Sovereign debt issuance and selective default
Title: Sovereign debt issuance and selective default
Series/Number: EUI ECO; 2016/04
We propose a novel theory to explain why sovereigns borrow on both domestic and international markets and why defaults are mostly selective (on either domestic or foreign investors). Domestic debt issuance can only smooth tax distortion shocks, whereas foreign debt can also smooth productivity shocks. If the correlation of these shocks is sufficiently low, the sovereign borrows on both markets to avoid excess consumption volatility. Defaults on both types of investors arise in equilibrium due to market incompleteness and the government's limited commitment. The model matches business cycle moments and frequencies of different types of defaults in emerging economies and we show our hypothesis is confirmed by the data. We also find that secondary markets are not a sufficient condition to avoid sovereign defaults. The outcome of the trade in bonds on secondary markets depends on how well each group of investors can coordinate their actions.
Subject: Sovereign debt; Selective default; Debt composition; Secondary markets; E43; F34; G15; H63
Type of Access: openAccess