Sovereign Default Risk with Stochastic Risk-free Interest Rates
Abstract: The debt level in advanced economies has vastly increased over the last two decades thanks to the era of risk-free bonds with low interest rates. But this era may be over as the Fed and the ECB have been targeting higher interest rates, increasing the cost of borrowing. Will the governments be able to sustain their high debt level? To analyze the effect of rising `risk-free' interest rates on the accumulation of debt and probability of default, we entertain the excusable default model with stochastic risk-free interest rates. We calibrate the model to the debt crisis in Greece, and document the following: (1) When risk-free interest rate is low, the optimizing sovereign increases debt at more rapid rate due to lower cost of borrowing than when high risk-free interest rate prevails. (2) But an increase in risk-free interest rate leads to higher probability of default, when accompanied with high level of debt. An increase in risk-free interest rate lowers a sovereign's ability to pay due to higher discount rate and this may put the sovereign in near crisis position. Our findings suggest that in the midst of increasing interest rates, highly indebted economies may experience default due to a decreasing ability to pay.
The Greek Debt Crisis: Excusable vs. Strategic Default (with Betty C. Daniel) - (Replication files) (Older WP version)
Journal of International Economics, Vol.138, September 2022, 103632
Abstract: The Greek debt crisis revealed that sovereign default is not limited to emerging and developing countries. Can we take the strategic default model, developed for emerging markets, and recalibrate it to explain the crisis in Greece? The Greek economy differs from an emerging market in having higher government debt relative to GDP, counter-cyclical government debt, and consumption smoother than income. Our recalibrated strategic default model matches the high debt/GDP, but it misses the other two features of advanced countries. And it fails to generate a crisis. We propose an alternative model, replacing the absence of commitment to repay with commitment. Default occurs due to inability to repay and is excusable. Our alternative model of excusable default allows us to match the behavior of debt and the spread as the crisis approaches, as well as key features of business cycles in advanced countries. It also generates a crisis with correct timing.
Stabilization Policy in Sovereign Default Models with Downward Sticky Wage
Strategic Default Model and Debt Cyclicality in Greece
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Peculiarity in Sino-DPRK Trade Statistics
KDI Review of the North Korean Economy, Vol.17(7), Sejong: Korea Development Institute, 63-74, July 2015 (in Korean)
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in J. James Kim and Han Minjeong eds., Outside Looking in: A View into the North Korean Economy, Seoul: The Asan Institute for Policy Studies, 96-111, 2014