Domestic Debt and Sovereign Defaults

• Published date: 01 September 2022
• Author: ENRICO MALLUCCI
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/jmcb.12864

DOI: 10.1111/jmcb.12864

ENRICO MALLUCCI

Domestic Debt and Sovereign Defaults

This paper examines how the internal–external composition of government

debt affects the government’sborrowing policy, sovereign risk, and welfare

in a small open economy.To this end, I develop a dynamic stochastic general

equilibrium model with endogenous default risk that includes both external

and domestic debt. I calibrate the model to Argentina, and I show that the

model closely reproduces key empirical moments. Moreover,I highlight the

existence of an externality that distorts debt composition: Domestic debt

levels are inefciently lowand default risk is inefciently high. The welfare

loss associated with the externality is roughly 0.7% when it is measured

in permanent units of consumption. A Pigouvian subsidy that incentivizes

domestic purchases of government bonds restores efciency.

F34, F41, H63

Keywords: sovereign defaults, domestic debt, debt composition, debt

crises, credit market

T     focused on two

factors to explain sovereign risk: the size of external debt and the business cycle.

Equally important, however, is the internal–external composition of debt.1In a sem-

inal paper, Reinhart and Rogoff (2008) highlight the importance of domestic debt

and they note the “forgotten history of domestic debt”: Domestic debt is crucial to

understanding sovereign default episodes, but little research has been devoted to it.

Since then, a growing literature has ourished studying the effect of domestic govern-

ment debt on default risk. My paper contributes to this literature studying the optimal

government borrowing and default policies when both domestic and foreign creditors

The viewsin this paper are solely the responsibility of the author and should not be interpreted as reect-

ing the views of the Board of Governors of the Federal Reserve System or of any other person associated

with the Federal Reserve System. I would like to thank Gianluca Benigno and Keyu Jin for their support

and advice, and the editor, the anonymousreferees, Cristina Arellano, Fernando Broner, Nicola Gennaioli,

Vincenzo Quadrini, and participants at the LSE brown bag seminar, 7th FIW Research Conference, and

XVIII Workshop in International Economics and Finance for helpful comments and suggestions.

E M is a Senior Economist at the Federal Reserve Board (E-mail:en-

rico.mallucci@frb.gov).

Received January 2, 2020; and accepted in revised form August 23, 2021.

1. Throughout the paper, I use the terms “domestic debt” and “internal debt” interchangeably to refer

to domestic holdings of government debt.

Journal of Money, Credit and Banking, Vol. 54, No. 6 (September 2022)

© 2021 The Ohio State University.

1742 :MONEY,CREDIT AND BANKING

hold government debt. I show that debt composition matters to determine government

incentives to default. Additionally,I highlight the existence of an externality that dis-

torts government debt composition when domestic investors are price takers and the

domestic and external markets for government bonds are not segmented. When the

model is calibrated to Argentina, this externality leads to a welfare loss of 0.71%

when measured in permanent units of consumption. Efciency can be restored with

a Pigouvian subsidy that incentivizes domestic purchases of government debt.

Five empirical regularities highlight the importance of domestic debt. (i) Domestic

debt is the largest fraction of government debt. (ii) Outright defaults on domestic debt

happen frequently. (iii) Debt composition matters to determine defaultrisk. When the

domestic share is large, sovereign yields are low. (iv) Output contracts sharply around

defaults that affect domestic investors, (v) as does credit. Based on these regularities,

I construct a dynamic stochastic general equilibrium model with endogenous default

risk á la Eaton and Gersovitz (1981) that incorporates both domestic and external

debt and I quantitatively study the normative implications of such extension.

The theoretical model builds on Sosa-Padilla (2018) and is composed of four sec-

tors: a benevolent government, households, rms, and international investors. Gov-

ernment issues long-term bonds that are purchased by households and foreign in-

vestors. Households supply credit to rms that are subject to a working capital con-

straint. The price of government debt is determined by arbitrage by international in-

vestors that have access to government bonds and to a risk-free asset. Finally, the

government takes the borrowing and default decisions maximizing the welfare of the

domestic economy.2

This paper makes two contributions to the literature. The rst contribution is posi-

tive. I developa theoretical model with both domestic and external debt that highlights

the disciplinary role of domestic debt and replicates the negative correlation between

the relative size of domestic debt and sovereign spreads. In this framework,the output

cost of defaults becomes endogenous. Sovereign defaults weaken domestic investors’

balance sheets causing a contraction of credit and a decline of output.3Although this

mechanism is not new to the literature, this paper studies this mechanism in an open

economy characterized by the simultaneous presence of domestic and external debt.

