Abstract
Abstract In this paper, the author considers sovereign debt in the form of one-period government bonds with default risk, which can be purchased by and traded among domestic and foreign investors. She shows that the “good equilibrium” is the only stable equilibrium under some quite general assumptions, while the “bad equilibrium” is an unstable one—a possible explanation for why the former is observed in practice. Given the “good equilibrium”, the author further shows that the domestic debt share also determines the default risk: a higher domestic debt share means a lower default risk, ceteris paribus, which leads to a lower risk premium; while a lower domestic debt share means a higher default risk and a higher risk premium. Finally, she discusses some alternative interpretations of the domestic debt share.
Highlights
The term sovereign default has received considerable attention in both the literature and the public discussion
If some shock were to drive the contracted interest rate to a value between G0 and B0, there would be excess demand for government bonds because the expected return is higher than the market return, which would lead to a continually lower zt until it converges to G0.16 if the initial interest cost zt were to lie below G0, there would be no demand because the expected return is below the market return, and zt would continue to rise until it converges to G0
This paper only shows that, first, a higher α value is associated with a lower default risk and lower borrowing cost, second, only the α value at the time of debt repayment matters, and third, the α value corresponds to the weight assigned to lenders by the borrowing government in its objective function
Summary
The term sovereign default has received considerable attention in both the literature and the public discussion. Calvo’s finding regarding default in the form of debt repudiation is in line with my paper, namely that in the "good equilibrium", a lower α means more ex post default risk and at least the same risk premium Because his focus is on domestic debt, he only considers the case in which α is close to 1.3 in his "bad equilibrium", the effects of all variables, including α, on interest costs have the opposite sign as in the "good equilibrium". The remainder of the paper is organized as follows: Section 2 describes the model, proves the positive impact of α on the repayment propensity of the borrowing government for the Calvo-type model and for the Eaton and Gersovitz-type model, and shows that the good equilibrium is the only stable equilibrium and that a higher repayment propensity almost certainly leads to lower default risk and better borrowing conditions for the government.
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