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Investment Cycles and Sovereign Debt Overhang

This paper explores the joint dynamics of sovereign debt and foreign direct investment in a small open economy. Our analysis brings to the forefront two important political economy considerations. We follow the seminal work of Thomas and Worrall (1994) in that the government cannot commit, leaving capital and debt exposed to expropriation or repudiation. However, in Thomas and Worrall (and more generally in Ray (2002 )), the government eventually accumulates sufficient assets to overcome its lack of commitment.

To this environment we introduce a second prominent political economy implication. Namely, that the risk of losing office makes the government impatient relative to the market. This simple but empirically relevant change in environment leads to dramatically different longrun properties of the economy.

We show that the combination of the government simpatience and inability to commit generates perpetual cycles in both sovereign debt and foreign direct investment in an environment in which the first best capital stock is a constant. The expected taxon capital endogenously varies with the state of the economy and investment is distorted by more in recessions than in booms, amplifying the effect of shocks.

The predictions of the model are consistent with two important phenomena in less developed markets. One is the well known "debt overhang effect" on investment, where current levels of debt negatively effect future investment. Second is the rise in expropriation risk during crises in emerging markets and the depressed level of investment following these crises. We also use our framework to analyze the effect of budgetary restrictions, recently being considered in countries such as Chile and Brazil, on the volatility of consumption and investment.

Investment Cycles and Sovereign Debt Overhang