Commodity price risk management and fiscal policy in a sovereign default model

By Bernabe Lopez-Martin ; Julio Leal ; Andre Martinez Fritscher

http://d.repec.org/n?u=RePEc:bis:biswps:620&r=dge

Commodity prices are an important driver of fiscal policy and the business cycle in many developing and emerging market economies. We analyze a dynamic stochastic small-open-economy model of sovereign default, featuring endogenous fiscal policy and stochastic commodity revenues. The model accounts for a positive correlation of commodity revenues with government expenditures and a negative correlation with tax rates. We quantitatively document the extent to which the utilization of different financial hedging instruments by the government contributes to lowering the volatility of different macroeconomic variables and their correlation with commodity revenues. An event analysis illustrates how financial hedging instruments moderate fiscal adjustment in response to significant falls in the price of commodities. We evaluate the conditional and unconditional welfare gains for the representative household, generated by financial derivatives and commodity-indexed bonds.

This is a really big deal for little diversified economies, and in particular those depending on few commodities. The question is then obviously whether they would be granted such contracts given that they are often on shaky financial grounds admittedly often because of their lack of diversification.