Sovereign Debt and Default

• Author: Emine Boz
• Pages: 1-5

Page 1

While public attention has focused on when and why sovereigns default, the academic literature has analyzed a seemingly different question: why do sovereigns repay their debt? Since—unlike with corporate defaults—lenders do not have the legal right to seize the assets of sovereigns and the enforcement of any penalty is difficult, it has been hard to reconcile why sovereigns repay their debt. If sovereigns' assets cannot be seized, default maybe costless for them, so rational lenders would optimally choose not to lend, and in equilibrium there would be no debt or default. This argument, however, does not help explain the empirical facts because the data reveal positive levels of debt—in some cases high levels of debt compared to the country's GDP—along with several episodes of default, suggesting that there must be costs associated with default. (continued on page 4)

Page 4

Hence, researchers have aimed at understanding potential costs of default.

The sovereign debt literature considers two main costs of default: reputational costs and direct sanctions. Reputational costs operate through loss of access to international capital markets (autarky) and hence inability to smooth consumption over time. Direct sanctions refer to trade sanctions that are likely to lead to a disruption in trade and therefore a reduction in output. The empirical relevance and relative importance of these costs have been disputed and the recent sovereign debt literature has modeled the reputational costs rigorously but has captured the other direct sanctions simply as a decline in output during default.

On the modeling of reputational costs, Eaton and Gerso-vitz (1981) provide a tractable, incomplete markets framework. They model a sovereign that optimally chooses to default or to repay. If the sovereign chooses to repay, it also chooses how much to borrow. There is a single lender that represents perfectly competitive private sector creditors. The punishment for default is permanent exclusion from international capital markets. The endogenous default probability of the sovereign pins down the equilibrium interest rate.

More recently, Arellano (2008) studied the quantitative implications of Eaton and Gersovitz's setup by introducing stochastic output and exclusion from capital markets for a period with stochastic length and direct output losses to capture direct sanctions during default. This model delivers many of the observed patterns in...