Description
Standard economic theory suggests that states that fail to repay their debt obligations should be punished by financial markets with higher interest rates and restricted access to future loans. Empirically, many states face limited repercussions for default. Why? In this paper, we argue that the states that largely escape the punitive consequences of default are supported by the United States. These borrowing states' relationships with the United States will affect markets' perceptions of states post-default. US support repairs states' reputations faster than non-supported states. As a result, U.S.-supported states have less to fear by abandoning their debt obligations. We test our argument with a series of empirical analyses using data on debt restructuring episodes from 1975 to 2016. We find that states with stronger relationships with the United States are more likely to restructure existing debt obligations and are more likely to force large losses on investors. Yet these same states largely avoid the harsh consequences normally associated with debt restructuring. Supported states face lower borrowing costs and wait shorter periods of time to re-enter the bond market after a debt restructuring. Our argument and findings show the importance of how international factors change the incentives on how states operate in financial markets.
