The costs of sovereign default: theory and empirical evidence

Economic policymakers sometimes perceive a sovereign default as a jump into the unkown. The main piece of information missing is what the costs of the default are going to be. Assessing these costs correctly is crucial for evaluating how far a country should go to avoid a default. This paper analyzes the main sources of the costs of default discussed in the theoretical literature and evaluates the empirical evidence on the matter. I classify these potential sources in three groups: (1) sanctions imposed as penalties by creditors; (2) costs related to the information content of default; and (3) costs related to domestic agents’ sovereign bond holdings. I then present a simple model that captures the main intuition behind each of them. A review of the empirical evidence suggests that while the costs generated in the aftermath of defaults by traditional mechanisms, such as trade sanctions or exclusion from credit markets, have not been significant in recent decades, costs deriving from information revelation and the impact on domestic bondholders, particularly the banking system, have become major consequences of sovereign defaults.