Constrained efficient borrowing with sovereign default ris

Francisco Roch, Juan Carlos Hatchondo, Leonardo Martinez

2019-08-22 - We propose a tractable algorithm for solving quantitative models of sovereign default with constrained efficient borrowing (i.e., with commitment to the optimal borrowing policy but not to a default policy). Our algorithm utilizes the government's optimality condition that, compared to the Markov condition, only requires one additional state variable summarizing the effect of current borrowing on past consumption. Comparing the simulations of the model with and without commitment, we find that the overindebtedness chosen by the Markov government is small but accounts for most of the default risk. With commitment, the government also has a much higher probability of completing a successful deleveraging (without defaulting), even with weaker initial austerity. These results underscore the importance of governments' efforts to limit their future policies with fiscal rules and independent fiscal councils. Additionally, commitment does not affect significantly the procyclicality of fiscal policy, which casts doubts on the emphasis on countercyclical fiscal policy in existing fiscal rules. Our algorithm could be extended to study other aspects of debt management in which time inconsistency plays a role.