Transmission of Quasi-Sovereign Default Risk: Evidence from Puerto Rico"

Intro

Background

Model

Empirics

Transmission of Quasi-Sovereign Default Risk: Evidence from Puerto Rico

Anusha Chari UNC

Ryan Leary Brattle Group

Toan Phan FRB Richmond

GIC, Drexel 28 Feb 2020

The views expressed do not necessarily reflect the position of the Federal Reserve Bank of Richmond or the Federal Reserve System.

1/27

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Background

Model

Empirics

Classic question

How does risk of sovereign default affects domestic economy?

I

Substantial legal uncertainty, as no clear bankruptcy procedures for sov debt (unlike private/muni debt)

I

Difficult to isolate effects of default risk from concurrent banking/currency crisis risk

I

Difficult due to reverse causality

2/27

Intro

Background

Model

Empirics

This paper Novel setting to identify & isolate effects of default risk: Puerto Rican debt crisis I

PR debt is similar to sov debt: No clear bankruptcy procedures (no chap 9)

I

Effects of default risk isolated from banking/currency crisis risk (PR banks FDIC insured; PR is dollarized)

I

Detroit bankruptcy & non-bailout is exogenous shock to PR default risk

We document strong evidence for government demand channel I

Default risk disproportionately hurts industries dependent on gov demand

3/27

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Model

Empirics

Main related literatures

On costs of sovereign debt crises, esp. empirical analyses: Borensztein Panizza (2009), Yeyati Panizza (2011), Zettelmeyer et. al. (2013), Cruces Trebesch (2013), Bocola (2016), Hébert Schreger (2017), Perez (2018), Acharya et al. (2018), Asonuma et al. (2019), Arellano et al. (2019), ...

I

Banking crises’ effects on external-finance dependent sectors: Rajan Zingales (1998), Dell’Ariccia et al. (2008), ...

On austerity & growth: Auerbach Gorodnichenko (2012), Blanchard Leigh (2014), Chari Henry (2015); House Tesar (2015), Jordà Taylor (2016), ...

4/27

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Model

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Background

Pop2010 ≈ 3.7m, > 22 states 5/27

Intro

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Empirics

Context Became U.S. territory since Spanish-American war 1898. Subject to U.S. contracts clause, usage of USD. Industrialization & catch-up growth, esp. after passage of Section 936 of Tax Reform Act 1976 (tax exemptions for U.S. firms on income originating from PR).

I

Manufacturing roughly 46% GDP and 69% GNP 2007-2016.

But Section 936 phased out in 1996, fully repealed by 2006.

Recession & rapid accumulation of public debt.

Structural break in default risk 2013m7: Detroit bankruptcy → downward shift in expectation of federal gov bailout.

PR gov announced default 2015m6, but cannot access Chap 9 procedures.

I

US congress passed Puerto Rico Oversight, Management & Economic Stability Act (PROMESA) 2016m6.

6/27

Intro

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Model

Empirics

-.1

logE (normalized to 0 at 2008) -.05 0

.05

US and PR total employment

1 8m

200

1

0m

201

1

2m

201

PR total employment

t troi m1 De 2014

1 6m 201

US total employment 7/27

Intro

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Model

Empirics

.4

.05

.1

.6

Risk

.15 .2 Spread

.8

.25

1

.3

PR bonds and Detroit bankruptcy

1 0m

201

2m 201

1

t troi m1 De 2014

Estimated default risk

1 6m 201 Average spread 8/27

Intro

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Model

Empirics

15

Billions (2016$) 17 19

21

PR government spending

2010

2011

2012 Total

2013

2014

2015

2016

Excluding debt service 9/27

Intro

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Model

Empirics

Simple Model Two-period NK SOE (GalĂ­ Monacelli 2005 + Benigno 2015) Add sovereign borrowing Add multiple sectors w. heterogeneous exposure to gov demand.

