Domestic and External Debt with Strategic Default under Shortage of Assets

Résumé

Why do governments borrow both domestically and abroad? What determines the composition of domestic and external borrowing? How does that composition in turn affect the probability of a sovereign default? We address these and other related questions within an extension of the dynamic general equilibrium model of the kind developed by Arellano (2008). There has been great progress in the understanding of sovereign debt and default in recent years. However, the link between domestic and external debt has remained largely unexplored. We provide a model that links domestic and external government debt and default through the shortage of stores of value in the domestic economy. The government can restrict capital outflows from the private sector and thereby exercise market power in domestic asset markets. Therefore, the possibility of defaulting entails a benefit for insurance purposes and a cost stemming from a loss of market power. The optimal behavior prescribes more domestic borrowing in good times and more external borrowing in bad times. Default is more likely in bad times. Thus, government defaults more often when the ratio of external to domestic debt is higher, absent any predetermined preference for the type of bondholder.Finally, we solve and simulate the model by varying the intensity of the shortage of assets. The average external to domestic debt ratio is high when the friction is severe or negligible and low when it is moderate. Default rates are low when the friction is severe or negligible and high when it is moderate.