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Institutions, Public Debt and Foreign Finance

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Author Info
Nicola Gennaioli ()
Alberto Martin ()
Stefano Rossi

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Abstract

We study the role of domestic financial institutions in sustaining capital flows to the private and public sector of a country whose government can default on its debt. As in recent public debt crises, in our model public defaults weaken banks’ balance sheets, disrupting domestic financial markets. This effect leads to a novel complementarity between private capital inflows and public borrowing, where the former sustain the latter by boosting the government’s cost of default. Our key message is that, by shaping the direction of private capital flows, financial institutions determine whether financial integration improves or reduces government discipline. We explore the implications of this complementarity for financial liberalization and debt-financed bailouts of banks. We present some evidence consistent with complementarity.

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Publisher Info
Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1170.

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Date of creation: Aug 2009
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Handle: RePEc:upf:upfgen:1170

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Related research
Keywords: Sovereign Risk; Capital Flows; Institutions; Financial Liberalization; Sudden Stops;

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Find related papers by JEL classification:
F34 - International Economics - - International Finance - - - International Lending and Debt Problems
F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management

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