Construction of facilities under asymmetric information: do constitutional constraints matter?

This paper studies construction of facilities in a federal state under asymmetric information. A country consists of two regions, each ruled by a local authority. The federal government plans to construct a facility in one of the regions. The facility generates a local value in the host region and has spillover effects in the other region. The federal government does not observe the local value because it is the local authority's private information. 80 the federal governrnent designs an incentive-compatible mechanism, specifying if the facility should be constructed and a balanced scheme of interregional transfers to finance its cost. The federal governrnent is constitutionally constrained to respect a given leveI of each region's welfare. We show that depending upon the facility's local value and the spillover effect, the governrnent faces different incentive problems. Moreover, their existence depends crucially on how stringent constitutional constraints are. Therefore, the optimal mechanism will also depend upon these three features of the model.

Comments on public debt indexation and denomination, the case of Brazil

In this work I analyze the model proposed by Goldfajn (2000) to study the choice of the denomination of the public debt. Some potential shortcmomings of the mo dei in explaining the data are discussed. Measures of the overestimation of the welfare gains of reducing distortions from taxation, under the model's simplified time frame, are also provided. Assuming a time-preference parameter of 0.9, for instance, welfare gains associated with a hedge to the debt that reduces to half a once-for-all 20o/o-of-GDP shock to governemnt spending run around 1.43% of GDP under the no-tax-smoothing structure of the model. Under a Ramsey allocation, though, welfare gains amount to just around 0.05% of GDP.

Rational expectations and the service of public debt: a recursive approach

This paper uses dynamic programming to study the time consistency of optimal macroeconomic policy in economies with recurring public deficits. To this end, a general equilibrium recursive model introduced in Chang (1998) is extended to include govemment bonds and production. The original mode! presents a Sidrauski economy with money and transfers only, implying that the need for govemment fmancing through the inflation tax is minimal. The extended model introduces govemment expenditures and a deficit-financing scheme, analyzing the SargentWallace (1981) problem: recurring deficits may lead the govemment to default on part of its public debt through inflation. The methodology allows for the computation of the set of alI sustainable stabilization plans even when the govemment cannot pre-commit to an optimal inflation path. This is done through value function iterations, which can be done on a computeI. The parameters of the extended model are calibrated with Brazilian data, using as case study three Brazilian stabilization attempts: the Cruzado (1986), Collor (1990) and the Real (1994) plans. The calibration of the parameters of the extended model is straightforward, but its numerical solution proves unfeasible due to a dimensionality problem in the algorithm arising from limitations of available computer technology. However, a numerical solution using the original algorithm and some calibrated parameters is obtained. Results indicate that in the absence of govemment bonds or production only the Real Plan is sustainable in the long run. The numerical solution of the extended algorithm is left for future research.

Does liquidity constraints matter for Ricardian equivalence?

The paper analysis a general equilibrium model with two periods, several households and a government that has to finance some expenditures in the first period. Households may have some private information either about their type (adverse selection) or about some action levei chosen in the first period that affects the probability of certain states of nature in the second period (moral hazard). Trade of financiai assets are intermediated by a finite collection of banks. Banks objective functions are determined in equilibrium by shareholders. Due to private information it may be optimal for the banks to introduce constraints in the set of available portfolios for each household as wellas household specific asset prices. In particular, households may face distinct interest rates for holding the risk-free asset. The government finances its expenditures either by taxing households in the first period or by issuing bonds in the first period and taxing households in the second period. Taxes may be state-dependent. Suppose government policies are neutml: i) government policies do not affect the distribution of wealth across households; and ii) if the government decides to tax a household in the second period there is a portfolio available for the banks that generates the Mme payoff in each state of nature as the household taxes. Tben, Ricardian equivalence holds if and only if an appropriate boundary condition is satisfied. Moreover, at every free-entry equilibrium the boundary condition is satisfied and thus Ricardian equivalence holds. These results do not require any particular assumption on the banks' objective function. In particular, we do not assume banks to be risk neutral.

