Academic journal article Economia

The Costs of Sovereign Default: Theory and Empirical Evidence

Academic journal article Economia

The Costs of Sovereign Default: Theory and Empirical Evidence

Article excerpt

(ProQuest: ... denotes formulae omitted.)

How costly will a sovereign default be for the defaulting country? How can these costs be limited? These are crucial questions for policymakers facing a debt crisis. Being able to estimate these costs is necessary for deciding how far a country should go to avoid default. In addition, understanding the sources of these costs is crucial to mitigate them and improve the workings of sovereign debt markets.

In recent years, governments have fought tough political battles to avoid a default, cutting pension payments or public wages, postponing investments, or risking the health of the domestic banking system by pushing banks to hold more sovereign debt. Governments have been willing to do all this to avoid a default because sovereign defaults are perceived to be very costly. However, the origin of these costs is not immediately clear. Sovereign debt contracts differ from corporate debt contracts mainly in that their legal framework is weaker, resulting in limited enforceability. The holder of a corporate debt contract owns a legally enforceable claim on the assets of the corporate borrower, and, in the event of default, the lender has the right to initiate actions against the borrower under the framework of a bankruptcy code. This is not the case with sovereign debt contracts. Sovereign governments are immune from bankruptcy procedures, and few of their assets could be seized in the event of a default. In addition, the overwhelming majority of sovereign debt contracts are not collateralized. Given this legal framework, it would seem that a sovereign default should not be terribly costly.

To explore the costs of sovereign default, this paper classifies the different theories into three groups. First, creditors impose costs as a penalty. The literature analyzes two main types of penalties: exclusion of the sovereign from international credit markets; and trade and other sanctions.1 Second, costs can also derive from the information content of a default, to the extent that the default reveals information that affects agents' expectations.2 Third, there are costs related to domestic agents' sovereign bond holdings: domestic bondholders are negatively affected by a default when the government cannot discriminate in their favor in the event of a default and is unable to compensate them adequately after it.3

The paper begins by presenting a simple model for each of these theories that captures the main ideas behind them. This provides the basis for exploring the similarities and differences between the various approaches. A common thread that runs through all these theories is that, although defaults are costly in terms of both output and welfare, they are the result of an optimal decision of a social-welfare-maximizing government.

The paper then reviews the empirical evidence on the costs of sovereign default. As a first pass, I evaluate the relationship between defaults and economic growth. Different empirical studies suggest that sovereign defaults are associated with declines of approximately one or two percentage points in the growth of gross domestic product (GDP). These declines are larger when the economy suffers a banking crisis in addition to the default.

This section also analyzes the empirical evidence on the effects of default on trade, foreign direct investment, and foreign and domestic credit to the private sector. This analysis clarifies the different mechanisms through which defaults affect output. The empirical evidence shows that, after controlling for fundamentals, total trade in the defaulting country declines by approximately 3.2 percent a year in the first five years following the default. Given the pattern of the drop in trade, it is unlikely that these declines were generated by trade sanctions.4 Foreign direct investment is also found to decline in the aftermath of defaults.5 Furthermore, microdata on private sector borrowing from international credit markets indicates that sovereign defaults are systematically accompanied by a significant decline in foreign credit to domestic private firms during the debt renegotiations, which persists more than two years after the restructuring agreement is reached. …

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