Razones de actividad o rotación de Activos

Direction of results are readily intuitive and can be derived from the propositions in the previous section. This application provides two lessons, first that the stand alone Arellano (2008) model would imply a different path of periphery spreads in the 2000’s, and second, that the inclusion of a bailout mechanism can reconcile this with the 2008 initial surge in interest rates. For this, I will use Italy and Germany as the periphery and the core country, respectively. Italian stylized facts are presented in Table (2.2). One can see that the spread of Italian debt over German Bunds was highest in the period 1993-1999, and as figure (2.5) depicts, plummets abruptly to an average spread of 0.15 percent in the period 2000-2007, a period which coincides with the introduction of the Euro.

Table 2.2: Italian statistics on five year government debt by periods. Source: Bloomberg tickers GDBR5, GBTPGR5 are used for yields. B stands for debt, DS stands for debt service. Source: Bloomberg.

Gov. Bond Spread B/GDP Debt CA/GDP CA/ GDP

5y yield Serv. var

1993-2013 5.18 1.51 113.59 1.47 0.0004 -0.01

1993-1999 8.51 3.25 118.19 2.51 0.0004 0.01

1999-2007 4.01 0.15 107.42 1.08 0.0001 -0.01

2007-2013 3.80 1.94 117.88 1.12 0.0002 -0.02

Table 2.3: Model Performance

Statistic Spreads Debt service CA/GDP std Default

Statistic (%) to GDP (%) probability

Data 3.25 2.51 0.02 0.02

2000 2001 2002 2003 2004 2005 2006 2007 2008 −1 0 1 2 3 4 5 6 7 8 9 Dates: 2000Q1 − 2007Q4

Italian Spreads over Bunds %

Credible no bailout clause Implicit bailout

Figure 2.7: Simulation counterfactual: Spreads for 2000-2007 in a calibrated

model to 1993-1999 for Italy in the absence of implicit guarantees

Table 2.3 reports the performance of the model. In particular, the parameter values of the calibration can achieve 2.28% spread for the 90’s period, when the actual spread on Italian debt was 3.25%. That is, the model slightly under-performs on this dimension. Let us now assess the counter factual spread dynamics for Italy, under the baseline calibration. Now we want to extend the model into the 2000s, in order to compare it to actual spreads. To do this, we save the estimated forecast errors from OLS output regressions to the model, take the endowment process as given and compute the default probabilities and spreads. Figure 2.7 depicts in blue a completely different story. Italian spreads should have been above 5% by 2006, but instead we actually observed a mean 0.15% spread in the 2000-2007 period. The mean of spreads in that period, in the absence of a bailout guarantee would have been instead 1.806%. Using the same calibration, we now investigate if the

model can insulate interest rates. In figure 2.7, we see that the bailout guarantee can easily do that.

After the collapse of Lehman Bro. in September 2008, the world economy cut projections for future income for both the periphery economy and the core economy. This event had two main consequences. First, spreads for periphery economies was higher only because their own income was lower. Second, this model predicts that if income of the core economy is lower it is less likely for the latter to save its neighbor in case of default which amplifies the initial spike in periphery sovereign spreads.

2.5 Conclusions

We consider the introduction of strategic bailouts from a creditor country (core) to a defaulting borrower country (periphery), in the context of the sovereign default model in the tradition of Eaton and Gersovitz (1981). In the same way that default is strategic because debt is not enforceable, bailout extensions from a creditor coun- try are strategic as there is no obligation to provide such alleviation. Thus, this is a theory of bailout extension from a creditor country, and not from an interna- tional financial institution like the IMF, whose mandate would be global financial stability. The creditor economy wants to extend a bailout because there is money at play. Its inhabitants have invested resources in periphery debt, and would lose their savings if default is to materialize. However bailouts are costly. Either because there is a cost in coordinating all creditors, or simply because creating a fund like

the European Financial Stability Mechanism requires initial equity.

The introduction of this implicit guarantee on sovereign debt has two opposing effects on its pricing. First, spreads are lower simply because the expected recovery rate is higher. However incentives to default are also changed. In particular, if there is a chance that the defaulting economy will receive financial assistance after declaring default and part of its outstanding debt will dilute, then the value of exerting the default option is higher, and these events more frequent. This would raise spreads. We show that bond price schedule is decreasing in the haircut fraction of debt after re-structuring, is bounded from below, and is less sensitive to income fluctuations with the inclusion of a bailout probability. We also show that bailouts are more likely to happen when there are good realizations of income for the creditor economy. A final application of our model and a benchmark calibration can generate spreads close to zero for Italy even when income fluctuations and debt accumulation would predict otherwise. Shutting off the bailout implicit guarantee would have raised spreads from 0.03% to 1.8%.

Appendix Chapter 1