Discussion on
Default and Interest Rate Shocks: Renegotiation
Mattersby Almeida, Esquivel, Kehoe, and Nicolini

Jing Zhang1
Federal Reserve Bank of Chicago

IMF-CARF-TCER-WASEDA University Conference
June 8, 2024
1 The views expressed here are those of the author and are not necessarily reflective of viewsof the Federal Reserve Bank of Chicago and the Federal Reserve System.
Jing Zhang

FRB Chicago

1 / 16

Summary: a great paper

Question: How can we reconcile mild quantitative predictions fromsovereign debt models with the narrative that the Volcker rate hikes
caused the 1982 Mexican default?
Solution: Introduce renegotiation that endogenously determines thehaircut rate into an otherwise standard sovereign debt model
Mechanisms: Lenders accept a larger haircut when rates are highbecause the opportunity cost of holding defaulted debt is higher.
Thus, rate hikes are much more likely to lead to defaults.

Jing Zhang

FRB Chicago

2 / 16

Related strands of sovereign debt literature
Debt renegotiation:Nash bargaining vs games with endogenous delays
Benjamin-Wright (2009), Bai-Zhang (2012), Asonuma-Joo (2020)

Within Nash games, different outside options
Yue (2010), D’Erasmo (2008)

Debt exchange or preemptive renegotiation
Hatchondo-Martinez-Sosa-Padilla (2014), Asonuma-Trebesch (2016)

Interest rate v.s. productivity shocks (growth or levels)
Aguiar-Gopinath (2006), Arellano (2008), Bai-Zhang (2010), .....
Guimaraes (2011), Johri-Khan-Sosa-Padilla (2022)

Jing Zhang

FRB Chicago

3 / 16

Debt renegotiation: Nash bargaining

Nash bargaining: the outside option for both parties is to wait tonegotiate in a later period:b R (y , r ) = arg maxhS LEN (y , r )iα hS GOV (y , r )i1− α b̃

where the surpluses are:
S GOV (y , r ) = V P (b̃, y , r ) − V D (y , r ) ≥ 0hi
S LEN (y , r ) = γ + (1 − γ)q P (b P (b̃, y , r ), y , r ) b̃ − Q D (y , r ) ≥ 0

Jing Zhang

FRB Chicago

4 / 16

Lenders’ outside option: Q D (y , r )Q D (y , r ) =hnoi 1−θ hiθE γ + (1 − γ)q P (b ′′ , y ′ , r ′ ) b R (y ′ , r ′ ) +E Q D (y ′ , r ′ )1+r1+rA higher r lowers lenders’ outside option Q D in the renegotiationb R adjusts down to reallocate some of that surplus to government
Key idea: lenders’ opportunity cost of holding onto the debt has
increased due to higher risk free rate

Jing Zhang

FRB Chicago

5 / 16

Two mechanisms in bond pricing

q P (b ′ , y , r ) =hnoi
1
E 1 − d (b ′ , y ′ , r ′ ) γ + (1 − γ)q P (b ′′ , y ′ , r ′ )1+rQ D (y ′ , r ′ )1E d (b ′ , y ′ , r ′ )+1+rb′“Standard” mechanism: a higher r lowers q P (more discounting)Renegotiation mechanism: a higher r lowers Q D and thus q P
Key idea: raising funds becomes more difficult for government

Jing Zhang

FRB Chicago

6 / 16

Key finding 1

Renegotiation generates higher default risk after rate hikePr(dt = 1 | dt −1 = 0, rt = rH , rt −1 = rL )Pr (default event|interest-rate hike)

Jing Zhang

No renegotiation, Fixed exogenous
no recovery
haircut
0.06
0.13

FRB Chicago

Endogenous
renegotiation
0.24

7 / 16

Key finding 2
Quantitatively, rate hikes lead to bigger potential haircuts

Jing Zhang

FRB Chicago

8 / 16

Comment 1 on modeling and experiments

Compare equilibrium outcomes for controlled scenarios
Default rates (unconditional and conditional), interest rates (cyclicalityand volatility), debt ratios and dynamics
The impact of different outside options on Q D

Robustness analysis of renegotiation protocols
bargaining power α and expected delay θ
potential negative impact of high interest rates on sovereign countries(financial crisis, higher costs of borrowing for private sector)

Jing Zhang

FRB Chicago

9 / 16

Comment 2 on quantification of interest rate shocks
Is Pr(dt = 1 | dt −1 = 0, rt = rH , rt −1 = rL ) the right outcome
measure? What if r changes from L to H, but there is also a bad
output shock – did rate hikes “cause” the default?

suppose economy starts here in period t-1

Jing Zhang

FRB Chicago

10 / 16

Comment 2 on quantification of interest rate shocks
Is Pr(dt = 1 | dt −1 = 0, rt = rH , rt −1 = rL ) the right outcome
measure? What if r changes from L to H, but there is also a badoutput shock – did rate hikes “cause” the default?

then economy moves here at t,
government defaults

Jing Zhang

FRB Chicago

11 / 16

Comment 3 on haircut
Highlight the power of renegotiation mechanism on this key finding
SZ-haircuts(1)(2)
real risk-free rate

7.030**(2.951)37.06***(5.196)

6.329*(3.800)-0.225**(0.107)
1.091***(0.377)
1.914(4.254)35.29***(6.965)35.48***(6.051)6.807*(3.966)-0.222**(0.107)1.226***(0.410)3.292(4.554)32.96***(7.468)

139
17
Yes

78
14
Yes

94
14
Yes75
13
Yes

maturity of instrument (years)
coupon rate (fixed, percent)coupon rate (float, dummy)
constant
Observations
Number of episodes
Episode random effects

Model haircuts(3)(4)
7.602**(3.484)

Data source: Asonuma, Niepelt, and Ranciere (2023)

Standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

Jing Zhang

FRB Chicago

12 / 16

Comment 4: recent U.S. interest rates hikes
We have not observed a surge in sovereign defaults by emerging
markets: Ghana, Sri Lanka, Suriname and Zambia

Jing Zhang

FRB Chicago

13 / 16

Comment 4: recent U.S. interest rates hikes
Moreover, in other emerging economies, currencies are quite strong

Jing Zhang

FRB Chicago

14 / 16

Comment 4: recent U.S. interest rates hikes
Does not seem to be much risk in the EMBI data

EMBI Global: Sovereign Spread

1600

1200

800

4002000Jing Zhang

2005

2010

FRB Chicago

2015

2020

2024

15 / 16

Conclusion

This is a great paper.
It highlights an interesting and important mechanism in sovereign
debt renegotiation.
I look forward to the next draft.

Jing Zhang

FRB Chicago

16 / 16