Download This PDF is a selection from a published volume from... of Economic Research Volume Title: NBER International Seminar on Macroeconomics 2012

This PDF is a selection from a published volume from the National Bureau
of Economic Research
Volume Title: NBER International Seminar on Macroeconomics 2012
Volume Author/Editor: Francesco Giavazzi and Kenneth D. West,
organizers
Volume Publisher: University of Chicago Press
Volume ISBN: 978-0-226-05313-4 cloth; 978-0-226-05327-1 paper;
0-226-05327-X paper
Volume URL: http://www.nber.org/books/giav12-1
Conference Date: June 15-16, 2012
Publication Date: August 2013
Chapter Title: Comment on "Banks, Sovereign Debt and the International
Transmission of Business Cycles"
Chapter Author(s): Marius Jurgilas
Chapter URL: http://www.nber.org/chapters/c12788
Chapter pages in book: (p. 219 - 222)
Comment
Marius Jurgilas, Norges Bank
Usually considered the safest investment, and in most cases given the
highest mark of quality, the AAA rating, sovereign debt is subject to
nonnegligible sovereign default risk. According to Sandleris (2012), in
the last 30 years there have been 116 instances of sovereign defaults
with private creditors and 269 instances with official creditors. With
financial globalization increasingly a substantial part of government,
bonds are held by foreign entities. Thus while sovereign default may
come at a cost to the defaulting country, it may also have a significant
impact on the economies of the other countries as well.
The international sovereign default contagion channel put forward
is very simple. Foreign intermediaries that have invested in the debt
of defaulting sovereign have to deleverage to meet binding capital requirement. Thus the cost of external finance for firms in the other country may be affected, leading to comovements in economic fluctuations.
The paper by Guerrieri, Iacoviello, and Minetti tries to quantify this
contagion channel. More specifically, the model economy is calibrated
to simulate the impact of a sovereign default in the European Periphery (Greece, Italy, Portugal, and Spain) on the rest of the Core Europe
(euro area countries together with United Kingdom and Switzerland).
The key takeaway number is that a sovereign default of 10 percent of
Periphery GDP translates into a half of a percent drop in GDP in the
Core after two years.
The empirical literature on the costs of sovereign default faces the difficulty to discern costs due to default and costs due to the initial shock
that caused default. The second contribution of Guerrieri, Iacoviello,
and Minetti is that the model employed allows to make such separation.
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220
Jurgilas
It is a real economy model of two countries, subject to several financial frictions. Financial intermediaries as well as intermediate good
producers are subject to capital requirements, while period-by-period
revenue maximizing government is subject to a borrowing limit. It is
only financial intermediaries that can hold cross- border assets (i.e.,
government bonds), although intermediaries are not allowed to have
cross-border liabilities or lend to foreign firms. Finally, all agents face
quadratic adjustment costs, which allows for smoothness in adjustments to shocks.
Financial intermediaries extend loans to entrepreneurs and invest in
sovereign debt. But unlike one would expect, loans to entrepreneurs are
riskless, while it is the government debt that is subject to default risk.
Still, it is lending to entrepreneurs that draws a capital surcharge for the
intermediaries, while government bonds have a risk weight of zero. But
it is not immediately obvious that making risk weights consistent with
the risks implied by the modeling assumptions would have a significant effect on the main results.
Government may choose to default on its debt, if it finds beneficial
to do so. The key trade-off is whether a lower borrowing limit due to
default is outweighed by an increase in period consumptions due to
lower debt repayment. Importantly, a simplifying assumption is that
there is no dynamic consideration as to how sovereign default would
affect government’s consumption in the future. Which may seem to be
a reasonable assumption given the empirical regularity that a sovereign
default is almost always followed by a change in political power.
It is important to stress that the paper estimates the marginal effect
of the government’s decision to default or not, on top of the negative
effects of the initial perturbation. This being a real economy model,
the shock possibly triggering an endogenous default is a productivity
shock. A negative productivity shock lowers endogenous borrowing
limit, and thus the threat of not being able to issue debt becomes less
important compared to the fixed default benefit. Thus there always exists a large enough productivity shock that will lead to endogenous
default.
But how good is this simplification reflecting the reality? Was it the
case that Greece, Italy, Portugal, and Spain experienced a sizable productivity shock? Eyeballing the situation, it did not seem so. Over the
last decade, the Periphery has not shown extremely bad economic performance, nor has the debt grown to extreme levels. Not at least if extremes are measured by taking Japan as a scaling factor.
