Sovereign Risk and Dutch Disease (Job Market Paper) [PDF]
Abstract: This paper studies the impact of natural resource discoveries on default risk. I use data of giant oil field discoveries to estimate their effect on the spreads of 37 emerging economies and find that spreads increase by up to 530 basis points following a discovery of average size. I develop a quantitative sovereign default model with capital accumulation, production in three sectors, and oil discoveries. Following a discovery, investment and foreign borrowing increase. These choices have opposite effects on spreads: borrowing increases them and investment reduces them. The discovery also generates a reallocation of capital away from manufactures and toward oil extraction and the non-traded sector, the so-called Dutch disease. This reallocation increases the volatility of tradable income used to finance debt payments, which undermines the effect of investment on spreads. Under the benchmark calibration the model accounts for 300 out of the 530 basis points of the increase in spreads observed in the data, out of which 200 result from the Dutch disease.
Default and Interest Rate Shocks: Renegotiation Matters [PDF], joint with Victor Almeida, Timothy Kehoe, and Juan Pablo Nicolini (previously presented as "Did the 1980s in Latin America Need to Be a Lost Decade?")
Abstract: In this paper we develop a sovereign default model with endogenous re-entry to financial markets via debt renegotiation. We use this model to evaluate how shocks to risk-free interest rates trigger default episodes through two channels: borrowing costs and expected renegotiation terms after default. The first channel makes repayment less attractive when risk-free interest rates are high due to higher borrowing costs. The second channel works through the expected subsequent renegotiation process: when risk-free rates are high, lenders are willing to accept a higher haircut in exchange for resuming payments. Thus, high risk-free rates imply better renegotiation terms for a borrower, making default more attractive ex-ante. We calibrate the model to study the 1982 Mexican default, which was preceded by a drastic increase in federal funds rates in the US. We find that the renegotiation process is key for reconciling the model to the widespread narrative that the increase in US interest rates triggered the 1982 default episode.
Lessons from the Monetary and Fiscal History of Latin America [PDF], joint with Timothy Kehoe and Juan Pablo Nicolini, final chapter in The Monetary and Fiscal History of Latin America
Abstract: Studying the modern economic histories of the ten largest countries in South America and Mexico teaches us that the lack of fiscal discipline has been at the root of most of the region’s macroeconomic instability. The lack of fiscal discipline, however, takes various forms, not all of them measured in the primary deficit. Especially important have been implicit or explicit guarantees to the banking system, denomination of the debt in US dollars and short maturity of the debt, and large transfers to the private sector, which are large in times of crisis and are not part of the budget approved by the national congresses. Comparing the histories of our eleven countries side by side, we see that, rather than leading to an economic contraction, in general fiscal stabilization leads to growth. On the other hand, rising commodity prices are no guarantee of economic growth, nor are falling commodity prices a guarantee of economic contraction.
Pricing Following the Nominal Exchange Rate [PDF]
Abstract: This paper studies how the informativeness of the exchange rate affects the sensitivity of prices to nominal depreciations. In an environment with imperfect information, the exchange rate is a signal of the state of the economy and thus relevant for pricing decisions, even if it does not affect costs. This “information channel” gives rise to a policy trade-off: a currency intervention that reduces the level of a depreciation also reduces exchange rate volatility and, therefore, increases its precision as a signal. This increases the elasticity of prices with respect to the exchange rate through the information channel. Overall, the effect of such currency interventions on inflation is ambiguous: on one hand they reduce the magnitude of the shock and, on the other, they increase the responsiveness of firms when adjusting their prices. To test the relevance of the information channel I use policy changes in Mexico to identify an increase in the precision of information provided by the Central Bank. I calibrate this increase in precision using data from a survey of private inflation forecasts. Holding everything else constant, this increase accounts for 4 out of a 12 point drop in the elasticity of prices with respect to the exchange rate.
Abstract: This paper studies the impact of natural resource discoveries on default risk. I use data of giant oil field discoveries to estimate their effect on the spreads of 37 emerging economies and find that spreads increase by up to 530 basis points following a discovery of average size. I develop a quantitative sovereign default model with capital accumulation, production in three sectors, and oil discoveries. Following a discovery, investment and foreign borrowing increase. These choices have opposite effects on spreads: borrowing increases them and investment reduces them. The discovery also generates a reallocation of capital away from manufactures and toward oil extraction and the non-traded sector, the so-called Dutch disease. This reallocation increases the volatility of tradable income used to finance debt payments, which undermines the effect of investment on spreads. Under the benchmark calibration the model accounts for 300 out of the 530 basis points of the increase in spreads observed in the data, out of which 200 result from the Dutch disease.
Default and Interest Rate Shocks: Renegotiation Matters [PDF], joint with Victor Almeida, Timothy Kehoe, and Juan Pablo Nicolini (previously presented as "Did the 1980s in Latin America Need to Be a Lost Decade?")
Abstract: In this paper we develop a sovereign default model with endogenous re-entry to financial markets via debt renegotiation. We use this model to evaluate how shocks to risk-free interest rates trigger default episodes through two channels: borrowing costs and expected renegotiation terms after default. The first channel makes repayment less attractive when risk-free interest rates are high due to higher borrowing costs. The second channel works through the expected subsequent renegotiation process: when risk-free rates are high, lenders are willing to accept a higher haircut in exchange for resuming payments. Thus, high risk-free rates imply better renegotiation terms for a borrower, making default more attractive ex-ante. We calibrate the model to study the 1982 Mexican default, which was preceded by a drastic increase in federal funds rates in the US. We find that the renegotiation process is key for reconciling the model to the widespread narrative that the increase in US interest rates triggered the 1982 default episode.
Lessons from the Monetary and Fiscal History of Latin America [PDF], joint with Timothy Kehoe and Juan Pablo Nicolini, final chapter in The Monetary and Fiscal History of Latin America
Abstract: Studying the modern economic histories of the ten largest countries in South America and Mexico teaches us that the lack of fiscal discipline has been at the root of most of the region’s macroeconomic instability. The lack of fiscal discipline, however, takes various forms, not all of them measured in the primary deficit. Especially important have been implicit or explicit guarantees to the banking system, denomination of the debt in US dollars and short maturity of the debt, and large transfers to the private sector, which are large in times of crisis and are not part of the budget approved by the national congresses. Comparing the histories of our eleven countries side by side, we see that, rather than leading to an economic contraction, in general fiscal stabilization leads to growth. On the other hand, rising commodity prices are no guarantee of economic growth, nor are falling commodity prices a guarantee of economic contraction.
Pricing Following the Nominal Exchange Rate [PDF]
Abstract: This paper studies how the informativeness of the exchange rate affects the sensitivity of prices to nominal depreciations. In an environment with imperfect information, the exchange rate is a signal of the state of the economy and thus relevant for pricing decisions, even if it does not affect costs. This “information channel” gives rise to a policy trade-off: a currency intervention that reduces the level of a depreciation also reduces exchange rate volatility and, therefore, increases its precision as a signal. This increases the elasticity of prices with respect to the exchange rate through the information channel. Overall, the effect of such currency interventions on inflation is ambiguous: on one hand they reduce the magnitude of the shock and, on the other, they increase the responsiveness of firms when adjusting their prices. To test the relevance of the information channel I use policy changes in Mexico to identify an increase in the precision of information provided by the Central Bank. I calibrate this increase in precision using data from a survey of private inflation forecasts. Holding everything else constant, this increase accounts for 4 out of a 12 point drop in the elasticity of prices with respect to the exchange rate.