## _wp15167 — 1990. Relative to classical studies of pre-WWII spreads by Bordo and Rockoff (1997), ## Source details **Canonical URL:** [_wp15167 — 1990. Relative to classical studies of pre-WWII spreads by Bordo and Rockoff (1997),](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15167.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15167.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15167.pdf.json) --- ### Contributions and scope - Adds more countries, fixes data issues, and comprises more control variables, including global market factors highlighted in recent work. - Extends many series on sovereign spreads back to the 1970s and 1980s and adds advanced countries to allow coverage of major recent events in sovereign debt markets. - Combines an expanded historical sample and extended post-WWII series (with advanced countries) to document empirical default premia (DPs) by decomposing the spread into: - a vector of observable fundamentals, - the DP, - surpluses from borrowers in certain circumstances, - an estimation error, - distinct functional forms for memory formation, - re-evaluation of the importance of the actual size of the default (the final “haircut”) in shaping DP evolution. - Focus is on competitive bond markets where collusion is arguably more limited. ### Main empirical results (summary) - Impact DP estimates: - around 250 basis points in the period 1870-1938, - 400 bps in 1970-2011. - Decay profile of the DP: - by the end of the 5th year after debt settlement it averages some 150 basis points in the pre-WWII period and 200 bps post-1970, tapering off thereafter. - Statistical properties and variance: - the DP is significant at conventional statistical levels but displays considerable variance; limited sampling can greatly affect inference on the mean DP. - Contribution of observables vs. DP: - changes in observable fundamentals account for less than half of variations in market spreads between pre-default and post-settlement spells; the DP contribution is key. - DP and serial defaulting: - the DP rises with the number of years a sovereign stays out of the market; serial defaulters pay a higher DP. - Robustness to memory specifications: - the DP is no smaller for alternative specifications on how investors’ memories evolve. - Role of actual haircut: - direct control for the size of the actual haircut in spread regressions is not necessary to obtain a significant and longer lasting DP. - close to 90% of the actual haircut can be predicted by the length of the default and country-specific fundamentals; the informational content from the haircut “shock” to DP evolution appears to be very small. ### Theory (model setup and implications) - Market and agents: - competitive market populated by risk-neutral lenders who break-even given their beliefs; - lenders have access to a risk-free technology with gross rate Rf,t = 1 + rf,t taken as exogenous. - Default technology and costs: - in case of default at t+1, creditors expect to recover a fraction E(c_{t+1}) of contractual repayment obligations D_t with 0≤E(c_{t+1})<1; - expected haircut E(h_{t+1}) = 1 − E(c_{t+1}); - default entails a fraction κ of the sovereign’s current output ˜Y_t being lost, where 0<κ<1 (deadweight loss). - Break-even condition and spread: - lenders hold bonds if: [π_t E(c_{t+1}) + (1−π_t)] R_t = R_{f,t}. - defining spread s_t = R_t / R_{f,t} − 1 yields s_t = π_t E(h_{t+1}) / [1 − π_t E(h_{t+1})]. - Sovereign repayment decision (linear utility, one-period bond): - repayment if Y_t − D_t + β_t V^r_{t+1}(.,ϵ_t) ≥ (1−κ) Y_t − E(c_{t+1}) D_t + β_t V^d_{t+1}(.,ϵ_t). - rearranged: β_t [V^r_{t+1}(.,ϵ_t) − V^d_{t+1}(.,ϵ_t)] ≥ E(h_{t+1}) D_t − κ Y_t. - Role of information asymmetry and signaling: - if lenders do not observe persistent component ϵ_t but sovereign does, sovereign actions (repay/default) are informative about D/Y and future default risk; - repayment signals bright growth outlook, raising V^r and lowering R; adverse persistent shocks raise default likelihood and R. - General implications: - borrower’s past actions are informative about future default risk; - existence of a threshold ϵ^*_t below which default occurs; - a positive premium R^d − R^r > 0 which is a function of credit history; - probability of default and expected haircut are jointly determined; expected haircut may differ from final actual haircut due to ex-post bargaining. ### Empirical specification of DP - Spread decomposition: - s_{i,t} = α_i + F_{i,t} β + DP_{i,t}, where s_{i,t} is country i spread at time t; F_{i,t} is row vector of common-knowledge observable fundamentals; DP_{i,t} is default premium. - DP functional form: - DP_{i,t} = γ_1 MEM1_{i,t} + γ_2 MEM2_{i,t} + Σ_{j=1}^m δ_j DS(j)_{i,t}. - Definitions: - MEM1_{i,t}: ratio of the number of years country i is in default to the total number of years in the sample up to year t (proxy for credit history). - MEM2_{i,t}: number of years since the last default. - DS(j)_{i,t}: dummy equal to one if t is the jth year after settlement on the defaulted debt; there are m such dummies (0 0, γ_2 expected to be negative. - Role of DS dummies: - capture discrete post-settlement discontinuities; empirical choice m = 5 (post-default dummies beyond a 5-year window are no longer statistically or economically significant). - restricting credit history to settlement dummies reduces DP size by between 60 to 100 basis points and its persistence. - Full panel specification: - s_{i,t} = α_i + F_{i,t} β + γ_1 MEM1_{i,t} + γ_2 MEM2_{i,t} + Σ_{j=1}^m δ_j DS(j)_{i,j} + ε_{i,t}. - Important caveat: - ∆DP_{i,t,T} = ∆s_{i,t,T} − ∆F_{i,t,T} β: changes in market spread equal changes in DP only if observable fundamentals do not move between pre-default and market re-entry. - DP can be positive even if spread at