Munich Personal RePEc Archive

Political Constraints and Sovereign Default Premia

Mitra, Nirvana (2020): Political Constraints and Sovereign Default Premia.

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Abstract

I study the relationship between political constraints and the probability of sovereign default on external debt using a dynamic stochastic model of fiscal policy augmented with legislative bargaining and default. I find that political constraints and default probability are inversely related if the output cost of default is not too high. The model government comprises legislators who bargain over policy instruments, including over a local public good that benefits only the regions they represent. Higher political constraints are equivalent to more legislators with veto power over fiscal policies. This implies that during a default, the released resources need to be distributed among more regions as local public goods, with a smaller benefit accruing to each region, discouraging default. However, if default is too costly, even governments with lower political constraints default less frequently. Empirical evidence from South American countries is consistent with this result. I calibrate the infinite horizon model to Argentina. It confirms the negative relationship. A counterfactual exercise with even higher political constraints shows that the default by Argentina in 2001 could not be avoided.

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