Why do governments pay back their debt?

In public discussion debt is simply debt. But different flavors of debt exist. In fact, debt issued by sovereigns is very different from debt that is issued by private firms (and debt issued by sovereigns in a monetary union is still different, but I will not discuss that here). The reason is that a country’s creditors have very limited means to enforce their claims. Countries can not credibly offer their production assets as collateral for a loan, while the doctrine of sovereign immunity in international law protects sovereign assets even when they are located in foreign jurisdictions (though there are exceptions and immunity can be waived)

This begs the question why sovereigns pay back their debt at all. Rational governments will pay back their debt as long as the benefits of doing so outweigh the costs of defaulting on their debt payments. In practise, countries and their creditors will renegotiate the debt contracts. The costs of default will then determine the outcome of this process. Four types of costs exist. See Panizza, Sturzenegger and Zettelmeyer for an overview.

Exclusion from capital markets

The first potential source of costs arises because sovereigns that do not pay back their debt may be shut out of international money markets. However, for several reasons this cost may not be so high in practice. Logically, default reduces the sovereigns’ debt burden and increases its creditworthiness. Sufficiently reduced debt levels would then make lending profitable again. Consequently, the threat to exclude sovereigns that default on their debt from future lending is not credible. In addition, sovereigns might have recourse to other sources of emergency financing, further undermining the disciplining force of capital market exclusion. This limits the ability of capital markets to discipline governments into paying their debt.

Empirical evidence indeed suggests that renewed access to international capital markets is currently faster than in previous decades. Borensztein and Panizza find that the economic costs of exclusion are short-lived. The spread increases with about 400 basispoints the first year after a default, which reduces to 250 basispoints the second year and becomes small after that.

Direct punishment

A second source of costs may be direct punishments. This means that creditors try to impose sanctions on a country, for example through seizure of tradeable assets or payments that occur outside a country’s borders. This should of course both credible and be legally possible, which restricts the type of sanctions creditors will impose in practise. The threat of imposing sanctions will be credible if the creditor benefits from them. Some recent litigation cases (see e.g. here) may have strengthened the legal possibilities to impose such sanctions.

Empirical evidence suggests that foreign direct investment and trade credit indeed drop after a default. But where some studies find this effect to last for more than a decade, see Rose, others find that the negative effect dissapears after one or two years, see Borensztein and Panizza. In addition, it is unclear that this drop is due to sanctions, see Martinez and Sandleris.

Costs from impaired financial sector

A third potential cost arises from the substantial fraction of sovereign debt is generally held by national banks. Thus, when a country defaults on its debt, banks take a loss. This may induce a credit crunch where banks try to restore their equity levels by reducing credit to the private sector. The economic costs of such a credit crunch are sizeable.

Borensztein and Panizza find that sovereign default does not lead to a credit crunch by impairing the financial sector. For countries in a monetary union, however, this might be different because they lack the ability to recapitalize their banks via their own central bank.

Political costs

Finally, governments may pay back their debt because they face political costs if they fail to do so. Voters may blame ministers and the top executive politicians if a country defaults on its debt and vote them out of office. Voters’ adverse attitude towards default will most likely be stronger if they hold some level of the debt themselves, either directly or through institutionalized savings such as pension schemes.

The political consequences of a debt crisis for incumbent governments and finance ministers seem to be significant. Borensztein and Panizza find that, on average, ruling governments in countries that defaulted observed a 16 percentage point decrease in electoral support, and that in 50 percent of the cases there was a change in the chief of the executive either in the year of the default episode or in the following year.

Why is this important?

All in all, political costs and the consequences of a default for the financial sector in a country may be important elements in providing incentives for sovereigns to pay back their debt. If debt held nationally, either by voters, banks or pension funds, plays a role in strengthening these incentives, then we should realize that increased diversification of the holding of sovereign debt within the eurozone, for example through the introduction of eurobonds, may diminish these incentives.

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