settlement is lower than before default; conversely spread can be higher while DP is zero. ### Dataset and measurement - Default definition and dating: - Uses Standard and Poor’s (S&P) definition of default (unilateral interruption of repayment and/or exchange offer accepted by lenders). - Uses S&P dating of the end of defaults (settlement when S&P concludes no further near-term resolution likely). - Treatment of rescheduling: - Rescheduling episodes that are ramifications of the initial default are not counted as new defaults. - Example: Brazil defaulted in 1983 with renegotiations in 1984, 1986, 1988 and a full renegotiation in 1992; treated as default year 1983 and market re-entry 1993. - Inclusion of averted defaults: - Adds credit events where country borrowed from IMF more than 200% percent of quota. - This adds events including Argentine and Mexico debt crises of 1995, Asian and Russian crises of 1997-98, European debt crises of 2008-2011. - New sovereign spreads database: - Extends post-WWII data backward to 1970 for both advanced and emerging markets by combining yield data from primary bond issuance and secondary market trading. - Controls for potential differential effects in spreads from primary vs. secondary yields. - End-product: annual database on sovereign spreads totaling more than 2,900 observations: - 1,639 in 1870-38, - 1,294 in 1970-2011. - Comparison to other datasets (annual-equivalent observations cited): Ozler (131-144), Flandreau and Zumer (215-265), Borenzstein and Pannizza (144-162), Benczur and Ilut (169), Cruces and Trebesch (310-447). - Dependent variable measurement: - Country spreads generally measured as difference between country sovereign bond yields (in pounds sterling before WWII or US dollars after WWII) and the UK consol or the US 10-year government bond yield, respectively. - For some 1970-2011 observations, spread measured vs relevant benchmark yield curve at similar maturity. ### Econometric controls and sample construction (Section 5.1) - Sample split: - pre-WWII: 1870-1938; - post-WWII: early 1970s–2011. - Variables included in F_{i,t} (all lagged one year; robust standard errors clustered at country level): - public debt to GDP ratio; - real world (risk-free) interest rate; - trend-like measure of real GDP growth (3-year moving average); - indicators of output cost of default: trade openness, foreign exchange reserves (ratio to imports or GDP), fixed exchange rate dummy; - global risk-aversion indicator (stock price volatility indices for UK and US); - share of external debt in total debt. - Additional robustness controls tested: - ratio of M2/GDP; - log-level and rolling standard deviations of external terms of trade from its 3-year past moving average; - general government fiscal balance to GDP; - sovereign dummy for newly independent countries in the post-WWII period. - Pre-1939 regressions include a World War I dummy equal to 1 in 1914-18. - Years where debt was in arrears are eliminated from the sample to mitigate endogeneity biases. - Model uncertainty addressed via model averaging following Pesaran and Timmermann (2007). ### Regression highlights (1870-1939 and 1970-2011) - 1870-1939: - public debt/GDP ratio, ratio of external to total debt, gold-peg dummy generally significant with expected signs. - world real interest rate and/or composite stock market volatility are important. - foreign exchange reserves and 3-year moving average of real GDP growth have expected negative sign; trade balance yields opposite sign; none significant. - MEM1 sizeable and statistically significant. - MEM2 has a negative coefficient of 0.01 (investors’ memories fade at 1 basis point per year); MEM2 significance reduced when time effects included. - debt settlement dummies yield sizeable and significant coefficients through the second or third year after settlement. - 1970-2011: - trade balance, global stock market volatility, reserves show up as highly significant. - post-settlement impact dummies significant through only the first or second year after default but with sizeable coefficients higher than pre-WWII. - MEM variables are highly significant and sizeable; removing MEM variables makes post-settlement dummies significant at 5% through the fifth year after market re-entry. - summing fitted values for DS(1), MEM1 and MEM2: default premium on impact is about 150 bps higher than pre-WWII. - Robustness: - TOT volatility, fiscal balances, and polity index not significant in many specifications. - alternative default definition including large IMF support ((IMF)) makes debt/GDP lose significance, but default premium variables remain broadly significant. ### Controlling for actual haircuts - Theoretical point: expected haircut matters for forward-looking bond pricing; past haircuts matter only as information about expected future haircuts. - Empirical tests: - interacting actual haircuts with DS dummies roughly halves observations; F-test on joint significance of interactive (DS*HC) dummies yields p-value = 33 percent; original DS dummies remain significant at 5 percent. - including actual haircuts renders memory variables insignificant (possible multicollinearity). - regressions with actual haircuts as dependent variable (sample of 42 debt settlement episodes): explanatory variables explain as much as R-square = 0.88 (full sample) and R-square = 0.91 (emerging markets sample). - actual haircut highly predictable by length of default (captured by MEM2) and size of debt. - Interpretation: - expected haircut (= 1 − E(c)) is highly predictable by other controls; adding cross-country dispersion of actual haircuts yields little additional explanatory power. - authors remain agnostic about value added of unexpected component of past haircuts due to data limitations. ### Memory alternatives - Additional memory indicator mem4r (number of defaults per country) tested: - captures whether more frequent defaults (holding average duration constant) lead to higher spreads. - result: difference is insignificant; if anything, fewer but longer defaults tend to trigger higher default premia. - Alternative functional forms for MEM2 tested: - quasi-hyperbolic, hyperbolic, exponential, inverse (geometric) discounting. - MEM1 remains significant across alternatives; MEM2 results vary in sign consistent with functional form but regression fits are no better than linear baseline. - evidence supports sticking to linear MEM2; default premium is higher rather than lower under alternatives. ### Default premium (DP) estimates and contrasts (Section 5) - DP defined as in equation (5); cross-country mean DP summarized for pre- and post-WWII sub-samples using favored specification (no time effects; removing most statistically insignificant variables). - Key DP findings: - sizeable DP in first few years after market re-entry; DP does not die out thereafter although it becomes very small for the bottom quartile. - model-uncertainty robustness: median DP computed across eight alternative specifications yields positive and sizeable DP with corroborating error bands. - Comparison between DP and raw sovereign spreads: - median DP and median sovereign spread differ non-trivially. - failing to net out publicly-observable fundamentals leads to mismeasurement: - underestimation of DP at market re-entry by as much as 150 bps in pre-WWII era; - overestimation by over 50 bps in post-1970 era. - incorrect inference example: assuming DP decayed more rapidly post-WWII would be misleading (300 bps vs. 150 bps between first and third year after settlement). - Qualitative point: - DP can jump, consistent with asymmetric information and default as a discrete signal; spread changes decomposed into changes in publicly-observed fundamentals vs. changes in DP. ### Fundamentals vs. Default Premium (Section 5.4) - Decomposition of sovereign spreads: - combining estimated parameters with equation (7) measures contribution of publicly-observable fundamentals (Fβ) vs. DP and estimated error term. - Contributions within five years after debt settlement: - Pre-WWII (1870-1938): default premium accounts for between 35 to 50% of the spread within five years after debt settlement. - Post-1970: default premium contribution is even higher on impact, reaching up to 60%. - Serial defaulters vs. non-serial defaulters: - Both the spread and the DP are larger for serial defaulters. - Estimation error is low in both cases. - Serial defaulters face costlier borrowing for the same set of fundamentals compared to non-serial defaulters. - No significant difference in DPs between countries that defaulted more often but for shorter periods vs. those that defaulted less often but for longer periods: what matters is total number of years in default and recency of last default. - Economic significance (example): - For the average post-1970 defaulter (mean public debt/GDP ratio of 50 percent and which never defaulted before): - Point estimates of the DP imply an extra interest cost of 2 percent of GDP upon market re-entry, tapering to 1 percent of GDP five years hence. - A serial defaulter with otherwise similar characteristics would face an even higher interest bill. - Drivers of larger and more persistent DP estimates: - broader DP metric (non-linear effects of post-settlement dummies and slowly-decaying memory variables); - a much broader cross-country panel (longer time-series and wider cross-section); - wider variety of controls and averaging across alternative specifications. ### Policy-relevant implications - The positive, sizeable, and persistent default premium that rises on market exclusion spells helps rationalize: - why governments typically try hard not to default; - why, when they default, they seek early renegotiation. - Quantitatively relevant magnitudes: - Default premium accounts for between 35 to 50% of the spread within five years after debt settlement in 1870-1938. - Default premium contribution reaches up to 60% on impact in the post-1970 period. - For an average post-1970 defaulter with mean public debt/GDP ratio of 50 percent and no prior defaults: extra interest cost of 2 percent of GDP on market re-entry, tapering to 1 percent of GDP five years later. *Source: _wp15167 - 1990. Relative to classical studies of pre-WWII spreads by Bordo and Rockoff (1997),* ### 1990. Relative to classical studies of pre-WWII spreads by Bordo and Rockoff (1997), ### _wp15167 - 1990. Relative to classical studies of pre-WWII spreads by Bordo and Rockoff (1997), ### Contributions and scope - Adds more countries, fixes issues with the data and comprises more control variables, including for global market factors highlighted in recent work (Borri and Verdelhan, 2011; and Longstaff et al., 2011). - Extends many series on sovereign spreads back to the 1970s and 1980s and adds advanced countries to the sample, allowing coverage of major recent events in sovereign debt markets. - Combines two contributions (expanded historical sample and extended post-WWII series with advanced countries) to yield a third: documents salient features of empirical default premia (DPs) by decomposing the spread into: - a vector of observable fundamentals, - the DP, - surpluses from borrowers in certain circumstances (e.g., relationship banking and syndicated loans), - an estimation error, - distinct functional forms for memory formation, - re-evaluation of the importance of the actual size of the default (the final “haircut”) in shaping DP evolution. - Focus is on competitive bond markets, where scope for collusion is arguably more limited. ### Main empirical results (summary) - Impact