Cristina Arellano

Monetary Advisor

arellano.cristina@gmail.com
CV
Personal Website

Interests:
International macroeconomics
Sovereign debt
Financial crises

Cristina Arellano has been a senior economist with the Federal Reserve Bank of Minneapolis since 2009. She has also been an assistant professor in the Department of Economics at the University of Minnesota (2004–9). Cristina received her B.S. in economics from Indiana University in 1999 and earned a Ph.D. in economics in 2004 from Duke University. Since 2009 she has also served as a faculty research fellow at the National Bureau of Economic Research. Her research focuses on international macroeconomics, sovereign debt, and financial crises.

Cristina’s work has appeared in the American Economic Review, the Journal of Political Economy, the Journal of Monetary Economics, the Journal of Economic Theory, and the Journal of Development Economics.

Fiscal Austerity During Debt Crises

This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the government’s inability to raise tax revenues. Aggregate defaults occur even if the government could raise tax revenues; debt is simply too high to be sustainable. In a quantitative exercise calibrated to Greece, we find that our model can predict the recent default, but that increasing taxes would not have prevented it. In fact, increasing taxes would have made the recession deeper because of the distortionary effects of taxation.

External and Public Debt Crises

The recent debt crises in Europe and the U.S. states feature similar sharp increases in spreads on government debt but also show important differences. In Europe, the crisis occurred at high government indebtedness levels and had spillovers to the private sector. In the United States, state government indebtedness was low, and the crisis had no spillovers to the private sector. We show theoretically and empirically that these different debt experiences result from the interplay between differences in the ability of governments to interfere in private external debt contracts and differences in the flexibility of state fiscal institutions.

Internal Debt Crises and Sovereign Defaults

Internal and sovereign debt crises occur together and happen more frequently in economies with weak bankruptcy institutions. This paper provides a novel explanation. Internal crises arise because of the inability to liquidate private debtors when many default. In an optimal contract, a successful entrepreneur repays yet an unsuccessful one defaults and liquidates his assets. The bounds on liquidation generate, however, a second equilibrium where domestic borrowers default because others are also defaulting. During these coordinated defaults tax collections fall which increases sovereign default risk. In the model joint debt crises are an optimal response to informational problems in private-sector lending.

Renegotiation Policies in Sovereign Defaults

This paper studies an optimal renegotiation protocol designed by a benevolent planner when two countries renegotiate with the same lender. The solution calls for recoveries that induce each country to default or repay, trading off the deadweight costs and the redistribution benefits of default independently of the other country. This outcome contrasts with a decentralized bargaining solution where default in one country increases the likelihood of default in the second country because recoveries are lower when both countries renegotiate. The paper suggests that policies geared at designing renegotiation processes that treat countries in isolation can prevent contagion of debt crises.

Firm Dynamics and Financial Development

Using comprehensive firm-level datasets, this paper studies the impact of cross-country variation in financial market development on firms’ financing choices and growth. In less financially developed economies, small firms grow faster and have lower leverage than large firms. As financial development improves, the growth difference between small and large firms shrinks, while the leverage difference rises. The paper then develops a quantitative model where financial frictions drive firm growth and debt financing through the availability of credit and default risk. The model explains the observed cross-country variations in firm size, leverage and growth in response to changes in financial frictions.

Default and the Maturity Structure in Sovereign Bonds

This paper studies the maturity composition and the term structure of interest rate spreads of government debt in emerging markets. In the data, when interest rate spreads rise, debt maturity shortens and the spread on short-term bonds rises more than the spread on long-term bonds. We build a dynamic model of international borrowing with endogenous default and multiple debt maturities. Long-term debt provides a hedge against future fluctuations in spreads, whereas short-term debt is more effective at providing incentives to repay. The trade-off between these hedging and incentive benefits is quantitatively important for understanding the maturity structure in emerging markets.

Dollarization and Financial Integration

How does a country’s exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government responds to shocks by adjusting monetary policy and foreign borrowing. Sovereign borrowing is subject to endogenous limits, which ensure repayment when the default punishment corresponds to financial autarky. Dollarizing implies renouncing monetary policy, but can make access to international debt markets more valuable, thereby loosening borrowing constraints. This mechanism linking dollarization to financial integration is consistent with observed declines in spreads on foreign-currency debt in countries adopting the dollar or the euro.

The Dynamic Implications of Foreign Aid and its Variability

The paper examines the effects of aid and its volatility on consumption, investment, and the structure of production in the context of an intertemporal two-sector general equilibrium model, calibrated using data for aid-dependent countries in Africa. A permanent flow of aid mainly finances consumption rather than investment—consistent with the historical failure of aid inflows to translate into sustained growth. Large aid flows are associated with higher real exchange rates and smaller tradable sectors because aid is a substitute for tradable consumption. Aid volatility results in substantial welfare losses, providing a motivation for recent discussions of aid architecture stressing the need for greater predictability of aid. These results are also consistent with evidence from cross-country regressions of manufactured exports, presented later in the paper.