10/27

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Model

Empirics

Setup SOE, representative hh, benevolent gov

u(C ) + v (G) + β E u(C 0 ) + v (G 0 ) Domestic economy has two sectors I I I

m: more exposed to gov demand l: less exposed to gov demand f : foreign imported good h i1−χ (Cf )χ C = (Cm )1−λ (Cl )λ C0

= ...

Nominal wage is: I I

fixed at W in t = 0 (“short run”) but flexible in t = 1 (“long run”)

11/27

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Labor market Competitive firms in sector j ∈ {m, l} maximize profit: Πj

= max Pj Ahjα − W hj

Π0j

= ···

hj

Aggregate labor demand: h = hm + hl 0 h0 = hm + hl0 .

HH supply labor inelasticaly up to h̄. In equilibrium: I I

t = 0: h ≤ h̄ (due to sticky wage) t = 1: h0 = h̄ (flexible wage)

12/27

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Import/Export Imported good price: Pf = Pf0 = 1 I I I

Law of one price: Pf = ePf∗ Fixed exchange rate e = 1 Normalize Pf∗ = 1

Export: exogenous foreign demand Xj for domestic goods j ∈ {m, l} Xj

−ρ

≡ ζ Pj

0ρ

Xj0 ≡ ζ 0 Pj .

HH budget: Pm Cm + Pl Cl + Pf Cf

= Wh+Π−T

0 0 Pm Cm + Pl0 Cl0 + Pf0 Cf0

= W 0 h̄ + Π0 − T 0 13/27

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Gov spending & asymmetry Gov provides public good G, with input only from domestic sector m: 0 G = f (Gm ), G 0 = f (Gm )

Financed by lump-sum tax + borrowing + exogenous federal transfer Pm Gm ≤ T + qB + F 0 0 Gm ≤ T 0 − (1 − def )B + |{z} F0 .

Pm stochastic

t = 1: After seeing F 0 , gov chooses def .

I

If def = 1, gov receives cont. payoff V def .

t = 0: Competitive bond price: q=

1 − Pr (def ) 1+r∗ 14/27

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Competitive Equilibrium

Given gov policies G, G 0 , B, and def , a competitive equilibrium consists of P’s & Q’s that satisfy the optimization of HHs, firms, labor market conditions & good market clearing conditions.

Given competitive equilibrium P’s & Q’s as functions of its policies, gov chooses I I

Short run: G, B Long run: G 0 , def

to maximize utility of HH.

15/27

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Proposition A negative shock (first-order stochastic dominance) to future federal transfer F 0 raises Pr(def ), reduces hl and especially hm : ∆hm < ∆hl < 0.

More generally, an increase in the default risk (e.g., ↑ V def , ↓ A0 ) reduces short-run employment, with effect stronger on more government-demand-dependent sector m.

Intuitively, G has asymmetric effects on short-lun labor market: −ρ Cm + ζ Pm −ρ

Cl + ζ Pl

+G

α = Ahm

= Ahlα

16/27

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Heterogeneous effects of shock to default risk F 0 ↓ =⇒ q ↓ =⇒ q B(q) ↓ ⇒ austerity Austerity ⇒ employment ↓ esp. in more exposed sector m

17/27

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Empirics

18/27

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Key Datasets Macro Data I I

PR fiscal balance: PR financial statements 2000-2016 PR GNP: Government Development Bank 2000-2016

Manufacturing Industry Data I I I I I

Employment 3-digit NAICS: BLS 1990m1-2016June (73 industries) Output 3-digit NAICS: PR Planning Board 2002-2015 (19 industries) Share of sales to PR gov: Economic Census of Island Areas 2012 (2007) Banking balance sheet data for PR banks: FDIC Call Reports External finance-dependence: Compustat/CRSP 2000-2015

Financial Market Data I I

CDS spreads: JP Morgan Markit 2008-2016 Extrapolate Pr(def) from 5-year CDS (White 2013, HĂŠbert Schreger 2017) Details

19/27

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Model

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Basic DiD

log Eit = α + β HighGOVi ∗ PostDetroitt + ρ log Eit−1 + γi + γt + εit

Eit : employment of industry i in month t (seasonally adjusted) HighGovi = 1 if GOVi above median PostDetroitt = 1 if t ≥ 2013m7 Window: 2 years before and after Detroit (2011m8-2015m6) Theory predicts β < 0

20/27

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Empirics

Basic DiD log Eit = α + β HighGOVi ∗ PostDetroitt + ρ log Eit−1 + γi + γt + εit

HighGOV*PostDetroit

(1) -0.01** (0.01)

GOV*PostDetroit EXTFIN*PostDetroit GOV*P def L.logE Constant 0 Industry f.e.

