Legal Enforcement, Public Supply of Liquidity and Sovereign Risk

Sovereign debt crises in emerging markets are usually associated with liquidity and banking crises within the economy. This connection is suggested by both anecdotical and empirical evidence. The conventional view is that the domestic financial turmoil is caused by foreign creditors’ retaliation. Yet, there is no clear-cut evidence supporting the existence of “classic” default penalties (e.g., trade sanctions or exclusion from international capital markets). This paper then proposes a novel mechanism linking sovereign defaults with liquidity and banking crises without any intervention of foreign creditors. The model considers a standard unwillingness-to-pay problem assuming that: (i) the enforcement of private contracts is limited and, as a result, public debt represents a source of liquidity; (ii) the government cannot discriminate between domestic and foreign agents. In this setting, the prospect of drying up the private sector’s liquidity restores the ex-post incentive to pay of the government without any need to assume foreign penalties. Nonetheless, liquidity crises might arise when economic conditions deteriorate and the government chooses opportunistically to default in order to avoid the repayment of foreign agents. The interaction between the enforcement friction and sovereign risk is then exploited to study the implications on international capital flows and legal and institutional domestic reforms.