Sovereign Debt:: Election Concerns and the Democratic Disadvantage

Amrita Dhillon; Andrew Christopher Pickering; Tomas Sjöström

Sovereign Debt: Election Concerns and the Democratic Disadvantage

Amrita Dhillon
, Andrew Christopher Pickering
, Tomas Sjöström

Economics

Research output: Working paper › Discussion paper

Abstract

We examine default decisions under different political systems. If democratically elected politicians are unable to make credible commitments to repay externally held debt, default rates are inefficiently high because politicians internalize voter utility loss from repayment. A politician who is motivated by election concerns is more likely to default in order to avoid voter utility losses, and, since lenders recognize this, interest rates and risk premia rise. Therefore, democracy potentially confers a credit market disadvantage. Institutions that are
shielded from political competition, such as independent central banks, may ameliorate the disadvantage by adopting a more farsighted perspective, taking into account how interest rates respond to default risk. Using a numerical measure of institutional farsightedness obtained from the Government Insight Business Risk and Conditions database, we find that the observed relationship between credit-ratings and democratic status is indeed strongly conditional on farsightedness. With myopic institutions, democracy is estimated to cost on
average about 2.5 investment grades. With farsighted institutions there is, if anything, a democratic advantage.

Original language	English
Publisher	Centre for Competitive Advantage in the Global Economy
Pages	1-33
Number of pages	33
Publication status	Published - 2016

Publication series

Name	Working Paper Series
Publisher	Centre for Competitive Advantage in the Global Economy, University of Warwick
No.	308
Volume	Nov 2016

Keywords

Sovereign debt
Default
Risk premia
Autocracy
Democracy
Institutions

Access to Document

http://www2.warwick.ac.uk/fac/soc/economics/research/centres/cage/manage/publications/308-2016_dhillon.pdf

Cite this

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abstract = "We examine default decisions under different political systems. If democratically elected politicians are unable to make credible commitments to repay externally held debt, default rates are inefficiently high because politicians internalize voter utility loss from repayment. A politician who is motivated by election concerns is more likely to default in order to avoid voter utility losses, and, since lenders recognize this, interest rates and risk premia rise. Therefore, democracy potentially confers a credit market disadvantage. Institutions that are shielded from political competition, such as independent central banks, may ameliorate the disadvantage by adopting a more farsighted perspective, taking into account how interest rates respond to default risk. Using a numerical measure of institutional farsightedness obtained from the Government Insight Business Risk and Conditions database, we find that the observed relationship between credit-ratings and democratic status is indeed strongly conditional on farsightedness. With myopic institutions, democracy is estimated to cost on average about 2.5 investment grades. With farsighted institutions there is, if anything, a democratic advantage.",

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N2 - We examine default decisions under different political systems. If democratically elected politicians are unable to make credible commitments to repay externally held debt, default rates are inefficiently high because politicians internalize voter utility loss from repayment. A politician who is motivated by election concerns is more likely to default in order to avoid voter utility losses, and, since lenders recognize this, interest rates and risk premia rise. Therefore, democracy potentially confers a credit market disadvantage. Institutions that are shielded from political competition, such as independent central banks, may ameliorate the disadvantage by adopting a more farsighted perspective, taking into account how interest rates respond to default risk. Using a numerical measure of institutional farsightedness obtained from the Government Insight Business Risk and Conditions database, we find that the observed relationship between credit-ratings and democratic status is indeed strongly conditional on farsightedness. With myopic institutions, democracy is estimated to cost on average about 2.5 investment grades. With farsighted institutions there is, if anything, a democratic advantage.

AB - We examine default decisions under different political systems. If democratically elected politicians are unable to make credible commitments to repay externally held debt, default rates are inefficiently high because politicians internalize voter utility loss from repayment. A politician who is motivated by election concerns is more likely to default in order to avoid voter utility losses, and, since lenders recognize this, interest rates and risk premia rise. Therefore, democracy potentially confers a credit market disadvantage. Institutions that are shielded from political competition, such as independent central banks, may ameliorate the disadvantage by adopting a more farsighted perspective, taking into account how interest rates respond to default risk. Using a numerical measure of institutional farsightedness obtained from the Government Insight Business Risk and Conditions database, we find that the observed relationship between credit-ratings and democratic status is indeed strongly conditional on farsightedness. With myopic institutions, democracy is estimated to cost on average about 2.5 investment grades. With farsighted institutions there is, if anything, a democratic advantage.

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