The Costs of Sovereign Defaults:Theory and Empirical Evidence

Economic policy makers sometimes perceive a sovereign default as a jump into the unkown.The main piece of information missing is what the costs of the default are going to be. Assessing them correctly is crucial to evaluate how far a country should go to avoid a default. This paper analyzes the main potential sources of the costs of defaults discussed in the theoretical literature and evaluates the empirical evidence on the matter. I classify these potential sources in three groups: (1) sanctions imposed as penalties by creditors; (2) costs related to the information content of defaults; (3) costs related to domestic agents sovereign bond holdings, and present a simple model that captures the main intuition behind each of them. A review of the empirical evidence suggests that while costs generated in the aftermath of defaults by traditional mecha-nisms such as trade sanctions or exclusion from credit markets have not been significant in recent decades, the information revelation and the impact on domestic bond holders, particularly the banking system, seem to be the main costs of sovereign defaults.