ADEMU Conference on Debt Sustainability and Lending Institutions

1. Endogenous Political Turnover and Fluctuations in
Sovereign Default Risk
Satyajit Chatterjee and Burcu Eyigungor
FRB Philadelphia
Cambridge-INET Inst Conf
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 1 / 31

2. Focus
Foreign borrowing and conflict of interest between sovereigns and
citizens
Three emerging economies — Mexico, Peru and Turkey
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 2 / 31

3. Motivation
A vibrant quantitative-theoretic literature that builds on Eaton and
Gersovitz (1981)
Posits high discount rates to account for observed default risk (2-3
defaults per century)
Not uncommon to see annual discount rates close to 20 percent (com-
parable discount rates for AE DSGE models would be 4 percent or
less)
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 3 / 31

4. What We Do
EG framework augmented with politically induced short-termism
Conventional discount rate, but drop the benevolent dictator assump-
tion
Instead, sovereign is a public good provider with an agency cost; di-
verts a portion of public expenditures for private consumption
Conflict of interest: anticipated loss of power makes sovereign
myopic
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 4 / 31

5. What We Do
EG framework augmented with politically induced short-termism
Empirically, political turnover is linked to economic performance
Brender and Drazen (2008): For democratic EMEs, a 1 percentage
point increase in growth rate during term increases reelection probabil-
ity by 6-9 percentage points
Growth follows a 2-regime Markov-switching process as in Hamilton
(1989)
Link reelection prob positively to prob that regime is good
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 5 / 31

6. What We Get
Political short-termism microfounds high discount rates – exogenous
political turnover model ∼ benevolent dictator w/ high discount
rate
Endogenous political turnover implies growth-linked variations in the
effective discount factor – large fluctuations in sovereign default
risk
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 6 / 31

7. Regimes and Spreads
Prob. of the Low-Growth/High-Volatility Regime and Spreads
0
0.2
0.4
0.6
0.8
1
1.2
0
2
4
6
8
10
12
14
16
1994 - Q1
1994 - Q3
1995 - Q1
1995 - Q3
1996 - Q1
1996 - Q3
1997 - Q1
1997 - Q3
1998 - Q1
1998 - Q3
1999 - Q1
1999 - Q3
2000 - Q1
2000 - Q3
2001 - Q1
2001 - Q3
2002 - Q1
2002 - Q3
2003 - Q1
2003 - Q3
2004 - Q1
2004 - Q3
2005 - Q1
2005 - Q3
2006 - Q1
2006 - Q3
2007 - Q1
2007 - Q3
2008 - Q1
2008 - Q3
2009 - Q1
2009 - Q3
2010 - Q1
2010 - Q3
2011 - Q1
2011 - Q3
2012 - Q1
2012 - Q3
2013 - Q1
2013 - Q3
2014 - Q1
2014 - Q3
2015 - Q1
Spreads Mex Bad Regime Prob
Figure: Mexico
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 7 / 31

8. Regimes and Spreads
Prob. of the Low-Growth/High-Volatility Regime and Spreads
0
0.2
0.4
0.6
0.8
1
1.2
0
1
2
3
4
5
6
7
8
9
1997 - Q2
1997 - Q4
1998 - Q2
1998 - Q4
1999 - Q2
1999 - Q4
2000 - Q2
2000 - Q4
2001 - Q2
2001 - Q4
2002 - Q2
2002 - Q4
2003 - Q2
2003 - Q4
2004 - Q2
2004 - Q4
2005 - Q2
2005 - Q4
2006 - Q2
2006 - Q4
2007 - Q2
2007 - Q4
2008 - Q2
2008 - Q4
2009 - Q2
2009 - Q4
2010 - Q2
2010 - Q4
2011 - Q2
2011 - Q4
2012 - Q2
2012 - Q4
2013 - Q2
2013 - Q4
2014 - Q2
2014 - Q4
2015 - Q2
Spreads Peru Bad Regime Prob
Figure: Peru
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 8 / 31