DP estimates: - around 250 basis points in the period 1870-1938, - 400 bps in 1970-2011. - Decay profile of the DP: - by the end of the 5th year after debt settlement it averages some 150 basis points in the pre-WWII period and 200 bps post-1970, tapering off thereafter. - Statistical properties and variance: - the DP is significant at conventional statistical levels but displays considerable variance; limited sampling can greatly affect inference on the mean DP. - Contribution of observables vs. DP: - changes in observable fundamentals account for less than half of variations in market spreads between pre-default and post-settlement spells, implying the DP contribution is key. - DP and serial defaulting: - the DP rises with the number of years a sovereign stays out of the market; this being higher for serial defaulters implies they pay a higher DP. - Robustness to memory specifications: - the DP is no smaller for alternative specifications on how investors’ memories evolve. - Role of actual haircut: - unlike Cruces and Trebesch (2013), direct control for the size of the actual haircut in spread regressions is not necessary to obtain a significant and longer lasting DP. - close to 90% of the actual haircut can be predicted by the length of the default and country-specific fundamentals; thus the informational content from the haircut “shock” to the evolution of the DP appears to be very small. ### Theory (model setup and implications) - Market and agents: - competitive market populated by risk-neutral lenders who break-even given their beliefs, - lenders have access to a risk-free technology with gross rate Rf,t = 1 + rf,t taken as exogenous. - Default technology: - in case of default at t+1, creditors expect to recover a fraction E(c_{t+1}) of contractual repayment obligations D_t with 0≤E(c_{t+1})<1, - expected haircut E(h_{t+1}) = 1 − E(c_{t+1}), - default entails a fraction κ of the sovereign’s current output ˜Y_t being lost, where 0<κ<1, and deadweight loss is assumed. - Break-even condition and spread: - lenders hold bonds if: [π_t E(c_{t+1}) + (1−π_t)] R_t = R_{f,t}. - defining spread s_t = R_t / R_{f,t} − 1 yields s_t = π_t E(h_{t+1}) / [1 − π_t E(h_{t+1})]. - Sovereign repayment decision (linear utility, one-period bond): - repayment if Y_t − D_t + β_t V^r_{t+1}(.,ϵ_t) ≥ (1−κ) Y_t − E(c_{t+1}) D_t + β_t V^d_{t+1}(.,ϵ_t). - rearranged: β_t [V^r_{t+1}(.,ϵ_t) − V^d_{t+1}(.,ϵ_t)] ≥ E(h_{t+1}) D_t − κ Y_t. - Role of information asymmetry: - if lenders do not observe persistent component ϵ_t but sovereign does, sovereign actions (repay/default) are informative about D/Y and future default risk; - signaling: repayment signals bright growth outlook, raising V^r and lowering R; adverse persistent shocks raise default likelihood and R. - General implications: - information asymmetries make borrower’s past actions informative about future default risk; - existence of a threshold ϵ^*_t such that realizations below trigger default; - a positive premium R^d − R^r > 0 which is a function of credit history; - probability of default and expected haircut are jointly determined; expected haircut may differ from final actual haircut due to ex-post bargaining. ### Empirical specification of DP - Spread decomposition: - s_{i,t} = α_i + F_{i,t} β + DP_{i,t}, - where s_{i,t} is country i spread at time t, F_{i,t} is row vector of common-knowledge observable fundamentals, DP_{i,t} is default premium. - DP functional form: - DP_{i,t} = γ_1 MEM1_{i,t} + γ_2 MEM2_{i,t} + Σ_{j=1}^m δ_j DS(j)_{i,t}. - Definitions: - MEM1_{i,t}: ratio of the number of years country i is in default to the total number of years in the sample up to year t (proxy for credit history; Reinhart et al. (2003) used similar). - MEM2_{i,t}: number of years since the last default (Eichengreen and Portes (1986); Reinhart et al. (2003); Flandreau and Zummer (2004); Esteves (2007)). - DS(j)_{i,t}: dummy equal to one if t is the jth year after settlement on the defaulted debt (the year the country fully re-enters the international debt market after its last default); zeros otherwise; there are m such dummies (0 0, γ_2 expected to be negative (longer time since last default lowers DP). - Interpretation of MEM variables: - MEM1 summarizes unobserved nature of size and persistence of shocks that trigger defaults; MEM2 complements with timing and duration information. - MEM1 and MEM2 may also proxy for unobserved parameters like β (country “type”). - Role of DS dummies: - capture discrete post-settlement discontinuities; empirical choice m = 5 (post-default dummies beyond a 5-year window are no longer statistically or economically significant). - combining MEM1, MEM2 and DS(j) nests previous specifications (Reinhart et al., Eichengreen and Portes, Flandreau and Zummer, Borenzstein and Panizza, Cruces and Trebesch). - restricting credit history to settlement dummies reduces DP size by between 60 to 100 basis points and its persistence. - Full panel specification: - s_{i,t} = α_i + F_{i,t} β + γ_1 MEM1_{i,t} + γ_2 MEM2_{i,t} + Σ_{j=1}^m δ_j DS(j)_{i,j} + ε_{i,t}. - Important caveat: - DP does not necessarily move one-to-one with unconditional market spreads s_{i,t}. - ∆DP_{i,t,T} = ∆s_{i,t,T} − ∆F_{i,t,T} β: changes in market spread equal changes in DP only if observable fundamentals do not move between pre-default and market re-entry. - DP can be positive even if spread at settlement is lower than before default; conversely spread can be higher while DP is zero. Pre-post spread differences can mislead on true interest cost of default. ### Dataset and measurement - Default definition and dating: - Uses Standard and Poor’s (S&P) definition of default (unilateral interruption of repayment and/or exchange offer accepted by lenders). - Uses S&P dating of the end of