Sovereign Default, Domestic Banks and Exclusion from International Capital Markets

Abstract

Abstract Why do governments borrow internationally? Why do they temporarily remain out of international financial markets after default? This paper develops a quantitative model of sovereign default to propose a unified answer to these questions. In the model, the government has an incentive to borrow internationally since the domestic return on capital exceeds the world interest rate, due to a friction in the banking sector. Since banks are exposed to sovereign debt, sovereign default causes a financial crisis. After default, the government chooses to reaccess international capital markets only once banks have recovered and efficiently allocate investment again. Exclusion hence arises endogenously.