Sovereign default and changing government types

Author: 
Philip Barrett

The SSD Summer Grant helped to support me whilst I was writing the central chapter of my thesis.  My research seeks to uncover governments' motives for default from patterns in the prices that they pay to borrow.  Most current explanations of sovereign default rely on changing government circumstances to explain why defaults happen; the economy deteriorates, tax revenues fall, and the outstanding debt becomes unaffordable. 

I argue that this is not the whole story.  Changing government preferences and priorities are also an important driver of defaults.  The central piece of empirical evidence for this explanation is that governments pay higher interest rates on their debt for a few years once they re-enter international capital markets following a default.  These post-default interest rates cannot be fully accounted for by the changing economic conditions that drive other sovereign default models.  Something else must cause this additional cost.

I argue that this extra rise in interest rates following return from default can be explained by changes to the government's own cost of default.  This can be interpreted as any change which alters the political priorities of the government with respect to default.  For example, it could be due to elections changing the influence of different social groups on the government, or changes in the individuals at the executive level. 

I show that these changes can explain the size and duration of the premium that governments pay on their borrowing.  However, the information available to investors also plays a role.  If the government's type is common knowledge, this pattern is hard to produce.  If the government's type is imperfectly known, then default itself is an informative signal about type, and so investors beliefs about the government type become both worse on average and more precise following a default.  And with worse beliefs about the government type, investors expect more frequent default and so require greater interest rates on their debt, matching the pattern seen in the data.

Philip Barrett is a doctoral candidate in the Department of Economics.