Rare Disasters, Financial Development, and Sovereign Debt

Abstract

We propose a model of sovereign debt in which countries vary in their level of financial development, defined as the extent to which they can issue debt denominated in domestic currency in international capital markets. We show that low levels of financial development generate the "debt intolerance" phenomenon that plagues emerging markets: it reduces overall debt capacity, increases credit spreads, and limits the country's ability to smooth consumption.AN INTRIGUING FACT ABOUT SOVEREIGN debt markets is that emerging economies pay high credit spreads on their sovereign debt, despite generally having much lower debt-output ratios than developed countries. Reinhart, Rogoff, and Savastano (2003) call this phenomenon "debt intolerance."In this paper, we propose a model of sovereign debt in which countries vary in their level of financial development. By "financial development," we refer to the extent to which a country can issue debt denominated in domestic

Sovereign Debt Ratchets and Welfare Destruction

“…Most of the literature focuses on the quantitative implications of this class of models for consumption, default probabilities, the behavior of the current account, but the authors rarely analyze the welfare costs incurred by a government that lacks a commitment technology. More recently, Rebelo, Wang and Yang (2021) recast the sovereign debt problem in continuous time but continue to assume short-term debt.…”

Sovereign debt responses to the COVID-19 pandemic

“…This study is closely related to the literature on sovereign borrowing capacity, especially during difficult times. Governments' capacity to borrow from the debt market varies substantially with sovereign credit risk ( Reinhart et al, 2003 ), global financial risk and monetary policy ( Gilchrist et al, 2022 ; Uribe and Yue, 2006 ), business cycles ( Ottonello and Perez, 2019 ), the interaction between political conflicts and institutional transparency ( Pancrazi and Prosperi, 2020 ), levels of financial development ( Rebelo et al, 2022 ), and the capitalization of domestic banks ( Crosignani, 2021 ), among many other factors. Sovereign borrowing capacity is particularly relevant in time of need, when governments require urgent fiscal stimulus, or run into unexpected fiscal deficits, among many other scenarios.…”

Natural disasters, climate change, and sovereign risk

“…In doing so, this paper also stresses the importance of non-economic shocks and disaster events in explaining default risk. 2 Closely related, Rebelo et al (2018) examine the relation between rare financial disasters, financial development, and sovereign risk and find that rare financial disasters restrict governments' ability to issue debt in countries with low financial development. This paper shares a similar message in that it shows that natural disasters and climate change may also reduce governments' ability to borrow from abroad.…”