Working Papers
2023
August 25, 2023
The Economics of Sovereign Debt, Bailouts, and the Eurozone Crisis
Description: Despite a formal ‘no-bailout clause,’ we estimate significant net present value transfers from the European Union to Cyprus, Greece, Ireland, Portugal, and Spain, ranging from roughly 0.5% (Ireland) to a whopping 43% (Greece) of 2010 output during the Eurozone crisis. We propose a model to analyze and understand bailouts in a monetary union, and the large observed differences across countries. We characterize bailout size and likelihood as a function of the economic fundamentals (economic activity, debt-to-gdp ratio, default costs). Our model embeds a ‘Southern view’ of the crisis (transfers did not help) and a ‘Northern view’ (transfers weaken fiscal discipline). While a stronger no-bailout commitment reduces risk-shifting, it may not be optimal from the perspective of the creditor country, even ex-ante, if it increases the risk of immediate insolvency for high debt countries. Hence, the model provides a potential justification for the often decried policy of ‘kicking the can down the road.’ Mapping the model to the estimated transfers, we find that the main purpose of the outsized Greek bailout was to prevent an exit from the eurozone and possible contagion. Bailouts to avoid sovereign default were comparatively modest.
August 25, 2023
From Extreme Events to Extreme Seasons: Financial Stability Risks of Climate Change in Mexico
Description: This paper explores the financial stability implications of acute physical climate change risks using a novel approach that focuses on a severe season associated with a sequence of tropical cyclone and flood events. Our approach was recently applied to study physical risks in the Mexican financial sector, but the framework is applicable to other countries as well. We show that even if the scale of individual climate events may not be material at an aggregate national scale, considering a sequence of events could lead to potentially significant macro-financial impacts in the short term. This could occur even if none of the individual events affect the particular region(s) with highest concentrations of banking sector exposures. Our results indicate potential for even greater effects in the future given the increasing severity and frequency of extreme events from climate change. Thus, this paper highlights the importance of considering sequences of extreme physical risk events driven by climate change, rather than just individual extreme events, to better understand financial stability implications and design effective policies.
August 25, 2023
Delays in Climate Transition Can Increase Financial Tail Risks: A Global Lesson from a Study in Mexico
Description: This paper explores a novel forward-looking approach to study the financial stability implications of climate-related transition risks. We develop an integrated micro-macro framework with a new class of scenario called delayed-uncertain pathways. An additional stochastic financial modeling layer via a jump-diffusion process is considered to capture continuously changing risks, as well as the potential of large/sudden shocks in the financial markets. We applied this approach to study transition risks in the Mexican financial sector. But the implications are global in scope, and the framework is easily adaptable to other countries. We quantify the projections of future distributions of various risk metrics and, hence, the evolving tail risks due to compounding effects from delays in transitioning to a low-carbon economy and the consequent uncertainty of the future policy path. We find that the longer the delays in transition, the larger the future tail financial risks, which could be material to the overall system.
August 25, 2023
Default Risk and Transition Dynamics with Carbon Shocks
Description: Climate mitigation policies are being introduced around the world to limit global warming, generating new risks to the economy. This paper develops a continuous time heterogeneous agents model to study the impact of carbon pricing policy shocks on corporate default risk and the consequent transition dynamics. We derive a closed-form solution to corporate default probability based on firms' intertemporal optimization decisions and explicitly characterize the transition speed. This allows for studying policy implications in an analytically tractable way. The model is calibrated to different US corporate sectors to quantify the heterogeneous effects of carbon price shocks. While carbon-intensive sectors face increased default risks, there are notable asymmetric effects within sectors. Higher carbon prices increase default risk but also induce faster transition towards the new post-shock steady state with a highly non-linear impact. Our results suggest that once a range of possible price shocks are accounted for, the increase in the cost of capital/risk premiums might be sharply different across sectors.
