Discussion: Illiquidity in Sovereign Debt Markets

Discussion Illiquidity in Sovereign Debt Markets

by J. Passadore and Y. Xu Satyajit Chatterjee FRB Philadelphia

February 2020 Disclaimer: The views expressed are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.

Sovereign Spreads

I Sovereign debts of EMEs trade at a positive spread relative to comparable AE sovereign debt I The possibility of default — credit risk — is the most common explanation of sovereign spreads I This paper takes the view that credit risk cannot be the only factor at play I Combines credit risk with liquidity risk

What is Liquidity Risk?

I For investors, buying is easy but selling is hard !

I If an investor wants to sell, she has to find a buyer and that takes time I Buyers understand this and bargain down the price they pay to investors looking to sell I The loss incurred in selling bonds at a discount is factored into the price investors to pay to buy bonds in the first place I This spread exists even if prob of default is zero

Do We Need More Comprehensive Models of Sovereign Spreads?

I Yes, totally !

I Frequency of default and near-default events fall short of explaining the magnitude of spreads for most countries I And sovereign spreads move around way too much to be driven by country fundamentals alone

Spreads

Source: Aguiar, Chatterjee, Cole and Stangebye “Quantitative Models of Sovereign Debt Crises,� in Handbook of Macroeconomics, Volume 2B, 2016, Table 1, p. 1701

Spreads

Source: Aguiar, Chatterjee, Cole and Stangebye “Quantitative Models of Sovereign Debt Crises,� in Handbook of Macroeconomics, Volume 2B, 2016, Table 2, p. 1702

Couldn’t Risk Aversion Help Account for High Spreads?

I In reality, perhaps. In QSD models, not quite !

I Risk aversion of investors adds a premium for risk, but tends to lower the magnitude of the spread itself I Prudent investors act as disciplinarians who make sovereigns circumspect about borrowing in good times I When debt has long duration, this circumspection matters and risk aversion induces lower spreads I We must think harder about what’s behind high spreads

Explanation Offered In This Paper I Focuses on liquidity risk to give a better account of EME sovereign spreads I Builds on insights from corporate finance I Generates intuitive results: I Liquidity risk can account for high spreads that exceed default probabilities I Liquidity risk can increase with default risk if it takes longer to find buyers for defaulted bonds I Improved market functioning in normal times can lower spreads and raise welfare

Summary

A well-executed and thought-provoking paper !