Time f.e.

Ind. spec. trend Observations Adjusted R2

0.92*** (0.01) 0.64*** (0.10) Y Y N 893 0.89

Note: β = −1% vs. ave monthly growth of PR manu employment 2010-2016 of -0.3%.

21/27

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Model

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DiD with all manufacturing industries log Eit = α + β GOVi ∗ PostDetroitt + ρ log Eit−1 + γi + γt + εit

HighGOV*PostDetroit

(1) -0.01** (0.01)

GOV*PostDetroit

(2)

-0.24** (0.11)

EXTFIN*PostDetroit GOV*P def L.logE Constant Industry f.e.

Time f.e.

Ind. spec. trend Observations Adjusted R2

0.92*** (0.01) 0.64*** (0.10) Y Y N 893 0.89

0.95*** (0.01) 0.38*** (0.09) Y Y N 799 0.92 22/27

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Model

Empirics

DiD with industry-specific trend (full sample) log Eit = α + β GOVi ∗ PostDetroitt + ρ log Eit−1 + γi + γt + θi (αi ∗ t) + εit

HighGOV*PostDetroit

(1) -0.01** (0.01)

GOV*PostDetroit

(2)

(3)

-0.24** (0.11)

-0.19** (0.09)

0.95*** (0.01) 0.38*** (0.09) Y Y N 799 0.92

0.97*** (0.00) 0.26*** (0.04) Y Y Y 5185 0.99

EXTFIN*PostDetroit GOV*P def L.logE Constant Industry f.e.

Time f.e.

Ind. spec. trend Observations Adjusted R2

0.92*** (0.01) 0.64*** (0.10) Y Y N 893 0.89

23/27

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Background

Model

Empirics

Rajan Zingales: dependence on external finance log Eit = α + β GOVi ∗ PostDetroitt + δ EXTFINiUS ∗ PostDetroit + ρ log Eit−1 + γi + γt + εit

HighGOV*PostDetroit

(1) -0.01** (0.01)

GOV*PostDetroit

(2)

(3)

(4)

-0.24** (0.11)

-0.19** (0.09)

-0.28** (0.12) -0.01 (0.00)

0.95*** (0.01) 0.38*** (0.09) Y Y N 799 0.92

0.97*** (0.00) 0.26*** (0.04) Y Y Y 5185 0.99

0.95*** (0.01) 0.36*** (0.09) Y Y N 799 0.92

EXTFIN*PostDetroit GOV*P def L.logE Constant Industry f.e.

Time f.e.

Ind. spec. trend Observations Adjusted R2

0.92*** (0.01) 0.64*** (0.10) Y Y N 893 0.89

24/27

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Background

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Empirics

Interaction with Default Risk log Eit = α + β GOVi ∗ Ptdef + ρ log Eit−1 + γi + γt + εit

HighGOV*PostDetroit

(1) -0.01** (0.01)

GOV*PostDetroit

(2)

(3)

(4)

-0.24** (0.11)

-0.19** (0.09)

-0.28** (0.12) -0.01 (0.00)

EXTFIN*PostDetroit GOV*P def L.logE Constant Industry f.e.

Time f.e.

