Financial Development and Vulnerability to External Shocks: The Role of Sovereign Debt Composition

Résumé

There has been a growing concern about the vulnerability of emerging countries to fluctuations in international interest rates. Empirical evidence shows that these countries suffer significant output drops when developed countries raise their interest rates. In this paper, I document that an important determinant of the magnitude of this effect is the ability of countries to issue sovereign debt domestically, rather than to external creditors. Moreover, I find that the level of financial development of domestic markets is positively related with the share of total public debt that is domestically held. I build a model that integrates a domestic banking sector into a sovereign default model where governments can issue domestic and external debt and decide whether to default on debt selectively. Due to financial frictions, issuing domestic debt crowds out investment in capital. As financial markets develop, i) crowding-out costs decrease, and ii) banks demand lower interest rates on domestic bonds. Both effects reduce the relative cost to the government of borrowing domestically, leading to a higher share of domestic debt. I calibrate the model and show that the results are consistent with the pattern of discriminatory default in developing countries. Then, I use the model to decompose the effect of external and domestic shocks on output volatility, and find that financial development decreases the susceptibility of emerging economies to external shocks.