The Politics of Debt in the Era of Rising Rates

Marina Azzimonti and Nirvana Mitra ()

No 24-12, Working Paper from Federal Reserve Bank of Richmond

Abstract: We examine how the post-pandemic trajectory of risk-free rates—from historically low levels in 2020 to a steep rise in 2022—affects sovereign debt management and default risk in emerging markets (EMs). Using a dynamic political economy model, we show that weak institutional environments with political incentives to engage in corruption spending lead to over-borrowing and increased default risk, especially during low-rate periods. As rates rise, EMs face high risks of default or the need for austerity programs, depending on the severity of productivity shocks. While International Financial Institution (IFI) lending provides short-term relief, it can fuel moral hazard and corruption. Making IFI loans contingent on anti-corruption efforts reduces default risk. However, even full monitoring cannot eliminate the incentives for fiscal mismanagement, as governments may still over-borrow during favorable periods without addressing sustainability. We also find that Quantitative Performance Criteria (QPC), such as a debt-ceiling rule, are less effective as they leave room for corruption that creates default risk and can generate welfare losses relative to a scenario without IFI debt.

Keywords: Sovereign Debt Crises; Institutions; Corruption; Sovereign Default; IFI loans; Emerging Markets (search for similar items in EconPapers)
JEL-codes: D72 E43 E62 F34 F41 (search for similar items in EconPapers)
Pages: 33
Date: 2024-10-25
New Economics Papers: this item is included in nep-dge, nep-fdg, nep-opm and nep-pol
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DOI: 10.21144/wp24-12

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