Crises and Consequences: The Role of US Support in International Bond Markets

• In Event: Politics of Sovereign Debt and International Finance

Abstract

According to economic theory, creditors should punish defaulters with higher borrowing costs or, at the extreme, capital market exclusion. Empirically, the results are mixed. Punishment isn’t uniform. To explain this disconnect, we argue that sovereign credit outcomes are more than a function of state-level characteristics. Borrowing states’ political relationships with major powers, like the United States, affect both their preferences for repayment and the markets’ propensity for punishment. US support conditions the expectations of both borrowers and lenders by providing a fiscal cushion and subsidized insurance. These expectations incentivize borrowing states to engage in riskier financial behavior, increasing their likelihood of default. Post default, US support continues to signal a greater ability to pay compared to non-supported states, decreasing creditor incentives to sanction. This reinforces supported states’ incentives to pursue risky behavior in the first place. Using data on commercial defaults from 1975-2012 alongside a new latent Bayesian measure of American support, we find that states with higher levels of US support restructure their debts at higher rates. After restructuring, they face lower borrowing costs and wait shorter periods of time to re-enter the bond market.

Authors

• Lauren Elizabeth Ferry, University of Mississippi

• Patrick E. Shea, University of Glasgow