Paola Di Casola
and Spyridon Sichlimiris
Paola Di Casola: Monetary Policy Department, Central Bank of Sweden, Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
Spyridon Sichlimiris: Örebro University, Postal: 701 82 Örebro, Sweden
Abstract: Why do countries tend to repay their domestic and external debt, even though the legal enforcement of the sovereign debt contract is limited? Contrary to conventional wisdom, we argue that temporary market exclusion after default is costly. When the domestic financial market is characterized by a scarcity of private saving instruments, a government can partition its debt market into domestic and external segments, by restricting capital flows, to exploit its market power. The government's market power mitigates the problem of limited commitment, by making default a more costly option. Consequently, it extends the government's external debt capacity. We replicate the domestic and external sovereign debt for non-advanced economies, by unveiling their link to financial repression.
51 pages, November 1, 2017
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