Updates from Chicago Booth

The cycle behind sovereign debt disasters
By Michael Maiello – In theory, sovereign debt can be a healthy part of a growing economy. Governments can borrow from creditors to fund trade deficits, importing goods from other countries so their citizens can buy the products and enjoy the benefits.

While that may be the idea, the results of such borrowing are generally disastrous, warns research by Stanford’s Peter M. DeMarzo, Chicago Booth’s Zhiguo He, and Copenhagen Business School’s Fabrice Tourre. There is no default plan for a sovereign borrower the way there is for, say, a corporate one—and borrower countries have proven unable or unwilling to commit to anything like one. Without the disciplining force of covenants, which are common in private-sector borrowing, the system doesn’t wholly account for the risks associated with economic booms and busts, which works against strategic, responsible borrowing.

The trio’s work on sovereign debt risks rests on a foundation of work by DeMarzo and He on private-sector debt, in which they describe the tendencies of corporations to borrow without restraint when they do not pledge collateral to specific lenders. As uncollateralized borrowers tend to issue debt in good times and bad, lenders demand ever-higher borrowing costs over time, erasing the benefits to the borrower company and increasing default risk. Collateral adds discipline to the process. In another study, DeMarzo argues that sovereign borrowers should pledge assets to creditors as collateral in the event of default. This latest research, with He and Tourre, suggests that such collateralization could crystallize the consequences of default and break the debt cycle that is so costly to so many citizens. more>

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