Persistent Gaps and Default Traps

We show how vicious circles in countries’ credit histories arise in a model where output persistence is coupled with asymmetric information between borrowers and lenders about the nature of output shocks. In such an environment, default creates a pessimistic outlook about the borrower’s output path. This translates into higher debt to- expected-output ratios, pushing up interest rates and hence debt servicing costs. By raising the cost of future repayments, this creates “default traps”. We provide empirical support for the model by building a long and broad cross-country dataset spanning over a century. This data is used to provide evidence on the existence of a history dependent “default premium” and to show that the effect of output persistence on sovereign creditworthiness is significant and consistent with the model’s predictions after controlling for other determinants of sovereign risk.