Irreversibility, Lumpy Investment, and the Dynamics of Public Capital and Sovereign Debt

We build a sovereign default model of a small open economy where the government’s public capital accumulation faces two investment frictions: capital irreversibility and lumpy investment induced by fixed costs. We show that irreversible public capital and lumpiness both individually and together, lower default risk. A model with convex adjustment costs and neither investment friction requires 13% higher default costs at mean productivity in order to match the data relative to our Benchmark. Borrowing costs are lower when the government invests to grow the public capital stock relative to when it does not, ceteris paribus. When the public capital stock is low, the government issues debt primarily to invest, whereas at higher public capital levels, it borrows mainly for consumption smoothing. We provide evidence from emerging economy data for these results.