Pathways through Financial Crisis

The need to increase accountability is frequently invoked in discussions of governance reform of international financial institutions (IFIs). This project analysed the accountability architecture of the Bank and Fund, identifying gaps between evaluation processes and the implementation of measures drawn from evaluation.  The findings of this project were published in a special issue of Global Governance and a series of GEG working papers.

To read more, visit Pathways Through Financial Crisis.

Other recommended research:

Eduardo Levy Yeyati and Ugo Panizza (forthcoming) The elusive costs of sovereign defaults Journal of Development Economics

Abstract: The evidence supporting the presence of output losses associated with sovereign defaults is based on annual observations and suffers from measurement and identification problems. This paper examines the impact of default on growth using quarterly data and finds that output contractions precede defaults and that output starts growing after the quarter in which the default took place. This indicates that default episodes mark the beginning of the economic recovery and that the negative effects of a default on output are likely to be driven by the anticipation of default, independently of whether or not the country ultimately decides to validate it.

Dale F. Gray (2009) Modeling Financial Crises and Sovereign Risks Annual Reviews: Financial Economics 1:117-144

Abstract: The complex interactions, spillovers, and feedbacks of the global crisis that began in 2007 remind us of how important it is to improve our analysis and modeling of financial crises and sovereign risk. This review provides a broad framework to examine how vulnerabilities can build up and suddenly erupt in a financial crisis, with potentially disastrous feedback effects for sovereign debt and economic growth. Traditional macroeconomic analyses overlook the importance of risk, which makes them ill-suited to examine interconnectedness, risk transmission mechanisms, and contagion.

After presenting an overview of the key features of the global 2007-2009 crisis, this review discusses new directions for research on modeling financial crises and sovereign risk, including the need for integrating risk into macroeconomic policy models and enhancing early warning system and financial contagion models through a more comprehensive view of economy-wide risks. Also, new tools to mitigate and control macro risk need to be developed, along with new approaches to regulate financial sector risk-taking and monitor and manage the interactions between private sector and sovereign risk.

Jun Pan and Kenneth J. Singleton (2008) Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads The Journal of Finance Vol. LXIII, No. 5: 2345-2384

Abstract: This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events (λQ), but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single-factor model with λQ following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in λQ are found to be economically significant and co-vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy.

Udaibir S. Das, Michael G. Papaioannou and Christoph Trebesch (2009) Sovereign Default Risk and Private Sector Access to Capital in Emerging Markets in Carlos A. Primo Braga and Doerte Doemeland, eds. Debt Relief and Beyond: Lessons Learned and Future Challenges Washington DC: World Bank

Extract: This chapter analyzes how sovereign default risk affects private sector access to international capital markets, in the form of external credit (loans and bond issuance) and equity issuance. As a first step it extends the existing research on the effect of sovereign debt crises on corporate external credit for the period 1980-2004. As a second step, it broadens the analysis by investigating the role of additional measures of sovereign default risk (sovereign bond spreads and sovereign ratings) using a shorter sample for a more recent period (1993-2007). The results provide new insights into corporate access to capital in emerging markets during crisis periods, sovereign risk spillovers to the private sector, and the broad domestic costs of sovereign default.

Huixin Bi (2009) Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy Working Paper, Department of Economics, Indiana University

Abstract: We develop a closed economy model in order to study the interactions among sovereign risk premia, fiscal limits and fiscal policy. Default risk premia reflect the market’s expectations about the ability and willingness of the government to service its debt. The government’s ability arises endogenously from fiscal limits implied by Laffer curves, while the government’s willingness is determined by the flexibility of its fiscal policy. The model rationalizes different sovereign ratings across developed countries. The distribution of fiscal limits is country specific and depends on the size of the government, the degree of the countercyclical policy responses, economic diversity and political uncertainty. The model also produces a nonlinear relationship between sovereign risk premia and the level of government debt. In recessions, the default risk premia of long-term bonds jump ahead of shortterm bonds and provide early warnings of sovereign defaults. The nonlinearity is consistent with the empirical evidence that once risk premia begin to rise, they do so rapidly. In addition, the model predicts substantial risk premia that are close to those observed, even when the probability of defaulting is remote. Risk premia carry substantial economic costs, lowering consumption and output for extended periods.

Vivian Z. Yue (2010) Sovereign default and debt renegotiation Journal of International Economics 80: 176–187

Abstract: This paper develops a small open economy model to study sovereign default and debt renegotiation for emerging economies. The model features both endogenous default and endogenous debt recovery rates. Sovereign bonds are priced to compensate creditors for the risk of default and the risk of debt restructuring. The model captures the interaction between sovereign default and ex post debt renegotiation. We find that both debt recovery rates and sovereign bond prices decrease with the level of debt. In a quantitative analysis, the model accounts for the debt reduction, volatile and countercyclical bond spreads, countercyclical trade balance, and other empirical regularities of the Argentine economy. The model also replicates the dynamics of bond spreads during the debt crisis in Argentina.

Miguel Fuentes and Diego Saravia (2010) Sovereign defaulters: Do international capital markets punish them? Journal of Development Economics 91:336–347

Abstract: We empirically study whether countries that default on their debt experience a reduction in their capital inflows, as suggested by the literature. Our data contain information on (i) the defaulter countries and their creditors and (ii) bilateral foreign direct investment (FDI) flows. With these we can study how FDI flows are affected by sovereign default by distinguishing between those flows coming from defaulters’ creditor countries and others. According to our estimations, this distinction is crucial since the decline of FDI in flows after default is markedly concentrated on those flows originating in defaulters’ creditor countries. The decay in FDI flows is higher in the years closer to the default date and for countries that have defaulted more times. We do not find evidence that countries shut their doors to defaulters’ investment abroad, which is also a cost of default suggested in the literature.