9. Regimes and Spreads
Prob. of the Low-Growth/High-Volatility Regime and Spreads
0
0.2
0.4
0.6
0.8
1
1.2
0
2
4
6
8
10
12
1996 - Q3
1997 - Q1
1997 - Q3
1998 - Q1
1998 - Q3
1999 - Q1
1999 - Q3
2000 - Q1
2000 - Q3
2001 - Q1
2001 - Q3
2002 - Q1
2002 - Q3
2003 - Q1
2003 - Q3
2004 - Q1
2004 - Q3
2005 - Q1
2005 - Q3
2006 - Q1
2006 - Q3
2007 - Q1
2007 - Q3
2008 - Q1
2008 - Q3
2009 - Q1
2009 - Q3
2010 - Q1
2010 - Q3
2011 - Q1
2011 - Q3
2012 - Q1
2012 - Q3
2013 - Q1
2013 - Q3
2014 - Q1
2014 - Q3
2015 - Q1
Spreads Turk Bad Regime Prob
Figure: Turkey
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 9 / 31

10. Government Stability and Spreads
ICRG Government Stability Index and EME Spreads
Country Corr(GSI, Spreads)
Argentina −0.53
Brazil −0.11
Ecuador 0.35
Malaysia −0.65
Mexico −0.12
Peru 0.01
Russia −0.33
Venezuela −0.28
Uruguay −0.72
Source: Scholl (2016, Table 1, pp. 28). All series are HP-filtered with
smoothing parameter of 100
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 10 / 31

11. Literature
Politics and short-termism Alesina and Tabellini (1990), Persson
and Svensson (1989), Inman and Fitts (1990) . . .
Sov debt with politically-induced myopia: Cuadra and Sapriza
(2008), Scholl (2016), Amador (2012), Aguiar and Amador (2011),
Alfaro and Kanczuk (2016)
Sov debt with exogenously fluctuating myopia: Cole, Dow, and
English (1995), Hatchondo, Martinez, and Sapriza (2009), D’Erasmo
(2012)
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 11 / 31

12. MODEL
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 12 / 31

13. Preferences
Politician, conditional on being in power
U([1 − τ]Kt ) + Ψ U(τKt )
Politician, when out of power
U([1 − τ]Kt )
Citizens (voters)
U([1 − τ]Kt )
U(C) = C1−γ
1−γ
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 13 / 31

14. Revenue Process
gt = Yt /Yt−1
ln(gt+1) = µi(t) + ρln(gt ) + εt εt ∼ N(0,σi(t)) i(t) ∈ {G,B}
Pr{it+1 = B|it = G} = αG ( analogous defn for αB )
θt = Pr{i(t) = G|g(t),θt−1}
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 14 / 31

15. Market Structure
Sovereign can borrow externally (only) with option to default
Debt is long-term: λBt is due & (1 − λ)Bt earns coupon z
Default option
Creditors get nothing in default
Default leads to exclusion and φYt is lost each period until re-entry
Re-entry occurs with probability (1 − ξ)
Market price of debt: q(Yt,gt,θt,Bt+1)
Ωt = {Yt,gt}
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 15 / 31

16. Timing
Inherit Bt & θt−1
Observe gt and update θt
With prob π election is called
If challenger wins, θt is reset to θ
Leader chooses default or Bt+1
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 16 / 31

17. Election Uncertainty
Pre-election value of citizens under access V (Ω,θ,B)
Incumbent wins if
V (·,θ,·) − V (·,θ,·) >
(a shock in favor of the challenger) ∼ Type 1 EV with var ∝ κ
η(Ω,θ,B) =
exp(V (·,θ,·)/κ)
exp(V (·,θ,·)/κ) + exp(V (·,θ,·)/κ)
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 17 / 31

18. Decision Problem of Leader
VP (Ω,θ,B) =
max
B ≤0
U(K) + βE(Ω |Ω,θ) [1 − π]WP (Ω ,θ ,B ) + π[η WP (Ω ,θ ,B ) + (1 − η )WO(Ω ,θ,B )]
s.t.
K + q(Ω,θ,B )[B − (1 − λ)B] = Y + [λ + z(1 − λ)]B,
θ = H(θ,Ω ), η = η(Ω ,θ ,B )
and
XP (Ω,θ) =
U([1 − φ]Y ) + βE(Ω |Ω,θ) ξ[(1 − π)XP (Ω ,θ ) + π(ηXXP (Ω ,θ ) + (1 − ηX )XO(Ω ,θ))] +
(1 − ξ)[(1 − π)WP (Ω ,θ ,0) + π(η WP (Ω ,θ ,0) + (1 − η )WO(Ω ,θ,0))] ,
s.t.
θ = H(θ,Ω ), ηX = η(Ω ,θ ) and η = (Ω ,θ ,0)
and,
WP (Ω,θ,B) = max{VP (Ω,θ,B),XP (Ω,θ)}.
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 18 / 31

