Introduction

Theory

Results

Conclusion

Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation Sergey V. Popov

David Wiczer

1 Department

of Economics University of Illinois

2 Department

of Economics University of Minnesota

8 July 2010

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Stylized Facts

Countries default (250 default episodes in 106 countries since 1824, according to Tomz(2007)). After default, country’s currency is depreciating (De Paoli and Hoggarth (2006)).

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Stylized Facts: Currency Depreciates

Paraguayan Default Foreign Currency/Home(normalized)

1 0.95

NEER REER

0.9 0.85 0.8 0.75 0.7 2002

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

2003

UIUC and UM

Introduction

Theory

Results

Conclusion

Stylized Facts: Currency Depreciates Ukrainian Default Foreign Currency/Home (normalized)

1 0.95

NEER REER

0.9 0.85 0.8 0.75 0.7 0.65 1998

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

1999

UIUC and UM

Introduction

Theory

Results

Conclusion

Defaults Examples

∆ rGDP ∆ LCU/USD ∆ REER Ukraine, 1998 0.05% 59.32 % 78.88 % 30.20% 84.70% Argentina, 2001 -10.56% Paraguay, 2003 0.38% 86.72% 91.17% Egypt, 1984 2.67% 100% 71.16% Russia,1998 -6.41% 27.66% 68.79% ∆ rGDP is the change of real GDP. ∆ LCU/USD is the change of nominal exchange rate. ∆ REER is the change of real effective exchange rate.

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Stylized Facts

Countries default. After default, country’s currency is depreciating (De Paoli and Hoggarth (2006)). Is it purely nominal effects and financial flows? We want to show Terms of Trade penalty explains it, and more.

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Stylized Facts

Countries default. After default, country’s currency is depreciating (De Paoli and Hoggarth (2006)). Is it purely nominal effects and financial flows? We want to show Terms of Trade penalty explains it, and more.

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Modeling The Default We want: countries borrow until threshold, default if borrowed too much. Bulow and Rogoff (1989): temporary exclusion from credit markets does not return acceptable borrowing. Arellano (2008): exclusion plus progressive penalty on income returns acceptable borrowing. Aguiar and Gopinath (2007): exclusion plus proportional penalty on income with persistent shocks returns acceptable borrowing. Chatterjee and Eyigungor (2009): need long-term borrowing for proper borrowing threshold behavior. All have no explanation for international trade changes. Tomz (2007): 40% of defaults are after positive income shocks. Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Modeling The Default We want: countries borrow until threshold, default if borrowed too much. Bulow and Rogoff (1989): temporary exclusion from credit markets does not return acceptable borrowing. Arellano (2008): exclusion plus progressive penalty on income returns acceptable borrowing. Aguiar and Gopinath (2007): exclusion plus proportional penalty on income with persistent shocks returns acceptable borrowing. Chatterjee and Eyigungor (2009): need long-term borrowing for proper borrowing threshold behavior. All have no explanation for international trade changes. Tomz (2007): 40% of defaults are after positive income shocks. Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Trade Disruptions

Gross change Mean 20% Q 40% Q Median 60% Q 80% Q

NEER 0.8492 0.6835 0.8729 0.9102 0.9505 1.0168

REER 0.8900 0.7861 0.8688 0.9220 0.9429 0.9755

Export Prices 0.9184 0.8291 0.8984 0.9075 0.9269 1.0068

I/Y 0.8968 0.7773 0.8978 0.9211 0.9436 1.0070

Note: Exchange rate listed as foreign goods per home currency unit. IMF’s IFS database; defaulters since 1975, as identified by Standard&Poor’s (2003) research report by Beers and Chambers.

Table: One year effect of sovereign default.

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Default Disrupts Trade

Rose (2005): default reduces international trade volume by 8%. Arteta and Hale (2008): private firms cannot find international credit. In the 1861 Mexican default, creditors actually seized the port of Veracruz (see Todd (1991)). Hummels (2001): a day of procrastination adds 1% to real costs.

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Default Disrupts Trade

Rose (2005): default reduces international trade volume by 8%. Arteta and Hale (2008): private firms cannot find international credit. In the 1861 Mexican default, creditors actually seized the port of Veracruz (see Todd (1991)). Hummels (2001): a day of procrastination adds 1% to real costs.

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Mechanism

Country can default. If default happens, lenders can make imports costlier. Thus, others being equal, price of foreign goods goes up. Questions are: How would that affect consumption and imports? Is trade channel penalty a good default deterrent? How robust are predictions?

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Mechanism

Country can default. If default happens, lenders can make imports costlier. Thus, others being equal, price of foreign goods goes up. Questions are: How would that affect consumption and imports? Is trade channel penalty a good default deterrent? How robust are predictions?

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

The Environment Country is represented by an infinitely-lived agent. Every period, agent has y - endowment for this period. b - borrowed amount that agent needs to repay. status of "being punished" or not.

Agent chooses whether to default on total borrowed amount or not. If agent defaults, she cannot borrow gets less import for his or her export stays punished next period with probability φ

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

The Environment Country is represented by an infinitely-lived agent. Every period, agent has y - endowment for this period. b - borrowed amount that agent needs to repay. status of "being punished" or not.

Agent chooses whether to default on total borrowed amount or not. If agent defaults, she cannot borrow gets less import for his or her export stays punished next period with probability φ

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

How People Trade?

Agent has home production. Other countries like it. Agent trades home production for production of abroad (import). m = f (x) If agent defaults, she has worse terms of trade. m = (1 − π)f (x)

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

How People Trade?

