Sovereign Defaults, Domestic Credit Market Institutions and Credit to the Private Sector

During sovereign debt crises, even after controlling for the decline in relevant macroeconomic variables, both foreign and domestic credit to the private sector decline. This paper presents a mechanism through which sovereign defaults can lead to this decline, even if domestic agents do not hold government debt. The mechanism highlights the interaction between sovereign defaults, domestic credit market institutions and firms’ collateral constraints. In developing countries firms are usually collateral constrained. In a model with endogenous sovereign debt, a sovereign default, through its effect on expectations about fundamentals, affects the value of the firms’ international and domestic collateral, which limits the availability of foreign and domestic credit. The model also shows that, by attracting private capital flows to the private sector, stronger domestic financial institutions reduce governments’ incentives to default, which, in turn, facilitate public borrowing.