Reputation, Risk and Moral Hazard in Sovereign Debt Markets (PI Catherine Schenk)

One of the precepts of lending to governments is that they have little collateral security to offer up front and few assets to seize in the case of a default.  Moreover, defaults can be triggered by complex political factors rather than underlying credit-worthiness or ability to repay. The market for sovereign debt is thus different from other financial markets in terms of its uncertainty but the ability to access international capital markets is a crucial element in the fiscal and economic growth strategies of both developing and developed economies.  In most economic theories of sovereign debt, it is argued that the main constraint that keeps governments from defaulting is the likelihood that this will prevent them from borrowing in the future.  But this assumption has repeatedly proved to be false as serial defaulters such as Argentina (which defaulted repeatedly from the 1890s to 2001) continue to be able to access the market (for a review of the economics of sovereign debt see, Acharya and Rajan, 2013). So, how and when is the past used in the assessment of credit risk in sovereign debt markets and how has this changed over time and across institutional structures? This work stream will focus on the long record of sovereign debt crises from the 1890s to the 1990s to examine how financial markets use the past in their assessment of risk.  Understanding this phenomenon will help to explain the process of sovereign lending as well as how the past is ‘used’ by bankers and financial markets, including in the construction of moral hazard from debt resolution.