Government Reputation and Debt Repayment

Abstract: Emerging economies that have repeatedly defaulted on their external obligations are still able to accumulate considerable amounts of debt. On average, they default 4 times every 100 years and the ratio of government debt to output is 65%. Standard models of sovereign debt are unable to jointly explain the default frequency and the debt to output ratio. To address this puzzle, I develop a small open economy model that incorporates two key ingredients: government reputation and endogenous resolution of defaults. In this model, reputation plays a role because the government transits through different political states that cannot be observed by lenders. In addition, after a default, the government chooses when to renegotiate over a debt reduction. The combination of government reputation with endogenous periods of exclusion and debt renegotiation produce a debt to output ratio that is between 2 to 5 times higher than previous models in the literature and explains 55% of that observed in the data. A novelty of this model is that reproduces the relation between interest rates and sovereign ratings (viewed as the market measure of the a country’s likelihood of default) and sheds light on the determinants of the sovereign risk of default. Finally, the model is consistent with a number of salient features of the sovereign debt market such as the average recovery rate, the timing of default and repayment and the main business cycle regularities of emerging economies.