Honoring Sovereign Debt or Bailing Out Domestic Residents: A Theory of Internal Costs of Default

Abstract

The internal cost of default, an important driver of sovereign debt repayment, increases with domestic portfolios' home bias. And so, when using capital controls or other instruments to steer these portfolios, a country faces a trade-off between commitment to repay and diversification. But why does a borrowing country not eschew the internal cost of default through domestic sector bailouts? And why does their sovereign not intermediate the diversification through swaps and other hedging devices? Answering these two questions is key to fathom the nature of internal costs of default. This paper investigates sovereign debt sustainability in a model where domestic and foreign investors optimally select their portfolios and the sovereign optimizes over its debt, default and bailout policies. It derives conditions under which internal bailouts do not preclude sovereign borrowing and establishes when, despite their disciplining benefits, capital controls are undesirable.