Essays on Sovereign Debt Auctions

Abstract

This dissertation consists of three chapters. In the first chapter, using a dataset containing individual bids on Portuguese debt auctions, I document changes in investors' demand for sovereign debt during a debt crisis. I find that bid functions become more inelastic during the crisis. Particularly, the inverse of the price elasticity is, on average, up to thirteen times larger leading up to and during the crisis. That is, on average, in order to increase the amount raised by 1%, the price would need to decrease, in percentage terms, by thirteen times more than it had before the crisis. I then decompose the changes in demand into two components: a fundamental component, due to changes in valuation, and a strategic component, that arises from investors' market power. Although the role of market power is negligible in normal times, it gets more pronounced leading up and during the crisis. The auction mechanism loses efficiency during that period as the government is not able to extract the full surplus from strategic investors. At their peak, inefficiency costs jump to 0.6% of the issued amount. Finally, I discuss a possible mitigation strategy. Everything else constant, shorter maturities should be used to avoid higher inefficiency costs. The second chapter is joint work with Stelios Fourakis. We study the impact that alternative ways of issuing sovereign debt have on borrowing decisions and the cost of debt. We build a model of sovereign borrowing and default with repeated auctions, disciplined with proprietary bid level data. We calibrate the model to the Portuguese economy and find that it generates spreads with a volatility that significantly exceeds their mean, as in the data, a documented shortcoming of previous sovereign debt models. We then use the calibrated model to perform a counterfactual, comparing the two most common types of auction: uniform and discriminatory price auctions. We find that switching to a uniform protocol constitutes a Pareto improvement, and that the difference in welfare is highest during crises (up to 0.6% of permanent consumption in the small open economy). This result aligns with the observed switch to a uniform protocol in Portugal following the sovereign debt crisis of the 2010s. We find that accounting for dynamic effects is crucial. In a single auction setting, given standard values for risk aversion of the government, the discriminatory protocol is optimal. However, with repeated auctions, the insurance properties of the discriminatory protocol lead to over-borrowing. This mechanism, and its effect on prices, makes the uniform protocol a better option. The third chapter is joint with Stelios Fourakis. We study how different auction protocols make the government more or less vulnerable to multiplicity driven by self-fulfilling prophecies. First, we describe how using a discriminatory price protocol may create a new type of static multiplicity: as investors pay as bid, equilibrium bids depend on investors' beliefs about how much debt the government is going to issue in a given auction, and different beliefs may support different equilibria. Then, we show that for linear flow utility the equilibrium under a discriminatory price protocol is still unique. We conjecture that this static multiplicity requires a substantial level of risk aversion, and for low risk aversion, we should still expect uniqueness. Finally, we show that using the discriminatory price protocol eliminates the type of multiplicity found in Calvo (1988).