19. Pricing of Sovereign Debt
q(Ω,θ,B ) = (1 + rf )−1
×
E(ω |ω,θ)


[1 − π + πη ][1 − D ][λ + (1 − λ)[z + q(Ω ,θ ,B )]
+ π(1 − η )[1 − D ][λ + (1 − λ)[z + q(Ω ,θ,B ))]


Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 19 / 31

20. MECHANICS
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 20 / 31

21. Effective Discount Factor
Set (1 − τ)1−γ
+ Ψ τ1−γ
= 1 and (1 − τ)1−γ
= ζ
VP (Ω,θ,B) = U(K) + βE(Ω ,θ |Ω,θ)[1 − π + πη ] U(K(Ω ,θ ,B )) +
βE(Ω ,θ |Ω,θ)[π(1 − η )]ζ U(K(Ω ,θ,B )) + ...
If θ >> θ then η ≈ 1 and
VP (Ω,θ,B) ≈ U(K) + βE(Ω ,θ |Ω,θ)U(K(Ω ,θ ,B )) + ...
If θ << θ then η ≈ 0 and
VP (Ω,θ,B) ≈ U(K) + β [1 − π + πζ]E(Ω ,θ |Ω,θ)U(K(Ω ,θ,B )) + ...
If η = 0.5 always, then
VP (Ω,θ,B) ≈ U(K) + β (1 − π) + (1 + ζ)
π
2
E(Ω ,θ |Ω,θ)U(K(Ω ,θ ,B )) + .
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 21 / 31

22. CALIBRATION
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 22 / 31

23. Parameters Chosen Independently
Parm. Description Targets {PE,MX,TR)} Values {PE,MX,TR)}
Revenue Process
ρ Autocorrelation of growth rates { 0.43, 0.28, 0.19 } { 0.43, 0.28, 0.19 }
µG % Mean growth, G regime { 0.39, 0.16, 0.20 } { 0.39, 0.16, 0.20 }
µB % Mean growth, B regime { −0.59, −0.28, −0.17 } { −0.59, −0.28, −0.17 }
σG % S.D. of growth, G regime { 0.88, 0.67, 0.69 } { 0.88, 0.67, 0.69 }
σB % S.D. of growth, B regime { 3.80, 1.82, 3.19 } { 3.80, 1.82, 3.19 }
Preferences
β Discount Factor {0.9876,0.9876 ,0.9876 } {0.9876,0.9876,0.9876}
γ Utility Curvature 0.5 0.5
Default Cost
ξ Prob of Re-entry 1 year to settlement, on average 0.25
Bond Market
rf Risk-free Rate 0.01 0.01
λ Prob of maturity Avg. maturity in years {8.18,9.65,6.70} {0.031,0.026 ,0.037}
z Coupon rate 0.01 0.01
Politics
π Prob. of election Every 4 years, on average 1/16
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 23 / 31

24. Parameters Chosen Jointly
Parm. Description Targets {PE,MX,TR)} Values {PE,MX,TR)}
Revenue Process
αG Prob of G to B {0.07, 0.04, 0.10} {0.06, 0.04, 0.10 }
αB Prob of B to G {0.11, 0.07, 0.11} {0.06, 0.02, 0.08 }
Bond Market
φ Default Cost Avg. haircut × Avg. (b/y)
0.37× {1.5, 0.92, 0.91} {0.20, 0.11, 0.11}
Politics
ζ Diversion % Annualized avg. spreads {3.4, 3.4, 3.9} {0.38, 0.07, 0.12}
θ Prob. new gov’t is G Avg. incumbency of 8 years, equivalently,
avg. reelection probability of 0.5 {0.81, 0.87, 0.64}
κ Election uncertainty A reelection prob. increase of 6-9 ppts
for 1% rise in average g over term {0.24, 0.06, 0.05}
“Tremble”
¯m m ∼ U[− ¯m, ¯m] Convergence in < 104 iterations 10−2× {1, 2.5, 1.5}
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 24 / 31

