Sovereign Default, Domestic Banks and Exclusion from International Capital Markets

Abstract

Why do governments borrow internationally, so much as to risk default? Why do they remain out of financial markets for a while after default? This paper develops a quantitative model of sovereign default with endogenous default costs to propose a novel and unified answer to these questions. In the model, the government has an incentive to borrow internationally due to a difference between the world interest rate and the domestic return on capital, which arises from a friction in the domestic banking sector. Since banks are exposed to sovereign debt, sovereign default causes losses for them, which translate into a financial crisis. When deciding upon repayment, the government trades off these costs against the advantage of not repaying international investors. After default, it only reaccesses international capital markets once banks have recovered, because only then are they able to efficiently allocate the marginal unit of investment again. Exclusion hence arises endogenously. The model is able to generate significant levels of domestic and foreign debt, realistic spreads, quantitatively plausible drops of lending and output in default episodes, and periods of postdefault international financial market exclusion of a realistic duration.