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The role of risk aversion in a sovereign default model of polarization and political instability

Yasin Onder () and Enes Sunel ()

Review of Economic Dynamics, 2020, vol. 35, 123-132

Abstract: We show that, in models of endogenous sovereign default with symmetric polarization and political turnover, disagreement in the distribution of consumption among distinct political groups or random political turnovers lead to elevated default risk only when preferences feature decreasing concavity in consumption. Consequently, if preferences are in the commonly assumed CRRA form in this class of models, the risk aversion parameter needs to be taken as smaller than one. Our result builds on early insights of the literature, which underscore precautionary insurance and strategic borrowing motives as two competing forces under polarization and political uncertainty. When uninsured income shocks and limited commitment to debt repayment are introduced, high consumption states overlap with increased borrowing. Under declining concavity in preferences, political instability and polarization cause the incumbent sovereign to perceive the consumption of the two constituencies as closer substitutes, which reinforces its borrowing bias and elevates default risk. Our findings fix the calibration of a canonical default model with symmetric polarization and exogenous turnovers by Cuadra and Sapriza (2008) and are robust to alternative numerical approximation methods as well as sovereign debt maturities. (Copyright: Elsevier)

Keywords: Political uncertainty; Polarization; Risk aversion; Default risk (search for similar items in EconPapers)
JEL-codes: F34 F41 P16 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1016/j.red.2019.05.003

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