Domestic and External Sovereign Debt

Abstract

Why do countries tend to repay their domestic and external debt, even though the legal enforcement of the sovereign debt contract is limited? Contrary to conventional wisdom, we argue that temporary market exclusion after default is costly. When the domestic financial market is characterized by a scarcity of private saving instruments, a government can partition its debt market into domestic and external segments, by restricting capital flows, to exploit its market power. The government's market power mitigates the problem of limited commitment, by making default a more costly option. Consequently, it extends the government's external debt capacity. We replicate the domestic and external sovereign debt for non-advanced economies, by unveiling their link to financial repression.

History Remembered: Optimal Sovereign Default on Domestic and External Debt

“…The key difference relative to our setup is that these studies assume a representative agent and do not focus on default on domestic debt-holders. Other studies in this literature related to our work include those focusing on the effects of default on domestic agents, foreign and domestic lenders, optimal taxation, the role of secondary markets, discriminatory versus nondiscriminatory default and bailouts (e.g., Guembel and Sussman [30]; Broner et al [15]; Gennaioli et al [29]; Aguiar and Amador [1]; Mengus [42]; Di Casola and Sichlimiris [23]; Perez [46]; Bocola [14]; Sosa-Padilla [50]; and Paczos and Shakhnov [44]). As in some of these studies, default in our setup is nondiscriminatory, but in general, these studies abstract from distributional default incentives and social benefits of debt for self-insurance, liquidity and risk-sharing.…”

“…where M m (Θ) and M d are 3×1 vectors with model-and data-target moments, respectively. 23 Model moments are averages from 160 repetitions of 10,000-period simulations, with the first 2,000 periods truncated to avoid dependency on initial conditions, and excluding default periods 21 Total public debt refers to total general government net financial liabilities as a fraction of GDP. The ratio of domestic to total debt corresponds to the fraction of general government gross debt held by domestic investors from Arslanalp and Tsuda [10], extended with the ratio of marketable debt held by residents to total marketable central government debt from OECD Statistics.…”

“…22 Duration is measured as the average maturity of total central government debt, which is available in OECD Statistics until 2010. 23 The model moments depend on all parameter values, but our choice of parameters to align with moment targets is based on the fact that, everything else equal, β affects the domestic demand for assets, ω affects the social welfare function and thus the optimal debt choice, and φ 1 affects the default frequency, which is informative about debt prices and spreads. because all Eurozone countries but Greece did not default in the sample period.…”

History Remembered: Optimal Sovereign Default on Domestic and External Debt

“…, where M m (Θ) and M d are 3×1 vectors with model-and data-target moments, respectively. 23 Model moments are averages from 160 repetitions of 10,000-period simulations, with the first 2,000 periods truncated to avoid dependency on initial conditions, and excluding default periods because all Eurozone countries but Greece did not default in the sample period. Table 2 shows the calibrated parameter values.…”

Optimal Domestic (and External) Sovereign Default

“…Other studies in the external default literature are also related to our work, in that they focus on the effects of default on domestic agents, optimal taxation, the role of secondary markets, discriminatory versus nondiscriminatory default and bailouts (e.g., Guembel and Sussman [27]; Broner, Martin and Ventura [14]; Gennaioli, Martin and Rossi [26]; Aguiar and Amador [1]; Mengus [36]; and Di Casola and Sichlimiris [21]). 7 As in some of these studies, default in our setup is non discriminatory, but in general, these studies abstract from distributional default incentives and social benefits of debt for self-insurance, liquidity and risk-sharing.…”