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Shiv Nadar University

Economics

(SoHSS) School of Humanities and Social Sciences

Political Constraints and Sovereign Default Premia

This dissertation studies the relation between political factors (political instability, political fragmentation, policy gridlock and the political color of parties) and fiscal policy outcomes (tax rates, debt levels, default episodes). The second chapter studies the empirical aspects of the aforementioned relation. The third chapter studies how policy gridlock affects tax policy and sovereign default. The last chapter studies the relation between political instability and fragmentation and sovereign debt and default. SOME EMPIRICAL EVIDENCE ON THE POLITICAL ECONOMY OF SOVEREIGN DEBT AND DEFAULT. The most well-known political economy theory of debt accumulation is the common pool problem of debt (Weingast et al., 1981; Velasco, 2000). This theory has been tested for advanced economies, mainly in parliamentary systems and there is empirical evidence that supports its conclusions. However, when data on political parties for emerging economies has been used, there is no support for the predictions of the theory (Stein et al., 1998; Elgie and McMenamin, 2008; Eslava and Nupia, 2010). This should not be surprising, because emerging markets are characterized by presidential systems, where the number of parties in the current government coalition does not play a crucial role in terms of the budget (the most common measure of political fragmentation). In this chapter presents alternative measures for political instability and fragmentation. The effective number of the political parties in power (or in the executive) is the proxy of political instability. The proxy for political fragmentation is the percentage of votes in Congress of all the parties that never were in power, or those parties that never belong to the government's coalition at any point in time. The idea of these two measures is to see if over time a country has had a stable group of political parties that alternate in power and how big the votes' share of those parties was in Congress. In a bipartisan system there would be only two parties over time that enjoy most of the votes in Congress. However, this is not the case of many emerging markets. Using a sample of 35 emerging countries between 1975 and 2012, this chapter documents that a higher degree of political instability and fragmentation is associated with lower levels of borrowing and a higher probability of default. Another result of the empirical analysis is that the political color of political parties is not a determinant of debt accumulation or default. Differently, the political color affects the tax rates observed in the data. In particular, left wing governments set higher tax rates than right wing parties. Muller, Storesletten and Zilibotti (2016) finds that the same holds for advanced economies. Also, using an event study analysis around default crises, the data reveals that emerging countries do exert a fiscal adjustment in terms of the tax rates before a default episode. POLICY GRIDLOCK AND SOVEREIGN DEFAULT Tax policy gridlock is defined as a situation in which political parties fail to reach an agreement that changes the current status quo tax rate and borrowing level. For that reason, the policies implemented the previous period are not changed. Policy inaction in terms of tax policy and its effects over debt accumulation has been studied in early political economy models (Alesina and Drazen, 1991). In terms of the more recent literature of sovereign default, Arellano and Bai (2014) and Andreasen, Sandleris and Van Der Ghote (2011) have focused on the inability to raise taxes. As it was mentioned in the abstract of the previous chapter, on average emerging countries do raise taxes before a default episode. In this chapter policymakers will raise taxes before a default event, but importantly, they will not be able to reduce borrowing levels. This is exactly what occurs in the data. Hence, a crucial aspect of policy gridlock highlighted in this chapter is the inability to reduce borrowing levels. The model shares the most relevant characteristics of the benchmark model of sovereign default (Eaton and Gersovitz, 1981; Aguiar and Gopinath, 2006; Arellano, 2008). Some differences are that the model contemplates a production economy and households value the provision of public goods. The model is also different due to its political economy dimension: (i) there are two parties that alternate stochastically in power and that represents two types of households (high and low productivity) and, (ii) the party in power offers a 'take-it-or-leave-it' policy proposal (tax rate, borrowing levels) to the other party, requiring unanimity to approve the proposal. There is no change to the status quo tax rate or the status quo borrowing policy if the proposal is rejected. In particular, the party that accepts or rejects will contrast the dynamic payoff of the proposal with the payoff of a scenario