Reputational Effects in Sovereign Default

Abstract

We present a tractable, quantitative model of sovereign borrowing that delivers empirically relevant regularities, such as graduation from default, sovereign debt spreads that may be high for an extended period of time, high debt-to-GDP ratios, and high default rates. The model is an asymmetric-information extension of otherwise standard models of endogenous default on sovereign debt, with borrowing levels determined in equilibrium. Governments could be of di↵erent types based on their level of responsibility (cost of default as perceived by the politicians). Only the governments observe their level of responsibility. International investors try to infer the unobserved types based on the history of all observable actions, which gives irresponsible politicians an incentive to choose the same actions as responsible ones would. Governments could tolerate periods of high interest rates without defaulting to signal that they are of better type and to gain good reputation. This leads to lower interest rates during future recessions. For the same reason, even responsible governments should pay at first high interest rates in order to signal their type and thus "graduate from default" afterwards. A calibrated version of the model features these regularities, matches standard business cycle moments, and leads to a more realistic default rate in equilibrium, with parameter values same as in the existing literature.

Endogenous political turnover and fluctuations in sovereign default risk

“…7 Egorov and Fabinger (2016) have a similar focus but assume that sovereigns differ with respect to their privately observed default costs. Cole, Dow, and English (1995) and Tomz (2007) are important precursors that argue for the importance of reputation in sovereign repayment decisions.…”

Reputation and Partial Default

“…ere are several papers that model reputational considerations in sovereign debt markets, such as Cole, Dow and English (1995), Alfaro and Kanczuk (2005), D'Erasmo (2011), Egorov andFabinger (2016), andDovis (2019). 2 e initial quantitative models of sovereign debt e ectively assumed that there are no partial defaults (all defaults are full), and the sovereign can subsequently re-enter nancial markets with a clean slate.…”

Reputation and Sovereign Default

“…Our paper also differs from D'Erasmo (2011) in that we impose no exogenous cost of default and are able to provide a complete characterization of the equilibrium. In complementary work, Egorov and Fabinger (2016) share our objectives of studying reputation, graduation, and debt and interest rate dynamics, and do so in a model where an unchanging government has private information about the realizations of a default cost process. Chatterjee, Corbae, Dempsey, and Rios-Rull (2020) study related questions but 7 Other recent models on reputation building include the discrete time models of Liu (2011) and Liu and Skrzypacz (2014), and the continuous-time models of Faingold and Sannikov (2011), Board and Meyer ter Vehn (2013), and Marinovic, Skrzypacz, and Varas (2018.…”