Reputational Effects in Sovereign Default

We present a tractable, quantitative model of sovereign borrowing that delivers empirically relevant regularities, such as graduation from default, sovereign debt spreads that may be high for an extended period of time, high debt-to-GDP ratios, and high rates. The model is an asymmetric-information extension of otherwise standard models of endogenous on sovereign debt, with borrowing levels determined in equilibrium. Governments could be of different types based on their level of responsibility (cost of as perceived by the politicians). Only the governments observe their level of responsibility. International investors try to infer the unobserved types based on the history of all observable actions, which gives irresponsible politicians an incentive to choose the same actions as responsible ones would. Governments could tolerate periods of high interest rates without defaulting to signal that they are of better type and to gain good reputation. This leads to lower interest rates during future recessions. For the same reason, even responsible governments should pay at first high interest rates in order to signal their type and thus graduate from default afterwards. A calibrated version of the model features these regularities, matches standard business cycle moments, and leads to a more realistic rate in equilibrium, with parameter values same as in the existing literature.