IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this paper

Using Balance Sheet to identify sovereign default and devaluation risk

The relationship between devaluation and default risk is a central issue in the discussion of the costs and bene…ts of dollarizing emerging economies. Correct measures of these two unobserved variables are essential for assessing the welfare implications of dollarization. This paper studies the role of private sector balance sheets in measuring devaluation and default risk. A leading argument in favor of dollarization rests on the causal link between devaluation risk and country default risk. According to this view, “…rms and households in emerging economies have dollar-denominated debts, some of them acquired through domestic transactions like the purchase of a car or a refrigerator. Therefore, ‡uctuations in the exchange rate run the risk of creating serious …nancial stress.” (Calvo, 2000). As devaluations cause defaults, dollarization can substantially reduce default risk in emerging economies by taking away the government’s ability to devalue. Assessing the empirical relevance of this argument requires the analyst to measure devaluation and sovereign risk. In our interpretation of the argument, the chain through which devaluations lead to defaults has two crucial links: the liability dollarization problem (net dollar liabilities and net peso assets) and explicit or implicit government bailouts designed to avoid generalized bankruptcy. This is the way in which the story goes. Assume that, under certain unexplained circumstances (an exogenous …scal shock?), a government must devalue while private sector balance sheets exhibit a liability dollarization problem. Under these conditions following a devaluation the credit market will collapse. To avoid the supposedly costly generalized default, the government may have to make transfers to banks. If this transfers are su¢ciently high, the government may have to default on its debt. If this is the way the world functions, then when the (exogenous in the story) expected devaluation goes up, the expected default will go up. A minimal empirical test that this theory should pass is a positive correlation between expected devaluation and default risk. The standard approach to measuring sovereign default risk and devaluation risk rests on two no-arbitrage conditions restricting the return on peso denominated (emerging) sovereign bonds and the return on dollar denominated (emerging) sovereign bonds on one hand, and the return on dollar denominated (emerging) sovereign bonds and the return on dollar denominated risk free bonds on the other. The absence of risk free peso denominated bonds creates an identi…cation problem as there are two arbitrage equations to measure three unobserved variables: sovereign default risk on peso bonds, sovereign default risk on dollar bonds, and devaluation risk. This paper shows that the identi…cation problem can be solved with information about government and private sector balance sheets and a simple of the shelf model of optimal default and devaluation. The model provides a theory on how a benevolent government jointly decides the three default alternatives it has available, namely, the devaluation rate, the default rate on peso denominated bonds and the default rate on dollar denominated bonds. A key assumption of the model, motivated by the current debate on dollarization, is that government guarantees banks a minimum level of pro…ts. This implies that if there is a currency mismatch in private sector balance sheets that would induce banks to go bankrupt in the event of a large devaluation, banks (depositors) will be bailed out by the government. The model predicts that the choice between defaulting on domestic currency debt through an explicit default or through devaluation depends on the private sector’s balance sheet positions. In general, government will prefer to default on its domestic currency debt by devaluing its currency rather than through an explicit default. The incentive to do so stems from the fact that a devaluation is more pro…table because it amounts to a default on the government’s domestic currency debt plus its monetary liabilities. In economies with a liability dollarization problem, where the private sector has net dollar liabilities (or net peso assets), governments may choose to explicitly default on domestic currency debt instead of devaluing. This is because, in this case, the devaluation will trigger a bailout of the banking system. The optimal choice between devaluation and explicit default will depend on the trade-o¤ between the …scal gain of depreciating government monetary liabilities and the …scal cost of bailing out the …nancial system. If the latter exceeds the former, the government will prefer to default on its domestic debt, rather than devaluing and triggering a bailout. Using data on Argentine balance sheets for the period 1994-2000 we …nd that it is never optimal for the government to default on its domestic currency debt when we take currency denomination of balance sheets at face value. Using this identifying assumption expected devaluations are measured by the di¤erence between the return on domestic currency sovereign bonds and the risk free dollar rate. If we assume that all non-secured loans denominated in dollars are actually in pesos this result is reversed: it is never optimal for a government to devalue since a devaluation will trigger a …nancial crisis and, therefore, a bank-bailout that will o¤set the …scal gain of devaluing.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: no

Paper provided by Universidad Torcuato Di Tella in its series Department of Economics Working Papers with number 009.

in new window

Length: 32 pages
Date of creation: Apr 2003
Handle: RePEc:udt:wpecon:009
Contact details of provider: Web page:

More information through EDIRC

No references listed on IDEAS
You can help add them by filling out this form.

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:udt:wpecon:009. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Martin Cecilia Lafuente)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.