that contemplates maintaining the status quo policy. The setup in (i) and (ii) corresponds to a dynamic bargaining game with endogenous status quo, as in Bowen, Chen and Eraslan (2014) and Ma (2014). The main result of the paper is that the inability to reduce borrowing levels plays a more important role than the inability to raise taxes in terms of default episodes. In an economy without policy gridlock, a default episode can be ruled out implementing a fiscal adjustment that considers raising taxes and reducing borrowing levels in absolute terms. However, the paper documents that reductions in the absolute level of debt are not observed in the data (same sample of 35 emerging economies used in the second chapter). The introduction of gridlock generates more default episodes, because even though policymakers can raise taxes before a crisis (as it is observed in the data), are not able to convince the other party to reduce borrowing. This implies that when economic conditions deteriorate, there is an increase in the burden of debt. In a non-gridlock economy, the default probability is 3.18%, while in the economy with the possibility of gridlock, the chances of default raise up to 4.24%. Even though this is a model with heterogeneous agents, policy gridlock induces similar borrowing levels and default probabilities by party, as reported in the second chapter. Also, the model can replicate the probabilities associated with political defaults, or defaults that occur simultaneously with government changes, as well as political defaults in which there is also a change in the political color of the new incumbent. SOVEREIGN DEFAULT, POLITICAL INSTABILITY & POLITICAL FRAGMENTATION The workhorse model of sovereign default (Eaton and Gersovitz, 1981; Aguiar and Gopinath, 2006; Arellano, 2008) shows that debt levels that can be sustained in equilibrium are extremely low when the observed probabilities of default are targeted (Mendoza, 2015; Claessens and Kose, 2014; Aguiar and Amador, 2013; Tomz and Wright, 2013). While the benchmark model has been extended in different dimensions (long-term bonds, positive recovery rates, convex cost of default) that yield higher debt ratios, none of these new features has tried to address the reasons for higher borrowing. This chapter provides a motivation for this based on two political features: fragmentation and instability. The model has the following characteristics: (i) the economy receives a stochastic endowment and can borrow from abroad; (ii) policymakers take a decision to repay previous obligations or default; (iii) the costs for default are the exclusion from capital markets and an output loss; (iv) government bonds are traded in international capital markets and their price incorporates the possibility of future default; (v) a number of political parties stochastically alternate in power (political instability) and bargain over the budget (endowment and net borrowing); and, (vi) the policymaker forms a coalition of parties to get the necessary votes to approve the budget, leaving out of the coalition a number of other parties (political fragmentation). Features (v)-(vi) follow the bargaining approach developed in Battaglini and Coate (2007, 2008) and in these authors' subsequent papers. The intuition of the mechanism is as follows. Every time the policymaker wants to borrow an extra dollar from abroad, he will need to get the votes of the members of his coalition. This implies that the extra dollar will be divided between the policymaker and the other coalition parties. Also, zero resources from the extra dollar will be allocated to those excluded from the coalition, simply because their votes are not necessary. In this setup, more debt provides not only more consumption to the policymaker, but also increases his share of the total resources. This political incentive to borrow more will confront market discipline. There exists a borrowing level at which issuing more bonds becomes counterproductive, because debt has become too high and risky. International markets will recognize this and the price of bonds will start falling, providing less resources to the country and diminishing the policymaker's share. Therefore, there is a non-monotonic relationship between borrowing decisions and the proposer's share. This mechanism accounts for two opposite forces: the political channel that provides a higher share and the endogenous borrowing constraint that hampers the distributional benefits. The novel interaction between these two forces differs from previous political economy models of sovereign default (Cuadra and Sapriza, 2008, Hatchondo et al., 2009, D'Erasmo, 2011). These papers focused on the two-party case, discount factors and only allow for a fixed policymaker's share of resources. If this share does not vary with borrowing decisions, there are no distributional incentives to borrow more. Importantly, because these distributional benefits only exist under access to capital markets, policymakers will find repayment more attractive. This will allow the model to