Heterogeneous Borrowers in Quantitative Models of Sovereign Default

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Heterogeneous Borrowers in Quantitative Models of Sovereign Default

by Juan Carlos Hatchondo of the Federal Reserve Bank of Richmond,
Leonardo Martinez of the Federal Reserve Bank of Richmond, and
Horacio Sapriza of Rutgers University

July 10, 2007

Abstract: We study an economy in which policymakers of different types (patient vs. impatient) alternate in power. Our framework builds on the model used in recent quantitative studies of sovereign default. We show that a default episode may be triggered by a change in the type in office, from a patient to an impatient policymaker. We also show that for this mechanism to be observed in equilibrium, it is necessary that there is enough political stability and that patient policymakers encounter sufficiently poor economic conditions during their tenure. Under high political stability, the presence of political turnover enables the model to generate: (i) a higher and more volatile spread (even when we focus on samples where only the patient type is in office), (ii) lower borrowing levels after a default episode, and (iii) a weaker correlation between economic conditions and default decisions. These results narrow the gap between the predictions of the model and the data.

JEL Classification: F34, F41.

Keywords: Sovereign Default, Political Risk, Endogenous Borrowing Constraints, Markov Perfect Equilibrium.

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