Sovereign borrowing, sanctions and yield spreads

Literature › Works

Rajna Gibson; Suresh M. Sundaresan (2005). Sovereign borrowing, sanctions and yield spreads. Swiss Banking Institute, University of Zurich / Columbia Business School (working paper, September 2005).

Type	working paper
Scope	Comparative and methods
Method	theoretical or conceptual
Period studied	1999–2001
Regions	Argentina, Brazil, Mexico, Russia
Themes	sanctions divestment, macro fiscal finance debt, comparative theory
Citation key	gibson2005

Argument

The paper builds a continuous-time bargaining model of sovereign debt with no bankruptcy code. Lenders' only enforcement tools are trade sanctions and seizure of a fraction of export earnings, and the borrower chooses its default (recontracting) trigger and debt level with these in mind. The model gives closed-form default triggers, debt values and credit spreads. It predicts that sovereign debt is renegotiated more often and trades at higher spreads than otherwise identical corporate debt. Spreads fall as the cost of sanctions and the seizable export fraction rise. Stylized facts from four emerging-market bonds (Oct 1999-Jun 2001) are said to fit this: trade concentration, read as a proxy for effective sanctions, goes with lower spreads. The paper has nothing on South Africa; it is relevant only as background theory on how sanctions and debt enforcement interact.

Evidence and method

Daily yield-spread series for one bond each from Argentina, Brazil, Mexico and Russia (18 Oct 1999 to 5 June 2001), plus IMF, UNCTAD and Datastream data on GDP, external debt, exports and trading partners. Model results are illustrated with numerical examples under base parameters. It also cites Bulow and Rogoff's World Bank-based estimates of sanction costs, including Rhodesia.

Findings

• Sanction costs matter for sovereigns; Rhodesia is cited as an extreme example of sanctions' estimated cost relative to GNP (a secondhand figure from Bulow and Rogoff). (p. 6)

  Even more extreme, is the example of Rhodesia, since the estimated cost of trade sanctions represented 15% of its annual GNP.

• The model's core mechanism: sanctions after default reduce output by a decaying factor, which defines the penalty parameter alpha. (p. 12)

  the trade sanction against the borrowing country amounts to a penalty such that the capitalized value of the goods and services at the time of default bt becomes equal to αVbt where α ∈(0, 1)

• Without a bankruptcy code the sovereign keeps a larger bargaining share than an otherwise identical corporate borrower, so lenders are worse off. (p. 16)

  if α is strictly between zero and one, i.e.if there are sanctions, we find that the share of the corporate borrower is always less than that of the sovereign borrower.

• Sovereign debt is renegotiated at a higher trigger than corporate debt, implying more rescheduling. (p. 18)

  The recontracting boundary for sovereign debt is strictly higher than the corresponding boundary for an otherwise identical corporate debt contract.

• Optimal borrowing under the threat of sanctions is below the first-best level. (p. 23)

  The optimal level of investment (I0) is strictly lower than the first-best level.

• The sovereign credit spread is strictly greater than the corporate spread, with illustrative basis-point values. (p. 25)

  for a 6.5% coupon rate issue, the sovereign and the corporate borrowers will have to yield spreads respectively equal to 38 and 37 basis points

• Higher exports recovery rates sharply lower sovereign spreads in the numerical examples. (p. 27)

  if we double the recovery rate of exports from 5% to 10%, for a cost of sanctions level of 0.5, the sovereign credit spread will drop from 198.87 to 119.41 basis points.

• Empirical stylized fact: Russia's average spread was almost three times Mexico's, which the authors attribute to Mexico's concentrated trade and so more effective sanctions. (p. 27)

  the average sovereign spread (10.98%) observed in Russia is almost three times higher than the one observed in Mexico (3.25%).

• Mexico's trade concentration with the US makes sanctions costly and is linked to its low spreads. (p. 9)

  Mexico's trade is lopsidedly linked with the United States both from the viewpoint of imports and exports. Implicitly, this means that the threat of a sanction is potentially very costly to Mexico.