Institutions, Public Debt and Foreign Finance

52 Pages Posted: 20 Mar 2009 Last revised: 15 Mar 2012

See all articles by Nicola Gennaioli

Nicola Gennaioli

Bocconi University - Department of Finance

Alberto Martin

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI); Centre for Economic Policy Research (CEPR)

Stefano Rossi

Bocconi University; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2009

Abstract

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.

Keywords: Sovereign Risk, Capital Flows, Institutions, Financial Liberalization, Sudden Stops

JEL Classification: F34, F36, G15, H63

Suggested Citation

Gennaioli, Nicola and Martin, Alberto and Rossi, Stefano, Institutions, Public Debt and Foreign Finance (August 1, 2009). AFA 2010 Atlanta Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1364863 or http://dx.doi.org/10.2139/ssrn.1364863

Nicola Gennaioli

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Alberto Martin

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI) ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Stefano Rossi (Contact Author)

Bocconi University ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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