defaults (settlement when S&P concludes no further near-term resolution likely). - Appendix Table A1 lists default and settlement dates (not reproduced here). - Treatment of rescheduling: - Treat sovereign defaults as watershed-like occurrences; re-scheduling episodes that are ramifications of the initial default are not counted as new defaults. - Example: Brazil defaulted in 1983 with renegotiations in 1984, 1986, 1988 and a full renegotiation in 1992; treated as default year 1983 and market re-entry 1993 (rather than multiple defaults). - Inclusion of averted defaults: - Expanded definition of credit events incorporates seemingly averted defaults due to last resort multilateral financing; adds credit events where country borrowed from IMF more than 200% percent of quota (as in Catão and Milesi-Ferretti (2014)). - This adds events including Argentine and Mexico debt crises of 1995, Asian and Russian crises of 1997-98, European debt crises of 2008-2011. - New sovereign spreads database: - Draws on variety of new sources to add more countries and correct inconsistencies. - Extends post-WWII data backward to 1970 for both advanced and emerging markets by combining yield data from primary bond issuance and secondary market trading. - Controls for potential differential effects in spreads from primary vs. secondary yields. - Improves on gaps in key fundamentals (ratio of external to total debt, monetary data) relative to Reinhart and Rogoff (2009). - End-product: annual database on sovereign spreads totaling more than 2,900 observations: - 1,639 in 1870-38, - 1,294 in 1970-2011. - Comparison to other datasets: - Ozler (1993, Table 1): 131-144 observations, - Flandreau and Zumer (2004, Table A.7): 215-265, - Borenzstein and Pannizza (2009, Table 5): 144-162, - Benczur and Ilut (2015): 169, - Cruces and Trebesch (2013): 310-447 annual-equivalent observations. - Dependent variable measurement: - Country spreads generally measured as difference between country sovereign bond yields (in pounds sterling before WWII or US dollars after WWII) and the UK consol or the US 10-year government bond yield, respectively. - For a few 1970-2011 observations where maturity and currency of issuance were known, spread measured vs relevant benchmark yield curve at similar maturity. ### Structure of remainder of paper - Section 2: presents the theory underpinning the empirical DP metric. - Section 3: specifies the empirical DP metric. - Section 4: introduces the new dataset. - Section 5: reports DP estimates, robustness tests, and spread decomposition exercises. - Section 6: concludes. - Appendix: specifics of the data. *Source: _wp15167 - 1990. Relative to classical studies of pre-WWII spreads by Bordo and Rockoff (1997),* ### 5.1 Econometric Controls ### _wp15167 - 5.1 Econometric Controls ### Econometric controls and sample construction - Sample broken into pre-WWII (comprising 1870-1938) and post-WWII sub-sample (starts in the early 1970s and ends in 2011). - Variables included in Fi,t (all lagged one year; robust standard errors clustered at country level): - public debt to GDP ratio; - real world (risk-free) interest rate; - trend-like measure of real GDP growth (computed as a 3-year moving average); - indicators of output cost of default: trade openness, foreign exchange reserves (as a ratio to imports or GDP), fixed exchange rate dummy; - global risk-aversion indicator (proxied by indices of stock price volatility in the UK and the US); - share of external debt in total debt. - Additional robustness controls tested: - ratio of M2/GDP; - log-level and rolling standard deviations of external terms of trade from its 3-year past moving average; - general government fiscal balance to GDP; - sovereign dummy for newly independent countries in the post-WWII period. - Pre-1939 regressions include a World War I dummy equal to 1 in 1914-18 and zero otherwise. - Years where debt was in arrears (limited or non-existent market access) are eliminated from the sample to mitigate endogeneity biases. - Model uncertainty addressed via model averaging following Pesaran and Timmermann (2007). ### Regression results (1870-1939 and 1970-2011) - 1870-1939 (Table 1): - country fixed effects and time fixed effects specifications reported. - key fundamentals: overall public debt/GDP ratio, ratio of external to total debt, gold-peg dummy yield expected signs and are statistically significant for the most part. - world real interest rate and/or composite stock market volatility (UK and US) are important. - foreign exchange reserves and 3-year moving average of real GDP growth have expected negative sign; trade balance yields opposite sign; none significant. - public debt to GDP ratio significant in all specifications. - debt settlement dummies (from year of market re-entry through 5 years hence) yield sizeable and significant coefficients through the second or third year after settlement in all four specifications. - memory variables: - MEM1 (years out of market as share of total years up to that point) is sizeable and statistically significant; - MEM2 has a negative coefficient of 0.01, indicating investors’ memories fade away at a rate of 1 basis point per year; MEM2 significance is reduced when time effects are included (multicollinearity). - Robustness checks (Table 2): - terms of trade gap (past three-year moving average), M2/Y, government balance/GDP, and seasoned borrower dummy are not statistically significant. - rolling 10-year standard deviation of terms of trade not significant. - 1970-2011 (Table 3): - many determinants (trade balance, global stock market volatility, reserves) show up as highly significant. - include dummy for primary market data for pre-1990 observations. - post-settlement impact dummies statistically significant through only