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Persistent Gaps and Default Traps

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Author Info
Luis A. V. Catao
Ana Fostel
Sandeep Kapur (Department 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, Department 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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Related research
Keywords: Sovereign default; spreads; persistence;

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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

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Ana Fostel & Graciela Kaminsk, 2007. "Latin America's Access to International Capital Markets: Good Behavior or Global Liquidity?," Working Papers Central Bank of Chile 442, Central Bank of Chile. [Downloadable!]
  2. 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)
  3. Christoph Trebesch, 2009. "The Cost of Aggressive Sovereign Debt Policies: How Much is thePrivate Sector Affected?," IMF Working Papers 09/29, International Monetary Fund. [Downloadable!]
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