Persistent Gaps, Volatility Types, and Default Traps

By Ana L Fostel, Sandeep Kapur, Luis Catão

June 1, 2007

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Ana L Fostel, Sandeep Kapur, and Luis Catão. Persistent Gaps, Volatility Types, and Default Traps, (USA: International Monetary Fund, 2007) accessed December 26, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

We show that cross-country differences in the underlying volatility and persistence of macroeconomic shocks help explain two historical regularities in sovereign borrowing: the existence of "vicious" circles of borrowing-and-default ("default traps"), as well as the fact that recalcitrant sovereigns typically face higher interest spreads on future loans rather than outright market exclusion. We do so in a simple model where output persistence is coupled with asymmetric information between borrowers and lenders about the borrower's output process, implying that a decision to default reveals valuable information to lenders about the borrower's future output path. Using a broad cross-country database spanning over a century, we provide econometric evidence corroborating the model's main predictions-namely, that countries with higher output persistence and conditional volatility of transient shocks face higher spreads and thus fall into default traps more easily, whereas higher volatility of permanent output tends to dampen these effects.

Subject: Asset prices, Bonds, Debt default, Output gap, Sovereign bonds

Keywords: Interest rate, WP

Publication Details

Pages:

45
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2007/148
Stock No:

WPIEA2007148
ISBN:

9781451867121
ISSN:

1018-5941

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