Sovereign Debt, Government Myopia, and the Financial Sector

Why do governments repay external sovereign borrowing? This is a question that has been central to discussions of sovereign debt capacity, yet the answer is still being debated. Models where countries service their external debt for fear of being excluded from capital markets for a sustained period (or some other form of harsh punishment such as trade sanctions or invasion) seem very persuasive, yet are at odds with the fact that defaulters seem to be able to return to borrowing in international capital markets after a short while. With sovereign debt around the world at extremely high levels, understanding why sovereigns repay foreign creditors, and what their debt capacity might be, is an important concern for policy makers and investors. In our paper, Sovereign Debt, Government Myopia, and the Financial Sector, forthcoming in the Review of Financial Studies, we attempt to address these issues.

A number of recent papers offer a persuasive explanation of why some countries service their debt even if they are not likely to experience coordinated punishment by lenders. As more and more of a country’s debt is held by domestic financial institutions, or is critical to facilitating domestic financial transactions because it is perceived as low-risk interest-bearing collateral, default on sovereign bonds becomes costly; default automatically hurts domestic activity by rendering domestic banks insolvent, or reducing activity in financial markets. If the government cannot default selectively on foreign holders of its debt, either because it does not know who owns what, or it cannot track sales by foreigners to domestics, then it has a strong incentive to avoid default and make net debt repayments to all, including foreign holders of its debt.

What is less clear is why a country with a relatively underdeveloped financial sector or with its sovereign debt largely financed by external lenders, and hence little direct cost of default, would be willing to service its debt. Of course, one could appeal to reputation models where governments strive to maintain the long-term reputation of their country even though default is tempting. However, we are more realistic (or perhaps cynical). Most governments care only about the short run, with horizons limited by elections or other forms of political mortality. Short-horizon governments are unlikely to see any merit in holding off default solely because their future reputation will be higher – after all, the benefits of that reputation will be reaped only by future governments.

Short-termism may, however, help in another way that explains why countries with little current cost of defaulting still continue to service their debt. Short-horizon governments do not care about a growing accumulation of debt that has to be serviced – they can pass it on to the successor government – but they do care about current cash flows. So long as cash inflows from new borrowing exceed old debt service, they are willing to continue servicing the debt because it provides net new resources. Default would only shut off the money spigot, as renegotiations drag on, for much of the duration of their remaining expected time in government. This may explain why some governments continue servicing debt even though a debt restructuring, and a write-off of the debt stock, may be so much more beneficial for the long-term growth of the country.

At the same time, short-horizon governments also have the incentive to set up entanglements between sovereign debt and the domestic financial sector that increase their current capacity to borrow, even while ensuring that future governments make net repayments and incur any costs of distress. Thus we have a simple rationale for why countries may be able to borrow despite the absence of any visible mode of current punishment other than a temporary suspension of lending; foreign lenders anticipate the country will eventually be subject to higher domestic costs of defaulting, and will then service its accumulated debt. In the meantime, the country’s short-horizon government is unlikely to be worried about debt accumulation, so long as lenders are willing to lend it enough to roll over its old debts plus a little more. Knowing this, creditors are willing to lend to it today.

Key in this narrative, and a central focus of our analysis, are the policies that a government has to follow to convince creditors that it, and future governments, will not default. To ensure that the country’s debt capacity grows, it has to raise the future government’s ability to pay (that is, ensure the future government has enough revenues) as well as raise its willingness to pay (that is, ensure the future penalties for default outweigh the benefits of not paying). The need to tap debt markets for current spending thus gives even the myopic government a stake in the future. When the binding constraint is the ability to pay, this stake in the future leads to more growth-friendly policies from myopic governments compared with the case when they have no access to debt market: even myopic governments lower tax rates in order to boost long-term (production and) revenues, so as to borrow and spend more today.

However, the policies that myopic government follows when the binding constraint is the willingness to pay potentially reduce the country’s growth as well as increase its exposure to risk. For instance, myopic governments choose a higher tax rate (or equivalently, a higher degree of financial repression), which will lead to lower real investment by the corporate sector, and therefore lower resources for a future government to tax, and a lower ability to pay. But it will also lead to more financial savings (because these typically escape the heavy taxes production is subject to), a larger holding of government bonds by domestic entities, and thus a greater willingness of the future government to service its debt for fear of doing widespread damage to the economy through default.

In deciding whether to service its legacy sovereign external debt or not, a myopic government has to trade off the benefits from added resources – if it decides to service the debt and can raise new debt – against the distortions from taxing the economy so as to preserve access to debt markets. We trace out the maximum debt that countries will be able to service.

Interestingly, as a government becomes less myopic and discounts the future less, its willingness to default on legacy debt increases. Default costs go up over time as a country’s financial markets depend more on government debt. Therefore, the long-horizon government not only anticipates rising default costs, it also internalizes the future cost of paying back borrowing, as well as the distortions that stem from tax policies required to expand debt capacity. This makes borrowing less attractive, and since the ability to borrow more is the only reason for a government to service legacy foreigner-held debt, the long-horizon developing country government has more incentive to default (or less capacity to borrow in the first place). Similarly, countries with a more productive technology may also have lower debt capacity because the distortionary taxation needed to sustain access to debt markets will be more costly for such countries.

Finally, we also allow the government to determine the vulnerability of the financial sector to government default. We show that shorter-horizon governments have a greater incentive to create more vulnerability, in part because the future costs of default will not be borne by them, while the benefit of greater debt capacity will. Thus, myopia is again important in creating debt capacity.

The full paper is available for download here.