Default Risk and Income Fluctuations in Emerging Economies

Recent sovereign defaults are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default is more likely in recessions because this is when it is more costly for a risk averse borrower to repay noncontingent debt. The model closely matches business cycles in Argentina predicting high volatility of interest rates, higher volatility of consumption relative to output, and negative correlations of output with interest rates and the trade balance.

Default Risk, Sectoral Reallocation and Persistent Recessions

Sovereign debt crises are associated with large and persistent declines in economic activity, disproportionately so for nontradable sectors. This paper documents this pattern using Spanish data and builds a two-sector dynamic quantitative model of sovereign default with capital accumulation. Recessions are very persistent in the model and more pronounced for nontraded sectors because of default risk. An adverse domestic shock increases the likelihood of default, limits capital inflows, and thus restricts the ability of the economy to exploit investment opportunities. The economy responds by reducing investment and reallocating capital toward the traded sector to support debt service payments. The real exchange rate depreciates, a reflection of the scarcity of traded goods. We find that these mechanisms are quantitatively important for rationalizing the experience of Spain during the recent debt crisis.
DOI: https://doi.org/10.21034/sr.555

Sovereign Default Risk and Firm Heterogeneity

This paper studies the recessionary effects of sovereign default risk using firm-level data and a model of sovereign debt with firm heterogeneity. Our environment features a two-way feedback loop. Low output decreases the tax revenues of the government and raises the risk that it will default on its debt. The associated increase in sovereign interest rate spreads, in turn, raises the interest rates paid by firms, which further depresses their production. Importantly, these effects are not homogeneous across firms, as interest rate hikes have more severe consequences for firms that are in need of borrowing. Our approach consists of using these cross-sectional implications of the model, together with micro data, to measure the effects that sovereign risk has on real economic activity. In an application to Italy, we find that the progressive heightening of sovereign risk during the recent crisis was responsible for 50% of the observed decline in output.

Financial Frictions and Fluctuations in Volatility

During the recent U.S. financial crisis, the large decline in aggregate output and labor was accompanied by both a tightening of financial conditions and a large increase in the dispersion of growth rates across firms. The tightened financial conditions manifested themselves as increases in firms’ credit spreads and decreases in both equity payouts and debt purchases. These features motivate us to build a model in which increased volatility of firm level productivity shocks generates a downturn and worsened credit conditions. The key idea in the model is that hiring inputs is risky because financial frictions limit firms’ ability to insure against shocks. Hence, an increase in idiosyncratic volatility induces firms to reduce their inputs and reduce such risk. We find that our model can generate most of the decline in output and labor in the Great Recession of 2007-2009 and the observed tightening of financial conditions.

External and Public Debt Crises

The recent debt crises in Europe and the U.S. states feature similar sharp increases in spreads on government debt but also show important differences. In Europe, the crisis occurred at high government indebtedness levels and had spillovers to the private sector. In the United States, state government indebtedness was low, and the crisis had no spillovers to the private sector. We show theoretically and empirically that these different debt experiences result from the interplay between differences in the ability of governments to interfere in private external debt contracts and differences in the flexibility of state fiscal institutions.

Linkages across Sovereign Debt Markets

We develop a multicountry model in which default in one country triggers default in other countries. Countries are linked to one another by borrowing from and renegotiating with common lenders. Countries default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. Defaulting is also attractive in response to foreign defaults because the cost of rolling over the debt is higher when other countries default. Such forces are quantitatively important for generating a positive correlation of spreads and joint incidence of default. The model can rationalize some of the recent economic events in Europe as well as the historical patterns of defaults, renegotiations, and recoveries across countries.

Renegotiation Policies in Sovereign Defaults

This paper studies an optimal renegotiation protocol designed by a benevolent planner when two countries renegotiate with the same lender. The solution calls for recoveries that induce each country to default or repay, trading off the deadweight costs and the redistribution benefits of default independently of the other country. This outcome contrasts with a decentralized bargaining solution where default in one country increases the likelihood of default in the second country because recoveries are lower when both countries renegotiate. The paper suggests that policies geared at designing renegotiation processes that treat countries in isolation can prevent contagion of debt crises.

Default and the Maturity Structure in Sovereign Bonds

This paper studies the maturity composition and the term structure of interest rate spreads of government debt in emerging markets. In the data, when interest rate spreads rise, debt maturity shortens and the spread on short-term bonds rises more than the spread on long-term bonds. To account for this pattern, we build a dynamic model of international borrowing with endogenous default and multiple maturities of debt. Long-term debt provides a hedge against future fluctuations in interest rate spreads, while short-term debt is more effective at providing incentives to repay. The trade-off between these hedging and incentive benefits is quantitatively important for understanding the maturity structure in emerging markets. When calibrated to data from Brazil, the model accounts for the dynamics in the maturity of debt issuances and its comovement with the level of spreads across maturities.

