Constrained efficient borrowing with sovereign default risk

Juan Hatchondo, Francisco Roch and Leonardo Martinez

No 899, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: We propose a tractable algorithm for solving quantitative models of sovereign default with constrained efficient borrowing (i.e., with commitment to a borrowing policy but not to a default policy). Our algorithm utilizes the government's optimality condition that, compared to the Markov condition, only requires one additional state variable that summarizes the effect of current borrowing on past consumption. Comparing the simulations of the model with and without commitment, we find that the overindebtedness chosen by the Markov government is small but accounts for most of the default risk. Higher bond prices with commitment imply that the Markov government is overindebted but underborrows. These results underscore the importance of governments' efforts to limit their future policies with fiscal rules and independent fiscal councils. Commitment does not affect significantly the procyclicality of fiscal policy, which casts doubts on the emphasis on countercyclical fiscal policy in existing fiscal rules. The government may commit to debt buybacks, showing that such policies may be part of optimal deleveraging plans. Our algorithm could be extended to study other aspects of debt management in which time inconsistency plays a role.

Date: 2019
New Economics Papers: this item is included in nep-dge
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Related works:
Working Paper: Constrained Efficient Borrowing with Sovereign Default Risk (2022)
Working Paper: Constrained Efficient Borrowing with Sovereign Default Risk (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed019:899

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