into self-fulfilling debt crises. The first chapter explores how governments in emerging economies optimally manage the currency denomination of sovereign debt. Empirically, I show that governments in inflation-targeting emerging countries tilt their borrowing towards foreign currency when expected inflation rises - a time when it is riskier to borrow in foreign currency, as domestic local currency is likely to devalue. I construct a New Keynesian model with inflationary default risk, where governments trade off containing distortionary inflation via foreign currency debt with consumption insurance via local currency debt. The model indicates that inflationary default risk is the primary factor driving governments to tilt their external borrowing towards foreign currency when expected inflation rises. I show that expectations of inflationary default risk explain a significant portion - approximately 37 percentage points - of foreign currency borrowing in Colombia. The second chapter is joint work with Giancarlo Corsetti. We investigate the role of reserve accumulation in averting self-fulfilling debt crises stemming from post-auction uncertainty about repayment. Through reserve accumulation, inter-temporal consumption smoothing improves and the government eliminates post-auction uncertainty at low costs. Our analysis helps to explain why governments hold large amounts of reserves without reducing them substantially in economic downturns - quantitatively, up to 3.0% of GDP if debt is short term, or 2.2% if debt maturity is long, as long bond maturities mitigate vulnerability to self-fulfilling debt crises. The third chapter, another collaborative work with Giancarlo Corsetti, explores self-fulfilling debt crises arising from inter-temporal concerns about debt repayment. We show that such concerns lead to either a loss of market access at high debt levels, or hikes in borrowing costs at intermediate debt levels. Moreover, our analysis reveals that the government generally prefers accumulating debt to deleveraging when confronted with the risk of encountering inter-temporal concerns of the bond market. These findings stand in sharp contrast to self-fulfilling debt crises resulting from concerns about post-auction default, where a loss of market access may occur at low debt levels and the welfare benefits from deleveraging instead dominate.