Comment on “Capital Flows Under Moral Hazard” by Viktor Tsyrennikov

Emerging markets economies have distinct business cycles and experience frequent financial crises. Relative to developed economies, emerging markets economies experience more volatile output and consumption and their current accounts are more countercyclical. Emerging markets also experience financial crises more often than developed countries. During these crises, emerging markets countries experience sudden stops of capital inflows, spikes in interest rates, and collapses in aggregate activity and credit. A priority for theoretical work in emerging markets macroeconomics is understanding markets for international credit, and particularly the joint analysis of capital flows, interest rates, and aggregate fluctuations.

Comment on “Robust Policymaking in the Face of Sudden Stops” by Eric Young

Chronic Sovereign Debt Crises in the Eurozone, 2010-2012

Two years after the rescue package for Greece provided by the European Union and the International Monetary Fund in May 2010, sovereign debt crises continue to threaten a growing number of countries in the eurozone. We develop a theory for analyzing these crises based on the research of Cole and Kehoe (1996, 2000) and Conesa and Kehoe (2012). In this theory, the need to frequently sell large quantities of bonds leaves a country vulnerable to sovereign debt crisis. This vulnerability provides a strong incentive to the country’s government to run surpluses to pay down its debt to a level where a crisis is not possible. A deep and prolonged recession, like those currently afflicting many eurozone countries, creates a conflicting incentive, however, to “gamble for redemption”—to bet that the recession will soon end, to sell more bonds in order to smooth government spending, and, if indeed the economy recovers, to reduce debt. Under some circumstances, this policy is the best that a government can do for the citizens of its country, but it carries a risk: If the recession continues too long, the government either will have to stop increasing its debt or will have to default on its bonds. The theory suggests that policies that result in high interest rates on government bonds and high costs of default provide incentives for a government to reduce its debt and avoid sovereign default. On the other hand, policies that result in low interest rates and low costs of default provide incentives for a government to gamble for redemption. We conclude that policy interventions taken to date by the EU and the IMF—by lowering the cost of borrowing and reducing default penalties—have encouraged eurozone governments to gamble for redemption.

Chronic Sovereign Debt Crises in the Eurozone, 2010-2012

Two years after the rescue package for Greece provided by the European Union and the International Monetary Fund in May 2010, sovereign debt crises continue to threaten a growing number of countries in the eurozone. We develop a theory for analyzing these crises based on the research of Cole and Kehoe (1996, 2000) and Conesa and Kehoe (2012). In this theory, the need to frequently sell large quantities of bonds leaves a country vulnerable to sovereign debt crisis. This vulnerability provides a strong incentive to the country’s government to run surpluses to pay down its debt to a level where a crisis is not possible. A deep and prolonged recession, like those currently afflicting many eurozone countries, creates a conflicting incentive, however, to “gamble for redemption”—to bet that the recession will soon end, to sell more bonds in order to smooth government spending, and, if indeed the economy recovers, to reduce debt. Under some circumstances, this policy is the best that a government can do for the citizens of its country, but it carries a risk: If the recession continues too long, the government either will have to stop increasing its debt or will have to default on its bonds. The theory suggests that policies that result in high interest rates on government bonds and high costs of default provide incentives for a government to reduce its debt and avoid sovereign default. On the other hand, policies that result in low interest rates and low costs of default provide incentives for a government to gamble for redemption. We conclude that policy interventions taken to date by the EU and the IMF—by lowering the cost of borrowing and reducing default penalties—have encouraged eurozone governments to gamble for redemption.

Firm Dynamics and Financial Development

This paper studies the impact of cross-country variation in financial market development on firms’ financing choices and growth rates using comprehensive firm-level datasets. We document that in less financially developed economies, small firms grow faster and have lower debt to asset ratios than large firms. We then develop a quantitative model where financial frictions drive firm growth and debt financing through the availability of credit and default risk. We parameterize the model to the firms’ financial structure in the data and show that financial restrictions can account for the majority of the difference in growth rates between firms of different sizes across countries.

Dollarization and Financial Integration

How does a country’s choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization.
We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen incentives to maintain access to debt markets. Given stronger repayment incentives, more borrowing can be supported, and thus dollarization can increase international financial integration. This prediction of theory is consistent with the experiences of El Salvador and Ecuador, which recently dollarized, as well as with that of highly-indebted countries like Italy which adopted the Euro as part of Economic and Monetary Union: in each case, around the time of regime change, spreads on foreign currency government debt declined substantially.