Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Politics of Sovereign Defaults

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Politics of Sovereign Defaults

Article excerpt

Sovereign debt issuance and repayment decisions are determined by public officials and may thus be affected by issues such as the proximity of elections; conflicts between the executive branch and the parliament; institutional breakdowns such as military coups; etc. This article first discusses theoretical and empirical studies about the role of political factors in sovereign default episodes. Before concluding, the article also discusses the role of political factors in five recent default episodes.1

The preferences of public officials and the environment in which they must act affect their perceived costs and benefits of defaulting. This has been recognized by several authors. For instance, in discussing the role of political factors as determinants of defaults, Sturzenegger and Zettelmeyer (2006) conclude that "a solvency crisis could be triggered by a shift in the parameters that govern the country's willingness to make sacrifices in order to repay, because of changes in the domestic political economy (a revolution, a coup, an election, etc.)... " Similarly, Rijckeghem and Weder (2009) argue that a country's willingness to pay is influenced by politics, i.e., by the distribution of political power and of benefits and costs of defaulting across voters. The heterogeneity of public officials' preferences is also highlighted by Santiso (2003) who writes, "One basic rule of the confidence game [in international financial markets] is then to be very careful when nominating the official government voicer. For investors it is mainly the ministry of economics or finance or the governor of the central bank."

We first describe theoretical studies that illustrate how the risk of losing elections may induce a sovereign to avoid a default even when creditors have no access to legal procedures that would allow them to force the sovereign to pay. This risk would be present when sovereign debt is at least partially held by local creditors with political power to deny support to political groups that advocate for a default. Note that, since it is difficult to declare a selective default on foreign bondholders only, the presence of these local creditors could also explain why foreign investors are willing to buy sovereign debt.

Second, we describe theoretical work that studies how political turnover, i.e., the alternation in office of policymakers with different objectives, affects incentives to borrow from foreign lenders and to default on debt held by foreigners. Policymakers may differ in the weights they assign to different constituencies of domestic residents when allocating fiscal resources and they may differ in their willingness to pay the debt. Studies that assume differences in policymakers' spending preferences find that a higher frequency of political turnover tends to generate higher debt levels and higher default probabilities. In contrast, studies that assume that policymakers differ in their willingness to repay debt find that the relationship between the default probability and the frequency of political turnover may be nonmonotonic.

Studies that assume that policymakers differ in their willingness to repay make possible the existence of defaults triggered by political turnover.2 We refer to such default episodes as "political defaults." Political defaults occur when a "creditor-friendly" government (with a higher willingness to pay) is replaced by a "debtor-friendly" government (with a lower willingness to pay). It should be mentioned that while political turnover may explain the timing of the default decision, poor economic conditions are likely to play a key role in political defaults. In fact, in Hatchondo, Martinez, and Sapriza's (2009) model of political defaults, political defaults are only likely to occur after a creditor-friendly government encounters poor economic conditions that lead it to choose high borrowing levels. These studies also find that after political defaults, debt and interest rate spread levels are lower than the levels observed after defaults caused by negative income shocks only, and are lower than the pre-default levels. …

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