Working Paper: CEPR ID: DP6055
Authors: Fernando A. Broner; Alberto Martin; Jaume Ventura
Abstract: Conventional wisdom says that, in the absence of sufficient default penalties, sovereign risk constraints credit and lowers welfare. We show that this conventional wisdom rests on one implicit assumption: that assets cannot be retraded in secondary markets. Once this assumption is relaxed, there is always an equilibrium in which sovereign risk is stripped of its conventional effects. In such an equilibrium, foreigners hold domestic debts and resell them to domestic residents before enforcement. In the presence of (even arbitrarily small) default penalties, this equilibrium is shown to be unique. As a result, sovereign risk neither constrains welfare nor lowers credit. At most, it creates some additional trade in secondary markets. The results presented here suggest a change in perspective regarding the origins of sovereign risk and its remedies. To argue that sovereign risk constrains credit, one must show both the insufficiency of default penalties and the imperfect workings of secondary markets. To relax credit constraints created by sovereign risk, one can either increase default penalties or improve the workings of secondary markets.
Keywords: commitment; default penalties; international borrowing; international risk sharing; secondary markets; sovereign risk
JEL Codes: F34; F36; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Sovereign risk (F34) | Credit constraints (E51) |
| Sovereign risk (F34) | Welfare (I38) |
| Secondary markets (G10) | Sovereign risk (F34) |
| Foreigners holding domestic debts (F34) | Welfare (I38) |
| Sovereign risk (F34) | Secondary markets (G10) |
| Absence of default penalties (G33) | Sovereign risk impact on welfare (D69) |
| Secondary markets facilitate debt transfer (G19) | Asset value maximization (L21) |