Persistent Gaps and Default Traps

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Persistent Gaps and Default Traps

Author Info

Luis A. V. Catao
Ana Fostel
Sandeep Kapur (School of Economics, Mathematics & Statistics, Birkbeck)

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Abstract

We show how vicious circles in countries’ credit histories arise in a model where output persistence is coupled with asymmetric information between borrowers and lenders about the nature of output shocks. In such an environment, default creates a pessimistic outlook about the borrower’s output path. This translates into higher debt to- expected-output ratios, pushing up interest rates and hence debt servicing costs. By raising the cost of future repayments, this creates “default traps”. We provide empirical support for the model by building a long and broad cross-country dataset spanning over a century. This data is used to provide evidence on the existence of a history dependent “default premium” and to show that the effect of output persistence on sovereign creditworthiness is significant and consistent with the model’s predictions after controlling for other determinants of sovereign risk.

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Paper provided by Birkbeck, School of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 0803.

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Date of creation: Feb 2008
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Handle: RePEc:bbk:bbkefp:0803

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Find related papers by JEL classification:
F34 - International Economics - - International Finance - - - International Lending and Debt Problems
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management
N20 - Economic History - - Financial Markets and Institutions - - - General, International, or Comparative

This paper has been announced in the following NEP Reports:

NEP-ALL-2008-02-23 (All new papers)
NEP-BAN-2008-02-23 (Banking)
NEP-LAM-2008-02-23 (Central & South America)

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Ana Fostel & Graciela Laura Kaminsky, 2007. "Latin America's Access to International Capital Markets: Good Behavior or Global Liquidity?," NBER Working Papers 13194, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)

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