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Persistent Gaps, Volatility Types, and Default Traps

Author/Editor: Catão, Luis | Fostel, Ana | Kapur, Sandeep
Authorized for Distribution: June 1, 2007
Electronic Access: Free Full Text (PDF file size is 466KB)
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Summary: We show that cross-country differences in the underlying volatility and persistence of macroeconomic shocks help explain two historical regularities in sovereign borrowing: the existence of "vicious" circles of borrowing-and-default ("default traps"), as well as the fact that recalcitrant sovereigns typically face higher interest spreads on future loans rather than outright market exclusion. We do so in a simple model where output persistence is coupled with asymmetric information between borrowers and lenders about the borrower's output process, implying that a decision to default reveals valuable information to lenders about the borrower's future output path. Using a broad cross-country database spanning over a century, we provide econometric evidence corroborating the model's main predictions-namely, that countries with higher output persistence and conditional volatility of transient shocks face higher spreads and thus fall into default traps more easily, whereas higher volatility of permanent output tends to dampen these effects.
 
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Series: Working Paper No. 07/148
Subject(s): Production | Sovereign debt | Economic models | Borrowing
Author's keyword(s): Sovereign Debt. Default | Country Spreads | Output Volatility and Persistence.
 
English  
    Published:   June 1, 2007        
    ISBN/ISSN:   1934-7073   Format:   Paper
    Stock No:   WPIEA2007148   Pages:   45
    Price:   US$18.00 (Academic Rate: US$18.00 )
       
     
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