Sovereign default and capital controls

This paper explores a role for capital control policies in enhancing a sovereign’s commitment to repay its debts. I study the equilibrium of an economy in which a sovereign must finance some expenditure, is constrained by the savings decisions of domestic households, and cannot discriminate between foreign and domestic lenders. I show that capital controls are crucial for implementing an equilibrium with lending from abroad and that optimal controls exhibit threshold behavior, instituted when domestic disposable income is low. Controls impose a wedge between the bond prices faced by foreign and domestic lenders. By crowding in domestic lending, and increasing the value of repayment, the sovereign can credibly enforce future repayment. The implementation result is robust to the introduction of labor taxes and uncertainty over the cost of default. These results offer a novel rationale for procyclical capital controls, distinct from conventional theories that stipulate controls be employed countercyclically to regulate capital inflows during expansions. The optimal policy is characterized and empirical implications are discussed.