Serial sovereign default: the role of shocks and fiscal habits

J. R. Faria, Peter McAdam () and J. Orrillo

No 2629, Working Paper Series from European Central Bank

Abstract: We confront five stylized facts related to sovereign default: 1) the presence of serial defaulters; 2) the prevalence of partial over complete default; 3) the counter-cyclicality of default; 4) non-linearity of sovereign spreads; and 5) heterogeneous outcomes among serial defaulters. In a model that integrates fiscal uncertainty and habit formation in policy, assuming incomplete financial markets, we demonstrate that default is habit and shock driven as well as non-strategic and involuntary. Moreover, there is no need for sanctions to sustain trading. Importantly, in spite of dealing with serial defaulters, partial default is a robust equilibrium. We characterize good and bad fiscal habits and, that with the latter, expected default increases with habit persistence. The impact of habits on the expected default rate is the opposite of its effect on both the interest rate on public debt and base interest of the economy. The presence of habits also has implications for the cost of debt, default risk premium and the cost of default, and can shed light on country heterogeneities. JEL Classification: G18, H63

Keywords: default probability; fiscal shocks; habit formation; topological robustness (search for similar items in EconPapers)
Date: 2021-12
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20212629

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