Sovereign Risk and Strategic Debt

Abstract

The world economy is engulfed in an economic crisis. In an attempt to avert a repetition of the Great Depression, governments across the globe have borrowed heavily to finance fiscal stimulus packages. Rising debt levels have put the credit ratings of many countries, including those in the developed world, at risk. A lower credit rating increases the cost of borrowing. Whilst it thus decreases leverage in fiscal policy, it also has, as this article will show, a positive side effect: since borrowing is costly, a lower credit rating decreases a government's incentives to increase the deficit shortly before elections to enhance its electoral stakes (resulting in a so-called political budget cycle). This proposition derives empirical support from 25 countries between the years 1980 and 2008.