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The role of risk aversion in a sovereign default model of polarization and political instability

Author

Listed:
  • Yasin Kursat Onder
  • Enes Sunel

    (Sunel and Sunel)

Abstract

We show that, in models of endogenous sovereign default with symmetric polarization and political turnover, disagreement in the distribution of consumption among distinct political groups or random political turnovers lead to elevated default risk only when preferences feature decreasing concavity in consumption. Consequently, if preferences are in the commonly assumed CRRA form in this class of models, the risk aversion parameter needs to be taken as smaller than one. Our result builds on early insights of the literature, which underscore precautionary insurance and strategic borrowing motives as two competing forces under polarization and political uncertainty. When uninsured income shocks and limited commitment to debt repayment are introduced, high consumption states overlap with increased borrowing. Under declining concavity in preferences, political instability and polarization cause the incumbent sovereign to perceive the consumption of the two constituencies as closer substitutes, which reinforces its borrowing bias and elevates default risk. Our findings fix the calibration of a canonical default model with symmetric polarization and exogenous turnovers by Cuadra and Sapriza (2008) and are robust to alternative numerical approximation methods as well as sovereign debt maturities. (Copyright: Elsevier)

Suggested Citation

  • Yasin Kursat Onder & Enes Sunel, 2020. "The role of risk aversion in a sovereign default model of polarization and political instability," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 35, pages 123-132, January.
  • Handle: RePEc:red:issued:18-455
    DOI: 10.1016/j.red.2019.05.003
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    File URL: http://dx.doi.org/10.1016/j.red.2019.05.005
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    References listed on IDEAS

    as
    1. Cuadra, Gabriel & Sapriza, Horacio, 2008. "Sovereign default, interest rates and political uncertainty in emerging markets," Journal of International Economics, Elsevier, vol. 76(1), pages 78-88, September.
    2. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Political uncertainty; Polarization; Risk aversion; Default risk;

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • P16 - Economic Systems - - Capitalist Systems - - - Political Economy of Capitalism

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