Commodity Prices and Sovereign Default: A New Perspective on The Harberger-Laursen-Metzler Effect

Paulina Restrepo-Echavarria, Enrique Mendoza and Franz Hamann

No 806, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: This paper documents the main facts about the relationship between country risk and default episodes in oil producing economies. We find that oil prices are strongly negatively correlated with risk premia. Furthermore, the ability to extract oil, which enhances a country's ability to repay reduces risk premia, while countries with a large stock of oil reserves exhibit higher risk premia. The latter reflects the fact that having a large stock of oil increases a country's outside option, augmenting the probability of default. We develop a small open economy model, where there is a sovereign government who owns a stock of oil and delegates extracting activities to an oil producing company. The sovereign can trade non-state contingent bonds with risk neutral competitive foreign lenders in international financial markets and cannot commit to repaying its debt. We show that the model can rationalize the empirical findings and explore the following questions: How does the introduction of default risk affect the correlation between the trade balance and terms of trade? How does it affect the co-movement between that correlation and the persistence of terms of trade shocks? What happens in the model if we do conditional versus unconditional comparisons to evaluate this relationship?

Date: 2016
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