Sovereign debt with adverse selection : a quantitative approach

We construct a dynamic equilibrium model to quantitatively study sovereign debt with contingent services and country risk spreads such that the benefits of defaulting are tempered by higher interest rates in the future. For a wide range of parameters, the only equilibrium of the model is one in which the sovereign defaults in all states, unless defaulting incurs additional costs. Due to the adverse selection problem, some countries choose to delay default in order to reduce reputation loss. Although equilibria with no default imply in greater welfare levels, they are not sustainable in the highly indebted and volatile countries.

Do borrowing constraints decrease intergenerational mobility? evidence from Brazil

In this paper, we find evidence that suggests that borrowing constraints may be an important determinant of intergenerational mobility in Brazil. This result contrasts sharply with studies for developed countries, such as Canada and the US, where credit constraints do not seem to play an important role in generating persistence of inequality. Moreover, we find that the social mobility is lower in Brazil in comparison with developed countries. We follow the methodology proposed by Grawe (2001), which uses quantile regression, and obtain two results. First, the degree of intergenerational persistence is greater for the upper quantiles. Second, the degree of intergenerational persistence declines with income at least for the upper quantiles. Both findings are compatible with the presence of borrowing constraints affecting the degree of intergenerational persistence, as predicted by the theory.

A risk management approach to emerging market's sovereign debt sustainability with an application to Brazilian data

In this paper we study the question of debt sustainability from a risk management perspective. The debt accumulation equation for any country involves variables that are stochastic and closely intertwined. When these aspects are taken into consideration the notion of debt sustainability is expanded to studying the stochastic properties of the debt dynamics. We illustrate the methodology by studying the Brazilian case. We find that even though the debt could be sustainable in the absence of risk, there are paths in which it is clearly unsustainable. Furthermore, we show that properties of the debt dynamics are closely related to the spreads on sovereign dollar denominated debt.

Informational spillovers in the pre-1914 London sovereign debt market

We document a novel type of international financial contagion whose driving force is shared financial intermediation. In the London peripheral sovereign debt market during pre-1914 period financial intermediation played a major informational role to investors, most likely because of the absence of international monitoring agencies and the substantial agency costs. Using two events of financial distress – the Brazilian Funding Loan of 1898 and the Greek Funding Loan of 1893 – as quasi-natural experiments, we document that, following the crises, the bond prices of countries with no meaningful economic links to the distressed countries, but shared the same financial intermediary, suffered a reduction relative to the rest of the market. This result is true for the mean, median and the whole distribution of bond prices, and robust to an extensive sensitivity analysis. We interpret it as evidence that the identity of the financial intermediary was informative, i.e, investors extracted information about the soundness of a debtor based on the existence of financial relationships. This spillover, informational in essence, arises as the flip-side of the relational lending coin: contagion arises for the same reason why relational finance, in this case, underwriting, helps alleviate informational and incentive problems.

Inglorious revolution : sovereign debt, tropical credibility, and financial underdevelopment in imperial Brazil

In 1824 the creation of institutions that constrained the monarch’s ability to unilaterally tax, spend, and debase the currency put Brazil on a path toward a revolution in public finance, roughly analogous to the financial consequences of England’s Glorious Revolution. This credible commitment to honor sovereign debt resulted in successful long-term funded borrowing at home and abroad from the 1820s through the 1880s that was unrivalled in Latin America. Some domestic bonds, denominated in the home currency and bearing exchange clauses, eventually circulated in European financial markets. The share of total debt accounted for by long-term funded issues grew, and domestic debt came to dominate foreign debt. Sovereign debt yields fell over time in London and Rio de Janeiro, and the cost of new borrowing declined on average. The market’s assessment of the probability of default tended to decrease. Imperial Brazil enjoyed favorable conditions for borrowing, and escaped the strong form of “original sin” stressed by recent work on sovereign debt. The development of vibrant private financial markets did not, however, follow from the enhanced credibility of government debt. Private finance in Imperial Brazil suffered from politicized market interventions that undermined the development of domestic capital markets. Private interest rates remained high, entry into commercial banking was heavily restricted, and limited-liability joint-stock companies were tightly controlled. The Brazilian case provides a powerful counterexample to the general proposition of North and Weingast that institutional changes that credibly commit the government to honor its obligations necessarily promote the development of private finance. The very institutions that enhanced the credibility of sovereign debt permitted the systematic repression of private financial development. In terms of its consequences for domestic capital markets, the liberal Constitution of 1824 represented an “inglorious” revolution.