August 25, 2023
Macro-Prudential Stress Test Models: A Survey
Description: In this paper, we survey the rapidly developing literature on macroprudential stress-testing models. The scope of the survey includes models of contagion between banks, models of contagion within the wider financial system including non-bank financial institutions such as investment funds, and models that emphasise the two-way interaction between the financial sector and the real economy. Our aim is two-fold: first, to provide a reference guide of the state-of-the-art for those developing such models; second, to distil insights from this endeavour for policy-makers using these models. In our view, the modelling frontier faces three main challenges: (a) our understanding of the potential for amplification in sectors of the non-bank financial system during periods of stress, (b) multi-sectoral models of the non-bank financial system to analyse the behaviour of the overall demand and supply of liquidity under stress and (c) stress testing models that incorporate comprehensive two-way interactions between the financial system and the real economy. Emerging lessons for policy-makers are that, for a given-sized shock hitting the system, its eventual impact will depend on (a) the size of financial institutions' capital and liquidity buffers, (b) the liquidation strategies financial institutions adopt when they need to raise cash, and (c) the topology of the financial network.
August 24, 2023
IMF Fossil Fuel Subsidies Data: 2023 Update
Description: This paper provides a comprehensive global, regional, and country-level update of: (i) efficient fossil fuel prices to reflect supply and environmental costs; and (ii) subsidies implied by charging below efficient fuel prices. Globally, fossil fuel subsidies were $7 trillion in 2022 or 7.1 percent of GDP. Explicit subsidies (undercharging for supply costs) have more than doubled since 2020 but are still only 18 percent of the total subsidy, while nearly 60 percent is due to undercharging for global warming and local air pollution. Differences between efficient prices and retail fuel prices are large and pervasive, for example, 80 percent of global coal consumption was priced at below half of its efficient level in 2022. Full fossil fuel price reform would reduce global carbon dioxide emissions to an estimated 43 percent below baseline levels in 2030 (in line with keeping global warming to 1.5-2oC), while raising revenues worth 3.6 percent of global GDP and preventing 1.6 million local air pollution deaths per year. Accompanying spreadsheets provide detailed results for 170 countries.
August 18, 2023
Reported Social Unrest Index: August 2023 Update
Description: This paper is the second update of the Reported Social Unrest Index (Barrett et al. 2022), outlining developments in global social unrest since March 2022. It shows that the fraction of countries experiencing major social unrest events has been stable. Reasons for social unrest can be broadly categorized as stemming from sdebate over constitutional issues, protests connected to specific policies, and other generalized disorder.
August 11, 2023
How Nations Become Fragile: An AI-Augmented Bird’s-Eye View (with a Case Study of South Sudan)
Description: In this study we introduce and apply a set of machine learning and artificial intelligence techniques to analyze multi-dimensional fragility-related data. Our analysis of the fragility data collected by the OECD for its States of Fragility index showed that the use of such techniques could provide further insights into the non-linear relationships and diverse drivers of state fragility, highlighting the importance of a nuanced and context-specific approach to understanding and addressing this multi-aspect issue. We also applied the methodology used in this paper to South Sudan, one of the most fragile countries in the world to analyze the dynamics behind the different aspects of fragility over time. The results could be used to improve the Fund’s country engagement strategy (CES) and efforts at the country.
August 11, 2023
The Elasticity of Substitution Between Skilled and Unskilled Labor in Developing Countries: A Directed Technical Change Perspective
Description: We develop a model of endogenous skill-biased technical change in developing countries. The endogenous response to a rise in skill supply counters the traditional substitution effect and dampens its role in reducing wage inequality. The model re-enforces consensus estimates of the elasticity of substitution between more/less educated workers by reconciling dispersed existing estimates. It also rationalizes estimates that were hitherto deemed implausible or model-inconsistent. We produce new estimates for developing countries with a novel global panel (finding values at or just above 2) and with Latin American data that facilitates analysis of dynamics (which reduce estimates to 1.7-1.8). We therefore shed new light on a parameter that is crucial for inequality, growth, and other key macroeconomic questions.
August 11, 2023
The Dominant Currency Financing Channel of External Adjustment
Description: We provide evidence of a new channel through which exchange rates affect trade. Using a novel identification strategy that exploits firms’ maturity structure of foreign currency debt around a large depreciation in Colombia, we show that firms experiencing a stronger debt revaluation of dominant currency debt due to a home currency depreciation compress imports relatively more while exports are unaffected. Dominant currency financing does not lead to an import compression for firms that export, hold foreign currency assets, or are active in the foreign exchange derivatives markets, as they are all hedged against a revaluation of their debt. These findings can be rationalized through the prism of a model with costly state verification and foreign currency borrowing. Quantitatively, the dominant currency financing channel explains a significant part of the external adjustment process in addition to the expenditure switching channel. Pricing exports in the dominant currency, instead of the producer’s currency, mutes the effect of dominant currency financing on trade flows.