When a sovereign government decides to default, it recognizes that such an action may have adverse consequences for the domestic economy, specifically for the domestic financial sector. On the other hand, default may improve consumption by reducing repayments to foreign lenders. The optimal decision of the government balances the costs of default against its benefits. This paper focuses on the effect of domestic economic costs of default on optimal government policy. Firstly, the consideration of such costs is important for determining whether or not the government should default, and for deciding the scale of debt repudiation in the event of default. The existence of output costs enables the government to credibly assure foreign lenders that it will repay at least a portion of its debt, and this will enable the government to borrow ex ante. Secondly, the governmentks ex ante debt issuance decision is shaped by its expectations about the costs of default in future periods. If the government can structure its debt issuance policy so as to manipulate the domestic economic costs of default in future periods, it may optimally choose a high level of exposure of the economy to these costs. This enables the government to borrow more ex ante, or to borrow the same amount at lower interest rates.
Evidence from recent default episodes suggests that sovereign default affects the domestic economy. Sturzenegger and Zettelmeyer (2005) report that both domestic and foreign creditors to the government suffer losses on their holdings of government debt in the event of default. De Paoli et al. (2006) record that sovereign default is often associated with substantial output costs for the domestic economy, especially when the default episode is mired in concurrent banking and/or currency crises.
The survey of defaults and debt restructurings in Sturzenegger and Zettelmeyer (2006) is instructive. In the run up to the Russian debt crisis of 1998, domestic banks had increased their exposure to government debt, so that in the first quarter of 1998 income from government securities amounted to 30 percent of total bank income. The default by the government on domestically held public debt was roughly equal to the economyks aggregate banking capital. In the aftermath of the default, there were runs on some banks. Interbank transactions ground to a halt and the payments system became non functional. Real GDP fell by 5.3 percent that year. In the Argentinian debt crisis of 2001 2005, 60 percent of the defaulted debt was held by domestic residents. Forced pesification of dollar denominated assets and liabilities of the financial sector transferred resources from the banks to the government. The banking system became insolvent. Output fell by 3.4 percent in 1999. After the default, it fell by 4.4 percent in 2001 and 10.9 percent in 2002. Clearly, not all the output costs in these default episodes arose from the default decision nin both cases, the default decision was influenced by a prior negative shock to the domestic economy. Nevertheless, the decision by the government to default on its debt contributed to a worsening of the initial crisis, in particular through a disruption to the financial system.
In this paper, the government cannot contractually commit to repaying its debt in future periods. In addition, we depart from much of the existing literature by considering a framework where default does not lead to reduced access to international capital markets. On the contrary, the government is not sanctioned by foreign creditors even in the period of default. However, when the government defaults on its debt it is forced to default on both domestic and foreign holders of government debt. Default on foreign lenders improves the asset position of the country, but default on domestic lenders generates an output cost that increases with the extent of the default. In a model with a benevolent government which borrows from abroad on behalf of all of its citizens, the default decision trades off these benefits and costs. This paper produces two sets of results. Firstly, we explore the effect of domestic output costs on the optimal government default decision. In particular, we show that the contemporaneous output cost of default prevents full default, and therefore supports debt. More generally, the fear of economic crisis is the mechanism that sustains sovereign debt in our model.
The second contribution of the paper is to endogenize the vulnerability of the domestic economy to crisis. Vulnerability of the financial system is a recurring phenomenon in emerging markets (de Bolle et al. [2006]). The above argument suggests that foreign lenders are willing to lend more to the country if they believe that default will have severe effects on the domestic economy. Suppose that the government can manipulate the output cost resulting from default, for example by influencing the exposure of domestic lenders to government$issued defaultable debt. This paper proposes that the government may well choose to increase this exposure in order to raise more debt from abroad, or to raise the same amount of debt at lower cost. Therefore, vulnerability of the economy is an optimal response to the underlying economic problem (and market failure) of the sovereignks lack of commitment. In this case, advice to reduce financial system vulnerability may have the counterintuitive side effect of a reduction in the ability of the government to borrow.
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