Reputations and Sovereign Debt

Why do countries repay their debts? If countries in default have sufficient opportunities to save, Bulow and Rogoff [6] have shown that the answer cannot stem from a country’s desire to preserve a reputation for repayment. As a result, researchers have explained the existence of sovereign debt by either placing restrictions on the deposit contracts banks can offer, or by looking outside the credit market for alternative means of enforcement, including the imposition of trade embargoes, or spillovers to other reputational relationships of the country. In contrast, in this paper we demonstrate that a country’s concern for it’s reputation can work to enforce repayment without placing any technological restrictions on the ability of banks to offer contracts, and without appealing to any mechanisms outside of the credit market itself, as long as there are incentives for banks to tacitly collude in punishing a country in default. Such incentives exist as long as the number of banks is not too large, even if banks make zero profits. ∗I thank, without implicating, Daron Acemoglu, George-Marios Angeletos, Jeffrey Campbell, Christian Hellwig, Chad Hogan, Ken Kletzer, Ricky Lam, Jaume Ventura, and numerous seminar participants, for helpful comments and discussions. Further comments welcome. Email: [email protected].