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A striking feature of sovereign lending is that many countries with moderate debt-to-income ratios systematically face higher spreads and more stringent borrowing constraints than others with far higher debt ratios. Earlier research has rationalized the phenomenon in terms of sovereign reputation and countries' distinct credit histories. This paper provides theoretical and empirical evidence to show that differences in underlying macroeconomic volatility are key. While volatility increases the need for international borrowing to help smooth domestic consumption, the ability to borrow is constrained by the higher default risk that volatility engenders.
Debts, External --- Business cycles --- Economic cycles --- Economic fluctuations --- Cycles --- Developing countries --- Economic conditions. --- Exports and Imports --- Macroeconomics --- Public Finance --- International Lending and Debt Problems --- Macroeconomics: Consumption --- Saving --- Wealth --- Debt --- Debt Management --- Sovereign Debt --- Aggregate Factor Income Distribution --- International economics --- Public finance & taxation --- Debt default --- Consumption --- Public debt --- Income --- Debt burden --- Economics --- Debts, Public --- United States
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We show that cross-country differences in the underlying volatility and persistence of macroeconomic shocks help explain two historical regularities in sovereign borrowing: the existence of "vicious" circles of borrowing-and-default ("default traps"), as well as the fact that recalcitrant sovereigns typically face higher interest spreads on future loans rather than outright market exclusion. We do so in a simple model where output persistence is coupled with asymmetric information between borrowers and lenders about the borrower's output process, implying that a decision to default reveals valuable information to lenders about the borrower's future output path. Using a broad cross-country database spanning over a century, we provide econometric evidence corroborating the model's main predictions-namely, that countries with higher output persistence and conditional volatility of transient shocks face higher spreads and thus fall into default traps more easily, whereas higher volatility of permanent output tends to dampen these effects.
Exports and Imports --- Investments: Bonds --- Macroeconomics --- Production and Operations Management --- General Financial Markets: General (includes Measurement and Data) --- Price Level --- Inflation --- Deflation --- International Lending and Debt Problems --- Macroeconomics: Production --- Investment & securities --- International economics --- Asset prices --- Debt default --- Bonds --- Output gap --- Sovereign bonds --- Prices --- Debts, External --- Production --- Economic theory --- United States --- Fiscal policy --- Budget deficits --- Finance, Public --- Econometric models.
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