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Persistent Gaps and Default Traps

Luis Catão (), Ana Fostel and Sandeep Kapur

No 803, Birkbeck Working Papers in Economics and Finance from Birkbeck, Department of Economics, Mathematics & Statistics

Abstract: We show how vicious circles in countries’ credit histories arise in a model where output persistence is coupled with asymmetric information between borrowers and lenders about the nature of output shocks. In such an environment, default creates a pessimistic outlook about the borrower’s output path. This translates into higher debt to- expected-output ratios, pushing up interest rates and hence debt servicing costs. By raising the cost of future repayments, this creates “default traps”. We provide empirical support for the model by building a long and broad cross-country dataset spanning over a century. This data is used to provide evidence on the existence of a history dependent “default premium” and to show that the effect of output persistence on sovereign creditworthiness is significant and consistent with the model’s predictions after controlling for other determinants of sovereign risk.

Keywords: Sovereign default; spreads; persistence (search for similar items in EconPapers)
JEL-codes: F34 G15 H63 N20 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-lam
Date: 2008-02
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