On the role of financial aid in a default episode

Abstract

In the academic literature, there is some consensus on the negative effects of sovereign default episodes. For instance, De Paoli et al. (2011), and Yeyati and Panizza (2011) find that sovereign defaults have an adverse impact on economic growth. The literature has underscored several transmission channels as sovereign defaults affect economic activity. For example, Fuentes and Saravia (2010) find that foreign direct investment tends to fall after a default event. Moreover, other papers have documented that default episodes commonly lead to higher borrowing costs, and at times, to lose access to international financial markets. Borensztein et al. (2009) find that the cost of borrowing is significantly higher immediately after a default episode (relative to the cost prior to the default). Arteta et al. (2008) document that foreign credit to the private sector declines after a sovereign default episode. Cruces and Trebesch (2013), and Richmond et al. (2009) find that debt restructuring can have a significant and lasting impact on access to foreign financing. In short, sovereign defaults are costly. However, for a government, there are benefits related to defaulting on its outstanding debt obligations. The economic literature has highlighted such benefits, particularly so, in papers that model sovereign default events based on a willingness to pay approach (Eaton and Gersovitz (1981)). In this context, an important issue for the international financial community, particularly so for multilateral institutions, has been the