Sovereign Debt and Domestic Economic Fragility

Recent sovereign default episodes have been associated with substantial output costs. In this paper, we construct a parsimonious …nite horizon model which captures two key market imperfections: (i) the government’s inability to commit to repay debt; (ii) liquidity constraints in the domestic …nancial sector. We use the model to answer two sets of questions. First, we characterize the optimal sovereign default decision. The optimal haircut on debt is decreasing in the productivity shock and the exposure of domestic banks to the debt, and increasing in the proportion of the debt held by foreign agents. Second, we characterize the optimal sovereign debt issuance decision. The government can e¤ectively “purchase commitment”by engineering a high exposure of the domestic banking system to defaults, but this has the negative side-e¤ect of limiting international risk diversi…cation bene…ts. If government debt is tradable between domestic and foreign holders, the government may have to constrict domestic activity and push up interest rates in order to ensure that domestic banks are willing to hold su¢ cient quantities of the debt. The methodology used enables tractable analysis by e¤ectively reducing the number of state variables, and it can be easily generalized. Keywords: Sovereign Default, Capital Flows, Emerging Markets, Optimal Government Policy JEL Classi…cations: E61, F34, F36, G15 The views expressed in this paper are those of the author and should not be attributed to the IMF, its Executive Board or its management. This paper has bene…ted from insightful advice from my Ph. D. advisors Olivier Blanchard, Guido Lorenzoni and Iván Werning. For valuable suggestions and comments, I thank Daron Acemoglu, George-Marios Angeletos, Ricardo Caballero, Gita Gopinath, Roberto Rigobon, Ufuk Akcigit, Mauro Alessandro, Filippo Balestrieri, Thomas Oliver, Jose Tessada and seminar participants at MIT, Cornell University, the Bank of England, the Federal Reserve Board of Governors, the Federal Reserve Bank of San Francisco, the International Monetary Fund, the World Bank, the LACEA-LAMES conference 2009 and in advance, the SITE 2010 conference. All remaining errors are my own. E-mail address: [email protected]. Corresponding address: International Monetary Fund, 700 19th Street, NW, Washington, D.C. 20431.