Centre de Referència en Economia Analítica

Conventional wisdom says that, in the absence of su¢ cient default penalties, sovereign risk constraints credit and lowers welfare. We show that this conventional wisdom rests on one implicit assumption: that assets cannot be retraded in secondary markets. Once this assumption is relaxed, there is always an equilibrium in which sovereign risk is stripped of its conventional e¤ects. In such an equilibrium, foreigners hold domestic debts and resell them to domestic residents before enforcement. In the presence of (even arbitrarily small) default penalties, this equilibrium is shown to be unique. As a result, sovereign risk neither constrains welfare nor lowers credit. At most, it creates some additional trade in secondary markets. The results presented here suggest a change in perspective regarding the origins of sovereign risk and its remedies. To argue that sovereign risk constrains credit, one must show both the insu¢ ciency of default penalties and the imperfect workings of secondary markets. To relax credit constraints created by sovereign risk, one can either increase default penalties or improve the workings of secondary markets. Keywords: sovereign risk, secondary markets, default penalties, commitment, international risk sharing, international borrowing. JEL Classi cation: F34, F36, G15. We are grateful to Rui Albuquerque, Galina Hale, Jing Zhang, and seminar participants at the NBER Summer Institute, SED Meetings in Vancouver, Toulouse, IMF, SAIS, Princeton, Harvard, MIT, Chicago Fed, CREI and Univesitat Pompeu Fabra for their comments. We acknowledge nancial support from the Spanish Ministry of Education and Sciences (grant SEJ2005-01126), the Generalitat de Catalunya (DURSI, SGR2005 0049), and from CREA-Barcelona Economics. yCREI and Universitat Pompeu Fabra (www.crei.cat). Consider the hypothetical situation of a country that has borrowed in the past and must now pay back to its foreign creditors. It does not matter whether it was the private sector or the government who borrowed in the rst place. After all, even government debts must ultimately be paid by taxing the private sector. The last word on whether the country pays its foreign debt must come from the countrys government however, since nobody else holds enough power to force the private sector to pay. The problem, of course, is that the government cares more about the private sector than foreign creditors, and nds it tempting not to enforce payments to foreigners. What prevents this? Only the expectation of costly default penalties, such as the loss of collateral and reputation, trade embargoes or even military interventions. These penalties eliminate sovereign risk, namely, the risk that the country willingly defaults on its foreign debt. What would happen if these penalties are absent and the government decides not to enforce payments to foreigners? The standard answer is that foreign creditors will nd at the time of enforcement that the country defaults on its debt. Once this answer is accepted, one immediately realizes that the situation being considered is hypothetical and not real. Anticipating default, foreign creditors could not have lent to the country in the rst place. This inability to borrow prevents the country from taking advantage of good investment opportunities and from sustaining its consumption during bad times. Sovereign risk therefore constrains credit and lowers welfare. To relax this constraint, the country must make itself more vulnerable to default penalties. Only then foreigners will feel safe enough to lend to the country. This is, we think, a fair description of conventional wisdom. This paper reviews the situation above and questions this conventional wisdom. Foreign creditors will not passively hold their debts until the time of enforcement arrives and default takes place. Instead, they will try to sell them in the secondary market and recover any value they can. Who will buy these debts? Certainly not other foreign creditors since the government will not enforce payments to foreigners. But the private sector will be willing to buy these debts if the government enforces payments to domestics. Moreover, it must be the case that the private sector always has enough funds to purchase them since otherwise foreign creditors would not have lent in the rst place. In fact, the main result of this paper is that there is always an equilibrium in which the private sector buys back the debts at face value and the government chooses to enforce payments to domestics.1 Moreover, in the presence of (even arbitrarily small) default penalties this equilibrium is unique. Hence, secondary markets transfer debts to those that value them most, leading The proof of this result is based on two observations. The rst one is that, once the private sector has bought back the debt, not enforcing domestic payments can at most redistribute wealth within the private sector but cannot increase its level of wealth. The second observation is that trading in the secondary market always ensures that the redistribution that would result from not enforcing domestic payments is undesirable for the government.