Default Costs and Self-fulfilling Fiscal Limits in a Small Open Economy

We revisit the link between the risk of sovereign default and default costs. Contrary to prior literature, we show that higher costs of default may result in higher default probabilities, lower bond prices, and fiscal limits that are not pinned down by economic fundamentals. Government debt sustainability depends on private investment behavior, which is affected by expectations about defaults and capital returns. We argue that this feedback loop gives rise to multiple equilibria. In `bad' equilibria, investors expect default and low capital returns; their low capital investment tightens the governments' fiscal constraints and reduces the probability of debt repayment, validating investor pessimism. In `good' equilibria, optimistic investors choose higher capital investment; this results in higher future fiscal surpluses, raises the probability of debt repayment and validates investor optimism.