25. RESULTS
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 25 / 31

26. Data and Model Performance
Mexico Peru Turkey
Moments Data AG Model Data AG Model Data AG Model
Targeted
% Annual spreads 3.40 3.39 3.40 3.37 3.40 3.41 3.90 3.92 3.90
Unsec. Debt-to-GDP ratio 0.34 0.34 0.34 0.56 0.56 0.55 0.34 0.34 0.34
Avg. reelection prob. - - 0.5 - 0.5 0.5 - 0.5 0.5
Untargeted
% S.D. of spreads 2.50 0.33 1.73 1.96 1.35 2.83 2.20 0.44 1.55
S.D. of reelection prob. - 0 0.39 - 0 0.36 - 0 0.38
Corr(g, θ) 0.26 0 0.23 0.36 0 0.25 0.13 0 0.09
Corr(Spreads, θ) -0.59 0 -0.90 -0.68 0 -.45 -0.35 0 -0.71
Corr(Spreads, g) -0.34 -0.68 -0.42 -0.31 -0.52 -0.50 -0.37 -0.65 -0.46
Corr (Spreads, NX) 0.73 0.36 0.13 0.31 0.37 0.31 0.84 0.42 0.19
AG: Aguiar and Gopinath (2006) with long-term debt
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 26 / 31

27. Sources of Improvement
Moments Data AG ARX GRX Model
Mexico
% S.D. Sp 2.50 0.33 0.33 0.67 1.73
Corr (g, θ) 0.26 0 0 0.24 0.23
Corr (Sp, θ) -0.59 0 0 0 -0.90
Corr (Sp, g) -0.34 -0.68 -0.68 -0.45 -0.42
Peru
% S.D. Sp 1.96 1.35 1.42 2.14 2.83
Corr (g, θ) 0.36 0 0 0.27 0.25
Corr (Sp, θ) -0.68 0 0 -0.31 -0.45
Corr (Sp, g) -0.31 -0.52 -0.51 -0.53 -0.50
Turkey
% S.D. Sp 2.20 0.44 0.44 0.89 1.55
0Corr (g, θ) 0.13 0 0 0.09 0.09
Corr (Sp, θ) -0.35 0 0 -0.22 -0.71
Corr (Sp, g) -0.37 -0.65 -0.66 -0.56 -0.46
AG : Aguiar and Gopinath (2006) (with long-term debt)
ARX: AR1 growth process with exogenous political turnover
GRX: AR1 growth regimes with Markov switching and exogenous political turnover
Each model is calibrated to match avg. b/y and avg. spreads for each country
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 27 / 31

28. Spreads: Data and Simulation
0.00E+00
2.00E-02
4.00E-02
6.00E-02
8.00E-02
1.00E-01
1.20E-01
1.40E-01
1.60E-01
1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3 1998Q1 1998Q3 1999Q1 1999Q3 2000Q1 2000Q3 2001Q1 2001Q3 2002Q1 2002Q3 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 2013Q1 2013Q3 2014Q1 2014Q3 2015Q1
Benchmark Growth Regimes AR1 Growth Process Data
Figure: Mexico
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 28 / 31

29. Spreads: Data and Simulation
0.00E+00
1.00E-02
2.00E-02
3.00E-02
4.00E-02
5.00E-02
6.00E-02
7.00E-02
8.00E-02
9.00E-02
1997Q2 1997Q4 1998Q2 1998Q4 1999Q2 1999Q4 2000Q2 2000Q4 2001Q2 2001Q4 2002Q2 2002Q4 2003Q2 2003Q4 2004Q2 2004Q4 2005Q2 2005Q4 2006Q2 2006Q4 2007Q2 2007Q4 2008Q2 2008Q4 2009Q2 2009Q4 2010Q2 2010Q4 2011Q2 2011Q4 2012Q2 2012Q4 2013Q2 2013Q4 2014Q2 2014Q4 2015Q2
Benchmark Growth Regimes AR1 Growth Process Data
Figure: Peru
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 29 / 31

