In a recent work by Emircan Yurdagul from U. Carlos III, joint with Max Dvorkin and Juan Sanchez from the Federal Reserve Bank of St. Louis and Horacio Sapriza from the Federal Reserve Board, the authors study sovereign debt restructurings. The paper makes an empirical contribution to the literature by documenting new facts on maturity extensions in sovereign debt restructurings. In particular, authors impute a measure of maturity extensions from the existing empirical work on sovereign debt restructurings. Then they show that these extensions are usually positive, and particularly large if the output has recovered more between the default and the restructuring.
In the theoretical analysis, they build a defaultable sovereign debt framework with endogenous maturity choice and debt restructurings. Upon default, the borrower government and the lenders make alternating offers each period until they reach an agreement in terms of the total market value of the new debt. After this agreement, the government chooses the size and the maturity of the new portfolio to satisfy the agreed market value. Since the market value of a portfolio and the continuation value for the government (in exclusion or after restructuring) depend on the fundamentals of the country, the duration of negotiations, the haircuts implied by the agreement, and the maturity of the new portfolio all arise endogenously in equilibrium and vary with these fundamentals. The model closely replicates the observed levels of haircuts and maturity extensions in restructurings. In addition, it gives the empirically supported predictions that a higher volume of defaulted debt leads to larger haircuts, and a better income recovery until restructurings gives higher maturity extensions.
Once establishing that the model is a good laboratory to study the debt restructurings, the authors use the model to illustrate the key mechanisms that increase the extensions. First, as it usually takes a few years until the restructuring is agreed, and the governments typically default with below-average output levels, the output levels recover between default and the restructuring. In line with the procyclicality of maturity, this recovery in income leads to longer maturity at the time of restructuring that what had been chosen right before default. Second, post-restructuring episodes often exhibit certain “stigma” in which the country is not allowed to issue new debt for a number of periods. The government hedges against such a risk of exclusion by choosing a longer maturity in the restructuring. Finally, the results point to regulatory costs of book value haircuts as a factor that increases the maturity extensions.
This paper also has a technical contribution to the literature. Authors follow the methods from the dynamic discrete choice models in introducing idiosyncratic shocks to the value of the government obtained by each discrete choice. They use these shocks to construct the probabilities for the default and portfolio decisions before the realization of these shocks. These probabilities lead to a smooth price function in equilibrium, and dramatically facilitate the numerical solution.
The paper, titled “Sovereign Debt Restructurings”, is published in the April 2021 issue of American Economic Journal: Macroeconomics.