Corneli & Tarantino: Sovereign debt and reserves with liquidity

Abstract:

During the recent financial crisis developing countries have continued to accumulate both sovereign reserves and debt. To account for this empirical fact, we model the optimal portfolio choice of a country that is subject to liquidity and productivity shocks. We determine the equilibrium level of debt and its cost through a contracting game between a country and international lenders. Although raising debt increases the sovereign exposure to liquidity and productivity crises, the simultaneous accumulation of reserves can mitigate the negative effects of such crises. This mechanism rationalizes the complementarity between debt and reserves.

 

Available for download here.

Andolfatto & Williamson (Fed): Scarcity of Safe Assets, Inflation, and the Policy Trap

ABSTRACT:

We construct a model in which all consolidated government debt is used in transactions, with money being more widely acceptable. When asset market constraints bind, the model can deliver low real interest rates and positive rates of inflation at the zero lower bound. Optimal monetary policy in the face of a financial crisis shock implies a positive nominal interest rate. The model reveals some novel perils of Taylor rules.

Available for download here.

De Grauwe & Ji: Market sentiments and the sovereign debt crisis in the Eurozone

ABSTRACT:

In this paper we test two theories of the determination of the government bond spreads in a monetary union. The first one is based on the efficient market theory. According to this theory, the surging spreads observed from 2010 to the middle of 2012 were the result of deteriorating fundamentals (e.g. domestic government debt, external debt, competitiveness, etc.). The second theory recognizes that collective movements of fear a panic can have dramatic effects on spreads. These movements can drive the spreads away from underlying fundamentals, very much like in the stock markets prices can be gripped by a bubble pushing them far away from underlying fundamentals. The implication of that theory is that while fundamentals cannot be ignored, there is a special role for the central bank that has to provide liquidity in times of market panic, so as to avoid that countries are pushed into a bad equilibrium. We tested these theories and concluded that there is strong evidence for the second theory. The policy implications are that the role of the ECB as lender of last resort in the government bond markets is an important one. The recent attempts by the German Constitutional Court risk undermining this role and by the same token the stability of the Eurozone.

Available for download hereCurrency-Revaluation.

Tavares: The Role of International Reserves in Sovereign Debt Restructuring under Fiscal Adjustment

ABSTRACT:

International reserves have become increasingly important policy tools for developing economies that are, simultaneously, highly indebted. This fact seems puzzling given that governments in these countries borrow with an interest rate penalty to compensate lenders for default risk. Reducing debt to the same extent as reserves would maintain net liabilities constant while decreasing the cost in interest payments. However, holding reserves can have insurance benefits if the economy experiences financial crisis. To rationalize the levels of international reserves and external debt observed in the data, a standard dynamic model of equilibrium default is studied with two fundamental extensions: distortionary taxation and debt restructuring. This paper shows that fiscal adjustments induced by sovereign default can generate large demand for reserves if taxation is distortionary. At the same time, a non-negligible position in reserves modifies the debt restructuring negotiations upon default. A calibrated version of the model produces recovery rate schedules that are increasing with reserves, as seen in the data, being also able to replicate large positions of reserves and debt to GDP. Finally, I study how both mechanisms play a key quantitative role to generate such result, in fact, not including them, produces a counterfactual demand for reserves that is close to zero.

 

Available for download here.

Skeel: What is a Lien? Lessons from Municipal Bankruptcy

From the Introduction:

As the initial shock of Detroit’s bankruptcy filing has worn off, and the parties have attempted to tackle the major issues that stand in the way of a successful reorganization, an unlikely issue seems to keep coming up: what exactly is a lien? In ordinary bankruptcies, this question is not much in dispute. The parties may disagree on the value of the collateral securing the principal lender’s security interest, but it generally is clear whether the lender or other creditors do indeed have a property interest or its equivalent.

Not so in Detroit. Some of Detroit’s general obligation bondholders believed that their bonds could not be restructured, due to Detroit’s promise to use its “full faith and credit” to assure repayment. Even after it became clear that ordinary GO bonds are simply unsecured claims in bankruptcy, the holders of “unlimited tax” GO bonds insisted that they have a lien on Detroit’s ad valorem taxes, and this lien must be recognized in bankruptcy. The beneficiaries of Detroit’s two major pensions have insisted that they too are fully protected, due to a provision in the Michigan constitution stating that accrued pensions cannot be “diminished or impaired.”  In 2006, Detroit entered into a swap transaction designed to stabilize the interest rate it paid on bonds that were issued to plug a gap in its pension funding. The swap transaction was restructured three years later to give the counterparties a lien on Detroit’s casino revenues. This transaction too has raised lien-related issues.

