Domestic Debt and Sovereign Defaults

Abstract

This paper examines how domestic holdings of government debt affect sovereign default risk and government debt management. I develop a dynamic stochastic general equilibrium model with both external and domestic debt that endogenously generates output contraction upon default. Domestic holdings of government debt weaken investors' balance sheets and induce a contraction of credit and output upon default. I calibrate the model to the Argentinean economy and show that the model reproduces key empirical moments. Introducing domestic debt also yields relevant normative implications. While domestic debt is crucial to determining the risk of default, the efficient internal-external composition of debt cannot be achieved without government intervention. Pigouvian subsidies can restore efficiency.JEL classification: F34, F41, H63.

Domestic and External Sovereign Debt

“…Our contribution to the sovereign debt literature is that we make financial market exclusion quantitatively relevant punishment after default. We are closer to the papers that introduced domestic debt, such as Mallucci (2015), Perez (2015) and , who also assume non-discriminatory default for domestic and external debt. Mallucci (2015) and Perez (2015) include a domestic financial sector and focus on the negative effect of the sovereign default on domestic banks.…”

“…We are closer to the papers that introduced domestic debt, such as Mallucci (2015), Perez (2015) and , who also assume non-discriminatory default for domestic and external debt. Mallucci (2015) and Perez (2015) include a domestic financial sector and focus on the negative effect of the sovereign default on domestic banks. Their mechanism is based on the theoretical contribution in Gennaioli, Martin and Rossi (2014), who show how the development of domestic financial institutions affect the governemnt's default incentives, due to the effect of default on the level of credit in the domestic economy.…”

Optimal Bailouts in Banking and Sovereign Crises

“…A branch of the literature uses stylized models of domestic and external sovereign debt in which domestic debt weakens the balance sheets of banks (e.g., Bolton and Jeanne, 2011, Gennaioli et al, 2014, Gaballo and Zetlin-Jones, 2016, and Balloch, 2016. Other papers, more quantitative in nature, explicitly consider how banks are either affected by or amplify default risk (e.g., Boz et al, 2014, Mallucci, 2015, Thaler, 2018, Abad, 2019, Guo and Pei, 2020, and Moretti, 2020. Without explicitly modeling banks, Arce (2020) studies how government bailouts of the private sector can lead to increased sovereign risk.…”

Real Interest Rates, Inflation, and Default

“…D'Erasmo and Mendoza (2016), Pouzo and Presno (2014), and Arellano and Kocherlakota (2014) tackle the issue of default on domestic debt but do not include inflation. 5 Araujo et al (2013), Sunder-Plassmann (2016), Mallucci (2015), and Fried (2017) study how the currency composition of debt interacts with default crises in emerging economies, while Berriel and Bhattarai (2013), Faraglia et al (2013), and Perez and Ottonello (2016) study nominal debt with inflation in the absence of default. Kursat Onder and Sunel (2016), Nuño and Thomas (2016), and Arellano et al (2018) consider the interaction of inflation and default on foreign investors.…”