Political Constraints and Sovereign Default Premia

Nirvana Mitra

No 2021-01, Working Papers from Shiv Nadar University, Department of Economics

Abstract: I study the relationship between political constraints and the probability of sovereign default using a dynamic model of fiscal policy augmented with legislative bargaining and default. I find that the tightness of political constraints and default probability are inversely related if the output cost of default is not too high. The model government consists of legislators who bargain over multidimensional fiscal policy, including over a local public good that benefits only the regions they represent. Tighter political constraints are equivalent to more legislators with veto power over fiscal policies. In this case, a default implies that the released resources need to be distributed among more regions as local public goods. Thus, a smaller benefit accrues to each region, decreasing the incentive to default. However, if default is too costly, even relatively unconstrained governments default less frequently because the individual share of cost is too high. Empirical evidence from South American countries is consistent with this result. I calibrate the infinite horizon model to Argentina. It confirms the inverse relationship. A counterfactual exercise with even higher political constraints shows that the default by Argentina in 2001 could not be avoided.

Keywords: Sovereign debt; Default risk; Interest rates; Political economy; Minimum winning coalition; Endogenous borrowing constraints. (search for similar items in EconPapers)
JEL-codes: D72 E43 E62 F34 F41 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2021-01-15
New Economics Papers: this item is included in nep-cdm, nep-dge, nep-mac, nep-opm and nep-pol
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