Domestic and External Sovereign Debt

Abstract

Why do countries tend to repay their domestic and external debt, even though the legal enforcement of the sovereign debt contract is limited? Contrary to conventional wisdom, we argue that temporary market exclusion after default is costly. When the domestic financial market is characterized by a scarcity of private saving instruments, a government can partition its debt market into domestic and external segments, by restricting capital flows, to exploit its market power. The government's market power mitigates the problem of limited commitment, by making default a more costly option. Consequently, it extends the government's external debt capacity. We replicate the domestic and external sovereign debt for non-advanced economies, by unveiling their link to financial repression.

Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default

“…Some studies in this area have examined models that include tax and expenditure policies, as well as settings with foreign and domestic lenders, but always maintaining the representative agent assumption (e.g., Cuadra et al 2010;Vasishtha 2010;and more recently Dias et al 2012) have examined the benefits of debt relief from the perspective of a global social planner with utilitarian preferences. Basu 2009;Broner et al 2010;Broner and Ventura 2011;Brutti 2011;Di Casola and Sichlimiris 2014;Gennaioli et al 2014;Guembel and Sussman 2009;Mengus 2014). 5 As in most of these studies, default in our setup is nondiscriminatory, because the government cannot discriminate across any of its creditors when it defaults.…”