The politics of sovereign default under financial integration∗

In this paper we study the role of portfolio diversification on optimal default of sovereign debt in a two-country model with large economies that are financially integrated. Financial integration increases the incentives to default not only because part of the defaulted debt is owned by foreigners (the standard redistribution channel), but also because the endogenous macroeconomic cost for the defaulting country is smaller when financial markets are integrated. We show that the sovereign default of one country may be triggered by higher debt (liquidity) issued by other countries. Because the macroeconomic costs of default spill to other countries, creditor countries may find it beneficial ex-post to bail-out debtor countries. Although bailouts create moral hazard problems, they can be welfare improving also ex-ante. ∗We would like to thank seminar and conference participants for helpful comments at the Atlanta Fed, Bank of Canada, Claremont McKenna College, Minnesota Workshop in Macroeconomic Theory, Penn State University, Philadelphia Fed, SED meeting in Toulouse, University of California San Diego, University of Georgia, University of Wisconsin, the Stockman Conference at the University of Rochester.