Equilibria in exchange economies with financial constraints : beyond the Cass trick

We consider an exchange economy under incomplete financiaI markets with purely financiaI securities and finitely many agents. When portfolios are not constrained, Cass [4], Duffie [7] and Florenzano-Gourdel [12] proved that arbitrage-free security prices fully characterize equilibrium security prices. This result is based on a trick initiated by Cass [4] in which one unconstrained agent behaves as if he were in complete markets. This approach is unsatisfactory since it is asymmetric and no more valid when every agent is subject to frictions. We propose a new and symmetric approach to prove that arbitrage-free security prices still fully characterize equilibrium security prices in the more realistic situation where the financiaI market is constrained by convex restrictions, provided that financiaI markets are collectively frictionless.

Endogenous borrowing constraints and default when markets are incomplete

Incomplete markets and non-default borrowing constraints increase the volatility of pricing kernels and are helpful when addressing assetpricing puzzles. However, ruling out default when markets are in complete is suboptimal. This paper endogenizes borrowing constraints as an intertemporal incentive structure to default. It modeIs an infinitehorizon economy, where agents are allowed not to pay their liabilities and face borrowing constraints that depend on the individual history of default. Those constraints trade off the economy's risk-sharing possibilities and incentives to prevent default. The equilibrium presents stationary properties, such as an invariant distribution for the assets' solvency rate.

Debt management in Brazil: evaluation of the Real Plan and challenges ahead

The Brazilian domestic debt has posed two challenges to policy-makers: it has grown very fast and its maturity is extremely short. This has prompted fears that a default or a compulsory lengthening scheme would be imposed. Here, we analyse the domestic public debt management experience in Brazil, searching for policy prescriptions for the next few years. After briefiy reviewing the recent domestic public debt history, we decompose the large rise in federal bonded debt during 1995-2000, searching for its macroeconomic causes. The main culprits are the extremely high interest payments-which, unti11998, were caused by the weak fiscal stance and the quasi-fixed exchange-rate regime; and since 1999, by the impact ofthe currency depreciation On the dollar-indexed and the externai debt-, and the accumulation of assets of doubtful value, much of which may have to be written off in the future. Simulation exercises of the net debt path for the near future underscore the importance of a tighter fiscal stance to prevent the debt-GDP ratio from growing further. Given the need to quickly lengthen the debt maturity, our main policy advice is to foster, and rely more on, infiation-linked bonds.

Firm financial constraints and the impact of monetary policy: evidence from financial conglomerates

Building on recent evidence on the functioning of internal capital markets in financial conglomerates, this paper conducts a novel test of the balance sheet channel of monetary policy. It does so by comparing monetary policy responses of small banks that are affiliated with the same bank holding company, and this arguably face similar constraints in accessing internal/external sources of funds, but that operate in different geographical regions, and thus face different pools of borrowers. Because these subsidiaries typically concentrate their lending with small local businesses, we can use cross-sectional differences in state-level economic indicators at the time of changes of monetary policy to study whether or not the strength of borrowers' balance sheets influences the response of bank lending. We find evidence that the negative response of bank loan growth to a monetary contraction is significantly stronger when borrowers have 'weak balance sheets. Our evidence suggests that the monetary authority should consider the amplification effects that financial constraints play following changes in basic interest rates and the role of financial conglomerates in the transmission of monetary policy.

Public debt management, monetary policy and financial institutions

Despite the large size of the Brazilian debt market, as well the large diversity of its bonds, the picture that emerges is of a market that has not yet completed its transition from the role it performed during the megainflation years, namely that of providing a liquid asset that provided positive real returns. This unfinished transition is currently placing the market under severe stress, as fears of a possible default from the next administration grow larger. This paper analyzes several aspects pertaining to the management of the domestic public debt. The causes for the extremely large and fast growth ofthe domestic public debt during the seven-year period that President Cardoso are discussed in Section 2. Section 3 computes Value at Risk and Cash Flow at Risk measures for the domestic public debt. The rollover risk is introduced in a mean-variance framework in Section 4. Section 5 discusses a few issues pertaining to the overlap between debt management and monetary policy. Finally, Section 6 wraps up with policy discussion and policy recommendations.