Agent has home production. Other countries like it. Agent trades home production for production of abroad (import). m = f (x) If agent defaults, she has worse terms of trade. m = (1 − π)f (x)

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

How People Trade?

Agent has home production. Other countries like it. Agent trades home production for production of abroad (import). m = f (x) If agent defaults, she has worse terms of trade. m = (1 − π)f (x)

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

How Penalty Affects Exchange Rate?

Imports

Normal Trade Penalized

e

e

Disposable Income

Domestic Goods

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

The Model - Don’t Default

U(y, b) = max(V (y, b), W (y)) V (y, b) = max u(c, m) + βEU(y ′ , b′ ) c,b′ ,m,x

s.t. c + x = y − b + q(y, b′ )b′ m = f (x) ln y ′ = ρ ln y + ǫ, ǫ ∼ N (0, s 2 )

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

The Model - Default

U(y, b) = max(V (y, b), W (y)) W (y) = max u(c, m) + βE φW (y ′ ) + (1 − φ)EU(y ′ , 0) c,x,m



s.t. c+x =y m = (1 − π)f (x) ln y = ρ ln y + ǫ, ǫ ∼ N (0, s 2 ) ′

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

The Model - Borrowing

There is an infinite supply of lending. It has interest rate of R. Lenders have to account for probability of default. Default-adjusted price of debt is q(y, b′ ) =

P (V (y ′ , b′ ) > W (y ′ )|y) 1+R

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

The Model - Borrowing

There is an infinite supply of lending. It has interest rate of R. Lenders have to account for probability of default. Default-adjusted price of debt is q(y, b′ ) =

P (V (y ′ , b′ ) > W (y ′ )|y) 1+R

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Base Parameters

Arellano (2008) calibrations: Name Risk aversion Risk-free interest Autocorrelation Variance Discount factor Prob of staying punished

Parameter σ R ρ s2 β φ

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

Value 2 0.017 0.985 0.026 0.953 0.718

UIUC and UM

Introduction

Theory

Results

Conclusion

Utility Function Aggregate consumption is u(c, m) = (αc κ + (1 − α)mκ )1/κ Based on INDEC and European Bank data, regressions of Argentina time series: Name Relative preference Elasticity parameter

Parameter α κ

Value 0.586 0.845

Lifetime utility is a usual CRRA-based vNM utility function.

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Our Import-Export Mechanism Production function is m = θ1 (x − θ0 )θ Based on INDEC and European Bank data, regressions of Argentina time series: Name Fixed costs Scale Curvature Import penalty

Parameter θ0 θ1 θ π

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

Value 0.047 0.196 0.208 0.500

UIUC and UM

Introduction

Theory

Results

Conclusion

Predictions: Countercyclical Exchange Rate 1.3 1.25

exchange rate, level

1.2 1.15 1.1 1.05 1 0.95 0.9 0.5

Good standing Default 1

1.5

2

y Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Predictions: Countercyclical CA 0.02 0

current account, level

−0.02 −0.04 −0.06 −0.08 −0.1 −0.12 −0.14 −0.16 −0.18 0.5

Good standing Default 1

1.5

2

y Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Penalty: Borrowing Threshold 0.5 0.45

borrowing limit, fraction of y

0.4 0.35 0.3

π=0.2 π=0.5 π=0.8

0.25 0.2 0.15 0.1 0.05 0 0.5

1

1.5

2

y Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Penalty: Exchange Rates 1.4

exchange rate depreciation

1.35 1.3 1.25 π=0.2 π=0.5 π=0.8

1.2 1.15 1.1 1.05 1 0.5

1

1.5

2

y Sergey V. Popov, David Wiczer

Notice: we were not calibrating to that!

Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Penalty: Consumption

domestic good consumption, fraction of y, after default

0.98

0.96

0.94 π=0.2 π=0.5 π=0.8 Before default

0.92

0.9

0.88

0.86

0.84 0.5

1

1.5

2

y Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

expenditure on imported good, fraction of y, after default

Penalty: Consumption of Imports 0.16 0.14 0.12 0.1

π=0.2 π=0.5 π=0.8 Before default

0.08 0.06 0.04 0.02 0 0.5

1

1.5

2

y Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Comparative Statics: Limits 0.45

borrowing limit, fraction of y

0.4 0.35 0.3 Benchmark α smaller

0.25

2

s bigger φ bigger

0.2 0.15 0.1 0.05 0.5

1

1.5

2

y Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Comparative Statics: Exchange Rates 1.16

exchange rate depreciation due to default

1.158 1.156 1.154 Benchmark α smaller

1.152

s2 bigger φ bigger

1.15 1.148 1.146 1.144 1.142 0.5

1

1.5

2

y Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

What Governs Exchange Rates? 1.28 Baseline Smaller κ Bigger θ

exchange rate depreciation

1.26

1.24

1.22

1.2

1.18

1.16

0.5

1

1.5

2

y Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Introduction

Theory

Results

Conclusion

Summing Up

Real reasons for exchange rate fluctuations are significant. We offer a sovereign default model with explicit international trade. We have a pretty good fit without calibration. Predictions of statics are coherent with common sense. Trade is important when making predictions about default decisions.

Sergey V. Popov, David Wiczer Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

UIUC and UM

Equilibrium Sovereign Default with Endogenous Exchange Rate ...

Jul 8, 2010 - REER is the change of real effective exchange rate. Sergey V. Popov .... Is trade channel penalty a good default deterrent? .... It has interest rate of R. Lenders have ... Based on INDEC and European Bank data, regressions of.

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