30. Spreads: Data and Simulation
0.00E+00
2.00E-02
4.00E-02
6.00E-02
8.00E-02
1.00E-01
1.20E-01
1.40E-01
1996Q3
1996Q4
1997Q1
1997Q2
1997Q3
1997Q4
1998Q1
1998Q2
1998Q3
1998Q4
1999Q1
1999Q2
1999Q3
1999Q4
2000Q1
2000Q2
2000Q3
2000Q4
2001Q1
2001Q2
2001Q3
2001Q4
2002Q1
2002Q2
2002Q3
2002Q4
2003Q1
2003Q2
2003Q3
2003Q4
2004Q1
2004Q2
2004Q3
2004Q4
2005Q1
2005Q2
2005Q3
2005Q4
2006Q1
2006Q2
2006Q3
2006Q4
2007Q1
2007Q2
2007Q3
2007Q4
2008Q1
2008Q2
2008Q3
2008Q4
2009Q1
2009Q2
2009Q3
2009Q4
2010Q1
2010Q2
2010Q3
2010Q4
2011Q1
2011Q2
2011Q3
2011Q4
2012Q1
2012Q2
2012Q3
2012Q4
2013Q1
2013Q2
2013Q3
2013Q4
2014Q1
2014Q2
2014Q3
2014Q4
2015Q1
2015Q2
Benchmark Growth Regimes AR1 Growth Process Data
Figure: Turkey
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 30 / 31

31. Conclusion
An Alternative Approach to Sovereign Debt and Default
Sovereign as a public-good provider with agency costs
Agency costs imply short-termism in the face of political turnover
Short-termism is amplified in bad times (when turnover is more likely)
leading to volatility
Well-suited to aggregative analysis of EMEs
For the future: Connect to literature on political institutions and
agency costs
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 31 / 31

32. []Aguiar, M., and M. Amador (2011): “Growth in the Shadow of Expro-
priation,” Quarterly Journal of Economics, 126, 651–697.
[]Aguiar, M., and G. Gopinath (2006): “Defaultable Debt, Interest Rate
and the Current Account,” Journal of International Economics, 69, 64–
83.
[] Alesina, A., and G. Tabellini (1990): “A Positive Theory of Fiscal
Deficits and Government Debt in a Democracy,” Review of Economic
Studies, 57, 403–414.
[] Alfaro, L., and F. Kanczuk (2016): “Fiscal Rules and Sovereign De-
fault,” Manuscript.
[] Amador, M. (2012): “Sovereign Debt and the Tragedy of the Com-
mons,” Unpublished, Stanford University.
[] Brender, A., and A. Drazen (2008): “How Do Budget Deficits and
Economic Growth Affect Reelection Prospects? Evidence From a Large
Panel of Countries,” American Economic Review, 98(5), 2203–2220.
[] Cole, H. L., J. Dow, and W. B. English (1995): “Default, Settlement,
and Signalling: Lending Resumption in a Reputational Model of Sovereign
Debt,” International Economic Review, 36, 365–85.
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 31 / 31

33. []Cuadra, G., and H. Sapriza (2008): “Sovereign Defaults, Interest Rates
and Political Uncertainty in Emerging Markets,” Journal of International
Economics, 76, 77–88.
[] D’Erasmo, P. (2012): “Government Reputation and Debt Repayment
in Emerging Economies,” Manuscript.
[]Eaton, J., and M. Gersovitz (1981): “Debt with Potential Repudiation:
Theoretical and Empirical Analysis,” Review of Economic Studies, 48(2),
289–309.
[] Hamilton, J. D. (1989): “A New Approach to the Economic Analysis
of Nonstationary Time Series and the Business Cycle,” Econometrica,
57(2), 357–384.
[]Hatchondo, J. C., L. Martinez, and H. Sapriza (2009): “Heterogeneous
Borrowers in Quantitative Models of Sovereign Default,” International
Economic Review, 50(4), 1129–1151.
[] Inman, R. P., and M. A. Fitts (1990): “Political Institutions and Fis-
cal Policy: Evidence from the U.S. Historical Record,” Journal of Law,
Economics and Organization, 6(April), 79–132.
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 31 / 31

34. [] Persson, T., and L. Svensson (1989): “Why a Stubborn Conserva-
tive Would Run a Deficit: Policy with Time-Inconsistent Preferences,”
Quarterly Journal of Economics, 104, 325–345.
[] Scholl, A. (2016): “The Dynamics of Sovereign Default Risk and
Political Turnover,” Discussion paper, University of Konstanz.
Chatterjee-Eyigungor Politics and Fluctuations Cambridge-INET Inst Conf 31 / 31