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1 What are the economic costs of sovereign default, in theory and in practice? Would international debtor countries benefit from a reduction in the cost of default?

1 What are the economic costs of sovereign default, in theory and in practice? Would international debtor countries benefit from a reduction in the cost of default?

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An essay for the 2012 Undergraduate Awards (International Programme) Competition by Michael Bottjer. Originally submitted for Applications of Economic Analysis at University of Edinburgh, with lecturer Stuart Sayer in the category of Business & Economics
An essay for the 2012 Undergraduate Awards (International Programme) Competition by Michael Bottjer. Originally submitted for Applications of Economic Analysis at University of Edinburgh, with lecturer Stuart Sayer in the category of Business & Economics

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Published by: Undergraduate Awards on Aug 31, 2012
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01/06/2014

 
Exam No. 24360471
What are the economic costs of sovereign default, in theory and in practice? Wouldinternational debtor countries benefit from a reduction in the cost of default?
 
Abstract
This essay outlines potential economic costs that may arise from sovereign default boththeoretically and in practise, honing in on literature over the past 30 years covering capitalmarket exclusion, international trade and domestic costs. With regards to capital marketexclusion it finds little evidence to support extensive periods of capital market exclusion.Secondly it finds inconclusive evidence with regards to international trade, given the failureto determine the channel through which trade affects default. It looks at domestic coststhrough GDP growth, failing to determine the direction of causality between trade anddefault, and also bank crises which exacerbate the automatic consequences. Lastly, it uses asimple model to show that policy intervention by some representative of the internationalfinancial community can reduce the costs to default and bring welfare benefits to the debtorcountry.The abundance of economic literature based on the costs of sovereign default is due to theapparent absence of simple legal mechanisms by which creditors can enforce the repaymentof debt. Panizza, Sturzenegger and Zettelmeyer (2005, p.2) draw attention to the fact thatalthough there exists such legal penalties and remedies they are very limited relative to thelaws governing the corporate world. Therefore why do debtors repay? This essay concerns
 
Exam No. 24360472
itself with such analysis by researching the possible costs faced by sovereign default boththeoretically and in practise. It begins by honing in on the literature covering capital marketexclusion, international trade, and domestic costs finding, in general, these costs to be short-lived. Thereafter we explore whether a reduction in the cost of default would benefit thedebtor, and find it possible, in theory, providing policy intervention is carefully constructed.Eaton & Gersovitz (1981) produce a theoretical model in which preservation of future capitalmarkets access is adequate to prevent default. Notable assumptions in this model are outputcannot be stored and default is punished by permanent capital market exclusion. In the modelincome is stochastic and utility from consumption in each period is represented by a constantrelative risk aversion utility function, hence consumption smoothing is preferred by thecountry. Countries smooth consumption by borrowing in low income periods and repayingtheir debt in high income periods. The debtors default in the event that the present value of utility without consumption smoothing is greater than with. Lenders, knowing this, set anupper credit ceiling that is determined by their expectations of the cost in reduction of utilityfrom exclusion of credit markets (Stahler, 2011, p. 8).The assumption of permanent market exclusion is time inconsistent, due to the potentialbenefits in renegotiating the debt the creditor foregoes. The debtor anticipating this,understands punishment isn't a credible threat and the sub-perfect Nash equilibrium is defaultwith no punishment (Panizza, Sturzenegger, & Zettelmeyer, 2009, p. 10). With this in mindEaton and Gersovitz (1981, p. 304) conclude by identifying a key elaboration to the model,the use of an endogenous period of exclusion variable and analysis of its length. Grossmanand Huyck (1988) instead relax the assumption of permanence, and use a contingent service
 
Exam No. 24360473
model in which there exists an equilibrium in which the debtor defaults. The key difference inthis model is that lenders distinguish between excusable and unjustifiable default. Default isdeemed excusable in periods of low income and is usually partial, a country only repudiatesin the worst state of the world. They conclude that excusable default does not exclude thepossibility of continued access to loans. Unjustifiable default, default in normal/good periods,results in long-run costs characterised by a loss in trustworthy reputation (Grossman & VanHuyck, 1988, p. 20). The model therefore suggests we should observe very little, in fact 0 inequilibrium, in the sense of reputational costs given countries never unjustifiably default.This cannot be taken literally and as we will see in practise there is some opposing evidence.Richmond and Dias (2008, p.6), through empirical analysis of defaults from 1980-2005, findthat on average it takes 5.5 years to achieve partial re-access to capital markets, defined aspositive net bond and bank transfers to the public or private sector. Additionally, if defaultwas preceded by a natural disaster there are substantial reductions in capital marketexclusion, lending some support to the idea of excusable default (Richmond & Dias, 2008, p.11). Despite these findings, upon looking at figure 1, we see there was a general decreasingtrend in private capital flows collectively before default, posing a possible problem indetermining the direction of causality. Fuentes and Saravia (2006) find that the followingdefault the debtor faces a reduction in FDI inflows originating solely from those involved inthe renegotiation. This lends support to the idea that capital market exclusion is indeed aconsequence of default. Given the evidence we conclude that capital market exclusion istransitory at best.

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