joint with George Alessandria and Yan Bai

[WP version]

Abstract: During sovereign debt crises, countries experience persistent economic declines, spiking spreads, and outflows of capital and workers. To account for these salient features, we develop a sovereign default model with migration and capital accumulation. The model has a two-way feedback. Default risk lowers workers’ welfare and induces emigration, which in turn intensifies default risk by lowering tax base and investment. Compared with a no-migration model, our model produces higher default risk, lower investment, and a more profound and prolonged recession. We find that migration accounts for almost all of the lack of recovery in GDP during the recent Spanish debt crisis.

joint with Min Fang

[WP version]

Abstract: We study how debt maturity heterogeneity determines firm-level investment responses to monetary policy shocks. We first document that debt maturity significantly affects the responses of firm-level investment to conventional monetary policy shocks: firms who hold more long-term debt are less responsive to monetary shocks. The magnitude of responses due to debt maturity heterogeneity is comparable to the well-documented responses due to debt level heterogeneity. Evidence from credit ratings and borrowing responses indicates that the higher future default risk embedded in long-term debt plays an essential role. We then develop a heterogeneous firm model with investment, long-term and short-term debt, and default risk to quantitatively interpret these facts. Conditional on the level of debt, firms with more long-term debt are more likely to default on their external debt and consequently face a higher marginal cost of external finance. As a result, these firms are less responsive in terms of investment to expansionary monetary shocks. The effect of monetary policy on aggregate investment, therefore, depends on the distribution of debt maturity.

Working Papers

April 2022.

Abstract: Income inequality and worker migration significantly affect sovereign default risk. Governments often impose progressive taxes to reduce inequality, which redistribute income but discourage labor supply and induce emigration. Reduced labor supply and a smaller high-income workforce erode the current and future tax base, reducing the government’s ability to repay debt. I develop a sovereign default model with endogenous non-linear taxation and heterogeneous labor to quantify this effect. In the model, the government chooses the optimal combination of taxation and debt, considering its impact on workers’ labor and migration decisions. With the estimated model, I find that income inequality and its interactions with migration explain one-third of the average U.S. state government spread.

joint with Chang Liu (Rochester)

Nov 2021. New update coming soon.

Abstract: This paper measures the output and TFP costs of sovereign risk incorporating its impact on firm intangible investment. Using Italian firm-level data, we show that firms reallocated from intangible assets to tangible assets during the recent sovereign debt crisis. This asset reallocation is more pronounced among small firms and high-leverage firms. We build a sovereign default model incorporating both firm tangible and intangible investment to explain the empirical findings. In our model, sovereign risk deteriorates bank balance sheets, disrupting banks’ ability to finance firms. Firms with greater external financing needs are more exposed to sovereign risk. Facing tightening financial constraints, firms internalize that tangible assets can be used as collateral while intangibles cannot, thus reallocating resources towards tangible investment to offset tightening financial conditions. In a counterfactual analysis, we find that elevated sovereign risk explains 86% of the observed output losses and 72% of TFP losses during the 2011-2013 Italian sovereign debt crisis.

In Progress

  • "Public Financing under Balanced Budget Rules". Preliminary draft.

joint with Chang Liu (NUS)

Abstract: This paper analyzes the impact of a balanced budget rule (BBR) on government financing costs. We construct alternative measures of BBR at the US state level and find that states with tighter BBRs are associated with significantly lower bond spreads. Furthermore, the credit default swap (CDS) spreads are significantly lower when states have tighter BBRs, indicating the importance of default risk in understanding our results. In a sovereign default model incorporating a BBR, a state government is further constrained in its borrowing capacity if it's restricted by BBR. Therefore, it's associated with a lower default risk hence lower borrowing cost. With the parameterized model, we find that debt spreads for the state government of Illinois would decline by 52% (from 2.3% to 1.1%) in ten years if it imposes a BBR today.