Institutions, Public Debt and Foreign Finance
Bocconi University - Department of Finance; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research
Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI); Centre for Economic Policy Research (CEPR)
Krannert School of Management; Centre for Economic Policy Research (CEPR)
August 1, 2009
AFA 2010 Atlanta Meetings Paper
We study the role of domestic financial institutions in sustaining capital flows to the private and public sector of a country whose government can default on its debt. As in recent public debt crises, in our model public defaults weaken banks’ balance sheets, disrupting domestic financial markets. This effect leads to a novel complementarity between private capital inflows and public borrowing, where the former sustain the latter by boosting the government’s cost of default. Our key message is that, by shaping the direction of private capital flows, financial institutions determine whether financial integration improves or reduces government discipline. We explore the implications of this complementarity for financial liberalization and debt-financed bailouts of banks. We present some evidence consistent with complementarity.
Number of Pages in PDF File: 52
Keywords: Sovereign Risk, Capital Flows, Institutions, Financial Liberalization, Sudden Stops
JEL Classification: F34, F36, G15, H63
Date posted: March 20, 2009 ; Last revised: March 15, 2012
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