Emerging markets borrow substantial amounts of foreign debt. Most of what they borrow, they eventually repay even though there are no clear punishments available to creditors. This paper provides an answer to why these countries repay their debts.
A simple dynamic tragedy of the commons model is analyzed: a country is composed of different groups with common access to a savings technology. Dynamic common-pool models of this type have been used in the public debt literature to explain why countries over-spend and under-save. The economic logic behind is as follows: different groups inside a country tend to demand too much spending from the government because each of them enjoys the benefits privately but they all share the costs. A free-rider problem ensues and as a result, countries will tend to spend too much and save too little.
The main contribution of this paper is to show that the same economic forces that generate overspending in a tragedy of the commons model can guarantee that a small open economy repays its sovereign obligations. It is also shown that the reason why it repays is because the country would like to borrow again. Hence, a tragedy of the commons model can explain why emerging markets do not save and why they repay their debts.
This reputational argument for debt repayment was first formalized by Eaton and Gertsovitz (1981) in the context of a small country subject to income shocks: a defaulting country loses access to international credit markets and wont be able to smooth its consumption profile after default. This threat of financial exclusion might be strong enough to enforce repayment. However, Bulow and Rogoff (1989) demonstrated that this argument for repayment breaks down if countries could save. In particular, by defaulting and using the asset markets to self-insure, a country achieves a higher consumption at any point after default. Hence default is an arbitrage.
