Sovereign defaults: Information, investment and credit

Abstract

Why would a sovereign government, immune from bankruptcy procedures and with few assets that could be seized in the event of a default, ever repay foreign creditors? And, correspondingly, why do foreign creditors lend to sovereigns? This paper finds general conditions under which, even in the absence of sanctions, lending to sovereigns can emerge in a single shot game. Furthermore, it shows that positive borrowing can be sustained both in pooling and separating equilibria. In this way, it makes clear that neither sanctions nor reputation considerations, the two classical explanations, are necessary to enforce repayment. Information revelation is the crucial mechanism for these results. The repayment/default decision is interpreted as a signal used by the government to communicate information to domestic and foreign agents about the fundamentals of the economy. Governments repay to affect agents' expectations about them. A default, through its effect on expectations about fundamentals, can generate a decline in foreign and domestic investment and a credit crunch in domestic credit markets. Governments repay to avoid these costs, but may default (in equilibrium) when hit by a negative shock.

Sovereign Theft: Theory and Evidence about Sovereign Default and Expropriation

“…Having learned about the government's preferences, foreigners refrain from making new investments, not because they are participating in a coordinated retaliatory embargo, but simply because they now think that further investment would be a money-losing proposition. Given what they know about the government's type, the risk of sovereign theft would be too great to warrant future investment (see, for example, Cole, Dow, and English 1995;Sandleris 2008;, with the latter documenting the importance of reputation throughout history).…”

Does External Debt Contribute to Malaysia Economic Growth?

“…At the other end of the spectrum, debt repayment has been used as a signaling device to reveal the competence of the government and can display the fundamentals of the country's economy (Sandleris, 2008). Moreover, the ability to repay debt is closely related to Malaysia's sovereign debt rating (probability of default) as well as the future borrowing opportunities.…”

Sovereign defaults and liquidity crises

“…5 These papers have in common with mine the assumption that government's repayment is non-discriminatory across domestic and foreign creditors, but they emphasize different implications: the welfare and distributional effects of default, the political process governing sovereign repayment and the interaction between private and public capital flows, respectively. My paper concentrates on the emergence of a liquidity crisis in the event of default and on the disruption 5 See also Sandleris (2008) and Basu (2008).…”