Essays on Sovereign Debt

Emerging economies accumulate a significant amount of foreign debt at the same time, frequently defaulting on their external obligations. However, standard models of sovereign debt cannot jointly explain the debt-to-output ratio and the default frequency observed in the data. Chapter 1 introduces sovereign's recursive preferences and uncertainty on default costs to a standard sovereign debt model which allows capturing the above-mentioned statistics. Uncertainty about default costs makes risk-averse agents default less and get better prices on bonds from competitive lenders. Therefore, the sovereign borrows more, resulting in the debt-to-output ratio and default frequency observed in the data.

In chapter 2, we explore a sovereign debt model where all agents have recursive preferences and lenders are small in the sense that the default events impact their marginal utility. We develop a new technique to solve this class of models by iterating on an endogenous stochastic discount factor until convergence. We find that model dynamics differ significantly from the canonical case in which lenders are `large' relative to the country. Spreads not only price default risk but are also used to entice lenders to adjust their holdings.

Emerging economies' debt to China is large, non-marketable, and opaque. We study the impact that such borrowing from China has on the equilibrium quantities and prices for marketable sovereign debt. We use a standard sovereign debt model with long-term debt and find that following a positive inflow from China our model economy chooses to rebalance its debt portfolio by delevering from market debt. In the process, it pays lower spreads and faces less volatile consumption. On the other hand, when facing a capital outflow from China, the economy taps international debt markets, levers up on defaultable debt, and ends up paying higher and more volatile spreads in equilibrium.