the first or second year after default but with sizeable coefficients higher than pre-WWII. - MEM variables are highly significant and sizeable; removing MEM variables makes post-settlement dummies significant at 5% through the fifth year after market re-entry. - summing fitted values for DS(1), MEM1 and MEM2: default premium on impact is about 150 bps higher than pre-WWII (see Figure 1). - Additional robustness (Table 4): - TOT volatility, fiscal balances, and polity index not significant. - alternative definition of default events to include large IMF support programs (labeled (IMF)) makes debt/GDP lose significance, but default premium variables remain broadly significant. ### Controlling for actual haircuts - Theoretic and practical discussion: - expected haircut (future haircut) is what matters for forward-looking bond pricing; past haircuts relevant only to the extent they inform expected future haircuts. - estimated coefficients on some regressors (including DS dummies) already capture panel average haircut. - Empirical tests (Table 4 and Table 5): - interacting actual haircuts with DS dummies roughly halves the number of observations; F-test on joint significance of interactive (DS*HC) dummies yields probability value of 33 percent; original DS dummies remain significant at 5 percent. - including actual haircuts renders memory variables insignificant (possible multicollinearity with haircut size and inclusion of time fixed effects). - regressions with actual haircuts as dependent variable (Table 5): - sample of 42 debt settlement episodes: explanatory variables in baseline specification explain as much as 88 percent of actual haircuts (R-square = 0.88). - sample limited to emerging markets: R-square = 0.91. - actual haircut highly predictable by length of default (captured by MEM2) and size of debt. - Interpretation: - expected haircut (= 1 − E(c)) is highly predictable by other controls, so adding cross-country dispersion of actual haircuts yields little additional explanatory power. - authors remain agnostic about the value added of the unexpected component of past haircuts due to data limitations. ### Memory alternatives - Additional memory indicator mem4r (number of defaults per country) tested: - captures whether more frequent defaults (holding average duration constant) lead to higher spreads. - result indicates difference is insignificant; if anything, fewer but longer defaults tend to trigger higher default premia. - Alternative functional forms for MEM2 tested: - quasi-hyperbolic discounting, hyperbolic discounting, exponential discounting, inverse (geometric) discounting. - MEM1 remains significant across alternatives; MEM2 results vary in sign consistent with functional form but regression fits are no better than linear baseline. - evidence supports sticking to linear MEM2; default premium is higher rather than lower under alternatives. ### Default premium (DP) estimates and key contrasts - DP defined as in equation (5); Figures 1 and 2 summarize cross-country mean DP for pre- and post-WWII sub-samples using favored specification (no time effects; removing most statistically insignificant variables). - Key DP findings: - sizeable DP in first few years after market re-entry; DP does not die out thereafter although it becomes very small for the bottom quartile. - model-uncertainty robustness: median DP computed across eight alternative specifications for each sub-period yields positive and sizeable DP with corroborating error bands (Pesaran and Timmermann (2007) approach). - Comparison between DP and raw sovereign spreads (Figures 3–6): - median DP and median sovereign spread differ non-trivially. - failing to net out publicly-observable fundamentals leads to mismeasurement: - underestimation of DP at market re-entry by as much as 150 bps in pre-WWII era; - overestimation by over 50 bps in post-1970 era. - incorrect inference example: assuming DP decayed more rapidly post-WWII would be misleading (300 bps vs. 150 bps between first and third year after settlement). - Additional qualitative point: - DP can jump, consistent with asymmetric information and default as a discrete signal; authors decompose spread changes into changes in publicly-observed fundamentals vs. changes in DP. *Italic: Content unit summarized from _wp15167 - 5.1 Econometric Controls (source PDF: _wp15167 - 5.1 Econometric Controls).* ### 5.4 Fundamentals vs. Default Premium ### 5.4 Fundamentals vs. Default Premium ### Decomposition of sovereign spreads: fundamentals vs. default premium (DP) - Combining estimated parameters with equation (7) gauges how much of the change in the sovereign spread is accounted for by publicly-observable fundamentals versus the DP and the estimated error term. - Pre-WWII (1870-1938): the default premium accounts for between 35 to 50% of the spread within five years after debt settlement. - Post-1970: the contribution of the default premium is even higher on impact, reaching up to 60%. - The contribution of fundamentals to changes in the market spread is strikingly stable across samples. - Figures referenced: Figures 7-8 illustrate the mean spread decomposition for pre-WWII and post-WWII samples respectively (cross-country mean fitted values of Fundamentals, Fβ, and DP). ### Serial defaulters vs. non-serial defaulters - Spread decomposition is broken down between countries that defaulted only once and those that defaulted more than once, computed separately for pre- and post-WWII data. - Figures 9-12 show: - Both the spread and the DP are larger for serial defaulters. - Estimation error is low in both cases (gauged by the gap between the spread in dotted lines and the top of the vertical bars for each year). - Serial defaulters typically face costlier borrowing for the same set of fundamentals