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Comment
221
Shock identification is beyond the scope of this paper, but future
research could extend the list of possible candidate shocks that could
trigger or, more importantly, lead to sovereign default situations. Currency overvaluation/undervaluation comes to mind. One could also
investigate if troubles in the Periphery were not precipitated by similar
issues in the Core just several periods earlier. This would be in line
with the results of the paper, that a negative productivity shock in one
country block, absent default, has a positive impact on growth in the
other country block and thus an increased borrowing limit. If the story
is about relative productivity, it must be noted that at least some countries that are in the Periphery group consistently experienced economic
growth rates well above euro area averages up until 2007.
The default in the Guerrieri, Iacoviello, and Minetti paper is never
unavoidable. Actually, the assumptions of the model make it look as if
a rough government takes a unilateral decision that puts all domestic
agents at a disadvantage. Or put differently, everybody, except for the
government, is better off if default does not take place. And besides
the government’s objective to maximize consumption, there does not
seem to be any reason for default to take place. This is puzzling. One
would expect a sovereign default to be the last resort action, especially
given large costs of sovereign defaults. But even just the strategic notion
of government default may look suspicious to a layman policymaker
reading the paper.
So does it make any sense? Yes, probably, but with a bit of additional
interpretation. While the Core of Europe would like to think that current government expenditure in the European Periphery is fully flexible, it may not exactly be the case. Thus, consistent with the model, a
significant cut in the debt issuance limit may push the government into
the default region, simply because it cannot scale back planned expenditure, and default is the only way to improve the cash flow. In terms of
the model, there could be a significant implicit government expenditure
adjustment cost.
The international transmission channel of the sovereign default identified by the authors and elaborated in the model is clean. But judging
the quantification of the impact, is a bit more difficult. Mostly because
of the abstraction level. The model economy assumes away any crossborder interbank exposures. A recent report by Allen et al. (2011) exposes the importance of cross-border banking in Europe. It is difficult
to assess how important contagion via interbank network may be, compared to contagion via cross holdings of the sovereign debt.
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222
Jurgilas
We should also consider the possibility of the effects of a sovereign
default to be overestimated. As pointed out by the authors, Yeyati and
Panizza (2011) find that a sovereign default actually marks the beginning of the recovery in the country that defaults. Thus, debt restructuring in case of a country in a debt overhang situation may be a preferred
way forward even from the European Core perspective. Especially if
it is evaluated from a supranational point of view. But as shown by
Aguiar, Amador, and Gopinath (2009), the answer is not trivial.
The model economy is also silent on the safe haven considerations
that may arise. Especially if the Core Europe may never default (as is
assumed in the model). An expectation of a sovereign default in the
Periphery has pushed down the sovereign borrowing costs of the likes
of Germany quite substantially, while European Core financial intermediaries are on the receiving end of the capital flight from the Periphery.
This must have at least some counterbalancing effect.
To conclude, the paper tackles a very relevant issue and makes a valuable contribution to the literature by pushing forward our understanding of the cross-border impacts of sovereign defaults. But it is up to the
individual reader to decide if half a percent drop in GDP is something
to worry about, or if there is more to the story and the cost obtained by
the paper reflects only part of it.
Endnote
The views expressed herein are those of the author and do not necessarily reflect the views
of Norges Bank. For acknowledgments, sources of research support, and disclosure of the
author’s material financial relationships, if any, please see http://www.nber.org/chapters
/c12788.ack.
References
Aguiar, M., M. Amador, and G. Gopinath. 2009. “Investment Cycles and Sovereign Debt Overhang.” Review of Economic Studies 76 (1): 1–31. http://ideas.repec
.org/a/bla/restud/v76y2009i1p1-31.html.
Allen, F., T. Beck, E. Carletti, P. Lane, D. Schoenmaker, and W. Wagner. 2011.
Cross-Border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies. London: Centre for Economic Policy Research. http://www
.cepr.org/pubs/books/P223.asp.
Sandleris, G. 2012. “The Costs of Sovereign Defaults: Theory and Empirical Evidence.” Business School Working Paper no. 2012-02. Universidad Torcuato
Di Tella. http://ideas.repec.org/p/udt/wpbsdt/2012-02.html.
Yeyati, E. L., and U. Panizza. 2011. “The Elusive Costs of Sovereign Defaults.”
Journal of Development Economics 94 (1): 95–105. http://ideas.repec.org/a/eee
/deveco/v94y2011i1p95-105.html.
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