One of the objectives of this Article is simply to sort through these issues, and to determine which of these creditors do have liens or lien-like protection. Answering this question will require an exploration of two related sets of concerns. First, what is the relationship between liens and lien substitutes—such as priorities and exceptions from bankruptcy’s automatic stay? As similar as liens and priorities are, the bankruptcy laws have long drawn a sharp distinction between state-created liens, which are honored in bankruptcy; and state-created priorities, which are not. We will want to consider why this is so.

The second question is the question in my title: what is a lien? The dictionary defines a lien as the “right to take and hold or sell the property of a debtor as security or  repayment for a debt.” Not a bad definition, but whether a purported lien actually is a lien is not always clear, especially in the municipal context. Shortly before the little town of Central Falls, Rhode Island filed for bankruptcy, the Rhode Island legislature passed a statute giving general obligation bondholders a lien on all of a municipality’s ad valorem taxes and general revenues—that is, on nearly all of the municipality’s revenues. Blanket liens are hardly unheard of; most small businesses and many large ones have lenders who have a security interest in most or all of their assets. Yet despite using the language of liens, the Rhode Island statute seems to function more like a priority rule than a traditional lien. The breadth of the statute raises the question whether a court should decline to honor a statutory lien if it does not serve the functions of a traditional lien.

Available for download here.

Kupelian & Sol Rivas: Vulture Funds – The Lawsuit Against Argentina and the Challenge They Pose to the World Economy

From the Introduction:

After the sharp downturn of the Argentine economy in 2001 that culminated in the default on its external debt in December of that year, the Government, as part of the economic recovery process, offered in 2005 a swap of its defaulted debt with the aim of normalizing its situation. The restructuring process was successful, on the one hand, because of the haircut on the principal amount of its debt and the extension of terms that were agreed upon and, on the other, due to the level of acceptance obtained, which subsequently increased, in 2010, when the exchange was reopened, leading to the participation of over 91% of the total number of eligible creditors. The remaining 9% that chose not to enter into the negotiation is represented by bonds held by private investors, holdouts and vulture funds that waited out the restructuring process only to reject it and bring legal actions demanding full payment of those bonds. That is precisely how vulture funds operate, as they are high-risk investment funds that deliberately purchase debt securities from economies that are weak or on the verge of collapse, at very low prices, and later demand in court the full value of those bonds plus any accrued interest. A distinction should be drawn between those funds and holdouts, which are merely creditors who, for different reasons, do not accept the restructurings but do not speculate about bringing legal actions.

A part of those legal actions is currently being dealt with by Argentina and, in this case, they represent 0.45% of the debt defaulted on in 2001. This dispute is on everyone’s lips, since the decisions to be made by the US courts will have significant implications at a global level.

 

Available for download here.

Balteanu & Erce: Bank Crises and Sovereign Defaults in Emerging Markets – Exploring the Links

ABSTRACT:

This paper provides a set of stylized facts on the mechanisms through which banking and sovereign distress feed into each other, using a large sample of emerging economies over three decades. We first define “twin crises” as events where banking crises and sovereign defaults combine, and further distinguish between those banking crises that end up in sovereign debt crises, and vice-versa. We then assess what differentiates “single” episodes from “twin” ones. Using an event analysis methodology, we study the behavior around crises of variables describing the balance sheet interconnection between the banking and public sectors, the characteristics of the banking sector, the state of public finances, and the macroeconomic context. We find that there are systematic differences between single” and “twin” crises across all these dimensions. Additionally, we find that “twin” crises are heterogeneous events: taking into account the proper time sequence of crises that compose “twin” episodes is important for understanding their drivers, transmission channels and economic consequences. Our results shed light on the mechanisms surrounding feedback loops of sovereign and banking stress.

 

Available for download here.

U.S. Supreme Court Rules Against Argentina on Sovereign Debt Discovery Claims

The U.S. Supreme Court issued its ruling in a highly-anticipated case stemming from Argentina’s sovereign debt default.  Justice Scalia delivered the opinion.

