Essays on Sovereign Default and the Link with the Domestic Economy

Abstract

This thesis studies the causes and consequences of sovereign defaults focusing on non traditional links between sovereign default and the domestic economy: the impact of sovereign defaults on the external financial conditions for the private sector and the ex-ante implications of the redistributive effects of default and repayment on the political support that the government requires to implement either of these decisions. In the first chapter of my thesis I analyze the worsening of the external financial conditions for the private sector that follows sovereign defaults. To explore the issue I develop a signaling model in which sovereign defaults reveal negative information to foreign lenders regarding the institutional quality in the country. Foreign lenders care about institutional quality because it affects the expected repayment of loans. Therefore, if foreign lenders receive negative information on the institutional quality from the sovereign default they worsen the financial conditions they offer to local firms triggering a sharp reduction in credit and investment ( updating effect ). The model can rationalize the worsened financial conditions in international capital markets for the private sector observed after default episodes. In the second chapter, a joint work with Guido Sandleris and Alejandro Van der Ghote, we analyze how the presence of political constraints affects sovereign governmentsborrowing and default decisions. We do so in a standard DSGE model with endogenous default risk where we introduce two novel features: heterogeneous agents in the domestic private sector and a requirement that the government obtains some of their support to implement the fiscal program needed to repay the debt. In this framework, we demonstrate that sovereign default can also arise due to insufficient political support and we explore the implications of different income distribution, political systems and tax systems over the repayment decision.