Defaulting on Covid debt

Abstract

The COVID-19 pandemic causes sharp reductions in economic output and sharp increases in government expenditures. These increase the riskiness of sovereign debts, especially in emerging economies. This paper proposes a framework to study debt sustainability. The economy is subject to productivity and expenditure shock. The government sets distortionary labour taxes and decides whether to repay its past domestic and foreign obligations. Foreign default is more likely after a negative productivity shock, while domestic default is more likely after a negative expenditure shock. This mechanism finds support in the data. Recent proposals that would ease the burden of foreign debt after COVID-19 would not prevent a wave of domestic defaults.