Ind. spec. trend Observations Adjusted R2

0.92*** (0.01) 0.64*** (0.10) Y Y N 893 0.89

0.95*** (0.01) 0.38*** (0.09) Y Y N 799 0.92

0.97*** (0.00) 0.26*** (0.04) Y Y Y 5185 0.99

0.95*** (0.01) 0.36*** (0.09) Y Y N 799 0.92

(5)

-1.05** (0.47) 0.95*** (0.01) 0.41*** (0.09) Y Y N 799 0.92 25/27

Intro

Background

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IV: Detroit shock → PR default risk → PR employment GOVi ∗ PostDetroitt as instrument for GOVi ∗ Ptdef \ def + ρ log E log Eit = α + β GOV i ∗ Pt it−1 + γi + γt + εit HighGOV*PostDetroit

(1) -0.01** (0.01)

GOV*PostDetroit

(2)

(3)

(4)

-0.24** (0.11)

-0.19** (0.09)

-0.28** (0.12) -0.01 (0.00)

EXTFIN*PostDetroit GOV*P def L.logE Constant Industry f.e.

Time f.e.

Ind. spec. trend Observations Adjusted R2

0.92*** (0.01) 0.64*** (0.10) Y Y N 893 0.89

0.95*** (0.01) 0.38*** (0.09) Y Y N 799 0.92

0.97*** (0.00) 0.26*** (0.04) Y Y Y 5185 0.99

0.95*** (0.01) 0.36*** (0.09) Y Y N 799 0.92

(5)

(6)

-1.05** (0.47) 0.95*** (0.01) 0.41*** (0.09) Y Y N 799 0.92

-1.69** (0.81) 0.95*** (0.01) 0.43*** (0.10) Y Y N 799 26/27

Intro

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Empirics

Conclusion

Novel setting to identfy & isolate effects of default risk: PR debt crisis Theory & evidence for government demand channel I

Increased default risk disproportionately affects industries dependent on government demand

27/27

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Model

Empirics

Calculating Pr(def) from CDS data Follow White (2013), Hébert Schreger (2017) Calculate hazard rate from Markit CDS par spread data λ=

I I

S5 1−R

S5 : payment for 5 years of insurance against PR default R: average recovery rate reported by dealers contributing to Markit.

DEF : Pr (default within 5 years) = 1 − exp(−5λ ) I I

Average up to monthly frequency. ∆DEFt = DEFt − DEFt−1 .

Back

28/27

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Robust standard errors HighGOV*PostDetroit

(1) -0.01* (0.00)

GOV*PostDetroit

(2)

(3)

(4)

-0.17* (0.08)

-0.20*** (0.06)

-0.20** (0.08) -0.00 (0.00)

EXTFIN*PostDetroit GOV*P(def) L.logE Constant Industry f.e.

Time f.e.

Ind. spec. trend Observations Adjusted R2

0.95*** (0.02) 0.40*** (0.12) Y Y N 1368 0.93

0.97*** (0.01) 0.29*** (0.09) Y Y N 1224 0.95

0.98*** (0.01) 0.25*** (0.05) Y Y Y 5287 0.99

0.97*** (0.01) 0.29*** (0.09) Y Y N 1224 0.95

(5)

-1.00** (0.40) 0.96*** (0.01) 0.32*** (0.09) Y Y N 1207 0.95 29/27

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Empirics

GOVi average 2007-2012 censuses HighGOV7*PostDetroit

(1) -0.01** (0.00)

GOV7*PostDetroit

(2)

(3)

(4)

-0.20* (0.12)

-0.23** (0.10)

-0.25** (0.12) -0.00 (0.00)

EXTFIN*PostDetroit GOV7*P(def) L.logE Constant Industry f.e.

Time f.e.

Ind. spec. trend Observations Adjusted R2

0.95*** (0.01) 0.39*** (0.07) Y Y N 1425 0.94

0.97*** (0.01) 0.29*** (0.07) Y Y N 1125 0.95

0.98*** (0.00) 0.24*** (0.04) Y Y Y 4710 0.99

0.97*** (0.01) 0.29*** (0.07) Y Y N 1125 0.95

(5)

(6)

-1.00** (0.44) 0.96*** (0.01) 0.33*** (0.08) Y Y N 1080 0.95

-1.31* (0.69) 0.96*** (0.01) 0.36*** (0.07) Y Y N 1380

30/27