Sovereign Debt Without Default Penalties

Alexander Guembel and Oren Sussman

No 2005-FE-17, Economics Series Working Papers from University of Oxford, Department of Economics

Abstract: The basic question regarding sovereign debt is why sovereign borrowers ever repay, provided that creditors have no power to foreclose on any of their assets. In this paper we suggest an answer: sovereign debt will be served as long as the median voter is a net loser from default. Default generates a reallocation of wealth from locals to foreigners, but also from local debtholders to local tax payers. Sovereign debt is stable as long as the median voter`s interests are more aligned with the foreign lenders than with the local taxpayers. We further augment the model with elements of market microstructure theory to address the question how markets rationally use capital flows so as to infer the stability of debt structure. We show that foreign demand shocks can destabilise debt even though they are not fundamental. We also show that more volatile foreign demand reduces a country`s debt capacity. Our work thus integrates elements of market microstructure theory into political-economy modeling.

Date: 2005-11-01
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