ABSTRACT
This paper aims to explore the empirically documented strategic use of debt in
a quantitatively relevant sovereign default model of political uncertainty. Partisan
dynamics are captured by differentiating sovereigns in terms of their preference
towards time. Strategic use of debt is found to drive non-trivial consequences
for sovereign risk premium and default dynamics. In particular, we
show that sovereigns who would borrow less in a world that ignores the risk
of removal from office, dilute outstanding stock of debt by the help of multiperiod
debt contracts. The concurrent borrowing bias is connected with the
urge to avoid likely default penalties that might be triggered by more myopic
successors under political turnovers. Following a similar argument, more myopic
sovereigns are found to display an underborrowing bias to level the playing
field for potential investor-friendly successors. We show that debt maturity
plays a profound role in the workings of these effects. Our framework is consistent
with empirical findings on the strategic use of debt depending on partisan
characteristics and improves on the fit of existing sovereign default models that
are quantitatively realistic.