The second contribution is normative. I show that, whenever domestic investors

are price takers and the domestic and external markets for government bonds

are not segmented, the simultaneous presence of domestic and foreign investors

2. The recent paper by Du and Schreger (2016) stresses the importance of monetary policy credibility

to explain the currency composition of government debt and default patterns. This paper abstracts from

the currency composition of government debt. The external–internal composition of government debt is

determined by domestic investors’ need to purchase assets to transfer liquidity across time.

3. Theoretical sovereign default models havetypically associated output losses with exogenousexter-

nal forces (i.e., Arellano 2008; Mendoza and Yue 2012). In retaliation against defaults, lenders exclude

countries from international nancial markets and international trade causing output contraction. How-

ever, severalempirical works (i.e., Borensztein and Panizza 2009; DePaoli, Hoggarth, and Saporta 2009;

Sandleris 2012) have challenged this view, showing that output contraction around defaults is actually

explained by the contraction of domestic credit.

ENRICO MALLUCCI :1743

introduces an externality in the economy.Domestic agents fail to internalize that their

investment choices affect the government’s borrowing terms, and as a result, domes-

tic purchases of government bonds are inefciently low. This distortion reduces the

welfare of the economy along two channels. First, suboptimally high yields reduce

the government’s ability to borrow from abroad hampering consumption smoothing.

Second, as domestic investors’ purchase inefciently low quantities of government

bonds, their balance sheet is suboptimally small and nancial conditions are tight.

When I calibrate the model to Argentina, I nd that the average welfare loss is about

0.71% when measured in permanent units of consumption. About half of the wel-

fare loss is due to tighter nancial conditions, while the remaining half is due to the

government’s reduced ability to borrow from abroad. Efciency can be restored by

introducing a Pigouvian subsidy that corrects domestic investment. A simple subsidy

scheme that subsidizes domestic purchases of government bonds and taxes domes-

tic savings in the form of a risk-free storage technology can already reduce welfare

losses to 0.58%.

My paper relates to the literature of quantitative sovereign default models as it

proposes a model with endogenous default risk á la Eaton and Gersovitz (1981) that

is calibrated to the Argentinean economy as in Arellano (2008). Within this litera-

ture, my paper is especially close to the recent work of Sosa-Padilla (2018). In this

paper, the author develops a quantitative sovereign-default model with domestic in-

vestors that replicates the evolution of the Argentinean economy. My paper extends

this model to an open economy setup introducing external investors. This extension

has non-trivial normative implications. The simultaneous presence of domestic and

external investors generates an externality that distorts the composition of govern-

ment debt and reduces the government’s borrowing ability. As I show in the paper,

correcting the externality increases the welfare of the economy.

My work is also related to studies investigating the role of domestic debt and the

interplay among sovereign defaults, nancial intermediaries, and credit markets. Bo-

cola (2016), Gennaioli, Martin, and Rossi (2014), Bolton and Jeanne (2011), and

Brutti (2011) develop quantitative models of sovereign default to study the relation

between sovereign defaults and the banking sector.4My paper builds on these stud-

ies in that it also assigns a crucial role to the interaction between the sovereign debt

market and the credit market. Specically, in my model, sovereign defaults generate

a contraction of credit supply and ultimately a contraction of output. My paper, how-

ever, departs from this literature as it studies the relation between sovereign defaults

4. Gennaioli, Martin, and Rossi (2014) propose a model relating the size of output contraction to the

development of the domestic nancial sector. More developed nancial sectors sustain higher quantities

of government debt. As sovereign defaults weaken the balance sheet of banks, greater exposure reduces

the incentives to default. Similarly, Brutti (2011) proposes a stylized model in which governmentdebt is

used to store liquidity and sovereign default causes a liquidity shortage. Finally,Bolton and Jeanne (2011)

also develops models that link default costs to bank holdings of government debt.