A Gravity Model of Sovereign Lending: Trade, Default and Credit

1. A Gravity Model of Sovereign Lending:Trade, Default and Credit Andrew K. Rose and Mark M. Spiegel 4th annual I.M.F. Research Conference November 6, 2003

2. Sovereign defaults are still exceptional • Direct penalties are elusive • “Gunboat diplomacy” no longer viable • However, countries largely behave “as if” default penalties were perceived • Motivation for sovereign debt service therefore remains an important issue

3. One posited penalty in literature is loss in trade • Bulow and Rogoff (1989): Trade sanctions as potential penalty • Also loss of trade credit • However, unclear whether creditors can levy such penalties • Empirical questions about efficacy of default penalty • Creditors may be unable to levy such penalties • Penalties may not be “renegotiation proof” [Kletzer and Wright (2000)]

4. Some empirical evidence of trade default penalties • Ozler (1993): Evidence of positive, but small premia charged to countries with default histories • Cline (1987): Bolivia and Peru experienced disruption in trade credits subsequent to Paris Club renegotiation • Rose (2002): Sovereign Paris Club reschedulings followed by significant reductions in trade

5. We examine notion of lost trade as enforcement mechanism • Harsher penalties in sovereign debt usually improve global welfare by moving closer to first-best outcome • Nations that can threaten heavier trade disruptions therefore have a comparative advantage in lending • We explore that idea

6. Simple borrowing model • Sovereign borrowing by small debtor country from two creditor countries • Creditors identical except for bi-lateral trade volumes with debtor country • Model predicts that borrowing will be concentrated on country with greater bi-lateral trade • Then confirm empirically

7. Model Assumptions • Three countries: borrower country, i, and two creditor countries, a and b • is a random variable reflecting total trade between country i and country j in the second period • Expectations of are unbiased • where is an i.i.d. disturbance term with expected value 0 on the interval

8. Model Assumptions (2) • Bilateral gains from trade are exogenous and equal to , where is a positive constant • r is one plus the world risk-free interest rate, which is exogenous • Lenders are risk-neutral • If the debtor defaults on country j it suffers a penalty equal to a fraction of its gains from bilateral trade with country j

9. Extensive form • Model has two periods • In first period, the representative lender in country j extends a loan of magnitude in return for the promise of a fixed payment in the second period • In the second period, is realized and the debtor makes its default decisions • If the debtor chooses to service its debt it pays • If it defaults, it suffers default penalty

10. Agent Characteristics • Creditor nations differ only in their expected trade volume with the debtor • Expected debtor utility satisfies where is exogenous • 1st-pd consumption satisfies • is exogenous in both periods

11. Default Decision • Default decision based on maximizing second period consumption • Conditional on debt service, satisfies where and represents cost of default decision on debt owed to country k • Debtor chooses default on country j when

12. Equilibrium • Define as minimum realization of that induces debt service. Satisfies • Equilibrium is defined as a pair of debt obligations that maximize expected debtor utility subject to both creditors’ zero profit conditions

13. Borrowing decisions • Two decisions: the overall borrowing level, and the allocation across countries • Given allocation satisfies • Debtor skews borrowing towards nation with lower probability of default with equal borrowing • Doing so increases the default probability in “safe” nation and narrows this difference

14. Result 1: Lending Shares • Demonstrate in text that • Holding total lending constant, the share of lending originating in country a is increasing in the expected volume of trade with country a

15. Result 2: Overall borrowing • Maximizing expected utility over the choice of and the optimal allocation rule, and then totally differentiating with respect to and yields which implies that total borrowing increases with • We next test these empirically

16. Data Set • Use annual panel data set of trade and lending • 20 creditors, 149 debtors, 1986-1999 • Bank claims from BIS • Rest from Glick-Rose

17. Methodology • Estimate “gravity” model of lending: • ln(Cijt) = ln(Xijt) + Zijt + ijt • where Z are gravity variables (distance, GDP, …) • IV critical because of simultaneity • Use different instrumental variables from gravity model, especially geographic (landlocked status …)

18. Miscellany • Robust standard errors (clustered by country-pairs) recorded in parentheses. • Intercepts and year effects not recorded. • Instrumental variables for trade are: distance; land border; number landlocked; number island nations; log of area.

19. Table 1: OLS Estimates of Effect of Trade on Claims

20. Table 2a: IV Estimates of Effect of Trade on Claims, Geographic Instruments

21. Table 2b: IV Estimates of Effect of Trade on Claims, Excludable Instruments

22. Table 3: IV Estimates of Effect of Trade on Claims, Controlling for Total Claims

23. Table 3: IV Estimates of Effect of Trade on Claims, Controlling for Total Debt

24. Table 4: IV Estimates of Effect of Trade on Claims, Panel