The Price of Haircuts: Private and Official Default

Abstract

In this paper we examine the link between sovereign defaults and credit risk, by taking into account the depth of a debt restructuring (haircut) and by distinguishing between commercial and official debt. The focus is on debt restructuring events, which take place at the end of a default, or renegotiation spell. Using dyadic data for the relationship between rated countries and agencies, we find that private credit events are more costly than private ones, when it comes to ratings. Moreover, the rating decline is larger for cases with deeper haircuts. Similar results are found when taking bond yield spreads (EMBIG) as measure of a country's creditworthiness. Results are robust to using the local projection approach (Jordà and Taylor 2016) for the identification of causal effects. Therefore, we find evidence that official and private defaults may have different costs and then induce selective defaults. In the wake of the Covid-19 pandemic, since official lending is likely to increase and official debt sustainability is going to become an important concern, understanding the difference between private and official deals has become even more important.

Keywords: Sovereign defaults, Haircut, Credit Rating Agencies, bond yield spreads, local projection

JEL Classification: F34, G15, G24, H63