compared to non-serial defaulters. - The paper finds no significant difference in DPs between countries that defaulted more often but for shorter periods vs. those that defaulted less often but for longer periods: what matters is the total number of years in default and how recent was the last default. - Implication: a serial defaulter pays a higher DP because it stays in default for a higher percentage of its time as sovereign. - These results hold for both the pre-WWII and the post-1970 periods. ### Economic significance and persistence of the default premium - The paper argues the interest rate cost of default has been previously underestimated. - Illustration for the average post-1970 defaulter (mean public debt/GDP ratio of 50 percent and which never defaulted before): - Point estimates of the DP imply an extra interest cost of 2 percent of GDP upon market re-entry, tapering to 1 percent of GDP five years hence. - A serial defaulter with otherwise similar characteristics would face an even higher interest bill. - The paper attributes larger and more persistent DP estimates to: - A broader metric of the DP (comprising the non-linear effects of the post-settlement dummies and slowly-decaying memory variables). - A much broader cross-country panel (longer time-series and wider cross-section) than previous studies. - Longer time-series is important to capture slowly decaying DP effects. - A broader cross-section avoids sample selection pitfalls caused by idiosyncratic periods (e.g., syndicated banking lending era mid-1970s/early 1980s; bright emerging market outlook 2002-2007). - Subjecting estimates to a wider variety of controls (including the actual size of haircuts) and averaging across alternative specifications to identify anomalies and obtain robust DP measures. ### Two additional novel results highlighted - Changes in publicly-observable or "common-knowledge" fundamentals typically account for less than one-half of the changes in the spread between pre-default and debt settlement. - This underscores the importance of the DP in accounting for large shifts in the spread and in borrowing costs around major sovereign credit events. - The DP depends on total years in default and recency of last default rather than on frequency vs. duration tradeoffs of default spells. ### Overall interpretation and policy-relevant implication - The findings point to a positive, sizeable, and persistent default premium that rises on market exclusion spells. - This helps rationalize: - Why governments typically try hard not to default. - Why, when they do default, they seek early renegotiation. - Quantitatively relevant magnitudes cited: - Default premium accounts for between 35 to 50% of the spread within five years after debt settlement in 1870-1938. - Default premium contribution reaches up to 60% on impact in the post-1970 period. - For an average post-1970 defaulter with mean public debt/GDP ratio of 50 percent and no prior defaults: extra interest cost of 2 percent of GDP on market re-entry, tapering to 1 percent of GDP five years later. *Source: _wp15167 - 5.4 Fundamentals vs. Default Premium* ### Section 4, partial re-scheduling and debt negotiation attempts following the original ### _wp15167 - Section 4, partial re-scheduling and debt negotiation attempts following the original ### Classification of sovereign credit events and default length - Partial re-scheduling and debt negotiation attempts following the original default decision which, nevertheless, do not result in a complete or near complete settlement of arrears, are not classified as new default or a final settlement of the debt. - The years between the initial default and full (or near full) settlement of arrears as per the S&P definition are taken as the length of the default. - The approach follows Sutter (1992), Beim and Calomiris (2001), and Reinhart and Rogoff (2009). - The framework does not distinguish between “voluntary” and “involuntary” defaults or “market-friendly” vs. “market-unfriendly” reschedulings; focus is on the breach in the original contractual terms of the debt agreement. ### Complementary sovereign credit event definition based on IMF financing - A complementary definition of sovereign credit events is based on large resort to multilateral financing. - Events that imply resort to 200% or more the respective country’s quota at the IMF are defined as credit events. - The share of IMF’s credit to country members is computed from the IMF’s International Financial Statistics (IFS) database (publicly available online). - Table A1 reports the exact country/year dates of all the credit events in the series. ### Construction of credit history indicators (A.3) - Illustration Case 1: Single Default - Suppose sovereign history starts in 1850 for country i. In 1898 the country defaults and it settles its debt with creditors in 1902. There is no default thereafter. - MEM1_i,t = 0 for all t < 1898 - MEM1_i,t = (t − 1898) / (t − 1850) for 1898 ≤ t ≤ 1902 - MEM1_i,t = (1902 − 1898) / (t − 1850) for all t > 1902 - MEM2_i,t = 0 for all t < 1898 - MEM2_i,t = t − 1898 for all t > 1898 - For a window of m = 2, the two DS(j)_i,t dummies are defined as: - DS(1)_i,t = 1 for t = 1903 and DS(1)_i,t = 0 for t ≠ 1903 - DS(2)_i,t = 1 for t = 1904 and DS(2)_i,t = 0 for t ≠ 1904 - Illustration Case 2: Serial default - Using the same initial history but with a second default in 1928 and settlement in 1935: - MEM1_i,t = 0 for all t < 1898 - MEM1_i,t = (t − 1898) / (t − 1850) for 1898 ≤ t ≤ 1902 - MEM1_i,t = (1902 − 1898) / (t − 1850) for 1902 < t ≤ 1928 - MEM1_i,t = (1902 − 1898 + t − 1928) / (t − 1850) for 1928 < t ≤ 1935 - MEM1_i,t = (1902 − 1898 + 1935 − 1928) / (t − 1850) for all t > 1935 - MEM2_i,t = 0 for all t < 1898 - MEM2_i,t = t − 1898 for 1898 ≤ t ≤ 1902 - MEM2_i,t = t − 1928 for t > 1928 (MEM2 is reset upon the second default) - Debt settlement dummies in this example: - DS(1)_i,t = 1 for t = 1903, 1936 and DS(1)_i,t = 0 otherwise - DS(2)_i,t = 1 for t = 1904, 1937 and DS(2)_i,t = 0 otherwise ### Data sources and construction for key series (A.4–A.16) - GDP data - 1870-1939: Nominal and Real GDP data are Mitchell (2013) and Maddison (2003), complemented with Barro and Urzua (2008), with exceptions: - Argentina, Brazil, Chile and Mexico: Aiolfi, Catão, and Timmermann (2011) - Greece: new estimates provided by George Kostelenos (Money and Output in Modern Greece, 1858-1938, Athens, 1995) - Russia: net national product estimate from Paul Gregory, Russian National Income, 1885-1913 (Cambridge University Press, 1983), Table 3.1, pp. 56-7, (“variant 1”) - Spain: Prados de la Escosura, Leandro 2003, El Progreso Economico de España, 1850-2000 - Venezuela: Baptista, Asdrœbal, 1997, Bases Cuantitativas de la Economia Venezolana, 1830-1995 - Nominal GDP from Obsfeld and Taylor (2003) except for above countries; New Zealand from Rankin, Keith, 1992; Hungary and Yugoslavia from Mitchell, Brian, 2003 - 1970-2011: IMF’s International Financial Statistics database - Total Government Debt - 1870-1939: Chief source Obstfeld and Taylor (2003), with country exceptions (Aiolfi et al. 2011; Dimitrova and Ivanov (2014); Lazaretou (1993); Kelly (1998); Stoenescu et al. (2014); Hinic, Durdevic, and Sojic (2014); Baptista (1997); League of Nations Yearbooks; Reinhart and Rogoff (2009)) - 1970-2011: IMF’s World Economic Outlook and World Bank’s World Development Finance databases; where conflict or missing information, Abbas et al (2010), IMF working paper 10/245 used - External Government Debt - 1870-1939: Chief sources Flandreau and Zulmer (2004, Table DB3, 1880-1913) and League of Nations Yearbooks for 1919-1939; numerous country-specific sources listed in the text - 1970-2011: World Bank’s Global Development Finance database; for advanced countries assumed externally issued debt was zero except when under IMF program (then debt to the IMF deemed to represent all external debt) - Fixed Exchange Rate Regime (Fixed) - 1870-2013: Dummy = 1 when country was on the gold standard. Sources: Catão and Solomou (2005) for 1870-1913; Obstfeld and Taylor (2003); Officer, Lawrence, “Gold Standard” - 1970-2011: Fixed exchange rate dummy constructed based on the IMF classification (categories “1” and “2”), as compiled in Reinhart, Rogoff and Ilzetzki, 2009 (updated by the authors based on IMF information) - Nominal interest rate in the world (i_WORLD_t−1) - 1870-1939: GDP weighted average of the (short-term) money market interest in the UK and the US (the latter from 1920) deflated by CPI inflation. Nominal interest source: Holmer and Silla, A History of Interest Rates (1996). CPI inflation: Catão and Solomou (2005) for 1870-1913; Obstfeld and Taylor (2003) and Global Financial Data for post-1914. GDP data from Maddison (1995). - 1970-2011: Computed same as for 1870-1939 but including all G-7 economies plus Australia. Money market rates, CPI and inflation and US dollar GDP data from IMF’s International Financial Statistics. - Stock Market Volatility - 1870-1939: Standard deviation of month-to-month change over the 12-month annual window for the London stock market index from Global Financial Data for 1870-1918; for 1919-1939, the US stock market index from Global Financial Data used. - 1970-2011: Measured by the VIX/VOX index compiled in Philips, Steve et al., “External Balance Assessment Methodologies”, IMF working paper 13/296 from 1986. Pre-1986 the index was spliced based on the S & P 500 index actual volatility, calculated as standard deviations of monthly changes as for 1870-1939. - Exports and Imports - 1870-1939: Mitchell, B.R. International Historical Statistics - 1970-2011: IMF’s International Financial Statistics - Terms of Trade - 1870-1939: Sources include Blattman, C. J. Hwang and J. Williamson (2007) and Catão and Solomou (2005) online appendix; some Latin American countries from Base de Datos de Historia Económica de América Latina Montevideo-Oxford - 1970-2011: IMF’s International Financial Statistics and World Economic Outlook databases, various vintages, as compiled in Catão and Milesi-Ferretti (2014) - Foreign Exchange Reserves - 1870-1939: Advanced countries mostly from Flandreau and Zummer (2004), complemented by numerous country-specific sources listed in the text - 1970-2011: IMF’s International Financial Statistics - Broad Money (M2) - 1870-1939: Mitchell (2013) and Flandreau and Zummer (2004), complemented with country-specific sources - 1970-2011: IMF’s International Financial Statistics, World Economic Outlook, and World Bank’s Global Development Finance databases, as revised and combined by Catão and Milesi-Ferretti (2014) - Government Expenditures and Revenues - 1870-1939: Mitchell (2013) and Flandreau and Zummer (2004), complemented with country-specific sources - 1970-2011: IMF’s International Financial Statistics, World Economic Outlook, and World Bank’s Global Development Finance databases, as revised and combined by Catão and Milesi-Ferretti (2014) - Polity index (Polity) - Available at: http://www.icpsr.umich.edu/icpsrweb/ICPSR/studies/6695 and http://www.systemicpeace.org/polity/polity4.htm - Haircuts on Foreign Debt - Cruces and Trebesch (2013), updated to 2014 as available from https://sites.google.com/site/christophtrebesch/, and Reinhart and Trebesch (2014) *Italic: Content derived from _wp15167 - Section 4, partial re-scheduling and debt negotiation attempts following the original.* ### References ### References ### Sovereign default, debt restructuring, and sovereign risk - Aguiar, M. and G. 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