After petitioner, Republic of Argentina, defaulted on its external debt, respondent, NML Capital, Ltd. (NML), one of Argentina’s bondholders, prevailed in 11 debt-collection actions that it brought against Argentina in the Southern District of New York. In aid of executing the judgments, NML sought discovery of Argentina’s property, serving subpoenas on two nonparty banks for records relating to Argentina’s global financial transactions. The District Court granted NML’s motions to compel compliance. The Second Circuit affirmed, rejecting Argentina’s argument that the District Court’s order transgressed the Foreign Sovereign Immunities Act of 1976 (FSIA or Act).

Held: No provision in the FSIA immunizes a foreign-sovereign judgment debtor from postjudgment discovery of information concerning its extraterritorial assets. Pp. 4–12.

(a) This Court assumes without deciding that, in the ordinary case, a district court would have the discretion under Federal Rule of Civil Procedure 69(a)(2) to permit discovery of third-party information bearing on a judgment debtor’s extraterritorial assets. Pp. 4–5.

(b) The FSIA replaced an executive-driven, factor-intensive, loosely common-law-based immunity regime with “a comprehensive framework for resolving any claim of sovereign immunity.” Republic of Austria v. Altmann, 541 U. S. 677, 699. Henceforth, any sort of immunity defense made by a foreign sovereign in an American court must stand or fall on the Act’s text. The Act confers on foreign states two kinds of immunity. The first, jurisdictional immunity (28 U. S. C. §1604), was waived here. The second, execution immunity, generally shields “property in the United States of a foreign state” from attachment, arrest, and execution. §§1609, 1610. See also §1611(a), (b)(1), (b)(2). The Act has no third provision forbidding or limiting discovery in aid of execution of a foreign-sovereign judgment debtor’s assets. Far from containing the “plain statement” necessary to preclude application of federal discovery rules, Société Nationale Industrielle Aérospatiale v. United States Dist. Court for Southern Dist. of Iowa, 482 U. S. 522, 539, the Act says not a word about postjudgment discovery in aid of execution.

Argentina’s arguments are unavailing. Even if Argentina were correct that §1609 execution immunity implies coextensive discovery in-aid-of-execution immunity, the latter would not shield from discovery a foreign sovereign’s extraterritorial assets, since the text of §1609 immunizes only foreign-state property “in the United States.” The prospect that NML’s general request for information about Argentina’s worldwide assets may turn up information about property that Argentina regards as immune does not mean that NML cannot pursue discovery of it. Pp. 5–10.

 

The case is available for download here.

De Grauwe and Ji: Disappearing government bond spreads in the eurozone – Back to normal?

ABSTRACT:

Since the announcement of the Outright Monetary Transactions (OMT) programme by Mario Draghi, President of the ECB, in 2012, the government bond spreads began a strong decline. This paper finds that most of this decline is due to the positive market sentiments that the OMT programme has triggered and is not related to underlying fundamentals, such as the debt-to-GDP ratios or the external debt position that have continued to increase in most countries. The authors even argue that the market’s euphoria may have gone too far in taking into account the same market fundamentals. They conclude with some thoughts about the future governance of the OMT programme.

 

Available for download here.

Ugarteche: Public debt crises in Latin American and Europe – a comparative analysis

ABSTRACT:

The debt problems of Latin America in the 1980s were of external origin, were related
to external borrowing, exploded when international interest rates hit a historical high,
were basically international commercial bank loans in floating rate notes, and had a
negative impact on the balance of payments. The Brady Plan solved them after a
decade of falling output having undergone IFIs conditionalities, adjustment policies,
structural reforms and financing. The European crisis that started in 2007 is also of
external origin, is related to domestic borrowing, and exploded when the US sub
prime crisis hit the international financial community, is basically privately held in
bonds by European financial institutions in Euros, and has had a negative fiscal
impact. The debt solution in Latin America changed the regional process of trade and
integration begun in the late 1960s through Latin American Integration Association
(1980, previously LAFTA, 1960) as new export led policies were introduced in the late
1980s and four new sub regional schemes were subsequently created: NAFTA
(1994), SICA, MERCOSUR (1991) and CAN (1993). In this paper we are going to
inspect the economic elements of the two sets of debt problems, the international
political economy elements involved and the lessons learnt.

 

Available for download here.