Political Constraints and Sovereign Default

Azzimonti, Marina and Mitra, Nirvana (2022): Political Constraints and Sovereign Default.

Abstract

We study how political constraints, characterized by the degree of flexibility to choose fiscal policy, affect the probability of sovereign default. To that end, we relax the assumption that policymakers always repay their debt in the dynamic model of fiscal policy developed by Battaglini and Coate (2008). In our setup, legislators bargain over taxes, general spending, debt repayment, and a local public good that can be targeted to the region they represent. Under tighter political constraints, more legislators have veto power, implying that local public goods need to be provided to a larger number of regions. The resources that are freed after a default have to be shared with a higher number of individuals, which reduces the benefits from defaulting in per-capita terms. This lowers the incentive to default compared to the case with lax political constraints. The model is calibrated to Argentina and the results conform to robust empirical evidence. An event study for the 2001/2002 sovereign debt crisis shows that political constraints had an important role in the buildup that led to the crisis.

• Item Type: MPRA Paper
• Language: English
• Keywords: Sovereign debt, Default risk, Interest rates, Political economy, Minimum winning coalition, Endogenous borrowing constraints.
• Subjects: D - Microeconomics > D7 - Analysis of Collective Decision-Making > D72 - Political Processes: Rent-Seeking, Lobbying, Elections, Legislatures, and Voting Behavior; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; F - International Economics > F3 - International Finance > F34 - International Lending and Debt Problems; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

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