Institutions, Public Debt and Foreign Finance

52 Pages Posted: 11 Oct 2009

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

Stockholm School of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: August 18, 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 18, 2009). Available at SSRN: https://ssrn.com/abstract=1485448 or http://dx.doi.org/10.2139/ssrn.1485448

Nicola Gennaioli

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Alberto Martin (Contact Author)

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

Stockholm School of Economics

PO Box 6501
Stockholm, 11383
Sweden

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