A central issue in limited contract enforceability is that if the identity of a defaulting party is forgotten, then it can reenter the market with a fresh start. The acts of countries and major banks, however, are remembered, thus they cannot simply walk away after breaking their commitments. This implies that one can view sovereign bank lending as a long-term relationship (to use the terminology of Baker, Gibbons and Murphy, 2002, a relational contract) between borrowers and lenders. In such contracts, parties honor their obligations in order to influence the terms of future interactions.
This can mean that a default or any other form of misbehavior leads to an increase in borrowing costs or, as an extreme form, a capital market exclusion. As shown by Kletzer and Wright (2000), Wright (2002), and Kovrijnyikh and Szentes (2007), such punishments are fully compatible with competitive markets, due to the repeated lender interactions that characterize relational contracts.
There is indeed evidence that a default leads to an increase in spreads (Ozler, 1993, Eichengreen and Mody, 1999, Reinhart et al, 2003). This literature, however, has been unable to identify the precise mechanism of this effect. In particular, it cannot tell apart a relational contract argument from a signaling alternative: a default reveals some adverse information about the expectation of the debtor’s future output (for example, the type of the debtor), which hurts its future outcomes (Eaton, 1996, Sandleris, 2008). This mechanism can be labeled as “domestic costs”, or “reputational spillovers” in the classification of Panizza et al (2009).
Can we separate the two mechanisms? Our identification strategy is based on the following observation. In the signaling case, reputational spillovers indirectly contribute to a higher spread by increasing the probability of a future default, but lenders still earn zero expected profits. In contrast, in relational contracts punishments are incorporated directly into future prices, giving positive surpluses to lenders.
The existing empirical literature cannot determine whether a default is followed by an increase in sovereign bank spreads in excess of the increase of future nonrepayment risk. We present empirical evidence that a sovereign default is followed by positive lender surpluses, which is consistent with the relational contract mechanism.
Such evidence has immediate consequences for understanding sovereign risk, as it points to the presence of dynamic incentives as a repayment mechanism. It is also relevant for the broad context of repeated games and reputations: besides prices and markets, “relationships provide an alternative mechanism that also plays an important role in allocating resources ”(Samuelson, 2006, Section 1.3).
In both cases, there is very little direct evidence on dynamic incentives themselves the sovereign risk literature, for example, usually calibrates its models to match various aggregate outcomes, like the cyclicality of sovereign debt flows and interest rate spreads, or the timing and frequency of default.
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