The Costs of Sovereign Defaults:Theory and Empirical Evidence

A sovereign default is sometimes perceived by economic policy makers as a jump into the unkown. The main piece of information missing is what the costs of a sovereign default are going to be and how they arise. Knowing this is crucial when trying to evaluate how far a country should go to avoid a default. This paper analyzes the theoretical and empirical evidence on the costs of sovereign defaults. It classi…es the costs of defaults in three categories: (1) Costs imposed as penalties by creditors; (2) Costs related to the information content of defaults; (3) Costs related to domestic agents´sovereign bond holdings. A simple model that captures the main intuitions behind each of these costs is presented. The paper also reviews the empirical evidence on the costs of sovereign defaults. Contrary to the conventional wisdom that seems to believe that the main costs of defaults are related to the exclusion of the sovereign from credit markets or higher subsequent borrowing costs for the sovereign, this paper argues that, under the light of the existing evidence, the main costs of defaults are related to their negative effects on credit both foreign and domestic to the domestic private sector and trade. These e¤ects do not seem to be caused by penalties imposed by creditors. They seem to be the result mainly of the effect of defaults on domestic agents´balance sheets and expectations.