Internal Debt Crises and Sovereign Defaults
In this paper, we use data from developing countries to argue that sovereign defaults are often caused by fiscal pressures generated by large-scale domestic defaults. We argue that these systemic domestic defaults are caused by shocks best interpreted as being non-fundamental. We construct a model that is consistent with these observations. The key ingredient of the model is that it is impossible to liquidate large amounts of entrepreneurial assets. This restriction generates the possibility of a domestic coordinated default crisis, in which domestic borrowers find it optimal to default because all other borrowers are also defaulting. We conclude that avoiding sovereign defaults requires better internal institutions, not better external ones.
We thank Katya Kartashova and Jacek Rothert for research assistance, and participants at seminars at the Federal Reserve Banks of New York City and Philadelphia for their comments. The opinions expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis, the Federal Reserve System, or the National Bureau of Economic Research.
Arellano, Cristina & Kocherlakota, Narayana, 2014. "Internal debt crises and sovereign defaults," Journal of Monetary Economics, Elsevier, vol. 68(S), pages S68-S80. citation courtesy of